A Taxing time for Brazil

This week, Brazil is the most talked about emerging market after an announcement on Monday 19 October 2009 that the government is introducing a 2% levy on currency inflows into Brazil from non-resident investors. After the announcement from the Brazilian Minister of Finance, the policy was made effective immediately on the 20 October.

The tax is effectively an attempt by Brazilian policy makers to curb the rapid appreciation of their currency, the Brazilian Real, which has strengthened against the dollar throughout 2009. Their view is that the strength of their currency is likely to impact on exports, a critical driver of the Brazilian economy and they are trying to exercise a control over this.

This is not the first time Brazil has employed such a policy. In 2008 a similar tax was applied to fixed income investments with the intention of halting currency appreciation. The measure had short term success with the Real depreciating across the two weeks following the policy’s implementation then resuming on its growth trend thereafter. The tax was removed as soon as the scale of the credit crisis became apparent.

This time, the policy is wider reaching, with the tax rate being 0.5% higher and applying to equities as well as fixed income investments. The initial reaction was a 4% drop in Brazilian market value but there is wider scepticism as to how long the policy will remain effective. Most analysts took the view that it may well deter shorter term investments but that it was unlikely to be sufficient to stifle the Real’s appreciation over a longer period.

From the perspective of a UK investor in Brazil the impacts are mixed. Existing investments are unaffected, although depending on their nature, they will obviously factor in any wider Brazilian market impacts that the policy triggers. The tax applies to the FX transactions related to new investments, as opposed to any investments themselves, so future investors may find the related transaction costs of products providing investment exposure to Brazil are likely to increase.

The question many investors may ask is “does this make Brazil more or less attractive as an investment opportunity?”. The natural reaction would be that a tax of any sort can only diminish appeal. However an alternative view would be that this policy intervention is actually an indication of value as an appreciating currency can be a clear indicator of growing economic strength.

To find out more about the dynamics of Brazil’s economy, the country’s future prospects and ways to get investment exposure, read our “Investment ViewPoint: Analysis – Brazil: time to smell the coffee?”.

Bear in mind that investing in emerging markets, either by region or by individual market, may not be suitable for everyone as they can be more volatile than developed equity markets. The value of emerging markets investments can fall as well as rise and you may receive back less than you invested.

Drag on the dollar? Cause and effect

On 15 October the dollar fell to its lowest value in more than a year against 14 of its 16 major counterparts. Is US fiscal policy likely to have lasting drag on the dollar and impact on the price of gold?

The Dollar Index, which is used to track greenback against the currencies of six major U.S. trading partners, sank 0.4 percent to 75.239, the lowest since August 2008 (see figure 1). Closer to home, the outlook for the dollar vs. sterling makes for interesting reading with Barclays Capital suggesting that a pound could be worth over $1.80* in six months time.

Figure 1. USD Index performance 2009

USD index measures the performance of the US Dollar against a basket of currencies: EUR, JPY, GBP, CAD, CHF and SEK

So why does the dollar continue to drag?

One school of thought suggests that the route cause is how the Fed is handling the US economic recovery and its fiscal policy.

On 16 October the Federal Reserve reported a second consecutive monthly rise in U.S. industrial output, estimating that, over the past two months, it will have increased by 1%.

Despite this improvement in growth, the Fed has made clear that it has no intention to change its current fiscal policy. Firstly, it does not intend to increase interest rates anytime soon and secondly, it has intimated that it will continue to increase liquidity into the market.

Minutes from the Feds September policy meeting published on 15 October showed that policy makers were, last month, open to boosting the central bank’s $1.25 trillion mortgage-backed securities purchase program. By encouraging the purchase of more mortgage backed securities in addition to an expected $200bn injection from other mortgage backed securities as they mature in the coming months, liquidity in the US will not be tightening anytime soon.

All of this shows a preference for the US to “get its house in order” perhaps at the expense of the value of the dollar against other currencies.

So if this is the cause, what are the effects?

Central governments around the world have already reacted by remarking that gold may become the reserve currency of choice over the dollar as its value drops compared to other safe havens. If the value of the dollar drops further there may be a reverse effect on the price of gold.

