Brazil
Inflation and the Volatility Ghost
Jun 13, 2006

Heloisa Marone (New York)

In recent weeks, I have heard several stories from market participants attempting to explain the increase in volatility in emerging markets in general and Brazil in particular. From unconvincing stories on domestic politics driving uncertainty in Brazil to more convincing (albeit less tangible) risk-reduction arguments, all seem to point to a scenario where current volatility is expected to be short-lived. 

The goal of this note is not to propose yet another potential explanation for volatility but to point out what appears to be a disconnect between recent market movements and inflation and interest rate expectations.   This is especially important, as some investors are starting to wonder whether there might indeed be negative signs in Brazilian fundamentals that they may have missed and that could be driving the recent volatility, or whether we might be changing our view on Brazil’s outlook in face of the current bout of volatility.

Although we believe that fundamentals are not driving volatility in the Brazilian markets, there is still the possibility that a sustained period of high volatility could increase risk aversion and uncertainty, and this change in sentiment could then have an adverse effect on expectations, which could affect decisions and ultimately inflation and the real economy.  Indeed, in the most recent COPOM minutes, the central bank appears to be raising its vigilance level.  It argues that volatility, even if temporary, could add a higher degree of uncertainty to inflation projections.

A puzzle?

January 2007 DI Futures reached 15.64% on May 24, after trading below 14.8% in the period between April 17 and May 9.  Meanwhile, 2006 year-end IPCA inflation expectations remained stable at 4.3% between the May 19 and June 2 central bank surveys, having previously dropped for seven consecutive weeks from 4.57% in March. Similarly, year-end Selic rate forecasts were stable at 14.25% between the May 19 and June 2 central bank surveys, having previously been stable at 14% for four consecutive weeks.

And while expectations on the average Selic rate have shown a modest upward movement — suggesting that market players are expecting a slowdown in the pace of rate cuts until the end of this year — the move has been too gentle to justify the larger swings priced in the short-dated DI Futures.

Whatever the triggers are of recent market volatility, we find that it is not possible to explain this volatility by only looking at movements in market expectations on inflation and interest rates.  Furthermore, even if we believe that volatility could bring a certain degree of uncertainty to future projections, we still think that the inflation outlook remains positive.

Attention to volatility around the globe and fundamentals abroad have outshone recent positive domestic inflation releases. São Paulo’s Inflation (FIPE) dropped 0.22% in May — the lowest monthly result since 2000; the IGP-M has shown deflation in year-over-year terms in the last two consecutive months (-0.9% in April and -0.3% in May) — a drop of more than 1,000bp from last April; and the IPCA reached 4.2% year over year in May — the lowest result since mid-1999.

But what is behind the sharp decline in inflation?

It is undeniable that real appreciation has played a key role in depressing prices in the last year.  Tradable goods have fallen at a much faster rate than non-tradable goods. Annual changes to tradable goods prices moved from around 5.9% in May 2005 to around 0.6% in May 2006.  Tradable goods annual inflation rates moved from 7.2% to around 5.9% in the same period.

And while the BRL lost ground against the USD in the last three weeks, moving from 2.06 in May 09 to the low of 2.40 on May 24, BRL/USD is still trading at around 2.25. This brings the BRL back to September and early December 2005 levels — which were then the strongest levels since early 2001.  We therefore reemphasize our assertion that the effect of the recent depreciation in the BRL on inflation and inflation expectations should be limited (see Brazil: Rate Reduction Slowdown, This Week in Latin America, May 29, 2006).

More recently, the decline in inflation rates was a consequence of a sharp drop in alcohol fuel prices coinciding with the new sugar cane harvest that put an end to the high fuel prices cycle that began in late 2005.  But the main driver to lower inflation rates since early this year has been the deflation trend in food prices — particularly in produce and semi-processed prices.

A simple exercise indicates that, had we excluded the food group (that accounts for more than 20% of the consumer basket), the variation of the IPCA would have been on average 0.11 percentage points higher than the actual 0.27% average of the last four months.

