Letter to investors – 1st quarter 2020

Dear shareholders,

This quarter we saw the biggest reversal of market expectations in history (the biggest drop in the shortest period of time). This movement can be explained by virtue of a sudden change in the base scenario in just a few sessions, leaving an optimism and growth to an environment of complete global paralysis, the result of the social isolation adopted to fight the new Coronavirus. The movement was further exacerbated by strong deleveraging, that is, dismantling of positions.

Although we adopted a defensive posture before the crisis, as we had already been aware of asset inflation, especially in recent months, it was not enough to anticipate the speed and magnitude of the movement. It did not seem credible to us that the social isolations observed in China would be replicated in Western economies and, thus, the abrupt reversal of expectations surprised us, as well as the market in general.

We now have two realities that we need to confront. The first, which is more difficult to measure, especially in a completely atypical period in the world, is what will be the effective impact of the downturn on the economy, and also how will the resumption of activity be (format “U”, “V” or “L”). We know we will be back to normal soon, but we don’t know when or how.

In order to combat the crisis, central banks around the world have resorted to an aggressive stimulus plan, associated with government fiscal packages, which together will inject a volume of resources into markets and economies unprecedented in history. Nevertheless, here in Brazil we must spend a significant amount, more than half of the savings generated with the pension reform (an estimated R$500 billion package), to fight the disease and smooth its economic impact.

So far, we have identified that the measures taken by the economic team and the Congress, despite some misconceptions, are in the direction of limiting spending and stimulus in this year of 2020, maintaining the fiscal commitment in the long term. Here, it is worth emphasizing that we must be careful that the fiscal trajectory does not deviate from the route in the long term and, thus, we are able to maintain a structurally low cost of capital. This will be an important indicator of the markets’ direction. Another aspect worth drawing attention to is the solidity of our banking system.

One of the risks we see right now is an inflationary exit. It seems to us that agents are quite complacent, understanding that the demand shock will be enough to keep inflation low. However, if inflation loses anchorage, it can cause a significant increase in the cost of capital and a relevant loss of asymmetry for the markets.

In addition to the fiscal aspect, it is very important to respect contracts and, thus, we can continue in the post-crisis with legal certainty and the necessary confidence to resume investments, putting the country back on a sustainable path.

Companies listed on the stock exchange, as mentioned in previous letters, have a large advantage over their smaller and less capitalized competitors. In a recovery, albeit late, in general, listed companies are the ones that manage to emerge stronger, more efficient and inserted in a less competitive environment. This group made good use of the formation of variable income savings in recent months and significantly strengthened their balance sheets. After this atypical period of quarantine, we will probably observe some changes in habits, or even accelerate other trends (example: e-commerce), which will contribute to increase the productivity of companies and economies in general.

Our currency was one of the most devalued globally. The dollar, once again, has proven to be the world’s greatest store of value, being the safe haven for liquidity in this adverse period. This rush for the American currency has taken the dollar to one of the highest levels against all currencies in recent years. It is worth mentioning Brazil’s low indebtedness in dollars, compared to our emerging peers.

We have never seen an economy in quarantine, let alone almost all Western economies simultaneously. Therefore, we understand that we are suffering a shock of magnitude yet to be measured, but that it does not structurally change the growth bases for Brazil to develop in the cycle. Even though risks have risen, prices have been impacted more than the associated risks.

The prices of companies traded on the stock exchange returned to the levels of 2015 (Dilma) or even the great global crisis of 2008. We understand that today we still have a healthier balance sheet condition and better long-term growth prospects, making the risk x return ratio attractive to the patient investor.

Looking beyond the pandemic, we continue with an outlook of extremely low interest rates and ample liquidity provided by central banks. Consequently, a scenario where fixed income investment alternatives are unprofitable. If there is an economic recovery ahead, we could see, with high probability, an even higher asset inflation than we have seen in recent months. Ray Dalio, one of the most renowned global managers, described this moment as Cash is Trash, referring to the current context of the lowest profitability in history to retain cash resources.

From the perspective of risks, it is worth noting the option of the American Democratic Party for a “pro-market” candidate, reducing what could be a great volatility, if they opted for Bernie Sanders (although his victory was unlikely). On the other hand, the debate will focus on the stimuli made to sustain the economy, that is, whether the medicine will save or kill the patient.

Despite the difficulty of the moment, we would like to emphasize that the entire world has been concentrating efforts on solutions to the pandemic. As time passes, knowledge about the virus increases and, thus, we evolve in treatments, vaccines and prophylaxis (prevention), shortening the economic shock, which could generate a surplus of resources in the markets. Therefore, we must be careful not to perpetuate the extreme short-term situation we are experiencing, in a context of long-term investment.

The profitability obtained in the past does not represent a guarantee of future results. Investments in funds are not guaranteed by the administrator or by any insurance mechanism, or even by the credit guarantee fund. For more information, visit the website www.moat.com.br

 

Graciously,

Moat Capital

Moat Publications