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“There is no cause for worry.  The high tide of prosperity will continue”.

-Andrew Mellon, June 1928.


Clearly, Mr. Mellon’s statement proved to be inaccurate and untimely. 


Fortunately for him, Irving Fisher stole the limelight with his immortal quote made days before the 1929 crash, “stock prices have reached what looks like a permanently high plateau”.  As John Kenneth Galbraith writes, in reference to Mellon’s statement, in his seminal work titled The Great Crash, “Mr. Mellon did not know.  Neither did any of the other public figures who then, as since, made similar statements…it is not to be supposed that the men who make them are privileged to look further into the future than the rest”. 


Later in The Great Crash, as Galbraith moves to discuss the weeks and days more closely preceding the ultimate stock market collapse of October 1929, he writes, “When markets fell many Wall Street citizens immediately sensed the real danger, which was that income and employment – prosperity in general – would be adversely affected.  This had to be prevented.  Preventative incantation required that as many important people as possible repeat as firmly as they could that it wouldn’t happen.  This they did.”  Here we are, in 2011, and important people are once again turning to preventative incantation.  This time, dare I say it, is different.


As the “roaring twenties” came back down to Earth, the informational resources that were available to Main Street were rather limited.  The New York Times, the Wall Street Journal, Barron’s and other legacy newspapers were the primary source of financial news for the vast majority of shareholders in this country.  Indeed, during the most volatile days of the period leading up the 1929 crash, the tickers in the New York Stock Exchange could not keep up with the real-time prices.


Today, ordinary people are increasingly on par with so-called important people.  Twitter, YouTube, and the acute desire for transparency are ensuring that this trend continues.  Yesterday’s most important geopolitical event highlights this point perfectly.  Muammar Gaddafi was dragged out of a sewer and killed by rebel forces in Libya after, in an ironic twist of events, pleading for mercy. 


One of his captors decided to make a digital recording of the event and, forty-five minutes or so after the dictator was executed, anyone in the world with access to YouTube could see evidence of the event on their mobile phone or laptop computer.  Not only could we watch an historic event unfold in just as timely a fashion as the Secretary of State, we could also see a clip on YouTube of Secretary Clinton being passed a phone with a message informing her of Gaddafi being captured.  Newsreaders in years past may have wondered, “I wonder what it was like?”


“The Veil of Ignorance” is a concept discussed by political philosopher John Rawls in his book A Theory of Justice to frame an unbiased determination of the morality of a certain issue.  Behind the Rawlsian “veil of ignorance”, parties to a debate on a social issue know nothing about their abilities, position in society or preferences.  A less sophisticated interpretation of the phrase could be that a veil exists between Main Street and the elites of Wall Street and Washington.  Movements like Occupy Wall Street and the Tea Party epitomize dissatisfaction with the status quo.  Social media is enabling democracy, however indefinite the aims of some groups may seem.


Social media is to democracy what the Bloomberg terminal was to finance.  Like the investors of the late 1920’s that had to wait until the ticker on the floor caught up with market prices, voters at the time were also deprived of the information flow that we are benefitted with.  Preventative incantations, in the US, Europe and elsewhere, are fact checked and debated by main streeters everywhere.  It has been said that deliberation is the essence of democracy and, if that is true, technology is the engine behind democracy today.


 I can’t claim to have visited Zuccotti Park to decipher exactly what it is that the Occupy Wall Street movement wants, but I would imagine that a higher jobs rate might assuage some of the dissatisfaction they are feeling.  Inequality is certainly a large theme of the protest, but a lack of jobs while corporate profits and cash balances remain so high seems to be central to what is causing discontent along all parts of the political spectrum. 


Chief Executive Officers, like politicians should be to voters, are accountable to their shareholders.  Growing profits and increasing shareholder returns are primary goals of any CEO.  Does it make sense, then, to leave so much cash on the sidelines earning little-to-nothing?  The easy answer is no, but most executives don’t want to risk the hard earned capital either.  So what is a CEO to do - wait and watch?  Here are some comments from CEO’s on the current economic environment:


Steve Wynn, CEO Wynn Resorts: “I cannot predict what healthcare costs are going to be, what regulatory load they are going to heap on us, what new taxes or other burdens this insatiable governmental appetite for money from the citizens will take us to.”


