Brazilian Tug-of-War

Conclusion: Is it time to buy Brazilian equities? We think not, though we are certainly much less bearish on them than we have been in recent months.

When we when we initially turned bearish on Brazilian equities in November (alongside most other emerging markets), we were making the call within the context of our contrarian intermediate-term TREND thesis of Global Growth Slowing as Global Inflation Accelerates. Understanding full well history’s lessons of inflation eroding EM growth and asset returns augmented our conviction then.

Fast-forward nearly five months, and we have no less conviction with our fundamental call – if anything, $115 crude oil is incrementally supportive. We do, however, have less conviction in being bearish on Brazilian equities, as a lot of the scenarios we initially forecasted have already played out. Simply put, we’re running out of catalysts on the short side, so, naturally, we’re reining in our bearishness: 

  • Slowing Growth: YoY GDP growth slowed sequentially by (-170bps) in 4Q and both the Brazilian government and the sell-side have been taking down their 2011 GDP forecasts recently, currently at +4.5% YoY and +4.1% YoY, respectively.
  • Accelerating Inflation: Since bottoming in August, Brazilian CPI has crept up +150bps to the current +6% YoY reading (Feb). Consensus estimates for Brazil’s 2011 CPI are now at +5.5% YoY - up from +4.7% YoY when we initially called out Brazil’s inflationary headwinds.
  • Rate Hikes: Since our initial forecast for Brazil to resume raising interest rates (late October), the Selic Rate has been hiked +100bps and we expect an additional +50bps hike at the central bank’s next meeting (April 19-20). After that, we expect Tombini to go on hold and await more data, particularly given his dovish comments following Japan’s crisis and his reiteration that recent fiscal and monetary tightening will slow CPI to the target range by 2012. Further, the Finance Ministry recently revised down their 2011 CPI forecast (-50bps) to 4.5% – a sign that declining inflation expectations are spreading throughout the policy-making spectrum.
  • Prices: Since the start of November, the Bovespa is down (-5.7%) and are underperforming the S&P 500 and the MSCI EM Index by (-1,605bps) and (-598bps), respectively. 

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Given that we’re inclined to be less bearish on Brazilian equities at current prices (relative to our entry point), the next risk management question to ask is, “Is it time to get long?”

For now, our answer is “no”, for two reasons: 

  1. The Bovespa is broken from an intermediate-term TREND perspective; and
  2. The sell-side is increasingly bullish. 

Addressing the latter point specifically, Morgan Stanley and Citigroup have come out recently recommending buying Brazilian call options (MS) and overweighting Brazilian equities (Citi). While we don’t want to dismiss their recommendations just for the sake of being contrarian, both history and our own anecdotal experience has shown sell-side recommendations tend to be lagging, if not outright contrarian, indicators.

Combining this idiosyncrasy with our quantitative context gives us a more cautious outlook. For now we’re content to wait, watch, and trade the rage. We’d need to see a sustained breakout above the TREND line or breakdown below the TRADE line before we are willing to make a new call from here, given that much of our current call has likely been priced in.

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What would be incrementally bearish for Brazilian equities relative to our November forecast is if crude oil prices continue to make higher-highs over the intermediate term (incrementally accelerating inflation) and if the real weakens over the intermediate term due to (potential) Japanese repatriation, which gives Tombini more headroom to hike interest rates and escape the accompanying currency appreciation. Currently, Japan is the largest holder of real-denominated debt according to PIMCO and has some $34.3B in Japanese deposits according to HSBC.

What’s next for Brazilian equities and her currency? Stay tuned to find out.

Darius Dale

Analyst