Triangulating Latin America

Topics/Questions Addressed:

  • Does the Rally in Brazilian Equities Have Legs?
  • Is It Time to Hedge Against a Pullback Across EM Asset Classes?
  • Mexico’s Stagflation Problem

Does the Rally in Brazilian Equities Have Legs?

After being down just over -18% in 2011, Brazil’s benchmark equity index, the Bovespa, is off to a +16% start in the YTD. The question now, however, is: can the rally sustain itself? That is, are Brazil’s intermediate-term macro fundamentals strong enough to convince investors who may have missed the rally to participate?

Looking at how we screen for country-level opportunities, the quick answer is yes – for now. Our proprietary GROWTH/INFLATION/POLICY modeling puts Brazil in the equity-supportive Quadrants #4 and #1, in 1Q12 and 2Q12, respectively.

Triangulating Latin America - BRAZIL

Using this standardized framework allows us to efficiently vet where we could be wrong, which is what we spend the majority of our time researching.

From a policy perspective, Brazil looks to continue employing growth-supportive monetary and fiscal policy. Last week, the Finance Ministry unveiled R$55 billion in cuts from the 2012 budget (R$35B from discretionary spending; R$20B from mandatory programs) to continue making room for the central bank to ease monetary policy. Per Finance Minister Guido Mantega:

“With lower rates, the country will grow more… When the state saves more and inflation is falling in the country, we’re able to open room to reduce interest rates.”

His commentary is generally in line with how we view fiscal policy’s effect on rates of inflation within an economy. Turning back to the budget specifically, we see that social expenditures such as anti-poverty programs and construction of low-income housing were spared from the cuts. Populist measures like this will continue to give President Rousseff clout with Brazilian voters and strengthen her combative stance against corruption and union demands.

The budget does, however, assume +4.5% GDP growth for the year, which is ~100bps higher than our current projection (subject to change w/ new data), imposing the risk that they come in light on the revenue front should growth come in below the official target.

Looking at monetary policy, both pressure from Rousseff/Mantega and the central bank’s latest commentary suggest that Brazilian interest rates are headed lower in 2012 – perhaps even below 10% (from 10.5% currently), according the central bank’s “high probability” scenario. Brazilian rate markets continue to take fiscal and monetary policymakers’ guidance on interest rates quite literally, pricing in roughly -120bps of cuts over the NTM.

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Inflation is where we think Brazil could “miss” relative to current expectations. According to the same “high probability” scenario, Brazilian CPI is projected to fall to the mid-point of the target range of +4.5% +/- 200bps (from +6.2% YoY in JAN) by year-end. To put it simply, there is a near-Bernank (“zero percent”) chance that this will happen if global energy prices continue to make higher intermediate-term highs and remain in Bullish Formations quantitatively.

As of now, the Bovespa remains a semi-defensive play in a rising inflation environment, with 42.3% of the index’s market cap weighted to energy and basic material companies. At a point, however, rising profits at companies like Vale and Petrobras will come at the expense of the Brazilian consumer, producer, and economy at large. Additionally, we’d be remiss to forget that the Bovespa failed to participate in the 1H11 Global Inflation Trade, peaking in early NOV ’10 – just shortly after Qe2 was officially announced.

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All told, we continue to like Brazil fundamentally, but certainly not at every price and level of inflation expectations. What would get us to buy Brazil is twofold: 1) stability in the U.S. dollar (i.e. a TRADE-duration breakout); and 2) a subsequent deflating of the inflation to create lower, more attractive prices (Bovespa’s trailing 30-day correlation to DXY = -0.84). Our quantitative risk management levels on the Bovespa are included in the chart below.

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Is It Time to Hedge Against a Pullback Across EM Asset Classes?

Investors in emerging market assets have seen a fair amount of green on their screens in the YTD; to generalize:

  • The MSCI EM Equity Index is up +16.2%;
  • The Morgan Stanley EM Local Currency Debt Fund is up +18.4%; and
  • The JPMorgan EM Currency Index is up +6.8%.

While the long-term growth fundamentals remain supportive of EM perma-bull storytelling, it’s fair to attribute a good deal of this performance to a relief rally of sorts stemming from the waning of systemic pressure within the Eurozone (as quantified by the Euribor-OIS spread), as well as a dramatic decline in global cross-asset volatility. To measure the latter point, we’ve created a proprietary index that uses an unequally-weighted average of the following volatility indices:

  • CBOE SPX Volatility Index (VIX);
  • Merrill Lynch Treasury Option Volatility Estimate Index (MOVE);
  • CBOE Oil ETF Volatility Index (OVX);
  • JPMorgan Global FX Volatility Index; and
  • JPMorgan EM FX Volatility Index. 

