IS BRAZIL’S RECENT BREAKDOWN A HUGE RED FLAG FOR RISK ASSETS?

Takeaway: The Bovespa’s TREND-line breakdown diminishes our formerly positive bias and affirms our negative cyclical concerns regarding “risk assets”.

SUMMARY BULLETS:

  • Since late 2008, the Bovespa Index has generally led global equities on nearly every major intra-cycle rally and correction, with the exception of the most recent intra-cycle bottom and the current topping process.
  • Supported by an improving GIP outlook (chart below) and an anticipated deceleration of Big Government Intervention (there’s growing speculation that the government will allow PBR to raise prices, which would be a noteworthy step in the right direction), we have held a positive fundamental bias on the Brazilian equity market since SEP 25; that’s obviously been the wrong call (the Bovespa is down roughly -5.5% since then). Importantly, the index is flirting with a TREND line breakdown. If that holds, we would expect to see the index re-test its JUN ’12 lows – roughly -8% to -9% lower.
  • We are not smarter than the market here and are inclined to suspend our bullish bias until we receive confirmation of a TREND-line breakout. The risk of that catalyst not materializing is rising rapidly, however, given the ominous Global Macro fundamental picture staring investors right in the face at the current juncture.
  • And given Brazil’s unique qualities as a weathervane of global economic activity and reflation expectations, a failure for Brazil to recapture its TREND line would imply further weakness ahead for risk assets broadly over the immediate-to-intermediate term.

Since late 2008, the Bovespa Index has generally led global equities on nearly every major intra-cycle rally and correction, with the exception of the most recent intra-cycle bottom and the current topping process:

  • 10/27/08 the Bovespa bottoms; the MSCI World Equity Index bottomed ~4.5 months later on 3/9/09;
  • 4/9/10 the Bovespa peaks; the MSCI World Equity Index peaked 5 days later on 4/15/10;
  • 5/20/10 the Bovespa bottoms; the MSCI World Equity Index bottomed ~1.5 months later on 7/5/10;
  • 11/4/10 the Bovespa peaks; the MSCI World Equity Index peaked 6 months later on 5/2/11;
  • 8/8/11 the Bovespa bottoms; the MSCI World Equity Index bottomed ~2 months later on 10/4/11;
  • 3/13/12 the Bovespa peaks; the MSCI World Equity Index peaked 6 days later on 3/19/12;
  • 6/5/12 the Bovespa bottoms; the MSCI World Equity Index bottomed 1 day prior on 6/4/12; and
  • 9/14/12 the Bovespa peaks; the MSCI World Equity Index peaked on the same day amid mass QE-ternity hysteria.

IS BRAZIL’S RECENT BREAKDOWN A HUGE RED FLAG FOR RISK ASSETS? - 1

A couple of questions arise here:

  1. Why has Brazil been generally led on nearly every meaningful world equity market delta since 2008?
  2. Why has Brazil’s leadership dissipated, as evidenced by the latest cycle?

To address question #1, we think Brazil’s unique setup from a capital markets and economic perspective exposes it to getting pulled aggressively in both directions of global inflation expectations (reflation and de/dis-inflation). From an index perspective, the Bovespa is heavily weighted to reflation with 67.6% of its market cap having direct exposure to top line and margin leverage that stems from rising prices of commodities and risk assets (Energy, Basic Materials and Financials sectors).

IS BRAZIL’S RECENT BREAKDOWN A HUGE RED FLAG FOR RISK ASSETS? - 2

On the way down, the Brazilian economy is heavily weighted towards domestic consumption, so the tailwind of disinflation/falling inflation expectations tends to become a positive for both Brazil’s GROWTH outlook and speculation around easier monetary and fiscal POLICY in Brazil. Eighty-one percent of Brazilian GDP is consumption (household = 60.3%; government = 20.7%) and, on a comparable basis, Brazil’s Unemployment Rate (NSA) continues to make all-time lows.

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Regarding question #2, which, admittedly, is much tougher to answer, we think the reason investors have appeared far less willing to stick their respective “necks” out there on Brazil early in the selloff like they were in previous Global Macro swoons is largely due to the demonstrable acceleration in perceived political risk (more on this later).

As it relates to the current topping process across “risky assets”  we think investors were far less willing to sell Brazil early because it would’ve been a tacit admission that the only catalyst that supported leaning long in the face of terrible fundamental data in the first place (i.e. rising inflation expectations born out of Fed POLICY) was, in fact, culminating. Again these are just our opinions, but, in talking to clients, we can confirm that many of them continue to agree with our negative fundamental conclusions but have chosen to stay long largely due to the Bernank’s explicit dare to chase yield.

Delving back into the aforementioned political risk, Brazilian policymakers led by President Dilma Rousseff and Finance Minister Guido Mantega have certainly been busy making Brazil a less attractive destination for international capital in the YTD. Dilma has been at the forefront of an aggressive year-long drive to lower consumer and corporate lending rates, essentially using her influence over the central bank to accomplish her goals. Mantega, on the other hand, continues to use aggressive rhetoric and IOF tax hikes/expansion (i.e. capital gains taxes for foreign investors) to boost manufacturing and export competitiveness by promoting weakness in the BRL, which has declined -13.6% vs. the USD over the past year (inclusive of a -18.9% drop from late-FEB to mid-MAY). As recently as today, Mantega was quoted in the news (Valor Economico) as saying, “the government’s ‘dirty float’ currency policy will last as long as necessary to defend the country’s competitiveness”.

All of this has come at a time where Brazil’s southerly neighbor Argentina is demonstrably eroding investor confidence as a result of President Cristina Fernandez’s aggressive series of capital controls. We would argue that the “Fernandez Effect” has painted a dark cloud over the economic reforms Rousseff and Mantega have sought to implement, likely making Brazil’s bout of Big Government Intervention appear worse to investors than it otherwise would have. As such, it’s no surprise that outflows of international capital have accelerated in 2012: since JAN, the Bovespa Stock Exchange has seen an average monthly net outflow of -R$7.9 billion; this compares to an average monthly net outflow of -R$1.4 billion in 2011 and an average monthly net inflow of +R$6 billion in 2010.  

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WHERE TO FROM HERE?

Supported by an improving GIP outlook (chart below) and an anticipated deceleration of Big Government Intervention (there’s growing speculation that the government will allow PBR to raise prices, which would be a noteworthy step in the right direction), we have held a positive fundamental bias on the Brazilian equity market since SEP 25; that’s obviously been the wrong call (the Bovespa is down roughly -5% since then). Importantly, the index is flirting with a TREND line breakdown. If that holds, we would expect to see the index re-test its JUN ’12 lows – roughly -8% to -9% lower.

IS BRAZIL’S RECENT BREAKDOWN A HUGE RED FLAG FOR RISK ASSETS? - BRAZIL

 

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We are not smarter than the market here and are inclined to suspend our bullish bias until we receive confirmation of a TREND-line breakout. The risk of that catalyst not materializing is rising rapidly, however, given the ominous Global Macro fundamental picture staring investors right in the face at the current juncture. And given Brazil’s unique qualities as a weathervane of global economic activity and reflation expectations, a failure for Brazil to recapture its TREND line would imply further weakness ahead for risk assets broadly over the immediate-to-intermediate term.

Not good.

Darius Dale

Senior Analyst