Wednesday, July 27, 2011

Reduction and Closing of Short IBOV (1x) + Short USDBRL (1.4x)

On April 11th I started a short of the Brazilian stock index, the Bovespa and short the USDBRL, volatility-weighted. Spot references at 68164 for the Ibovespa and 1.5833 for the USDBRL.

The sizing was 100% of the NAV in Ibov and 140% of the NAV in USDBRL.

Why these sizes?
The annualized volatility of the Ibovespa has been around 1.2x to 1.5x of the currency pair. At the time I checked and it was around 1.4x.

What are the main drivers of this trade:
- Carry: current carry of around 10-10.40%/year with lower volatility (good carry-sharpe)
- The 2 parts of the trade have a negative correlation (which has been kind-of-breaking of late)
- With the current situation of Brazil I believe in times of mild stress the Ibovespa would take a major beating while the BRL might outperform the USD because it means global issues are at stake and more US-Money printing will emerge.
- Macro outlook on Brazil does not make me happy.

* The current situation in Brazil, at the time (and still present, perhaps worse now) was marked by increasing inflation.
* Both headline and core: it wasn't just commodities, but services, which are sticky in the case of Brazil.
* Recent memory of inflation affecting expectations AND an inflation indexed-economy. In Brazil rent, minimum wage, electricity and other things are indexed to inflation. So current inflation brings in more future inflation + expectations.
* The local Central Bank appears to have a dovish stance. It is adopting macro-prudential measures, trying to curb credit for example, instead of outright rising rates (which are already high).
* I don't believe the populist government of the PT (with Dilma Roussef and Guido Mantega) will be capable of cutting spending or the BNDES subsidized lending program.
* All these macro-prudential measures are making people more wary of what will happen to profitability of banks, a huge part of the Ibovespa Index.
* Brazil has been affected by a HUGE commodity boom, during which is has exported its way to prosperity while not adopting structural reforms. Taxation on corporations is still huge.
* Full employment in Brazil is pushing wage-costs up and businesses will soon feel this. 
* My favorite after inflation and dovish CB: The current and forward P/E for the Index was still printing yields way below the 1y forward CDI (the risk-free rate). With much more uncertainty and risks.

Why would someone buy increasing inflation + a bad start in a new government (I don't like the PT-party, commodity boom surfers) + behind-the-curve Central Bank + peak employment (soon I believe decreasing) + etc, etc?

If you believe the US is okay, why would I buy the Ibovespa at negative premium to risk-free rate when the S&P has an yield (1/ (P/E)) way below its risk-free rate/bond?

If you don't then there's the US money printing machine which I believe will never be ABLE to stop or activity will collapse and the equity markets world-wide would follow anyway and the USDBRL will also go down.

So... We closed 50% of the trade on July 20th and then, today, after Mantega's new measures, I decided to get out completely.

I'm not too sure I made myself clear as it is almost 11pm and I need some rest.
Returns were:
50% +9.01% = 6.18% nominal + 3.03% carry
50% +9.70% = 6.67% nominal + 2.83% carry
Total weighted return = +9.35%

Remaining positions in the portfolio are:
- long Gold / short Silver
- currency basket (long BRL/CLP/CAD/NOK/CHF x short USD/EUR/GBP)
- long USDCNY 3y calls 6.80
- long JPY 3y swaption 4.00%
- long Germany 5y CDS

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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