The Future Is No Longer What It Used To Be

A very interesting piece from Morgan Stanley's Marcelo Carvalho.



Despite renewed turbulence in US markets, Brazilian asset prices have done well in recent weeks, with the local stock market close to all-time highs, and the currency remaining strong. As for the outlook for 2008, analysts continue to paint a rosy picture for Brazil. But what could be wrong with this picture?

The consensus remains too optimistic on Brazil’s trade balance outlook for 2008, in our opinion. We recently argued that the market consensus for a US$35 billion trade surplus next year is simply too upbeat (see “Brazil: Waiting for Godot”, WIB, October 26, 2007). Our out-of-consensus forecast instead looks for a much narrower surplus, of about US$20 billion. The consensus forecast for the 2008 trade balance has started to drift lower, but still has a long way to go.

The current account balance should soon dip into deficit. The market consensus still looks for a current account surplus in 2008. That should change soon. As prospects for the trade surplus are revised down, so should the current account balance. After running in surplus for several years, the actual current account balance could move into negative terrain as early as 2Q08, in our view.

The consensus assumes just more of the same. What are analysts missing? We think the main problem is that the market consensus seems to simply assume ‘business as usual’ for 2008. It fails to recognize an evolving global landscape and its implications for Brazil’s trade outlook, against the backdrop of robust domestic demand growth and a strong currency.

The future is no longer what it used to be

The global environment is changing. History may view the years since 2003 as a uniquely favorable backdrop for emerging markets, with a potent combination of strong global growth and rapidly rising commodity prices. That picture may be changing in the coming year. The IMF, for instance, foresees a decline of 7% in non-fuel commodity prices next year, and a slowdown in global growth from 5.2% in 2007 to 4.8% in 2008, with risks biased to the downside.

Global growth risks are biased to the downside. Morgan Stanley now judges that the risks of a US recession have risen to about 40% (from around one-in-three before), and has recently revised down its 2008 US growth forecast to 1.7% (on a 4Q-over-4Q basis) from 2.1% before (see “The Credit Recession”, WIB, November 9, 2007). At the start of the year, the US 2008 forecast called for 3.0% growth.

The implications of a euro area growth slowdown tend to be overlooked. Although much market attention focuses on the US, analysts often appear to forget the importance of Europe for emerging markets. In fact, while the US takes 19% of emerging market exports, the Eurozone takes 28%. For Brazil’s exports, the US represents 19% and the Eurozone 22%. Morgan Stanley has called for euro area growth of 2.0% in 2008, down from 2.6% in 2007. But high oil prices, a strong euro and tight credit conditions could slow euro area growth to 1.5% next year (see “Oil at 100, Euro at 1.5, Credit Crunch: The Bill”, Global Economic Forum, November 5, 2007).

In all, our global GDP growth forecast now stands at 4.6%, but risks still seem biased to the downside. After several years in which global growth figures were repeatedly revised upwards, we may be entering a cycle of growth downgrades.

Let’s do the math

Soaring export prices have been a major plus for Brazil’s trade performance, but that could change. Amid strong global growth, Brazil’s export prices have climbed more than 50% since 2002. The trade surplus, which has run above US$40 billion lately, would be already running close to the US$20 billion mark at 2002 average prices. Note that, at 2002 prices, the trade surplus has actually started to narrow already since 2006. And as we have argued before, even a moderate decline in export prices can make a significant dent in the trade surplus.

The outlook for export volumes in 2008 is uninspiring. A historical series gauging the external demand for Brazil’s exports can be constructed, based on total import growth at Brazil’s main export destinations, weighted by their share of Brazil’s exports. The correlation of that series with Brazil’s exports is high. In addition, we projected the global demand for Brazil’s exports, based on Morgan Stanley’s individual country forecasts. The upshot is that the external demand for Brazil’s exports is projected to slow from 18% in 2006 to 16% in 2007, and then to 12% in 2008.

And a strong currency does not help export competitiveness. Our econometric work suggests that a change of one percentage point in global real GDP growth implies a change of four percentage points in the external demand for Brazil’s exports. In other words, if global real GDP growth slides to the 3-4% range, external demand would slow to the 5-10% range. This in turn could easily pull Brazil’s export volume growth close to a halt, as currency appreciation since 2003 has already acted to slow export volume growth to about 6% in the latest data.

