Some Thoughts on Brazil--Your Keys to the 2017 Macro Alpha Supercar

It’s been a long time since we’ve covered any ground in Brazil--but it is great macro territory. Brazil has so much that other markets don’t:

• Liquidity--a super tight, regulated futures market for swaps and FX, stocked with a delightful mix of domestic and foreign real money, hedge funds, and rank speculators.
• Carry--where else do we still talk about double digit interest rates?
• Stories--there’s no limit to the narrative you can build around a trade idea in Brazil.  
• Idiosyncratic, uncorrelated prices. Low correlation = alpha.

What’s not to like? For starters, when the top management of one of the country’s biggest banks gets hauled off to prison for corruption, and it is the same bank, if I recall, that paid rates in massive size ahead of a surprise central bank hike because one of the executives had a “dream” they would hike….well, you have to be pretty careful who you are trading against.

All that being said, Brazil has grabbed EM headlines this year as the “Car Wash” scandal drags on. Back in May, President Temer was implicated in a bribery/hush money scheme earlier this year, local markets gapped lower on the assumption that Temer would be impeached or crippled for the remainder of his term. If that were to happen, important structural and fiscal reforms would fall by the wayside, and the country would continue to stagnate and run up huge amounts of debt.

Amazingly, despite Temer’s complete lack of scruples and the moral compass of a wolverine, he has persevered, winning a vote earlier this week to avoid being put on trial by the Supreme Court. Temer was also able to jam through an important labor reform bill. That has increased the market’s optimism about the passage of the big one--a pension reform bill that would plug a gaping hole in Brazil’s off balance sheet liabilities.

In the past I’ve alluded to the EM metaphor that “energy reform only gets done in the dark”--well, in Brazil the lights went out last year. The country is in the third year of a depression...domestic demand has cratered...Rio is broke….crime is out of control...and pension costs are bankrupting the government. Even the crooked politicians know they have to act.

But will they? That is literally the million dollar question. I tend to think Temer has some cards to play this year, despite a popularity rating of 5% (fill in your own “he’s less popular than” joke here). This is what makes Brazil idiosyncratic, and a great way to generate alpha….or lose money. I’m positive on the story--valuations aren’t particularly attractive here but if you believe the structural story will improve, there is still good money to be made here.

With that, lets go to the charts.  

Indigestion from years of misallocated capital (to put it delicately), corruption scandals and the end of the commodity super-cycle have rabbit-punched growth for the past three years.

Yet the trend for growth is higher...domestic demand is recovering, and FDI never went away. As export growth has returned the flow picture has perked up quite nicely. A balanced current account and 3% FDI/GDP shows continued confidence in the country from abroad.

Most foreigners, at least in the real money “community”, express views in Brazil via external debt.  This chart is a group of 5y CDS spreads on similar credits--with only Indonesia on the RHS. You can see here there is still some space between Brazil and Turkey and South Africa after the gap wider in May. Much better credit dynamics in those countries, but again--if you buy into the Brazil reform story, there is still some juice there.

Indeed, the debt situation has gotten ugly fast...total net debt unwound ten years of progress in less than two. Keep in mind in 2002 there were fears that Brazil would be forced to default or restructure their debt!

Another positive for the credit is that despite this huge acceleration in net debt, it has all been in local currency. Gross external debt/GDP hasn’t moved in three years. So a big deval in the currency doesn’t have the multiplier effect of making the debt more expensive to pay back.

A related point is that local markets really haven’t outperformed all that much over the past year, when markets had recovered from the depths of hell brought on by the depression and impeachment of President Rousseff. This chart shows equity markets have done well, but roughly in line with global markets--only with a heckuva lot more vol.

Looking to FX, BRL is in the middle of the pack for 1-year performance. Behind RUB, roughly in line with MXN, ZAR and COP (although WAY ahead of those currencies in total return, after you add in BRL’s tasty carry), and ahead of TRY and ARS. Again, good performance, but not disjointed from the EMFX rally theme of the past year.

We had a little back and forth on inflation--the central bank’s target is 4.5% +/-1.5% (although it will purportedly be lower next year). If you draw lines through 3% and 6% on the chart below, you’ll see the dark blue line (IPCA = CPI) hasn’t spent much time in that interval since 2012, when a central banker by the name of Alexandre Tombini took over and slashed rates from 12.5% to 7.5%, despite no evidence of a structural decrease in inflation.

The government and it’s state-run banks took this cheap money as a green light to open the credit floodgates….a phenomenon which probably isn’t too far disconnected from the massive, endemic government/corporate corruption that metastasized throughout the economy during that time.

So yeah--while inflation has hit 3%, I don’t think this is the Volker trade. You can see in this chart that regulated prices have played a big role in sandbagging already high headline inflation in the past, and moderating it over the past two years. As the reform movement progresses there could be more hikes in regulated prices as subsidies get unwound--but on the other hand, a more competitive economy and stronger BRL would help keep the lid on inflation. Regardless...less vol in inflation, and thus overnight rates, would be massively supportive of asset prices. If a center-right reformist wins the presidency next year, that is a big possibility--similar to the renaissance in Argentina over the past year and a half since the Macri victory.

Indeed, the lower inflation figures and positive momentum on the politics has given the central bank the space to cut rates aggressively. This has led to a big rally in interest rates. The chart below is the pre-cdi Jan21, essentially Brazil’s version of a eurodollar contract.

I know, a 9-handle!! I can’t believe it either.

Similar picture in the benchmark Jan25 contact--I think there could be some value in the steepness here if we get more progress on reforms and Lula fades to black.

Putting it all together--I think there is still value in Brazil--I’ve been positive on rates there most of the year, but it is getting tenuous here with a 7.75% terminal rate by the end of the year. I’ll need more evidence of structural reform progress to buy into that--but as I mentioned I still see value in duration and real rates at these levels.

BRL...I don’t think we’re done--lay off some risk against the EMFX dog of your choice if it helps you sleep at night.

Credit--I think the first couple of charts are persuasive--while debt dynamics are still negative, and the country is likely to run a primary deficit for the third year in a row, significant reforms would fix problems other countries still have, and you have some margin for error relative to countries with problems of their own.

It all comes back to reforms. Do you buy into the story? Reforms get done, economy perks up, a centrist wins the election….Brazil is off to the races. But….Temer weighs on the reform movement like a concrete anchor, the economy stagnates, Lula wins the presidency….then we start back at square one.  

I continue to be optimistic--but it is an alpha game--there will be a winner and a loser.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista