The turn of the tide in the stock market

Dear investors,

Over the past four months, the IBOV index has risen by approximately 20%. This raises the question of whether there are still good investment opportunities on the stock market, or whether the market has already adjusted to something approaching what should be a normal price level.

Before addressing this question, let's revisit the stock market's recent history, from the pandemic to the present day, which forms the necessary backdrop for considering what the future may hold.

The shock of the pandemic

In 2019 and early 2020, interest rates were quite low (4.5% at the end of 2019 and 2.0% at the end of 2020), and finding cheap stocks on the stock exchange was a arduous process of prospecting. When the pandemic began to gain significant proportions in late February 2020, the IBOV index fell approximately 40% in a one-month period, reflecting the fear and uncertainty that gripped global markets in the face of an atypical threat with consequences that were very difficult to quantify.

Surprisingly, after this fall, the stock market rose more than 75% by the end of 2020, surpassing its pre-pandemic peak and continuing to rise until June 2021, when the IBOV reached 130,000 points, almost double compared to the low of 67,000 points reached in March 2020.

This dizzying recovery was, in part, driven by the world's ability to adapt to the health restrictions imposed by the pandemic and maintain a reasonably productive economy. However, two other factors played a significant role in this upward cycle.

The first, and most impactful, were massive government actions to stimulate the economy, both in Brazil and around the world, through subsidies and expansionary monetary policies. This is how the SELIC reached 2%, and this is how the seeds of the inflation problem of the following years were planted.

The second factor was a wave of market enthusiasm for this low-interest-rate scenario and for some sectors that were boosted by the sudden shift in consumption patterns caused by restrictions (e.g., technology and e-commerce). A narrative that from then on there would be a "new normal" in which interest rates would remain low and these businesses would remain thriving. This theory quickly fell apart.

Amidst all the enthusiasm of the time, the facts that no expansionary monetary policy is sustainable for long and that the restrictions imposed during the pandemic could only have had a negative economic impact were ignored. Production shutdowns, changes in production methods, and additional health protection measures had enormous costs, without any positive counterpart. Starting in July 2021, these factors began to weigh heavily, and the stock market's bull run came to a halt.

The hangover and the war

In the second half of 2021, reality set in. Inflation rose, driven by the monetary policy adopted during the pandemic, and to combat it, the Central Bank of Brazil (BACEN) began raising interest rates. In a year and a half (Mar/21 to Aug/22), interest rates rose from 2.0% to 13.75%. At the same time, the "new normal" thesis lost traction, as the world gravitated back to the "old normal" after the lifting of health restrictions.

As if that weren't enough, in February 2022, the war between Russia and Ukraine began, resulting in much of the West becoming politically involved and imposing economic sanctions. The main impact was on commodity markets, where Russia was a key supplier. The sanctions caused a negative supply shock and caused prices to rise rapidly, worsening the global inflation problem.

Brazil did not suffer as much from the war between Russia and Ukraine, being far from the center of the conflict, both geographically and politically, and because it is a commodity-exporting economy, it benefited from the rising price cycle. However, we suffered significantly from the Central Bank's monetary tightening policy employed to combat inflation. High interest rates, maintained for a long period, had a strong contractionary effect on our economy, suppressing consumption and weighing on the balance sheets of several companies that leveraged themselves during the low-interest period.

In addition to this impact on the real economy, high interest rates led to a massive reallocation of capital between asset classes. With the opportunity to invest 13.75% per year "risk-free" and a macroeconomic scenario full of uncertainty, many Brazilian investors withdrew their capital from equity and multimarket funds, transferring it to fixed income. Naturally, this movement severely penalized the prices of listed stocks.

This is a very brief summary of the bearish cycle we experienced between June 2021 and March 2023, a period in which the IBOV fell from 130,000 points to around 100,000 (-23%). Let's now look at the more recent events that caused the stock market to rise from April of this year onward.

