Why Bonds Are Set To Bounce Back

by James Gruber

Asset returns were all over the map in the first half of 2013. Stocks outperformed bonds. But within equities, developed markets pummelled emerging markets, with the U.S. and Japan leading the way. A similar trend happened in bonds, where investors who’d poured money into emerging markets promptly fled in May and June of this year. Of course, commodities were the biggest loser, and among these, precious metals trailed the pack on worries over QE tapering and Indian demand.

What then can we look for the second half of the year? Broadly, I expect deflationary concerns to take centre stage again as the U.S. economy stagnates, Japan intensifies currency wars and thereby exports deflation while Chinese GDP dips below 7% by the fourth quarter. This will take any talk of significant QE tapering in the U.S. off the table while Europe and Japan continue to provide ample liquidity amid weakening economies. China will be the only country tightening policy as it resists calls to reflate its credit bubble.

If this is right, bonds will be the big winners in the second half. Emerging market bonds may see more volatility with outflows intensifying in July before picking up as global stimulus ramps up. Stocks should have a sharper correction, possibly from September, as the U.S. economy stalls and China worsens. The “Bernanke put” will limit the correction though. Meanwhile, commodities should dip before bouncing hard as stimulus picks up again, with gold and agriculture significantly outperforming industrial metals.

That’s a broad, tentative roadmap, but let’s break it down a bit further:

1. The U.S. – The Fed will take fright at rising bond yields. It knows higher interest rates would stifle any housing recovery and lead to much higher interest costs on government debt, something the U.S. can ill afford. Not to mention that rising yields in the U.S. puts upward pressure on rates around the world. With much of the developed world economies near or at recessionary levels, increased yields are the last thing that they need. This will limit any QE tapering, if it happens this year at all. 

Meantime, the U.S. economy will stagnate as European economies fail to recovery, Japan depreciates the yen more aggressively and exporting deflation while China’s credit bubble pops. Yes, the U.S. will be better off than the rest of the developed world, but increasing talk of “recovery” will be put to bed.

Given the above, and the extraordinary performance of the S&P 500, I expect a more significant pullback in the stock market in the second half. Globally, equities should struggle but Europe may well outperform the U.S. given much cheaper valuations and lower expectations.

2. Europe – Crudely, you should expect more of the same. That is, weak economies burdened by the Euro and extraordinary debt loads. Partially offset by the European Central Bank and Bank Of England wearing out the world’s money printing machines by providing more and more stimulus.

France will become the big concern as investors realise that it is the next Greece, but this is probably a 2014 issue. A significant, compounding debt burden, extravagant social welfare system, stifling regulations limiting the private sector, worsening tax revenues and a clueless Socialist President make France the next domino to fall in Europe.   

3. Japan – After this month’s elections for the upper house, Shinzo Abe should have a stronger mandate to pursue reform, the so-called third arrow of his strategy to defeat deflation. He may provide broader reform, perhaps including badly need changes to the labor market and the agricultural sector. But any reform will be limited by the influence of powerful lobby groups. Given the low expectations for reform, there may be another temporary leg up for the Japanese stock market.

If the reforms do positively surprise, bond yields will spike, raising concerns again about the impact on interest costs of the government’s unprecedented debt levels. This will bring further government buying of bonds, crowding out private players, thereby leading to increased volatility. The stock market should again sell off when this happens.

The long-term picture remains that Japan is a train wreck waiting to happen. Given government debt of 245% of GDP or 20x government revenues, Japan has only two bad choices left: 1) Cut back on government services to such an extent that would cause an immediate depression or 2) Print truckloads of money to inflate the debt away. The government’s chosen no. 2, which will lead to significant yen depreciation and a blow-up in the bond market at some point. It’s a matter of when, not if this happens. 2014, perhaps?

4. China – It’s become clear that the China’s credit bubble is bursting. And the new government doesn’t want to risk reflating the bubble, preferring to deal with the mess now rather than later. This is a political choice, but a wise one. This way, blame for the economic downturn can be sheeted home to the previous government.

