History shows that the best thing a country can do to get out of dire financial straits is to make structural reforms.
But it can take years – long, difficult years – for the country that’s attempting reform, and the politicians responsible have a funny way of not getting re-elected.
So many countries opt for the “currency war” method, artificially debasing their currencies. It works fast, it’s politically expedient, and improved exports mask inflation in other sectors of the economy.
Now we have proof from the International Monetary Fund, which is meeting in Peru right now, of why countries are using this method more often today. The IMF has released a strategically timed report that confirms currency devaluation is effective at boosting a nation’s GDP.
Currency wars don’t really help in the long run, of course. Debt weighs even more heavily, and the piper must always be paid. But these bouts of manipulation can create huge opportunities for savvy investors…
“Cheap Growth” Is Irresistible
According to the Washington-based IMF, the world’s lender of last resort, currency manipulation since the financial crisis has been “unusually large.”
Norway is a great example. It’s facing unemployment at 11-year highs.
The country, which isn’t a member of the European Union (EU), has been hit especially hard over the past few years. That’s thanks to its dependence on oil and natural gas, which account for a whopping 67% of exports and 22% of GDP.
Meanwhile, its currency, the krone, has lost 21% in the last year. In September, the Norges Bank unexpectedly cut interest rates for the second time this year – the third time in the past 10 months – and economists are forecasting even more rate cuts to come.
Manipulation fever is catching in Norway’s European neighborhood. Germany has just reported that its annual inflation turned negative in September, falling by 0.2%. That was the first fall in eight months, and the plunge has raised the specter of below-zero rates in the Eurozone. That could in turn spur the European Central Bank (ECB) into even more quantitative easing (QE) on top of its current €1 trillion ($1.12 trillion) bond buying.
Now the sort of bandwagon effect that can make currency wars seem absolutely contagious is in full swing.
The emerging markets are beginning to look at the kind of manipulation that the EU, United States, and Japan have pulled off.
And, long-term consequences aside, they like what they see.
More Countries Join the Race to the Bottom
Malaysian Prime Minister Najib Razak, who, thanks to a Malaysian constitutional quirk, is also Finance Minister, announced a few weeks ago that his government would be injecting $4.6 billion into the state investment fund to help shore up its foundering stock market.
The oil-exporting nation is hurting thanks to weak oil prices. That dented its currency, the ringgit, which has seen 26% of its value sliced off versus the U.S. dollar in the past year. We can expect it to slide even more as the government moves to make its exports more attractive.
For its part, India has just lowered key interest rates by 50 basis points (more than was expected) as it struggles with slowing economic growth. It’s the country’s fourth cut year to date.
And now the IMF’s recent report has come out confirming unequivocally that currency devaluations are indeed beneficial, at least for a time, to those who embark on them.
As stated in The Guardian, “A 10% fall in the value of a nation’s currency can boost exports by an average 1.5% of GDP, according to a study by the International Monetary Fund that reveals the benefits of a cut in the exchange rate for foreign trade.”
Naturally, the IMF is wringing its hands over its own data’s conclusions, worried that nations and currency unions alike will keep launching new rounds of currency wars, as global trading is still led by the exporting of manufactured goods, which are suddenly cheaper when exchange rates weaken.
Yet speaking out of the other side of their mouths, the IMF stated their relief at the fact that a weaker exchange rate boosted trade as it confirms that, according to The Guardian, such fluctuations “…continued to act as a rebalancing mechanism in world trade and stimulus to sustainable global growth.”
I guess they have their own definition of “sustainable global growth.”
Which brings us to the central planners at the Federal Reserve…
Expensive Debt Is the Price Currency Warriors Pay
When the Fed announced at its recent meeting that it wouldn’t raise rates, one of the most significant, though least understood, concerns dealt with emerging markets.
It appears that this time, perhaps more than any previous, the Fed appreciates the interconnectedness of global finance and global trade – and the central role of debt.
In its most recent Global Financial Stability report, the IMF warned that emerging market corporate debt has ballooned to a record $18 trillion, particularly in sectors like construction, mining, and oil and gas.
Large portions of that debt have been issued in U.S. dollars (made attractive by low rates, of course), making interest payments increasingly onerous as local currencies weaken against the dollar.
This dilemma weighs most heavily on one of the most important emerging markets: Brazil.
The Brazilian real recently hit all-time lows, losing more than 50% of its value against the dollar since the start of 2015.
Petroleo Brasileiro SA – Petrobras (NYSE ADR: PBR), Brazil’s gigantic state-owned oil company, is seeing its debt trade at distressed prices, while government bonds have recently “attained” junk status.
São Paulo’s Índice Bovespa stock index is 38% below its 2010 October peak.
Conventional investors absolutely hate Brazil right now, but contrarians should most definitely have a kick at the tires.
Brazil: A New Contrarian Play on Ongoing Currency Wars
There’s lots of potential in the country, which sports the world’s eighth-largest economy and more than 204 million people.
Brazil’s $3.2 trillion economy is the biggest in South America. Its two largest cities, São Paulo and Rio de Janeiro, are Globalization and World Cities Research Network “alpha and beta world cities” that provide indispensable financial and political links between South America and the world. It has an incredibly diverse, young population – the largest group is just 30 years old.
The country has an embarrassment of natural resource riches, and relatively recent, widespread infrastructure – especially compared with its Latin American neighbors. Rio de Janeiro hosted the FIFA World Cup in 2014 and is slated to host the 2016 Summer Olympic Games, which is likely to promote a “carnival” atmosphere for investors.
One of the simplest ways to play this opportunity is through the iShares MSCI Brazil Index (ETF) (NYSE Arca: EWZ).
Right now, the fund trades at a P/E ratio of just 12 and yields 4.17%.
That absolutely thrashes the S&P 500 by comparison. It’s trading 50% higher at a P/E of 18 and yielding only half as much at 2.04%.
I’ll leave you with a chart comparing EWZ with the S&P 500 since the start of 2010.
It’s clear which is the better bargain right now. I should add that the Brazil index is not without risk, but my research shows that much of that pessimism has already been priced in.
Consider buying EWZ at current levels, but be sure to use a 25% trailing stop as protection.
The IMF just confirmed what the whole world knows: That currency wars are a superficially effective way to keep growth growing. They can be prolonged easily.
And with the Fed gun-shy thanks to the global risks of higher rates, emerging markets are looking much more attractive.
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