Topics discussed this week:
- Refreshing Our View on Brazilian Equities
- Staying Afloat In EMs Amid A Flood Of Liquidity
- Default or Hyperinflation?: Argentina’s Tough Choice
Refreshing Our View on Brazilian Equities
Later today, Brazil’s central bank is likely to dip into historically rare territory by lowering its benchmark monetary policy rate (the Selic) to ~10%, which is only a mere 125bps above its all-time low of 8.75% (2009-10). Such a cut would be a continuation of a highly-politicized series of interest rate cuts designed to accomplish three very important political initiatives. In addition to lowering the interest burden within government expenditures, the central bank looks to:
- Spur Brazilian economic growth: In 2011, the Brazilian economy grew by +2.8%, which, barring 2009, is the slowest rate of Real GDP growth in Brazil since 2003. Moreover, default rates on consumer credit have risen to a 2yr high of 7.6% per the latest data, further incentivizing the central bank to maintain its trend of easing monetary policy. We are, however, starting to see some positive effects of recent monetary easing, with Brazil’s PMI indices making higher-highs since SEP; and
- Quash speculative capital inflows: The Brazilian real has appreciated +5.6% YTD, largely on the strength of a marked acceleration in foreign portfolio investment targeting some exposure to the G20’s highest real benchmark yield (4.3%). In just the YTD alone, Brazilian issuers have issued $19.1B in USD-denominated debt to circumvent the relative tightness of domestic monetary conditions (the proceeds of which subsequently get repatriated, boosting the currency further). That sum is on pace to overtake the record for issuance in a half-year period, which was set back in 1H11 – not coincidentally during the Federal Reserve’s second round of Quantitative Easing. Looking to Brazilian equities, R$6.1 billion have flowed into Brazil’s equity market through FEB, which is the highest JAN+FEB total ever (data going back to JAN ’08).
To help accomplish stated goal #2, Brazil’s government recently instituted a tax on foreign financing that matures in 3yrs or less, a figure that’s as high as 6% for Brazilian exporters’ loans under advanced payment agreements within 360 days. In conjunction with the announcement, Finance Minister Guido Mantega said:
“The [Brazilian] government won’t be a passive observer in this currency war. The government will continue to take measures to prevent the real from strengthening, from hurting Brazil’s manufacturers.”
His statement echoes tightly with President Rousseff’s recent commentary (courtesy of our Portuguese-speaking Chief Compliance Officer, Moshe Silver, who regularly mines the Brazilian local press for value-added data points):
- “There is a currency war based on an expansionary monetary policy that creates unfair conditions for competition.”
- “Developed nations literally poured $4.7 trillion out into the world in a very adverse, very perverse, way.”
- “Developed countries are relying on absolutely irresponsible monetary policy to compensate for the lack of room to use public spending to shore up economic growth.”
- “Brazil needs to create tools to combat perverse policies being implemented by rich economies, such as the European Union, that are flooding the world with dollars… We need to create other tools to fight against the consequences of policies that are increasing global liquidity.”
Of course, the risk to the Brazilian economy is that policymakers overshoot their monetary easing and capital controls, which would cause them to have to dramatically reverse course on the former should another large-scale asset purchase program get implemented by the Fed or another large central bank.
While our models point to a continued benign outlook for Brazilian inflation over the intermediate-term, we’d be remiss to ignore the risk that a Qe3 would pose to Brazil and other emerging economies by, once again, stoking inflation and forcing them to tighten monetary policy. Recall that, from a price, Qe2 got us broadly bearish on EM equities and L/C fixed income (Brazil in particular) in NOV ’10.
Given its underappreciated role in setting global food and energy prices, the USD remains our key focus and its recent stability affords Brazil additional headroom to continue easing monetary policy in support of economic growth – which is exactly what Brazilian interest rate markets have been signaling of late. Thus, from a fundamental GROWTH/INFLATION/POLICY perspective, we remain favorably disposed to Brazilian equities on an intermediate-term TREND duration.
Staying Afloat In EMs Amid A Flood Of Liquidity
As we mention in the previous section, the seemingly ever-growing pool of excess liquidity emanating from DM monetary policy creates systemic risk across emerging markets – particularly due to developed-world investors using easing speculation as an excuse to bid up EM assets under the tired guise of mistaking accelerating inflation for faster economic growth.
In recent Early Looks and intra-day research notes, we have been very critical of this practice, especially given that 2012 has the potential for consensus to repeat the broad mistakes of 2008 and 2011. That said, we’re all in the business of making money at the end of the day; thus, it helps to have a strategy to properly contextualize what further dollar-debauchery could look like from here (see: intraday Qe3 speculation).
Over a short-term duration, we know that investors will chase yield shortly after an announcement is made. Using the MSCI Latin America equity index as a proxy for the region, Latin American equities rallied +18.6% from Jackson Hole ’10 to their cyclical peak in APR ‘11. The equity peak was led by Latin American L/C bond yields by nearly a full month.
Going back to our point on accelerating inflation and inflation expectations, Latin American currencies, which appreciated vs. the dollar over that same duration due to an obvious acceleration of capital inflows, simply do not have enough juice to keep pace with higher-beta global food and energy prices. This dramatic underperformance resulted in regional inflation readings accelerating sequentially and widespread monetary policy tightening.