The choice though means that there’ll be a significant slowdown in economic growth, probably below a 7% GDP rate by the fourth quarter. At the same time, however, the government may significantly surprise markets by announcing deep structural reforms to restructure the economy. The changes may include the widespread privatisation of state assets, extensive financial de-regulation, broad-based tax reform and increased incentives for foreign investment.  

In the opinion of this author, Xi Jinping is both a pragmatist and a likely reformer. He’s thinking about the next 10 years, not the next three months. That means he’s willing to take short-term pain to reap the benefits later on.

How will China’s stock market react to all this? It’ll probably focus on the economic pain rather than structural reform, at least initially.

5. India – A depressed investment cycle needs to restart if India is to turn around. There are tentative signs that this may be starting to happen. Combined with a bounce in the rupee as the current account deficit stabilises from lower commodity prices, and India’s stock market could be one of the best performers in Asia in the second half.

The risk is around general elections next year and the pork barrelling which will occur before that. The positive thing about the large current account deficit is that it keeps pork barrelling in check to a certain extent. At least investors should hope this is the case.

6. South-East Asia – Foreigners have poured into this market since 2009 as it’s one of the few regions with genuine growth prospects. At the first recent hint of trouble though, this money headed for the exits. With more QE tapering talk over the next month or two, there’s more downside for South-East Asia. However, when this talk dies down, the region should once again attract foreign money.

That money is likely to head to Thailand and the Philippines. Indonesia will underperform as commodities suffer, its current account deficit deteriorates and attention turns to who will govern the country, with general elections set for next year. Meantime, Malaysia may attract investors with reasonable market valuations and a potential bounce in commodities later this year.

7. Commodities – I am among a significant minority of investors who believe that the commodities super-cycle isn’t over. To be specific, the best days of industrial commodities are behind it. But for precious metals and agriculture, they’re likely ahead. Precious metals remain an attractive hedge against central bank profligacy and currency debasement. While agriculture’s supply and demand situation is extremely tight, meaning any future supply disruptions should drive prices higher.

For the second half, you’re likely to have the continuing headwind of softening demand out of China. On the other hand, quietening taper talk will prove a nice tailwind. Many commodities are now seriously oversold and when it becomes clear that the U.S. will continue stimulus for several years to come, many of them will bounce hard. Pencil in the fourth quarter?

8. Currencies - I did a piece that attracted a fair amount of interest earlier this year called “Who will win the currency wars?” In it, I looked at potential currency winners and losers in the long term (3-5 years).  I suggested commodity currencies would be significant losers, highlighted the Aussie dollar as being particularly at risk. My preferences were the Singapore dollar, Thai baht and Malaysian ringgit due to the strong balance sheets and relatively attractive growth profiles. The call on commodity currencies has been correct, while my favoured currencies have performed ok on a global basis, less so versus the U.S. dollar.

I still see significant risks to commodity currencies, with the Aussie dollar heading towards 80 cents to the U.S. dollar this year, on its way to 60 cents in a few years. As China slumps, Australia should enter recession by the end of the year, as mining investment cutbacks deepen and the housing market stalls or declines as unemployment rises.

I still like the Singapore dollar, Thai baht and Malaysian ringgit. However, the U.S. dollar could well strengthen in the next 8 weeks before re-commencing its steady decline. That means my preferences should once again catch bids towards the fourth quarter. Having some money in U.S. dollars may make some sense, bearing in mind that it’s heading for trouble in the long-term given the country’s continued commitment to currency depreciation via money printing.

The Chinese yuan is a tricky one. I’ve been dead wrong calling for a yuan decline earlier this year. It’s been a great performer. But as China’s credit bubble unwinds and the Japanese yen weakens further, I can’t help but think that the government will want a weaker currency, and soon.

Lastly, the Japanese yen remains probably the world’s biggest short (yes, more than the Aussie dollar). Japan needs a significantly weaker yen to deflate its debt in yen terms. 