Paul Coghlan, CFO Linear Technology Corp: “Customers continue to be very cautious and are concerned over general global macro economic conditions. They acknowledge in-demand opportunities, but are in a wait-and-see mode. They're running tight inventories and order to the low end of our lead times.”


Stephen G. Newberry, CEO Lam Research Corp:  “Since our June quarter call, macro-economic uncertainty has continued, including concerns over European debt issues and ongoing struggles in the U.S. with high unemployment and a growing budget deficit.”


All in all, it is clear that neither the stimulus nor preventative incantations from American or European politicians are reassuring those that matter – the job creators.  Voters, too, can now see the impact – or lack thereof – of politicians’ lip service.


At Hedgeye we are trying to build a business that catches the wave of transparency that is changing how events unfold and are perceived. In 1929, political elites shifted blame and responsibility to each other with little fear of meaningful exposure, at least not in the immediate term. 


Today, their successors are not afforded that buffer.  In 1929, Joseph Stagg Lawrence’s book Wall Street and Washington, attempted to expose government policy and the impact it had on the prosperity of the nation.  Today, the same aim, if it is to gain traction, has to be synthesized within the construct of social media.  That is where Hedgeye is going. 


While hope is not an investment process, we hope that this time it is different.


Function in disaster; finish in style,


Howard Penney






The Macau Metro Monitor, October 21, 2011




According to Jornal Tribuna de Macau, as of Oct 19, Macau GGR reached MOP17BN (HK16.6BN, US2.13BN).  October is on track to reach a new monthly record.  In terms of market share, SJM 26%, Galaxy 22%, LVS 'close to 15%', MPEL 14.5%, WYNN 13%, and MGM 9.5%.



An internal memo from LVS General Counsel, Gayle Hyman, shows that LVS is seeking to secure a list of government officials who have gambled its Macau casinos.  Macau law prohibits local government officials from gambling.  LVS disclosed in March that the SEC and the U.S. Justice Department were investigating whether the company violated the Foreign Corrupt Practices Act (FCPA).


Hyman's memo instructs employees at Sands to retain documents regarding "transmission of anything of value" to current and former Macau government officials and their family members.  The memo also names several Sands employees and contractors about whom documents must be preserved.  Among those people is a prominent Macau lawyer--Leonel Alves, a Macau legislator, a member of the Macau government's top advisory body and a member of China's top political advisory body, the Chinese People's Political Consultative Conference--who is a focus of a dispute between Sands China and its former CEO Steve Jacobs.  An outside counsel for LVS called the memo "extremely standard operating procedure" and said it is no indication of whether the documents that were requested actually exist. 


In another memo, LVS has hired Ira Raphaelson, a special counsel in the Justice Department during the administration of President George H.W. Bush, to the new position of global general counsel.  Hyman will take the new position of senior vice president of corporate affairs and report to Mr. Raphaelson, according to the memo, which was sent by Chairman Sheldon Adelson.


LVS has hired law firm O'Melveny & Myers LLP to conduct an independent investigation of the company in connection with the government probe.  In July, a 30-member team from the firm went to Macau to collect documents.  The O'Melveny team looked at the activities of at least two Sands China staff with connections to the Macau government that aren't named in Ms. Hyman's memo.  One of those people cited by O'Melveny is the company's vice president of community relations Melina Leong.  Ms. Leong is the sister of Lionel Leong, a member of Macau's executive council, who is considered a potential future CEO of Macau. 


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TODAY’S S&P 500 SET-UP - October 21, 2011


It’s been a good week to manage risk around the range – all of the levels (ranges) are tightening up; makes life easier, for now.  As we look at today’s set up for the S&P 500, the range is 42 points or -2.34% downside to 1187 and 1.12% upside to 1229. 












