- With the exception of the Brazilian real, which we maintain our bearish bias on (vs. the USD), the TREND-duration outlooks for Brazilian equities and BRL-denominated debt is rather binary in each case.
- Expectations for further monetary easing out of the Brazilian central bank are completely muted, creating a binary scenario whereby rising inflation expectations beget tightening expectations or accelerating global growth concerns beget incremental easing from here.
- We continue to see heightening risk that inflation does not converge to the mid-point of the central bank’s target over the intermediate term, as guided to by officials.
To say that Brazilian policymakers are giving investors the run-around would among the more aggressive understatements of the year. We too were on the less-desirable side of a few noteworthy shifts in policy expectations in recent months:
- 5/3: WHAT THE HECK IS GOING ON IN BRAZIL?: An expectation that Brazilian policymakers would limit further downside in the BRL made bullish on Brazilian equities with respect to the TREND duration;
- 5/31: WAIT ON BRAZIL: An outlook for continued Big Government Intervention was a key factor in our decision to withdraw our bullish bias on Brazilian equities and the Brazilian real with respect to the TREND duration; and
- 7/30: IS BRAZIL IN A BOX?: Growing inflationary concerns amid muted expectations for a policy response made us bearish on Brazilian equities, the Brazilian real and Brazilian real-denominated debt with respect to the TREND duration.
At Hedgeye, we are no strangers to keeping score – even when it goes against us: from 5/3 to 5/31, the Bovespa dropped -12.3% in the face of our bullish bias. Leaving behind that misfire, the index is largely flat from 7/30 to present; the real has declined -0.5% vs. the USD and Brazil’s 10yr sovereign debt yield has backed up a modest +5bps over that same time frame. Looking ahead, we continue to expect more downside in the BRL relative to the USD over the intermediate term, though we no longer hold high conviction in our bearish bias on Brazilian equities and BRL-denominated debt. In the sections below, we update our thoughts on each asset class.
BRAZILIAN REAL (BRL)
With last night’s unanimous decision to reduce the SELIC Rate -50bps to a new all-time low of 7.5%, exactly what we said would happen is happening in Brazil – specifically in that the central bank is completely looking past the recent pickup in inflation and continuing on with its easy monetary policy. Looking ahead, their lack of prudence/vigilance is likely to continue weighing on expectations for Brazilian real interest rates over the intermediate-term TREND – likely a critical headwind for the BRL (vs. the USD) with respect to that duration.
Moreover, investors should continue to anticipate help from the powers that be: “Brazil’s government will continue to take action to weaken the real in benefit of local manufacturers,” per Finance Minister Guido Mantega in a statement from yesterday. Ironically, Mantega’s “beggar-thy-neighbor” policies have done little promote Brazilian exports (-5.6% YoY in JUL) or manufacturing activity (PMI = 48.7 in JUL), while at the same time completely sticking Brazilian manufacturers with COGS inflation (+7.2% YoY in JUL from +6.6% in JUN). The obvious risk here is that Mantega is emboldened to do more of what hasn’t worked – particularly as economic concerns in China – Brazil’s largest export market – continue to weigh heavily on prices for one of Brazil’s key export products.
BRAZILIAN EQUITIES (BOVESPA INDEX)
On our proprietary GIP factoring alone, Brazilian equities look almost as attractive as they did to us back in early MAY – particularly from a growth perspective, where our models continue to point to a back-half ramp in real GDP. Of course a lot has happened since then, especially on the fiscal policy front, including the recent extension of the IPI tax cut though OCT, increase in home buying subsidies, decrease in minimum mortgage down payments, increase in State-level debt ceilings, the introduction of a $66B/30yr infrastructure investment program (with 59.7% coming in the first 5yrs) and an incremental R$1.5 billion capital injection in Caixa Economica. And that’s just for the month of AUG!
Needless to say, it remains to be seen whether or not the Brazilian government’s aggressive year-long stimulus efforts will provide the intended boost to growth without spurring a measured ramp in inflation. We continue to see that as the key question to debate regarding Brazilian equity exposure over the TREND and TAIL durations. As we outline in our 75-page presentation titled, “THE ROADMAP TO INVESTING IN BRAZIL” (AUG ’11), Brazil remains an economy at risk of a sustained and material spike in inflation – a conclusion only enhanced by the BRL’s -22.3% YoY decline. QE3-inspired commodity inflation also remains a heightened risk to the Brazilian econmy with respect to the intermediate term.
Net-net-net, we wash out largely neutral on Brazilian equities from here (TREND), fully understanding the merits of the both the bull and bear case. In instances like these, we typically defer to the market to do the concluding for us – though, given our below-consensus expectations for global growth over intermediate term, we don’t necessarily find it prudent to be long of Brazilian equities at the current juncture.
BRAZILIAN SOVEREIGN DEBT
Upon cutting the SELIC to 7.5%, Brazil’s central bank subtly signaled to the market that they were at/very near the end of their monetary easing cycle by inserting the word “maximum” in their statement, which did not appear in previous iterations:
“Considering the cumulative and delayed effect of policy action implemented until now, which are partially reflected in the ongoing economic recovery, the Copom considers that if the prospective scenario were to allow for an additional adjustment in the monetary conditions, this move should be carried out with maximum parsimony.”
Looking to Brazil’s interest rate swaps market, OIS are now essentially pricing in no further reductions in the SELIC over the NTM. To the extent that scenario plays out amid a positive inflection in Brazilian growth and a continued ramp in NTM inflation expectations, we could see selling pressure on both the short and long ends of Brazil’s sovereign debt curve. Additionally, QE3-inspired commodity inflation could actually perpetuate tightening expectations in the Brazilian bond market, much in the way QE2 did.
On the flip side, our top-down view on global growth suggests that Tombini and Co. might not necessarily be done cutting rates in the current cycle, contrary to market expectations. Moreover, we anticipate that as Brazil’s consumer credit metrics – a lagging indicator – continue to deteriorate over the near term, pressure from Rousseff and Mantega upon Tombini to resume monetary easing is likely to reaccelerate. Rousseff in particular, is likely to continue pursuing such means of populism amid her current heavyweight bout with Brazil’s public labor unions as she seeks to slow growth in public pensions and public worker salaries, which combine to represent a whopping 65% of federal expenditures.
All told, the outlook for Brazilian financial markets is confusing, to say the least. With the exception of the Brazilian real, the TREND-duration outlooks for Brazilian equities and BRL-denominated debt is rather binary in each case.