Short Brazil to Latch onto the Global Slowdown Thesis

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Colin Symons.
Firm: Symons Capital Management. Hedge Fund.
Location: Pittsburgh, PA.

Recommendation: Short Shares of iShares MSCI Brazil Index (NYSE: EWZ)
Timeframe: 3 to 6 Months
Recent Price: $53.30
Target Price: $31.00
Strategy: Special Situation

Disclosure: The author of this report had an active position in this security at the time of its posting.

Quick Thesis:
Brazil is running into a number of problems:

*Domestic demand growth has been a key driver of the Brazilian economy. But a combination of a slowdown in export demand and a slowdown in domestic spending could be a toxic combination.

*49% of exports go to the US, EU, and China, according to the central bank of Brazil. All of these economies are seeing significant, rapid slowdowns, with ISM data falling fast.

*Iron ore, a major export, is seeing a big slowdown. China seems worried about the health of their own steelmakers, telling banks to be cautious lending money to them. Brazil has also seen a slowdown, with industrial production down 4.3% in May, YoY.

*Economic growth in Brazil, of late, has been poor, with 2011 GDP growth of 2.7%. The central bank is trying to lower rates to stimulate growth, but inflation is a concern, currently at 4.99%. Despite cutting rates 400bps since August, GDP barely grew in the first quarter, at 0.8% YoY.

*Government spending is almost 40% of GDP, supporting an expensive welfare state.

*The recent currency war, attempting to devalue against the USD, is hurting some indebted companies, particularly those that have foreign-denominated debt.

*Credit expansion was quite strong over the last several years. But credit booms are often followed by credit busts, which seems to be the case here. Consumer debt defaults are at a 30-month high, at 8% in May. Credit as a share of GDP has doubled over the last 5 years, as has the amount Brazilian households are dedicating to paying that debt, according to the firm Capital Economics.

*More than a quarter of Brazilian households spend more than 30% of their income servicing debt, compared to an average debt service of 11% in the US. The BIS has also voiced concern over the increase in debt in Brazil, worrying about a credit gap. http://www.bis.org/publ/arpdf/ar2012e3.pdf

*The plan to grow the economy though credit expansion seems to be running out of steam. Retail sales barely rose in February and March. Vehicles sales dropped 11% in April.

*Technically, EWZ appears to be setting lower highs and lower lows. It may make sense to have a stop on a close over $54.50, as this would violate the pattern.

*Everything has a value, though. EWZ is almost half what it was a few years ago, and the trailing P/E is 10. That doesn’t sound expensive, but the volatility of their materials sector and signs of household credit stress could create a hard reversal.

Given the already evident global slowdown and domestic problems, I think it’s far more likely that we will see a further decline. A cautious investor could lean against the technical pattern and cover at $54.50, with only a 2.25% loss from the current price of $53.30.

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