And the overall inflation outlook remains positive — although some of these recent positive developments stem from temporary factors, and the lagged fiscal and monetary effects may produce additional inflationary pressure in the months to come by increasing aggregate demand.

Bottom line

Volatility has generated some puzzling behavior in the market.  While we cannot explain definitively what might be triggering this volatility, we find that it is not possible to explain the recent volatility by looking only at movements in market expectations on inflation and interest rates.  Furthermore, even if we believe that volatility could bring a certain degree of uncertainty to future inflation projections, we still think that the inflation outlook remains positive.

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India
The Coming Credit Slowdown
Jun 13, 2006

Chetan Ahya (Mumbai)

What’s new? India is witnessing one of its longest credit cycles of the past 35 years. Bank credit growth has accelerated to 31% from the bottom of 10.7% in September 2003. Indeed, India has cumulatively added credit of US$180 billion since January 2003.

Conclusion. We believe that the credit cycle is about to reverse, considering the steady rise in real rates over the past few months, the increasing supply constraint in banks’ balance sheets (i.e., low deposit growth), and the RBI’s measures to control aggressive credit by increasing the risk weighting on consumer credit lending, housing loans, commercial real estate and capital market-related advances.

Implications. We believe that debt-funded consumption growth, which has been at the heart of the above-trend GDP growth over the past three years, will be hit by the rise in the cost of capital and the consequent soft landing of the credit growth cycle.

Current credit cycle the longest since the 1970s
Low real rates and a sharp rise in bank credit have been at the heart of India’s growth acceleration story over the past three years. Nominal bank credit growth has accelerated from the bottom of 10.7% in September 2003 to 31% currently. The 12-month moving average of nominal credit growth has been accelerating for 27 straight months. Indeed, the current credit cycle is already the longest credit cycle India has witnessed since the early 1970s. Commercial credit to GDP has increased to 47% as at end-May 2006 from 35% in January 2003. Credit outstanding has increased by almost US$180 billion to US$380 billion over the past three years.

Credit cycle is at the peak, slowdown is coming
We believe that the credit cycle is about to reverse, considering the lagged effect of the steady rise in real rates over the past few months, the increasing supply constraint in banks’ balance sheets (i.e., low deposit growth), and the RBI’s measures to control aggressive credit by increasing risk weights for banks lending to select sectors.

Rising real rates. The trend in real rates has been a good leading indicator for India’s credit growth cycle. In the current cycle, due to the high level of financial integration, interest rates in India have followed a similar trend to those in the rest of the world. A decline in real rates (10-year bond yield) from 6.1% in March 2002 to negative 1.9% in September 2005 supported a big acceleration in real credit growth to 27% currently from 5.8% in September 2003. However, due the steady reversal in the global (particularly the US) cycle and consequently the Indian rate trend, we believe that credit growth is likely to reflect a slowing trend over the next six months. We have observed a significant lag in the trend in bank credit growth compared with the real 10-year yield trend as financial intermediaries tend to be slow in reflecting this trend in lending rates. For instance, in the current cycle, the market-oriented 10-year government bond yield started to move up from the second half of 2004, while banks’ lending rates began increasing only over the past five months, which we believe will now start weighing on borrower behavior.

Supply constraint in banks’ balance sheet. Not surprisingly, low real deposit rates have also meant a relatively slower time deposit growth in the banking system. Aggregate bank deposit growth has been 16% on average over the past 20 months. This compares with the credit growth average of 29% in the same period. With the bank credit-deposit ratio already at 70%, banks’ capability for credit creation going forward is constrained by them having to meet the minimum statutory liquidity ratio of 25%. As a result, banks will find it difficult to grow their credit book by more than 20-22% in the fiscal year ended March 2007, in our view. The government is working on reducing the statutory liquidity ratio for banks to create the room for the credit-deposit ratio to rise further. However, this is unlikely to help much, considering that the government will still have a large fiscal deficit funding requirement. If banks do reduce the government bond portfolio below 25% of deposits, it could result in sharper rise in government bond yields, in turn hurting public-sector banks as they hold about 30% of their assets in government bonds, with an average maturity of about five years.

