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Conclusion: More bullish data points affirm our bullish stance on domestic consumption within Brazil.

 

Position: Long Brazilian Equities (EWZ)

As a result of favorable employment, inflation, and credit conditions, the Brazilian consumer is strengthening. Unemployment came in today at just 10bps off all-time lows (6.9% in July vs. 7% in June); inflation has improved on the margin for the past three months (down to 4.6% in July vs. 4.84% in June); and, as a result of benign inflation, interest rate hikes have come to a halt (recent reports suggest the central bank expects 3Q inflation to come in below forecast, further reducing the risk of a Selic Rate increase).

The Brazilian Consumer – Getting Hotter - 1

The favorable interest rate environment has led to an expansion in consumer and business credit that has reduced Brazilian bank holdings of government debt to record lows (22.7% of assets), according to Austin Rating, a Brazilian financial research firm. Moreover, recent central bank data show lending within Brazil has jumped to 36.3% of assets from 30% five years ago and outstanding loans rose for the 17th straight month in July.

The expansion in consumer and business credit is a national trend that is expected to continue, at least according to Rogerio Calderon, Director of Investor Relations at Itau, which expects its loan portfolio to grow as much as 23% in 2010. This is in stark contrast to the U.S. banking industry, which has seen commercial and industrial loans by banks fall 24% from the 2008 peak, according to the latest data from the Federal Reserve.

Long story short, consumers and businesses in Brazil want credit and banks have been more than willing to lend to them as a result of excellent labor market conditions. Brazil has added jobs ever month this year helping to push the unemployment rate to a near record-low in July. Wages have also been headed in the right direction: the average real income of workers grew 2.2% M/M in July and 5.1% Y/Y to R$ 1,452.50.

The confluence of these positive factors has been quite bullish for Brazilian consumer confidence, which rose 0.7% M/M in August (+9.2% Y/Y), according to Fundacao Getulio Vargas. The component index which measures the percentage of Brazilian families who are happy about their current financial situation grew 170bps M/M to 25.8% in August. Even more bullish for the outlook for Brazilian consumption is the August reading for the component index that measures the percentage of Brazilian consumers who intend to make major purchases in the coming six months rose 260bps M/M to 16.6% in August.

The uptrend in Brazilian consumer confidence, employment, and consumer credit is in stark contrast to what is happening domestically, and that is one of the key tenets of our bullish stance on Brazilian equities. We have conviction that capital will continue to seek yield globally and that will accelerate once U.S.-centric investors come to grips with slowing growth domestically. U.S. housing prices are setup to decline 15-50% (based on our proprietary Hedgeye supply, demand and inventory models). This will likely restrain consumer spending (~70% of the U.S. economy). Furthermore, we hold conviction that the cash sitting on U.S. corporate balance sheets will either continue sitting there or leave this country in search of higher yield. CFO’s are pro-cyclical and seldom invest during slowing business cycles. If they invest at all, it will likely be abroad as their capital seeks yield either through growth or higher rates of return. The Brazilian consumer has both. Perhaps that’s why one-third of the 77 foreign acquisitions of Brazilian companies in 1H10 were by American firms. Expect that trend to continue as long as the jobless, deleveraging and disheartened U.S. consumer stunts growth domestically.

The Brazilian Consumer – Getting Hotter - 2

Managing Risk: Petrobras and Election Update

Regarding the Petrobras saga, unnamed sources claim that the talks between the company and the government are advancing and the agreed-upon prices for the reserves will be $8 per barrel. The source affirms that the talks are being mediated by President Lula and he plans to announce the final price by the beginning of next week.

Regarding the election, Dilma Rousseff (Lula’s endorsee) has taken a commanding 20-point lead over her opposition in the latest Datafolha poll take on August 23-24 (10,848 voters). Her 49% of voter support is a mere 1 percentage point away from winning the election outright on October 3rd (a candidate must secure 50% of the vote to ensure a first round victory). Investors have been rightfully worried that her reputation for big government will keep a floor under the Selic rate as inflation looks to accelerate during her tenure. In a response to such fears, an unnamed source recently reported via Folha de S. Paulo that she agrees with the need to cut government spending in order to keep a lid on the Selic rate and that she and current President Lula have been discussing austerity measures. Keep in mind that this report was released just days before the government revised down its Jan-Aug. budget surplus target due to excessive spending. If, however, these reports are in the area code of true, expect big things from Brazilian equities as we roll forward into 2011.

Darius Dale

Analyst

Moshe Silver

Chief Compliance Officer