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SPX Nimitz Manager 2015 Annual Letter : New Year, Old Problems

SPX Nimitz Manager letter to the investors for the year ended December 31, 2015; titled, “New Year, Old Problems.” This is considered one of the top hedge funds in Brazil, note some similar positions to Verde (which we are slightly more familiar with. Also see the latest from BTG Pactual’s hedge fund here.

Dear Investor,

Taking the opportunity offered by the start of a new year to have a more detailed look at the fundamentals of the Brazilian economy, in this letter we present our views on the main themes in discussion.

The fiscal and political spheres have dominated our presentations and reports. Readers will recognize that we have taken a very pessimistic view of the fiscal outlook. Nevertheless, the fiscal results are deteriorating even more rapidly than we foresaw. One of the most daunting problems is the sharp rise in the social security deficit in recent months, discussed below. Moreover, the political system has proved incapable of tackling the economic problems, at least for now. Let us begin with the political outlook.

Political Outlook

Operation Car Wash (“Lava Jato”) has rendered the Brazilian political system dysfunctional. Right now, considerable proportion of the political class is divided into three groups: (i) those who are striving to stay clear of the Federal Police investigation about corruption in Petrobras; (ii) those who have already been caught in the net and are trying to delay punishment; and (iii) those who are outside the investigation and are interested in inheriting the spoils left by their mortally wounded fellow-politicians. In short, little time and attention remain in Brasília to deal with the economic situation and the badly needed structural reforms. And it is in this context that we are forced to turn to the impeachment proceedings now under way.

In our view the attempt to impeach President Dilma Rousseff is likely to fail because of the composition of Congress. Even assuming “betrayal” by several members of the ruling coalition, it is highly unlikely that the 342 votes needed for the proceedings to pass the lower house and move on to the Senate will be reached. However, uncertainty about the outcome remains acute, and this makes any important economic decision impossible, as well as accentuating the government’s left-leaning tendency.

The left-wing parties are the Government´s core supporters. Their members are the most likely to vote against impeachment. But the cost of this support may be reflected directly in increased public spending.

Against this background, Finance Minister Joaquim Levy’s resignation appears to us to have been aligned with the government’s move to relinquish fiscal austerity and intervene more in the economy. This process will tend to be gradual in order to avoid a highly negative response by the markets – but it is evidently inevitable.

SPX Nimitz – Economic Activity

The economic data points to a recession of such depth and duration that many are calling it a depression. We estimate a 3.8% GDP contraction in 2015 and project a further contraction of 3.4% in 2016. Business confidence indicators are close to the all-time lows.

If a snapshot of the current economic situation is already somber, it may get even worse if the inflation adjusted credit supply contracts even faster. (It contracts by 2,7% in real terms, as of November 2015, YoY). We find this risk to be increasingly likely. The financial accelerator is starting to kick in, amplifying the recessionary shock and deepening GDP contraction. We see problems in both demand for credit and the supply of credit in Brazil. On the supply side, delinquencies have risen, and will restrict the availability of credit in the months to come, given the natural procyclical banking system behavior. On the demand side, companies that generate strong cash flow are paying out debts and will remain reluctant to invest until they glimpse an end to the recession and acute political uncertainty. All in all, the pool of borrowers is deteriorating.

Inflation

Several important factors will tend to drive inflation higher in 2016:

  1. Pass-through of local currency depreciation to inflation has been low so far, but only because it has not yet been possible to raise consumer prices to a considerable extent. In wholesale inflation indexes there are strong signs of a sharp acceleration in prices of tradables, such as durable goods and industrialized food products. Pass-through to consumer prices is just a matter of time.
  2. Inflation inertia is high. Both the IPCA and the IGP-M rose sharply in 2015 so that prices pegged to past inflation, such as urban transportation fares, are already being raised significantly and will be more so in the coming months.
  3. The annual minimum wage hike is a specific case of inertia, as it reflects at least past inflation. A hike of 11.7% has been approved for 2016. This affects not only workers who are paid the minimum wage, but also those whose wages and salaries are informally indexed to it, as the minimum wage has a strong signaling effect. In Brazilian labor markets.
  4. Inflation expectations have deteriorated. For 2016, the median consensus forecast is already 6.9%, above the upper limit of the tolerance band.
  5. Lastly, widespread consumer tax hikes is in the offing. In an attempt to balance the budget, the federal government is set to hike the CIDE fuel tax in 2016. States, in dire financial conditions, have raised rates of ICMS sales tax on several products.

