Conclusion: We see limited downside in the Brazilian real over the intermediate term and, thus, remain bullish on Brazilian equities given the erosion of this headwind. Further, along with China, we view Brazil as the safest place to be in the EM space, from a fundamental perspective, over the intermediate term.
Virtual Portfolio Position: Long Brazilian equities (ETF: EWZ).
In recent weeks, Brazil’s Bovespa Index – a market we’ve explicitly favored on the long side since SEP ’11 – has come under a fair amount of selling pressure in recent weeks (down just over 9% from a MAR 13 cycle peak). We attribute this largely to weakness in the Brazilian real, which is down roughly -12% vs. the USD from a late-FEB cycle peak. The key issue here as it relates to the Brazilian equity market is two-fold:
- An increasingly subdued outlook for currency appreciation/an outlook for outright depreciation limits the appeal of Brazilian assets to international investors.
- A weaker currency – particularly vs. the USD – drives up the cost of servicing international debt as well as expenditures on FX and interest rate hedging for Brazilian corporations. All of this acts as a headwind to earnings growth.
To point #1, net foreign inflows into the Bovespa Stock Exchange were negative in MAR (-R$1.29B) and for a large portion of APR, where late-month buying saw the month finish with a net positive inflow of R$474M – just 36.6% of the previous month’s outflows. Additionally, aside from the Argentine peso (currency of a country with a host of serious issues to contend with), the Brazilian real screens most bearishly from a market perspective over the NTM across our investable EM coverage universe.
To point #2, Brazil has the second-highest real interest rate in the developing world at 3.76% (behind Russia’s 4.30%); this forces a great many domestic borrowers to turn offshore for sources of cheaper capital – particularly in the USD debt market, where Brazilian issuers have sold a record $27.35B of USD-denominated debt in international markets in 1H12. Those repatriated inflows have slowed dramatically in recent weeks, however, with only $1.75B of that coming since the end of MAR.
We interpret that last nugget in two ways – one negative and one positive:
- It suggests international capital markets are drying up – which they indeed are. Per Bloomberg, global issuance of junk-rated USD-denominated debt fell -27% MoM in APR as those bonds fell -1.1% (per a Credit Suisse index) – good for the largest monthly decline since NOV. No junk-rated Brazilian company has been able to price a deal since Magnesita Refratarios SA’s MAR 30 sale of $250 million worth of notes.
- Brazilian corporates, which rushed to take advantage of the window of opportunity afforded them in the global low-volatility environment at the beginning of the year, simply have lower near-term borrowing needs. Brazil’s lowly $1.6B worth of APR issuance contrasts with a record $15.5B of issuance out of Asian corporate borrowers for the month – many of whom may be accelerating issuance to get ahead of what we’ve identified a probable breakout in global volatility/widening of credit spreads over the intermediate term. Net-net, the Brazilian real, which has underperformed every EM currency (vs. the USD) over the last three months appears to have limited downside from a capital inflows perspective, given that Brazil has front-run a slowdown in the repatriation of international capital that looks to impact other EMs in the coming months.
Getting back to point #2 above, we look no further than the recent string of bad operating results out of companies like Vale SA (world’s largest iron ore producer), Fibria Celulose SA (world’s largest pulpmaker) and Telemar Norte Leste SA as proof of what weakness in the BRL/USD cross has done to corporate profits in Brazil. In fact, in the three quarters through 1Q12, YoY growth in Bovespa EPS (which has averaged -39.6% in that time frame) has trailed YoY growth in revenues and EBITDA by an average of 5,877bps and 2,809bps, respectively – largely highlighting the impact interest payments and other non-operating expenses have had on corporate earnings in Brazil.
Importantly, as the currency’s decline slows and finds a bottom (likely well ahead of other EM currencies), we anticipate that the erosion of this massive headwall (“headwall” > “headwind”) will become a pseudo tailwind, on the margin, for Brazilian equities. The next few paragraphs detail why we think the Brazilian real has limited downside from here (vs. the USD, relative to other EM currencies) over the intermediate term.
