Brazil Wins Currency War...Not

08/29/2013 9:00 am EST

Focus: CURRENCIES

In the international currency war, it would appear that Guido Mantega has turned traitor and gone over to the other side, writes Charles Sizemore of The Sizemore Letter

If you’re not familiar with Mr. Mantega, he is the colorful—and quotable—finance minister of Brazil and one of the most vocal critics of the easy money policies pursued by the United States, Europe, and Japan. It was Mantega who introduced us to the term “international currency war” in 2010 and—with a touch of bravado—promised that Brazil wouldn’t lose.

What did he mean by that? Mantega was concerned that the soaring price of the Brazilian real (or the plunging price of the dollar, euro and yen, depending on your perspective) due to loose monetary policy in the developed world put Brazilian exporters at a disadvantage and ran the risk of hollowing out the economy by making manufactured imports artificially cheap.

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Source: tradingeconomics.com
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For perspective, take a look at the embedded chart. I set the start date to 2003, which happens to correspond to the year I went to Brazil for the first time. It almost brings a tear to my eye to think that I could buy a steak dinner for the price of a Big Mac then.

Alas, those days are over. In 2003, a dollar would buy you 3.5 Brazilian reais. But as yield-hungry investors and speculators jumped into the market throughout the 2000s emerging markets boom, the real more than doubled in value in dollar terms. By the beginning of 2011, a dollar would barely buy you 1.5 Brazilian reais (for those unfamiliar with the terminology, “reais” is the plural of the “real,” Brazil’s currency).

As the real continued to strengthen, Mantega did everything in his power to weaken it. In an attempt to deter “hot money” speculators and Western fund managers, he instituted a tax on foreign investment…and then raised it to 6%. He also encouraged the central bank governor to go on an aggressive dollar buying spree.

Generally speaking, it’s a bad idea to bet against a country that is determined to weaken its currency. Strengthening a currency is tough; it requires a fat stash of hard currency reserves and an ability to instill confidence in a fickle, temperamental market. But weakening a currency requires nothing more than a willingness to print money and flood the international currency markets with it.

Brazil won the currency war. The real had been steadily weakening since mid-2011…until the US Fed’s “taper scare” turned the decline into a rout. Now the victory is looking like a Pyrrhic one, and Mantega and his compatriots are more concerned about a destabilizing currency collapse. The foreign transaction tax has been scrapped, and the central bank is actively intervening to prop up the real with a new $60 billion program.

All of this has sent investors running for the door. The iShares MSCI Brazil ETF (EWZ) is down 21% year to date in a year when the S&P 500 is up 20%. The Brazilian Bovespa, in local currency terms, is down only 14%. Most of the damage came in the May/June “taper” scare, which rattled India, Turkey, and most of the rest of the emerging world as well.

So, what are we to do with this information? Is Brazil cheap enough to warrant a look after the recent rout?

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iShares MSCI Brazil (EWZ)
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Brazil is reasonably cheap. By Financial Times estimates, the broad market trades for about 15 times earnings and yields 4%. And after the recent slide, the real is sitting near five-year lows. The currency could always go lower, of course. But it would appear that the hot money has largely already fled the coop.

Brazil has also been rattled by the slowdown in China, which has hit all commodity-producing countries hard. Yet the recent data coming out of China suggests that the worst might be behind us. Industrial production and fixed investment both saw improvement in the latest data release.

Finally, we get to market psychology. This is notoriously hard to measure and subject to change at the drop of a hat. But in general, investors haven’t exactly been lining up to buy emerging market stocks. Emerging market mutual funds and ETFs have lost nearly $6 billion in outflows this year, suggesting that investors have given up hope. All else equal, that’s a contrarian bullish sign.

I may be a little early on this trade, but I would recommend accumulating shares of Brazilian and other emerging market stocks at these prices. It’s not time to back up the truck just yet, but I would start with a small position and average in over the course of the next several weeks.

By Charles Sizemore, Editor, The Sizemore Letter

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