  • ADVANCE/DECLINE LINE: 631 (+1985) 
  • VOLUME: NYSE 958.13 (-0.61%)
  • VIX:  34.78 +0.99% YTD PERFORMANCE: +95.94%
  • SPX PUT/CALL RATIO: 1.40 from 1.78 (21.21%)




TREASURIES: long-term bonds up small on the week with US stocks down small - managing risk around the bigger ranges was what won.

  • TED SPREAD: 40.54
  • 3-MONTH T-BILL YIELD: 0.03%
  • 10-Year: 2.20 from 2.18    
  • YIELD CURVE: 1.92 from 1.90


MACRO DATA POINTS (Bloomberg Estimates):

  • Noon: Ex-Fed President Hoenig to speak in NY
  • 1 p.m.: Baker Hughes rig count
  • 1 p.m.: Fed’s Kocherlakota to speak in Minneapolis
  • 1:20 p.m.: Fed’s Fisher speaks in Dallas
  • 3 p.m.: Fed’s Yellen speaks in Denver


  • European finance ministers meet in Brussels today to lay groundwork for Oct. 23 meeting of govt. leaders that had been deadline for solution to debt crisis
  • European summit for Oct. 26 set yesterday after Germany, France said EU needs more time to seal “global and ambitious” accord
  • President Obama nominated Thomas M. Hoenig as vice chairman of the FDIC board of directors
  • Samsung said to ship more than 20m smartphones in qtr-ended Sept. 30, topping Apple, Nokia, WSJ says
  • Fed’s Tarullo said the central bank should consider resuming purchases of mortgage bonds
  • Democrats failed last night in first attempt to salvage parts of President Barack Obama’s jobs plan

COMMODITY/GROWTH EXPECTATION                                             


COPPER – to a degree reflects this marked-to-market reality of Asian demand but also piggy backs on our call for a Correlation Crash that continues to find its way into the land of Commodities. At $3.11/lb, Copper is immediate-term TRADE oversold, but the bigger point is that it remains in a Bearish Formation (bearish on all 3 core durations)


GOLD: the TREND level has now been tested and tried ($1685), so the new range to manage risk within is 1





  • Worst Thai Floods in 50 Years Hit Apple, Toyota Supply Chain
  • Qaddafi Death Unlikely to Spur Libyan Oil Return: Energy Markets
  • Sugar Traders Most Bearish in Three Months on Glut: Commodities
  • Oil Gains Before Europe Rescue Talks; Libya Says to Boost Output
  • Gold Pares Worst Weekly Loss in a Month as Commodities Advance
  • Alrosa Follows Gazprom to Shortest Dollar Debt: Russia Credit
  • Cofco Seeks Acquisitions to ‘Balance’ China’s Food Demand
  • Copper Advances Most in Two Weeks on European Crisis Optimism
  • Copper Jumps 3.4% in London Trading After Selloff: LME Preview
  • Freeport Exhausted Copper Stocks on Peru Strike, Union Says
  • Corn Advances as U.S. Export Sales Climb to Seven-Month High
  • Gold May Extend Weekly Decline as Stronger Dollar Cuts Demand
  • Tin Producers in Indonesia Plan Fresh Measures to Defend Price
  • Duet Commodities Fund Fell 3.8% in September as Metals, Oil Slid
  • Iron’s Worst Rout in 15 Months May Deepen as China Slows
  • Bovespa Index Drops on Brazil Rate Outlook, Commodities Tumble
  • Shrinking Beef Supply Spurs Record Prices as Sales Decline
  • Gold Drops for Fifth Day, Set for Longest Slump Since January




EUR/USD – starting to numb itself into a range that makes sense to me – immediate-term TRADE support =1.36 and long-term TAIL resistance = 1.39. This was a monster short position in the hedge fund community that is in the midst of shaking some people out. Happens. Manage risk around the range into October 26th which is the latest Eurocrat Bazooka push date.