9. Bonds – U.S. long-term government bond yields should head higher in the very short-term before heading down towards 2% by year end. That’s if my view of a renewed commitment to QE proves correct.

Emerging market bonds may experience more pain over the next couple of months given continued QE tapering talk, accentuated by heightened political risk in some countries (Turkey & Egypt). But they should see some money flowing back in by the fourth quarter.

Understand that all predictions are fraught with danger and the ones above are no exception. What I call a tentative roadmap, others may just see as wishful thinking. Either way, it’s meant to be the starting point for a discussion. Please feel free to agree or disagree with any or all of it.

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Gold And Silver – Silver Market Sending A Message

By: Michael_Noonan

When the markets “speak,” we “listen.” For all of the non-stop bullish “news” about the unprecedented demand, more for gold than silver, and all of the talk about how useless the COMEX paper market is, it has been the paper market that the forces of supply and demand have been heeding. If it were otherwise, the unprecedented demand for gold would have the price of gold higher than the bogus paper market. Yet, that has not been the case.

When will this bear market in PMs turn around? When it does, and not a moment before. This is not some flip answer, it just happens to be the way all bear markets end: when they do. We have seen calls for a turnaround for several weeks now, none of which have been even close.

If you want to make rabbit stew, first, you have to catch the rabbit.

First, lets’ see some concrete signs that a bottom is in before the regurgitation of “Gold is going to $10,000!” starts showing up in a host of new articles pandering for attention. It sure did not work for the previous ones.

The best way is to decide for yourself. Anyone can read a chart, [just not necessarily well], so let us go to the most reliable source, the market, and see what the prices of gold and silver have to say about what everyone else has been saying about them. People have been known to exaggerate, even lie in their “opinions,” but the market never does either. It just is.

The issue we have with gold is a lack of an immediately identifiable support area. There is support, a little lower, and for that reason, we do not see a strong message coming from gold, just yet. On the other hand, [never take anything for granted in the markets], the fact that price is holding above obvious support is an indication of underlying strength. IF that is the case, we still need to see some concrete sign of stopping activity before price can turn around.

We show some potential support resting under current the price. Silver, unlike gold, is already at an area of support. We will get to that, shortly.

The reminder about the importance of how a wide-range bar usually contains future price activity is shown to keep it fresh in your mind when you see it again in the future. If you pay attention to charts, you will definitely see this pattern repeat over and over.

As we did these charts, in order as presented, after seeing the daily silver chart, you can come back and revisit this one with a different “eye” for its content. The difference between gold and silver was the synergy in all the time frames in silver, not so for gold.

It is a great example of reality is always there to be seen, but sometimes we fail to see it. The truth is often under the brightest light, while people look elsewhere for a “hidden” message.

Here is silver on the monthly, already into an identifiable area of support. We should be looking closely for some form of stopping action, telling us price may stop going down.

Last week’s bar stands out as a red flag for its price and volume. The same bar in gold was too similar to one that had already failed, so it could not be viewed in a more important vein as this one. We give a more detailed analysis on smart money and high volume activity on the daily chart, below. Suffice it to say that what is true on the daily is also true for the weekly. It is just more visible and easier to explain with more bar examples.

When you understand the explanation given on the daily, come back and look at this one again so you increase your discerning eye more when it may seem less is apparent.

Finally! The explanations on the chart as to why silver is sending a message. What needs to be understood is that there is no confirmation that a bottom is in. Before a trend can turn, it must stop going down.

No one can definitively say the trend has stopped going down, and even when it does, then we must deal with how long it may take to reverse. That can take many more months, or a year or two. It could turn around very quickly, but we cannot know the odds for that event, were it to occur. What we do, in the interim, is prepare! If this happens, then do that.

It never pays to buy the first rally after a bear market ends. There is usually a form of retesting of the lows before a market can begin to move higher. This is the first time we have talked about specifically preparing for a possible change in trend, at least from a pragmatic perspective. Sentiment for a change has been long-standing, [but of no avail.]

