Yesterday, I had a call with one of our more astute long-term customers and he asked me a version of a question that we have been receiving a lot in recent months:
“Nice call on [INSERT INTEREST RATE-SENSITIVE ASSET CLASS HERE]. But how much more upside do you see from these levels?”
I specifically say “version”, because as a true believer in our repeatable and unbiased approached to front-running asset class rotations, he understood our calls from the beginning of the year while also getting involved on the long side of some of the more bombed-out macro markets where we saw opportunity – including Brazil.
Contrast this with what has clearly become consensus across the investment community in the YTD: chalking up the domestic growth slowdown to “weather” and sticking with the outcrop of 2013’s #StrongDollar + #RatesRising = #GrowthAccelerating trade.
Indeed, Brazil has had a nice run since our FEB 27th Best Ideas conference call and we continue to anticipate further upside from here. Specifically, the iShares MSCI Brazil Index Fund (EWZ) has appreciated +19.3% since then; that compares to a +1.7% gain for the SPY and to a sample mean of +5.7% for the 24 country-level ETFs we track across the EM space. Moreover, the EWZ’s +19.3% delta ranks third in the aforementioned sample, trailing only India (EPI) at +22.1% and Turkey (TUR) at +31%; we were fortunate to have been in print liking both throughout this time frame – India as a core long idea and Turkey as a beneficiary of our EM “junk” relief rally theme.
Going back to Brazil specifically, one of the reasons we’ve liked Brazilian equities – Petrobras (PBR) in particular – is because of our anticipation of a continued rally in the Brazilian real (BRL). Specifically, that would have a number of positive effects for Brazilian capital markets, including, but not limited to:
- Easing operating margin pressure on domestic importers – most notably PBR; refer to our 72-slide presentation for more details;
- Reducing pressure on net income margins as USD debt service costs are deflated; and
- Attracting marginal financing for the current account deficit, which tends to be accretive to broad economic growth.
The BRL has indeed appreciated a fair amount since FEB 27th (+5.9%, which ranks second among the 21 currencies we track across Asia and Latin America and compares to a sample mean of +1.9%). Importantly, our proprietary FX valuation models see at least +10% upside from here on both a REER and carry basis.
Valuation is not a catalyst, however. What is a catalyst is continued poor performance by Dilma Rousseff and her Workers Party (PT) in the polls leading up to OCT’s general election; her support among voters dropped again to 37% from 38% in the latest Datafolha poll, which was published MAY 9th. Both consumer and business confidence trends – each at the lows of her administration – support a continuation of the aforementioned polling trends.
She’s clearly received little boost from the backing of former Brazilian president Lula da Silva and he’s already ruled out running in this election, effectively mitigating any upside surprise to credible promises for additional Big Government Intervention that investors have now come to associate with the PT – as most recently highlighted by PT president and Dilma’s campaign coordinator Rui Falcao who suggested this week that Brazil should consider capital controls to ward off speculative capital inflows and reiterated his opposition to an independent central bank.
Newsflash Falcao: global investors are responding to opinion polls and using their capital to vote you and Rousseff “off the island” for a reason. Your economic policy flat-out sucks…
Another catalyst for staying long of Brazil is improving GIP fundamentals. Our math shows World Cup host teams tend to receive a ~190bps sequential boost to real GDP growth and a ~100bps increase in the current account/GDP balance.
Brazil has yet to see these likely tailwinds roll through the system and, as a result, we remain well above both the street and the BCB on 2014E growth and [marginally] below both on 2014E inflation. If we’re right, Brazil’s woeful fiscal situation will show optical improvement and monetary policy will remain tight (not that it wouldn’t have anyway – the BCB just sold and rolled over a cumulative ~$450M of FX swaps yesterday, signaling a renewed commitment to supporting the currency).
One last catalyst that remains non-consensus is a continuation of recent global macro asset class flow trends. We’ve spent much of the past 12-18M designing and backtesting a quantitative model that can help investors front-run said flows at both the primary and secondary asset class levels. At a bare minimum, our TACRM™ All-Weather System consistently provides investors with a real-time “look-see” on rotation-based asset class flows.
There are four primary tools our All-Weather System employs to accomplish its stated goals (please email us if you’re interested in having an in-depth discussion regarding the rigorous quantitative methods employed in each tool):
- TACRM™ Global Macro Thermodynamic Monitor: We first take the “temperature” of nearly 200 global macro ETFs that represent individual markets or specific plays within each market. From there, we can track the current temperature of any market and compare it to both other markets and its own recent trends. Brazil is still exhibiting signs of a classic bearish-to-bullish reversal on this measure.
- TACRM™ Global Macro Weathervane: By taking the temperatures of all the individual markets that comprise a particular primary asset class, we can then calculate a measure of relative momentum by first calculating intra-asset class dispersion and then normalizing said dispersion. The result is a generalized dynamic asset allocation reading for each primary asset class on a 0-100% scale. From there we can track the current reading (i.e. the “weather”) of any asset class and compare it to both other asset classes and its own recent trends. Both Fixed Income & Yield Chasing and EM Equities continue to take share – supportive of our call on Brazil. Specifically, that gives us a green light for carry trading strategies, as well as portending positive EM equity beta.
- TACRM™ Global Macro Barometer: By taking each asset class’ current reading from the aforementioned weathervane system and normalizing it as a percentile of its respective TTM and trailing 5Y peaks, we can get a generalized sense of how much “pressure” is developing in any given asset class. The pressure is on to the upside both in Fixed Income & Yield Chasing and EM Equities, forcing investors to divest their DM Equity, FX and Commodity holdings to keep pace. This setup is also supportive of our call on Brazil.
- TACRM™ 40/40 Club Thermodynamic Monitor: By plotting a similar thermodynamic analysis with the “hottest” 20 and “coldest” 20 markets, we can get a sense of what secondary asset classes are really in or out of favor. The growth style factor remains for sale domestically – supportive of Brazil via a continuation of #DownDollar and #RatesFalling.
All told, both the fundamentals and TACRM™ support remaining long of Brazil, so we will – for now at least. When it is appropriate to deviate from this strategy, I promise we’ll/you’ll be among the first to know. Marrying top-down quantitative signals with bottom-up fundamentals analysis is one of the reasons we continue to add value to our institutional customer base – effectively differentiating ourselves from most other sell-side macro research providers.
Have a great night and/or wonderful Thursday morning,
Associate: Macro Team