EUROPE: continues to oscillate between TREND (bearish) and TRADE (bullish) lines across the region


GREECE: up +3% this morning to 762 on the ATG index (TRADE resist = 789)






CHINA – big negative divergence for this week came from Chinese stocks losing another -0.6% last night to close out the week on its YTD lows; HK remains below its TRADE line of support, so let’s keep this accelerating deceleration of Asian Growth in mind









The Hedgeye Macro Team

Howard Penney

Managing Director

Italy’s 10YR at 6.02% Ahead of EU Summit!

Positions: Short EUR-USD (FXE)

Ah, the chaos… it’s hard to know what to believe out of Europe this week – from falsified media reports to conflicting statements from Eurocrats on solutions to Europe’s sovereign and banking imbalances, all on the backdrop of intense strikes and riots in Greece, heightened volatility in capital markets and rising risk metrics across Europe’s core and periphery. While we don’t have a crystal ball, we’d like to review the proposals on the table to aid the sovereigns and recapitalized the banks, the challenges and contradictions and market implications imbedded in these proposals, and suggest a framework for thinking about the timing of this European soap opera. 


Directly below we show a near-term calendar of European meetings, which begins tomorrow with the European Finance Ministers’ meeting.  As we move into Sunday’s EU Summit, the major issues for discussion will include expansion of the EFSF, bank recapitalization funding, and a broader Eurozone fiscal union (which would require constitutional amendments) to govern country budgets, set terms on loans, and more broadly enforce fiscal responsibility (think Stability and Growth Pact 2.0). Note: this last point, however, is far out on the curve.  The key word here is “discussion”. There has been no indication/we’re not of the opinion that concrete policy—that is signed, sealed, and ready for implementation—will be delivered for Monday morning (10/24).


Oct. 21 – European Finance Ministers’ Meeting, Brussels

Oct. 22 – European Affairs Ministers’ Meeting, Brussels

Oct. 23 – EU Summit, Brussels

Nov. 4 –  G20 Heads of State, Cannes, France


Buy the Rumor, Sell the News

A clear mismatch has however developed between market participants wanting clear cut resolution to Europe’s sovereign and banking crisis NOW, versus the much slower hand of Eurocrats who have yet to show that they 1.) know how to handle this situation, and 2.) can collectively agree on the terms of a bailout for the sovereigns and banks.


Remember, ratifying the July 21 EFSF terms took months to carry out. And as recently as today there’s talk that a second EU Summit will have to be called (possibly next Wednesday) because German Chancellor Merkel has not been able to get a mandate from the Bundestag to increase the size of the €440B EFSF, namely because there was delay in Troika announcing that Greece would receive its 6th tranche of funding –approval came just today.  [To get to the €750B EFSF rescue fund = €440 from Eurozone member nations + €250B from the IMF + €60B from the EU]. 


In any case, we’re not saying that Eurocrats can’t craft something in the coming weeks, we just wouldn’t put all of our eggs in the basket of it happening this weekend.  This chain gang of Eurozone heads has not proven to be efficient in decision making, so, the “Bazooka”, may be on hold, and the November 3/4 G20 Heads of State meeting would be the next logical event around which a more concrete proposal could be pushed/the market would expect some decision.


According to Merkel: "Government debts were built up over decades and that's why they won't be removed in one summit," she warned this week, saying the meeting would be just one of several important steps.


Contradictions at Play

Here it’s important to point out key differentiators among the players at work.  The heavyweights in decision-making are Germany and France—notably Trichet and the ECB continue to hold the tight line that they don’t want to take on the balance sheet exposure to the region.  In short, Trichet sticks to the convenient but impractical line that the ECB’s sole mandate is price stability across the 17 member states -- that is governing through monetary policy. While the ECB reignited its bond purchasing program in early August, named the Securities Market Program [SMP], to buy secondary sovereign issuance (total = €165B), mainly from the periphery and in particular to support Italy and Spain, there’s clear positioning from the ECB that the SMP will not be THE facility to shore up sovereign funding issues. Instead, and without providing the details, Trichet has referred to the EFSF as a facility to address both sovereign and banking risk (ie provide bailouts and buy up debt) across the member states. 


So what’s the problem? The EFSF is far undercapitalized to deal with these funding issues (more below).