The consensus forecast for imports looks too sanguine. Imports look bound to keep growing at a strong pace next year. Imports are highly correlated with domestic demand, as proxied by industrial production. In fact, in light of steady currency appreciation since 2003, imports have grown even faster than industrial production would have suggested. Looking ahead, the market consensus sees industrial production growth at 4.5% in 2008, relatively stable compared to recent figures. But the consensus forecasts a slowdown in import growth to about 15% in 2008, from a pace of almost 30% in the latest data, despite the consensus view that the currency will remain strong next year. Something has to give.

For years, strong export growth has allowed fast import growth amid currency appreciation without trade deterioration. This is changing. Since 2003, strong global growth and rising commodity prices, and the resulting push for export growth, has allowed imports to grow quickly under an appreciating currency at the same time that the trade balance still kept improving. However, as the global economy slows and prospects for exports turn less exuberant, the combination of robust domestic demand and a strong currency will likely take its toll on the trade balance.

It does not take absurd assumptions to see potential for a significant erosion in the trade balance. A simple sensitivity analysis suggests that a range of plausible assumptions on import and export growth can result in relatively large swings in the trade balance next year. For instance, a 10% change in exports means a change of about US$15 billion in the trade balance, while a 10% change in imports alter the trade balance by about US$11 billion.

Bottom line
The market consensus forecast for Brazil seems to assume business as usual. It fails to recognize important changes in the global environment. As the outlook for exports turns more challenging while imports keep growing on strong domestic demand, the trade surplus is bound to narrow faster than the market expects. In turn, Brazil’s current account balance should soon dip into deficit.

Brazil Retail Sales September 2007

Bloomberg this morning:

Brazil's retail sales rose more than expected in September, led by sales of cars, computers and home appliances, as record low interest rates stoke consumer demand in Latin America's biggest economy.

Retail, supermarket and grocery store sales, as measured by units sold, rose 8.5 percent in September from the year-ago month, the national statistics agency reported today. Economists expected an 8 percent gain, according to the median of 31 forecasts in a Bloomberg survey.

The report added to speculation that central bankers won't move to lower the benchmark lending rate anytime soon on concern that accelerating economic growth will fuel inflation, said Zeina Latiff, an economist with ABN Amro NB's Brazilian unit.

``The figure reinforces the central bank diagnosis about the need to pause,'' said Latiff, in a phone interview from Sao Paulo.

Against the backdrop of the fastest economic growth since 2004, the bank on Oct. 17 paused after 18 straight cuts, holding the overnight rate at an all-time low of 11.25 percent, down from 19.75 percent in September 2005

Higher food and gasoline prices last month helped quicken annual inflation last month to 4.12 percent compared with an eight-year low of 2.96 percent in March. The bank targets annual inflation of 4.5 percent.

Sales of computer, office materials and communication equipments jumped 30.4 percent in October from the year-ago month. Sales of home appliances climbed 12.7 percent. Sales of cars and construction materials rose 19.8 percent and 9.1 percent respectively.

``Higher sales are disseminating among all sectors,'' said Zeina, who doesn't expect policy makers to lower the so-called Selic rate again until 2009.

The Brazilian real rose for a second day in early trading, climbing 1.7 percent to 1.7355 per dollar at 9:16 a.m. New York time from 1.7660 late yesterday.

Yields on interest-rate futures fell. The yield on the inter-bank deposit contract for Jan. 2, 2010, delivery, the most traded interest-rate futures contract in Sao Paulo, fell 6.6 basis points, or 0.066 percentage point, to 11.940 percent.

Brazil and Safe Havens

Ok, as the US starts to slow, and Japan and Germany follow suit, the interesting question is going to be to try and follow who in the emerging markets sector can hold up under the pressure. Brazil will be an interesting test case in this sense. Bloomberg today:

Brazil's real rose after the Federal Reserve cut the benchmark U.S. lending rate more than expected, making yields on Brazilian bonds more attractive and buoying expectations that demand for the country's exports will remain strong.

The real rose to a six-week high, climbing 2.2 percent to 1.8770 per dollar at 3:41 p.m. New York time after the Fed cut the benchmark rate by a half-percentage point to 4.75 percent. The real touched 1.8730, the strongest since Aug. 3. Brazil's currency has appreciated 13.9 percent this year, the second- biggest gain among the 16 most actively traded currencies tracked by Bloomberg News.