Looking to the current setup, our models suggest that, with the exception of Mexico, Latin American YoY CPI readings will continue to make lower-highs – at least for the next quarter or so. This, coupled with their currencies’ relative outperformance of global energy prices and absolute outperformance of global food prices, suggests a favorable outlook for Latin American economies from a monetary policy perspective (i.e. easing speculation will continue to dominate the headline risk).
Of course, at a point, the opposite will be the case; but as we saw in late ‘10/early ’11, it will pay to manage risk appropriately on the misguided melt-up, insomuch as it will pay to [eventually] be appropriately positioned for the fundamentally-driven melt-down in the event further Qe becomes a high-probability scenario.
Default or Hyperinflation?: Argentina’s Tough Choice
Since her election win in the fall of last year, Argentine President Cristina Fernandez de Kirchner has made a plethora of headlines with her policy intervention and aggressive regulatory changes – all designed to spur financial repression, quell capital outflows, and build FX reserves.
To say that she has been successful in achieving her goals would be largely an understatement; capital flight slowed in 4Q11 to $3.3B – down from a record pace earlier in the year – finishing 2011 at $21.5B, just shy of the 2008 record of $23.1B. The marginal increase in the supply of pesos in the economy helped to depress the rate Argentine banks must pay for 1-month peso deposits > $1M down to 13% from a cyclical peak of 22.9% in NOV. Additionally, the artificial, one-way flow of capital allowed the central bank to arrest the decline in its FX reserves, which bottomed out in DEC at $44.7B and are now at $46.8B per the latest data.
Despite all of her aggressive maneuvers, Fernandez’ goal of rebuilding Argentine FX reserves to a level consistent with her wishes remains elusive. Argentina, which remains one of the few countries willing to risk using their FX reserves to service external debt, needs to see “free and available” reserves (i.e. FX reserves in excess of the monetary base) substantially higher than the current $109.6M in order to meet a budgeted $5.7B payment on the country’s dollar bonds in 2012.
As such, we, and the forex market, continue to expect additional currency devaluation in the event Argentina is unable to grow its existing stock of FX reserves the old-fashioned way (through accelerating export growth). It’s no surprise to see the Argentine peso underperform the region’s currencies in the YTD, falling -0.6% vs. a regional median gain of +5.9%.
While a “controlled” currency devaluation is certainly no laughing matter, that is not the largest risk facing the Argentine economy at this current juncture; accelerated interventionist measures out of the Fernandez regime risk a more permanent brand of capital flight as international investors lose faith in the projected long-term returns on and of capital from investing in the country. Most disconcerting is Fernandez’ recent proposal to Congress to revoke the “free and available” clause from the 1991 Dollar-Convertibility Law, which would imply that she is seeking access to all of Argentina’s FX reserves in order to service debt.
It’s important to remember that the law was put in place after Argentine consumer prices surged +1,300% in 1990 amid rapid currency devaluation. Moreover, an assault on the country’s FX reserves, which have historically been used to shield EM currencies from aggressive sell-offs, would likely drive investors to lose confidence in the long-term sustainability of the Argentine peso, risking another episode of hyperinflation or draconian monetary tightening to ward off that outcome.
All told, investors in Argentine peso-denominated assets clearly have a vested interest in seeing Fernandez fail on her latest policy initiative. Her success could spell disaster for the Argentine economy over the long-term TAIL.
Fundamental Price Data
All % moves week-over-week unless otherwise specified.
- Median: -0.2%
- High: Venezuela +6.5%
- Low: Chile -1.2%
- Callout: Argentina down -22.5% over the LTM vs. a regional median decline of -1.5%
- FX (vs. USD):
- Median: -0.1%
- High: Argentine peso +0.5%
- Low: Brazilian real -2.7%
- Callout: Argentine peso -7.1% over the LTM – the worst performer in the region over that duration
- S/T SOVEREIGN DEBT (2YR YIELD):
- High: Mexico -1bps
- Low: Colombia -15bps
- Callout: Brazil -302bps over the LTM vs. Colombia +98bps
- L/T SOVEREIGN DEBT (10YR YIELD):
- High: Colombia flat wk/wk
- Low: Mexico -4bps wk/wk
- Callout: Mexico -30bps YTD vs. Brazil -4bps
- SOVEREIGN YIELD SPREADS (10s-2s):
- High: Colombia +15bps
- Low: Mexico -3bps
- Callout: Mexico -11bps YTD vs. Brazil +65bps
- 5YR CDS:
- Median: -0.4%
- High: Venezuela +3%
- Low: Peru -2%
- Callout: Venezuela -27.9% over the LTM vs. a regional median gain of +21.4%
- 1YR O/S INTEREST RATE SWAPS:
- High: Chile +4bps
- Low: Brazil -29bps
- Callout: Swaps traders are pricing in -155bps of rate cuts over the NTM vs. +36bps of rate hikes in Mexico.
- O/N INTERBANK RATES:
- High: Chile +8bps
- Low: Argentina -40bps
- Callout: Colombia +202bps over the LTM vs. -142bps in Brazil
- CORRELATION RISK: Given the widespread addiction to cheap money asset reflation, it’s no surprise to see the MSCI Latin American Equity Index’s inverse correlation to the DXY strengthen over shorter durations (from -0.43 over a 30-day study to -0.57 over a 15-day study).