Brazil is Not Argentina: Its a Matter of Stock Vs Flows
Remember a few years when investors looked at the upside of Argentina because of their untapped commodity resources and said if only Argentina could follow market friendly policies like Brazil? So, it is not a surprise that the markets are reacting positively to the the change in government in Argentina that is reform focused and market friendly. I also can see why the markets are also reacting positively as Brazil is now becoming Argentina after its own change in government to one that is also more market friendly and focused on reform. I believe that the markets are mistaken probably for Argentina but more clearly for the case of Brazil.
First, clearly the commodity opportunity is not like it was in 2010 after the surge in commodity prices as demand grew from China investment stimulus.
Second, reform is great to talk about but extraordinary difficult to implement particularly when it means hardships for consumers, workers, and other getting government subsidies.
Third, the difference between flows on stocks. This is the issue of ongoing policies--the flows-- that are not constrained by a mountain of debt--the stocks. On this basis Argentina has chance of reform because it is now not buried by the burden of too much debt. However, Brazil on going policies need to be much more restrictive because they need to deal with a debt bubble ten years in the making.
So, first commodities. Commodities are the single biggest factor driving EM economies and ultimately their equity markets. Do you think Brazil would have grown as much as it did during 2002-2012 without commodity prices surging along with commodity investment that were in turn driven by a surge in China demand? That growth would seem completely unatanable given that Brazil is a consumption economy that relies on external funding for investments, which are by and large commodity investments. So oil may go to $60 but unlikely to go to back to the peaks of $100 anytime soon. Same for iron ore.
Second, the reality of reform. How do you think the average voter in Brazil will deal with actual reform that means they cannot continue to consume at 85% of GDP, receive generous transfer payments, have lower retirement age than the French, receive government subsidized low interest loans, have wages index to inflation? My guess is they will not react well. And that means political risk will grow as reform takes hold. Yet, that is what Bovespa seems to be pricing. Yes, the new government can say many positive things about changing the direction of their economy. However, without the tailwind of commodity investments, the ability to implement those changes is limited.
Third, stock vs flows. Brazil has built a mountain of debt both private and public over the last ten year. Yes, the public debt of Brazil would not seem so onerous, so debt to GDP is high but does not seem like it would be constraint on government policy. However, it’s not just the notional of the debt it is also is the yield level of the debt. Accordingly, the government is now paying over 10% of GDP for interest payment on their debt. It looks even worse in the private sector. So, how do ease the transition from a consumer driven economy to one that driven and supported by domestic investment, and at the same time reduce the government deficit. The answer for Brazil is you cannot because the debt burden is too great. However, the answer for Argentina is maybe you can. That reflects the 10 years in which Argentina was prevented from borrowing externally so they could not build their own mountain of debt. So, now they can and it is likely that Argentina will yet become the current Brazil over time. But for now, they have the resources to implement reform while Brazil does not.
All of these issues I will cover in my next SOM on Brazil. But for now, I am arguing for buying puts on Bovespa. Again the key factor for Brazil and Bovespa is commodities. Unfortunately, we have probably seen the end of the commodity super cycle. Yet, Bovespa is pricing in an Argentina outcome with the resources to do it without a surge of commodities back to their peaks.