Brazil ETF: Prime Opportunity Or Trap?

Brazilian equity ETFs are suddenly hot.

The biggest fund in this segment, the iShares MSCI Brazil Capped (EWZ | B-96), is up nearly 30% year-to-date, making it one of the best-performing emerging market ETFs this year.

And in the past month alone, investors have poured more than $350 million of fresh net assets into the fund, according to FactSet data, pushing it to become a $2.7 billion ETF.

That’s a significant tide change for Brazil and EWZ, if you consider that, coming into 2016, Brazil had been the worst-performing BRIC market for at least two years. EWZ, in fact, had dropped more than 50% since the beginning of 2014, as the economy there stalled under an anti-business populist government that’s been embroiled in corruption scandals.

But the question that really matters is, should you jump in? There are a few factors you should consider first.

From Impeachment To Oil To Dollar

The Brazilian government, led by President Dilma Rousseff, remains in power, but protests and calls for impeachment are escalating. Just this week, Brazil’s largest party, the Brazilian Democratic Movement Party known as the PMDB, said it was exiting Rousseff’s governing coalition, leaving her even more exposed to the possibility of impeachment. Many locals say she can’t withstand the pressure much longer.

That prospect has done wonders for investor sentiment.

What has also helped in recent months is the stabilization of oil prices. As Accuvest’s Dave Garff points out, “Like it or not, as a commodity exporter, Brazil’s fate is somewhat tied to the price of oil.”

The weakening of the U.S. dollar—the dollar index is down 4.1% year-to-date—is another factor helping not just Brazil, but emerging markets in general, which have been outperforming U.S. stocks so far this year, and attracting renewed investor interest.

Value Opportunity

There’s no question that Brazilian stocks are cheap. Share prices of EWZ recently slid to levels not seen in at least a decade, dropping even below the credit-crisis lows seen in early 2009, as the chart below shows:

Charts courtesy of StockCharts.com

“If you're a value investor, you’re definitely looking hard at Brazil,” Garff said.

The Optimistic View

To asset managers such as Jamie Anderson, managing partner at Tierra Funds, there’s plenty of opportunity in Brazil, particularly in certain segments.

“The big picture is there's a clear shift in assets going into emerging markets now,” he recently told ETF.com. “We hit a bottom in the broad EM space back in September/October 2015. Since that period, emerging market currencies have either been range-bound or have been actually appreciating.”

“And that's on the back of a 2 ½-year period where the trade-weighted U.S. dollar appreciated almost 35%,” he added. “The weak-EM/strong-U.S.-dollar/preference-for-development market theme is not new. We're really into our third year here. But investors are sniffing out a bottoming process, and they’re allocating capital.”

The ETF he manages, the Tierra XP Latin America Real Estate ETF (LARE) is about 50% allocated to Brazilian companies that generate the majority of their revenues from real-estate-related ventures. At the end of the day, for him, “one of the keys to surviving in the EM space is really to buy assets when they're cheap.” Brazil fits that bill right now.

The Not-So-Fast View

To Garff, whose firm focuses on single-country investing based on a multilayered model, it’s still too early to jump onto the Brazil bandwagon even if things are beginning to look better.

“When you get a huge snapback like the one we’ve seen recently, there’s a tendency to try to override your process,” Garff said. “In our case, this momentum has to persist for a little while longer. The fundamentals have yet to turn positive, and the risks are still high. So, Brazil is not headed in our portfolios yet.”

Part of the problem is that Brazil is showing no signs of economic growth, and without growth, there’s only so much that assets can rise, Tyler Mordy of Forstrong notes.

Instead, he says, the Brazilian economy is stuck in a “vicious stagflationary environment" marked by a weakening currency that’s pushing inflation higher, and monetary tightening is “crushing” domestic demand. And that’s to say nothing of suppressed tax revenues, and the high cost of servicing government debt, currently estimated at 7.9% of GDP, he adds.

“The country is facing its worst slump ever—worse than the Great Depression or the late 1980s’ hyperinflation years,” Mordy said. “Looking ahead, no obvious catalyst to force a new course has surfaced.”

“There’s no evidence that currency weakness has had a broad positive impact on the manufacturing sector or exports,” Mordy added. “Brazil’s political system remains highly dysfunctional. And, importantly, the commodity supercycle—which drove massive flows into the country during the boom years—is over. Until these conditions change, a sustained improvement in economic vitality looks highly unlikely.”

His take on whether buying into Brazil right now is a good idea? “The enthusiasm for Brazil is premature,” he said. “Despite the 50% depreciation of the real in the last 18 months and low price earnings ratios, the stock market is almost certainly a value trap.”

Contact Cinthia Murphy at [email protected].