Keep accumulating physical gold and silver, a pragmatic stance we have advocated during the entire market decline, but for a different purpose. We cannot say the turnaround for gold and silver is “rabbit stew” ready, just yet. If the end is near, there will be many more signs. The market never lies.

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SPY Trends and Influencers July 6, 2013

by Greg Harmon

Last week’s review of the macro market indicators suggested, heading into the Holiday shortened week that the Equity markets looked tired in their bounce. We Looked for Gold ($GLD) to consolidate or bounce in its downtrend while Crude Oil ($USO) was biased higher in the consolidation. The US Dollar Index ($UUP) looked strong and ready to continue higher while US Treasuries ($TLT) might continue their bounce in the downtrend. The Shanghai Composite ($SSEC) and Emerging Markets ($EEM) both looked to bounce in their downtrends. Volatility ($VIX) looked to remain subdued but drifting higher keeping the bias lower for the equity index ETF’s $SPY, $IWM and $QQQ. Their charts all looked to be tired in the upward move within their intermediate downtrends in the long term uptrend.

There were plenty of fireworks outside and in the market. Gold played out a dead cat bounce while Crude Oil broke out to the upside. The US Dollar continued higher while Treasuries bounced before plummeting Friday. The Shanghai Composite continued to consolidate in a tight range at the recent lows while Emerging Markets met resistance and moved back lower. Volatility drifted sideways before a selloff Friday. The Equity Index ETF’s, SPY and IWM tested the recent highs in the range with the QQQ moving higher. What does this mean for the coming week? Lets look at some charts.

As always you can see details of individual charts and more on my StockTwits feed and on chartly.)

SPY Daily, $SPY

SPY Weekly, $SPY

The SPY printed a series of rising small body and doji candles under the 20 and 50 day Simple Moving Averages (SMA) before surging higher to close above both on Friday. The Hanging Man candle still raises caution as it can be a reversal candle if confirmed lower on Monday. The Relative Strength Index (RSI) on the daily chart is rising back through the mid line, and never touched in bearish territory with a Moving Average Convergence Divergence indicator (MACD) that is turning higher and crossed up. These support more upward price action. The weekly picture is also leaning to the upside. The continued rise off of the retest of the wedge breakout comes with a RSI that is moving back higher and in bullish territory and a MACD that is leveling after a small pullback. There is resistance higher at 166 and 168 before 169.07, the all-time high. Support lower comes at 161.60 and 159.70 before 157.10. A move under 157.10 looks very bearish and a failure to move over 166 is bearish as well. Upward Price Action in the Intermediate Downtrend in the Long Term Uptrend.

Heading into the first full week of July sees the markets improving and possibly ready to move higher again. Look for Gold to continue its downward move or consolidate in a broad range while Crude Oil continues higher. The US Dollar Index also looks to continue to the upside while US Treasuries resume their move lower. The Shanghai Composite may continue its bounce in its downtrend, but the Emerging Markets are biased to the downside. Volatility looks to remain low and drifting lower keeping the bias higher for the equity index ETF’s SPY, IWM and QQQ. Their charts show that the IWM is the strongest and ready to continue higher while the SPY and QQQ still have some resistance to work through in their short term moves higher before they are in the clear to move higher. Use this information as you prepare for the coming week and trad’em well.

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Is The Low In Place For Gold?

by Tyler Durden

Citi's FX Technicals group is biased to believe that the low in this correction may have been posted for Gold. Here's why...

Via Citi FX Technicals,

Gold

Two years ago gold bugs ran wild as the price of gold rose nearly six times. But since cresting two years ago it has steadily declined, almost by half, putting the gold bugs in flight. The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels.

The rout says a lot about consumer confidence in the worldwide recovery. The sharply reduced rates of inflation combined with resurgence of other, more economically productive investments, such as stocks, real estate, and bank savings have combined to eliminate gold's allure.

Although the American economy has reduced its rapid rate of recovery, it is still on a firm expansionary course. The fear that dominated two years ago has largely vanished, replaced by a recovery that has turned the gold speculators' dreams into a nightmare.

