Conclusion: With the recent spike in crude oil prices, one might think Brazil is a good derivative play on the geopolitical risk in Northern Africa. Unfortunately, the math suggests otherwise and we are inclined to maintain our cautious stance on Brazilian equities.
Position: Bearish on Brazilian equities; Bullish on the Brazilian Real.
This is known: Brazil is an economy with vast natural recourses and uses those resources to profit from global demand for crude oil, sugar, corn, wheat, iron ore, and other commodities.
This is, at times, is overlooked: Brazil is home to one of the world’s most unequal economies from an income distribution perspective. Brazil’s GINI Coefficient, which measures income distribution, is 57 – good for 11th highest in the world. That means Brazil is the 11th most unequal country in the world from a wealth dispersion standpoint – significantly more so than Egypt (34.4), Tunisia (39.8) and the United States (40.8).
We’ve been calling this out since November, but it’s worth repeating: You don’t want to be long countries where growth is slowing and inflation is accelerating – especially in poorer countries, where the citizenry is most apt to be plugged by rising food and material prices. While we didn’t necessarily predict events such as the Jasmine Revolution and Egypt’s current uprising, the tea leaves were most definitely telling us to stay out of Emerging Markets for the last 2-3 months.
Today, Brazilian equities continue to lose bids, despite the strength we’re seeing in crude oil prices (up over 3%) and commodity prices (up over 1.5%) on the day.
We are all well aware that Brazil is home to arguably the most robust consumer story in all of global macro. With record low unemployment (5.3% in Dec) and near-record low consumer loan rates (6.79%), it’s no surprise investors (including us) poured money into this story in 2010 – sending the Brazilian Consumer etf (BRAQ) up +30.3% in 2010 from its first trading day (7/8/10).
Both the price action and investor interpretation of the fundaments have reversed sharply in 2011, sending the BRAQ down over (-12%) YTD. The fundamentals themselves have been eroding for the last four to six months – particularly on the inflation front:
- The benchmark IPCA CPI reading accelerated in Dec to +5.91% YoY – a 25-month high;
- Food Inflation, as captured by the same official IPCA index accelerated in Dec to +10.39% YoY – a two-year high; and
- January is off to a “hot” start as well, with the unofficial FGV IGP-M CPI accelerating to +11.5% YoY – a 26-month high.
Ignoring the delta between the government’s reported numbers and the unofficial series (see: Egypt, Argentina, US, etc.), we see that inflation is indeed becoming the problem we anticipated a few months back. This issue is reflected in the Bovespa’s underperformance – falling (-7%) since it peaked on the 12th of January. With the exception of the now infamous EGX 30 (Egypt), that decline is tops among global equity markets over that duration. The fall leaves Brazil decidedly bearish from an intermediate-term TREND perspective.
With the dollar catching no bid amid the acceleration of global geopolitical risk, we don’t see inflation as something that will quietly go away in Brazil. Brazil’s bond market agrees; yields on 10Y government securities having backed up +79bps since January 3rd. For what it’s worth, Brazilian economists see the same thing: the latest survey for full year 2011 CPI estimates came in at +4.7 YoY, up +16bps wk/wk.
Unfortunately, for the poorest of Brazil’s citizenry, Brazilian policy makers have been reluctant to let the real appreciate meaningfully. Of the firm belief that the current bout with inflation is driven by rising commodity prices (see: India) the central bank is reluctant to use further rate hikes to beef up the real in an effort to combat rising inflation. Instead, Brazil continues to manufacture attempts to weaken the real, raising the reserve requirement on short dollar positions, authorizing the sovereign wealth fund to buy dollars and auctioning reverse swaps – all since January 1st.
Until Brazil’s central bank stops buying the IMF-led hype of “destabilizing fund flows” and “global capital imbalances” and realizes that inflation is priced locally and is a direct function of local monetary policy, the inflation issue will hang like a dark cloud over Brazil’s economy.
Perhaps the market is discounting this, understanding full well that Rousseff is a woman of the people and a strong advocate for Brazil’s poor. She’ll likely not let inflation get further out of control than it already is. Given this, we expect measured tightening on the horizon in the Brazilian economy, and a potential subsiding in anti real-strength policies. Perhaps the prospect of future real strength is the underlying reason Brazil’s Industrial Confidence fell in January (-1.5%) MoM. While merely a hunch at this point, we’d be remiss to ignore the interconnectedness of these risks.
If you’re still bullish on Brazilian equities, we’d recommend you buy them at an even greater discount at some point in the intermediate future. If you’re bearish, continue to watch the US dollar and how it interplays with commodity inflation. For now, the dollar is decidedly bearish-TREND, which, in turn, is bullish for global commodity prices on the margin. We don’t think we’ll see the usual benefit of these rising prices reflected in Brazilian equities until inflation subsides in Brazil – which is likely only to happen after a measured increase in hawkish monetary policy.