While it is difficult to handicap the next moves of the policymakers, we suspect that they are limited in what they can do. After all, Brazil's economy is increasingly dependent on portfolio inflows (see "Brazil: Financing Mismatch", This Week in Latin America, October 18, 2010). Indeed, a move to limit inflows could easily crimp Brazil's powerful domestic demand story. This is worth taking into account, given talk that Brazil could take additional measures to further limit pressure on the real to strengthen.
Last week we argued the following: although Brazil's current account deficit still appears to be manageable, the composition of how the deficit is being financed should give reason for pause. During the past decade, foreign direct investment (FDI) consistently outstripped portfolio flows to Brazil. With the exception of a brief period in 2007, FDI has been the dominant source of inflows for more than a decade.
Today, however, we have seen a dramatic reversal: portfolio flows now dwarf FDI by a ratio of more than two to one. That might not be reason for alarm, except for one additional factor: the surge in portfolio flows is coinciding with a widening current account deficit and today roughly half of the current account deficit is being financed by portfolio flows. In the past 12 months, the current account deficit reached $47.3 billion, while FDI reached only $30.1 billion (the gap was filled by portfolio financing). With portfolio flows at $71.7 billion in the past 12 months, it is clear that the authorities can afford to reduce the portfolio flows somewhat without risking the financing of the current account deficit. But the authorities need to be careful lest their measures are misinterpreted or cause a reversal in flows.
It is also worth noting that the authorities have adjusted the IOF tax on numerous occasions since its introduction in March 2008, including a period (following October 2008) when the tax was reduced to zero. If the authorities' measures create too dramatic a change in portfolio flows, we would expect to see similar fine-tuning of the taxes.
The growing current account deficit, which on a 12-month basis has nearly doubled since December 2009 to $47.3 billion, is in part the result of an increasing disconnect or mismatch between demand drivers in Brazil and output. A look at the data from the past week is telling. The unemployment rate in September reached a new record low (6.2%) in the history of the series. Indeed, while all the demand drivers - real wages, employment, credit and confidence - have been at or near record levels, Brazil's broadest measure of output, namely GDP, began to diverge from the strong demand picture. 2Q GDP was up only 5.1% in real terms on a quarter-over-quarter annualized basis. And even there, the GDP report's quarter-over-quarter upturn likely obscured a significant stalling out in activity seen by looking at the monthly GDP series (see "Brazil: Slowdown - Comfort or Caution" and "Brazil: What Slowdown?", This Week in Latin America, July 26 and August 16, respectively).
Last week, even as the authorities were announcing a new record low rate of unemployment (a clear driver for strong demand), GDP for the month of August showed once again that overall output has largely stalled. August GDP was flat - 0% change relative to July, the fifth such month of very weak reports from the output side. While GDP was still up relative to a year ago, this largely reflects the strong momentum that was driving output in the 2H09 and 1Q10.
The gap between Brazil's strong domestic demand and stalling supply is increasingly financed by portfolio flows at a pace we have rarely seen. A reduction in portfolio flows may be desirable, but it would need to be either met with an offsetting increase in other supply of flows such as FDI or with a slowing in the growth of demand. Of course, we are forecasting, as are others, that growth in GDP is set to slow in 2011, and indeed it is already slowing. Our concern, however, is that so far the slowdown has been seen much more pronounced on the output side than on the demand side.
Bottom Line
While there is growing debate over whether the next move by the central bank will be to hike or cut rates next year and the first signs of a debate over the pace of growth in 2011 (a debate we have been advocating in recent months), there is actually one thing that we think we know about Brazil: the authorities have very little maneuvering room to limit portfolio flows. The growth during this year in Brazil's current account has not been accompanied by an increase in FDI. To the contrary, FDI has been sluggish. That has left Brazil more reliant on the very portfolio flows that it seeks to limit. Ultimately, that is likely to limit the measures that the authorities can take.
Key Observations Based on the MSCBCI
Macro View: A Visible Softening
Morgan Stanley's Business Conditions index softened in October, with all of the three components of MSCBCI - headline, expectation and composite - having declined from September readings. However, all readings are still well above the expansion-contraction threshold of 50, suggesting that, while sequential growth may be losing some momentum, overall economic expansion is still intact.
The headline MSCBCI in October edged down modestly from last month's reading, suggesting no major change in business conditions. However, the expectation MSCBCI - which indicates the trend over the next six months - reads lower, at 59.1, compared to the headline MSCBCI at 67 in October. The composite MSCBCI, an early gauge of PMI, is also deteriorating, reflecting a decline in most of its components, except new order. Thus, the official PMI is likely to fall, in our view.
