Conclusion: The recent collection of hawkish monetary policy and prudent fiscal policy has Brazilian equities feeling the ill-effects of waning stimulus due to higher interest rates and budget cuts. In addition, we detail below how we are playing Global Stagflation from a Global Macro perspective.
Position: Short Brazilian Equities via the etf EWZ.
On Thursday, we shorted Brazilian equities in the Hedgeye Virtual Portfolio on the expectation that the Bovespa was indeed rallying to another intermediate-term lower-high. From a top-down perspective, a confluence of bearish factors has had us sour on Brazilian equities since early November:
Slowing Growth: The higher-frequency data in Brazil (Retail Sales, Consumer Confidence, Economic Activity Index, Trade Balance, and Industrial Production) has inflected negatively in Dec/Jan reporting.
Accelerating Inflation: Even in the face of recent rate hikes and higher reserve requirements, the official IPCA National CPI reading accelerated +10bps to a 26-month high of +6% YoY in Jan. The unofficial, more sobering FGV IGP-M CPI reading accelerated to a 26-month high as well in Jan (+11.5% YoY).
Recent news suggests Brazil may have to import crude oil to offset a mix-shift by consumers and producers away from ethanol consumption, where prices are becoming prohibitively expensive. Unfortunately, the proverbial “poison” will have to be picked: WTI crude oil prices accelerated to +17.3% YoY in Jan from +8.5% YoY in Dec.
Interconnected Risk is compounding: In what we consider a bullish long-term data point, the inexperienced President Rousseff won a major battle within the Lower House of the Brazilian Congress to increase the minimum wage to 545 reais – a +6.8% YoY increase. Opposing lawmakers had been calling for an increase to as high as 600 reais. The bill, which was passed by a vote of 361-120, now goes to the Senate floor for debate.
This decisive “win” helps Rousseff stay the course on her plan to cut spending by 50 billion reais ($30B) from the budget. This victory sets the stages for additional frugality, as over two-thirds of pension and welfare costs are indexed to the minimum wage. Every one-real increase in the minimum wage translates to a +300 million reais increase in public spending.
Rousseff, who has yet to detail where additional budget cuts will come from aside from “eliminating waste” and freezing government hires, appears to remain steadfast in her commitment to work with Central Bank President Alexandre Tombini and Finance Minister Guido Mantega to rein in inflation through a combination of tighter fiscal and monetary policy. As a result, Brazilian interest rate futures have been on the decline of late. Despite the prospect of less aggressive rate hikes, however, the outcome remains the same: less liquidity to perpetuate demand growth and chase stock prices higher.
While we are not in the camp that considers stock market performance to be indicative of a country’s long-term health, we do believe in its merits as an indicator of a country’s near-term growth/inflation trends. Both are going the wrong way for Brazil and are weighing on Brazilian equities. Also, the proactively predictable interconnected risk associated with MENA instability certainly doesn’t help either:
The March Towards Global Stagflation:
While prudent fiscal and monetary policy is not a “risk” by definition, it is a bearish factor for near-term equity market performance. As we’ve seen for the past two years, global equity market performance has been in-part driven by loose monetary policy worldwide. Now, we’re seeing emerging markets get tagged as they rein in the laxity which has helped global growth advance to its current cyclical peak.
We maintain our belief that global growth (including in the US) topped out in 4Q10, as bearish factors combine to quell the current momentum of growth: global inflation accelerating, higher interest rates and tighter monetary policy globally, global credit risk rising, US consumption growth slowing, US housing deflating… the list continues on. Consensus' current bullish sentiment is supported by lofty global growth assumptions and elevated earnings forecasts which will likely be revised down from current estimates in the coming months.
Regarding our virtual investment positions specifically, we’ll continue to watch the US dollar like a hawk for cues on the direction of global inflation (we're currently short the US Dollar via the etf UUP). While supply/demand fundamentals have certainly contributed to the current elevated prices of many commodities, we’d be remiss to ignore the medium by which they are PRICED and traded in to determine our expectations of future PRICES.
As long as Bernanke, Geithner, and Obama continue to Burn the Buck, we see no reason for commodity prices to back off meaningfully. Don’t assume slowing global growth will lead to decelerating inflation; Global Stagflation is a definite possibility and, in that scenario, not even the “flows” will protect investor portfolios. We remain short Brazilian equities (EWJ), Indian equities (IFN), Japanese equities (EWJ), Emerging Market equities (EEM), US Treasuries (SHY), and US Consumer stocks (XLP, COH, VFC, MCD; recently closed/still bearish on: XLY, TGT, SAM, and JNY) in anticipation of this scenario playing out.