SPX Nimitz letter for the month ended April 30, 2016.
Prices of risk assets continued to recover and sentiment again improved in April. Equities made gains on emerging-market and developed-country exchanges alike; the US dollar weakened against other currencies; and commodities, especially iron ore and oil, rose strongly throughout the month.
The Fed’s signaling that the US monetary tightening cycle would be more gradual than expected and the release of marginally negative US economic data were the drivers of these gains across all markets. The members of the FOMC appeared to be more concerned about the evidence of weaker activity in the first quarter and the persistence of below-target inflation, even though the unemployment rate had fallen below the historical average. The Fed was in no hurry to raise rates because wage pressure remained weak and uncertainty persisted regarding the global economic outlook, especially as far as China was concerned. We take the view that if tightening proceeds too slowly it will heighten the risk of inflationary acceleration at some point, in which case the Fed will have to react more incisively.
In China, the recent improvement comes at the cost of fiscal sacrifice and worsening corporate leverage ratios. Adjustments to the imbalances in the economy, which would probably entail decelerating growth in the short run, have been postponed and the deterioration of these imbalances proceeds as modus operandi. We believe the maintenance of this model will cause a more abrupt adjustment in the future, with damaging consequences for the economy in the long run.
In Brazil, where impeachment proceedings continued in Congress, the lower house decided by a respectable majority that President Dilma Rousseff must indeed stand trial in the Senate for misuse of public office and dereliction of duty. The size of the majority reflected the weakness of the incumbent administration’s congressional suppor t. In early May the Senate itself voted to put Ms. Rousseff on trial and she was suspended from office for up to six months pending the Senate’s final verdict. A two-thirds majority is required to impeach the president in the Senate, which has 81 members.
The new government, which theoretically lacks legitimation via elections but looks set to enjoy stronger support in Congress, faces the challenge of restoring credibility and confidence by winning the trust of society. To achieve this it must begin by implementing measures that are effective in the short and medium term. The fiscal situation remains precarious and solutions must be found before the conclusion of the impeachment process, at which time the incumbent president’s term of office will end. In addition to taking short-term emergency action, the Temer administration will have to pave the way for structural reforms.
If the new administration is to restore a primary fiscal surplus in 2017 it will have to move swiftly to cut subsidies, de-earmark a larger proportion of federal revenue, and probably raise taxes. Social security and pensions reform is fundamental to maintain the surplus in the medium term. Despite the difficulty of stabilizing the public debt during the life of this government, such measures will be essential to restore credibility and reduce the probability of sovereign insolvency, toward which Brazil was moving under the previous economic model.
The changed political situation will not stop unemployment from continuing to rise, and this should h elp b ring down inflation, e specially in the service sector. There is ample leeway for economic growth to resume without significant inflationary pressure thanks to the output gap and below-average capacity utilization. Recent local currency appreciation has suppressed pent-up pass-through in several segments, positively affecting inflation expectations for the next 12 months. The Central Bank continues to leave rates on hold while awaiting the convergence of inflation expectations to the midpoint of its target band. However, the deep ongoing recession and the prospect of an improvement in the fiscal situation should permit substantial monetary easing in the near term.
Our main allocations are described below.
SPX Nimitz – Interest rates
Brazilian inflation continued to display positive signs in April, owing mainly to weak economic activity. We expect falling current inflation and inflation expectations, combined with the wide output gap, to allow the monetary authorities to start lowering interest rates in due course. In light of this, we continued to hold a receiving position in the short portion of the curve and added a receiving position in real interest rates.
As for US rates, the markets have now priced in less than one hike per year in response to the dovish statement issued after the last FOMC meeting. We maintained a paying position in the middle portion of the curve.
We remained long the USD against a basket of currencies
In international equity markets we remained moderately short in US equities based on our view that current valuations are too high in light of the lack of earnings growth and that the global economy is structurally incapable of improving.
In emerging markets, we increased our short exposure in Mexico and maintained our long positions in Chile and Argentina. We remained neutral in directional terms.
In the Brazilian equity market we remained directionally neutral. We ended the month long in financial services and utilities, and short in producers of metal commodities.
We continued to hold short positions in copper and corn.
We star ted a long position in crude oil. In recent weeks we have noted signs that a balance between supply and demand is close to being restored. Crude oil inventories have stopped growing in several par ts of the world, and some have even embarked on an unseasonal decline due to widespread production stoppages and strong imports by China and India. More importantly, supply is set to fall short of demand in 2017 and the gap will steadily widen in the ensuing years. Given the level of futures prices at this time, we do not foresee production hikes capable of keeping pace with the growth in demand.