Dear investors,
It is curious how popular the discussion about monetary policy has become in Brazil, a highly technical and complex area even for market professionals. What everyone has already learned is that high interest rates reduce inflation and that the government's fiscal deficit increases inflation. Things get a little more complicated when we hear that, even with inflation under control, the government still needs to be more committed to fiscal responsibility in order to also control expectations of future inflation. Otherwise, interest rates will remain high.
For those who are not experts in macroeconomics and monetary policy, which is certainly our case, there is always the risk of getting lost in jargon and abstractions, making it difficult to judge the coherence of what is being discussed. Complex and abstract arguments are more likely to hide errors. That is why we prefer simple and direct analyses, without embellishments or pomp.
With this preference in mind, let's discuss what is happening with Brazilian monetary policy and how we deal with the situation in our investments, in the simplest way possible.
The SELIC rate and its impact on the real economy
The basic function of a bank is to raise money in the market and lend it out at a higher rate. The difference between the interest paid on raising money and the interest charged on lending money is called the bank spread, which is the main source of operating income for banks.
In this tangle of borrowings and loans, it is common for a bank to end the day with excess or insufficient cash, but banks are not allowed to end the day with a negative balance in their “current account”. To solve this problem, there is the Special Settlement and Custody System (SELIC), which allows banks to lend money to each other for short periods, typically just one day, so that their accounts do not become negative at the closing of the daily cash register. The interest rate charged on these daily loans is the SELIC Rate, called the basic interest rate because it is the return obtained from the lowest-risk credit operation in the country.
In principle, this rate could be freely defined by the supply and demand of capital existing in the market. However, the Central Bank acts in the SELIC by lending (or borrowing) money at the rate determined as the SELIC Target. Since the Central Bank participates in a significant portion of the total volume of these daily credit operations, the rate charged by it is a strong reference for the rate of the entire market. This is how the Central Bank controls the basic interest rate of the national economy.
With the option of lending money to the Central Bank at the basic interest rate, it makes no sense to lend money to any company or person at a lower rate. Since banks still need the bank spread to cover their operating costs and remunerate their invested capital, all loans, with the exception of subsidized ones, are made at interest rates higher than the SELIC rate. In other words, when it rises, borrowing money in Brazil becomes more expensive.
The effect of the increase in interest rates is quite broad. Since most companies have some level of debt, they start spending more on paying interest or paying off these debts, which are now more expensive, and there is less capital left over for investments in growth or innovation. Consumer credit also becomes more expensive, so it becomes more difficult to finance any purchase, including retail purchases in 12 interest-free installments (i.e. cash prices with interest on 12 installments). The natural consequence is that demand in the domestic market decreases and, through the traditional mechanism in which prices are determined by the balance between supply and demand, prices tend to fall. This is how high interest rates help control inflation, with the side effect of hindering economic growth.
Fiscal responsibility, inflation and interest rates
Fiscal responsibility simply means that the government spends less money than it earns. The rule is so universally applicable that it is strange that there should be a long debate about whether the government should or should not follow it. The situation becomes more understandable when we consider the practical perversities of politics.
A government that spends recklessly during its term generates a deficit, but gains popularity by delivering social projects and programs, in the same way that a reckless consumer happily enjoys his purchases until the credit card bill arrives. The detail is that, for the ruler, the “credit card bill” can be postponed until the next term. Whoever inherits the government will have a problem on their hands: either they restrict spending to rebalance public finances, a measure that is always unpopular, or they further aggravate the problem by maintaining the deficit. If the decision to restrict spending comes from an opposition ruler, the person responsible for the debt incurred in the previous term will still make comparisons saying that they delivered much more to the population during their term, without going into the merits of the damage caused to public finances in the process. Political frustrations aside, let's look at what happens when the government increases its spending.
Due to the large size of the State, when it spends more, the total demand of the domestic market for goods and services increases significantly and this generates upward pressure on prices, due to the same mechanism of balance between supply and demand that we have already discussed. In other words, the increase in government spending contributes to the increase in inflation.