The above note is probably a close representation of consensus market view at the moment, except that it is taken from an article in the… New York Times, 29 August 1976 (3 days after the corrective low had been posted in 1975-1976 before Gold started a 3 year rally into late 1979/early 1980)

Long-term Gold Chart

Between 1973 and 1974 the DJIA fell 45%. As the Equity market then recovered Gold went into a corrective phase within 3 months that saw it fall 445 as the Equity market rallied.

This time around gold has in fact been much more resilient.
– It did not peak until Sept 2011 ( 2 ½ years after the Equity market bottomed out)
– It has so far corrected 39% with an Equity market that has rallied 140% off the March 2009 low (DJIA). In 1975-1976 it corrected 44% as the equity market rallied 76%

In 1976 the Gold correction ended in August and the Equity market began a deep correction in September (27% over 18 months). During that period Gold rallied by about 78% and over the 1976-1980 period it multiplied in value by a factor of 8 from just over $100 to over $800. The final part of that rally saw Gold rise from about $470 to $850 over about 4 weeks on the back of the USSR invasion of Afghanistan. Even without that move it still multiplied by about 4.5 times in just over 3 years.

So what are we looking at to increase the likelihood of the “low being in”?

In addition daily momentum is turning up from more oversold levels than those seen before the $270 bounce in 2012. On a daily chart this is the most oversold we have seen since the turn higher in Gold in 2001.

In addition it has become very stretched to the 55 and 200 day moving averages which now have a big gap between them

An important thing to note is that Gold broke its support level the same week as the S&P broke above its 2007 high. As long as the equity market stays resilient (As we saw in 1975-1976) it may be a drag on Gold’s ability to rally substantially. In the 1980-2000 period when financial assets were aggressively rallying, Gold took a back seat. We may need the market to be more concerned about the financial/economic backdrop before Gold can get any real traction again.

The pattern into the low on Gold also reminds us of how the S&P set its low in March 2009

Once the first impulsive low at 741 was regained by the S&P it never revisited it.

A close above $1,322 on Gold, if seen, would look similar

In 1976 the move lower in Gold overshot the 55 month moving average by about 14%

A similar move this time would equate to about $1,185 compared to a low so far of $1,181

The 55 month moving average stands at $1,379

The 200 week moving average stands at $1,459

IF and when we start to overcome these levels from $1,322 to $1,459 our conviction of a bottom being in place will grow. While we remain below these levels (especially if the Equity market continues to remain robust) we cannot rule out the danger that we could get another move lower.

In that respect we would remain focused on the 1975-1976 correction which if replicated could suggest as low as $1,075

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Breaking Bad Habits

by Stephen S. Roach

NEW HAVEN – It was never going to be easy, but central banks in the world’s two largest economies – the United States and China – finally appear to be embarking on a path to policy normalization. Addicted to an open-ended strain of über monetary accommodation that was established in the depths of the Great Crisis of 2008-2009, financial markets are now gasping for breath. Ironically, because the traction of unconventional policies has always been limited, the fallout on real economies is likely to be muted.

Illustration by Margaret Scott

The Federal Reserve and the People’s Bank of China are on the same path, but for very different reasons. For Fed Chairman Ben Bernanke and his colleagues, there seems to be a growing sense that the economic emergency has passed, implying that extraordinary action – namely, a zero-interest-rate policy and a near-quadrupling of its balance sheet – is no longer appropriate. Conversely, the PBOC is engaged in a more pre-emptive strike – attempting to ensure stability by reducing the excess leverage that has long underpinned the real side of an increasingly credit-dependent Chinese economy.

Both actions are correct and long overdue. While the Fed’s first round of quantitative easing helped to end the financial-market turmoil that occurred in the depths of the recent crisis, two subsequent rounds – including the current, open-ended QE3 – have done little to alleviate the lingering pressure on over-extended American consumers. Indeed, household-sector debt is still in excess of 110% of disposable personal income and the personal saving rate remains below 3%, averages that compare unfavorably with the 75% and 7.9% norms that prevailed, respectively, in the final three decades of the twentieth century.

