EWZS - EWZS: Mixed Macro Signals Add To Volatility For Brazil Small Caps

2024-01-22 00:31:24 ET

Summary

• The iShares MSCI Brazil Small-Cap ETF offers exposure to a diverse group of Brazilian companies well-positioned for long-term growth.
• Weakness from China as Brazil's major trading partner is hitting sentiment across emerging markets.
• We highlight current trends in the Brazilian economy and expect volatility to continue.

The iShares MSCI Brazil Small-Cap ETF ( EWZS ) tracks a portfolio of 92 Brazilian stocks. The attraction here is the exposure to a diverse group of companies that are well-positioned to capture long-term growth trends from Latin America's largest economy.

What we like about the fund is that compared to the more widely followed large-cap focused iShares MSCI Brazil ETF ( EWZ ), EWZS is less concentrated among the top holdings with limited exposure to commodity exporters. This is important as companies with core operations in the domestic market often better reflect local economic conditions compared to just international trends.

Despite recurring volatility and Brazil's largely disappointing investors over the past decade, the good news is that EWZS delivered a positive return in the last year. On the other hand, more recent mixed macro data adds a layer of uncertainty for the year ahead. We highlight some of the themes to watch in 2024 for Brazilian small caps.

What is the EWZS ETF?

EWZS through the MSCI Brazil Small Cap Index includes approximately "the bottom 14% of the free float-adjusted market capitalization" of the Brazil equity universe. Essentially, EWZS is covering everything outside the large-cap market leaders like Petrobras ( PBR ), Vale S.A. ( VALE ), and Itau Unibanco Holding S.A. ( ITUB ) that dominate the alternative EWZ fund.

What makes Brazil relatively unique as an emerging market is the size of its well-developed financial system. Simply put, there are many larger countries in terms of GDP that do not offer a universe of over 150 publicly traded stocks.

The idea here is that small-cap companies can generate stronger growth as they consolidate market share across various industries that remain highly fragmented in Brazil.

Going through the current holdings , aircraft manufacturer Embraer S.A. ( ERJ ) is the largest holding of EWZS with a 5% weighting, followed by a pair of real-estate development firms in "Allos S.A." with a 4% weighting and "Multiplan Empreendimentos Imobiliarios S.A." at 3%.

Down the list, we find everything from regulated utilities, healthcare sector players, small banks, and even some technology names with the iShares fund .

Keep in mind that the majority of stocks within EWZS do not have a corresponding U.S. ADR listing. This dynamic is part of the attraction of the fund for diversification purposes with exposure to companies that are not typically held by foreign investors.

In terms of performance, EWZS has returned a tepid 3.5% over the last 5 years, slightly below the 6.5% return from EWZ, but above the 2.6% gain in the iShares MSCI Emerging Markets ETF ( EEM ) as a market segment benchmark.

This timeframe included significant disruptions during the pandemic with the bulk of the weakness based on FX volatility against a strong U.S. Dollar in recent years. The actual index priced in the local currency is near an all-time high.

What stands out is that EWZS managed to outperform EWZ bullish trending timeframes. The understanding here is that small caps can offer the opportunity to generate higher long-term risk-adjusted returns.

Brazil Macro Outlook

The story with Brazil has been one of steady economic growth in recent years going back to the strong post-pandemic recovery. High inflation that reached double digits in 2021 forced the Central Bank to aggressively high rates through 2022, but some of that financial tightening has already been rolled back with a series of rate cuts since the second half of 2023.

The latest inflation figure at an annual rate of 4.5% for December is now technically within the official Central Bank target range between 1.5% and 4.75%.

According to the " Itau Economics Research ", inflation is seen trending lower towards 3.6% by the end of 2024. The group also forecasts further Central Bank interest rate cuts taking the "SELIC" benchmark from a current 11.75% down to 9% as a cycle terminal rate.

While these developments are positive, the expectation is that GDP growth will slow to 1.8% in 2024 from 2.9% in 2023. This balances the boost in a new round of credit demand against a weaker fiscal impulse.

Government spending in the first full year of the Lula administration pushed the primary budget deficit to -2.3% of GDP which is expected to narrow toward -0.8% in 2024, in an attempt to control public debt levels. There is also a sense that a trade surplus moderates amid lower commodity prices.

That insight leads to Itau's forecast that the exchange rate remains nearly flat from current levels balancing the various factors. The takeaway is that the Brazilian economy appears stable but missing stronger momentum and is still exposed to global macro conditions

EWZS 2024 Price Forecast

From the price chart of EWZS, we'll notice that the fund has been trading around a range between ~$15.00 and ~$11.00 going back to mid-2022. The question becomes whether there is enough for the Brazil small-caps to break out higher into a new bull market.

The upside here will likely need economic indicators from Brazil to outperform expectations. We want to see inflation surprisingly lower, opening the door for even further rate cuts by the Central Bank, as well as stronger activity trends in retail sales and industrial production. These factors could support a stronger Brazilian Real translating into an incremental positive return driver for the fund.

The challenge we see is Brazil's connection within emerging markets, eyeing the current weakness in data from China as a major trade partner. Since the start of the year, the theme has been a broad-based selloff in emerging market stocks, led lower by the poor performance of Chinese equities tracked through the iShares MSCI China ETF ( MCHI ).

We sense that the bearish sentiment is spilling over into Brazil adding to the volatility. From a high-level perspective, U.S. Dollar strength and a rebound in global bond yields have added to the environment of risk aversion.

Final Thoughts

EWZS is a high-quality fund that can work for investors in the context of a more diversified portfolio. The fund can complement a broader allocation to emerging markets or work as a standalone alternative to the large-cap EWZ. We rate EWZS as a hold representing a "neutral" view on small-cap Brazil stocks from the current level.

Balancing our favorable long-term expectation of this important market segment, what's missing here is a macro catalyst to break out significantly higher. A move in EWZS above $15.50 would confirm a new wave of positive momentum. Inversely, a break below $13.00 would suggest a more concerning deterioration of the outlook.

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