The Economic Data calendar for the week of the 16th of August through the 20th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.
Conclusion: CDS Spreads are widening from Europe to Latin America, which may spell near-term trouble for U.S. equities.
As my colleague Matt Hedrick pointed out in a note today, European sovereign CDS has risen 15-30% week-over-week for many countries, which is attracting some Manic Media attention back to Europe’s sovereign debt issues.
Shifting gears to Latin America, we have seen a similar weekly up move in these CDS markets – most notably Venezuela and Argentina (up 112bps and 44bps, respectively). In what consensus is calling “risk-on”, these global CDS moves suggest risk is back in the global marketplace. We’ll take the other side of that statement, however, as risk is always on in financial markets.
Broken down individually, we see that Venezuela recently agreed to pay debts to Colombian exporters in the area code of $800 million, which is obviously a large incremental strain on the country’s budget. In Argentina, things appear much worse and could be the start of a longer term issue that could lead the country to eventual default. The Argentinean Central Bank is boosting the amount of short term sovereign debt to absorb the excess liquidity from their recent dollar purchases. In this effort to reduce inflation, which has surged to a four-year high of 11%, the bank has boosted the nominal amount of short term debt sold in weekly auctions by 67% Y/Y! What’s worse, they are doing it at incredibly high rates. On August 10th the central bank sold notes maturing in 679 days at a yield of 14.8%, which is ~1430bps higher than 2-year U.S. Treasury notes. Regardless of how effective this proves to be in the short term, we’ll take the other side of Argentina being able to comfortably finance this unsustainable borrowing over the next two years – particularly in light of our bearish outlook for global growth.
Over the next couple of years we’ll find out whether Argentina is doing the right thing from a monetary policy perspective. What we don’t have to wait as long for is where the S&P is likely headed. On today’s Morning Call, Keith mentioned that he might not be bearish enough on the U.S. consumer – which is incremental to our street-low U.S. 2011 GDP estimate of 1.7%. While we aren’t yet ready to revise down our estimates, we still believe the S&P at these levels is a severe disconnect from the reality that is U.S. economic and fiscal health. The Latin American CDS markets agree with our assessment.
Using an equally-weighted basket of CDS spreads for six select Latin American countries, we found that moves in these credit markets are a decent proxy for the direction of the S&P 500 in the following week. The inverse correlation in this relationship has an r-squared of 0.72 over a 5-year duration, which is reasonably significant from a statistical perspective. Given the current week-over-week move in Latin American CDS, we can cautiously expect the S&P 500 to trade down from the current ~1080-1090 range next week. We express caution because, obviously, correlation does not equal causation. Keeping that in mind, the inverse relationship is what matters here as it relates to globally interconnected risk management.
Risk is always on.
Position: Bullish Bias on Germany (EWG); Long the British Pound (FXB)
The negative reaction from European capital markets to positive Q2 GDP numbers out of Europe today is another confirming signal of our call for “trouble ahead” in the region in the back half of the year.
We’ve maintained a bullish bias on Germany over the last weeks. Certainly the outperformance of Germany’s Q2 GDP print (2.2% Q/Q, the largest quarterly gain in over 20 years) over its European peers has also translated to its equity market outperformance: the spread of the DAX over Greece’s ASE is 2700bps! (see charts below)
However, our outlook on Germany and the region still remains cautious in 2H10. Importantly, we’re still looking for the DAX to confirm its TREND line of support at 6076 before we’re a buyer. We believe that August and September European data will be especially critical for it will show an inflection point to the downside.
Certainly Germany’s strong Q2 growth is in line with the fundamentals we’ve followed over the last months: a weak Euro (esp. in May/June) boosted exports, German exports found strong demand from China, the country’s employment and inflation picture remains stable, and comps have been “healthy”, especially when compared with bombed out levels in 2009.
Yet the inflection we’re expecting to see has yet to show up in the data, both due to the skew in the numbers because of the World Cup in the early summer and the impact that austerity measures issued throughout European countries will have in 2H10 and 2011, namely in choking off growth.
Taking a look at the charts below, “risk-on” in Europe has shown up over the last week. Sovereign CDS for many European countries rose ~15-30% over the last week and Greece continues to flash weakness, with its 10YR bond yield spread over German Bunds busting out (see charts below). As a reminder we believe that sovereign debt risks in Europe are not rear-view. Debt come due this year and next is one outstanding issue that the ‘PIIGS’ will continue to wrestle with.
We remain long the Pound (FXB) with a trading range for the GBP-USD of $1.54-$1.61.
