“If gambling is exciting, you’re doing it wrong.”
I thought that was a very appropriate quote for the times we currently reside in as stock market operators. From my own read through of sentiment among our diverse client base, buying U.S. equities with the SPY trading within 2% of its all-time high feels a bit more like gambling than allocating capital to the reflation trade did in late-January/early-February was – gambling on monetary policy that is.
With the two sectors most exposed to reflation expectations leading the way higher off of the February 11th YTD lows in the SPY – i.e. Energy and Materials – we don’t need to employ advance statistical concepts to arrive at the conclusion that marginally dovish monetary policy out of the Federal Reserve is a principle component of this epic short squeeze in U.S. equities.
The aforementioned quote is sourced from a good “process evolution” book I’ve been reading titled How Not to Be Wrong: The Power of Mathematical Thinking and it was specifically in regards to the legal and systematic rigging of the Massachusetts state lottery in the mid-2000s by a handful of quantitatively-oriented cartels. Ellenberg goes on to say:
“If you can make enough bets with the odds tilted in your favor, the sheer volume of your advantage dilutes any bad luck you might experience. That makes playing the lottery less exciting, to be sure. But for Harvey and the other high-volume bettors, excitement wasn’t the point.”
Back to the Global Macro Grind…
In a market where we can all agree to agree that quant strategies have become a significant degree of the trading volume, it’s easy to imagine a guy like Cliff Asness as James Harvey and Asness’ AQR Capital Management as Harvey’s Random Strategies LLC.
Indeed, Harvey’s genius was only betting on days where the “roll-down” jackpot would be triggered. Perhaps the genius of Asness and other quant strategies this year was “betting” (i.e. switching their trading algorithms into unadulterated offensive risk taking) only during times when they knew rising expectations of a dramatically easier Fed would act as a tailwind for reflation assets and an impetus to chase and/or cover high among other market participants.
Perhaps no other reflation assets have benefitted more from this directional shift in policy expectations than Brazilian capital and currency markets:
- The Bovespa Index is up +39.4% over the past 3M;
- The BRL is up +12.5% vs. the USD over the past 3M (inclusive of yesterday’s dovish intervention); and
- Bloomberg’s Brazil Local Currency Bond Index is up +17.5% over the past 3M.
Obviously Brazil has idiosyncratic tailwinds perpetuating the aforementioned relief rallies – namely the rising probability of much-needed economic and political reform to the extent President Rousseff does not survive the impeachment process she was voted into by lawmakers in Brazil’s lower house over this past weekend. The process from here is somewhat convoluted, so it bears summarizing:
- On May 10th, Brazil’s upper house will vote to proceed with a formal trial against Rousseff, who is under investigation for alleged violation of federal budget laws by using loans from state-owned banks to mask the true size of the country’s fiscal gap.
- The impeachment process requires a simple majority of 41 votes to move forward and it is rumored that there are 47 senators in favor of the motion. According to Brazilian polling institute Datafolha, 61% of Brazilians support the impeachment process and 60% believe President Rousseff should simply resign.
- In the event of a trial, a two-thirds majority (54 votes) is required to convict Rousseff and remove her from office.
- The senate will have up to 180 days to deliberate, but market participants are expecting a prompt trial in order to ensure the smooth functioning of government and, potentially, a smooth transition of power.
- Vice President Michel Temer of Brazil’s PMDB party – a former PT ally as recently as last month – would take over as acting president if Rousseff is ousted. He has promised a myriad of market-friendly policies such as fiscal retrenchment, welfare reform and incentives to promote private sector investment.
In hindsight, I can see why an investor would’ve rolled the bones on bombed-out Brazil in light of #5 above. That said, however, the story deteriorates very quickly from there, as the river of corruption in/around Brazilian politics runs dishearteningly deep. Consider the following developments:
- The aforementioned impeachment process is separate and apart from corruption charges stemming from her alleged use of misappropriated funds during her 2014 reelection campaign, as well as from her willful blindness to widespread corruption as chairwoman of Petrobras during the heyday of the “Operation Car Wash” scandal – Brazil’s largest ever at $17B in related losses and 84 convictions thus far (mostly businesspeople; Brazilian lawmakers are immune to arrest without congressional or Supreme Court authorization).
- Temer himself is not without prosecution risk; he too faces corruption charges stemming from Rousseff’s 2014 reelection campaign.
- Third in line for Brazilian presidency is Rousseff’s sworn enemy and leader of Brazil’s lower house, Eduardo Cunha, who himself has been indicted for his alleged role in Operation Car Wash and a subsequent money laundering scheme – of which he is now officially a defendant after the PT voted to strip him of his immunity from prosecution the morning of the day Cunha finally decided to move forward with impeachment proceedings against Rousseff after having previously blocked 27 such motions. #catty
- The same Datafolha survey referenced above showed a whopping 77% of Brazilians support Cunha’s impeachment.
- Temer’s successor as PMDB party chief, Sen. Romero Jucá, is under investigation for alleged ties to the same scandal as well.
- According Transparência Brasil, a nonprofit government watchdog, 60% of Brazil’s federal legislators have been convicted or are under investigation for crimes ranging from electoral fraud, to corruption, to outright assault. Sixty percent!
- For example, upper house president Renan Calheiros is under investigation for his alleged involvement in Operation Car Wash.
- Cunha has strong political ties to ex-President Fernando Collor, who himself was the last Brazilian president impeached back in 1992. The irony of him chairing the upper house ethics committee while also being under investigation for his alleged involvement in Operation Car Wash is almost too much to bear.
While this all makes for good entertainment, our purpose for highlighting these facts goes beyond mere amusement. We want to stress that there is a high likelihood that political uncertainty reigns supreme in Brazil for months – if not years – to come. Brazil has 23 distinct parties operating in parliament with 12 in the ruling party alone. Consensus-building on the best plan forward will be a tall order for whoever winds up as president when all is said and done.
All told, with Brazil’s cyclical and structural economic bear cases fully intact (refer to slides 71-93 and 100 of our 3/16 presentation on Emerging Markets for more details), we think Brazilian capital and currency markets are priced to perfection and anticipate another flush down alongside other reflation assets over the intermediate term. Whether or not they make new lows ahead of market participants eventually starting to explicitly bet on QE4 remains to be seen.
But what is clear, however, is that investors have had ample opportunity to sell into every “face-ripping” short squeeze to lower-highs across the spectrum of emerging market assets over the past ~5Y – of which there have been many – as highlighted by the Chart of the Day below.
Being long of reflation assets has been nothing shy of a world-class trade over the past few months and one that we generally failed to anticipate. That’s our mistake. We can, however, take solace in the fact that we covered our thematic shorts in Energy and Industrials in early-January on our Q1 Macro Themes call. Covering reflation then was a great call; buying reflation then would’ve been a downright legendary flip. But, alas, hindsight is 20-20 and we are thankful for the opportunity to learn each day.
As always, the question remains, “Where to from here?” and with respect to anyone who appropriately got long of reflation earlier this year, we caution against overstaying your respective welcomes. The simple risk management question, “What exactly did we buy?” is one that we expect to get asked with increasing frequency over the intermediate term.
With respect to Brazil specifically, we believe many investors have positioned their portfolios to be adversely impacted by political disappointment that would make Narendra Modi’s failure to implement meaningful reforms in India look like some form of “Reaganomics” or “Thatcherism”.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.69-1.82% (bearish)
SPX 2045-2104 (bearish)
RUT 1086-1150 (bearish)
DXY 93.81-95.17 (bullish)
Oil (WTI) 37.58-43.98 (bearish)
Gold 1215--1268 (bullish)
Keep your head on a swivel,