Merkel vs Sarkozy

In numerous comments, Merkel has signaled a willingness to save the economies of the Eurozone (and the common currency) at ALL COSTS, however, hasn’t had the backing of her constituency, including her Finance Minister Wolfgang Schaeuble, who has been quick to temper expectations of expansion of the EFSF over the last weeks. On the other hand, French President Sarkozy has indicated the swift need to expand the EFSF (possibly through leverage), and indirectly implied that the Germans would carry more of the risk in expanding the facility.


Problem at hand: France’s credit rating. France holds a AAA credit rating from the three main agencies, however is in threat of losing it in our opinion. (For more see our recent work titled “France is Going to Get Downgraded” on 10/18).  With a 20% contribution to the collateral of the EFSF, the second largest behind Germany at 27%, this is after all a huge problem.  Eurocrats in recent days, including Michael Barnier of the European Internal Market Commission, said that his agency is considering a move to ban the agencies from publishing outlook reports on EU countries entangled in a crisis. This is a larger topic in and of itself, however the bottom line is that if France loses its AAA standing, the EFSF is back to square one, which has huge negative market implications.


The entire make-up of the EFSF (at least in theory) is to be a funding vehicle backed by AAA guarantors (although not all contributing members are) that can raise and buy up debt (in some cases toxic) from sovereign and banks and through its AAA rating (basically the handshake of Germany and France)maintain its credibility as a facility.


Market Implications

Going into this weekend, it’s clear the market wants a Bazooka—some funding package to capitalize the sovereigns and banks to pull them out of Europe’s ongoing crisis.  On the banking recapitalization side, the figures being thrown around are anywhere between €100-300B. If the lower end of the range was agreed upon, we’d largely expect the market to sell on the news, including the EUR-USD, equities (banks in particular), and bonds, especially across the periphery.


We’ve included Italy’s 10YR yield at 6.02% in the title of this note (and in charts below) for it’s a signal the market doesn’t think Eurocrats will get a plan done this weekend.  As we hit on numerous times, the 6% level on 10YR government bonds has been a historical level. When Greece, Portugal and Ireland broke through this level, yields shot up expediently and the individual countries required a bailout in short order. This time around, there’s no facility large enough to bailout Italy, which is sitting on €1.9Trillion of debt, or a Spain, or a large nation requiring assistance to prop up its banking sector. Here we mean to say that the game is not only dealing with the sovereign and banking needs of Greece, Portugal, and Ireland. [Below we also show the CDS of Italy and Spain, both trading above the 300bp line, which we’ve named the Lehman Line, after the bank moved expediently off the level into collapse].


On raising the size of the EFSF, numbers have been thrown around between its existing size of €440B up to €2-3 Trillion. The top side of the range factors in sovereign default/bailout needs of Italy, Spain, and banking bailout across the region. Here’s it’s hard to know exactly what the market views as appropriate to blanket the risks that have been growing across Europe over the last two years, but should proposals not come in towards the high side (which we think is very probable in the next couple of weeks), or the facility remain on hold at its current capacity, again, we’d expect this news to create selling pressure. Should the top-side be met, or closely considered, we’d expect markets (equities, bonds, and EUR-USD) to fly higher—perversely, despite this huge fiat socialization program, we still see the common currency getting a bid.


Known Unknowns

It’s not clear if the banking recapitalization proposals would come out of the EFSF, be directed from member countries on their own banks, some combination of the two, or from an entirely new facility altogether. European banks taking haircuts on Greek paper is also not understood -- whether write-downs would be at the previously established 21% (from JULY 21 Resolutions and the level pushed by Sarkozy) or closer to the 50-60% range that many German spokesmen have outlined.  However, both issues will need resolution. We'd also be surprised to see the ECB stay on the sidelines.


