FLBR: Skeptical Outlook as Inflation Approaches Target (NYSEARCA:FLBR)

investment thesis

I am reducing my recommendation to hold the Franklin FTSE Brazil ETF (NYSEARCA:FLBR). In recent months, there has been a deterioration in factors that could lead to higher inflation, such as the dollar and the price of electricity in Brazil.

Added to this are other factors such as higher than expected GDP and inflation almost falling below target. This process should lead to another interest rate hike in Brazil in September, and although Brazilian assets are very cheap, I think a widening of Brazilian asset multiples will be delayed.

Inflation vectors in Brazil

Brazil is a country of continental proportions, and since it is a commodity exporter, the price of commodities and the variation of the dollar can logically create an inflationary or deflationary process.

Another characteristic of Brazil is that the country has several sources of energy, but the most used (because it is cheaper) is hydroelectric power. However, this has become a problem in recent times, with droughts becoming more frequent and prolonged. I will discuss each vector in more detail below.

The Dollar – Settled at high levels

The dollar has appreciated significantly against the BRL since the start of the year, up 16% year to date. The worst part is that this does not appear to be a peak, but rather a settlement at high levels, as we can see below.

This happened for a number of reasons, such as political uncertainty in Brazil, high interest rates in the US, and investor aversion to emerging markets in general. This confirms my downgrade to neutral.

Electricity – another sign of deterioration

Basically, Brazil is going through a severe drought, and with less availability of hydroelectric power, thermoelectric power (more expensive power) is used, which affects inflation.

The public institution responsible for Brazil’s national electricity system has said that after 26 months, electricity rates will rise, and this will mean higher inflation for Brazilians.

High interest rates in sight?

With the facts I mentioned above, added to inflation of 4.35% (close to the top of the 4.5% band) in addition to a GDP above expectations and no sign from the government to reduce spending, only one solution seems appropriate.

Therefore, the Central Bank of Brazil will anticipate a possible inflationary process and should raise interest rates in September. The market is in a quandary whether this hike will be 25 bps or 50 bps and when it will happen. The fact is, this is a headwind for variable income assets and confirms my downgrade to a hold recommendation.

Cheap valuation, but for how long?

Although the Brazilian market is cheap given its historical P/E multiple, a new cycle of high interest rates will not be a catalyst for Brazilian stocks.

And my slightly more pessimistic view is corroborated by Seeking Alpha tools such as risk, liquidity and momentum scores.

Potential risks to the thesis

The market is pricing in the Fed to start cutting US interest rates, possibly in September. This will narrow the interest rate differential and could give the Brazilian Central Bank more room to maintain and, at a later stage, even cut interest rates.

Although the dollar and electricity have rallied, other commodities relevant to monitoring inflation are at very comfortable prices, such as agricultural commodities and even oil.

The risks mentioned above could mean that this possible interest rate hike by the central bank is only temporary, leading to the subsequent initiation of a new process of disinflation and interest rate cuts.

conclusion

In the last quarter, a dangerous scenario could have taken shape in Brazil. With GDP above expectations, inflation almost below target and little sign that the government will cut spending, I am becoming skeptical.

In addition, in recent months, some factors have gotten out of control, such as the Brazilian dollar exchange rate and the price of electricity. This should prompt the Central Bank of Brazil to raise interest rates in September.

Based on this analysis, I am downgrading my recommendation on the FLBR ETF to hold. A rate hike should delay an expansion in Brazilian asset multiples, and the risk/reward doesn’t look attractive to me at this point.