The Number One Reason Brazil Could be Headed for a Pullback

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Brazil is emerging as one of the great stories of the 21st century. Sound economic policies and abundant natural resources have led to sustained economic growth. And investors are racing to get in to this Samba party -- the iShares Brazil ( EWZ ) exchange-traded fund ( ETF ) has risen nearly +20% since late August.

Thus far, Brazil's government has played its hand perfectly, combating inflation while stimulating growth. But the road ahead is bound to get much trickier, and it's not at all clear that all the key metrics can keep moving in the right direction.

The resource curse -- fueled by hot money
Brazil's economy will be among the fastest-growing in the world in 2010. Foreign capital flows are pouring in to capitalize on the nation's rising economic prospects as well as the company's impressive position in the global commodities sector. But Brazil is now feeling the effects of what's known as the "natural resources curse" (also known as the "paradox of plenty").

By exporting massive amounts of minerals, beef, oil and grains, Brazil has been attracting a lot of foreign currency . And as other resource rich countries such as Australia and Norway will tell you, it's not long before the country's currency becomes too strong -- so strong in fact, that it makes all other export-oriented businesses much less competitive on the global stage.

Policy makers in Brasilia are looking at the Brazilian Real with dismay. The real has strengthened against the dollar for five straight months -- making Sao Paolo and Rio de Janeiro the first and third most expensive cities in the Americas, according to Mercer Consulting. (New York is second.)

Part of the real's attraction is also due to relatively high interest rates in Brazil. The government has kept interest rates above 10% to ensure that inflation stays under control. So global investors can sell currencies in countries where interest rates are low and buy currencies, and bonds, in countries like Brazil (this is known as the "carry trade").  If policy makers lower rates to help beat back that carry trade, global investors will grow alarmed that inflation may re-emerge while the economy is growing at a very fast pace. And that would spell trouble for the BOVESPA, Brazil's stock market.

Brazil's central bank has been buying back the real on foreign currency markets to help weaken it, but that effort proved futile and was recently abandoned. "It's very difficult for governments to do something when a wall of money is coming in," said Mauro Leos, a senior credit officer for Moody's, at a recent conference in Sao Paulo.

Not only has the Brazilian Real surged against the dollar, it's also gaining steam on neighboring currencies. Argentina's peso has declined nearly -35% against the real since May, 2009. That means Argentinean businesses can start to steal business from their Brazilian counterparts.  Looked at another way, Brazilian airplanes made by Embraer ( ERJ ) are becoming increasingly expensive on world markets unless the company chooses to slash prices, and profits, to stay competitive.

Currency traders think the real may power even higher. Currency futures contracts in Brazil are anticipating a much greater likelihood that the real will appreciate by at least +5% in the next six months when compared to contracts anticipating that the real will weaken by -5%. A net 250,000 contracts are going long on the Brazilian Real, according to Bloomberg.

Action to Take -->
Brazil's strength in recent years has been derived from its low-cost status and export strength. A rising currency changes the whole game. Brazilian economic data will likely be strong in coming months, and there's no reason to anticipate a swift market reversal. But the odds are growing that the Brazilian economic miracle will hit speed bumps. As investors flock to this market and push it ever higher, the risks rise in tandem that a hangover and correction will eventually hit. If you hold Brazilian stocks or index funds, this may be a great time to take profits.

-- David Sterman

David Sterman started his career in equity research at Smith Barney, culminating in a position as Senior Analyst covering European banks. David has also served as Director of Research at Individual Investor and a Managing Editor at Read More...

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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , ETFs , Investing Ideas
Referenced Symbols: ERJ , ETF , EWZ

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