The sub-indices show a mixed pattern in October. For the headline comparison, sales, pricing, profit margins, capacity utilization, capex and new order have witnessed a rise from September, while the others have declined. However, with regards to headline versus expectation, only risk to earnings, materials inventory and hiring are expected to rise over the coming months. So, the bottom line is that our analysts expect overall business conditions to become less favorable going forward, despite exceptions in certain themes such as upside risk to earnings, a pick-up in materials inventory, and an active hiring plan. That said, the potential deterioration in business conditions seems modest, given that the readings of all sub-indices are still well above 50.
Renewed uncertainty of late about the economic and policy outlook may have contributed to the softening in the MSCBCI. Specifically, the recent austere property sector policies aimed at curbing speculative investment are likely to affect property transactions. Second, monetary and credit conditions may prove to be less accommodative than originally expected, especially in view of the surprise interest rate hike early last week and a RRR hike earlier.
MSCBCI: An Early Gauge of Official PMIs
The composite MSCBCI is synthesized based on six components. Four of the six share similar features as those in the official PMIs, including new order, capacity utilization, materials inventory and hiring. However, the weight we assign to each component in the MSCBCI differs somewhat from that in the official PMIs. Thanks to these similarities, our composite MSCBCI can be used as an early gauge of the potential trend for the PMI, as the MSCBCI is compiled prior to the release of the official PMIs.
The composite MSCBCI declined in October; thus, if the MSCBCI-PMI relationship holds, it would indicate a lower reading in the PMI for October.
We attribute the drop in the composite MSCBCI for October mainly to the decline of capacity utilization expectation, materials inventory, hiring and credit conditions, while there was an uptick in new order.
Sector View: Consumer Discretionary and Utilities Lose Momentum
Compared to last month, consumer discretionary, consumer staples, energy, healthcare and utilities have seen their business conditions improved, while the cyclical and technology sectors, e.g., industrials, materials, IT and telecom, have recorded a lower reading. Financials remain unchanged. However, since their scores are still equal to or above 50, an expansion-contraction threshold, the lower reading does not mean an outright deterioration but a slower pace of expansion.
A comparison between headline and expectation components of the MSCBCI helps shed light on the potential change in future direction of business conditions facing different sectors. Business conditions for consumer discretionary and utilities will likely worsen as their scores are below 50. While consumer staples and materials also register lower readings, they are still above 50. Other sectors - energy, financials, healthcare, industrials, IT and telecom - are poised to improve or at least remain stable.
This sits against the backdrop that the central government tackled speculative property investment with new tightening measures, shut down energy-inefficient enterprises to achieve energy conservation targets, and recently hiked interest rates and the RRR to manage inflation expectations. Specifically,
•· First, based on our analysts' responses for these sectors, we find that the deterioration of business conditions for consumer discretionary mainly comes from the auto and home appliance sectors. Reflecting government subsidies to such big-ticket items purchase, sales of auto and home appliances grew very fast during the past months. However, such subsidies are expected to expire by the end of this year. Going forward, sequential growth rates of both might start to moderate, in part due to the phasing-out of subsidies and the high base.
•· Second, in the utility sector, the dismal outlook is primarily due to the upstream and downstream price-setting system. For gas distribution, the upstream and downstream prices are controlled by the government. The upstream price was raised nationwide in June 2010 while a similar downstream price adjustment either came late or has yet to take place, which is largely determined by local governments. For the power sector, the ASP of electricity is fixed by the government while the prices of raw materials (i.e., coal) are not. The high coal prices would squeeze the profit margin of these power plants.
•· Third, the business conditions for the cyclical sectors like energy and industrials are expected to maintain or improve from the current level. This reflects primarily the government's aggressive implementation of the social housing program, which constitutes an important cushion for any potential slowdown in private, market-based property construction and thus underpins such cyclical sectors (see China Economics: Social Housing: Lackluster Growth or Quantum Jump? August 12, 2010, and China Economics: Can Social Housing Program Help Secure a Soft Landing? June 17, 2010). Moreover, while China's political campaign-style effort to achieve its energy conservation target has closed down thousands of energy-inefficient production facilities, industry leaders - which tend to be covered by Morgan Stanley equity analysts - will be less affected and instead will benefit from potential industrial consolidation and the resultant stronger pricing power, in our view.
•· Fourth, other sectors have fared well so far and are likely to see further strength over the coming months. Consumer staples will be down slightly, but still much beyond 50, and it will be supported by a broad-based wage rise and should also benefit from a mild inflation environment. The reading for materials is expected to trend down from a high level. The energy sectors tend to do well while commodity prices are buoyant. Financials are uneven: while banks and insurance companies will enjoy a stable outlook, business conditions in the property sector are under downward policy pressures. The healthcare sector should benefit from the ongoing healthcare reform. IT will see better business conditions while the Telecom sectors will maintain at the current level.
