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Capital Flight

This note was originally published at 8am on April 30, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“Capital flight is a traditional response to currency collapse.”

-Jim Rickards

 

During most “bull” markets you see a decisively bullish pattern of rising volumes and fund flows to those markets. Not this one.

 

Not in Venezuela either. While Chavez has been less subtle about devaluing Venezuela’s currency than Ben Bernanke has ours, at up +121% for 2012 YTD, the fund flows to the Venezuelan stock market are as dead as Keynes too.

 

The failed political strategy of inflating asset prices via Currency Debauchery is not new. Neither is the hyperinflation sometimes born out of those strategies. As Jim Rickards reminds us in Currency Wars, “In 1922, the inflation turned to hyperinflation as the Reichsbank gave up trying to control the situation and printed money frantically…” (page 59)

 

Back to the Global Macro Grind

 

Don’t worry, we don’t have hyperinflation in the USA yet. Nor are we likely to if the Global Macro Ball that is being held underwater (the US Dollar) suddenly pops up. That, last I checked, has Deflated The Inflation in a hurry, multiple times in the last 5 years. So manage your risk accordingly.

 

People aren’t stupid. If you burn their bucks with broken promises of iQe upgrades over, and over, and over again – they’ll stop giving you their hard earned Dollars to burn. Selling Commodities and Equities into their Q1 tops of 2008, 2010, 2011 proved to be very smart 3-6 month timing decisions. When it comes to the pending flight of your capital, you don’t want to miss that flight.

 

Last week’s rally in asset price inflation was trivial. As the US Economic data worsened, expectations for iQe4 rose. Whenever that happens – and it has happened multiple times in the last 5yrs – the US Dollar goes down, and asset prices catch another lower volume bid. In context, here’s how that looked last week:

  1. US Dollar = down another -0.6% to $78.71 (down for 6 of the last 7 weeks)
  2. SP500 = up +1.8% (getting back to flat for April, right on time, into month-end)
  3. CRB Commodities Index = +1.4% (led by Natural Gas, up +14% on the week)

Now political people really like to argue with me on this, primarily because I’m holding them accountable for not only Policies To Inflate, but also A) the shortened economic cycles and B) amplified market volatilities born out of their policies.

 

Fortunately, the data doesn’t lie; politicians do. Growth Slowing again is as obvious as the sun rising in the East. If an un-elected Central Planner in Chief didn’t arbitrarily decide to move the goal posts on January 25th, 2012 (pushing easy money to 2014), I don’t think the US Dollar would have had this decline – and I don’t think US Growth would have slowed like it just did.

 

Here’s what US GDP Growth looked like in Q1 of 2012:

  1. Q1 2012 GDP slowed to 2.2% from 3.0% in Q4 of 2011
  2. Q1 US Fixed Investment Growth slowed to 0.18% from 0.78% in Q4 of 2011
  3. Q1 US Export/Import Growth accelerated to -0.01% from -0.26% in Q4 of 2011

Ah, the elixir of a Keynesian life – Exports. Yes, in their textbook it says that if you devalue the currency of a country, you will “boost” exports. Ok, sounds good – but it has not and will not work in the United States of America if the broken promise is to keep doing this with the US Dollar testing 40 year lows.

 

Consumption and Investment drive the US Economy, not Government and Currency Devaluation. If you perpetuate spikes in price inflation, Consumption will fall. If you perpetuate economic volatility, Fixed Investment will slow.

 

US Consumption = 71% of US GDP. That’s why gas prices matter so much to real (inflation adjusted) US GDP Growth. Sure, Final Retail Sales Growth rose to +1.6% in Q1, but a lot of that simply has to do with prices at the pump going up. Mistaking inflation for growth has been, and will continue to be, the legacy of Keynesian economic forecasters in the Bush/Obama era.

 

In order to account for inflation adjustments, the US Government estimates what they call the “Deflator” and subtract that price from what you are paying at the gas station, grocery store, etc.

 

Look at what the US GDP Deflator has done in the last 2 quarters:

  1. Q4 2011 Deflator = 0.84%
  2. Q1 2012 Deflator = +1.5%

You don’t need a Ph.D in applied math to realize that (even if you believe these ridiculously low government “estimates” of inflation in your life) their estimates just almost doubled, on the margin.

 

On the margin is how real human beings live. It’s also how Globally Interconnected Risk is priced. Paycheck to paycheck, tick by tick – it’s real life for all of us who have to balance a family budget and firm payroll. It’s what most of these conflicted and compromised central planners have never been held accountable to in their working life.

