Conclusion: Looking under the hood of the Brazilian economy and stock market, we see more confirmation of accelerating inflation and slowing growth on a global basis. Given, we expect both bonds and equities to underperform as asset classes in 1H11.
Position: Bearish on Emerging Market equities and bonds heading into 1H11.
The “accelerating growth” storytelling around rising bond yields of late gets stopped dead in its tracks once you pull up a chart of Brazilian equities. Since the U.S. dollar bottomed on 11/4 (coincidentally the day we went long UUP), Brazil’s Bovespa index has lost (-7.1%) of its value alongside the dollar’s +6.1% rise.
Of course, one would think with a rising dollar that Bovespa would come under pressure as its two largest constituents Petrobras and Vale suffer from declining crude oil and copper prices. Unfortunately for conventional wisdom’s sake, that hasn’t been the case: crude oil is up +1.4% and copper is up +5.1% over the same duration.
Given this underappreciated divergence, we posit the following explanation for the Bovespa’s underperformance:
Slowing growth perpetuated by global tightening as a result of accelerating inflation brought on by QE2. Better translated as: QG = inflation [globally] = monetary policy tightening [globally] = slower growth [globally].
The Brazilian economy is well past step one (YoY CPI accelerated to a 21-month high of +5.63% in November) and the market is pricing in steps two and three currently. Looking at Brazilian interest rate futures, we see Brazil’s bond market is anticipating a +25bps rate hike in January and an additional +175bps hike(s) by January 2012.
From a growth perspective, we recently saw 3Q10 GDP growth came in a full 250bps slower than 2Q10 at +6.7% YoY (after a +40bps revision to 2Q10). We expect growth to continue to slow over the next 3-6 months, a call aided by incredibly difficult comparisons starting in 4Q10 (+5% YoY in 4Q09, +9.3% YoY in 1Q10) and fiscal and monetary policy tightening (the central bank already hiked reserve requirements on 12/3 and set the stage for further “macro prudential” measures in the minutes of its latest meeting).
In recent reports, we’ve made note of Brazil’s late reaction to combating inflation, with the takeaway being that we’re likely to see an expedited tightening cycle in 1H11. Should growth continue to slow materially (as we expect), we could see the central bank handcuffed on the margin, which is obviously not good for Brazilian consumers, who have had to increase their financing of food expenditures through credit (~34% of supermarket sales) to keep pace with accelerating food inflation.
Looking at the Brazilian consumer from a broader lens, we see that Brazil’s Unemployment Rate hit a record low in November, ticking down (-40bps) to 5.7%. Consumer credit expansion hit a record high in November, climbing +6.2% MoM and growth in consumer delinquencies hit a five-year high in November, climbing +3.5% MoM.
In short, the Brazilian consumer is increasingly employed, levering up at record levels and not paying it back. That is a sure-fire recipe for accelerating inflation, which is why we think a meaningful tightening cycle is in Brazil’s intermediate-term future.
We aren’t the only ones who think so: the Bovespa is broken from both a TRADE and TREND perspective and it continues to make lower-highs. Further, it recently backed off its TREND line hard – an explicitly bearish quantitative signal.
From a broader perspective, Brazil’s outlook rhymes with what’s going on across much of Asia (including China and India) – the region many investors consider integral to global growth. The Ber-nank may be able to inflate U.S. real GDP growth by understating CPI, but the rest of the world isn’t buying the hoax.
Don’t be swindled; have a great weekend.