Mitigating Risk in This High Valuation Environment w/ Tavi Costa

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1:34Welcome back to another edition of Three Ideas. With me today is Tavi Costa, Portfolio Manager at Crestcat Capital. Hi, Tavi. It's great to see you. Hi, Maggie. Looking forward to this. Thanks for inviting me. So before we jump into your three ideas, just give us a sense of how you're thinking about the global macro landscape right now. What are you expecting in terms of global growth and inflation, and how is that informing your view? Yeah, I expect this interview to be more about medium, long-term views. And I think this is important because I spend most of my time looking to identify some of the macro, biggest macro trends we're going to see in the following five to 10 years.

2:15And I think these three macro ideas will kind of be important ones as we move forward. It's been of my view that we had financial assets being extremely expensive relative to tangible assets. We've been through a time in history that this other periods that we've had such an undervalued market for commodities relative to overall equities and bonds and fixed income in general, those tend to be times when you do want to be allocating your time and capital towards this natural resources industries. And so to me, this is an important way of trying to capitalize on what I think it's going to be a true generational wealth period for a lot of investors.

3:04I think Brazil is going to be an important one, as we're going to discuss. Other commodities will play a role into this as well. And as far as markets go, talking about especially the S &P 500 and other parts of the economy, it's just very difficult to be structurally bullish in the economy today, given especially what we've seen in the credit markets, treasury curve being as inverted as it is. Despite the fact that 10-year yields and long-term yields have been rising, they're not helping the fact of a yield curve inversion problem. This is classic of a stagflationary environment. This did not happen in the 08 times or even in a tech busted period when we've had yield curve inversions surging during those times.

3:53And so this is very similar to the 70s and the 80s, when we saw virtually all yields rising, despite the fact that short-term ones were rising faster than long-term ones, causing the yield curve inversion problem. And that is, again, brings back to the attention of owning tangible assets in this period. So we're seeing market correlations change. And I think there's at the very early stages of some big macro trends to be unleashed. And, you know, let's talk about those as well. Yeah. So that's very interesting. I heard you say stagflation because one of the things that everyone is sort of needs to get right here is your outlook for both the global economy, but also inflation.

4:35So on the inflation part, it sounds like you expect inflation. do you think it's just going to be a little sticky around these levels or do you see high inflation? How do you see that playing out? I think it's going to be sticky. I don't think it's, you know, we've been in this deceleration process. It's undeniable in inflation rates recently. And it's been, you know, the response of a lot of things. One is just the fact that we had very high rates of inflation in the past. So the base effects are playing a role into decelerating the pace of consumer prices. But there's other things in consideration, especially underlying issues that cause inflation to stay higher.

5:18It's something to do with necessarily AI. I think that will play a role as well as a deflationary more aspect or disinflationary aspect in the economy. But we really have four pillars of inflation that will continue to be, you know, I think, at full cylinders, forcing consumer prices to be higher, not lower over time. So despite the fact that inflation has accelerated, it's still higher than historical standards, especially in the last one to two decades period. And so, you know, think about this. I mean, oil is down 45 percent and inflation still is at the handles that we are seeing today. I mean, this is, you know, clearly a sticky environment.

5:57So wages and salaries growth is still happening across especially the lower income folks. We're still seeing a chronic underinvestments in natural resources that hasn't changed yet. So that's not going to reflect higher supply of those resources because we just haven't seen any spending yet. Number three, we're seeing reckless amount of fiscal spending in the government. I mean, you know, deficits are back to about 8 % of GDP and we haven't even seen a recession yet. And number four is the deglobilization trends, which I think it's clear for a lot of people that things are changing. And you're seeing G7 economies having to revitalize their manufacturing plants.

6:38That's creating a construction boom. Now, you think about all this. I mean, it's hard to believe that it's going to cost you less to build a bridge 10 years from now. It's going to cost you a lot more, in my opinion, from a labor and material perspective. perspective. So now I think that this is going to push the commodity markets. It's going to push a lot of different things and some market correlations will be changed. The 60-40 portfolios will be challenged. We're going to see different defensive assets play a role, which we'll talk about here as well. Gold may play an important critical role into those portfolios in the future.

7:16And so I'm really excited about this five to 10 years horizon because I think there's going to be a lot of ways to capitalize on this. Fantastic. Okay. So let's jump in and look at your trades. And so we'll go through each, but it sounds like across the board in terms of time horizon, they're all five to 10 years. Is that what you're looking at? Yeah. I mean, I think you can shorten that to three to five years, you know, and this just to make it easier. Cause I think people are probably going to be like a decade. I'm not going to be waiting for this and that's fine. I think three to five years is going to be a good portfolio to have.

