Conclusion: All told, we continue to view Brazil’s intermediate term economic outlook as supportive for Brazilian equities over that duration and, while the recent spate of Big Government Intervention has cast a dark cloud of regulatory uncertainty over Brazilian assets and introduced new risks to Brazil’s economy over the long term, our analysis suggests concerns here are vastly overblown – creating a fair amount of asymmetry between what’s being priced in relative to Brazil’s fundamental outlook.
Virtual Portfolio Position: Long Brazilian equities (EWZ).
While we pride ourselves on the highly differentiated nature of our Global Macro research, one certainly does not require a three-factor quant model borne out of the principles of chaos theory to know that this isn’t good:
Per the MSCI index in the chart above, Brazilian Financials stocks have retraced roughly 90% of their gains from their SEP ’11 trough in just over two months – largely on the strength of the central government’s plan drive down interest rates throughout the Brazilian economy, which will ultimately put a great deal of pressure on the profitability Brazil’s domestic banking sector.
Per President Rousseff: “[Brazil] will only be competitive when interest rates fall to global levels.” Per Nelson Barbosa, her Secretary for Macroeconomic Policy at the Ministry of Finance, last week’s changes to the 150-year-old savings account minimum return mandate (“poupanca” was reduced to 70% of SELIC rate when it falls < 8.5% vs. 7.3% per annum previously) will leave room for the benchmark SELIC rate to be cut to “as low as it needs to go”. According to the MOF spokespeople, lower interest rates will reduce pressure on debtors across all sectors, which, in turn, will drive down default rates – which have trended up over the last ~18 months and now rest at 5.7% across the entire banking system – and ultimately allow banks to maintain reasonable profit growth by accelerating underwriting into a healthier, more robust economy.
It’s clear that Rousseff and Co. are making a enormously “levered” bet on the Brazilian and its ability to repay debt in a lower interest rate environment. If they are right, Brazilian economic growth could accelerate to new heights over the long term, putting Brazil on par with some of its faster-growing “BRIC” competitors.
On the flip side, their politicized reforms could ultimately backfire and spur higher rates of inflation as credit and consumption growth expand faster than growth rates of productive capacity and/or the real continues to make a series of lower-highs over the long term as Brazil’s global real interest rate advantage (2nd highest globally) is eroded on top of global investors increasingly shunning Brazilian assets due to accelerating political interference (see: Value CEO ouster, IOF tax hikes and now this state-directed crusade to lower interest rates). Recent USD-debt issuance trends and Bovespa net flows data help elucidate the ill-effect the latest round of capital controls and Big Government Intervention have had on Brazil’s foreign investment inflows:
A banking crisis is also a heightened tail risk in any downside economic scenario over the long term if heightened liquidity temporarily masks an erosion of credit quality across the industry (i.e. systematic “adverse selection”).
As usual, time will reveal all truths. Right now, however, our task as Global Macro risk managers is to figure out what’s priced in and make a call on the more probable of the aforementioned scenarios from here.
WHAT’S PRICED IN?
Alluding to the chart above, it wouldn’t be a stretch to suggest that a secular narrowing of Net Interest Margins (NIMs) is in store for Brazilian banks as the government forces the industry to lower lending rates (likely affecting private banks via increased competition from state banks). Average interest rates on Brazilian loans were 37.3% per the latest report (MAR) – good for a 2,830bps cushion above the SELIC.
Looking at NIMs from a more traditional perspective, Brazilian banks in aggregate enjoy an average NIM of 2,800bps (MAR). Interestingly, this ratio has stayed largely flat over the past 10+ years, despite the SELIC rate being cut by nearly two-thirds over this time period. Also interesting, when analyzing NIM by sector (though not necessarily how it’s done in actuality), the spread between consumer lending and deposit rates has trended down over time roughly in line with the fall in the SELIC; a similar spread has trended UP over time in corporate credit operations.
Looking at inflation, both Brazil’s 2015 Breakeven Inflation Rate and L/T sovereign debt yields have actually trended down over the last two months – suggesting that long-term inflation expectations in the Brazilian fixed income market are not currently being exacerbated by the aforementioned drive to lower interest rates. This is a noteworthy signal, given that roughly 20yrs ago, the Brazilian economy was experiencing severe hyperinflation, which itself was buoyed by rapid credit expansion (YoY growth north of +4,000%!).
It could be argued, however, that the Brazilian central bank has become completely politicized, and any policy response to inflation will be both muted and delayed – thus suppressing the signaling ability of the Brazilian interest rate curve. While we stand counter to this view, investors would be keen to keep an eye on real asset prices in the Brazilian economy. Housing inflation accelerated dramatically to +12-13% per year during Brazil’s 2002-03 inflation scare (CPI peaked at +17.2% YoY in MAY ’03), which was largely predicated by a -47% fall/devaluation of the BRL vs. the USD during the global EM scare and ahead of the Lula presidency.