A second problem is that fiscal deficits force the government to increase public debt. If this regime is maintained for too long, there comes a point at which the government can no longer afford to pay the interest on the debt or issue additional debt, since there will be no one interested in lending more money to a government that always ends up in the red. In this situation, there would be two options: the government could declare a moratorium, an extreme measure in which payments related to the public debt are suspended, causing enormous damage to the country's reputation; or it could issue more currency through the central bank and use it to pay off the debt. Some people see this second solution as a magic formula for solving the problem. However, since it is not possible to generate economic value out of thin air, simply printing more currency only causes the same amount of goods that a country has to be represented by a larger volume of money and, thus, the value of the monetary unit decreases, causing nominal prices to increase. This is a second way of generating inflation.
There is another negative effect. Recurrent deficits cause investors to lose confidence in the sustainability of public finances. This lack of confidence reduces the inflow of foreign capital and, therefore, also reduces the volume of purchases of local currency. In addition to the obvious problem of receiving less investment, the lower demand for the purchase of reais causes our currency to depreciate and exchange rates to become less favorable for imports. In other words, the dollar rises and the price of everything imported increases. Since a significant portion of Brazilian consumption comes from imported products (around 20%), the rise in the dollar also increases inflation.
Meanwhile, the role of the Central Bank continues to be to control inflation through the only tool at its command: monetary policy. Thus, the larger the fiscal deficit, the greater the inflationary effect and the more the central bank will tend to increase (or keep high) the basic interest rate.
Where complexity arises
If these mechanisms could be analyzed in isolation, it would not be such a difficult task to understand the situation and project the likely developments. However, they all act simultaneously on the economy and have effects beyond those predicted by the simplified mechanics we have described. For example, raising interest rates reduces inflation at first, but makes it difficult to balance public finances, as it increases the interest paid by the government and reduces economic growth, thus reducing taxes collected. Since a fiscal deficit increases inflation, the side effect of raising interest rates can worsen the inflation problem in the medium term, in the same way that an overdose of medicine does more harm than good to the patient. Calibrating what the ideal interest rate is is not an exact science. The Central Bank uses mathematical models to calculate what the neutral interest rate would be, the one that would neither accelerate nor decelerate the economy, and adjusts its monetary policy accordingly. However, the model is theoretical and the real effect can only be known through good old trial and error. That is why the Central Bank changes the interest rate gradually. Go up 0.25% and wait to see what happens. Go down 0.25% and wait to see what happens.
There is also the issue of expectations. Although it is a subjective element, its impact on the economy is real. When businesspeople and investors believe that future inflation will be high, they incorporate this assumption into their calculations and make business decisions accordingly. They increase the selling prices of their products, anticipating increases in their production costs, and demand higher rates of return on their investments to compensate for the risk associated with inflation (e.g.: costs rising more than they can pass on in prices). Thus, actual inflation tends to converge towards expected inflation, in a form of self-fulfilling prophecy.
In turn, inflation expectations are guided by what the market expects the Central Bank and the government to do over time, since they are the agents with real power to significantly influence the economy. When both act in a consistent and coordinated manner, the scenario is more stable. When they act erratically and there is friction between the government and the central bank, what we are experiencing in Brazil happens. No one knows for sure what the future will hold, and expectations also fluctuate erratically.
What to do in investments
In complex and unstable scenarios, we prefer to accept uncertainty in all its breadth rather than overestimate our ability to predict the future. All this discussion around fiscal responsibility, monetary policy, inflation and interest rates makes up a complex and unstable scenario. So, instead of trying to project (or guess) what COPOM's next decision will be on the SELIC rate and its impacts on inflation, we seek to position ourselves in investments that tend to generate a good rate of return regardless of the exact path that interest rates and inflation follow over the years.
We often repeat in our letters what these investments are: shares in good companies, with sustainable competitive advantages, a history of high profitability and a resilient business model. Companies like these tend to be able to survive and prosper because they generate real economic value. They will advance faster when the macroeconomic scenario is favorable and will resist as best they can when it is unfavorable. Over long periods, they tend to generate good average returns on the capital invested in the operation.
We accept the uncertainties of macroeconomic variables and avoid investing time trying to project what cannot be predicted with sufficient assertiveness to support an investment thesis with good potential for return and controlled risk. We prefer to spend our days monitoring the companies in our portfolio, evaluating other listed companies and studying microeconomic cycles in sectors that attract our attention.
Our strategy is simple in essence. We seek to identify listed companies that have the characteristics mentioned, calculate a fair value for their shares assuming a very conservative scenario in the points that we cannot accurately predict, and wait until there is an opportunity to buy them at a price low enough that the investment is reasonably profitable even in this pessimistic scenario. Anything above that is profit. Literally.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
