Mining GFC monsters Brazil

Friday saw firming action in stocks, bonds and currencies for the global business cycle but behind the scenes the mining GFC is simmering away. Readers will recall that the MB thesis is that a healing US economy, tightening monetary policy and a US dollar bull market, combined the Chinese structural adjustment to lower and less commodity intensive growth, as well as financial market destocking of commodities will drive prices of same to undreamed of lows. Moreover, that that process will culminate in a cycle ending crisis of some sort in commodity producer and emerging markets (EM) debt that will accelerate the supply side shakeout in global excess supply.

The big victim Friday night was base metals which continue to set records to the downside, with copper and nickel both setting new post-GFC lows (iron ore did as well):

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The big diversified miner most leveraged to copper, Glencore, was hit 2% as well, though like the others still sits just above recent lows on forlorn hopes a rebound:

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The US dollar rebounded strongly from a few days of weakness suggesting plenty of buying on the dips. Since the GLEN panic six weeks ago, commodity producing emerging market currencies (including AUD) have all rebounded after being oversold and that continues but on the monthly chart there is no mistaking the trend:

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Meanwhile, US high yield debt (which is a decent proxy for marginal energy and mining debt) sold marginally on the night and remains right on its support lows of the European crisis:

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The mining GFC simmers on. We have no idea which commodity producer will go into meltdown to trigger the round of panic – miner or country – but today’s leading candidate is Brazil, from Barclays:

“Brazil is confronting a toxic combination of a primary budget deficit, high public debt (relative to EM countries), very high real interest rates (the Selic stands at 14.25%), sluggish trend growth, a negative commodity price shock and potential contingent liabilities for the sovereign, which together spell trouble for public debt dynamics.”

The combination of high debt/GDP and high interest rates means that Brazil suffers from ‘fiscal dominance’, a situation where monetary policy is driven by sovereign solvency concerns. Given the sensitivity of public debt to high interest rates in Brazil, the central bank is unlikely to tighten policy despite high inflation.

How much time does Brazil have before markets push sovereign yields higher, accelerating the unsustainable debt dynamics? There are some important risk mitigants. Brazil’s debt is predominantly payable in local currency, and what is payable in foreign currency is covered many times over by its international reserves. The problem is that, by our estimates, public debt in Q4 2015 will be more than 71% of GDP with average funding costs at more than 12%, with no prospects for a turn-around towards a sustainable primary surplus or stronger growth prospects.

The challenges of fiscal consolidation in Brazil are only beginning, and without policy changes, prospects of success are bleak.

In a stressed scenario, in which there is a lack of full Congress support and an unsuccessful asset sales program, we see the fiscal adjustment for 2016 amounting to only 1.0% of GDP.

This scenario is consistent with increased market pressure for the remainder of 2015 and 2016 (Figure 9). Market stress could increase, for example, due to a potential impeachment of the President, a loss of confidence in the fiscal outlook, and/or a significant increase in contingent liabilities. Our projection assumes that the primary balance worsens relative to our base case, reaching -2.3% of GDP in 2016. The deficit falls gradually thereafter but a deficit persists until 2019 (-0.5 percent).

The recession lasts for longer than in the base case, but inflation rises further because further BRL depreciation pushes actual inflation and inflation expectations higher. Inflation rises to 9% in 2015 and remains high (but gradually falls) thereafter. Interest rates rise 2pp more than in the base case in 2015 and 2016, as higher risk premia push up the cost of debt.

The chart depicts 40 paths for debt/GDP associated with increasingly higher interest rates in steps of 10bp, starting from the baseline path for debt/GDP to the last path corresponding to the baseline scenario for interest rates plus a 400bp shock. The shock is applied to the interest rate in the transition years, not to the steady state interest rate (set at 8%). The key takeaway is that as the cost of debt rises in the baseline scenario, public debt/GDP increases rapidly and stabilizes later relative to the base case. In the extreme case of a +400bp increase in the average cost of debt, the public debt/GDP ratio peaks at a whopping 114% in 2021.

“The prospect of such deterioration is likely to lead to a further sell-off in Brazilian assets andcould create contagion – especially to vulnerable EMs – given Brazil’s systemic importance.”

Goldman actually sees all of Latin America following this path:

Given the shifting external backdrop, the region is unlikely to count on strong balance of payments dynamics to leverage and support a visible economic recovery. The expectation of low-for-longer commodity prices, weak non-commodity export demand, moderating FDI and portfolio inflows, and likely more expensive and selective access to external funding, may well demand additional current account adjustment. This would require further currency depreciation, higher domestic savings and contained investment (i.e., weak domestic absorption). Furthermore, we see virtually no room for additional countercyclical fiscal or monetary stimulus to support a more vigorous recovery.

Despite the weak growth dynamics, inflation is expected to remain high across LatAm. Average inflation ex-Venezuela is expected to reach 8.1% in 2016, down slightly from the forecasted 8.7% average for 2015.

Overall, inflationary pressures across the Andean economies are expected to remain relatively high throughout 1H2016 given the expected lagged pass-through from currency depreciation and the impact from what is expected to be an intense El Niño weather phenomenon.

Regional currencies have weakened significantly in 2014-15 and we expect further weakness in 2016. We expect most currencies to depreciate moderately in 2016 given the evolving global backdrop (low commodity prices with additional declines forecasted for copper prices, rising dollar yields, and strengthening USD), the unhappy domestic combination of low growth and high inflation, and a number of idiosyncratic factors.

Despite the undistinguished growth outlook, in our assessment, the spectrum of risks is still tilted to the downside. In fact, the vector of risks is to a large extent not materially different from the risks the region was facing at the beginning of 2015, namely: (1) sharperthan-expected growth deceleration in China; (2) another leg down in commodity prices; (3) potential quasi-sovereign and private corporate sector forced deleveraging or balance sheet distress given heavy borrowing over the last few years and diminished profitability, and, last but not the least, (4) sharper-than-expected deceleration of capital inflows triggered by a strengthening USD, rising Dollar yields, and/or renewed bouts of volatility in international financial markets that could dampen sentiment towards emerging markets.

Correct. And when one thinks of Brazil leading a LATAM meltdown, the developed market most associated with it is Australia.

David Llewellyn-Smith
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