Looking to our proprietary G/I/P analysis, our predictive tracking algorithms suggests Brazil’s monetary easing cycle will trough here in 2Q12 and likely shift the central bank’s policy bias to neutral through the remainder of the year.
Central Bank President Alexandre Tombini has presided over -350bps of interest rate cuts since we first signaled that their policy bias would shift to dovish in AUG ’11. Thus, it appears increasingly likely that his board is close to entering a period of respite in order to judiciously monitor the pass-through effects of these previous rate cuts. Further, given the mere 25bps of proximity the Selic currently has to its Financial Crisis trough of 8.75% (an all-time low), we think incremental cuts may be viewed as an unwanted signal of fear and/or desperation out of the central bank that could threaten its credibility – especially given the politicized nature of the aforementioned rate cuts (essentially at President Rousseff and Finance Minister Mantega’s constant urging).
Per the central bank’s own survey (latest poll conducted on APR 27), domestic inflation expectations over the NTM are far from far tame, having increased each week since mid-FEB. This jives with our long-term view on the domestic inflationary pressures within the Brazilian economy; there’s simply too little slack throughout several key areas in the economy to convince market participants that “everything’s under control” from a long-term inflation expectations perspective. We walk though this topic in great detail in our 75-slide Black Book on Brazil titled “The Roadmap for Investing in Brazil”; please email us for copies in the event you missed it come through live in AUG ’11.
Additionally, recent weakness in the BRL/USD cross is eroding the currency’s marginal strength relative to global food and energy prices – which serves to threaten reported inflation statistics to the upside in the coming months. Notably, the IGP-M inflation index, which has been known to lead the benchmark IPCA CPI index by 2-6 months, bottomed in MAR. While we don’t see material upside in Brazil’s headline inflation rate over the intermediate term, this data point is in support of our model’s view that Brazilian CPI bottoms here in 2Q and accelerates in the back half of the year – likely preventing the central bank from reaching the midpoint of its inflation target of +4.5% (+/- 200bps), which it has repeatedly promised to accomplish by year’s end.
If Tombini’s cutting-edge SAMBA (Stochastic Analytical Model with a Bayesian Approach) forecasting techniques start to jive with our own quantitatively-based G/I/P outlook and support a marginally-hawkish shift to a neutral policy stance, we would expect Brazil’s interest rate and FX markets to respond accordingly. The one wild card here remains Finance Minister Guido Mantega and his politicized drive to weaken the real to protect Brazilian manufacturers and exporters from what he and President Rousseff have publically identified as a “currency war” beget by a “very adverse; very perverse” flood of international liquidity stemming from a developed-world “monetary tsunami” (i.e. QEs, LTROs, APPs, etc.).
As highlighted earlier, the slowdown of inflows of foreign capital/demand from Brazilian corporations to issue abroad largely coincided with Mantega’s broadening of the scope of the country’s financial transactions (IOF) tax in FEB. The new requirements force Brazilian corporations to pay 6% on international loans proceeds with maturities up to five years (from one year and then three years prior). This is on top of a 6% tax rate on foreign investor proceeds from investment in Brazil’s domestic fixed income market, a 6% tax rate on foreign investor’s margin deposits for futures contracts, and a 6.38% tax on foreign credit card purchases.
On positive in all of this is that Mantega has been known to completely rescind iterations of the IOF tax, as he did with the IOF tax on foreign investor equity transactions back in NOV. His own commentary leads us to believe he’s likely to reverse his harsh stance against currency appreciation alongside any confirmation/urging from the central bank in the coming months:
“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.”