 

The Fed’s “mandate” = Price Stability and Full Employment. US Jobless Claims just spiked +15% month-over-month (April versus March), and price volatility is plainly evident to anyone with live quotes. It’s time to get real about the credibility of the currency in this country, or we are going to see some serious Capital Flight.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, France’s CAC40, and the SP500 are now $1647-1664, $118.94-120.17, $78.66-79.22, 3099-3321, and 1391-1408, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Capital Flight - Chart of the Day

 

Capital Flight - Virtual Portfolio


THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP – May 14, 2012


As we look at today’s set up for the S&P 500, the range is 33 points or -1.36% downside to 1335 and 1.08% upside to 1368. 

                                            

SECTOR AND GLOBAL PERFORMANCE

 

THE HEDGEYE DAILY OUTLOOK - 1

 

THE HEDGEYE DAILY OUTLOOK - 2

 

THE HEDGEYE DAILY OUTLOOK - 3

 

 

EQUITY SENTIMENT:

  • ADVANCE/DECLINE LINE: on 5/11 NYSE -637
    • Down from the prior day’s trading of 717
  • VOLUME: on 5/11 NYSE 785.74
    • Increase versus prior day’s trading of 0.21%
  • VIX:  as of 5/11 was at 19.89
    • Increase versus most recent day’s trading of 5.63%
    • Year-to-date decrease of -15.00%
  • SPX PUT/CALL RATIO: as of 05/11 closed at 2.72
    • Up from the day prior at 1.60 

CREDIT/ECONOMIC MARKET LOOK:


TREASURIES – 10yr yields piking to 1.79% this morning and the Yield Spread (10s minus 2s) is hitting a fresh YTD low of 153bps wide (-24% from the mid-March peak when most stocks peaked). Falling rates and Yield Spread are bad for Financials on the margin – like they needed more to worry about… 

  • TED SPREAD: as of this morning 38
  • 3-MONTH T-BILL YIELD: as of this morning 0.09%
  • 10-Year: as of this morning 1.78
    • Decrease from prior day’s trading at 1.84
  • YIELD CURVE: as of this morning 1.52
    • Down from prior day’s trading of 1.58 

MACRO DATA POINTS (Bloomberg Estimates):

  • 11am: U.S. Fed to purchase $4.25-5b notes
  • 11:30am: U.S. to sell $30b 3-mo., $27b 6-mo. bills 

GOVERNMENT:

    • House not in session
    • Senate to consider motion to proceed to Export-Import Bank Reauthorization, 2pm
    • NRC discusses recommendations for containment-venting systems, rapid transfer of spent reactor fuel from pools to sealed storage casks, 9am
    • White House energy adviser Heather Zichal participates in API conference on hydraulic fracturing, 9am
    • Public comments due to CFTC on establishing minimum block sizes for certain kinds of swaps, block trades  

WHAT TO WATCH:

  • Yahoo! CEO Thompson steps down after inquiry into his academic credentials; Levinsohn is interim CEO
  • Chesapeake has 8:30am call; Co.’s $3b lifeline heaps pressure on CEO
  • Euro officials begin to consider Greek exit from currency
  • Avon says its board will respond to Coty’s offer within a week
  • LightSquared nearing bankruptcy protection filing; key creditor deadline: WSJ
  • China lowers banks’ reserve requirements to support growth
  • JPMorgan losses lead to moves in swaps indexes
  • JPMorgan executives are said to be preparing departures
  • Concho Resources to buy Permian Basin assets for $1b
  • Economy in U.S. buoyed with autos spurring glass-to-steel growth
  • Shale may double Australia’s nat-gas resources, report says
  • Disney’s “Avengers” sets second-weekend N.A. record with $103m
  • Merkel’s CDU suffers worst postwar result in biggest state
  • Quarterly deadline tomorrow for mutual, hedge funds to disclose holdings 

EARNINGS:

    • Silver Wheaton (SLW CN) 6:30am, $0.43
    • Eastern Platinum (ELR CN) 8am, ($0.01)
    • SouthGobi (SGQ CN) 8am, $0.00
    • Groupon (GRPN) 4pm, $0.01
    • Agilent (A) 4pm, $0.73
    • Air Lease (AL) 4:05pm, $0.28
    • Renren (RENN) post-mkt, $0.04 

COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG) 

  • Bullish Wagers Plunge Most in 2012 on Greek Impasse: Commodities
  • Commodities Decline for Ninth Day on Greek Crisis, China Concern
  • Oil Falls to 2012 Low on Greek Debt, Saudi Call for Price Drop
  • Gold Erases This Year’s Gain as Europe Concern Boosts Dollar
  • Copper Reaches Four-Month Low Amid Greek Euro-Exit Speculation
  • Palm Oil Plunges Most in 14 Months as Europe Debt Crisis Deepens
  • Soybeans Drop to Six-Week Low as U.S. Planting Accelerates
  • Cocoa Falls in London on Increased Sales and Weakening Demand
  • Gold VIX Near 10-Month Low Amid Bets Against Stimulus: Options
  • Power Company Bond Risk Climbs on Nuclear Shutdown: Japan Credit
  • Hedge Funds Cut Bets on Oil Before Seaway Shift: Energy Markets
  • China Coal Prices Drop in May for First Time in Three Years
  • Argentina as No Claims-Nation Revealed in Repsol Losses: Energy
  • ICE Adding Grains to Lure Hedge Funds Chasing USDA Price Swings
  • Gold ETF Assets in India Top Record 100 Billion Rupees in April
  • Tanzania Considers Copper-Ore Export Ban to Focus on Processing 

THE HEDGEYE DAILY OUTLOOK - 4

 

 

CURRENCIES


THE HEDGEYE DAILY OUTLOOK - 5

 

 

EUROPEAN MARKETS


ITALY – stocks down another -3.2% this morning puts Italy back into crash mode (down -21% from its March top); Spain is down -24% from its March top and Spanish CDS +24bps to a new record high of +540 this morning. How’s that Keynesian experiment treating everyone out there so far?

 

THE HEDGEYE DAILY OUTLOOK - 6

 

 

ASIAN MARKETS


INDIA – something not so funny happened on the way to India immediately after Bernanke decided to push easy money out to 2014 (Jan 25th Policy To Inflate date) – India started importing more inflation and real growth slowed; Sensex stopped going up in Feb = down -12.1% since; this morning’s inflation report for April was not good at +7.2% vs 6.9% in March.

 

THE HEDGEYE DAILY OUTLOOK - 7

 

 

MIDDLE EAST


THE HEDGEYE DAILY OUTLOOK - 8

 

 

The Hedgeye Macro Team



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Dollar Hostages

“I am determined that the American Dollar must never again be hostage in the hands of international speculators.”

-President Richard Nixon, 1971

 

In Currency Wars (page 86), Jim Rickards highlighted that very sad day in US Economic history (August 15th, 1971) when Nixon abandoned the Gold Standard and officially made the US Dollar a political football. We’re all hostage to its Correlation Risk now.

 

In the 1970s, Nixon would say “we’re all Keynesians now.” Jimmy Carter, George W. Bush, and Barack Obama’s economic policies of the 1970’s and 2000’s  would agree with that. But are we? Collectively, I think America is smarter than that. When something doesn’t work, we stop doing it – eventually. Monetarily, Reagan got that right. Fiscally, Clinton did. The People forced them to.

 

With Correlation Risk running at generational highs, “speculators” take their cue from the US Dollar. And the US Dollar takes its lead from policy makers. Markets are hostage to what the Dollar does because this is what we asked for. We asked for Bernanke. We asked for bailouts. Now that we see how this movie ends (Europe), are we going to be asking for more?

 

Back to the Global Macro Grind

 

Last week the USD was up for the 2ndweek in a row, trading up +0.96% to $80.26 on the US Dollar Index. Since Bernanke has trained them to expect short-term asset price inflation, Stock and Commodity Markets really do not like it when that happens. In the face of US Dollar strength, stocks and commodities were both down for the 2nd consecutive week.

 

The bad news about short-term commodity price inflation is that it Slows Global Economic Growth. If you are a country like India or Japan (and you are a net importer of Oil) you really get jammed by this sort of thing.

 

India’s Sensex Index was down another -0.54% last night (down -12.1% from where it topped when growth started slowing in February) after reporting that it’s Wholesales Price Index for April inflated, sequentially, to +7.2% versus +6.9% in March.

 

The good news about short-term stock and commodity price inflations is that they deflate. Sometimes fast. That’s plainly obvious to anyone who has blown up other people’s money being levered long Commodities at the Q1 tops of 2008, 2010, 2011 – and now, 2012.

