Brazil’s Perfect Storm

A worsening terms-of-trade, reduced capital inflows and diminishing domestic credit availability will generate major headwinds for the Brazilian economy in the months ahead.

BCA | Underweight Brazil

T he outlook for the Brazilian economy remains dim despite monetary easing. Brazil’s terms-of-trade has already rolled over and there is potential for a further slide in the country’s export prices. In addition, foreign funding is set to dry up as European bank deleveraging limits funding available for developing nations.

Brazil, in particular, would feel the pinch since European banks hold $350 billion in claims out of a total of $540 billion in foreign claims. Apart from funding difficulties, a deterioration of credit portfolios warns of severe constraints to private bank lending. Consumer delinquency rates are rising even though the unemployment rate is at a record low and income growth has been solid. The main reason for increasing defaults is that debt-servicing costs in Brazil have risen sharply and remain high relative to income.

As the potential credit crunch and deteriorating external environment weigh on growth and corporate profitability, the employment situation and wage growth will worsen and household delinquency rates will likely rise even further. Even the ongoing currency depreciation may fail to boost growth. Exports account for only 12% of Brazilian GDP so the positive impact from currency depreciation is limited, especially if commodity prices drop further. Also, the ongoing currency depreciation coupled with falling share prices could discourage capital inflows.

Bottom line: Our Emerging Markets Strategy service continues to recommend underweight positions in Brazilian equities within EM portfolios.

Outlook For U.S. Corporate Earnings

U.S. earnings growth will remain supportive for equity prices this year.

Outlook for U.S. Corporate Earnings

C orporate profits have been the bright spot for the economy. The recovery in corporate earnings has been boosted by a rapid fall in interest costs, a quick reduction in wage rates and a sharp gain in labor productivity.

Although earnings growth will slow as the cycle matures, profit contraction is not in the cards for now. The recent drop in bond yields has pushed real borrowing costs deeper into negative territory, which will benefit the corporate sector. Also, large labor market slack will keep labor costs in check and materials costs have also been lowered as a result of falling commodity prices.

All of these factors could more than offset the negative impact of soft top-line growth, helping keep profit margins high.

While there is growing concern that margins are already high and that “mean reversion” is inevitable, it is important to note that more than 30% of U.S. profits come from abroad and the share continues to get bigger. Yes, corporate margins are at a new high for the current cycle, but are not at a peak relative to long-term history. This is especially true when domestic profits are compared with domestic corporate GDP (rather than overall earnings to domestic GDP).

Cyclically, the market should move in tandem with underlying earnings growth, which our Global Investment Strategy service estimates to be around 6% by year-end. Of course, a much larger price appreciation is possible if multiples begin to expand, but heightened macro risks will limit any meaningful upward re-rating for common stocks.

Oil: A Temporary Selloff?

Oil prices may stay under downward pressure in the near term and are particularly vulnerable to euro volatility. Nonetheless, our cyclical bias is still positive.

A pullback in oil prices was overdue based on technical readings and sentiment, but the extent of the selloff was exacerbated by a confluence of factors: euro weakness, the stalling of the U.S. equity rally, a multi decade high in U.S. crude inventories and a buildup in speculative positions.

Oil Investment Strategy

True, a convincing break in the euro below 1.30 would likely trigger a washout in commodity prices. However, the outperforming German economy and EFSF/ESM facilities argue in favor of a slow grind lower in the euro rather than a sharp decline.  Moreover, many of the headwinds for oil prices should prove temporary even if a washout in the euro does develop. Generous Fed liquidity reduces the odds of sustained U.S. equity weakness at a time when the U.S. economy is on a stable, albeit slow growth path.

In this environment, lower oil and product prices have a self-stabilizing aspect by supporting consumer and business confidence, suggesting that without a major exogenous shock, the downside in oil prices from current levels is limited.

Bottom line: Our Commodity & Energy Strategy service maintains that oil prices should be higher by year-end.

A Case For U.K. Equities

Although the U.K. economy faces severe headwinds for a long time, there is a building case for adding exposure to U.K. equities within global stock portfolios.

A Case For UK Equities

I t is a well-known fact that the U.K. economic environment will remain very challenging due to harsh fiscal measures and its vulnerability to the rest of Europe. However, according to our Global Investment Strategy service, this information should already be discounted by financial markets.

Indeed, the forward P/E for the stock market is less than 10, implying a very high equity risk premium. Also, sterling is very undervalued on a purchasing power parity basis, which is positive for stocks. The Bank of England will keep policy ultra easy to counterbalance fiscal austerity and importantly, the FTSE index has many multinationals whose earnings are levered to global growth, not the U.K. economy.

Finally, sentiment toward the U.K. economy and its markets is negative, while market positioning is barely neutral. True, the U.K. equity market is close to a multi-decade high compared to euro area equity markets, but this is not the case relative to a larger basket of global stocks.

Our global team recommends boosting positions in U.K. stocks relative to global benchmarks.

Do Not Give Up On U.S. Refiners

A catch-up phase lies ahead for U.S. oil refinery stocks.

US Refinery Stocks

U.S. refinery stocks have been underperforming amidst negative news stories, shutdowns and bankruptcy announcements. However, these stocks are very cheap and the underlying positive story for the U.S. independent refinery sector remains unchanged. 

Equity prices should catch up with robust profits by year end as earnings continue to surprise on the upside. Independent refiners will continue to enjoy generous profit margins, as long as WTI-related grades continue to trade at a discount to other benchmarks, as we expect. Meanwhile, these refiners will continue to receive about 60% of their crude at a discount, which will support profits.

A sharp recovery of oil quality spreads after last year’s compression adds another tailwind for refiners’ profits. Very tight distillate inventories at a time when economic activity is improving suggest that distillate margins may widen even further from these high levels. Upcoming closure of over 2 million barrels a day of refinery capacity later this year will likely create product shortages and dislocations in the market, further supporting cracking margins.

Bottom line: U.S. refinery stock prices should catch up with robust profits as earnings continue to surprise to the upside over the next year.