7:53Yeah. Okay, good. So if it's across the board, then we won't repeat that question. But your first trade is going long Brazil as a sector. And so we're going to put up, we're going to look at that through a Brazil, a very broad Brazil ETF, just so we can sort of have a price to talk about it with. There are lots of other options, and we can kind of go into that. But why do you like Brazil right now? Well, first, I think it's been, you know, the sentiment, politically speaking, has been very negative regarding Brazilian assets. That's number one. The South American economy has been in a bearish environment since we've had the commodities not really performing very well since 2011.

8:36Now, you looked at the Brazilian equity market for the last, since the global financial crisis, it has drastically underperformed U.S. equity markets. It's clearly linked to the commodity space, to the natural resource space. If you think about Brazil itself, it's exposed to any commodity you can think of, agricultural commodities, from minings and metal, energy, and so forth. So it's certainly one of the most commodity-led economies you can find today. And so I look at the political environment with Lula, leadership, and so forth, which I think it's justifiable to have concerns about that. But we've had that in the past.

9:16In the early 2000s, Lula also came in as a president. And despite that, we still saw an 18-fold appreciation in the IboVispa index during that time, which is amazing. Just an incredible performance, completely outperforming developed economies at the time. And I think the last two years have been sort of a reflection of a beginning of that. I mean, we've had Brazilian equity markets and assets really outperforming, not only the U.S., especially last year when we had a decline in equity markets, but even this year when we've had this euphoria on AI and so forth, Brazil still is outperforming U.S.

9:58equities. And so it's really interesting that there is that environment. Now think about what the Fed has done. You know, if you were if you're a macro investor and you're just thinking about, you know, look, the Fed is likely to be raising rates, you know, up from zero to 5 % or so, you know, we're going to be doing QT. what do you think the Brazilian real would be doing? What do you think the Brazilian equities would be doing? It would be demolished. And we didn't see that. I love that. I love some of those situations where you have an asset that were supposed to be underperforming other things.

10:37And in fact, has done the exact opposite of that. It's been outperforming everything. And so I think if you look at commodity producers There's a correlation between that and equity markets in Brazil. They're very, very highly correlated. And so I think that if this is the beginning of a bull market in commodities, which will last a long period of time, I believe that institutional investors will at some point start spreading their wings into other parts of alternatives of the commodity space that are likely to perform well under that environment. And if that's the case, the commodity space is very thin and small.

11:19And so it won't take long until most of those institutions begin to really deploy capital in a place like Brazil, especially at the valuations that they are historically so cheap. You can look at the banks. The banks are insanely cheap. And on the price-to-book levels, every time we've had such depressed valuations was the beginning, or very beginning, of a secular market for Brazil or a large appreciation in price of those assets, either from the impeachment of Dilma in 2015-2016 environment or the early 2000s or the global financial crisis. and this is where we are today. It's sort of a classic time where I think it's a pivotal moment for folks to be invested.

12:06And one more point, just to finalize, you think about 60-40 portfolios, if you're going to carry 60 of that equity portion of your portfolio, no, I think a much, much rather own Brazil in that portion. So to me, that's where this is going to come from. Yes, it can get caught up on a recession and other things. However, I do think it's going to outperform U.S. equities over time. And looking at the differential evaluations in equity markets in the U.S. versus Brazil, it's really astonishing. So I'm happy to take that view for the next three to five years. Yeah, you made a couple of really interesting points.

12:48So we have, as I mentioned, we can broadly look at a Brazil ETF. iShares, MSCI ETF. That's one way to express this. And it is up 24 % year to date. So some people obviously agree with you and have been looking at that. The NASDAQ's up 40%. So if you're looking at it just from that point of view, it's not outperforming everything. But clearly, everything else has been losing out to people being so concentrated in the NASDAQ. So we do see it moving higher. You made two points I want to circle back to as we look at this. One of them is, given everything that's gone on and the strains on the system, you did not see the markets buckled, the real.

13:35Because if you look at six months, one month, even through the regional banking shockwaves that went through the US, you have pretty good performance holding up. One month, that broad ETF, 4%, almost 5%. Six months, 18%. Year-to-date, 24%. That paints a different picture than the typical emerging market. U.S. catches a cold or sneezes and emerging markets are on life support. Do you feel like it's different now that they're much more able to weather a sort of global crisis or a recession if it comes our way? Have you ever wanted to trade Bitcoin but haven't dared try? With Plus 500 Futures, you can trade crypto without the hassle of opening a wallet.

