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Monthly Commentary – September 2017

Planner Redwood Asset Management

MONTHLY COMMENTARY

SEPTEMBER 2017




This message has information which is only indicative and should not therefore be interpreted as a text accompanying report, study or analysis on specific asset values or specific assets which could help or influence investors in the investment decision-making process. The information, opinions, estimates and projections refer to current data and are subject to change without due notice due to alterations in market conditions. Investments or purchases of bonds and stocks involve risks, possibly implying, depending on each case, on the total loss of capital invested or even on the need to inject further resources. The information expressed in this document is obtained from sources considered secure. However, despite being adopted in its entirety, it should not be considered as such. Altogether, it has not been independently confirmed and no guarantee expressed or implied is given on accuracy. Although having taken all precautions to ensure the information here contained is not false or misleading. Planner Redwood Asset Management does not take responsibility for its accuracy or completeness. The writer is not a Stock Analyst, nor is this report an Analysis Report, as defined by instruction nr 483 of the Securities Commission (CVM). The reproduction of this message is prohibited without the express authorization of Planner Redwood Asset Management.

Agenda

Introduction

Economic Activity

Fiscal Policy

International Environment

Interest Rates

Foreign Exchange

Stock Market

Monthly Commentary / SEPTEMBER 2017




Epigraph of the month... a propos of Brazil’s current predicament.

3

“The most common reason why nations fail today is because they have

extractive institutions.”

Daron Acemoğlu – Turkish-born economist at MIT.



Introduction

4

In September we witnessed the change of the guard at the Federal Prosecutor’s Office (PGR in Portuguese).

Janot stepped down and Raquel Dodge’s took over at a crucial moment for the Brazil. On one hand, Janot leaves

under a seeming boomerang effect of his actions, and one shall not overlook how much he has “motivated” the

settling down of the “plea bargain” statute. On the other hand, Raquel Dodge’s take of office breeds hope that not

only the Car Wash probe will linger on, as she pushes forth with serenity and boldness in the cases in course and

many others so anxiously awaited by the Brazilian society. It is well within her skill set – and highly validated at

that.

In times when our institutions are routinely put to tests of resistance and integrity, when checks and balances are

“revisited”, a PGR that enjoys credibility as to its commitment and independence reinforces the institutionalized

process and rules. There is no way around it. In truth, institutions and political processes will determine, in the end,

our economic and welfare evolutions.

The path toward curbing corruption is, obviously, long and multifaceted. However, the first and most important step

– tackling impunity – requires we don’t pull back now. In this sense, all of the judicial framework and the political process must curtail the foremost evils

and thus will determine our economic institutions and its channels of action. Examples must come from top, that is, form our institutions. We need their

fortress without mutual interferences and with delimited scopes of action and fully functioning. As was well depicted by the authors of the book Why Nations

Fail (Daron Acemoğlu and James Robinson), the main issue to be discussed revolves around institutions and the roles they play in a society in order to

form its political regime and economic success, or even, how (inclusive!) political and economic institutions are necessary for sustained economic growth.

As the quote that opens this report states: “The most common reason why nations fail today is because they have extractive institutions.”

Off our shores, political tensions are no longer punctual and natural disasters impose the hardships on much impoverished peoples, who frequently lack the

basic material structure. In Venezuela, the people endure everlasting suffering, while the North Korea citizens face the threat of an ineffable nuclear war,

should tensions with US continue to escalate. In Germany, Merkel has won once again, but the extreme-right AfD party has attained a significant number of

seats in parliament (after more than 50 years) and its reach in representation came much to surprise and annoy the Chancellor. Independence Referendum

in Catalonia is a given, but the Spanish government won’t go about it. In Florida and the Caribbean, hurricanes ravage cities and communities – in the

former life slowly falls back in line, whilst in the latter recovery is bound to take years in some countries.