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On this metric, global cross-asset volatility is down -18.2% in the YTD, making it easier for global investors to extend the duration of their research (obvious L/T bullish theses across the EM universe) and for EM corporates and sovereigns to raise capital. This intuitive interpretation is supported by the math: the MSCI EM Equity Index (as a rough proxy for EM assets) has a -0.88 correlation to our proprietary Global Macro Volatility Index on a trailing 3-year basis.

Importantly, our index is at levels last seen since JUL ’11. As risk managers, we should be asking ourselves if this level of cross-asset volatility is sustainable over the intermediate-term. While only a crystal ball would give us the rightful answer to this question, we can make educated guesses based on handicapping what we see as meaningful catalysts coming down the pike.

On this basis, a potential sovereign debt scare in Japan (MAR), a likely downward revision to China’s growth target (early MAR), and accelerating global stagflation on a rolling basis due to the perpetuation of Weak Dollar Policy out of the U.S. all suggest that continued lower-highs in cross-asset volatility is increasingly less likely over the intermediate term. Given, we would support being appropriately hedged against a correction across EM asset classes, which have historically been highly correlated as highlighted in the table below.

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Key breakdown levels to watch across the EM debt space are included in the charts below. Gol’s (Brazil’s 2nd-largest airline by market value) recently-shelved $200M perpetual bond offer and Argentine corporates continuing to be shut out international capital markets (five consecutive months w/o a deal being priced) could be canaries in the coal mine for broader weakness over the intermediate term.

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Mexico’s Stagflation Problem

Recently, Mexico reported that its Real GDP growth slowed to +3.7% YoY in 4Q11 vs. +4.5% in the prior quarter. Alongside a sequential acceleration in Headline YoY Inflation in the quarter, Mexico’s economy closed out 2011 in Quadrant #3 of our G.I.P. analysis. More importantly, adopting our model’s baseline estimates, the country looks to stay put throughout 1H12.

Triangulating Latin America - MEXICO

Flat-to-down JAN PMI data (Manufacturing flat and Services down -2.6 pts. MoM) and accelerating inflation (CPI +4.1% YoY vs. +3.8% prior) amid the worst drought on record (higher domestic food costs) suggests our baseline outlook is off to a fairly accurate start. Furthermore, from a modeling perspective, we risk not being aggressive enough to the downside and upside with our growth and inflation assumptions, respectively, in the face of what we’ve chosen to label as The Bernank Tax.

Mexican rate markets agree with our view that Mexico’s Indefinitely Dovish central bank (benchmark held at a record-low 4.5% since mid-’09) may have to, at a bare minimum, talk hawkishly in the face of CPI likely remaining above their upside target of +3-4% for the intermediate term. 1yr O/S interest rate swaps and 1yr L/C sovereign debt yields are pricing in +37bps and +1bps of tightening over the NTM and this spread has been making higher-lows since SEP – in the face of other Latin American economies’ spreads making lower-highs over the same duration.

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All told, Mexico is the Latin American economy we view most at risk of experiencing stagflation over the intermediate term; as such, we are unfavorably disposed to their equity market.

Fundamental Price Data

All % moves week-over-week unless otherwise specified.

  • EQUITIES:
    • Median: +0.8%
    • High: Colombia +2.6%
    • Low: Brazil, Mexico -0.5%
    • Callout: Mexico +2.6% YTD vs. a regional median of +16.3%
  • FX (vs. USD):
    • Median: +0.2%
    • High: Chilean peso +0.8%
    • Low: Argentine peso, Mexican peso -0.1%
    • Callout: Argentine peso -1.1% YTD vs. a regional median of +8.4%
  • S/T SOVEREIGN DEBT (2YR YIELD):
    • High: Colombia +22bps
    • Low: Mexico +1bps
    • Callout: Colombia up +32bps YTD vs. Brazil -69bps
  • L/T SOVEREIGN DEBT (10YR YIELD):
    • High: Mexico +4bps
    • Low: Brazil -2bps
    • Callout: Mexico +46bps over the last six months vs. Brazil -85bps
  • SOVEREIGN YIELD SPREADS (10s-2s):
    • High: Mexico +3bps
    • Low: Colombia -19bps
    • Callout: Mexico -7bps YTD vs. Brazil +43bps
  • 5YR CDS:
    • Median: -3.8%
    • High: Colombia -2.9%
    • Low: Chile -8.1%
    • Callout: Regional posting a YTD median decline of -16.9%
  • 1YR O/S INTEREST RATE SWAPS:
    • High: Chile +10bps
    • Low: Mexico -3bps
    • Callout: Colombia +70bps YTD vs. Brazil -78bps
  • O/N INTERBANK RATES:
    • High: Brazil +1bps
    • Low: Chile -9bps
    • Callout: Colombia +18bps YTD vs. Brazil -58bps
  • CORRELATION RISK: The MSCI Latin America Equity Index is trading with an inverse correlation to the U.S. Dollar Index of -0.87 on a trailing 30-day basis.

Darius Dale

Senior Analyst