``A half-point cut sends a very clear message the Fed is not just looking at inflation, it's also making economic growth a priority,'' said Rogerio Chequer, who helps manage about $150 million of emerging-market stocks and bonds at Atlas Capital Management in White Plains, New York.

The real may strengthen to 1.85 reais per dollar over the next month, said Ronie Marcelo Germiniani, proprietary trading manager in Sao Paulo at Banco Itau SA, Brazil's biggest non- government bank in terms of market value.

The rate cut reassured investors that the world's largest economy will continue to grow, preserving demand for Brazilian exports such as orange juice, steel, coffee and soybeans.

Brazil's trade surplus widened to $3.54 billion in August from $3.35 billion the previous month, according to the Trade Ministry. That exceeded the $3.1 billion median estimate in a Bloomberg survey of 18 economists.

Record Exports

Exports rose to a record $15.1 billion last month from $14.1 billion in July, while imports also increased to a record $11.6 billion from $10.8 billion in July, the ministry said.

Brazil's 11.25 percent benchmark rate is among the highest in the world and is more than double the U.S. rate, helping lure capital to the country's fixed-income market.

The yield on Brazil's benchmark zero-coupon bonds due in January 2008 fell 2 basis points, or 0.02 percent, to 11.1 percent, according to B

Banco Santander in Brazil

This is an interesting piece from Bloomberg this morning:

Botin Builds `Republic of Santander' in Lula's Brazil

Brazil's trade minister is a former executive at Banco Santander SA. So is the man who oversees the country's monetary policy. Spain's biggest bank spent 1.8 million reais ($948,000) to back President Luiz Inacio Lula da Silva's campaign in 2002.

Now Santander is bidding for ABN Amro Holding NV's Brazilian unit to double its size in Latin America's largest economy. The deal would make Santander the biggest non-state bank in Brazil, ahead of Banco Itau Holding Financeira SA.

``Brazil is fast becoming the Republic of Santander,'' said Paulo Pereira da Silva, a federal deputy and head of Forca Sindical, the country's second-biggest union grouping. ``The bank's influence is growing.''

Santander Chairman Emilio Botin built ties to Lula as other lenders pulled back on concern the former labor leader would default on Brazil's debt, said Mauro Guillen, who wrote a history of the bank. Five years later, Citigroup Inc. and HSBC Holdings Plc are vying for a bigger slice of the Brazilian market as declining interest rates increase demand for loans.

``If they succeed in buying ABN Amro, Santander will become a Brazilian powerhouse,'' said Guillen, a professor at the Wharton School in Philadelphia. ``It's a quantum leap.''

Santander, based in the northern Spanish town of the same name, is part of a group led by Royal Bank of Scotland Group Plc that has offered 72 billion euros ($100 billion) for Amsterdam- based ABN Amro. The Spanish bank would get ABN Amro's Brazilian unit, Banco Real and Italian lender Banca Antonveneta SpA. A Santander spokesman declined to comment on ties to Lula.

Banespa Purchase

Botin appeared with Lula at a ceremony today in Madrid, where he said he expected Brazil to receive an investment-grade credit rating within 18 months.

``You know that we believe in Brazil,'' Botin told Lula, reminding him how they first met in his campaign office before the 2002 elections.

Santander, which entered Brazil in 1982, made its biggest push in 2000, when it bought Banco do Estado de Sao Paulo SA, known as Banespa, for $4.8 billion. Botin paid more than three times the price offered by the next-highest bidder, Uniao de Bancos Brasileiros SA, or Unibanco.

The rising value of Brazilian banks shows Santander's investment was sound, said Francisco Luzon, the bank's Latin America chief. Shares of Unibanco, Brazil's sixth-biggest bank by assets and the closest in size to Banespa, have risen fourfold since 2000, giving it a market value of 50.7 billion reais.

Yet Banespa's profitability and efficiency lag behind those of Brazil's biggest non-state banks, said Luis Miguel Santacreu, an analyst at Austin Rating in Sao Paulo.

Still Struggling

Banespa's return on equity was 15.5 percent last year, compared with 20.5 percent at Banco Bradesco SA and 18.3 percent at Itau. It also has the worst customer-complaint ranking among Brazil's biggest banks, according to the central bank.

``Buying Banespa was like a snake devouring a cow -- it takes a long time to digest,'' Santacreu said.

The payoff will be worth it, says Andrea Williams, who helps manage $2.4 billion in European banking stocks, including Santander, at Royal London Asset Management.