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15:12Well, I think so. I don't think a lot of the issues in the Brazilian market is already priced in, in my opinion. I mean, it will get caught up in a global recession. It's not an island. It will certainly get caught up in a severe economic downturn. You were referring to NASDAQ because NASDAQ has a lot of technology exposure. If you look at the S &P and equal weighted index, you can see that IBOVSPA is looking really attractive, especially the equal weighted index in Brazil as well, which I think is even more interesting, or small cap companies in Brazil as well. So there's different ways to be allocating capital there.

15:51I think there's a lot of state-owned companies that you should be not worried about, but knowing that you're investing in companies that have a large exposure to the government, and it's not the most efficient way to run a business in general. So, you know, that is one portion of it that maybe EWZ should be taken into consideration. You know, I think for the sake of this segment, I think it's important. Maybe EWZ, I do believe, will outperform the S &P. But I think there is a lot of opportunity for stock picking in Brazil. You know, Brazil is a place where I think because of the higher interest rates, when you look at the investors that are part of the market, it's a, it's very much a value investing community.

16:38Everyone is, it's very different in the U S where folks are much more focused on growth and technology and other things. And that is, you know, just the reflection of having higher costs of capital for a real long time. And so now to me, this is not a problem. This just means There's a lot of equity markets will reflect some of those opportunities on the value side in a big way. And at some point, that's going to have to have a shift in the U.S. as well in terms of how we approach equity markets. I do believe this is part of a trend towards value investing coming back and profitability and so forth.

17:19As we see, interest rates continue to stay higher globally. So, you know, if you look at profitability, I mean, Brazilian companies are one of the most profitable businesses in the world today. The banks have always been very profitable, but especially now relative to their prices, it's getting sort of absurd how cheap they are. Some of them trading at low single digits PE ratios in an environment that you may see, you know, oil. But let's just look at oil itself because oil has a very strong link to that economy. It's hard to believe that Brazil won't perform well if oil prices perform well. And oil already had a 45 % decline in prices recently.

18:02And Brazilian equities held up, you know, held up very, very well. Agricultural commodities have done terribly in the last, what, eight months or so. And despite that, Brazilian equities have held up very well. And so I think this is a signal that there are capital inflows coming into that place. And as a Brazilian, I am certainly seeing that shift firsthand. And I think this is just the beginning. It's not the end. And a lot of people are going to ignore that just because of the political leadership again. And I think that's just hiding a much bigger investment idea that is likely to play out in the next three to five years.

18:44I should point out, although you are Brazilian, I think in a show we did together before, you mentioned that you're not always bullish on Brazil, right? There is a long period where this would not have been one of your trade ideas. Well, I was not bullish even on commodities. I turned a lot more bullish in commodities after I'm very proud of saying that I was probably the first person to start doing charts on CapEx of natural resources. And that really caught my attention at the time. I was starting to aggregate all the industries and looking at overall CapEx for the space relative to technology and other industries, although they're not capital intensive businesses, you can still see the flows of capital towards one side of the one sector or two relative to basic necessities of the world.

19:34Now, I didn't predict COVID. I had no idea a lot of those things were going to happen at all. But usually in macro, you see some very large historical dislocations, and you just don't know what the trigger really is. And then eventually, something triggers a very large bull market, which is usually happens at a time when that asset is extremely unloved. You know, gold is a great example. In the 90s, for instance, back in late 90s, when the tech bust was starting to occur, gold was down 40 % in the last 20 years. Who in the right minds wanted to invest in gold? Can you imagine if we had Twitter at that time, I think people would have been, you know, completely dismissing that as an opportunity, saying this is not going to be an opportunity to be invested in the metal and so forth.

20:24And that was the very bottom of the market where gold entered a gold cycle or a cycle, which only happened in the 70s and early 2000s. All right, Tavi, you're jumping ahead. You're jumping ahead on your trades. But I see what you mean about the dislocation and it being time for Brazil right now with what sounds like a really tandem story of commodities and also what's happening domestically in Brazil. I liked your comment about it being a way to play commodities, a different way to play the commodity investment theme because there's just not enough maybe liquidity in all those markets. So we know your time horizon.

21:05What would make you change your mind on this? What would upend this and get you out of this trade? Well, my point about that was that if you see CapEx for most of those industries to surge and you start seeing major discoveries happen and you start seeing the supply picture change completely, because the demand side, it will shift over time. It's more cyclical, much more elastic. The supply is a lot more inelastic. So if we do see some sort of technology that changes that picture in the supply side drastically over the medium term, no, I think that would be an important shift. You know, I don't think that's going to happen.

