BRF - BRF: Bullish On Brazil As Monetary Easing Begins

2023-08-12 09:26:03 ET

Summary

• After months of decelerating inflation, Brazil finally pivots toward monetary easing.
• Given the excessively high real rates and with a BCB reshuffle catalyst on the horizon, the pace of easing could still surprise from here.
• The VanEck Brazil Small-Cap ETF offers investors a higher beta option to ride the domestic economic recovery.

The Brazilian central bank (i.e., Banco Central do Brasil or the 'BCB') kicked off its easing cycle with a big 50bps rate cut this month. Despite the rapidly easing inflation pressures, the decision was hardly unanimous - the monetary policy committee meeting was split 5-4 in favor of a 50bps cut (the remaining members opted for 25bps). While the contention has kept market expectations relatively cautious on the pace of monetary easing through H2 2023/2024, the pace of inflation declines and the upcoming BCB reshuffle (involving two hawkish BCB directors) could mean a more dovish tilt going forward.

In turn, an accelerated monetary easing cycle should benefit the valuations of domestic-oriented, consumer-heavy portfolios like the VanEck Brazil Small-Cap ETF (BRF). Also on the cards is an earnings boost from lower rates spilling through to overall economic activity and spending. While some of the positives are likely priced in here, the current ~9x P/E valuation is well below historical levels and likely underestimates the underlying Brazilian small/mid-cap earnings growth potential. The caveat is the fiscal risks associated with the Lula administration (e.g., higher corporate tax burdens to fund spending); investors willing to underwrite a higher earnings growth outlook, however, should still find enough safety margin here.

Fund Overview - Competitively Priced Play on the Brazilian Small-Cap Universe

The VanEck Brazil Small-Cap ETF, which tracks Brazilian mid and small-cap equities via the market cap-weighted MVIS Brazil Small-Cap Index (subject to size and liquidity constraints), held $35m of net assets at the time of writing. The fund's gross expense ratio is at 0.9%, though net of fee waivers (valid through May next year), the net expense ratio stands at a competitive 0.7%, only slightly above its key large-cap comparable, the iShares MSCI Brazil ETF (EWZ), at ~0.6%.

The fund's sector allocation is skewed toward Consumer Discretionary (21.8%), followed by Industrials (17.1%) and Consumer Staples (10.3%). BRF's portfolio composition differs from Brazil's large-cap funds, typically heavy on Financials, Materials, and Energy, with limited consumer allocations. Another key difference is the comparative lack of geographical diversification - BRF's currency exposure is ~80% Brazilian Real, while its country weighting is ~83% domestic.

The single-stock breakdown shows the 101-stock BRF portfolio is well spread out, with no single name contributing more than 5% of the portfolio. Aliansce Sonae Shopping Centers is the largest allocation at 4.8%, followed by 3R Petroleum (3.6%) and utilities investment company Alupar Investimento (3.0%). The comparative lack of state-owned entities is also notable relative to large-cap Brazil funds, insulating investors (to a greater extent) from fiscal and political risks.

Fund Performance - COVID Further Weighs on the Disappointing Track Record

BRF has enjoyed a bumper 2023, rising +40.2% YTD in NAV terms (+41.1% in market price terms), far outpacing its large-cap ETF counterparts. Zooming out, however, the fund's long-term track record hasn't been stellar at an annualized +2.0% increase since its inception in 2009. Over a five-year timeline, the total +2.6% annualized return has been similarly underwhelming (albeit ahead of EWZ) given the high risks involved with investing in Brazil's small to mid-cap market. The key near-term drag has been COVID, which, as the lagging three-year return indicates (+4.0% vs. +13% for EWZ), small to mid-caps have yet to recover from fully.

Besides the narrow tracking error (post-expenses), the fund stands out for its solid distribution, returning $0.56/share in 2022 (well above the pandemic low of $0.35/share). Assuming the recent earnings growth improvement flows through to distributions again this year, expect further upside to the current 2.6% trailing yield. Another key positive is BRF's heavier consumer exposure, implying far less cyclicality here than in the Brazil large-cap ETFs, where yields are typically tied to commodity/energy price swings. That said, this is still a small to mid-cap fund, and investors will need to tolerate additional volatility (~1.0 beta to the S&P 500 ( SPY ) and ~35% standard deviation of returns).

50bps Rate Cut Kicks off a More Dovish Monetary Policy Path

The BCB began its rate-cut cycle with a clear statement of intent. Alongside the 50bps cut, however, the post-meeting statement caveated that the central bank remains focused on "keeping a contractionary monetary policy to re-anchor expectations and bring inflation to the target in the relevant horizon." This might seem rather hawkish in contrast to the dovish rate cut, but the BCB does have a track record of aggressive rate moves under current president Campos Neto - for instance, the rapid rate cuts through the pandemic and the similarly aggressive hikes over the last year. Hence, a faster pace of cuts fits with the BCB's prior reaction function, particularly when you also consider the disinflationary context.

Looking ahead, there's a good chance the BCB will cut ahead of forecasts as well. Thus far, forward guidance has been rather conservative, and so have market expectations on the pace of easing in the coming policy meetings (the consensus Selic rate expectation is ~12% for 2023). Fundamentally, a steeper decline in inflation pressures (already dipping below the 3.25% target in July) would be a key swing factor, along with the pace of GDP growth. Perhaps more important, though, is the upcoming BCB reshuffle - two known hawks, Fernanda Guardado and Maurício Costa de Moura (recall both voted for a 25bps cut vs. the 50bps implemented), are reaching their end of terms by year-end and will be replaced by the Lula administration. Given President Lula's public calls for lower rates in the past, this likely means a more dovish BCB in 2024; in turn, I suspect a faster-than-expected pace of monetary easing is on the cards. Not only will lower rates boost equity valuations, but it also bodes well for overall economic activity, particularly on the consumer side. As BRF is far more levered to the domestic economy than its large-cap counterparts, the fund is well-placed to benefit.

Bullish on Brazil as Monetary Easing Begins

The BCB monetary easing cycle officially kicked off this month with a 50bps rate cut, moving the policy rate to 13.25%. The pivot was perhaps unsurprising, given the pace at which inflation has converged to the 3.25% target. What was surprising, though, was the divided opinions within the committee (5-4 in favor of 50bps), as well as the relatively conservative expectations for interest rates at 12% for 2023 and 9.25% for 2024. This leaves room for valuation upside, in my view, particularly with the BCB set to turn more dovish following the retirement of two hawkish directors this year (replacements to be nominated by the ultra-dovish President Lula). Small to mid-cap funds like the BRF offer a higher beta vehicle to play the lower rate theme, with the ETF set to benefit on the valuation side and via higher earnings as the accelerated easing cycle stimulates economic activity. At the current ~9x P/E, BRF still has room to re-rate higher.

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