Brazil inflation battle tests investors

For investors in Brazilian equities, a verbal barrage from the government against inflation this week could hardly have been better timed.

Inflation is this month set to test the upper limit of the central bank’s target range of 4.5 per cent, plus or minus 2 percentage points.

The problem for stock market investors is that the longer the threat of faster inflation hovers over Brazil, the more the benchmark equities index, the Bovespa, will lurk in no-man’s land – in spite of a strong economy that is expected to grow 4.5 per cent this year.

“The market has doubts as to whether measures by the finance ministry and the central bank will be sufficient to counter expectations for inflation,” says Rodrigo Mello, a partner at Oren Investimentos, a fund management firm in Rio de Janeiro.

Latin America’s biggest stock market last year looked close to revisiting its pre-crisis highs of May 2008, when the Bovespa hit a record 73,517 points. But, since the beginning of this year, the Bovespa has declined about 3 per cent. It was trading on Wednesday at 66,324, down 7.4 per cent from its 2011 high of 71,632.9 set in January.

The market’s troubles stem mostly from efforts by the government of Ms Rousseff, which took office on January 1, to deal with the effects of over-spending in the lead-up to the 2010 presidential election.

Disbursements from the state development bank, the BNDES, helped drive economic growth to a more than two-decade high of 7.5 per cent, contributing to rising inflation. At the same time, high real interest rates have been attracting foreign capital from sluggish developed economies, strengthening Brazil’s currency against the dollar.

The real has appreciated in recent weeks to between R$1.55 and R$1.60 against the dollar, up 40 per cent in more than two years, and frustrating the government, which worries the competitiveness of Brazilian industry is declining even as it is facing a flood of cheap Asian imports.

Concerned that even higher interest rates will only strengthen the currency further, the government has resorted to unconventional measures to try to stem inflation, such as taxes on consumer credit.

This softly-softly ap-proach on interest rates – the central bank at its meeting last week increased rates by the minimum 25 basis points to 12 per cent – has led to doubts in the market about the government’s resolve on inflation.

Until investors can predict with some certainty how this tightening cycle will play out, most are likely to shy away from buying stocks.