RBI’s keenness to slow credit growth. The RBI has clearly been concerned with the strong credit growth creation in the retail and real estate sectors. Over the past three years, only 44% of the incremental credit disbursed flowed to the industrial and agriculture sectors. In a bid to slow this aggressive credit growth in sectors other than industry and agriculture, the RBI has initiated a number of restraining measures, including increasing the risk weighting for commercial real estate-related loans to 150% from 100%, for housing to 75% from 50% and for consumer loans (unsecured credit and credit cards) to 125% from 100%. The RBI has also increased the mandatory standard loan provisioning in specific sectors (personal loans, capital market-related loans, residential loans greater than Rs2 million and commercial real estate loans) to 1% from 0.4%.

We believe that the RBI’s concern is justified, considering that about 50% of banks’ loan books have been created in the past three years while the bank credit risk pricing curve has been flattening. Indeed, during the same period, banks have reduced the provisioning of loans significantly. We believe that the underlying asset quality of banks is likely to have deteriorated, considering the rapid pace of growth over the past two years, with the banks’ risk assessment systems — particularly in lending for sectors other than industry — still not fully in place. Indeed, India’s current credit expansion qualifies as a ‘credit boom’ using the IMF definition (a credit expansion in a given country is a boom if it exceeds the standard deviation of that country’s credit fluctuations around trend (using a Hodrick Prescott filter) by a factor of 1.75). The IMF’s study highlights that this filter helps to identify emerging market economies that are at significant risk of facing a credit cycle slowdown.

Possible scenarios for credit cycle
The key possible outcomes for the credit cycle are as follows:

Soft landing. This is our base-case scenario. We believe that credit growth will decelerate to about 18-20% by end of the financial year (i.e., March 2007) from the current 31%, driven by factors mentioned above.

Party goes on. We believe that this scenario (not a probabilistic outcome) will need a decline in real interest again with much larger capital inflows. While this may help to ensure continued strong GDP growth, it could result in much sharper widening of the current account deficit, increasing credit quality risks and further fuelling property prices, raising the risk of an eventual hard landing.

Hard landing. If India does witness large portfolio outflows for a long period of 9-12 months, it would result in a sharp slowdown in capital inflows and a sharp rise in real interest rates, causing a hard landing for the credit growth cycle.

Bottom line
We believe that debt-funded consumption growth, which has been at the heart of the above-trend GDP growth over the past three years, will be hit by the rise in the cost of capital and consequent soft landing of the credit growth cycle.

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Australia
Australia's Slowdown
Jun 13, 2006

Gerard Minack (Sydney) and Mark Skocic (Sydney) and Toby Walker (Sydney)

Recent economic news has surprised on the upside. Ironically, it has reinforced our view that the domestic growth risks are skewed to the downside in 2007. Our new economic forecasts reflect this peculiar mix. We’ve revised up our GDP forecasts to 2.5% and 1.1% for 2006 and 2007, respectively, from 2.2% and 0.9% previously. However, we’ve cut our 2007 domestic demand forecast to just 0.2% from 0.5% previously.

We expect that several factors will slow domestic demand through 2007. 1) ongoing weakness in residential construction; 2) the approaching top in the business investment cycle; 3) mounting pressure on household-sector finances, which we expect will mute fiscal stimulus; 4) a disappearing terms-of-trade assist; and 5) a softer labor market, as the labor-intensive consumer sectors slow. As is usual, there are risks either way around our base case. If consumers decide to spend all their fiscal gifts, then demand will be higher. Conversely, we assume that global growth holds up; it may not.

Policy-makers won’t stand by as growth weakens. We expect to see both looser fiscal policy and lower interest rates next year. While the near-term call on the RBA is close, we expect a run of cuts next year. Lower rates point to a lower A$.

Economic weakness points to earnings weakness — which would be poison to an equity market that has been driven by an earnings bubble. We recently reiterated our long-term bear view: specifically, an ASX 200 at 3,000 in 2010 (see ASX200 Doubles in Three Years: How Long Until It Halves? May 10, 2006). The earnings downside in our economic forecasts is a step along that bearish medium-term outlook for the market.

