You’re Nuts If You Believe Brazil’s Naysers

Staring at a chalkboard behind the reception desk at my hotel in Campo Grande last night, my Brazilian friend Renato Roscoe let out an audible “tssst.”

The board showed Brazil’s currency, the real, at R$1.58 versus the dollar.

“It’s hard to keep track these days,” said Renato. “The real keeps getting stronger against the dollar. This is crazy.”

Renato told me that the real has risen by about 6.5% against the dollar since mid-March. In less than a month, in other words.

Renato has good reason to be worried. He’s one of Brazil’s top agronomists. He’s an expert on tropical soil and farm management. And he works for a group of farmers in Mato Grosso do Sul state in the southwest of the country.

Mato Grosso do Sul is what you might call Brazil’s “bread basket.” It produces vast quantities of soya, corn and sugarcane from its mineral rich, rust-colored soil. It is also a big beef producer.

If the real goes up against the dollar, the food commodities the state’s farmers export will go up in price in dollar terms, making them less competitive globally.

It’s not just Brazil’s vast food exports that will go up in price versus the dollar. So will all exports.

This has a lot of Wall Street analysts worried. It’s a natural reaction to worry when you see a rising currency in a big export-driven economy such as Brazil’s. A rising currency does indeed hurt exporters.

But what Wall Street isn’t seeing is the other half of the picture.

Brazil’s policy-makers are actually making a shrewd choice in letting the real rise. Because a rising real helps keep a lid on inflation pressures at home.

Brazil is taking some pain now (in terms of the squeeze on exports) to avoid a lot of suffering later (and runaway inflation).

Brazil’s history is important here. As recently as the mid-1990s, Brazil was trapped in a devastating hyperinflation. Prices and interest rates went wild. Credit cards were charging 25% a month in interest. Food prices went up 40% a month. And the value of Brazilians’ savings went down by 2,000% a year.

The financial suffering didn’t end until Brazil’s then finance minister replaced the old currency with the real, refused to ratify the government’s budgets and overhauled the country’s basket-case monetary policy.

For obvious reasons, Brazil doesn’t want to repeat the experience.

The last time inflation got out of hand in America was in the 1970s. It wasn’t nearly as severe as Brazil’s decade-long hyperinflation.

In the U.S., the inflation rate was 5.5% in 1970. And it peaked at 13.3% in 1979. For the decade as a whole, prices rose 7.4% a year. Nothing like the 2,076% rate of inflation in Brazil in 1994.

Put simply, Brazilians are more wary of the catastrophic effects of inflation and hyperinflation than Americans are. And so they’re willing to lose a bit of growth now to avoid a massive loss of growth in the future.

As Subir Gokarn, the deputy governor of the Reserve Bank of India put it recently:

Rising interest rates are making your projects little less attractive, making you little less inclined to invest, but the alternative to that will be a meltdown. So, a little bit of pain now, a little bit of medicine now, with the prospect of less suffering in the future is the way to look at it.

I want to emphasize that it is not a tradeoff between growth and inflation. It is tradeoff between growth now and inflation in future.

Brazil’s rising currency simply means that its policy makers get the that tradeoff better than America’s policy makers do.

Long-term, it’s not bearish for Brazil one little bit. In fact, investors should welcome it as a sign of economic maturity and strength.

Another way to look at is that Brazil is letting its currency rise because it can. Last year, the Brazilian economy grew at about 7.5%. This year GDP is set to grow at about 5%. Too little growth is not Brazil’s problem right now. Too much growth is.

Take a look at this chart. It gives you a quick snapshot of the Brazilian stock market over the last two years using the iShares MSCI Brazil Index ETF (NYSE:EWZ) as a proxy.

As you can see, Brazilian stocks have been in a sideways market since late October last.

I call this a “crocodile teeth” market because price movements trace a crocodile teeth pattern. And because this kind of market action gnashes away at portfolios as prices zigzag up and down.

But stocks don’t stay in this kind of sideways pattern forever. Eventually, they break out to the upside or to the downside.

Consider buying some shares in EWZ if we get another bounce off the lower blue line – the bottom of the recent trading range. It’s a quick 14% profit if EWZ rises back to the top of its range.

The market doesn’t know what to make of Brazil right now. But eventually traders will see the woods for trees.

Then Brazilian stocks will really take off again…