Investment Thesis

I am downgrading my recommendation to hold the Franklin FTSE Brazil ETF (NYSEARCA:FLBR). In recent months, there has been a deterioration in some factors that could lead to higher inflation, such as the dollar and the price of electricity in Brazil.

Added to this are other factors such as a higher-than-expected GDP and inflation almost falling below target. This process should lead to a new interest rate hike in Brazil in September, and although Brazilian assets are very cheap, I believe that an expansion of Brazilian asset multiples will be postponed.

Inflation Vectors In Brazil

Brazil is a country of continental proportions, and as it is an exporter of commodities, the price of commodities and the variation of the dollar can logically create an inflationary or deflationary process.

Another characteristic of Brazil is that the country has several energy sources, however the most widely used (because it is cheaper) is hydroelectric power. However, this has ended up creating a problem in recent times, as droughts have been more frequent and prolonged. I will discuss each vector in more detail below.

Dollar - Has Settled At High Levels

The dollar has appreciated significantly against the BRL since the beginning of the year, with an appreciation of 16% so far. The worst part is that this does not seem like a peak, but rather a settling at high levels as we can see below.

This happened for several reasons, such as political uncertainty in Brazil, high interest rates in the US, and investor aversion to emerging markets in general. This corroborates my downgrade to neutral.

Electric Energy - Another Sign Of Worsening

Basically, Brazil is going through a severe drought, and with less availability of hydroelectric power, thermoelectric power (more expensive energy) is being used, which affect inflation.

The public institution responsible for Brazil's national electricity system has stated that after 26 months, electricity rates will increase, and this will mean higher inflation for Brazilians.

High Interest Rates In Sight?

With the facts I mentioned above, added to inflation of 4.35% (close to the top of the 4.5% band) in addition to a GDP above expectations, and no sign from the government to cut spending, only one solution seems appropriate.

Therefore, the Central Bank of Brazil will anticipate a possible inflationary process and should raise interest rates in September. The market is in a dilemma whether this increase will be 25 bps or 50 bps and when it will occur. The fact is that this is a headwind for variable income assets and corroborates my downgrade to a hold recommendation.

Cheap Valuation, But For How Long?

Although the Brazilian market is cheap looking at the historical P/E multiple, a new cycle of high interest rates will not be a catalyst for Brazilian stocks.

And my slightly more pessimistic view is corroborated by Seeking Alpha's tools, such as risk, liquidity and momentum scores.

Potential Risks To The Thesis

The market is pricing in the Fed to start cutting interest rates in the US, possibly in September. This will reduce the interest rate differential and could give the Brazilian Central Bank more room to maintain and, at a later stage even cut, interest rates.

Although the dollar and electricity have risen, other commodities relevant to monitoring inflation are at very comfortable prices, such as agricultural commodities and even oil.

The risks mentioned above could mean that this possible interest rate hike by the central bank is only temporary, leading to a new process of disinflation and interest rate reductions being initiated later.

The Bottom Line

In the last quarter, a dangerous scenario may have taken shape in Brazil. With GDP above expectations, inflation almost falling below target, and few signs that the government will reduce spending, I am becoming skeptical.

In addition, in the last few months, some factors have also gotten out of control, such as the dollar exchange rate in Brazil and the price of electricity. This should cause the Central Bank of Brazil to raise interest rates in September.

Based on this analysis, I am downgrading my recommendation on the FLBR ETF to hold. A process of interest rate hikes should postpone an expansion of multiples of Brazilian assets, and the risk/return do not seem attractive to me at the moment.