In this landscape, the US Treasuries closed the month at 2.3336%. S&P varied 1.93%, NIKKEI closed at 3.61%, DAX at 6.41% and FTSE 4.74%. Ibovespa

finished the month at 4.88% and the IBrX at 4.69%. Highs of DIF18 at 7.78% and DIF21 at 9.21%. NTN-B 2050 ended the month at 5.11%, and the Dollar

(Ptax) at BRL 3.1680.



Economic Activity

5

There is no doubt that agriculture, despite its “meager” share in the

supply-side measure of GDP, has always been the “savior of the day”.

However, its indirect impacts are legion and do influence the economy

widely, given its competitiveness, its generation of foreign currency, etc.

In this sense, getting to know this segment better will provide a greater

understanding and a better assessment of the allocation of resources. For

that matter, IBGE will carry out the Agricultural Census with its data

scheduled to be released in a one-year’s time. Data collection will focus

the cultivated area, output, employed personnel, irrigation, use of

agrotoxics and family farming. The census also aims at informing the new

Annual Survey by the IBGE – the National Survey by Farming Units

Sampling – in order to collect data on revenues and production expenses,

rural credit and insurance, protection to waterside land, conservation of

fauna and vegetation, use of agrotoxics, production techniques, besides

the social and familial situation of rural workers. A marvelous initiative to

be commended!

In spite the exemplary attitude above, it is up to Consumption to jump start the economy (via falling unemployment, plunging inflation, escalating real

wages and increased purchasing power). Given its expressive share in the Brazilian GDP, any improvement in this sector has significant impacts on the

level of economic activity, thus becoming of utmost importance at this juncture of the economic recovery. The latter in part already shows (yet to be

confirmed if it is not another “chicken flight”) and it can be explained by the rising purchasing power, particularly due to falling inflation. It is a fact that the

deleveraging of households (still parsimonious) and the increase in income are likely to keep some momentum… and this is the bet many are making.

Consistent improvement in retail coupled with household financial relief indicate more solid foundations for consumption recovery… but let’s take it slowly.

The feet are indeed made of clay, investments are dragging… the level of idle capacity is still huge. Blaming entrepreneurs after years of economic

malfeasance is unfair… companies will only raise the productive capacities once blunter signs of comeback become more evident. Nothing is more

understandable. In this line, consumption is bound to be the new “savior of the day”.

Source: IBGE and Redwood Projections | Elaborated by Planner Redwood



Fiscal Policy

6

Fiscal figures are still overwhelming!

Social Security deficit has surpassed, up to August, the mark of BRL 113 billion,

that is, almost 75% of the target number for the whole year. The new target is now

at BRL 159 billion, almost entirely consumed until the end of the year by Social

Security spending.

Although August figures show primary expenditures outpaced Federal Government

revenues in almost BRL 10 billion, good news is that it is half the number of the

previous year. Great news, but unfortunately insufficient (by our estimates) to

achieve even the recently approved new target – unless we face a combination of

downswing in expenses (including postponing expenditures to the next fiscal year)

and a significant improvement in regular tax collection and the confirmation of

several extraordinary revenues; nothing plausible, though.

Nonetheless, it is undeniable that we see some improvement in process and some

achievements. With BRL 16 billion raised in auctions (attainment of a BRL 4.2

billion surcharge in hydroelectric plants and tranches of oil extraction), morale has

risen.

The main issue, as everyone knows, is expenditures. The social security expenses

continue to escalate with the adjustment in benefits and incoming beneficiaries, at

the same time that spending with public servants rise at a10% rate in real terms, as

verified between January and August.

Reality is indeed cruel. No one disputes that additional cuts in investments and discretionary spending could help balancing the books (with large losses!),

but our point is that mandatory spending “hinder” any comeback toward primary surpluses. The social security benefits, personnel and LOAS – Social

Security Organic Law (Continued Benefits Program, or BPC – guarantee of a minimum wage to elderly or disabled persons) add up to 72% of an

absolutely inflexible budget. Social Security Reform has to come!... we run the risk of falling short of the “golden rule” of budget in 2018, that is, the

prohibition of issuing debt to cover current expenses.

Oh! This likely noncompliance implies fiscal accountability felony… and we know quite well what that means!