Stock market recovery

The interest rate cut itself had been expected for some time, but its exact timing and speed were still uncertain. As the Central Bank of Brazil (BACEN) began signaling that it would begin its rate reduction drive, the market began to react by reallocating capital to the stock market. Greater clarity regarding the Central Bank's intentions triggered the recent stock market rally, but it was undoubtedly helped by the fact that the stock market was very cheap at the time, with valuation multiples close to 2 standard deviations below the mean.

Source: BTG Pactual

Note that, even after the recent surge, valuation multiples remain 1 standard deviation below the mean. Although this is a general metric, it makes it clear that we are far from an overheated market. Two other factors corroborate the view that we are likely witnessing the beginning of a new, longer bullish cycle in the stock market.

The first is that the impact of lower interest rates on the real economy only occurs some time after the rate has already been lowered, as the effectively lower cost of credit is what will revive demand, and only after months of stronger demand will the resulting financial results appear in companies' financial statements. Therefore, today we are still looking at weak financial results, pressured by the effects of contractionary monetary policy. However much the market tries to anticipate improvements based on expectations of lower interest rates, recent history always has a strong anchoring effect on projections. As the economy recovers, several businesses are likely to report better results than those currently assumed.

The second factor is related to the reallocation of capital back to the stock market, which should occur over the next few semesters and reverse the massive movement of redemptions from equity and multimarket funds that we saw in 2022 and the first half of 2023. This movement has not even begun, as the funds still had negative flow in recent months.

Source: BTG Pactual

Certainly, some investors are already anticipating and reallocating capital back to the stock market, but the majority of the market will likely hold onto its fixed-income investments while interest rates remain high, only seeking to reallocate them after the actual decline. In other words, there are still plenty of potential equity buyers to fuel a new upward cycle in prices.

Positive optionalities

In addition to the already predicted drop in interest rates and the positive flow of capital into the stock market that it should generate, there are other, more uncertain elements that could be sources of future positive surprises.

One of them is that market interest rate projections are generally anchored by the interest rate at the time the projection is made, as can be seen in the evolution of projections compiled in the Central Bank of Brazil's Market Expectations System. Below, we present the historical projections for two years in which the SELIC rate was at its extremes: 2020 and 2023.

Historical projections for the SELIC rate in 2020

Historical projections for the SELIC rate in 2023

Source: BACEN – Market Expectations System

Thus, there is a certain chance that the long-term interest rate projected by the market today is overestimated, as it was forecast while the rate was high. If realized interest rates turn out to be lower than projected, there will be a positive impact on stock prices.

We also expect the approval of tax reform, which would significantly simplify the Brazilian tax system, standardize the rates paid by different economic activities, and thus potentially bring productivity gains to the national economy. While it's difficult to quantify the impact of the potential reform, it's very likely to be positive. In May 2023, we wrote about this reform. Although some terms of the proposal have changed since then, the main concepts we explored still remain.

Brazil can still benefit from the trend toward decentralizing production chains, which are currently highly concentrated in Asia—a topic that gained prominence after supply disruptions amid lockdowns and the war between Russia and Ukraine. Brazil can also benefit from global efforts to decarbonize the economy, leveraging our country's clean energy matrix. We discuss these trends in more detail in November 2022 letter.

Outlook for the stock market

Even after the recent rally, which stemmed from a price base resulting from difficult years for the stock market, the stock market still appears cheap to us, with interesting opportunities in well-selected companies. In addition, the less contractionary monetary policy that the Central Bank (BACEN) announced it will adopt from now on will also contribute to the recovery of Brazilian companies and, consequently, the share prices of listed companies. Finally, we currently see more positive factors than major threats to the Brazilian economy and believe we are likely at the beginning of a new upward trend in the stock market. There will certainly be periods of price decline, as is natural in equity markets, but we are optimistic about the long term.

In any case, there's always the task of separating the wheat from the chaff. Not every listed company is cheap, and it's important to maintain the discipline of identifying high-quality businesses and only buying shares at prices that offer a comfortable margin of safety. In the current scenario, we've identified excellent opportunities, and our capital under management is almost entirely invested in companies we believe have excellent prospects for the coming years.