Brazil's mortgage market may grow more than fivefold in the next seven years, reaching 10 percent of gross domestic product from 2 percent now, according to Luiz Antonio Franca, mortgage director at Itau. Brazil contributed 455 million euros to Santander's first-half earnings, or 10 percent of group profit.

Santander backed Lula before the October 2002 elections, giving 1.8 million reais to Lula's party, according to Brazil's electoral court. It also donated 1.4 million reais to Jose Serra of the Social Democracy Party. By comparison, Itau donated 3.12 million reais to Serra's party and 350,000 reais to Lula's Workers' Party.

`Critical Time'

In August of that year, Botin restricted access to Santander's research after a New York analyst recommended selling Brazilian assets as the country's bonds and currency plummeted on concern Lula would default on 1.05 trillion reais of public debt.

After Lula's victory, Botin paid a call on the new president and pledged to maintain $2 billion in trade lines at a time when international lending to Brazil had plunged 16 percent.

``Santander believed in Lula and Brazil at a critical time,'' said Alexandre Marinis, who runs Mosaico Economia Politica, a consulting firm in Sao Paulo.

In March, Miguel Jorge, Banespa's corporate affairs director, was named trade minister. Mario Gomes Toros, a former vice president for Santander in Brazil, was appointed monetary policy chief at the central bank a month later.

A spokesman for Lula didn't return calls seeking comment. Jorge declined to be interviewed, a spokesman for the Trade Ministry said. Toros's representative declined to comment.

Jorge and Botin

At Banespa, Jorge helped leaders of United Workers' Central, Brazil's biggest union grouping, devise a plan for deducting loan payments from payroll checks, slashing costs for union members, said Jose Paulo Nogueira, executive director of the ABC Metalworkers' Union.

In previous corporate posts at Volkswagen AG's factory in Sao Bernardo and Autolatina, a venture of VW and Ford Motor Co., Jorge mixed with union leaders allied to Lula, including Luiz Marinho, who is now social security minister, Nogueira said.

Botin and Jorge hugged at today's meeting between Lula and Spanish Prime Minister Jose Luis Rodriguez Zapatero.

``Is Jorge someone Lula trusts? Well, he made him a minister,'' Nogueira said. ``They've been very astute.''

Brazil Q2 2007 GDP

Brazil's economy expanded at the fastest pace in three years in the second quarter as lower interest rates and a currency rally fueled higher consumer spending and business investment.

Gross domestic product, the broadest measure of a country's output of goods and services, jumped 5.4 percent from a year earlier after growing a revised 4.4 percent in the first quarter or put another way gross domestic product in the April-June period expanded a seasonally adjusted 0.8 percent from the first quarter.

The Brazilian economy's year-on-year expansion in the April-through-June period was the fastest since the economy grew 7.5 percent in the second quarter of 2004.

Brazil's currency gained on the news and the real gained 0.8 percent to 1.9090 per dollar at 4:08 p.m. New York time (13-09-07), the strongest since Aug. 9 when it traded at 1.90 reais per dollar. The real has gained almost 12 percent this year, the best performer among the six major Latin American currencies.

Brazil's central bank has cut the benchmark lending rate 18 straight times since September 2005 - from 19.75 percent to 11.25 percent, fueling consumer lending, business investment and industrial output. The real has appreciated 20 percent against the dollar in that period as export revenues for Brazil's commodity exports surged.

Consumer spending in Latin America's biggest economy rose 5.7 percent in the second quarter from the same period a year earlier, the 15th straight quarterly increase, the government said. Investment rose 14 percent compared with the second quarter of 2006, while industry rose 6.8 percent, services 4.8 percent and agriculture rose 0.2 percent.

The 12-month inflation rate has accelerated since March, when it reached 2.96 percent, its lowest level since February 1999. In August, the rate climbed to 4.18 percent.


Bank lending has increased every month since February 2004, helped by falling interest rates and the increase in paycheck- backed loans, created by Lula in September 2003, the central bank said Aug. 27.

The program allows workers to borrow at lower costs because repayments are deducted directly from their wages.

Vehicle sales in Brazil have risen more than 25 percent this year as lower borrowing costs, coupled with longer maturities for car loans, fueled demand. Automakers have stretched out maturities to as long as 84 months from 36 months last year, lowering the monthly payments for borrowers.