For some time now, part of the market has been positioning itself a little differently than usual. Signs of a buoyant US economy have been pushing down that country’s risky assets, with investors fearing they will force the Federal Reserve to raise rates further.
Frustrating macroeconomic data, on the other hand, is pushing the indexes up, interpreted as a sign that there may be less monetary tightening. For some experts, all this signals that there is a serious – and dangerous – problem in the world’s largest economy.
At first, analyzing these movements is strange. A heated economy would normally signal companies profiting more and, consequently, appreciation of risky assets. On the other hand, it is also not usual to think that signs that the economy is swinging make the main American indexes register highs.
For certain investors and specialists, this strange movement of risky assets makes it clear that the market is currently more concerned with the perpetuation of high liquidity and a more lenient monetary policy than with the performance of the “real economy”.
In Brazil, the one who has been alerting the most that there is a possible major structural problem in the American economy (and also in the world) is Pedro Cerize, founding partner of Skopos Investimentos, who gives part of the credits for the thesis, however, to Jeremy Grantham, manager of GMO and one of the giants of the financial market.
“We had years of zero or negative real interest rates, which caused a bad allocation of capital around the world”, he says. “This kept businesses that would have failed at other times running. Companies that capitalism would have already eliminated are open because, for some time now, money has become easy,” he added.
In the last 15 years, the world financial system has gone through two major crises, to say the least.
In 2008, to deal with the crisis of subprime, the US government poured about US$ 700 billion dollars into the financial market to save bankers and avoid, at least momentarily, bigger problems. In 2009, the G-20 announced a US$ 1 trillion package to mitigate the impacts of the crisis.
During 2020 and 2021, the same thing happened. To deal with the economic problems generated by Covid-19 in the economy, countries have returned to pouring huge amounts of money into the markets. The US alone has poured something close to $5 trillion into its economy to deal with the crisis.
The theory adopted by Cerize is that this phase of easy money, established by several governments of the world, created a bigger problem, that sooner or later will have to be faced.
High liquidity and low-yielding government bonds kept investors pouring into nonfunctional companies. In addition, lower base interest rates have reduced financial spending on quarterly balance sheets.
Russell 2000 and the “Zombie Companies”
Now, with uncontrolled inflation in developed countries, what is seen is the beginning of a movement to withdraw liquidity and tighten monetary conditions.
“I’ve been talking about the Russell 2000 because it’s an index that contains low-cap stocks, with a lot of small companies that are under threat in the US,” comments Cerize. “In it, according to Grantham, are most of the zombies stockswhich, in my view, can start this great crisis that is to come”.
The Russell 2000 is an index composed only of small capitalized companies and that contains the two thousand smallest stocks of the Russell 3000 Index. benchmark more common for funds that consider themselves focused on small caps.
The theory he supports is that a good part of the small companies in the United States, similar to the small caps Brazilian companies will not be able to survive the monetary tightening that will be imposed by the Fed.
With the American monetary institution making its budget balance sheet, the financial market is expected to become less liquid. Rising interest rates are likely to put pressure on balance sheets, with companies spending more to pay off their debts.
“The thing is, in the Russell 2000 there are a number of companies that have been operating at a loss. And if they suffer losses with the economy flying, with the market liquid and with low interest rates, what will happen when the monetary tightening accelerates?”, asks Cerize.
During monetary tightening, it is normal for economies to stop growing. Higher interest rates make access to credit more difficult and the withdrawal of liquidity reduces circulating money. Both measures directly impact the profitability of companies.
The expert claims that the Russell 2000 is traded at a multiple of 56 when taking into account the market values of all the companies that make up the index and their total earnings. When considering only companies that had positive results in the last year, however, that number drops to something close to 12.
“For one blend from 12 to 56, it means that many of the companies that are part of the Russell 2000 make a loss”, says the manager of Skopos Investimentos. “These are companies that produce cash to pay for services and roll over their debts. they paid spreads plus CDI, which was then zero. Imagine at the time that the interest has 3% or 4%. O spreadmoreover, will also increase”.
