Last week, ARCO was down 15% underperforming the S&P 500 by 850bps. The underperformance was not surprising given the MACRO environment, especially for the commodity centric countries. Yesterday, the macro team suggested that last week moves in Latin American financial and capital markets are signaling a very bearish outlook for the regional economy.
As measured by our recent meeting with management and consensus estimates moving up by 2.8% last week, the fundamentals for ARCO remain strong 3Q11. The following is taken from the Hedgeye Macro team Latin America Risk Monitor.
Latin American equity markets got completely tagged last week, closing down -7.2% wk/wk on a median basis. The cap-weighted MSCI EM Latin America Index (Brazil, Chile, Colombia, Mexico, and Peru) actually closed down -13.6% wk/wk as the Flight to Liquidity trade continues to roil emerging market assets worldwide. This was confirmed in the FX market as well, with the region’s currencies depreciating nearly a full four percent wk/wk vs. the USD on a median basis.
Latin American sovereign debt markets sang a similar tune, with yields generally backing up across the curve throughout the region. Brazil’s 2yr sovereign debt yields posted a noteworthy negative divergence on expectations of more dovish monetary policy, as indicated by the -20bps wk/wk decline in the country’s 1yr on-shore interest rate swap. From a credit quality perspective, Latin American 5yr CDS widened fairly dramatically wk/wk, with Brazil, Chile, Colombia, Mexico, and Peru all posting percentage gains north of +30%. With the exception of Chile – the region’s highest rated sovereign credit – 5yr CDS quotes for these countries have nearly doubled in the YTD.
Brazil: The key developments out of Brazil in the past week largely centered on the real’s plunge vs. the USD (down -15.3%
over the past two months, making it the 2nd-worst performing currency in the world over that time period). The declines were met with central bank action, as the bank stepped into the market to mitigate declines by auctioning currency swap contracts (112,290 in total with maturities between Nov and Jan). This effort, which is equivalent to selling dollars in the futures market, reverses a 28-month-old trend of implementing policy designed to limit real appreciation. With renewed speculation of a Greek default swirling about the financial media, Brazilian policymakers were quick to act in support of their currency.
The real, which declined -32.3% in the five months through Dec 31, 2008, is a major source of worry for Brazilian officials – which explains the hard line stance of defense provided by the central bank (per monetary policy director Aldo Mendes’ recent commentary). Aside from exacerbating the external debt burdens of the sovereign and Brazilian corporations alike, the real’s rapid depreciation also threatens to continue undermining Brazilian capital markets and make the cost of financing business ventures prohibitive for Brazilian corporations. For example, the cost of short-term trade financing for Brazilian investment grade companies has more than doubled this month (1yr credit line export contracts now cost 2.85% vs. 1.35% 1mo ago) and is fueling speculation that the central bank will have to step in to support this market as they did back in ’08.
All told, the real’s global underperformance vs. the USD of late is largely a function of a series of Big Government Intervention designed to limit real appreciation – inconveniently at the top of the global economic cycle. The cumulative effect of the measures, which included a tax on foreign currency derivatives transactions, caused foreign wagers for real appreciation (vs. the USD) to fall -85% from July’s record high of $25.6 billion in futures and dollar spread contracts. Now, Brazil is backpedaling as its currency suffers the most as a result of these capital controls:
“We established regulatory measures exactly for that, to add and take away. The IOF is one of those; we introduced it, then we can take it away when it’s no longer needed. We are always looking at all the possibilities, but there is no decision.”
-Finance Minister Guido Mantega (9/23)
Mexico: The Mexican peso, which just snapped its longest losing streak on record last Friday is in a similar boat as Brazil – though largely for a different reason (Indefinitely Dovish monetary policy as opposed to Big Government Intervention). The peso, which is down over -14% vs. the USD over the past two months is facilitating foreign liquidation across Mexican financial markets, headlined by the -13.2% loss for peso-denominated sovereign debt in the month-to-date (vs. +2.5% for U.S. Treasuries and an -8.2% average across all emerging markets). Central bank governor Augustin Carstens believes that peso weakness is “transitory” and expects it to “resume its upward trend” along with other Latin American currencies.
Clearly Carstens is modeling in a near-term inflection point in the global economic cycle – an outcome not being priced into any of the macro markets we monitor globally. This view is likely to leave the Mexican central bank on the sidelines for now as it relates to meaningfully supporting the peso in the FX market – potentially paving the way for further declines. As interest rates continue to back up and increase the cost of capital for Mexican corporations and consumers, we expect growth south of the border to continue slowing – just as we called out in early 2Q when we first went negative on the Mexican economy and its stock and currency markets.
Colombia: The key callout out of Colombia last week is undoubtedly the government’s decision to scrap a $240 million bond issue for the rest of year, citing “global financial turmoil”. The key takeaway here is that if the Colombian government is finding it hard to raise debt capital, we don’t think many Colombian corporations are able to do so either. Growth tends to slow when capital markets dry up.
Elsewhere in the Colombian economy, Finance Minister Juan Carlos Echeverry, who put his own job on the line if the Colombian unemployment rate doesn’t improve to single digits by year end (11.3% currently), did reiterate his forecast for Colombia to grow 5% next year. We interpret this as they’ll be quick to quick to fire the stimulus gun to help achieve this goal should Colombian economic data start to come in negative on the margin. He is also keen on maintaining national confidence so that financial intermediation can continue to support growth. This may prove to be a tall order, given the global economic backdrop.
Argentina: Continuing with the theme of capital flight, which is currently on pace for the largest yearly amount on record, new data does indeed confirm that Argentina is likely to run out of money to defend its currency, the peso, in 2012. Based on a law that FX reserves are not allowed to fall below the monetary base (put in place for this exact reason – to protect against capital flight), we can now see that Argentina has only a $3.4 billion buffer before FX reserves hit this dreaded level. To complicate matters, President Cristina Fernandez’s 2012 budget includes a $5.7 billion provision of FX reserves for international debt service. Moreover, Argentina’s inability to access international debt capital markets (especially in times of global stress) all but guarantees this payment is made – perhaps alongside other FX reserve-financed social spending in the event of an economic downturn (which we’d argue is already happening given that Argentina systematically underreports inflation by 10-15% – artificially boosting GDP growth on a real-adjusted basis).
Argentina’s FX reserves, which have declined by -5.8% YTD to $49.1 billion, are largely a function of trade revenue from agricultural commodities (over 50% of exports per Bloomberg). With our call for Deflating the Inflation to continue, over the intermediate term, we think the market will continue to price in a peso devaluation at some point over the next year to get reserves to a comfortable level when compared to the monetary base. This is what the FX market has been sniffing out and is largely the reason why the blue-chip exchange rate (a market that intensifies during bouts of capital flight) is trading at a -10.4% discount to the spot market rate (vs. the USD). The capital flight ahead of a perceived currency devaluation has pushed up yields on Argentine peso-denominated bonds due in 2033 +361bps YTD to 10.51% vs. an increase of “only” +283bps on Argentine dollar bonds. All told, we are bearish on the Argentine peso (and Argentinean assets in general from a USD perspective) until the FX reserve issue is adequately addressed – a resolution we don’t see taking place anytime soon.