Brazil has reason to celebrate, but don't buy its stocks

Most stockmarkets dipped last Friday due to disappointing American data. But Brazil's benchmark index, the Bovespa, received another shot of adrenaline: Rio de Janeiro has been selected to host the 2016 Olympics. The index is now 106% up from its October low.

Winning the Olympics is cause for celebration because it's a "mark of recognition" of how much Brazil's economy has changed over the past few years, says Economist.com. Once a byword for economic chaos, Brazil has now got its act together.

Brazil is in good shape...

In 2002, Brazil almost went broke, but under left-wing president Lula, it has stuck to a cautious fiscal policy. This has helped reduced external debt as a percentage of GDP from 40% to around 10%; all three big debt-rating agencies have now upgraded Brazil's debt to investment grade. Keeping interest rates relatively high over the past few years has squeezed out inflation, which has fallen from 17% in 2003 (and 5,000% in 1994) to a record low of 4.4%.

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As well as improved fundamentals, Brazil's long-term outlook is compelling. There is plenty of scope for consumption to grow: the household debt to GDP ratio, for instance, is a mere 14% compared to 54% in the euro area while mortgages are only 4% of GDP. It also boasts a huge range of soft and hard commodities.

Having kept rates high during the boom, Brazil avoided an asset bubble and had room to cut when growth slipped, says Martin Hutchinson on Breakingviews. There was also plenty of scope for a stimulus package worth 1%-1.5% of GDP. Exports only comprise 13% of GDP, which helped shield Brazil from the global downturn.

The upshot is that, after a mild recession, the economy expanded in the second quarter. Retail sales are now up by 5.9% year-on-year, and industrial production has risen for eight successive months, although it is still 7.2% down on last year.

Unemployment is edging down too. Brazil's finance minister is pencilling in GDP growth of 4% next year. Bank of America Merrill Lynch even thinks there is upside risk to its forecast of 26% profit growth (in dollar terms) in 2010.

...but stocks are vulnerable

Given all this, you can see why investors are bullish. Yet the rally is starting to look overdone. "If we continue at this pace, it could turn into a bubble again," says former central banker Arminio Fraga. Valuations look high: according to Bloomberg, the Bovespa is on a trailing p/e of 21.

What's more, says Capital Economics, Brazil is essentially a commodities play. While commodity exports comprise just 10% of GDP, raw materials stocks make up over half of the Bovespa.

And the biggest worry is that Western demand "is not going to pick up enough to replace the end of the restocking cycle in China", says Brock Salier of Ambrian Partners in London.

A sustainable rebound in the West looks unlikely, given the broken banking system and deleveraging consumers, notably in the US, the world's biggest economy.

As markets factor in weaker medium-term demand growth, commodities will slide, while an accompanying drop in global risk appetite also bodes ill for emerging markets, says Capital Economics.

Capital Economics believes that while the Bovespa may well keep climbing for now, it is likely to slide back to just under its current level by the end of 2010.