Not Enough Upside To Justify A Short-Term Investment In EWZ (NYSEARCA:EWZ)


My last article on iShares MSCI Brazil Capped ETF was July 21st, and since this date, EWZ fell by about 4% while the S&P 500 went up by almost 3%. A week before writing that article, I had already liquidated all my shares in EWZ because the Brazilian was just too stagnant.

Current Economic Indicators

EWZ’s return is a result of two components, the underlying index return and the exchange rate return. In this section, I will discuss the fx rate and possible 2020 scenarios.

Brazilian Inflation

According to the most recent Burgernomics report from the economist, the implied exchange rate for the Brazilian Real is R$3.66, up 4.3% from January’s implied exchange rate. Burgernomics index is based upon the purchase-power parity theory, and it gives us an idea of what the long-run exchange rate should be.

Figure 1 – Brazilian Inflation Rates

Source: Trading Economics

Inflation rates are at their lowest levels ever, and so is the Brazilian SELIC rate (Brazilian Fed Rate). I remember a time when people would ask me why they should invest in stocks that might give them a 10 to 20 percent return when they could get a guaranteed 10% return from a CD? Their question was a valid one at the time, but it is a question that they can no longer ask.

According to the most recent Brazilian Central Bank (“BCB”) Market Report, analysts believe that the Brazilian Real will close the year at R$5.20. These same analysts believe that the Selic rate will stay firm at 2%. The BCB aims for an inflation rate of 4% in 2020, give or take 1.5%. The current inflation rate is 2.31%, 19 bps below the minimum range. Inflation is increasing but at a slow pace. This gives the BCB plenty of breathing room, which is why I disagree with analysts’ forecast that the Selic rate will remain at 2% this year. There is a probability, in my opinion, that the BCB will reduce the rate by 0.25% to stimulate economic growth.

Figure 2 – Trading Economics Brazilian GDP Estimates

Source: Trading Economics

There is a big red box in figure 2, and that block is highlighting the forecasted economic performance over the next two quarters (and last quarter’s negative GDP). The BCB has the opportunity, low inflationary environment, to reduce the effects of COVID 19 by stimulating the economy with lower interest rates.

So how does this apply to the FX rate? The inflation rate usually determines the long-term performance of the exchange rate, while the interest rate determines the short-term performance (interest rate parity). If the BCB decides to reduce rates, as I suggested, this move would adversely affect the Brazilian Real in the short-term.

I see three possible scenarios for the Brazilian Real based upon the data.

  1. The analysts surveyed by the BCB are correct, and the Real closes the year at R$5.20, and the interest rate remains unchanged in 2020 (high probability).
  2. I am correct, and the BCB reduces its interest rate, the Real will close at R$5.40 (low probability).
  3. The dollar index falls below recent lows, and the Brazilian Real strengthens to R$5.20 (low probability).

Of course, there is a probability of events two and three occurring at the same, which would probably cause the Real to close at R$5.20.

MSCI Brazil 25/50 Index

In my second to the last article, I present the readers with the below graph (Figure 3). I will present this information again as evidence of my upside estimates for iBovespa.

Figure 3 – iBovespa Expected Returns By Market Analysts

Sources (all in Portuguese): Seudinheiro, moneytimes, and infomoney

On August 10th, iBovespa closed at 103,444 points. The average of all five analysts’ forecast is 106,200 points. Based on the average of all the analysts’ estimates, iBovespa has an upside potential of 2.6% in 2020. The upside potential in the graph is based upon the index at the time, which was 97,761 points.

Conclusion

The exchange rate is a complex animal to predict. My beliefs could most definitely be wrong, and the exchange rate could make an unpredicted move base upon political and country risks not mentioned in this analysis. At the current exchange rate of R$5.46, scenario one or two could produce an FX rate return of 6% for investors. Including the 2.6% upside potential in the underlying index, EWZ has a total upside of 8.6%. Over the course of the past year, EWZ had a standard deviation of 3.9% while the S&P 500’s was only 2.1%. Taking into consideration the level of volatility of EWZ and the single-digit upside potential, I am bearish on EWZ in the short-term.

In the long-run, the exchange rate should produce decent returns for EWZ investors.

If you like what you read, please “Follow” me via Seeking Alpha. I typically only cover the Brazilian markets, the Robotics Industry, and the Food Industry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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