International Environment

7

The General Assembly is one of the top events of the United Nations and, this year, the 72nd meeting

was opened, as tradition has it, by Brazil. All member countries convene with equal representation:

one nation, one vote. In this exclusive forum, all of 193 United Nations members are gathered to

debate and work together on a host of international matters covered by the United Nations Statute,

such as development, peace and security, international law, etc. It is also an occasion where world

leaders meet and a stage attracting all of the attention. This year was no different, but a specific

leader has taken center stage: US president Donald Trump.

No, it did not come close to an “abuse”, but the US Commander-in-Chief spoke loud and clear. The

mainstream media, as usual, focused its criticism on his demeanor and poise, but only few were not

ready to recognize the objectivity of his speech. An intervention that was in many aspects blunt, albeit

particular in the defense of its ideals (widely promised during his campaign) and the imminent conflict with North Korea. Donald Trump continues, beyond

the General Assembly, invested in undoing his predecessor’s legacy, in areas so diverse as climate and free trade agreements, market regulations,

immigration healthcare and LGBT and gender-related rights. It won’t be easy at all… this being the reason why so many people ask themselves what

Trump has done so far and sum the answer with a simple “nothing”. Fixing some areas will be, in truth, very challenging in the face of ever more

disseminated values among the US population.

In Europe, the Regional Government of the Catalonia province has embarked on another attempt at a referendum on the region’s independence, but

faced harsh criticism by the Central Government in Madrid, which considers the measure illegal before the Spanish Constitution. The Spanish Prime

Minister, Mariano Rajoy, made a strong pronouncement against the referendum and thanked, albeit indirectly, the support received by the international

and European community. The fact is: the European Union does not intend to recognize a unilateral declaration of independence and, therefore, conflicts

must be set aside and dialogue must prevail. In the economic realm, highlights go to PMI manufacturing in Germany and in the Eurozone itself climbed to

60.1 and 58.1, respectively – both at historical levels unseen in the last 6 years. In the UK, the PMI manufacturing dropped to 55.9 in September, a much

lower score than expected (56.4), and yet the figure indicates that the British manufacture continues to expand high above its long term average of 51.7 In

the Eurozone the unemployment rate remained at 9.1% in August, lowest level since February 2009.

FED, ECB, PBoC and other key Central Banks in the world continued without further change in their policies. Could it be the calm before the storm?



Interest Rates

8

Despite the troubled political moment and the terrible status of public finances, monetary policy has been conducted exemplarily.

However, we are coming to a crucial point in monetary policy where much debate is fueled on the supposed end of a downward cycle in nominal interest

rate (taking heed of the necessity of Reforms) and structural interest rates. However arid the subject, amongst the many takes that help us evaluate the

direction interest rate is taking in Brazil, we highlight only two that constantly inform our analysis. The first relates to projections couched on a Taylor rule,

which admits that the neutral rate is a short-term one that should prevail when the both difference between the effective and the target inflation rates and

the output gap (deviations of growth rates from its long-term equilibrium rate) are both nil. Thus, for 2017 and 2018, our projections point to:

Nonetheless, another way to approach the subject should be considered

that transcends inflation control (first and foremost!), which we have

frequently tackled in this space: the requirement that the interest rate

reflects the equilibrium between Savings and Investments (S≡I).

Contrasting with other schools of thought, the diagrams (Wicksell) show

that the problems are fundamentally monetary in nature. The diagram on

the left depicts the market with different levels of monetary supply. The Lm

curve represents the demand for cash balances, which depends inversely

on the interest rate: higher rates attract investments to financial assets. The

equilibrium interest rate in this market would be the “monetary interest

rate”. On the right, we find the capital markets where aggregate savings

and investment interact. The equilibrium level, i0, denotes the “neutral

(natural or equilibrium) interest rate”.