 

With the US Dollar up +0.96% last week, here’s your highly correlated move lower in Commodity prices:

  1. CRB Commodities Index (19 Commodities) = down another -2% (down -11% from their February 2012 top)
  2. WTIC Oil = down another -4% (down -11% from its February 2012 top)
  3. Gold = down another -4% (down -11% from its February 2012 top)

I couldn’t make up how linear and correlated these moves have been since February if I tried. God only knows Bernanke has avoided discussing the words Dollar, Correlation, and Risk like the bubonic plague (for good career risk management reason). But that certainly doesn’t mean these Correlation Risks to market prices cease to exist.

 

You see, if I was tasked with “price stability”, the last thing I’d do is bring up the causality (policy) driving people to “speculate” on up/down Gold and Oil prices. Accountability isn’t a word in Washington. And that’s just plain sad too.

 

Accountability in performance is definitely a word in the asset management community. Looking at the latest CFTC Commodities options data (Bloomberg) consider the following:

  1. Bullish bets on commodity contracts (19 CRB components) dropped -19% week-over-week last week! (723,239 contracts)
  2. Bullish bets on Gold contracts tanked -20% last week (to 92,498 contracts) = lowest level since December 2008!
  3. Bullish bets on US Farm Goods swooned -15% week-over-week to 435,801 contracts

In other words, if you bought the top in Commodities in February – and you did that with leverage – you’re definitely blowing up right here and now. Gold and Copper are down another -1.5% and -2.8%, respectively this morning!

 

Yes, that’s an exclamation point. I don’t use them that often. But they are very appropriate. We are fighting the Fed, and winning.

 

As a reminder, our Top 3 Global Macro Themes for Q2 of 2012 are:

 

1.       The Last War: Fed Fighting

2.       Bernanke’s Bubbles (Commodities)

3.       Asymmetric Risks

 

These were not easy calls to make at the end of another Q1 YTD top in Global Equities and Commodities. Neither was it easy to write a note titled “Selling Opportunity” in US Equities when they went green momentarily on Friday.

 

This Globally Interconnected Game of Risk is not easy. Neither is it going to be easy to convince the American People that they should be Dollar Hostages for another one of these Qe’s. Been there, done that (multiple times) – and it didn’t work.

 

My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, EUR/USD, and the SP500 are now $1, $109-45-113.89, $1.28-1.30, and 1, respectively.

 

Best of luck out there today,

KM

 

Keith R. McCullough
Chief Executive Officer

 

Dollar Hostages - Chart of the Day

 

Dollar Hostages - Virtual Portfolio


THE (COFFEE) PRINCE

“Before all else, be armed.”

-Machiavelli

 

For Howard Schultz, it is all about winning.  Even when he doesn’t want to communicate it, he does.  The word “Machiavellian” has come to represent, for many people, any human behavior that is cynical and self-interested.  While Schultz seems to have a strong social conscience – and this is meant as a compliment – we can’t help but believe that the single-serve strategy being employed by Starbucks seems to rhyme with The Prince, Machiavelli’s most famous book.  An appearance by Mr. Schultz on CNBC yesterday illustrates this perfectly.

 

We have been of the opinion for some time that Starbucks has never really intended to sit idly by and allow Green Mountain to dominate the home brewer market.  When Starbucks signed an agreement with Green Mountain in early 2011, we noted that the long term commitment of Starbucks to the Keurig brewer was conspicuous in its absence.  On the one hand, K-Cups are not a significant enough portion of the business to merit the amount of attention that Starbucks investors have been paying to the Green Mountain fall out.  On the other hand, while K-Cups only represent approximately 12% of the company’s earnings, the longer term upside for Starbucks appears much greater if it were able to capture a significant portion of what is currently Green Mountain’s business. 

 

Timing is everything and we believe that Starbucks is acutely aware of this as it cuts its teeth in the single serve business.  Showing its hand too early would obviously increase pressure on Green Mountain and possibly negatively impact Starbucks’ K-Cup business as it currently stands.  For that reason, we believe that Starbucks is to Green Mountain what the Trojan Horse was to Troy.  The partnership of Starbucks with Green Mountain is allowing Schultz and his team to get his product to customers in the home/office channel while building their knowledge of the single-serve category.  Manufacturing its own brewer is a clear step towards independence from Green Mountain and, we believe, when the stockpile of ammunition is sufficient, Starbucks will attack the home brewer segment.  Like a true Machiavellian Prince, Schultz will do so in one fell swoop – when the timing is right to do so.

