Brazil's Economy Drags Gerdau Down

08/07/2012 5:17 pm EST


Jim Jubak

Founder and Editor,

Remarkably slow growth, rebounding inflation, and knock-on effects from China are crippling the once-hot Brazilian economy, and even this promising steelmaker can't recover strongly enough, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

I think a modest amount of concern is in order about the Brazilian economy. Which, of course, has repercussions for Brazilian stocks, especially cyclical Brazilian stocks such as steelmaker Gerdau (GGB), a member of my Jubak’s Picks portfolio.

The central bank, the Banco Central do Brazil, keeps cutting interest rates—we’re talking about 4.5 percentage points of interest-rate reductions so far—but Brazil’s economy can’t manage to bust out of its slough of despond.

Economists surveyed by the central bank have cut their forecast for GDP growth in 2012 to 1.85% from 1.9% in the last week. That would come on top of very disappointing growth of just 2.5% in 2011.

What’s the matter with Brazil’s economy? In the short term, the answer is China. China is the biggest market for Brazil’s commodity-heavy export sector, and with growth in China slowing, exports of commodities such as iron ore have tumbled.

It hasn’t helped either that for much of 2011 and 2012, a soaring Brazilian real and a yuan pegged to the US dollar made Chinese goods so cheap that domestic Brazilian manufacturers had trouble competing.

Economists are now predicting that the country’s benchmark Selic interest rate will end the year at 7.25%, down from the current 8%.

But lower interest rates look like they’ve revived inflation. Bringing inflation down to the high end of the government’s acceptable range was one reason that the central bank raised interest rates to a peak of 12.5% in 2011. Inflation in June was up for a fourth consecutive month, and ran at an annualized rate of 6.7%.

This puts the central bank in a very uncomfortable position. Either cut interest rates again to get the economy growing at a faster rate—and risk having inflation get out of control—or raise interest rates to fight inflation, and risk cutting an already anemic economic growth rate.

At the moment, the bank seems to have opted for denial as a way out of this fix. Central bank president Alexandre Tombini continues to forecast a 4% annualized growth rate in the second half of 2012, although there is scant evidence for such a revival.

All this makes the recent extremely aggressive rally in shares of a cyclical like Gerdau, whose fortunes are closely tied to the Brazilian economy, somewhat suspect in my opinion.

The stock was up 21.7% from June 25 to the close on August 6. The August 6 close at $9.53 was a whole lot closer to the top of the stock’s 52-week range at $10.59 than it is to the bottom at $6.60.

Not that Gerdau is posting bad numbers. On August 1, the company reported 11% year-over-year growth in sales for the second quarter of 2012. Sales volume fell in North America by 9% from the first quarter.
Domestic demand from Brazil picked up most of the slack. with sales volumes in Brazil increasing by 8% from the first quarter. Exports from Brazil fell 26% year over year, thanks to the slowdown in European economies.

But in my opinion, the stock hasn’t climbed on the numbers for the second quarter, but on prospects for the second half of 2012. Wall Street currently projects that earnings will grow to 16 cents a share in the third quarter, and then 27 cents a share in the fourth quarter.

Therefore, Gerdau is very susceptible to any disappointments in the Brazilian economy. I think those are likely. The Banco Central do Brazil is trying to execute an almost impossible balancing act, and I think the odds of a tumble—nothing catastrophic, mind you—are very high.

With all that in mind, I’d suggest taking profits here—if you have any from swing trading—and then planning to re-enter on the next tumble.

As of today, August 7, I’m selling Gerdau out of my Jubak’s Picks portfolio, with a loss of 33.8% since I added the stock to the portfolio on September 22, 2010.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Gerdau as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.


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