Summary
- High real yields are positive for Brazilian stocks from a forward-looking perspective as they create potential for valuation expansion and provide support to the currency.
- Brazil's relatively strong fiscal and external fundamentals prevent rising borrowing costs from creating a self-reinforcing debt and currency crisis in which dollar weakness raises external debt in local currency terms.
- The EWZ is highly likely to outperform over the coming years, with 5-year total returns expected to be around 15% annually.
Brazilian real borrowing costs are extremely high, which have some investors concerned about the impact this may have on stocks. However, high real yields are positive for Brazilian stocks from a forward-looking perspective as they create potential for valuation expansion and provide support to the currency. I remain long iShares MSCI Brazil Capped ETF ( EWZ ), which I expect to significantly outperform its peers due it its extremely cheap valuation.
The EWZ ETF
The EWZ tracks the performance of the MSCI Brazil index and charges an expense fee of 0.57%. The ETF holds 50 companies at present and is heavily weighted towards commodities. The Materials sector accounts for 22% of the index, thanks to iron ore giant Vale, which has a 20% share. The Oil & Gas sector accounts for an additional 15% due to oil major Petrobras. The ETF's performance is also driven by the performance of the currency, which is itself in part a function of commodity export prices and real interest rates. High commodity prices have seen earnings surge over recent years, leaving the EWZ trading at extremely undervalued levels, while offering a dividend yield of 12.3%. This is likely to fall slightly over the coming months as the underlying MSCI Brazil yields 9.8%. However, this is still extremely high from a global and historical perspective.
High Real Borrowing Costs Are A Tailwind For The EWZ
Over the past few years investors have become overly concerned with the idea that low real borrowing costs are beneficial for stocks while high real yields are detrimental to stocks. I have shown in a number of articles on the US market that there is no evidence to support this. The reason being that high real yields tend to reflect optimism about the economic outlook, which also supports equity valuations, and so for the most part there is actually an inverse correlation between real borrowing costs and equity valuations.
For emerging markets, the situation is a little more complicated. As shown in the chart below, high real borrowing costs in Brazil, as measured by 10-year inflation-linked bond yields, are highly inversely correlated with equity prices. This reflects the high risk premium that foreign investors apply to both the equity and bond markets during times of heightened uncertainty.
However, from a forward-looking perspective, high real borrowing costs are highly positive for equity returns. Not only do they raise expected returns on equities by depressing valuations, they also provide support to the currency. The high real yields that prevailed during the global financial crisis paved the way for a subsequent recovery in the real . The same is true of the high real yields that we saw in 2016, which gave way to the following recovery. As shown in the chart below, high real borrowing costs are closely correlated with subsequent total returns for the EWZ and currently imply nominal total returns on the EWZ of around 15%.
Bloomberg, Author's calculation
Of course, the price of commodities played a key role in the performance of the EWZ over these periods. However, the ability and willingness of the central bank to hike rates aggressively to keep inflation anchored is a key factor shoring up international support for the currency and revenues and earnings in dollar terms. Brazil's relatively strong fiscal and external fundamentals prevent rising borrowing costs from creating a self-reinforcing debt and currency crisis in which dollar weakness raises external debt in local currency terms, putting further upside pressure on bond yields.
One could argue that although further upside pressure on real borrowing costs could depress EWZ valuations and cause further weakness in the short term. However, while this may be the case, the equity market is already cheap relative to current real bond yields. Current real bond yields are consistent with an EV/EBITDA ratio of around 6x compared to the current 4.5x.
Summary
High real borrowing costs are closely correlated with low Brazilian equity valuations, but also correlated with high subsequent returns. Brazil's relatively strong fiscal and external accounts allow real bond yields to remain elevated without triggering a debt and currency crisis, allowing an eventual recovery in valuations. The EWZ is highly likely to outperform over the coming years, with 5-year total returns expected to be around 15% annually.
For further details see:
EWZ: High Real Interest Rates Are Positive For Brazilian Stocks