 

Within the CNBC interview, Schultz responds to a question on Starbucks’ new machine being a sign that his company is unwilling to commit to a longer-term single-serve partnership with Green Mountain.  His statement that Starbucks “has the winning hand” offers us a glimpse of his competitive nature.  Irrespective of any wooden platitudes describing the complementary nature of the two companies’ respective brewers, his “winning hand” comment (a slip?) was a signal of intent.

 

Below is a paraphrased transcript of the exchange between Schultz and CNBC with our commentary on each exchange.

 

CNBC: Howard, you're coming out with your own single service machine later in the year to compete with the Keurig from Green Mountain.  Is that a sign you're unwilling to make a long-term commitment to Green Mountain and the K-cups you currently have a partnership on?

 

Schultz: I think the introduction with Verismo coming out this holiday is misunderstood.  It's not in competition with Green Mountain.  It is a complimentary machine -- Starbucks will have the winning hand because of VIA -- the platform we're on with Green Mountain with their 12 million machines of install base, and we already have 15% share and that's going to grow with us and them. We're coming out with a machine that's going to do something no other machine does, and that is make a perfect latte because we've cracked the code in terms of the technology on fresh milk, but it's a complementary machine.  Our partnership with Green Mountain is stable; I've talked to them.   You have to separate their problems and what happened with their chairman from the fact remains their install base is 12 million machines and those customers want Starbucks k-cups, and we're going to provide them.

 

HEDGEYEWe believe that the premise of this question was slightly off base in that the original agreement between Starbucks and Green Mountain gave no indication of any intent to maintain a long term partnership. 

 

The introduction of Verismo, with respect to Mr. Schultz, is not misunderstood.  Some consumers will replace their Keurig machines with it, some will not; they are in competition with each other.  We would not be surprised if Starbucks were already working on a home brewer that competes offers brewed coffee as well as espresso.

 

It’s difficult to prove and we are not qualified to make such an assertion, but the statement (or slip?) that “Starbucks has the winning hand” does not suggest that Schultz intends to curb his competitive instincts in his approach to single serve or any other area of his business.  Before he expresses it outwardly with respect to single serve, he will ensure he is armed and prepared.

 

 

CNBC: Are you friends, are they enemies, are they frenemies? What is your partnership with Green Mountain?

 

Schultz:  We have a very good partnership with Green Mountain and they knew all along we have interest in the espresso platform.  The espresso platform we introduce this fall it's going to be a game changer but not at their expense.  I think the market has overreacted with regard to us coming out with a machine they believe is going to be competitive to Green Mountain.  We will coexist.  We will sell k-cups in a big way and create a next generation game changing machine this holiday in every Starbucks store and every retail store in the country.

 

HEDGEYE:  The companies will co-exist but you can be sure that their respective positions in the home brewer segment will be different than they are today.  Schultz is handling an awkward situation very well but he is well aware of the opportunity that usurping Green Mountain in the single serve industry represents over the long term. 

 

THE (COFFEE) PRINCE - prince schultz

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst


Don’t Fight the Fed… In Brazil?

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:

 

Don’t Fight the Fed… In Brazil? - 1

 

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.

 

Don’t Fight the Fed… In Brazil? - 2

 

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:

 

Don’t Fight the Fed… In Brazil? - 3

 

Don’t Fight the Fed… In Brazil? - 4

 

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.

 

Don’t Fight the Fed… In Brazil? - 5

 

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.

 

Don’t Fight the Fed… In Brazil? - 6

 

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%!).

 

Don’t Fight the Fed… In Brazil? - 7

 

Don’t Fight the Fed… In Brazil? - 8

 

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.

 

Don’t Fight the Fed… In Brazil? - 9

 

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.

 

Don’t Fight the Fed… In Brazil? - 10

 

Don’t Fight the Fed… In Brazil? - 11

 

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.

 

Don’t Fight the Fed… In Brazil? - 12

 

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.

 

Don’t Fight the Fed… In Brazil? - 13

 

Don’t Fight the Fed… In Brazil? - 14

 

Net-net, any move toward fiscal tightening will help offset any inflationary pressures being introduced by this pending acceleration in liquidity throughout the economy.

 

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.

 

Have a great weekend,

 

Darius Dale

Senior Analyst


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