Brazil is in desperate need of savings! where S= Savings, I = Investments, i = interest rate, Lm = demand for cash

balances, M = stock of money

Taylor Rule Formula(2017): Target Rate = Neutral Rate + 0.5 × (GDPe − GDPt) + 0.5 × (Ie − It) =

Taylor Rule Formula(2018): Target Rate = Neutral Rate + 0.5 × (GDPe − GDPt) + 0.5 × (Ie − It) =

7.29%

6.86%



Interest Rates

Yield and Coupons Curves (NTN-Bs)

9



Foreign Exchange

10

If there is one topic that bothers the policy guided by the BACEN it is exchange rate policy. However, to this date the economic team has been quite sincere

in admitting the BACEN would interfere in the currency markets. Such a pity, for it seems that happiness is never complete. We always see the exchange

rate as a reflex of the general price level and, as any other, one that is subject to the law of supply and demand. Unfortunately, it seems a dogma that

Central Banks need to intervene in this market in order to achieve exchange rates targets set by the economic policy. In truth, not only the level, but also

the volatility make up for the arguments behind interventions – both in the short- and long-terms. We have previously shown how ineffective these

measures are.

The current exchange rate regime in Brazil is of the “dirty float” type, which means that the monetary authority prevent “major” swings in the USD quotes.

Knowing what “major swings” precisely means an insurmountable challenge and, in contrast with interest rate policy and the entire transparency framework

entailed by the inflation targeting guidelines, exchange rate policy has no such luck. An additional problem refers to the pressure coming from the business

community coupled with economists that preach such interventions… what for? Simple: as a rule, it is due to protectionist issues under the guises of

improving competitiveness of productive sectors. It doesn’t fit anymore. Competitiveness is tied to several factors – which amount to the real problems we

should be tackling.

Another issue relates to the enormous international liquidity that, even for an economy as closed as ours, ends up “contaminating” our market; this

movements falls outside the control of the Central Bank. Paradoxically, as our economy improves, chances of a greater inflow of USD to Brazilian shores is

certain, and thus a stronger BRL is likely to come soon.

The diagram above displays the evolution of the USD quotes through time and under various exchange rate regimes.



Stock Market

11

Ibovespa has closed the month at 74.294 points, with a 4.88% return in

September and 23.36% within the year of 2017. But it is not all. On

September 20th Ibovespa reached its peak in BRL terms: 76.004 points.

The moment calls for caution. The Price-Earnings index (P/E) for Ibovespa,

used by many to verify whether the Brazilian stock market is “expensive”,

also points to record scores. However, Ibovespa in USD terms (as foreign

investors, accounting for 50% of the volume of negotiations, also analyze)

is far from its peak. Complicated, isn’t it? Expensive to some and cheap for

others? Deep down and in the long run, the fundamentals for the Brazilian

economy must prevail… but wait! In the short and medium terms financial

markets always overreact.

In this line, the Brazilian stock market is likely to have its behavior tied to

some factors. Amongst them we highlight the performance by the US stock

market in the face of “strong” positive correlation with ours in certain

occasions. At this moment, Donald Trump’s policy, especially regarding tax

reform, should boost the American economy and with it feed into the stock market indicators in Uncle Sam’s land. But is this relation fit for the moment?

Possibly so. On the other hand, a more heated American economy can lead to higher inflation (a desirable effect to some extent) and with it a FED-

sponsored interest rate hike. This measure, different from nowadays gradual posture, can trigger a process frequently mentioned here: flight to quality.

Investors tend to redirect their funds toward Dollar-denominated investments… a “risk aversion” move.

Despite all the political turmoil we are mired in and the situation of public finances, this scenario of an outflow of foreign resources and strong sell off of the

Brazilian stock market does not seem likely as of now. With the realignment of the economy and a great international liquidity, all else constant, it is quite

possible to see some room for retraction of the Ibovespa in the short run, but nothing “disconcerting”. In relative terms, notably as regards emerging

markets, Brazil seems to rekindle, albeit timidly, investors’ interest.

Source: Bloomberg | Elaborated by Planner Redwood



Monthly Commentary SEPTEMBER 2017

planner redwood asset management monthly commentary€¦ · in catalonia is a given, but the...

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