EWZS - VanEck Vectors Brazil Small-Cap ETF: Ideal Conditions

Summary

• EMs could look to make up for a lost decade, and Brazil has the right profile to flourish.
• Political risks and fiscal profligacy are risks to be monitored.
• Valuations are cheap, and small-caps look well positioned relative to the broad Brazilian universe.

Brazil is the country of the future. - Charles de Gaulle

If you happen to be a subscriber of The Lead-Lag Report, you’d be well aware of my macro piece last week, where I wrote about the investment case for emerging markets after a lost decade of underperforming US large-caps. QE and a zero-interest policy spectrum proved to be inimical for EM outperformance; going forward, EMs won’t have to deal with those hurdles for the foreseeable future.

It isn’t just the abatement of Q3, you also have a massive valuation differential and a burgeoning commodity cycle that supports the investment case. As an aside, if you’re curious about finding interesting opportunities in the commodity space, you may consider listening to a recent Lead-Lag Live episode with Andrew Hoese who highlighted various opportunities worth pursuing.

Speaking of commodities and cheap valuations, one EM which reflects those themes rather well is Brazil. One way to play Brazil is to pursue the little-known VanEck Vectors Brazil ETF ( BRF ), which is a little more high-beta than the more popular iShares MSCI Brazil Small-cap ETF ( EWZS ); Utilities are the top sector for the latter, while industrials make up for the top sector for the former. If you've been keeping track of developments on the timeline of The Lead-Lag Report, you'd note that I've been talking up the supportive conditions for risk-on plays with even Lumber joining the party of late.

In a Twitter Spaces chat with a Brazilian-based equity strategist, we examined why the region has attracted a lot of foreign funds flows in the recent past. Fernando Ferreira believes that Brazilian equities may have received close to $20bn in Jan alone.

Some of the additional interest could be explained by the fact that an important cog of the BRIC universe- Russia has become uninvestable. At the same time, there still appears to be a massive trust deficit surrounding Chinese policies and disclosures. Recently India too has been hit by the Adani Group corporate governance issue which has dampened sentiment towards that cohort. That may well be an idiosyncratic issue, but yet still, let’s not forget that India remains one of the most expensive EMs around; just for some context, the flagship iShares MSCI India ETF trades at a hefty forward P/E of 19x . Conversely, BRF trades at only 7.3x P/E.

In fact Brazilian equities were at similar valuations a year ago, and the re-rating hasn't taken place because the EPS too has been buoyed by ample commodity-related earnings. The ambiguities surrounding tight Brazilian elections last year too were another reason why we didn't see the re-rating come through.

Speaking of elections, the winner, a left-leaning candidate- Luiz Inácio Lula da Silva, will look to embolden the economy by pushing through some populist measures and fulfilling some of his election promises. Reports suggest that he is looking to bring through a $32bn plan which would encompass social spending and investment initiatives.

A likely higher fiscal deficit could be a shame, given that the country has worked so hard to bring the gross debt to GDP down to levels of 73.5% , the lowest it’s been in over 5 years! One also wonders if the new fiscal plan would restimulate inflation levels which appear to be fading. Data from IMF show that Brazil's alacrity in raising rates quite early in the cycle has been instrumental in driving down both headline inflation and core inflation.

Even though the central bank in Brazil appears to be done with tightening for now, it's worth noting that both real rates and nominal rates are one of the most attractive around. Given this status quo, if investors were looking to short the Brazilian Real, they would think twice. Besides, as things stand, investors don't seem overly concerned with the fiscal management of things, as the spread of Brazil's hard currency debt over US treasuries continues to trend lower.

Longer-term, BRF’s industrial heavy portfolio could also benefit from Chinese support for developing Brazil as a manufacturing hub, as opposed to India.

Conclusion

Finally, also consider that technically Brazilian small-caps offer tremendous value within the broad Brazilian universe. A ratio that captures small-cap strength as a function of total Brazilian stocks looks like it may have formed a triple bottom around the 0.45 levels, a region it had visited in 2009 and 2016 before we saw a bounce.

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