The theory, then, is that a weaker American economy, on the one hand, will lower corporate profitability. On the other hand, higher interest rates should put pressure on debt spending. The combination of the two scenarios should lead several companies to bankruptcy.
“The combination of higher interest rates with downturn can make 500 companies fail”, he argues.
Cerize also declares that these companies are issuers of several junk bonds and that, in the event of a “failure”, American banks will have problems. Apart from that these companies, obviously, are also employers.
“Unemployment, if that happens, will rise. The Fed will be forced to raise rates because of the greater economic risk. The economy is going to need help,” he explains.
In addition to all the problem already outlined, finally, the pessimistic theory still states that the current level of world inflation is not transitory.
The “easy money” period of the last 15 years has been accompanied by low economic growth, with productivity dropping considerably.
“It was a period marked by poor market location and the survival of bad businesses”, points out the manager. “These companies have sucked resources, whether human or capital, and prevented further real growth. Authorities all over the world have created a kind of capitalism where nothing breaks or falls, which doesn’t seem very real to me.”
What we saw, for Cerize, was a period marked by the overvaluation of technology companies: with low real growth, investors preferred to cling to valuations of companies with the potential to advance – but these have not always been consolidated.
In June 2022, American labor productivity had its biggest decline since 1947, falling 7.3% in the first quarter, with a 2.3% decrease in production and with an increase of 5.4% in hours worked. .
If productivity impacts production, and consequently on supply, it is expected that this will have direct results in price dynamics, bringing even more upward trends.
In addition to the drop in productivity, the specialist also argues that the world is now experiencing a trend of retreat from globalization, a movement that has acted, in recent years, to reduce inflationary pressure.
The War in Ukraine, according to the manager, accelerated this process, which has been going on since 2014. “Starting in 2014, former American President Donald Trump created a series of frictions with China, with the so-called made in america”, he explains. “China, however, now has a strong enough domestic market to make a transition. The United States, on the other hand, has no manpower to work with.”
This year, with all the geopolitical problems, bilateral agreements were strengthened and the international market lost strength. “The deflationary pressure of globalization, for me, is disappearing”, says Cerize.
With productivity falling and globalization weakening – with a slight help even from the lower investment in energy due to the change in the energy matrix -, for the manager of Skopos, it is unlikely that the American interest rate will stop at 3.5% or 4% , as a large part of the market sees today (and which would already be a problem for most of the zombie companies). For him, it is more likely that the fed funds reach something close to 7%.
Commodities and treasury bonds
To protect himself from possible catastrophe, the Skopos manager defends a portfolio composed mainly of commodities, in bonds linked to inflation and CDI.
“We have the best companies in the world that manufacture commodities. These companies are trading at low multiples, because part of the market believes that the rise in prices is transitory”, says Cerize. “In my view, however, even if the rise in non-manufactured products does not continue, these Brazilian companies are cheap”.
For the manager, Brazil is well positioned in case the crisis really gets off the ground. In bad times of the economy, the priority purchases are, precisely, the basic products. “At big techs they are wonderful, but you will only buy an iPhone if you have money left over after you buy your food”, he defends.
Finally, bonds linked to CDI or IPCA provide the necessary protection for the dynamics between inflation and interest rates, with both currently at high levels.
“If commodities fall in price, exports stay there, inflation falls and interest rates fall. NTN-Bs, in this scenario, will appreciate a lot. In the event that commodities do not fall in price, exporters should continue to advance or at least pay good dividends,” he explains.
Among those who argue that the theory is too pessimistic, there are those who say that the current price crisis can increase investments around the world, with a “capex boom”, which would increase productivity and reduce inflationary pressure.
The idea behind this thinking is that, with more expensive commodities, the market will automatically increase investments in the sector of exploration of manufactured products and prices, with that, will tend to fall. Cerize, however, sees that the prospect of recession on the horizon is not encouraging for increased contributions.
“There is currently a ceiling for global GDP and any time you try to break that, there are obstacles in production and logistics capacities”, he says. “If everything goes wrong, we will spend a period in this dynamic, until inflation erodes part of the debts and the other part is restructured through defaults”, he concludes.
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