EWZ: Attractive Now, But Signs Of A ‘Flash In The Pan’ In Brazil’s Economic Future (EWZ)

The iShares MSCI Brazil ETF (NYSEARCA:EWZ) is poised to conclude a robust year marked by substantial gains, with Brazilian equities approaching levels close to the stock market’s all-time highs (Ibovespa). This performance comes amid widespread skepticism about the policies of the new Lula administration and a macroeconomic landscape that has exceeded expectations.

November witnessed the Brazilian stock market’s most impressive performance since 2020, driven by positive news that buoyed investor sentiment and diminished risk aversion. Key factors contributing to this positive trend include the anticipation of Brazil’s interest rate (Selic) dropping below 9% next year, an improved GDP outlook, controlled and decreasing inflation, and a stable exchange rate in the face of a declining U.S. yield curve—all of which have favored the EWZ.

My previous article adopted a cautious stance due to global economic conditions. However, it was highlighted that the EWZ, being significantly discounted compared to its emerging peers, could potentially experience a strong upswing with improved indicators. As this scenario materializes, Brazil and other emerging countries may likely experience a more positive fourth quarter of 2023, influencing short-term performance.

For the long term, the Brazilian economy’s baseline scenario typically involves growth cycles followed by slowdowns and persistent risks. Consequently, investing in emerging markets often necessitates a more cyclical approach. The ongoing EWZ cycle appears to present opportunities in line with this perspective.

Inflation Shows Benign Outlook as Interest Rates Experience Free Fall

In November, Brazil’s inflation monitor, the IPCA-15, recorded a modest 0.33% monthly increase. Over the past 12 months, the index has seen a 4.84% rise, aligning with the anticipated favorable conditions for Brazilian inflation.

The outlook for the remainder of the year suggests that inflation will continue subdued, aligning with the target set by the National Monetary Council. Projections indicate an IPCA of 4.75% for the end of 2023 and 3.8% for 2024.

In November, Brazil’s Cenbank reduced interest rates (Selic) by 50 basis points (0.50 percentage points), bringing the interest rate to 12.25% per annum. In my view, Copom’s decisions are proving to be judicious. Confronted with a more favorable inflationary scenario, the Central Bank expressed confidence in the ongoing reduction of interest rates. Despite initial concerns about growing external turbulence, pressures eased throughout the month.

The Central Bank emphasized the crucial need to enhance Brazil’s fiscal framework to mitigate risks and reduce inflation expectations. Copom (Monetary Committee) also underscored the importance of caution in the ongoing fight against inflation.

Expectations point to an additional 50 basis points cut in December, bringing the Selic rate down to 11.75% annually. For the January 2024 meeting, a similar magnitude cut is anticipated, with the Selic rate reaching 11.25% per annum. Our projection for the end of 2024 is 9.75% per annum.

Brazilian Equities Surge Amid Global Positive Trends

In November, the Brazilian stock market (Ibovespa) experienced a robust rally, nearing the mid-2021 all-time high of 131,000 points, concurrent with a continued decline in the dollar. Notable performers included Petrobras (PBR) and Banco do Brasil (OTCPK:BDORY), both significant components of the EWZ.

Moreover, the Brazilian economy exhibited a slight positive growth in the third quarter, defying pessimistic projections and prompting Luiz Inacio Lula da Silva’s government to challenge Brazil skeptics. However, I raise some questions regarding the government’s credit for these developments and their sustainability.

Brazil’s GDP exceeded market expectations, showing a 0.1% uptick in the third quarter and surpassing analysts’ predictions. Projections now indicate an annual GDP growth of 3%. While signs of a slowdown are apparent, specific sectors remain resilient, with expectations for a slight dip in the 4Q23 figure and reduced growth in 2024.

The Brazilian stock market’s November performance saw a remarkable 12.54% increase, marking the best month since November 2020. However, assessing whether this movement is specific to Brazil or part of a global trend is essential. Analyzing other emerging markets, such as Mexico, revealed a similar upward trend. Globally, November witnessed a reduction in risk perception, leading to a worldwide surge in stock market assets.

November’s global environment was optimistic, driven by expectations of interest rate cuts due to positive employment and inflation data in the United States. This resulted in rising stock markets, a weakening dollar, and lower US interest rates. Nevertheless, it’s crucial to consider that expectations of interest rate cuts might have been overstated.

In summary, November’s positive asset performance extends beyond Brazil, reflecting a favorable global environment. A closer look at Brazilian economic data indicates GDP growth propelled by consumption, while the financial market mirrors global conditions, with investors displaying optimism toward risk assets.

