Buoyed by favourable monetary and fiscal policies, significant improvement in its debt profile and a robust export performance, Brazil is enjoying a surge in capital inflows, a soaring stock market and a stronger currency. As a result, South America’s largest economy may be a worthy consideration for clients who are looking for emerging-market exposure and are prepared to take above-average risk.

“The macroeconomic and political picture in Brazil is positive,” says Mark Mobius, president of Templeton Asset Management Ltd. in Singapore and portfolio manager of Templeton BRIC Corporate Class Fund. “Brazilian president Lula da Silva has adhered to a conservative fiscal policy and a monetary policy aimed at keeping inflation and interest rates low, which has engendered greater confidence among both local and foreign investors, and encouraged both short- and long-term investments in the country.”

For proof, you need look no further than Brazil’s interest rates, which Deutsche Bank AG in London expects to average 15.7% this year and 13.1% in 2007, down from an average of 19% last year. As well, inflation is expected to fall to 4.5% in 2006 from 5.5% in 2005.

The continuing trend toward lower interest rates indicates that “the Brazilian central bank has turned the corner,” says Patricia Perez-Coutts, vice president of AGF Funds Inc. in Toronto and portfolio manager of AGF Emerging Markets Fund. “Fiscal discipline has come to the fore. Brazil has started to pay down and refinance its debts, and expectations are high that the country will soon be granted investment-grade status.”

According to a February 2006 report by the London-based Economist Intelligence Unit (EIU), Brazil’s massive foreign debt, which has been the country’s Achilles heel, is in a trend “toward continued decline.” At the end of 2005, Brazil’s foreign debt/export ratio had fallen to less than 150%, or one-and-a-half times the value of exports, down from a historical average of about 400%.

Brazil’s total external debt, which stood at US$180 billion at the end of 2005, down from US$201.4 billion in 2004, is expected to come down even further on the back of aggressive debt management by the country’s central bank and its treasury, which announced plans to repay US$20 billion in debt in February. Late last year, Brazil made early repayment of US$18.7 billion in debt to the International Monetary Fund and the Paris Club, a significant achievement for a country that once struggled to repay its debt.

As a result, Brazil is in line for a sovereign re-rating of its credit by international credit-rating agencies. According to the EIU, Brazil’s sovereign credit rating is still three notches below investment grade, but the “prized” investment-grade status “could come as early as 2007.”

“Brazil has also benefited from the bull market in commodities,” says Mark Grammer, vice president of investments at Mackenzie Financial Corp. in Toronto. “It is a major exporter of commodities such as sugar, iron ore, soybeans and crude oil, which have benefited from record high prices.”

Brazil’s surging exports have also allowed it to post its highest trade surplus on record, US$33.7 billion in 2005, leading to a current account surplus of US$15.4 billion. It is estimated that the trade surplus will reach US$44.8 billion this year, compared with a peak deficit of US$33 million in 2001.

“Strong dollar inflows, both from exports and investment, have pushed the real to its highest level in almost four years,” states the EIU. In addition, GDP growth is forecast to climb to 4.1% this year, up from 2.5% in 2005.

“The market has reacted positively to developments in Brazil,” says Perez-Coutts. As of Feb. 16, the MSCI Brazil index was up 25.4% in U.S-dollar terms year-to-date, while the Bank of New York Brazil ADR index, which tracks 95 issues traded on U.S. exchanges, mirrored the MSCI index’s performance.

Valuations have also contributed to the market’s success, Mobius says: “Price/earnings ratios are low and dividend yields are high.”

Adds Perez-Coutts: “Valuations are not currently outrageous; stocks are growth rather than value plays.”

According to New York-based Morgan Stanley Capital International Inc. ’s LatAm Equity Strategy report dated Feb. 12: “Brazil’s domestically focused companies are now trading at 13.6 times forward earnings” — slightly above the historical average.

Perez-Coutts expects the “expansion of earnings should keep its course,” making Brazilian stocks attractive.

@page_break@Mobius is concentrating on what he calls the “four Cs” — consumers, commodities, corporate governance and convergence. He likes the consumer sector because of Brazil’s growing per-capita income, and the commodities sector because Brazil is one of the “lowest-cost exporters of a number of commodities.” The other two Cs are based on the transparency of companies’ governance practices, as well as companies benefiting from global convergence.

Perez-Coutts also likes the consumer sector because interest rates are falling and wages are increasing, and the energy sector because its production profile is strong relative to similar global companies. In addition, she likes selected companies in banking, beverage and mobile telephone services.

But there are risks associated with Brazil. The MSCI report states many of Brazil’s domestic names “are trading at higher multiples relative to their developed-market counterparts, reflecting that a re-rating of the market has occurred. We believe the re-rating is deserved, but we caution against overdoing it.”

Brazil is also fraught with political risk. Elections will be held this year, and it is uncertain whether da Silva will return to power. Nevertheless, Perez-Coutts advises, “No matter who wins, the respect for market-oriented policies would prevail.”

Meanwhile, Mobius cautions: “We must remember there will be setbacks and corrections.”

As for investors who are interested in taking that risk, they can participate through some of the emerging-markets funds listed in the accompanying table, directly in the Brazilian domestic market or by purchasing American depository receipts listed on U.S. stock exchanges. Brazil has more ADRs listed on U.S. exchanges than any other Latin American country, with more than 20% of local firms choosing the ADR route to take advantage of greater transparency, access to the large U.S. markets and lower cost of capital.

Grammer notes the retail investor does not have to maintain a “full service” brokerage account to invest in ADRs. However, Perez-Coutts argues, even though ADRs might be cheaper, they could be priced at a premium compared with shares on the Brazilian domestic market. In addition, she says, the domestic market is usually more liquid.

But regardless of the route investors take, Brazilian ADRs tend to “follow what is happening in Brazil,” Mobius says.

The Dow Jones Brazil Titans 20 ADR index, for instance, comprises 20 of the largest and most liquid Brazilian ADRs traded on the New York Stock Exchange, the American Stock Exchange and Nasdaq. The largest of these ADRs, Petroleo Brasilerio SA (Petrobras), is the largest holding in both Templeton BRIC Corporate Class Fund and AGF Emerging Markets Fund.

Petrobras is Brazil’s largest industrial company, with operations in oil and gas exploration, production, refining, purchasing and transportation. The ADR has a P/E ratio of about nine, which is below the average P/E ratio of about 13 for Brazilian ADRs, indicating it has the potential to climb higher. Petrobras’ price is largely tied to the price of oil, but the diversified nature of the company and its low-cost base positions it to do well, regardless of whether oil prices trend lower.

Both Mobius and Perez-Coutts hold Banco Bradesco SA, the second-largest listing on the Titans index. Banco Bradesco is Brazil’s largest private bank, with 3,000 branches. It is also a leader in insurance and pension management. The stock has a P/E ratio of about 15 and is expected to benefit from the trend toward lower interest rates and pension reform.

Companhia Vale do Rio Doce (CVRD), the world’s leading iron ore miner, and Centrais Electricas Brasileiras SA (Electrobras), a holding firm for Brazil’s largest electricity suppliers, are part of Mobius’s top 10 holdings. Lojas Renner, Brazil’s largest non-food retailer, is a top holding in Perez-Coutts’ fund.

CVRD, which has a P/E ratio of about 18, also produces bauxite, manganese, steel, copper and aluminum, and is a beneficiary of the commodities boom.

Electrobras, which acts as a financing agent for the electricity firms on behalf of the federal government, is expected to benefit from the expansion of industrial activity.

Lojas has 49 stores, and should benefit from increased consumer purchasing power due to higher wages and lower interest rates. IE