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Conclusion: Price and issuance data out of Latin American credit markets suggest a more negative outlook for regional economic growth than do equity markets. Additionally, this week’s data analysis contains a handful of supportive nuggets for our King Dollar thesis.

 

PRICES RULE

Latin American equity markets were mixed last week, closing up +0.6% wk/wk on a median basis. The divergence between the three largest economies was striking: Mexico +2.4%; Brazil and Argentina down -0.2% and -0.4%, respectively. Mexico appears to have benefitted from some better-than-expected U.S. economic data last week.

The action in Latin American currency markets was a bit more muted, closing down only -0.1% wk/wk on a median basis. The Brazilian real outperformed, closing up +0.6% wk/wk.

There were a few notable moves across Latin American sovereign debt markets, headlined by the -26bps wk/wk drawdown in Brazil 2yr yields. Mexico, which got a bid largely due to the aforementioned factors, saw their longer maturities back up +18bps and +23bps on the 10yr and 30yr tenors, respectively. We saw similar divergences across Latin American interest rate swaps markets as well: Brazil -20bps tighter on the 1yr tenor; Colombia +35bps wider on the same maturity.

5yr CDS signaled a fairly dramatic heightening of risk across the region, widening +13% wk/wk on a median percentage basis. Keith has been vocal about the widening divergence between the credit markets and equity markets globally and our research, Virtual Portfolio, and Asset Allocation positioning all suggest we think the credit markets will continue to lead the equity markets down the road to perdition.

THE LEAST YOU NEED TO KNOW

Rather than delineate these data points by country, given the varying size and importance of these economies, we thought we’d try something different by grouping them by theme. Ideally, this should make it easier to absorb and contextualize anything of significance. Lastly, the callouts below are from the prior seven days:

Global Growth Slowing:

  • Brazilian retail sales growth slowed in Sept on both a real (+5.3% YoY vs. +6.3% prior) and volume-weighted basis (+4.8% YoY vs. +5.4% prior).
  • Even with total credit growth running 330bps higher than the central bank’s upwardly-revised 17% target in the YTD (through Sept), Brazilian policymakers are debating whether or not to remove the restrictions on credit they’ve imposed over the last year, which includes (but not limited to): increases to reserve and capital requirements and doubling a tax on consumer loans. The government may also consider implementing selective tax breaks on a per-industry basis. While a broad-based easing of regulatory policy is likely to be quite supportive for Brazilian economic growth, we think their desperation in the face of heightened inflation and heightening risk of adverse selection in credit extension speaks volumes to how sour the upcoming growth data in Brazil is likely to look. Patience will be key for those considering the long side of Brazilian equities at this juncture.
  • Mexican domestic vehicle sales and vehicle production growth both slowed in Oct; the former to +2.2% YoY (vs. +12.2% prior) and the latter to +9% YoY (vs. +14.1% prior).

Deflating the Inflation:

  • Brazil CPI slowed in Oct to +7% YoY vs. +7.3% prior – the first of what we expect are many sequential decelerations over the intermediate term.

King Dollar:

  • Petroleo Brasileiro SA saw its 3Q11 profit fall -26% YoY, as the real’s -17% decline in the quarter (vs. the USD) increased the company’s dollar-denominated debt service costs. Anticipating a breakout to new intermediate-term highs in the US Dollar Index, we remain bearish on emerging market equities due to many factors – not the least of which is the risk that FX translation imposes upon EM corporate earnings.
  • Contra-indicator: Demand for Mexico’s shortest term bills (28-day cetes), surged to 4.15x via the bid-to-cover ratio as investors bet increasingly on a peso rally. This was the highest total since July 26 – just prior to the global beta sell-off in late July/early Aug.
  • Mexican corporations are selling record amounts of peso bonds in the YTD (176.9 billion pesos), as rising dollar funding costs and global investor risk aversion contributes to a near-closure of Latin American international debt markets. The $9.33 billion in total issuance in the YTD is down -61% YoY. The rising scarcity of dollar-denominated issuance means a decreasing amount of USDs are being converted into EM currencies and an increasing amount of EM currencies being converted into USDs to meet debt service requirements (as opposed to dollar-based refinancing).
  • The decline in Argentina’s FX reserves and dollar deposits is accelerating, despite an aggressive sequence of government efforts to stem record capital flight. FX reserves have fallen -2% in the month-to-date to $46.6 billion, which is the largest 2wk drop since Oct ’08. Dollar deposits have declined -5% in the YTD (vs. -0.9% through Oct 28) as the newly-imposed, strict rules preventing easy transfer of money out of the country triggered bank runs – forcing Fernandez & Co. to lower the regulatory dollar reserve requirement ratio to 20% (from 100% prior) to help banks meet rising customer demand for cash. The FX market isn’t buying into the government’s manic efforts to prevent capital flight; 6mo peso non-deliverable forwards closed the week at 5.1150 – a -16.7% discount to last week’s closing spot price!

Sticky Stagflation:

  • Chilean CPI accelerated in Oct to +3.7% YoY (vs. +3.3% prior) – the highest since Apr ’09. No surprise to see this, as the prices of crude oil (Brent) increased +6.6% during the month. Consensus calls for further dollar debasement continue to weigh on international consumers.
  • Peru’s central bank, which is struggling with accelerating inflation into year-end as we had predicted, decided to keep rates on hold at 4.25% (rather than join Brazil in cutting).
  • Argentina is increasing peak electricity rates by +129% for large commercial users starting next month as a part of the plan to reduce energy subsidies nationwide. We expect to see some of these added operating expenses filter through to Argentinean consumers and slow real GDP growth on the margin – irrespective of the government’s made-up statistics.

Counterpoints:

  • Mexican industrial production growth accelerated in Sept to +3.6% YoY vs. +3.4% prior.

Other:

  • The Brazilian central bank, which has taken some heat for cutting interest rates in the face of near six-year highs in inflation, has confirmed that it is using a largely unproven economic model to calculate its monetary policy prescriptions. Their new, 18-variable DSGE model post-dates the analytical community’s 7-variable models and grants them a higher level of forecasting confidence in slowing inflation than currently exists in the Brazilian private-sector economist community. While we have been highly critical of Tombini succumbing to political pressure to lower the nation’s debt service burden, we commend him for standing by his evolved process in the face of groupthink and analytical complacency. Moreover, we continue to expect Brazilian inflation to make lower-highs over the intermediate term – putting our forecasts in line with their own.
  • Brazil is using to its worker’s compensation fund to buy up a record R$2.8 billion MBS in a plan to support homeownership by helping banks maintain funding for mortgage origination. As we detail in our Brazil Black Book, the country simply does not save enough on an aggregate basis to finance its robust portfolio of growth opportunities with domestic capital – hence the need to import capital from abroad. This makes Brazil especially vulnerable to the global risk appetite and capital markets volatility. To this point, only two Brazilian companies have issued dollar bonds since July 20; corporate and sovereign international debt sales are down -15.9% YoY in the YTD.
  • As mentioned before, Mexico’s proximity and leverage to the “safe-haven” that has become the U.S. economy in 2011 is helping it outperform its emerging market peers in the equity markets. Three-month implied volatility for the iShares MSCI Mexico Index Fund dropped to 6.58 points below the iShares MSCI Emerging Markets Index last week – the widest gap since Apr ’09. “Mexico is levered play on the U.S. economy,” remarks David Spegel, head of EM strategy at ING Groep NV.

Darius Dale

Analyst

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