Last week, the Brazilian Central Bank (BCB) president, Alexandre Tombini, stated the BCB is “carefully” watching all indicators, to decide on the next steps of economic policy. In this sense, most market economists forecast rates to be tightened by an average of 150bp in about three stages. Despite the weak economic activity in Brazil, the decision to increase rates should be positive for Brazilian equities, mainly because it shows prudence on macroeconomic policy.

The awaited rate hike would come after the recent numbers showing inflation above the 6.5% target ceiling. Also, there have been many local press reports on how inflation is eroding consumers’ purchasing power, despite all government efforts to unorthodoxly control inflation (e.g., electricity tariffs reduction, tax cuts, etc). Furthermore, Brazilian companies have also felt the inflation impact given higher costs, and inability to pass through, given competition, demand, regulation, and tighter margins.

Bullish for Bovespa

If the BCB increases the interest rate this week, it would be the 7th tightening cycle since 2001. In four of the last six cycles the Ibovespa outperformed global equities by 9.5% on average in the three months following the beginning of the rates hike. During those periods, domestic cyclical sectors usually outperform global peers, with the main highlights for financials and consumer discretionary. Utilities, surprisingly, also have a good performance, whereas for energy and materials the trend is not so conclusive.

According to Bank of America Merrill Lynch, the main outperformers in an increasing rate scenario are the Brazilian banks, given: 1) 75% of total income comes from net interest income (NII), and 2) the correlation between rates and retail credit spreads is ~90%. The bank is particularly positive with the private banks Bradesco and Itau, given “their attractive valuation of 11.0x average 2013E P/E and very high portfolio quality.”

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