The balancing act

The past two years in Australia have seen a macro-balancing act between, on the one hand, a consumer struggling under the burden of negative cash flow and, on the other hand, business and (federal) government sectors enjoying the fruits of a once-in-a-generation commodity windfall.

We have been bears, expecting the growth drag from consumer adjustment to overwhelm the positives. Our forecast revisions — which involve moderate upgrades to the 2006 outlook — are an admission that the positives continue to outweigh the negatives.

In particular, we underestimated the gush of cash heading into Canberra’s coffers, and the resultant ability of the federal government to loosen fiscal policy. Cycle-related revisions have improved the budget balance by 2-3% of GDP in the past two years. This has allowed the government to announce discretionary policy loosening of over 1% of GDP in each of the past four years (including the 2006-07 Budget), and still report large surpluses.

To be fair, missing this fiscal boost is not the only factor that has forced us to revise our 2006 forecast, but it is the most important. We have revised up our 2006 GDP estimate from 2.2% to 2.5%. The biggest component revision was to consumer spending (1.3% to 2.5%). We have also revised up our private investment forecast to 4.6% from 2.2%. The major negative revision has been cutting forecast export growth to 4.9% from 7.9%.

Why the balance may tip

The most important call, in our view, is for domestic demand next year. We expect domestic demand growth of only 0.2% in 2007 (was 0.5%), down from 3.1% this year.

Below are five factors that we expect will slow domestic activity through the next few quarters:

Weakness in residential construction. Notwithstanding falling vacancy rates, we expect that residential investment spending will fall next year.

A turn in business investment spending. Most leading indicators now point to significantly slower investment spending growth next year, if not an outright decline.

The pressure remains on household sector finances. Partly because consumer spending has held up better than we expected, household finances have become more not less stretched. Household leverage is at an all-time high, household saving remains negative, and the debt-service burden hit a new all-time high in the March 2006 quarter. Because of that pressure, we expect that most of the upcoming tax cuts — both those already announced, and the big tax cuts we’re forecasting for next year — will be saved. The biggest single upside risk to our forecasts is that we are wrong on that point, and that all the tax cuts get spent

The terms of trade windfall is likely to moderate. This is not such a brave forecast: remember that the windfall comes from the terms of trade improving — that is, from the terms of trade change, not their level. Through the course of 2005, real domestic income grew by 2.7 percentage points faster than GDP. In our forecasts, this gap is likely to reverse in 2007 — even though we expect only a moderate (and temporary) deterioration in the terms of trade

Employment weakness. Most leading indicators of employment are moderating. This is no surprise: the rebalancing of growth from consumers to business and exports has swung the economy’s centre of gravity from job-intensive sectors to capital-intensive sectors The result is slowing employment growth.

Versus these slowdown factors there is clearly one big positive in the outlook: the prospective lift in mining-related export volumes. We have strong mining-related export volumes in our forecasts. This is part of the reason why we have significantly stronger GDP growth next year than we do domestic demand (1.1% versus 0.2%).

Market implications

The most contentious element of our forecasts is the slowdown — the market implications are, in our view, straight-forward and unsurprising (given that macro view). We expect the RBA to cut rates and fiscal policy to be loosened further. Because the windfall from the terms of trade improvement disappears, the expected loosening in fiscal policy will actually push the federal budget into deficit in our outlook.

We expect the RBA to cut rates by 150-200bp through the downswing. We expect the first cut i in the March 2007 quarter.

Consistent with our global FX team’s view, we expect that the A$ will trade down to around mid-60¢ against the US dollar by the middle of next year.

But the most important implication of this growth slowdown, in our view, is the impact on corporate earnings. We expect a double-digit decline in the top-down measure of earnings.

Such an earnings decline would be poison to an equity market that is now, in our view, riding an earnings bubble. At the moment, we are seeing reported earnings significantly outpace the top-down measure of earnings. We suspect that this leverage will work both ways: it may be that reported earnings will fall faster than the top-down numbers we have forecast.

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