EWZ - EWZS: Brazil's Long-Term Interest Rates Sound The Alarm (Rating Downgrade)

2023-09-26 09:35:43 ET

Summary

• Brazilian small-cap stocks are impacted by long-term interest rates, and the expectation of slower rate cuts has tempered optimism in the second half of 2023.
• Rising inflation and fiscal uncertainties have led to a weakening Brazilian real, affecting commodities and agribusiness.
• While lower interest rates in the long term could favor the EWZS, the short-term outlook is cautious, with a shift to a neutral stance due to micro and macroeconomic challenges.

The iShares MSCI Brazil Small-Cap ETF (EWZS) consists of shares from companies with lower capitalization and liquidity listed on the Brazilian Stock Exchange, tracking the MSCI Brazil Small Cap Index. These assets are often undervalued due to a lack of data or because the companies are new to the market.

Over this year, EWZS has delivered strong results, primarily driven by a lower inflationary environment and anticipation of a reduction in Brazil's interest rate, the Selic. The declining 10-year Brazilian government rate has significantly contributed to its excellent performance in the year's first half.

In my most recent article regarding EWZS, I stated that given the ongoing reduction in the basic interest rate and its projected path, maintaining a cautious approach towards the Brazilian small-cap sector presents an excellent opportunity to capitalize on potential positive outcomes.

However, it is crucial to monitor the yield curve's movement closely. Since small caps are particularly sensitive to declining interest rates, this provides an additional reason to have confidence in investing in funds like EWZS.

While I still believe that the trend of lower interest rates over the next few years should be favorable for Brazilian small caps, the second half of 2023 suggests a more restrained sense of optimism due to a potentially more challenging macro and microeconomic environment. This is because the long-term interest rate curve is not declining as significantly as anticipated.

As such, I am changing my previous bullish stance to neutral for Brazilian small-caps in the short term.

Brazil's Long-Term Interest Rates Raise a Warning Sign

Many investors became excessively optimistic about the declining Brazilian interest rate ((Selic)) since the beginning of August, assuming that this change would propel the bull market forward without any hurdles.

However, contrary to consensus expectations, the opposite occurred: amid expectations of the first Selic rate cut and subsequent cuts, the Ibovespa (Brazilian stock market) peaked. The EWZ iShares MSCI Brazil ETF (EWZ) experienced a sharp decline in August before briefly correcting itself in September. The chart below illustrates the onset of the Selic rate cuts.

It turns out that many investors do not realize that long-term interest rates drive the costliness of risk assets, as they profoundly impact a company's valuation when calculating discounted cash flows.

The Brazilian central bank controls the prime rate but cannot directly influence long-term rates. Consequently, long-term rates can fluctuate significantly even if the prime rate remains unchanged. Their sensitivity lies not in response to the current prime rate but rather in the market's expectations regarding how the central bank will shape monetary policy over the long term.

As evident, the Brazilian 10-Year Government Bond Yield rate began its descent in July, anticipating the Selic rate cut and propelling the stock market upward.

However, despite the decline in the Selic rate, market participants have begun to revise their expectations for longer-term interest rates upward. They now factor in the possibility that the Central Bank may not act as swiftly in reducing the Selic rate as initially anticipated. This adjustment is directly reflected in the rising 10-year rates, the same trend that began in July.

Consequently, this shift in expectations has redirected investments away from companies closely tied to the domestic economy over the past two months, particularly impacting mid and small-cap firms. The chart below shows the correlation between the rise and fall of Brazilian 10-year government bonds and EWZS.

Furthermore, even with the Selic rate effectively decreasing, the market has been revising its interest rate expectations upward on a longer-term horizon. They are pricing in the possibility that the Brazilian Central Bank won't be as swift in its Selic rate reduction cycle as previously anticipated. This has directly impacted the 10-year rates, which have remained relatively stable instead of continuing to decline as expected since July.

Hence, it is challenging to imagine that the EWZS will continue its bullish rally, which began in March and April unless long-term interest rates further decline again.

Brazilian Real Depreciation vs. the U.S. Dollar

The EWZS is denominated in U.S. dollars, which means that fluctuations in the exchange rate can impact the performance of this investment. Consequently, when Brazilian small-cap companies, which compose the MSCI Brazil Small Cap Index, experience gains, it doesn't necessarily guarantee a proportionate increase in the EWZS.

This is because the gains may be compromised if the U.S. dollar strengthens. Conversely, if the U.S. dollar weakens, the effect of the surge in Brazilian small caps may be tempered. Therefore, it's possible to deduce that the combination of fluctuations in Brazilian small caps traded locally and the dollar-real exchange rate forms a value closely related to the EWZS index.

In August, Fitc h downgraded th e United States' credit rating from AAA to AA+, citing expected fiscal deterioration over the next three years and rising general government debt. Recent economic activity data displayed a degree of resilience, sparking concerns in the market about the potential for new interest rate hikes by the Federal Reserve (Fed).

