Why Did Brazil's Stock Market Crash 17% After Election? | Tavi Costa

Tavi Costa · Azuria Capital

Lula's re-election marks the beginning of his end, with a possible VP succession seen as a major market shift.

Costa personally believes Lula's term is the beginning of the end for him. He cites Lula's age (81) and says the vice president was once part of the opposition. If the vice president takes over, he expects that to be a major shift in markets, since the political premium that was excessive at the time has now reversed. He presents this as his personal view and admits many people disagree with him.

“I think this is the beginning of the end of Lula personally. That's my 2¢. And if I would, I feel very strongly about this is his second, his vice president is someone who used to be in the opposite.”at 6:10

Tavi Costa · Azuria Capital

Don't go all-in on emerging-market stories; their corruption and political risk runs several times developed-market levels.

Costa says Brazil's market was pricing its election as a near-certainty (80%+ odds), which left no room for a surprise. He argues that developed markets also have corruption, but emerging markets have it to a much greater degree, roughly three to five times as much. He also cites electronic voting and other external factors outside the norm. From this he concludes investors should not be fully invested in emerging-market stories where the outcome seems certain. Brazil is a cautionary example for that.

“in developed markets you also have corruption but in emerging markets, just another degree. You know, it's just like you multiply that by a factor of three or four or five.”at 15:27

Tavi Costa · Azuria Capital

Brazil's election premium has been wiped out, but the more conservative Congress is a positive the market is ignoring.

Brazilian shares rallied 30-40% after Bolsonaro's first-round surprise, then reversed after Lula won. Costa says the upside political premium is gone, so the market now prices the opposite. He argues the market is ignoring a structural positive: after the first round, both the upper and lower houses are more supportive of conservatives than they were twelve months ago, and Lula remains in office regardless. He cut Brazil exposure by roughly 70% before the election, which he says in hindsight should have been 100%. He is now gradually redeploying capital and not rushing. He frames the thesis as a long-term hard-assets/commodities bet, noting Brazil owns more hard assets than almost any country, and says the early-2000s Brazil bull market also happened under Lula.

“So basically the political premium that we had coming in ahead of elections has been wiped out. ... we now have, you know, a pretty much more supportive conservative party in place than what we used to have twelve months ago. And so that's a positive that is completely, you know, ignored by the market today.”at 5:07

Tavi Costa · Azuria Capital

US–Brazil ties provide a safety floor for Brazil that the market underappreciates.

Costa argues that Lula has less control over the country than people think, and that the potential for a more authoritarian drift is real. He says there is a floor of safety from US and other international intervention if something bad happens, and that people are under-appreciating it. He adds that the US needs Brazil and Brazil needs the US, so both sides will play ball regardless of who leads Brazil. This is a reason he is staying invested.

“there is a floor of safety and security that comes from the intervention of The US and others if something bad ever happens that I think people are also under appreciating.”at 11:13

Tavi Costa · Azuria Capital

Brazil's 15% rates are suffocating companies; expects a forced cut toward 5%, bullish for equities, bad for the real.

Costa calls the cost of capital the main problem in Brazil. Rates are so high that companies cannot borrow effectively and can only dilute equity. He cites a food company that pitched him a convertible bond at a 25-30% coupon, and says Brazil's small-cap universe is depressed because of rates. He expects the central bank under the new leadership to push rates down from about 15% toward 5% as a form of financial repression, aimed at adjusting the fiscal balance. He argues this would be very bullish for local equities but problematic for the currency, especially for an emerging market that is not the reserve currency. As a result he is now giving more thought to hedging currency exposure. He also says a rate cut of five to seven points over twelve months would have happened under the opposing candidate.

“That's a big question locally where we're seeing is the potential, more of a [an] intervention in the interest rate market in Brazil, taking it from 15% or so to 5% and trying to adjust the fiscal balance by doing that.”at 11:47

Tavi Costa · Azuria Capital

A blue sweep may hit markets less than expected, since the outcome is already widely priced in.