All these elements combined will be more inflationary than most analysts foresee. We forecast a rise of 8.7% in the IPCA in 2016.

Balance of Payments

The recession has had at least a positive effect on Brazil’s current account. The main reason is a sharp fall in imports and sharp decrease of expenditures of Brazilians traveling abroad.

However, the capital account is the main issue as far as the balance of payments is concerned. Capital flight is a strong possibility in the context of constant fiscal deterioration, a serious political crisis and a long recession, with part of the foreign capital that has entered Brazil in recent years being taken out again.

Public Accounts

Shaken by the turbulent political environment, deep economic recession and the absence of structural reforms, Brazil’s fiscal health is waning. For 2016, the main concern remains social security. The minimum wage hike, mentioned above, has further worsened the imbalance in the accounts of the social security and pension system. With the value of benefits climbing 11.7% and the number of Brazilians over 65 years of age rising 4% per year, expenditure on social security benefits is set to rise about 16% this year, while revenues coming into the system will rise less than inflation owing to higher unemployment. As a result, social security deficit is projected to reach 2.2% of GDP in 2016, or more than double the level printed two years ago.

Besides social security expenditure, other mandatory items indexed to the minimum wage will rise in proportion to GDP. The overall rise in mandatory expenditures is set to reach 0.9% of GDP in 2016, according to our projections. Furthermore, there is scant leeway to cut discretionary expenditure given that it was considerably reduced in 2015.

The only significant improvement in 2016 will come from extraordinary (nonrecurring) receipts from the November 2015 auction of hydropower concessions, sales of federal assets, and the program to repatriate and regularize funds held abroad illegally.

As a result, we expect the primary deficit to reach 1.4% of GDP this year. The national debt will continue to rise, reaching 80% of GDP by the end of President Dilma Rousseff ’s term. This is unsustainable in our view and is the basis for the debate about fiscal dominance.

Monetary Policy

As a reflection of the deteriorating inflation outlook, the Central Bank of Brazil signaled in an official communiqué that it intends to begin tightening interest rates at the January meeting of its Monetary Policy Committee (Copom).

Recent remarks by members of the Copom, however, have raised doubts about the start and length of this process, which is now a matter of considerable uncertainty. The substitution of the finance minister and the possibility of increased political interference in the Central Bank’s decisions suggest to us that caution is advisable when attempting to forecast the length and depth of the next monetary tightening cycle. We have likewise been cautious in our small directional positions in interest rates at the start of the year.

SPX Nimitz – Portfolio allocations

Our main allocations are described below.

Currencies

We remained long the USD, partly against the BRL and partly against a basket of currencies.

Equities

In international markets we continued to hold a short position in US equities, and in addition to the points highlighted in previous letters it is worth noting the risk that the continuing deterioration in the emerging economies, especially China, will affect the developed economies more significantly and the deterioration in the US highyield bond market will impact the economy and equity markets. In sectoral terms we started a few strategic positions in companies that are benefiting from the fall in oil prices. In emerging markets, we maintained our long exposure to Argentina and Chile. We started a short position in a basket of commodity companies. In directional terms we remained neutral.

In Brazilian equities we reduced our short position in light of the local market’s weak performance. We remained long in financial services and short in consumer goods. We continued to hold a long position in non-metallic commodities and a short position in metallic commodities.

Interest Rates

The Central Bank of Brazil (BCB) has signaled that it aims to reduce inflation to 4.5% in 2017, and will strive in 2016 to keep it below 6.5%, the upper limit of the target band. If this goal is to be achieved, it will have to raise rates even higher, since current inflation is above 10% and expectations for the coming years are de-anchored. On the other hand, there are signs that the government is pressuring the BCB not to raise rates. In light of this we closed out our paying position in interest rates. International rates have suffered from diverging monetary policies in the developed economies. On one hand, in the US the Fed has begun raising rates; on the other, central banks in Europe and Japan are still committed to monetary easing. In this context we have opted not to take significant directional positions.

Commodities

We continued to hold short positions in metals (copper and aluminum), soybeans, and oil. We started a short position in gold owing to three factors we see in the weeks ahead: (i) continuous strengthening of the US economy compared with the rest of the world, which will favor appreciation of the dollar against other currencies and gold; (ii) US rate hikes above the levels expected by the markets; and (iii) additional falls in commodity prices, solidifying deflation and removing the appeal of buying gold as a real asset.

SPX Nimitz – Assigning Performance

In December, the SPX Nimitz yielded 1.45%, compared with a CDI 1.16% in same period.

SPX Nimitz
SPX Nimitz