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Takeaway: Watch Brazil closely here. A TREND-line breakdown is likely a very dour signal for the Brazilian economy and other risk assets broadly.

SUMMARY BULLETS:

  • All told, if the Bovespa holds its TREND line here, we are looking to use the recent weakness as an opportunity to increase our allocation to Brazil on the long side of equities and the BRL.
  • If the index breaks down, however, that would be a signal to us that our bullish fundamental bias on Brazil is not yet a probable outcome and we’d suspend that view until further notice.
  • Additionally, the aforementioned breakdown would likely be a leading indicator for weakness across risk assets broadly over at least the next few weeks. Our analysis of previous cycles and the key drivers of the Brazilian economy is supportive of this conclusion.

WHAT NOW?

Brazil’s benchmark Bovespa Index is literally dancing on its TREND line right now; if it holds, we’re buyers. If it snaps, that’s likely a very bad leading indicator for “risk assets” globally. We hate using that colloquialism, as every asset holds some degree of risk (like US Treasury bonds in the YTD; are those also risk assets?), but it works for now.

WILL BRAZIL HOLD THE LINE? - 1

To quickly recap why we’re bullish on Brazilian equities  – particularly the consumer and industrials names – we think the combination of continued currency appreciation will help promote domestic purchasing power and inflows of international capital, on the margin, and historically-low interest rates will reinforce penned-up demand for capital outlays (World Cup and Olympic Games preparations are generally well behind schedule).

It helps that Brazil’s non-seasonally adjusted unemployment rate also just ticked down to a record low on a monthly basis (DEC) and on an average annual basis (2012).

WILL BRAZIL HOLD THE LINE? - 3

On the bearish side of the ledger (there’s always disconfirming evidence in Global Macro research; you just have to figure the appropriate weight to assign to it in your fundamental reasoning), inflation continues to be a major headwind to Brazilian economic activity and with the recent strength in global commodity prices, inflationary pressures continue to bubble up in Brazil.

WILL BRAZIL HOLD THE LINE? - 2

That’s why we continue to anticipate outsized gains in the Brazilian real over the intermediate term. Because President Rousseff has all but officially prohibited the central bank from hiking interest rates, Brazil must reverse course on capital controls and allow its currency to strengthen dramatically, or the inflation monster will strike the final nail into the coffin of Brazil’s once-ballyhooed “BRIC” status.

Make no mistake, Brazil’s recent spate of Big Government Intervention has threatened to make investing in Brazil a structurally taboo activity. On the strength of continued investor-friendly reforms (like the recent gasoline and diesel price hikes for PBR), however, we’re anticipating a revival in international investor sentiment towards Brazil in 2013, but are necessarily married to the idea. Rousseff and Mantega need to deliver.

For more details behind our bullish bias on Brazilian equities (TREND), please refer to the following two research notes:

WHY BRAZIL BREAKING DOWN WOULD BE A BAD SIGNAL

On 10/24, we published a note titled, “IS BRAZIL’S RECENT BREAKDOWN A HUGE RED FLAG FOR RISK ASSETS?” in which we forewarned of pending weakness across “risk assets” across the Global Macro universe. From the publication of that note to the 11/15 bottom in the SPX, the following price deltas were recorded:

  • S&P 500: -3.9%
  • MSCI World Index: -3.5%
  • CRB Index: -1.6%
  • JPM EM FX Index: -1.2%
  • RWR (SPDR REIT etf): -3.9%
  • US Junk Bond YTM (FINRA-BLP Index): +44bps

As detailed in the aforementioned note, we find merit in using Brazil as a stealth, short-cycle leading Global Macro indicator because, since late 2008, the Bovespa Index has generally led global equities on nearly every major intra-cycle rally and correction.

Specifically, 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). 

  1. On the way up, the Bovespa Index is heavily weighted to reflation with 65.7% 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).
  2. On the way down, the Brazilian economy is heavily weighted towards domestic consumption, so the tailwind of disinflation and/or falling inflation expectations tends to become a demonstrable tailwind for Brazil’s growth outlook and supportive of speculation around easier monetary and fiscal policy in Brazil. It’s worth noting that consumption accounts for 81% of Brazil’s GDP by expenditure (household = 60.3%; government = 20.7%).

WILL BRAZIL HOLD THE LINE? - 4

 

WILL BRAZIL HOLD THE LINE? - 5

All told, if the Bovespa holds its TREND line here, we are looking to increase our allocation to Brazil on the long side of equities and the BRL. If the index breaks down, however, that would be a signal to us that our bullish fundamental bias on Brazil is not yet a probable outcome and we’d suspend that view until further notice.

Additionally, the aforementioned breakdown would likely be a leading indicator for weakness across risk assets broadly over at least the next few weeks. Our analysis of previous cycles and the key drivers of the Brazilian economy is supportive of this conclusion.

Darius Dale

Senior Analyst