Brazilian Fiscal Scenario: A Closer Look at the Numbers and Concerns

Data from the Federal Revenue Service reveals that the federal government’s tax collection in October 2023 amounted to R$215.6 billion, indicating a slight 0.1% increase compared to the same period in 2022. This interrupts a four-month trend of declining revenue.

In the January-to-October 2023 period, revenue totaled R$1.9 trillion, reflecting a 0.68% decrease from the previous year’s corresponding period. Furthermore, the National Treasury reports a primary surplus of R$18.3 billion in October and a negative 12-month accumulated result of R$85.3 billion (equivalent to 0.83% of GDP).

As of September, Net Public Sector Debt (DLSP) and Gross General Government Debt (DBGG) stood at 60% and 74.4% of GDP, respectively.

There is a significant likelihood that Brazil will end the year with a 1% GDP deficit. This is attributed to decreasing revenue and continuous spending. The current government’s policies align closely with those proposed by the Workers’ Party [PT], sparking concerns about the possibility of a recurrence of past economic issues.

While attempting to implement their economic program, not all proposed measures receive congressional approval, emphasizing the checks and balances imposed by the legislature. Macroeconomic policies aim to boost spending in alignment with the government’s economic policy direction. However, the approval of the Fiscal Framework was less expansive than initially proposed, signaling a restraint on the initial idea of a more flexible, spending-oriented approach.

Despite this moderation, the fiscal scenario is deteriorating, prompting questions about long-term consequences. Understanding the cause-and-effect relationship and the lag in economic consequences is crucial. While fiscal deterioration doesn’t lead to immediate inflation, it can jeopardize debt, interest rates, inflation, and economic growth in the medium to long term.

The current government program, reminiscent of past strategies, particularly during 2009 and 2010, mirrors interventionist policies and fiscal stimulus. Public banks like the BNDES (Brazil’s National Development Bank) boosted growth during that period. However, similar policies in the past contributed to the subsequent recession from 2014 to 2016.

Foreign Exchange Tailwinds

To comprehend the Brazilian market’s dynamics in the past 12 months, the dollar’s behavior emerges as a pivotal factor.

Amid geopolitical tensions, such as the conflicts in Ukraine and the Middle East, the deglobalization trend, and increased intervention by the Communist Party in China, Brazil distinguishes itself among emerging nations. Notably, Russia, once a significant player, has faced international isolation.

The dollar index experienced its most substantial monthly drop since November of the previous year, mirroring a global risk reduction environment. In November, the real-dollar exchange rate (PTAX) closed at R$4.93, down from R$5.05 at the end of October. The month was characterized by anticipating a conclusion to the US interest rate hike cycle, driven by positive inflation, activity, and labor market data.

Furthermore, Brazil’s commitment to maintaining a zero deficit by 2024, coupled with favorable economic indicators, controlled inflation, and declining interest rates, collectively contributed to reducing country risk.

The Bottom Line

In the global panorama, Brazil’s prominence doesn’t stem from inherent strengths but rather from the diminished appeal of other investment destinations. Within the stock market context, Brazil has attracted capital primarily because its assets were more discounted than those of its global emergent peers.

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Regarding the exchange rate, there are reasons for the dollar to devalue or the Real to appreciate, although political uncertainty and instability could influence this dynamic. While political noise and uncertainties around tax reforms might impact the exchange rate, the Real remains below R$5 per dollar and could potentially fall further.

As highlighted earlier in the year, the exchange rate has remained relatively stable despite the actions of the current Lula administration. In essence, the repercussions of a flawed economic policy unfold over years rather than months. During periods of market growth, discounted assets, and a declining dollar, investment opportunities emerge.

Brazil is characterized by uncertainty and lacks economic robustness. The typical scenario involves cycles of growth succeeded by slowdowns, accompanied by persistent risks. The upcoming change in the Central Bank’s leadership next year, with the majority of the new board appointed by President Lula, raises questions about whether this composition aligns more with the government’s economic vision, possibly seeking a significant reduction in interest rates. However, certainty in this regard remains elusive.

Rather than betting on Brazil’s success or failure, the prudent approach involves maintaining a balanced and measured exposure. Avoiding extremes, such as going all-in on local investments or completely divesting from Brazil, aligns more with a global investment vision.

Despite the government’s interventionist policies, which may not indicate a sustainable cycle of economic growth and poverty reduction, the outlook for 2023 showed the potential for favorable asset performance due to previous discounts. I anticipate a similar trend for the beginning of 2024.