Rough numbers suggest European Banks have exposure to Greece in the amount of €128 Billion; €819B to Italy; and €2.2 Trillion to the PIIGS.  The web of European exposures is thick—so too is the resolve of Eurocrats to save the Eurozone at all costs. Given the structural imbalance of linking uneven economies by one currency and monetary policy, and the severe fiscal imbalance generated by its weaker members over the last ten years, we’re not of the opinion that a panacea, that is a “Bazooka”, is unloaded in the next days that is a cure-all for the region.  That said, depending on the size and scope, potential bailout package(s) could go a long way to boost European market performance, many of them hit hard over the last months. Getting ahead of the Eurocrats requires a crystal ball—we don’t have one but are trying to prepare for likely outcomes.


We remain short the EUR-USD in the Hedgeye Virtual Portfolio given the unlikelihood of an imminent panacea, bullish bias on the greenback, and larger sovereign and banking threats we see on the horizon.


Oh, and don’t forget that the Chinese and BRIC nations have whispered that they’ll come to Europe’s aid. Don’t you just love all the whispers!


Matthew Hedrick

Senior Analyst


Italy’s 10YR at 6.02% Ahead of EU Summit! - 1. a


Italy’s 10YR at 6.02% Ahead of EU Summit! - 1. b

Brazil: A Case Study in Sticky Stagflation

Conclusion: Sticky Stagflation and FX headwinds should continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.


On December 17thof 2010, we published a research note titled, Brazil: A Leading Indicator for the Global Economy?. The conclusion of the note was as follows:


“Looking under the hood of the Brazilian economy and stock market, we see more confirmation of Accelerating Inflation and Slowing Growth on a global basis. Given, we expect both emerging market bonds and equities to underperform as an asset class in 1H11.”


The purpose of flagging this isn’t at all to take a victory lap, as our team full of washed-up collegiate athletes is prone to do. Rather, it is merely to highlight the sheer amount of time that economic fundamentals can remain supportive or unsupportive of certain markets and/or asset classes. Consensus can remain right for longer than we’ve been trained to anticipate.


As institutional investors, we systematically choose to fade visible fundamentals in expectation that whatever news (good or bad) will eventually become priced in before the river card is revealed. This technique is certainly one that has been good to a great deal of investors, but today, Brazil is reminding us all that when growth is slowing and inflation remains sticky, valuation remains no catalyst on the long side. Furthermore, bad news/data can remain a headwind for a lot longer than we are paid to hope.


Brazil Cuts Rates Again

Consistent with our view that the King Dollar will receive a bid from monetary easing across the world – particularly in emerging markets – over the next 3-6 months, Banco Sentral do Brasil lowered the country’s benchmark interest rate, the SELIC, to 11.5%. This is the second cut YTD, after a -50bps reduction at the end of August. After eight hikes worth a cumulative +375bps in the recent tightening cycle, this latest cut is confirmation that the central bank is committed to its newly-adopted policy of lowering the country’s aggregate interest rate burden.


Brazil: A Case Study in Sticky Stagflation - 1


The central bank, which has repeatedly cited slower global growth and the potential for a Eurozone banking/sovereign debt crisis to send the world into another recession, may not be acting solely with the purpose of preemptively buffering Brazil’s economic growth. In recent months, there has been an immense amount of highly-publicized political pressure emanating from President Rousseff and her cabinet upon the central bank, now headed by Rousseff appointee Alexandre Tombini, to lower rates (email us for our expanded thoughts on this topic).


It’s worth highlighting that Brazil, which runs a primary budget surplus of 2-4% of GDP consistently runs a budget deficit in the 2-4% (of GDP) range – meaning that interest costs alone are roughly 4-6% of GDP on average. Rousseff, a self-proclaimed “woman of the people” would much prefer to use the interest expense savings on social spending, in addition to allocating more funds towards the government’s planned infrastructure initiatives over the next 2-4 years (email us for a copy of our Brazil Black Book, where we detail Brazil’s long-term infrastructure needs and plans).


