Conclusion: On an intermediate-term TREND basis, the tight grip of Stagflation continues to choke the Brazilian economy. Furthermore, we see Stagflation as a real risk to Brazil over the long-term TAIL.
Over the last few weeks we’ve been relatively quiet on Brazil, largely due to the data playing out in spades according to our expectations. Growth continues to slow and inflation continues to accelerate, which, in turn, incrementally slows growth.
As you may know, we prefer to analyze slopes rather than absolute values, believing that the 1st and 2nd derivatives of growth rates are often the best leading indicators for the absolute levels of future growth. On a marginal basis, economic conditions continue to deteriorate and we see little signs of reprieve on the horizon. With the Bovespa down over 8% YTD, it’s pretty clear to our Hedgeyes that Stagflation isn’t good for earnings growth in Brazil, nor the multiple the market is willing to pay for said earnings:
While certainly a lagging data point, Brazil’s 1Q GDP report showed that YoY Household Consumption growth slowed -160bps to +5.9%. On a QoQ basis, Household Consumption growth slowed to +0.6% vs. a prior reading of +2.4% in 4Q10 – indicative of the measured slowdown in Private Consumption we had been calling for since November. Furthermore, our proprietary Brazil Consumer Misery Index suggests further downside to consumer spending trends is likely on the horizon:
All told, though consensus estimates for Brazil’s 2011 GDP have come down alongside the government’s forecasts in recent months, we still see further downside to current projections. To the latter point specifically, the Finance Ministry late last month cut their 2011 GDP projection -50bps to +4.5% YoY, as well as increased their 2011 CPI forecast +60bps to +5.6% YoY. Further, the board reduced its 2012 GDP estimate by -50bps to +5% YoY, as well as its 2011-14 GDP projections to +5.1% YoY per annum vs. a previous forecast of +5.9%.
Whether or not this is function of the Brazilian government seeing what we see (the strong possibility that structural inflation takes hold in Brazil) remains to be seen. Time and more data will tell in that regard. For now, we remain bears on real-denominated debt as it becomes increasingly likely that the central government misses it’s deficit reduction target in the current fiscal year due to lower-than-anticipated tax receipts driven by slowing growth. Sovereigns can and do “miss” the numbers (see: Greece, Ireland, Portugal, US, etc.). In April, the Central Government’s Budget Balance missed expectations by 600M reals ($380M). We don’t see that as a one-off event.
While up measurably on a YTD basis, as well as since when we turned bullish on them in early November, Brazilian bond yields have been trending down of late, but that’s likely due to the fact that rate hike expectations are coming out of Brazil’s bond market as growth slows. That’s a dangerous place to be as an investor – buying/selling what you can vs. what you should. Specifically, two idiosyncratic mechanisms regarding Brazilian CPI and wages have us worried regarding the slope of Brazilian CPI for the long-term TAIL:
- Price increases for Services (24.1% of the benchmark IPCA CPI) are automatically increased as a result of indexation, a process whereby past inflation is used as a benchmark for raising prices; and
- Brazil’s minimum wage (currently at 545 reais) is reset based on the previous year’s CPI plus the GDP growth rate two years prior. In 2012, that formula is likely to produce a gain of over +13%. The level of many key payments throughout Brazil – including government pension payments – are determined based on the minimum wage.
Obviously, it’s too early to tell whether or not structural inflation once again takes hold of the Brazilian economy. It is, however, a situation we will continue to monitor closely – especially given the fact that the central bank has been very reactive in nature, rather than proactively quashing inflation in a prudent manner (recall that we highlighted this as a major risk to being long Brazilian equities back in November). If our hunches on the slope of long-term inflation in Brazil prove accurate, both Brazilian equities and real-denominated debt will become less attractive, on the margin, from a long-term perspective.