Conclusion: We continue to think Brazil's central bank simply isn't doing enough to fight inflation and, for the first time in this current cycle, we think that policy makers are risking a substantial loss in their credibility by refusing to be more proactive in reigning in accelerating inflation and its associated expectations.
Position: Bearish on Brazilian Equities for the intermediate-term TREND. Bearish on Brazilian real-denominated debt for the intermediate-term TREND.
Let’s cut right to the chase; even though Brazil’s central bank hiked its benchmark Selic rate +25bps yesterday, we continue to think they simply aren’t doing enough to fight inflation and, for the first time in this current cycle, we think that policy makers are risking a substantial loss in their credibility by refusing to be more proactive in reigning in accelerating inflation and its associated expectations.
While yesterday’s move came as no surprise to Brazil’s interest rate futures market, it did surprise consensus expectations of another +50bps hike, which would’ve been the sixth in the past year. Simply put, we don't find the central bank's "wait & watch" approach prudent in the face of accelerating inflation and accelerating inflation expectations.
At the time, we attributed the Bovespa’s late-March bounce to the fact that our Brazilian Stagflation thesis (which we introduced back in November) had become consensus – meaning that as supply of incremental sellers dwindled, short-covering and valuation buying would support the market. Moreover, the central bank’s rhetorical easing off of the tightening pedal at the end of the month also helped boost Brazilian equities a bit further. Specifically, Tombini & Co. stated that the cost of reducing CPI to its target range of 4.5% +/- 200bps in the current year was “too great”, and that they would postpone tightening efforts into 2012.
As we continue to warn, however, just because a central bank is done tightening doesn’t mean that inflation is no longer an issue. Simply put, Brazil is not China in this regard. One of the reasons we’re long Chinese equities in the Virtual Portfolio is because we think that Chinese CPI has topped out or will likely top out in the next couple of months, due to China’s proactive monetary policy over the last 15 months.
Contrarily, as we explicitly warned in November, Brazil’s monetary policy has been more reactive in nature, and, combined with today’s retreat in the severity of tightening, we expect Brazilian consumer and producer prices to surprise to the upside over the next couple of quarters. Cheap valuations aside, that’s not good for Bovespa margins. Economically speaking, that’s not good for Brazilian growth as higher prices stymie consumption growth and inflate the deflator by which real GDP is calculated.
With aggregate consumption at 81.7% of GDP in 2010, higher prices and higher interest rates certainly have the ability to meaningfully depress Brazilian growth rates by slowing household spending and straining the government’s budget. Based on our analysis of consensus reactions to the recent “budget cuts”, the latter point is an underrated issue that has the potential to add further upward pressure on Brazilian interest rates. As we called out in a report on March 3 titled “Brazil: One Step Forward; Three Steps Back”, the supposed budget cuts were rife with misleading accounting and/or flat-out bad assumptions regarding subsidies, etc. Net-net, we think the Brazilian central government could wind up missing its deficit reduction target in 2011. Brazil is not unlike India in this regard.
As we outlined a few weeks back in a March 30 post titled, “What’s Next For Brazil?”, one of the few things that remain supportive of the Brazilian economy is persistent real strength, and we continue to remain bullish on the currency for the intermediate-term TREND – particularly vs. the USD. If, however, the Brazilian government is able to finally implement a successful plan to weaken the real (after several months of failed attempts), that could potentially pose a systemic risk to the Brazilian economy from an inflation/inflation expectations perspective. We continue to wait and watch for more signs of Big Government Intervention on this front.
All told, we are jumping back on the bearish side of Brazilian equities after a brief, but cautious pause. The combination of reactive, rather than proactive, monetary policy and the potential for a marginal deterioration in fiscal policy is likely to keep inflation on the up-trend over the coming quarters. We were correct to warn clients in January (see report: “Time to Buy Brazil?”) that the Bovespa was not a feasible play on inflation on the long side this time around and we continue to affirm this conclusion.
The confluence of slowing growth (topline deterioration) and accelerating inflation (margin compression) relative to consensus already bearish forecasts is likely to make the “cheap” Bovespa look expensive when earnings forecasts start to be revised down to economic reality. Moreover, the likelihood that the central bank is going to have to re-accelerate tightening measures in the latter half of the year continues to make us bears on Brazil’s bond market as well.
Happy shorting and happy Easter.