To many in Brazil, these events and the hyperinflation saga of the 1990’s are not far enough in the past to escape the cognitive anchoring that naturally occurs with Big Government Intervention targeting lower rates of both interest and foreign exchange – of which current market expectations over the NTM are for -100bps and -5.4% (via 1yr OIS and 12mo USD/BRL forward rates). We continue to view the market sentiment here as both extreme and asymmetric, given where our predictive tracking algorithms suggest the slopes of Brazilian economic growth and inflation are headed over the intermediate term. Refer to our MAY 3 note titled, “What the Heck Is Going On In Brazil?” for more details regarding this topic and our bull thesis on Brazil from here.
Per the latest central bank minutes: “… even considering that the activity recovery has occurred more slowly than anticipated, the Committee believes that, given the cumulative and lagged effects of policy actions implemented so far [i.e. 350bps of rate cuts], any movement of additional monetary easing should be conducted with parsimony.” Brazilian FX and interest rate markets are pricing in far more easing than suggested by the central bank’s guidance – an event that could lead to, at a bare minimum, a floor in the BRL/USD cross in short-to-intermediate term. We walk through precisely how this event would be supportive of Brazilian equities (via a positive inflection in earnings growth) in the aforementioned note.
WHICH SCENARIO IS MORE PROBABLE?
We’ve already alluded to the more negative of the two scenarios laid about above, which leaves the positive scenario as the one in which we view as more probable over the long term. We are currently long (and wrong) Brazilian stocks in our Virtual Portfolio as a way to play what we view as a highly probable positive inflection point in Brazil’s economic fundamentals over the intermediate term. Thus, we are aware that our positioning might cause some clients to question whether or not we’re viewing the recent spate of policy maneuvers out of Brazil with an Optimistic Bias.
While we wouldn’t refute that as being a risk, our analytical integrity will always trump any Virtual Portfolio trade or research call we make; Brazil here is no exception and we’ll happily book the loss if it becomes clear to us that the government has no plan to combat the key risks we’ve highlighted above. For now, we are comfortable giving Brazilian policymakers the benefit of the doubt, given that they have shown us they can go both ways on both the fiscal and monetary policy front, depending on what the Brazilian economy has required, since Rousseff and her team took over the reins.
Taking a “glass half full” approach to the recent events, it’s clear to us that Brazil has an enormous opportunity to grow its economy by easing liquidity conditions, though this gain is likely to come at the expense of Brazil’s relatively high Return On Equity (ROE) across the banking sector. Still, one man’s trash is another man’s treasure; despite having a consumer debt service burden that is twice that of the US, Brazil’s aggregate consumer indebtedness and mortgage burden are a fifth and a fourth of their US equivalent ratios, respectively. While no doubt an apples-to-oranges comparison, we accept the US as an easily-digestible proxy of what Brazil could become given this hyper focus on improving domestic financial conditions and international competitiveness.
Credit growth – particularly in the consumer sector where growth has slowed by over one-third since peaking in FEB ’11 – could be poised to rebound in the coming quarters amid incessant urging from the central government and increased public/private competition among Brazilian banks. We’d be remiss to ignore the fact that during the Global Financial Crisis the Bovespa Index bottomed in OCT ’08 – well ahead of other global equity markets – as rapid [state-urged] credit expansion helped mitigate the effects of the Great Recession upon the Brazilian economy.
As an aside, Brazil has developed a tendency to cyclically trough well ahead of other global equity markets during the recent Global Macro summertime selloffs (OCT ’08, MAY ’10 and early AUG ’11).
Ironically, one area where the government’s recent drive to lower interest rates is potentially being dramatically mispriced is on the currency front. Our analysis shows the BRL/USD cross to be positively correlated with a narrowing of the Brazilian central government budget deficit – which would be a natural byproduct of a lower interest rate environment (assuming Rousseff and Mantega maintain their pledge to be fiscally hawkish). Brazil, which has enjoyed a persistent primary surplus of around +3-4% of GDP over the last 10+ years, has posted fairly wide budget deficits ranging from (2%)-(6%) of GDP over that same duration. This is a direct function of Brazil’s elevated interest expense burden, which has ranged from +5-9% of GDP over the last 10+ years.
Net-net, any move toward fiscal tightening will help offset any inflationary pressures being introduced by this pending acceleration in liquidity throughout the economy.
All told, we continue to view Brazil’s intermediate term economic outlook as supportive for Brazilian equities over that duration and, while the recent spate of Big Government Intervention has cast a dark cloud of regulatory uncertainty over Brazilian assets and introduced new risks to Brazil’s economy over the long term, our analysis suggests concerns here are vastly overblown – creating a fair amount of asymmetry between what’s being priced in relative to Brazil’s fundamental outlook.
Have a great weekend,