SELL BRAZIL?

Takeaway: Brazil is setting up as a short in 2H. Lots of capital has flowed into the country this year on a catalyst that is unlikely to materialize.

On JUN 3 we closed out a long recommendation in Brazilian equities and the BRL, citing a marked deterioration in Brazil’s high-frequency growth data that was likely to perpetuate incremental Policies To Inflate out of the Rousseff administration. While the initial recommendation did generate a substantial degree of alpha, our decision to “book” the gain was clearly the wrong one given that the iShares MSCI Brazil Index Fund (EWZ) and the BRL/USD cross have appreciated +7.2% and +2.9%, respectively, since then.

Nothing worse than leaving money on the table…

Since JUN 3, we’ve seen signs of economic stabilization, with PMI, Industrial Production, Consumer Confidence and Credit Quality data more-or-less flattening out relative to their recent trends, while Retail Sales and Consumer Credit growth have shown material improvement.

SELL BRAZIL? - Brazil High Frequency GIP Monitor

This economic stabilization comes in the wake of a slew of fiscal easing measures out of the Rousseff camp that is likely perpetuating what we’re identifying as renewed confidence in her failed economic policies. In fact, in her initial volley to start the campaign season, she proclaimed that Brazil had very little space to adjust fiscal policy. Moreover, her platform of increased spending on social welfare, health care and education represents little change to the inflationary fiscal and monetary policy she has promoted throughout her administration.

Looking at Brazil from a top-down perspective, we see that headline consumer price inflation has run above the mid-point of BCB’s target band of +4.5% YoY +/- 200bps for the entirety of her presidency. Again, this is largely due to an ever-expansionary fiscal policy mix that has weighed on Brazil’s fiscal and current account balances.

SELL BRAZIL? - CPI

SELL BRAZIL? - BUDGET BALANCE

SELL BRAZIL? - CURRENT ACCOUNT BALANCE

It’s worth noting that our predictive tracking algorithm has Brazilian inflation readings accelerating throughout 2H14. In the context of a OK-at-best outlook for growth, we think that will likely continue to erode expectations for real interest rates in Brazil over the intermediate term (e.g. Brazil's 1Y OIS spread has compressed -48bps over the past 3M). That should reduce (but not completely quash) the country’s allure in the context of our 3Q macro theme “#DollarDevaluation”.

SELL BRAZIL? - BRAZIL

SELL BRAZIL? - GROWTH

SELL BRAZIL? - INFLATION

No surprise here, but various readings of confidence – be it Consumer or Business – in the Brazilian government and/or Brazil’s economic situation are at/near cycle-lows – which is one of the factors that got us to believe back in FEB that the OCT presidential election will be tighter than what was priced into the markets at the time.

SELL BRAZIL? - CONSUMER CONFIDENCE

SELL BRAZIL? - BUSINESS CONFIDENCE

Fast-forward to today, however, it’s very clear that investors are well aware of this setup given the outperformance of Brazilian capital and currency markets since then. As we initially outlined, international investors took a page out of the Japan (2012-13) and India (2013-14) playbooks speculate on political change in Brazil.

What if the political change never comes? What if, after all is said and done in OCT, we have another four years of pro-inflation, pro-BoP deterioration policies in Brazil? What if the “Brazil discount” is reapplied to the prices of Brazilian financial assets?

That’s a key risk(s) for investors to consider going forward from today’s prices.

We’ve already seen Rousseff’s support in the polls stabilize in recent weeks amid positive developments on the political front (e.g. the PMDB – Brazil’s 2nd largest political party – backed her election bid while officially nominating PMDB lawmaker Michel Temer as her running mate).

Per the JUL 1 Datafolha survey, Rousseff rebounded to 38% from a trough of 34% last month. While the poll was conducted ~1W prior to Germany handing Brazil its worst-ever World Cup defeat (on home soil nonetheless), history would seem to suggest that the World Cup has little-to-nothing to do with the outcomes of Brazilian presidential elections (e.g. Henrique Cardoso won re-election in 1998 in spite of Brazil losing to France in the final and Lula da Silva defeated the incumbent to claim victory in 2002 despite Brazil beating Germany for the title that year).

We’ll get more polling data this week (i.e. Sensus JUL 15, Datafolha JUL 16 and Ibope JUL 18), which will help us begin to cement our views on the upcoming election and the prospect for meaningful political and economic reform in Brazil.

To the extent Rousseff starts to gain momentum, we’ll likely begin to recommend investors trade Brazil with a short bias going forward.

Best of luck out there!

DD

Darius Dale

Associate: Macro Team