Conclusion: Much like China and India, we believe the Brazilian central bank will continue to tighten the screws on its monetary policy over the intermediate term. Further, we don’t think a pending slowdown in Brazil’s domestic growth as well as a deceleration in global growth is fully priced into Brazilian equities.
We’ve been getting a lot of questions over the past few weeks asking us whether or not we would like to get long Brazil here. The quick answer is, “no”, largely due to the quantitative setup: Brazilian equities are broken TRADE and are flirting with being broken TREND.
From a fundamental perspective, the question remains, "Do you really want to be getting long anything emerging markets right here and now?"
Our answer there is, “no”, as well. We’ve been advising clients to reduce their EM exposure for the last 2-3 months, citing these three reasons:
- Slowing Growth Globally: growth, particularly in the bigger, more meaningful EM driver-seat economies (China, India and Brazil) is likely to slow in 1H11 due to:
- Accelerating Inflation Globally: rising inflationary pressures which will beget tightening of monetary policy and cause:
- Compounding Interconnected Risk: global EM redemptions are likely to accelerate as funds managers decrease their beta exposure due declines in the “Big 3” (China, India and Brazil) EM equity markets. Rising volatility and accelerating muni market risk in the US won’t help either. Don’t forget the structural issues associated with Europe’s PIIGiesS can’t be covered up by piling on more debt, irrespective of declining yields at recent auctions. No one ever beat a drug addiction by getting more drugs at lower prices…
The real question investors should be asking is: “What’s an emerging market equity worth if topline growth is decelerating due to slowing GDP growth and margins are compressing due to COGS inflation?” Probably the same as a domestic equity is worth with the same setup = less.
The bullish storytelling about buying Brazil or other EMs on the pullback(s) lies in the hope that earnings growth could be maintained as rising costs are passed through to consumers. A handful of recently-ousted Tunisian and Indian officials will advise against that.
Moving back to Brazil, as we expected, new Central Bank President Alexandre Tombini hiked the benchmark Selic rate +50bps on Wednesday to 11.25%. The language within the associated press release signaled to investors that Brazil may be less hawkish on the margin with respect to raising interest rates, which are now the highest real interest rates in the G20.
We caution, however, that this is not a buying opportunity. The bank reiterated that it will remain steadfast in containing the “surge in consumer credit” via “macro-prudential measures” (i.e. reserve requirement hikes, etc.) to get inflation back in line with their target of +4.5% YoY. To a small extent, the measures have been effective in boosting the cost of capital throughout the economy: average consumer loan rates rose in December for the second consecutive month to 6.79% vs. 6.74% in November.
They’ll will need to hope their “macro-prudential” measures increase in effectiveness because we don’t see inflation in Brazil as an issue that is going to be solved with Wednesday’s +50bps rate hike and a +5bps backup in consumer borrowing rates. Further, efforts to prevent the real from appreciating (three measures in the last two weeks alone) only reduce the effectiveness of any tightening of monetary policy.
Both the market and the “economists” see it our way as well: investor expectations for Brazilian inflation over the next two years, as measured by the breakeven spread between Brazil’s inflation-linked and fixed rate bonds, rose to +6.5% – the highest since November 2008; a survey of economists regarding Brazil’s 2011 inflation rate rose for the sixth straight week last week, climbing to +5.42% vs. +5.34% prior.
In summary, much like China and India, we don’t think the Brazilian central bank is done tightening the screws on its monetary policy over the intermediate term. Of course, the question then becomes, “When is that all priced in?” Judging the by the first chart above, we’d posit there’s more pricing in to be done.The Ber-nank may be able to trick US investors by inflating domestic real GDP growth by understating CPI, but the rest of the world isn’t buying the hoax. Inflation kills emerging markets.
Don’t be swindled; have a great weekend.