All told, we’re buying Brazil for a trade here, though our bullish fundamental outlook suggests we could hold it for longer if the quantitative setup shifts in our favor. Our proprietary risk management levels for the iShares MSCI Brazil Index Fund are included in the following chart:
Lastly, before we conclude this note, we wanted to share with those of you who follow Brazil closely our own “nuggets” which Moshe Silver, Hedgeye’s Portuguese-speaking Chief Compliance Officer, mines the Brazilian local press each day for relevant economic and political commentary. We always find local market color to be additive to our research process, so we wanted to share with you a few of his more interesting callouts from recent weeks:
- SELIC and savings – on the heels of yesterday’s cut in the SELIC rate to 9%, O Globo columnist Miriam Leitao presents an analysis of the effect of reducing the SELIC rate on personal savings in Brazil. She says that fluctuations in the SELIC rate can drive average returns on investment funds below the returns on normal savings accounts. Profits from investment funds are taxed at rates ranging between 15%-22.5%, while savings accounts are not subject to tax. Leitao quotes a study that finds 16 out of 20 scenarios in which a passbook savings account has a better return than average securities investments, with the SELIC at 9%. If there were a rush to passbook savings accounts, writes Leitao, funds available for real estate lending would swell, as banks are required to make 65% of savings account assets available for real estate loans. The government has to be careful, says Leitao: if they make savings accounts too attractive, it could disrupt the market for public debt, which is largely owned by investment funds and banks. Leitao says the government will have to find a workable resolution to this situation. Without it they will be in a bind and unable to continue to lower rates.
- President Rousseff to announce savings policy – Brazil’s president Rousseff is set to announce new government policies covering personal savings accounts. Reported in Veja, President Rousseff looks set to upset a large number of her citizens as she announces changes to passbook savings accounts designed to reduce the profitability of the accounts. Observers say Rousseff is forced into this – introducing a wildly unpopular policy in the middle of an election year – because reducing the profitability on savings accounts is the only way to prevent “a stampede” of investors out of the fixed income investment funds, which are seen as critical to enabling the government to roll its billions in federal debt issues. According to Veja, there are 10,800 private funds, which invest principally in government paper. 22% of these funds invest in federal debt – but they represent 65% of the total R$ 1.85 trillion invested.
- Central bank cautious on rates – the latest central bank COPOM monetary policy committee minutes released this week said “given the cumulative effects and in view of the policy measures implemented to date, any further monetary easing should be undertaken with moderation,” leading observers to say further rate cuts will depend on the pace of recovery in Brazil’s economy.
- Transportation – President Rousseff proposed a R$ 32 billion package for urban transportation projects, saying funds should especially be directed to metro projects – again, though not explicitly stated, it is clear the country’s major cities do not have sufficient urban transport facilities for the World Cup.
- Tax breaks for industry – finance minister Guido Mantega said payroll taxes will be reduced starting in July in the textile, auto parts, aerospace, footwear, and capital goods sectors, among others. Mantega also said subsidies will be increased for the manufacturing sector and for exporters who have suffered because of the appreciation of Brazil’s currency.
- Social spending at record high – the government’s Minha Casa, Minha Vida (“My House, My Life”) cash transfer program spent at record levels in the first quarter of 2012, laying out more than R$ 5 billion, which is more than five times the spending for the same period a year ago, and nearly half the budget allocation for this program over the next three years. It was not reported how the government intends to account for expenditures going forward, but we remind readers that off-budget facilities that are routinely applied to social programs, a “spend today, figure it out tomorrow” approach that Brazil still has not managed to shake.
- Government to capitalize banks – Brazil’s major state owned banks, Caixa and Banco do Brasil, are discussing cuts in the rates in their credit lines. As part of the government’s program to reduce banking spreads, the treasury is contemplating additional financing if the cuts in credit spreads affect the banks’ capitalization as required under Basel 3. The issue of government guarantees becomes more important for Brazil’s private banks. Before the 2008/2009 financial crisis, state-owned banks had issued about 30% of total credit. That is now up to 43%. Private banks have suffered greater rates of delinquencies and defaults. If the credit spreads are to be brought down further, they fear they will not have the profit cushion to permit them to operate.