First semester 2016

The first semester of 2016 was remarkably turbulent and we expect the volatility to stay high and possibly even increase by year’s end.

The markets are ignoring the existing risks, simply because they are counting on price manipulation by the Central Banks (CB). Unfortunately, by holding stock prices up, the bureaucrat professors in charge of the CBs are postponing the inevitable and making the consequences even worse and perverse.

The best recent example was the Brexit – it was a big surprise for the markets, made the pound sterling plunge and dragged the global stock indexes along with it. How did the CBs respond to it? They promised what they always do: more liquidity, more bond purchases and interest rate cuts. Result: the indexes bounced back and completely ignored one of the most important events of the 21st century, as if it was nothing to worry about.
We are going to list the most obvious potential problems that investors are ignoring – of course, these are the known ones. There could be a “black swan”, which would make the entire situation even worse.

• Countries’ leverage
Countries’ indebtedness has reached very high levels as measured by Debt-to-GDP, especially in ones whose economies are stagnated or recessive, such as Japan (229%), Italy (133%) and the Eurozone (90%). The very leader of this rank, Japan, uses 41% of its tax revenue just to serve its enormous debt (bear in mind that interest rates there are zerobound).

• Elections in the USA
The prognosis for the American future isn’t very exciting. Besides their innumerous problems that are always brought up in this blog (ZIRP, slow growth, high unemployment rate, high asset prices, etc.), this year is an election year and the candidates aren’t exactly the best ones in our opinion.

• Zero and even negative interest rates in many parts of the world.
The total amount of government debt yielding negative interest rates is increasing and had reached USD11.7 trillion last month, nearly twice as much as the amount in the beginning of the year. We consider the idea of investing in a bond, holding it until maturity with the certainty of getting less money than what was initially invested as inconceivable.

• Frightening corporate leverage.
The corporations took advantage of the extremely low interest rate to take on a lot of debt. Instead of investing in innovation, research, development and expansion, the executive officers decided to do buybacks, busting their own bonus, but clearly putting the company in jeopardy. As soon as the money authorities are obliged by the markets to increase interest rates, the companies’ capital structure will be compromised and they will no longer be competitive. On top of that, these companies will have to issue shares to serve the debt and correct operational weaknesses, at the very moment that investors are also selling their positions, sending the stock prices further down.

• Bank crisis in Europe (mainly in Italy).
Italy is responsible for less than 10% of Europe’s GDP, but it is responsible for almost 1/3 of the NPL’s of the entire Euro area. The vulnerability of the European banking system is quite evident.

• A possible (and probable) debasement of the Chinese currency
Big investors like George Soros and Kyle Bass have already pointed out what seems to be the trade of the year: the impossibility of China to keep the Yuan pegged to the USD. Last year, when China debased its currency by a little more than 2%, the markets melt down. That makes us wonder what would happen in case of a big devaluation.

• Puerto Rico’s default
That’s more evidence that that are some cracks in the system. The small territory of Puerto Rico hasn’t managed to pay down its maturing debt and has already warned that they aren’t going to be able to pay down the next ones. For now, the markets haven’t paid much attention to it, because the shock it too little, but let’s bear in mind what happened two years ago in Greece, where a tiny country responsible for 2% of the EU GDP almost brought the whole Union down.

• Deutsche Bank Derivatives Exposure (staggering USD 70 trillion, 20x the German GDP)
A derivatives exposure so big leaves the largest bank in Germany extremely susceptible to market stresses. Sudden moves in asset prices could lead to such an amazing bankruptcy that even the largest economy in Europe wouldn’t be able to bail out. Such a fail would spread shocks over the entire world, since all the big banks (and many big companies) have counterpart exposure to the Deutsche Bank.

• The Greek debt
The debt has been continuously rolled over. After every negotiation round, the government has to take austerity measures and hand over more of its sovereignty to the bureaucrats of the EU. The population suffers and little riots (protests) aren’t uncommon anymore.

• NATO´s aggression towards Russia (latest one via Finland´s possible engagement), War in Ukraine and ISIS’ attacks. The conflicts around the world are plentiful and many analysts believe a large-proportion war is on the way. There are a lot of “small” problems in different regions that are worsening (South China Sea is one example). Needless to say, over 1 million refugees have made their way into Europe over the course of the last few months.

• The Brexit
The outcomes of the Brexit aren’t clear yet. The Pound Sterling has lost more than 10% of its value on the day and someone (hedge fund or bank) has definitely lost money on its bets. This is also true for the real estate market, which is highly illiquid and, in London´s case, also overvalued.

The aforementioned risks are global, but the Brazilians have to consider one more: the return of the (ex)president Dilma Rousseff. The ultimate decision hasn’t been made by the Senate yet, but the markets don’t even take it into account. It’s worth saying that we don’t expect her to come back to the presidency, but that’s a risk we cannot ignore. Any failure in the impeachment process could trigger a massive selloff of Brazilian assets.

The stock indexes continue their way up based on the very same rhetoric: the news is bad enough to keep the interest rates in its historic lows, but isn´t so bad that stocks should go down…Unbelievable.

Since we are very thorough in our investments, we have had once again a fantastic performance: our international portfolios went up by 15% on average throughout the first 6 months of the year. Much of that can be accredited to our exposure to gold and silver and to mining companies, some event-driven plays, like Mitsubishi, Magnesita and Petrobras, and to buy-writes operations (mainly with silver).

On the Brazilian side, our Hedge Fund has performed really well, equivalent of 150% of the CDI (Brazilian Benchmark) in the last 12 months and we believe this performance should continue until the end of the year.


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