Cross-Sector Themes
Sales, Pricing, and Margins: Less Bright Outlook
The indices for October are higher for product pricing and profit margins but lower for sales than the previous month. This suggests that corporate earning abilities are performing well so far, although the top-line growth for sales might pace relatively slowly.
Going forward, the outlook for sales, product pricing and margins, however, are less bright than at present. All three expectation indices are falling from the current level. The decline in sales indicates that companies will face more pressure to keep rapid growth. The weakening pricing index is consistent with the moderation in PPI and non-food CPI inflation. But it would also point to narrowed profit margins. Overall, the business conditions will likely be less favorable than the current level.
Earnings: Cautiously Optimistic Outlook
Until now, the actual earnings of the companies covered by Morgan Stanley's equity research team have largely surprised to the upside, based on the survey results from August to October. In October, 36% of the responses reporting year-to-date (YTD) earnings exceeding estimates (less than 50% in September), 52% in line (versus 41% in September), and 11% below estimates (versus 7% in September). For the whole picture, the readings for risk to earnings estimate in October are less favorable than in September.
Looking ahead, the expectation of risk to earnings estimate envisages a better outlook than the headline, with 41% of the responses highlighting the upside and 7% flagging downside risk, indicating a cautiously optimistic outlook for earnings going forward.
Job Market: Tight Market for Skilled Labor
There is no broad-based labor shortage. On average, 84% of the responses (versus 77% in September) find no difficulty in hiring employees in October and only 16% of the responses (versus 23% in September) report a labor shortage, all due a to shortage of skilled labor. The skilled labor shortage exists in the consumer discretionary, consumer staples, financials, industrials and IT sectors, but it is not significant. Considering that these listcos are more productive and less labor-intensive through technology, the reported migrant labor shortage is expected to have little influence on these companies; instead, the skilled workers are always in need.
Despite no widespread labor shortage, wages have been on the rise. We expect that the recent policy in focus is to accelerate structural reforms to improve the quality and sustainability of growth, i.e., more reliance on consumption instead of investment. In this connection, wage rise is a key under this direction. In our MSCBCI, about 75% of the responses report a wage rise in their sectors, and 25% observe no change in wages.
Sector-wise, 100% of the responses in the energy sector and 33% in IT have found a significant rise in wages, and the other sectors identify a different degree in wage rises.
Of note, wage increases have not had a significant impact on corporate profits: 45% of the responses view that the wage rise has no impact on their profit due to product price rises at the same pace or faster than wage rises, while about 39% indicate a modest impact by reducing profit slightly, and 16% find no wage rise in their sectors. This means that wages may only account for a small part of the corporate cost structure among our company sample, and suggests that concern that wage rises would erode corporate profitability are overdone. This finding is consistent with the view we expressed in China Economics: Should We Be Worried about Large Minimum Wage Hikes? June 6, 2010.
With regard to hiring, 45% of the sectors have hired more people compared to six months ago, while hiring plans appear a little more aggressive as 55% of the sectors have plans to grow their headcount over the next six months.
Credit Conditions: Slightly Tighter Credit Conditions Expected
Credit conditions have been slightly tighter over the past three months, as reflected in the diffusion index. Going forward, 14% of the responses expect to find credit easier to obtain over the coming months; 12% think that it will be more difficult. This may have reflected on the demand-side rather than supply-side factors.
By sector, materials and IT expect to find it easier to obtain bank credit; consumer discretionary, industrials and healthcare expect it to be more difficult. The remaining sectors foresee no change.
Looking ahead, Morgan Stanley's view is that the credit conditions may become relatively tight, as the PBoC appears determined to forestall inflation expectations, and the bank lending target is unlikely be relaxed to a level significantly beyond the original target of Rmb7.5 trillion for this year.
Disconnect Between Capacity Utilization and Capex Persists
Capacity utilization is expected to decline. At present, only 27% of the responses envisage that capacity utilization will improve over the next six months, down from 52% in October. Meanwhile, the percentage expecting a lower utilization ratio over the coming months rises from 7% to 25%.
Among the sectors, six out of 10 expect lower utilization, including consumer discretionary, consumer staples, financials, industrials materials and utilities, leaving energy, IT and telecom unchanged. Healthcare is the only rise.
The disconnect between the relatively low capacity utilization expectations and relatively ambitious capex plan persists, indicating an optimism about the medium- and long-term growth outlook. Despite the rather cautious outlook for capacity utilization, 43% report that they have expanded capex during the past six months, and looking ahead, almost the same share of sectors will continue to expand their capex over the next six months, reflecting that the companies will downplay the temporary shock from capacity utilization and still embrace a persistent optimism over the longer term.
For details, see the full report AlphaWise Evidence Series: October MS China Business Conditions Index Softened, October 25, 2010.
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