With American consumers responding by hunkering down as never before, inflation-adjusted consumer demand has remained stuck on an anemic 0.9% annualized growth trajectory since early 2008, keeping the US economy mired in a decidedly subpar recovery. Unable to facilitate balance-sheet repair or stimulate real economic activity, QE has, instead, become a dangerous source of instability in global financial markets.

With the drip-feed of QE-induced liquidity now at risk, the recent spasms in financial markets leave little doubt about the growing dangers of speculative excesses that had been building. Fortunately, the Fed is finally facing up to the downside of its grandiose experiment.

Recent developments in China tell a different story – but one with equally powerful implications. There, credit tightening does not follow from determined action by an independent central bank; rather, it reflects an important shift in the basic thrust of the state’s economic policies. China’s new leadership, headed by President Xi Jinping and Premier Li Keqiang, seems determined to end its predecessors’ fixation on maintaining a rapid pace of economic growth and to refocus policy on the quality of growth.

This shift not only elevates the importance of the pro-consumption agenda of China’s 12th Five-Year Plan; it also calls into question the longstanding proactive tactics of the country’s fiscal and monetary authorities. The policy response – or, more accurately, the policy non-response – to the current slowdown is an important validation of this new approach.

The absence of a new round of fiscal stimulus indicates that the Chinese government is satisfied with a 7.5-8% GDP growth rate – a far cry from the earlier addiction to growth rates around 10%. But slower growth in China can continue to sustain development only if the economy’s structure shifts from external toward internal demand, from manufacturing toward services, and from resource-intensive to resource-light growth. China’s new leadership has not just lowered its growth target; it has upped the ante on the economy’s rebalancing imperatives.

Consistent with this new mindset, the PBOC’s unwillingness to put a quick end to the June liquidity crunch in short-term markets for bank financing sends a strong signal that the days of open-ended credit expansion are over. That is a welcome development. China’s private-sector debt rose from around 140% of GDP in 2009 to more than 200% in early 2013, according to estimates from Bernstein Research – a surge that may well have exacerbated the imbalances of an already unbalanced Chinese economy.

There is good reason to believe that China’s new leaders are now determined to wean the economy off ever-mounting (and destabilizing) debt – especially in its rapidly expanding “shadow banking” system. This stance appears to be closely aligned with Xi’s rather cryptic recent comments about a “mass line” education campaign aimed at addressing problems arising from the “four winds” of formalism, bureaucracy, hedonism, and extravagance.

Financial markets are having a hard time coming to grips with the new policy mindset in the world’s two largest economies. At the same time, investors have raised serious and legitimate questions about Japan’s economic-policy regime under Prime Minister Shinzo Abe, which unfortunately relies far more on financial engineering – quantitative easing and yen depreciation – than on a new structural-reform agenda.

Such doubts are understandable. After all, if four years of unconventional monetary easing by the Fed could not end America’s balance-sheet recession, why should anyone believe that the Bank of Japan’s aggressive asset purchases will quickly end that country’s two lost decades of stagnation and deflation?

As financial markets come to terms with the normalization of monetary policy in the US and China, while facing up to the shortcomings of the BOJ’s copycat efforts, the real side of the global economy is less at risk than are asset prices. In large part, that is because unconventional monetary policies were never the miracle drug that they were supposed to be. They added froth to financial markets but did next to nothing to foster vigorous recovery and redress deep-rooted problems in the real economy.

Breaking bad habits is hardly a painless experience for liquidity-addicted investors. But better now than later, when excesses in asset and credit markets would spawn new and dangerous distortions on the real side of the global economy. That is exactly what pushed the world to the brink in 2008-2009, and there is no reason why it could not happen again.