21:51Personally, don't think that that would be the case. Some huge shift in productivity caused by a large increase of supply of those commodities could be the case. Maybe a trend towards a globalized environment again. You know, that could happen. That's not my view. I don't think that those trends, just like the labor changes, where we're seeing the pressure of people asking for higher wages and salaries, those are usually very long-term trends. They tend to really develop themselves over time, and they become secular moves. And the same happens with globalization. And so we've had a long period of a globalized environment where folks were able to take advantage of low wages and salaries from other countries like China.

22:37And I think that companies are now going above and beyond to shift away from that dependency on China and rebuild their own manufacturing onshore. And if that's the case, you know, that's going to create a large increase of construction spending and other things. And one last thing would be the debt problem. I mean, if the debt problem is likely to get better from here, in terms of especially the U.S. deficit issue and the alarming pace we're going in terms of compounding the debt issue, you know, then that's that probably is not going to be good for commodities. And that means we're more like in the world that we've had over the last 20 years when with a low interest rate environment, high growth companies making incredible profits and being able to focus on growth solely.

23:27And I'm not sure that's going to be the case here. So I'm just going to spend a little bit extra time on this one because not everyone has Brazil and we get a lot of questions about whether they should have more international exposure, emerging market exposure. So we put a broad ETF up. But would you, depending on, this is, as always, not specific investment advice for people. We just want to caveat that. Only the individuals can know their risk appetite. But for somebody who is interested in going a little further down in this, would you also recommend or do you think it's a good idea for them to investigate more sector-specific or is there currency issues they have to think about?

24:08The reason people go into the broad ETFs is because they're, in addition to being pretty liquid, also they don't have to worry about some of that. But is it worth thinking about being more specific in Brazil? I think there's a lot of ways to capitalize in Brazil. I prefer not necessarily owning EWZ, although we own a small position even in our strategies. But I do think that EWZ is, there are better ways to play that in terms of looking for, you know, doing stock picking in general. The banks look extremely attractive. I don't think the banks are going away anytime soon. It seems like, you know, you think about some parts of the market have been kind of priced out, like, you know, coal businesses and other things globally have done because of the shift towards electrification and so forth have caused those businesses valuations to be extremely low, meaning that they are likely to go out of business in the next decade or so.

25:03That's kind of how the banks in Brazil are being priced today. And I don't think that will be the case. Some of those banks have been in business for decades. They are extremely profitable. If you're of the belief that the economy will prosper, especially because of its commodity exposure, no, that's going to be an interesting way to play this. And there are - Can you play them through the ADRs? Are there ADRs in the US that you play them through? Do you have to - Absolutely. I think ADRs are one of the ways to do it. And I would certainly welcome that way because there are some tax issues if you're going to own Brazilian equities in the Brazilian exchange, FYI.

25:41So, you know, you should be aware of that. But, boy, some of those businesses pay massive dividends as well. I'm not talking about the banks right now, but there's some other, even commodity businesses, that even in a market when commodities were not performing very well, were still incredibly profitable. We have to understand these businesses, they operate in an environment for decades with high rates and high costs of capital. They are used to finding a way to be profitable. Otherwise, they're out of business. It's a great point. Yeah. And so, you know, I think there's many, there are many industries one could focus on in terms of that.

26:24I mean, we like a lot of the commodity ones. I think there are steel producers that are really interesting to export to developed economies. I think there are a lot of also other commodity businesses in the energy space. I mean, Petrobras, for instance, is a state-owned company. It's a large weight of the EWZ. But, you know, you don't have to own Petrobras. Petrobras has actually been spinning off a lot of their assets and creating a privatization play of those assets of companies that have been taking up those and acquiring those parts of those projects. to then turn into their own businesses.

27:02And so that is a very interesting way to be exposed to high quality assets. I mean, Petrobras, despite the fact that it's one of the most inefficient companies in the world, unfortunately, it is not only profitable, but has one of the best acreage you can find in the world in terms of oil. And so it's really, really high quality assets. And so if they're gonna be spending off some of those to other companies that can be efficient, I'm all in. I want to understand and I want to see if there's a way to invest in those new projects. So I think there's a lot of opportunities there. In the metals and mining side, I would urge people to also look at things because the trends in terms of being very unexplored, Brazil still, despite the fact that it was explored in the past, but it's still very unexplored compared to other parts of the world, has very similar geological trends than Africa and other places that are very rich mineral areas.