Proceed With Caution On Brazil ETFs

May 13, 2016

Brazil has decided to impeach its acting president, Dilma Rousseff, and place her under trial for illegally manipulating the country's finances. The much-awaited Senate vote, which took place late Wednesday, could, at least in theory, put investor concerns at ease.

So far this year, Brazilian equities have been strong performers in anticipation of the impeachment proceedings.

Under Rousseff’s leadership, which began in 2011, Brazil sank into a deep recession, facing economic contraction and an ever-growing corruption scandal that seems to reach just about everyone in a position of power.

Brazilian Rebound

By and large, the recent market action has supported views that an ouster of the hugely unpopular and business-unfriendly president would be good news for the country’s economy and market.

Consider the year-to-date performance of some of the largest Brazil equity ETFs year-to-date, including the $3.5 billion iShares MSCI Brazil Capped ETF (EWZ | B-96), up 41% year-to-date; and the $86 million VanEck Vectors Brazil Small-Cap ETF (BRF | D-56), up 31%, as the chart below shows:

Chart courtesy of StockCharts.com

These gains have come after the funds faced steep declines for the better part of two years. EWZ lost more than 50% of its value in 2014 and 2015, while BRF dropped more than 61% in the two-year period.

But the question remains as to whether these gains are the bona-fide beginning of an upward recovery, or whether they could prove nothing more than a false start for a country that still has deep structural problems to face.

It seems that the prevailing sentiment among market participants is cautiously optimistic for Brazil going forward, but there are three key points investors should consider before deciding to jump in ...

1. Political Risk Goes On Unchanged

“When investing in any country, a portion of the risk analysis should involve an assessment of political risk. For investors in Brazil, political risk has been a significant risk factor for some time,” said Michael McClary of ValMark Securities.

In fact, the latest development in Brazil, with the impeachment proceedings beginning in full, doesn’t really change the “high level of political risk we had been allowing for in Brazil,” he added.

“Given the landscape in Brazil, specifically the structural economic issues and close ties to commodity prices, we would be surprised to see a change in leadership that could have as much positive economic impact as Prime Minister Modi had in India,” noted McClary.

“However, since this impeachment threat has been going on for some time, a somewhat positive factor would be the eventual reduction in uncertainty regarding this specific issue,” he said.

2. Poor Fundamentals Still Very Real

The political risk in Brazil has been high for months, if not years, since an investigation into corruption involving state-owned oil giant Petrobras first emerged in early 2014. But Brazil’s problems go beyond political risk.

“I believe that the combination of lower oil prices, declining economic activity—the two could be tied together—and corruption allegations make people believe Rousseff cannot govern,” said Dave Garff of Accuvest.

“We have been out of Brazil for the better part of 2 ½ years, and so have missed this rally,” he noted. “Brazil has, and continues to have, a deteriorating economy, poor momentum and high risk across the board. My belief is that the rally here has a lot more to do with oil prices spiking than anything else.”

“However, if there can be some clarity to the impeachment situation, then I think some of the risks will come out of the market,” added Garff. “For now, we’re sitting this one out.”

3. True Bottom Will Take Time

Brazilian equities have rallied significantly this year, in a resurgence that has many looking for a bottom in Brazil, and in emerging markets in general.

But to Mark Dow, of Dow Global, what’s going on in the region is a slow bottoming process that should comprise several false starts until fundamentals actually begin to change.

The impeachment in Brazil “helps [the bottoming process], but even with better policies, it will take Brazil and emerging markets more time to work out from under the private-sector credit overhang they built for themselves in the boom years,” said Dow.

According to him, a true bottom in emerging markets—Brazil included—requires a clearer view of where U.S. rates are headed; a better sense of the strength of the dollar going forward; and economic growth in emerging economies.

For now, he continues to stand by his view that, while it may be too late to short emerging markets, it’s certainly too early to buy in.

Contact Cinthia Murphy at [email protected].

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