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Exhausted Brazil

by Luiz Felipe Lampreia

RIO DE JANIERO – The demonstrations that are shaking Brazil’s normally laid-back society are channeling a widespread sentiment: enough is enough! But, with the exception of professional agitators, there is no hatred in the street protests. Instead, there is a kind of impatient fatigue.

Illustration by Paul Lachine

Brazilians are tired of being brutalized by public transport in the country’s metropolitan areas; tired of ghastly hospitals; tired of corruption scandals; and tired, especially, of inflation, which has returned like a dreaded disease, once again eroding people’s purchasing power and threatening to return millions to the poverty from which they only recently escaped.

It is difficult to disagree with the protesters. Nevertheless, there are many economic reasons to worry about the effect of the demonstrations.

Since the Plano Real was put in place in 1994, which brought inflation down to manageable levels, Brazil has achieved remarkable economic and social progress. Presidents Fernando Henrique Cardoso and Luiz Inácio Lula da Silva, both serving eight years in office, managed to ensure rapid economic growth while maintaining price stability and a sound fiscal position. Their success lifted a significant share of poor Brazilians into the middle class and made Brazil an attractive destination for foreign investors.

Yet the current situation is shifting expectations into reverse. To dampen the protests, President Dilma Rousseff’s government has launched various ruses – subsidizing fuel prices and reducing taxes on electric power, automobiles, and household appliances – and has attempted to conceal them in ways that allow the authorities to claim that inflation remains under control. Yet all of Brazil is feeling the impact on prices. If the official inflation target loses credibility, price growth will accelerate further.

The underlying problem is that Brazil’s growth model, which allowed 35 million people to enter the middle class in the last decade, is itself at the brink of exhaustion. The maximum benefit from reducing unemployment, increasing the real minimum wage, and expanding credit – creating a strong rise in consumption, owing to rapid gains in real (inflation-adjusted) income for much of the population – has already been reaped.

Indeed, consumption is now decreasing, with a recent poll by the Brazilian Confederation of Trade and Business Associations indicating a 6.2% annual decline this year. In March, household-debt levels reached a record high of 44% of income. Slower growth and more modest real wage increases are likely, which will reverse households’ optimistic expectations.

Meanwhile, for Brazil’s new middle class, higher incomes have meant higher tax payments – and thus a growing sense of entitlement to improvements in living standards. Many are especially resolved to fight for more and better public goods in view of the government’s misplaced spending priorities, which include soccer stadiums and other pharaonic construction projects.

In fact, Brazilians’ purchasing power could shrink further, owing to the depreciation of the real against the dollar. If Brazil’s government does not tighten fiscal policy, the exchange rate will generate more inflationary pressure from the rise in prices of imported goods. The alternative – an increase in interest rates – would undermine both consumption and productive investment.

What went wrong? Until recently, Brazilians enjoyed rapid GDP growth, full employment, rising incomes, a range of social-welfare benefits, and international praise. The government swore that the global crisis would not reach the country. Now GDP growth is slowing, investment is falling, the budget deficit is widening, and the external accounts are weakening.

One problem is that the inadequacy of Brazil’s infrastructure, which largely reflects poor official decision-making in the last ten years, directly impedes further growth in production and trade. For example, the authorities placed a high priority on a high-speed rail project that has already surpassed several cost estimates and has not yet left the planning stage. Meanwhile, the existing rail system is so precarious that it is impossible to travel by train from Rio de Janeiro to São Paulo or Belo Horizonte or Brasília. The public health-care system is a horror show. With rare exceptions, primary and secondary schools leave students badly prepared for university.

Rousseff’s administration faces a dismal outlook. Slow growth has been accompanied by a loss of competitiveness, leading to massive imports of Chinese goods, for example – and to a self-defeating protectionist reaction. Ambitious public-investment projects are advancing slowly, if at all – or are the wrong projects. And now Brazilians are in the streets demanding change.

As the economist and former president of the Brazilian Central Bank Afonso Celso Pastore put it, “Rousseff and her ministers simply do not believe in orthodox prescriptions.” The trouble is that they do not seem to have a viable alternative.

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