If you are an experienced investor and have a view on how the dollar will play out over the coming months our foreign exchange platform, BARXdirect: FX allows you to speculate on the movement of the world’s currencies and offers some of the tightest spreads in the market direct from Barclays Capital as well as daily access to their institutional-level research. Remember that leveraged foreign exchange trading carries a high level of risk to your capital and you should only deal with money you can afford to lose.

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For a more cautious investment choice right now, investors would be wise to consider why they might consider investing in gold and for how long. If gold is still of interest then read our latest Investment ViewPoint: Comment ‘Gold’s lustre returns’ for more detailed insight into the economics of the commodity and how to get investment exposure to it.

* Forecast as at 1st October

In terms of market engagement, we suggested in last week’s Investment ViewPoint Commentary “Sugar and spice and all things… equities” that equities may be in a sweet spot as market liquidity enables companies to turn their attention to stability and growth. Now, the October issue of Barclays Wealth Compass publication suggests that investor attention should also focus on the asset classes and sectors that typically do well in the early stages of a recovery. It points to two areas for consideration – emerging markets and developed equity market small caps, in particular US small caps.

Regular readers of Investment Viewpoint will be well versed by now on the emerging markets theme. Our recent Investment ViewPoint Analysis articles have discussed at length the resurgence of interest in these sectors and the various ways to get investment exposure here, either broad-based across the emerging markets spectrum or focused on specific markets such as China and Brazil. They have also highlighted the risks inherent in these markets, primarily their higher levels of volatility when compared to developed equity markets.

Small caps by definition are stocks with relatively small market capitalisations and the sector is often associated with fledgling companies with growth potential ahead of them. However small caps consequently carry higher risk due to the increased potential for these companies to fail. Our latest Cotter’s Corner article looks at the lessons to be learned from analysing top moving stocks and John touches on the characteristics of small caps, and the investment dangers that lie therein. There is certainly more risk involved in small cap investment and these need to be fully considered. However if this is an area that has appeal, and if US small caps are of particular interest, then ETFs or traditional funds might be worth consideration. For example, the iShares S&P Small Cap 600 is an ETF that provides exposure to 600 companies which reflect the risk and return characteristics of the broader small cap universe in the US – this covers companies with a market capitalisation in the range of US$200m – US$1bn and represents 3-4% of the US equities market. Alternatively look for funds in the ‘North American smaller companies’ IMA sector through our funds research centre. Bear in mind that ETFs and funds may not be suitable for everyone and their values can fall as well as rise.

In terms of a market correction, what should investors be looking at should one occur? That obviously depends on an individual’s investment approach but there are a number of strategies one might wish to consider.

Investors with a mid to long term time horizon may simply view a correction as part of the short term market movements that they largely ignore. In that case, they may sit tight and ride it out.

However others might see a correction as an opportunity. Some investors might look to exit current positions as the market starts to go down, then re-invest when they think the correction has levelled out. This could be a risky strategy as timing would be key and there are no guarantees of getting the exit and re-entry points right. Others may look to open new positions or top up on existing ones if they believe a market correction leads to investments being of fairer value.

Finally, investors with an appetite for higher levels of risk may be looking for a correction in order to take advantage of the downward market movement. In this case, the use of CFDs and FSTs may come into play as a leveraged way to maximise opportunities when confident of a sharp market movement in a particular direction. Bear in mind the risks associated here, these are leveraged products that place capital at risk and investor losses can quickly exceed their initial deposit. For those who may be looking to profit from a downturn in the market but in a less highly-geared manner, then consideration should be given to Covered Warrants and Turbos – instruments designed to offer a degree of leverage whilst also limiting potential losses to the amount originally invested. There is a series of Put Covered Warrants currently listed which focus on individual stocks or on specific equity indices, which should satisfy investors’ requirements to hedge their portfolios or indeed to gain overall short exposure to the market. Put Covered Warrant worked example

So regardless of which way the markets move next, there is likely to be a way to play it for most investment strategies. And with over a year having passed since the extraordinary events of the Lehman Brothers collapse, surely one key investment lesson learnt must be to be prepared for anything.