Conclusion: Depending on the result of the Brazilian Presidential election, the Brazilian economy may see an incremental boost in private sector investment, as a Serra victory is bearish for Brazilian interest rates. Also, Argentine CDS are at two year lows – this could potentially be a contrarian indicator.
Brazilian Presidential Election
As anticipated, Lula successor Dilma Rousseff won the initial election on October 3rd, though she failed to garner the 50% necessary to immediately emerge as Brazil’s new political leader. That leaves her and her main rival Jose Serra, who lost to Lula in the 2002 presidential election, to go head-to-head in a runoff election scheduled for October 31st. As it stands now, Rousseff has 46.9% of the popular vote and Serra has 32.6%; the wild card will be what happens with now-eliminated third place candidate Marina Silva’s 19.3% of voter support.
Assuming that a large percentage of Silva’s 19.6 million supporters show up at the ballot box in the runoff election, her followers will have a large voice in determining Brazil’s next president. Her supporters are typically university-educated young professionals, environmentalists, and a group of Evangelical Christians who oppose Rousseff because of her stance on legalizing abortion. Because of these qualities, many expect a large portion of her following to favor Serra over Rousseff, which could potentially push Serra over the top in the next round. Of course, this would assume that Rousseff’s fails to garner incremental votes from any potential non-participants during the first election.
As we called out back in July, a Serra victory is more bullish on the margin for Brazil’s private sector, as he is in direct contention with Brazil’s high interest rates and wasteful government spending. Rousseff, on the other hand, is essentially a Lula pawn and is expected to continue the social programs and heavy government spending that has made Lula such a popular president among the masses (~75-80% approval rating).
Considering the dichotomy between their fiscal positioning, a Serra victory may be incrementally bullish for the real, which the government has had trouble containing of late (up 12% vs. the U.S. Dollar since late May). While it may seem at first glance that Serra’s desire to lower the Selic rate would be negative for the real, his reputation for fiscal austerity and his support for Brazilian private sector growth may prove to be the deciding factors in the real’s pace of appreciation, should he become elected.
Elsewhere in the Brazilian economy, in the latest attempt to stem the real’s gains the Brazilian government will double to 4% the tax it levies on foreigner’s investment in the nation’s bonds. The tax was first introduced a year ago in October and was greeted with near-term success (the real declined 3.5% from mid-October through the start of November). It, however, resumed appreciation back to its original high one week later, only declining substantially after the U.S. Dollar bottomed out early December. Considering the intermediate and long term outlook for the fiscal health, economic growth, and interest rates in the U.S. and Brazil, we don’t see the real’s bullish fundamentals eroding anytime soon.
Argentine CDS Head Fake?
By now, it’s no secret that Argentine is doing well economically as evidenced by the government’s 9.5% GDP growth projection for 2010 and the S&P’s Sept. 13th upgrade of Argentina’s debt rating one notch to B (five levels below investment grade). What does come as a slight surprise to us is the market’s positive reaction to the Argentinean government’s decision to use FX reserves to pay down debt – an action that is typically frowned upon because of its propensity to stoke inflation.
Currently, Argentine President Fernandez de Kirchner is avoiding selling bonds internationally to service debt despite the lowest yields in two years (~8%). Rather, she and central bank President Mercedes Marco del Pont have elected to finance debt service with FX reserves, which have grown to a record $51.2 billion as a result of dollar purchases and strong export growth. YTD, Argentine has spent $5 billion of reserves this year and plans to use an additional $7.5 billion next year to service debt (TRANSLATION: Piggy getting hooked on the trough). Never mind that the former central bank president Martin Redrado was fired for refusing to back the plan because of its inflationary potential.
On the inflation front, many Argentinean economists have gone on record to publicly contest the government’s reported 11.1% inflation rate, suggesting that consumer prices may be growing at more than twice the rate. Moreover, a September 15 survey by Buenos Aires-based Torcuato Di Tella University showed that consumer prices are expected to rise 25% over the next 12 months, further supporting inflation skeptics’ views on the economy. To sterilize recent sales of the peso, the government is issuing short term local debt that pays about 12 to 14% interest. So effectively, the government is taking a loss on the dollars it is buying which yield ~40bps on 2-year U.S. Treasuries. The total supply of central bank debt maturing in one month to three years has grown 77.1% since June ’09 to 60.4 billion pesos. We interpret that as Argentina’s liquidity risk just increased by some fraction/multiple of 77.1% in the last 15 months.
Also, we’d be reckless to not callout the potential for Argentine’s export tailwinds to deteriorate, creating directional headwinds in the process. The Argentinean economy has benefitted YTD from record export tax revenue (+92% YoY in September) fueled by a record 55 million ton soybeans harvest. Soybeans (prices up +21.1% YoY) have an inverse correlation of 0.80 to the U.S. Dollar on a three-month basis, which has lost 12% of its value since its high on June 7th. Similar to company analysis, we callout peak revenue and peak margins on the country level as potential inflection points that are not to be streamlined into the future estimates of valuation.
To some extent, the Argentinean CDS market may be pricing in such peak revenues, as evidenced by Argentinean CDS hitting lows not seen since August 2008. Of course, two months later, the spread widened to over 4,000bps in the heart of the financial crisis. While we’re not suggesting a repeat performance, we are keen to highlight asymmetry of the current risk setup, considering the overwhelming positive investor sentiment regarding the Argentinean economy.