While last weekend kicked off tax free weekend 2010 for most states, there are a few noteworthy call outs as we head into another key tax free weekend – most importantly the addition of Illinois and Massachusetts to the list since our last post on the topic (see “To Be or Not To Be Tax Free” on 7/7). Neither state participated with an event last year. However with both states landing in the bottom quintile of the Forbes State Debt rankings at #50 and #42 respectively, we are a bit surprised to see them added to the list given the importance of incremental sales tax as a source of revenue. Clearly a balance is being struck here between local politics, the consumer, and business climate. Here are a few other notable observations:
With both the Midwest and Northeast underperforming other regions since the end of June according to our SportsScan trend data, state government clearly sees these events as an opportunity to stimulate both local demand and stimulate consumer purchasing habits alike. The results of these efforts will be a key focus come September sales day when we begin to see just how successful these stimulus efforts ended up.
The preliminary readings from the University of Michigan Surveys of Consumers improved marginally in August. This marginal uptick is not being confirmed by Mr. Market – XLY is the worst performing sector today. Furthermore, the two most important indicators in the national economy today – jobs and housing – are indicating that the narrative of recovery is, in fact, a fallacy.
The University of Michigan “preliminary” index of consumer sentiment climbed to 69.6 following 67.8 in July (which was the lowest since November 2009) and consensus of 69 (according to Bloomberg). The measure of current conditions rose to 78.3 from 76.5 last month and the measure of consumer expectations for six months from now, increased to 64.1 from 62.3.
The Consumer Sentiment Index is down 4.0% YTD and still 28% below the peak level of the chart - January 2007.
The big positive for the country over the past couple of weeks has been the developments in the Gulf and the positive spin around the cleanup efforts. Aside from that there is not much else to write home about.
The August preliminary reading might be a welcome sign for the “back-to-school” season, but it’s still going to be a hit-or-miss back-to-school season for some retailers, as suggested by advance retail sales figures reported today. Consumers continue to send mixed signals when it comes to the economy and spending.
A separate survey by the Prosper group done in the month of August suggested that a recovery is down the road “when 40.6% feel worse off financially compared to a year ago” and “only one in ten says they are better off.”
Lastly, while prices at the pump are only up $0.14 YoY, 68.1% of consumers surveyed say gas prices are still impacting their purchase decisions.
Despite the slight uptick in consumer confidence, the Consumer Discretionary (XLY) is the worst performing sector today. We remain bearish on the intermediate term TREND for consumer spending.
Conclusion: We want to be long markets where domestic consumption is trending up in light of a slowdown in global trade and Brazil is one of those economies.
Position: Long Brazilian equities via the etf EWZ.
On Wednesday, we bought Brazilian equities on sale with the Bovespa down 2.1% on the heels of negative data out of China affirming slowing demand. While it’s true that China is Brazil’s largest export market (18.5% in 2009), Brazil is much more defensive than consensus thinks.
To put things in perspective, the Bovespa is in the bottom fourth of performance for all major equity markets globally on a YTD basis (down just under 4%) – worse than both Mexico and Ireland. The Bovespa’s underperformance is due to a series of interest rate increases (from 8.75% to the current 10.75%), and weakness in Brazil’s main exports: copper (down -2% YTD), crude oil (down -4.6% YTD), soybeans (down -2% YTD), and sugar (-30 YTD). Moreover, the Bovespa index is dominated by Petrobras and Vale (a combined ~18-20% of market capitalization), so it’s no surprise that the Brazilian stock market trades similarly to crude oil and copper (both of which have been rocked on a weekly basis: down 7.6% and 2.1%, respectively).
We’ll leave consensus to wrestle with a two factor model, while we expand our analysis to determine the direction of Brazilian equities. Regarding foreign trade, Brazil’s economy is much more defensive than people think. Roughly 50% of Brazilian exports are commodities and basic materials, which can be interpreted in two ways. The first of which is that the short production chain on agricultural commodities limits any multiplier effect on the economy at large, which explains why despite YTD weakness in commodities, Brazilian unemployment is near all-time lows. Moreover, recent price appreciation in sugar and soybeans (up 11% and 8%, respectively on a monthly basis) is bullish for Brazil’s trade revenue.
Secondly, Brazilian trade revenue (~10% of GDP) is volatile and highly susceptible to swings in commodity prices. Furthermore Brazilian economists point out that Vale is the world’s largest producer of iron ore, which would imply that it could have a relative benefit in a time of industry consolidation. On Wednesday, we published a note highlighting the lack of Chinese demand for industrial commodities (iron ore, copper, crude oil, etc.) behind recent commodity REFLATION, which suggests that there is a substantial amount of downside risk that could weigh on commodity prices and Brazilian equities in the near term should this one-sided trade unwind in a meaningful way.
