Capital markets continue to dry up as Slowing Growth remains the dominant trend in the region (and globally). Get growth right and you’ll get a lot of other things right.
Latin American equity markets had a fairly solid week last week, gaining +1.7% wk/wk on both a median and average basis. Chile brought up the rear, closing down -1.2% wk/wk, as the market sold off largely due to the central bank’s decision to not cut interest rates.
In Latin American FX markets, the recent trend of sharp declines continues, with currencies falling nearly -2% vs. the USD on both a median and average basis. The Brazilian real (BRL) continues to lead the way to the downside (-3.5% wk/wk), which is largely a function of Banco Central do Brasil being the most aggressively dovish in of all the Latin American central banks (see: recent rate cut).
A noteworthy reevaluation of risk and the returns needed to justify holding onto certain exposures has swept across emerging market sovereign debt markets last week and Latin America was not spared. Indeed, the credit risk component of fixed income analysis came forcefully into play, as bond yields rose across the curve broadly throughout the region, with Mexico leading the way to the upside. In a similar light, 5yr CDS widened fairly notably across the region’s borrowers. With the exception of Mexico, Latin American interest rate swap markets did confirm that the back up in interest rates was not due to tightening speculation, but rather attributable to credit risk.
Brazil: Last week, we received some key commentary out of Brazilian central bank president Alexandre Tombini. First, he stated that he and other board members believed that the current “international economic crisis” will “last longer than the one in 2008”. We interpreted this as the bank is likely to remain in a netral-to-dovish stance for an extended period of time – a view that is supported by the general decline in yields across the maturity curve of Brazil’s interest rate futures contracts.
As it relates to the near-to-intermediate-term health of the slowing Brazilian economy, we see that the consumer is showing some resiliency: real retail sales growth, though flat YoY in Aug (+7.1%), accelerated to +1.4% on a MoM basis vs. +0.3% prior; CAGED formal employment growth also accelerated in Aug, increasing +190.4k MoM vs. +140.6k prior. Elsewhere, we see a continuation of the recent trend of dried-up capital markets in Latin America (see: Pemex notes below), as Brazilian corporate bond sales (R$44.9 billion YTD) outpace equity offerings (R$17.4 billion) for the first time since 2008, largely due to equity financing falling -1,070bps YoY to 22.1% of the total (vs. only a +500bps increase for debt issuance).
From a longer-term perspective, Brazil took one step forward and two meaningful steps back. Recall that we outlined Brazil’s woeful infrastructure, loose fiscal spending, and an inadequate supply of educated labor as reasons to expect either higher interest rates or elevated rates of inflation over the long-term TAIL. The one piece of good news is that the Ministry of Education confirmed that the government plans to hire 33,568 teachers in 2012 after not adding to school headcounts at all this year amid a public sector hiring freeze. Further, the ministry is budgeted to hire nearly 100k new employees through 2014 alongside government plans to open 38 new university campuses and plans to increase the number of technical schools by +56.8% to 555. While certainly not a panacea for Brazil’s great education needs, it is a meaningful step in the right direction as it relates to reducing the pressure on wages that continually poses a risk to reported inflation due to the perpetual supply/demand imbalance in the Brazilian labor market.
On the negative front and regarding infrastructure specifically, Brazil dropped a full 20 places (to 104th out of 142) in the 2011-12 version World Economic Forum’s yearly Global Competitiveness Report. This is not good for a country scheduled to host the world’s two largest sporting events in a span of three years (2014 World Cup & 2016 Summer Olympics). Additionally, as it relates to fiscal spending, Finance Minister Guido Mantega confirmed an earlier rumor we reported a few weeks back in that the government fully intends on using accounting tricks (worth R$40 billion in “savings”) to meet the country’s R$135 billion primary surplus target for 2012. While the government’s spending on PAC infrastructure initiatives will be crucial to aiding economic growth in 2012 and beyond, the net effect PAC spending will have on Brazil’s low gross national savings rate will serve to keep unwanted pressure on the real for years to come – a negative for Brazil’s already struggling manufacturing and export sector.
Mexico: Capital market developments continue to be the dominant theme throughout the region and Mexico has generally been at the forefront of recent occurrences. In yet another sign of general “dryness”, Pemex (Mexico’s state-owned oil producer) shelved a scheduled 10 billion pesos ($776 million) offering, citing “high volatility” in the markets. The falling peso, which is becoming a headwind for foreign participation in Mexican bond auctions (41% of total demand vs. 11.6% in Brazil and 3.5% in Colombia), is perhaps the most important market with “high volatility” that the company cited. The implied volatility on one-month at-the-money USD/MXN options has increased +82.1% since the start of August alongside the peso’s -11% decline over that duration. We’ve been appropriately bearish on the Mexican peso for the past couple of quarters and we’re starting see that view be expressed more broadly from a positioning perspective; the spread of bullish MXN/USD futures contracts vs. bearish contracts has fallen to 13,346 in the latest reporting period – the lowest since Oct ’09.
Despite the recent occurrences in Mexico’s bond and currency markets, the government is still looking to carry on with its plan to secure legislative approval for an additional $7 billion in overseas borrowing capacity for 2012 (vs. only a $1.52 billion increase for local borrowing capacity). This may indeed come at a time where global demand for emerging market sovereign paper is dramatically lower than what we’ve seen over the past couple of years – a confluence that may lead to higher bond yields (which, to some extent, is already being priced into Mexico’s sovereign yield curve). Since ’09, Mexico has increased its external debt issuance by +114.3% vs. the total of the three years prior ($7 billion). Like many other emerging market issuers, Mexican government paper has indeed been a beneficiary of the global rat race for yield; but to the extent credit risk starts to come into play, we could continue to see losses – especially in local currency-denominated bonds for un-hedged U.S.-based investors.
As it relates to Mexico’s economic fundamentals, data came in mixed last week: ANTAD same-store sales growth slowed in Aug to +1.8% YoY vs. +6.4% prior; domestic vehicle sales growth accelerated in Aug to +13.1% YoY vs. +10.6% prior; and vehicle production growth slowed in Aug to +7.7% YoY vs. +16.3%. The central bank, which has been on an Indefinitely Dovish hold since mid-2009, suggested that this hold is likely to continue a bit longer:
“A weaker global economic recovery and increased risk of slower domestic growth may lead to reduced inflationary pressures at home.”
-Aug 26 central bank survey minutes (posted last week)
“The balance of risks still calls for a relatively neutral monetary policy, which is precisely where we stand today. There may be circumstances in the future that call for lower rates.”
-Central bank governor Ron Carstens
We’ve been all over the calling for Carsten’s final point since early in 2Q and we expect expectations of lower interest rates to continue weighing on the Mexican peso over the intermediate-term TREND.
Argentina: One situation we continue to monitor in Argentina is the outflow of capital from the economy as foreign investors grow more risk averse in addition to heightened speculation around a devaluation of the Argentine peso (ARS) later in the year. As it stands, capital flight is projected to eclipse the record $24 billion mark set back in 2008 after accelerating to $3 billion in August, per Banco de la Ciudad. The trend of foreign investors converting peso deposits to dollars has pushed up Argentinean interest rates to the highest levels since 2009; the 30-day moving average on Badlar rates (30-day deposits of more than 1 million pesos) has increased to a two-year high 10.6%, putting upward pressure on interest rates throughout the economy (mortgages, bonds, etc.).