Costa compares the US midterms with Brazil. In Brazil, Lula's win was priced at 80%+ odds, but in the US the expected Democratic sweep is closer to 60-70%. Because expectations are already high, he says the market reaction to a blue sweep may be less severe than people expect. He also says a divided government would reduce spending, which is negative for gold near term, but that the market will focus more on what the presidential-election outlook implies, which he expects to dominate the near-term midterm effect.

“like we're seeing now in The US what's the expectation is that we're gonna see a blue sweep ... I guess the outcome in the markets may not be as severe as everybody else is expecting that just because there's a lot of expectation to that outcome to happen.”at 13:20

Tavi Costa · Azuria Capital

The Fed's tightening is suicidal: the US cannot afford these rates, so growth will slow and force financial repression.

Costa argues that the US is the country least able to afford current interest rates, and interest expense is a growing share of government spending, which he calls a cancer in the system. He says the US is currently growing about 5% nominal just to service and pay down debt. Nominal growth is high now, but that is not sustainable. When growth decelerates, toward zero or negative as in past recessions, the market will suffer. He expects the Fed to eventually have to adjust policy, through financial repression, once things break. He sees the Fed as near the end of its tightening cycle, and says last week's market moves were the first signs of breakage.

“if you just do the math, we hold these rate setting that we have currently here in The US. ... if any country cannot afford interest rates at these levels, that is The US. ... this policy that we're seeing is suicidal and it is completely unsustainable.”at 22:52

Tavi Costa · Azuria Capital

Long-end Treasury yields have been rolling over and will fall further, far below what consensus expects.

Costa says the long end of the curve, which everyone is worried about, has been rolling over for some time, and he sees that as the start of the end of the move higher. He expects much lower long-term rates than people are predicting as growth decelerates, and says the current rate pricing is mispriced if that deceleration happens. He ties this to the dollar also rolling over alongside long rates. He frames his broader view as a 12-24 month window of opportunity.

“the long end that people are so concerned about. It's been rolling over. It's rolling over for some time now. ... we're gonna see much lower long term rates here compared to what people are saying”at 26:07

Tavi Costa · Azuria Capital

The dollar is starting to roll over after its big move, alongside long-term rates, benefiting precious metals.

Costa says the dollar has rolled over after a big run and is moving in tandem with long-term rates, and the two are at a turning point. He links a lower-rate, weaker-dollar environment to assets such as precious metals, which benefit from both. He describes his view as a 12-24 month window.

“the dollar is also starting to roll over after a big move on the dollar that we've seen the dollar's rolling over alongside long rates, okay? Long term rates.”at 26:36

Tavi Costa · Azuria Capital

Both US parties keep spending, adding to inflation and the deficit; the fiscal addiction will eventually hit a wall.

Costa argues that both US parties add to the inflation problem through spending. He says the economy has become addicted to fiscal stimulus, and that politicians will keep spending because stopping spending would stop growth. He thinks people tend to criticise one party, but both are adding to the fiscal problem and both will hit a wall. He also argues that high debt to GDP globally makes growth harder, which leads politicians toward radical, unrealistic solutions. This is what he calls populism, and it breeds conflict and inequality on both the right and left.

“both parties add to the inflation problem in a big way. ... everyone is going to continue to spend in order to not let such an addicted economy to fiscal stimulus stop growing ... And I think that they're both gonna hit a wall regardless.”at 28:53

Tavi Costa · Azuria Capital

Precious metals are in a secular bull market; this year is a normal consolidation and a bottom is near.

Costa calls precious metals a secular bull market. This year's weakness is a normal consolidation after a big move, not the end of the trend. He argues that metals and miners are extremely oversold by any metric, and that miners' breadth is one of the worst he has seen in history. He does not think that is sustainable, so he expects a bottom to form. He expects a lower-rate, weaker-dollar environment to help, and argues that fiscal deficits and inflation favour metals regardless of which party wins. A gridlocked Congress would reduce spending, which is negative near term. A future left swing would be extremely positive. He frames the opportunity as a 12-24 month window.

“I think the precious metals are in a secular bull market. This year has been a consolidation or a difficult year, whatever you wanna call it, which is normal.”at 29:49