Despite this risk, we are comfortable holding the bag here on Brazilian equities for three main reasons: domestic consumption is trending up and looks to continue in that direction, inflation is trending down and should remain flat-to-slightly up from here, and interest rates hikes appear to be on hold for now.
On the consumption front, Brazil’s unemployment rate (7% in June) is just 20bps above all-time lows, which explains the recent strength in Brazilian retail sales. Brazil’s June retail sales came in yesterday at +11.3% Y/Y, up from 10.2% Y/Y in May and the 1% M/M increase far exceeded consensus expectations of a 0.3% gain. The 11.5% gain in 1H10 was the largest gain ever on a six-month basis. Furthermore, Brazilian companies have been taking advantage of the secular up-trend of Brazil’s middle class. Hypermarcas SA, Brazil’s fourth largest consumer goods company by market value, has spent $R787.6 million reais YTD on Brazilian consumer goods companies and has amassed an additional R$1.2 billion for more acquisitions in the next 12 to 18 months, citing rising employment and slowing inflation. On the inflation front, Brazil CPI has been headed in the right direction for the past three months, declining from the April high of 5.26% Y/Y to July’s 4.6 % Y/Y.
Regarding monetary policy, we are in line with market expectations for muted, if any, rate hikes throughout 2010, which is bullish on the margin for Brazilian growth. According to the most recent survey, SELIC rate projections came down for the third consecutive week, now at 11% by year end vs. an estimate of 11.5% last week, which is reflected in the currency market – the 3-month put/call spread for the Brazilian real is ~525bps, which is the most among 47 major currencies tracked by Bloomberg. The bond market is also expecting zero rate hikes throughout the year as yields on zero-coupon bonds due in 2012 fell to the lowest ever yesterday as the government sold 6.7 billion reais ($3.8 billion) of the securities in its biggest auction of a single maturity.
Weakening economic data also support this view: Brazil’s June industrial output fell the most in 18 months on a monthly basis, down 1.4% M/M (+12.4% Y/Y); Brazil’s service industry confidence fell for the fourth consecutive month in July to 129.5 vs. 131.5 in July. On the consumer front, select recent data has been worsening on the margin providing further downward pressure on interest rates: Brazilian consumer delinquencies have been on the uptrend, rising 1.5% M/M in July (+3.9% Y/Y) and Brazilian auto sales declined in June for the first time in 11 months on the heels of expiring government stimulus. All told, the combination of marginally weaker economic data and muted inflation will likely keep a lid on interest rates going forward, which is bullish for Brazilian growth and equities.
We do understand that owning Brazilian equities is quite contrarian here given all the noise coming down the pike regarding the elections and Petrobras’s share offering, both of which could be bearish on the margin for Brazilian equities over multiple durations. Petrobras, which was downgraded by UBS AG on Wednesday (after losing 25% of its market value YTD), is trading with an uncertainty premium in regards to the 5 billion barrels of oil it is seeking to purchase from the Brazilian government in exchange for stock. Investors are rightfully worried that a high price tag for the reserves (roughly $7.50 - $10 a barrel) will force the company to sell more shares to the public, which would result in incremental EPS dilution. Further complicating the situation are rumors from Societe Generale SA that Petrobras may delay the share offering again, citing a disagreement between the company and the National Petroleum Agency of Brazil on the price of the reserves. In no way is this a positive event for the Brazilian stock market, but as we pointed out earlier, Petrobras’ YTD decline suggests that a good chunk of this risk has been priced in. Furthermore, if the government agrees to sell the reserves at the low end of the range, Petrobras’ stock could surprise to the upside on the heels of that marginal tailwind.
Regarding the Brazilian elections, the current setup is less positive on the margin for Brazilian growth long term, though there is no shortage of near-term benefits should leading candidate Dilma Rousseff win the election. Rousseff, who is leading in the opinion polls (39% vs. 34% for Jose Serra) has raised more money than her opposition by a factor of 3x over Serra ($11.6 million reais). Unlike Serra, Rousseff has a reputation for relatively loose fiscal policy: as former head of the Government Accelerated Growth Progammes, she is linked to what will amount to over $500 billion – or ~33% of GDP – of infrastructure spending over the next five years. Money from the programs will continue to be a tailwind for the Brazilian economy over that duration, but longer term, investors fear that her heavy government hand will crowd out private sector investment – particularly if she is inclined to keep interest rates high to attract foreign capital to fund Brazilian government debt in order to finance increased deficit spending (3.4% of GDP currently). Although the construction jobs created by the current stimulus will not be around forever, we believe the growing Brazilian economy can withstand marginal deterioration of the government’s balance sheet over the next few years.
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