Brazil: A Case Study in Sticky Stagflation - 2


Was It the Right Thing To Do?
Needless to say, with inflation at a six-year high of +7.3% YoY in September and, more importantly, directionally divergent from the central bank’s prior expectations of an August peak, the central bank’s rate cuts are making the more hawkish members of Brazil’s political and investment communities rather nervous. For example, inflation expectations as measured by the central bank’s weekly economist survey expect the country to miss the central bank’s 4.5% (+/- 200bps) inflation target this year for the first time since 2003. Moreover, they are now forecasting consumer prices to rise 5.61% in 2012 – a new YTD high.


Brazil: A Case Study in Sticky Stagflation - 3


We don’t really put much stock in economists or consensus numbers; we do, however, trust in [at least] the conviction behind forecasts when capital is at risk. For a more market-oriented measure of inflation expectations, we turn to the spread between inflation-linked bonds and interest rate futures as a gauge of what investors believe Brazil’s benchmark IPCA CPI index will average in a given period. On the two-year maturity, Brazil’s breakeven spread has widened +30bps since Aug 31st(the date of the previous SELIC cut). As the chart below shows, this contrasts with Brazil’s regional peers such as Chile and Mexico, who saw similar measures decline over that duration.


Brazil: A Case Study in Sticky Stagflation - 4


Uncontained loan growth and the potential for the government to overextend itself in the upcoming fiscal year are also supportive of rising inflation expectations. In the year-to-date through August, domestic credit is growing at an average rate of +20.4% YoY – 340bps higher than the central bank’s upwardly-revised forecast of 17%. Moreover, next year a roughly +14% increase in the country’s minimum wage and [already generous] pension payments – which are already the government’s largest expenditure by line item – should at the very least keep a floor under the demand-pull side of the inflation calculation in Brazil.


Brazil: A Case Study in Sticky Stagflation - 5


Nevertheless, the central bank remains committed to its goal of lowering inflation to the mid-point of its target by year-end 2012 – at least per the rhetoric from Tombini & Co. As highlighted above, it remains to be seen whether or not he’ll be able to meet that expectation by many in and around the Brazilian economy.


Brazil is country with a history of policy blunders, having seen a cumulative 13.3 trillion percent of inflation in the 15 years before the 1994 Real Plan (per Bloomberg). CPI, as measured by the benchmark IPCA index topped +17% on a YoY basis as recently as May ’03, meaning there are a lot people in the country who vividly remember the days of helplessly watching their life savings disappear on a real basis. As such, both the central bank and the government will be under enormous pressure from both markets and voters to make sure their forecasts for CPI prove accurate.


Risk Management Setup

From our perspective, the long and short of the situation in Brazil remains what it has been since we turned bearish on the country in 4Q10. While inflation is likely to have peaked in September according to our models, it is equally as likely to remain elevated and strictly over the intermediate term. Further, we see no reprieve on the growth front until at least a potential bottom in 1Q12E. There’s a lot of risk to manage in between now and then – assuming more recent data (the latest GDP report out is 2Q11) doesn’t push that catalyst farther out in duration.


Moreover, our high-conviction Key Macro Themes of King Dollar and Deflating the Inflation should continue to put downward pressure on the Brazilian real vs. the U.S. Dollar (BRL/USD), as rate cuts will erode demand for Brazilian assets on the margin and falling commodity prices (roughly half of Brazilian exports) will limit both demand for reais in the international marketplace and lower the government’s revenue – potentially eating away at its good-but-not-great fiscal positioning. As an aside, a Senate budget committee recently scored President Rousseff’s 2012 budget and decided that the deficit was likely to come in R$25.6 billion higher than expected due her overstating growth by 50bps (Senate 2012 GDP forecast is at 4.5% vs. Rousseff/Mantega at 5%).


Net-net-net, slowing growth and sticky inflation = Sticky Stagflation and that’s not something we expect many investors to find attractive. Moreover, both monetary and fiscal policy are proving to be incrementally negative for the Brazilian real (BRL/USD is down -12.3% over the last 3mo), another headwind to investing in Brazilian stocks for a U.S. domiciled investor. We expect these fundamentals to continue to weigh on Brazilian equities – which are flirting with a TRADE-line breakdown – over the intermediate-term TREND.


Darius Dale



Brazil: A Case Study in Sticky Stagflation - 6