The BRL-USD exchange rate, after closing July at R$4.74, climbed to R$4.92 in August. External factors also played a role, including the U.S. debt rating downgrade, uncertainties surrounding the Fed's actions, developments in the Chinese economy, and conditions within the Eurozone.

The increase in the exchange rate was as expected due to the narrowing interest rate differential between Brazil and the United States, although it dipped to $4.89 in September. On the domestic front, political concerns and uncertainties related to tax collection and adherence to fiscal targets contributed to the appreciation of the U.S. dollar.

Brazil's Economic Indicators: Slowdown and Rising Inflation

The most recent economic indicators have pointed to a slowdown in economic activity in Brazil and an increase in inflation. The Brazilian Central Bank's Economic Activity Index (IBC-Br) increased by 0.6% in June compared to the previous month. However, it only grew by 0.4% in the second quarter of 2023, marking a significant deceleration compared to the 2.2% growth observed in the first quarter.

In August, the IPCA-15, a monthly inflation index in Brazil that measures price changes for the first 15 days of the month, showed a 0.28% increase. The inflation rate has risen over the past three months, reaching 4.61%, primarily driven by higher prices. It's important to note that the Brazilian Central Bank has set an inflation target for 2023 at 3.25%, with a tolerance range of 1.75% to 4.75%.

Additionally, fiscal uncertainties and challenges in the macroeconomic landscape have gradually weakened the Brazilian real against the U.S. dollar. These factors have impacted Brazilian commodities, leading to declining soybean and corn prices, which, in turn, affect Brazilian agribusiness.

Addressing Liquidity as a Potential Concern

Investing in small caps can offer substantial potential for high returns, but it also comes with increased risk. Brazilian small caps are better suited for investors with a higher risk tolerance familiar with the Brazilian financial market.

Considering that 21% of EWZS comprises industrial companies, such as the Brazilian aviation giant Embraer (ERJ), accounting for 4% of the fund, and 19% and 12% consist of Brazilian companies in Consumer Discretionary and Consumer Staples, respectively (including major real estate developers like Cyrela (CYRBY) and the food company BRF Brasil Foods (BRF)), the fund faces significantly lower liquidity compared to EWZ. This lower liquidity is exacerbated by its higher exposure to the long-term interest rate curve, which substantially influences its performance due to its association with capital-intensive businesses.

To put this into perspective, the average daily volume ((ADV)) of EWZ can be more than 55 times greater than EWZS considering that EWZ includes Brazilian giants like Petrobras (PBR) and Vale (VALE) as its top holdings.

From a statistical standpoint, when you gather data on the trading volume of shares (which indicates liquidity) and their market value across various companies, there is a tendency for liquidity to increase as market value rises.

Moreover, there is a specific positive cycle associated with small caps. Companies that enhance their performance and overall standing are rewarded, and the market starts to assign them higher value. This increased visibility and size attract more investors.

It's worth noting that investment funds, due to their size, face limitations when investing in smaller companies. For instance, consider a fund with $10 billion in assets. How could it invest in a company worth $100 million? Even if it acquired half of the company, it would only represent 0.5% of its portfolio.

The lack of liquidity could present challenges for the fund, particularly during divestments. Therefore, as a company demonstrates progress in its results, it becomes more highly valued and attracts more investors, ultimately leading to greater liquidity. This is the virtuous cycle.

The Bottom Line

For small-cap stocks to continue their growth in the current Brazilian economic landscape, the next catalyst should be the ongoing reduction in interest rates. Despite signs of increasing inflation that could threaten the target set by the Brazilian Central Bank, they are expected to continue cutting rates. The forecast is for rates to end the year at 11.75%, while they currently stand at 12.75%.

However, even with interest rates effectively declining, the longer-term outlook among market participants has been upward, which is reflected in Brazilian 10-year government bonds. This hasn't resulted in the desired effect of lowering rates compared to the actual rate cuts. I believe this could indicate that the Central Bank of Brazil may not be as aggressive in its interest rate reduction cycle.

Nevertheless, it's crucial to emphasize that the Brazilian stock market is trading at an exceptionally low valuation multiple, approaching levels last witnessed in 2008 during the subprime crisis. The EWZS is trading at a modest P/E ratio of 6.2x, and the EWZ stands at 5.3x.

Since Brazilian small-cap stocks are the most sensitive to interest rate cuts, I view this with skepticism in the short term. I have limited expectations for the rally seen in the first half of this year to be repeated in the second half. Therefore, I am shifting my stance to neutral in the short term. However, I still believe that as the Brazilian economy exhibits more optimistic economic metrics in the long term, further rate cuts could make Brazilian small-caps an attractive long-term investment, particularly given the current historic low valuation.

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