How Brazil Correlates To U.S. Industrials

Includes: EWZ, XLI
by: optionMONSTER

By Bryan McCormick

A few times over the last year I have tried to find the best correlations to help us understand how a movement in one asset can be useful in forecasting another. The most recent article touched on how closely France's CAC-40 index related to the U.S. financial sector.

In that case the correlation was driven largely by the European financial crisis and the way banking shares globally have behaved as a result. The tight correlation of those particular assets may not extend beyond the time frame in which the crisis, somehow, becomes resolved.

Today, in the percentage return graph below, I wanted to look at the iShares MSCI Brazil Index (NYSEARCA:EWZ) exchange-traded fund. There are two sectors in the U.S. S&P 500 index that have consistently high degrees of co-movement with Brazil's ETF over the last six months: the industrials and the materials. (We can also see a high degree of correlation currently with financial shares, but that is actually a very recent phenomenon.)

The two were relatively inversely correlated until the eurozone crisis once again came to prominence this summer. I chose to look at the industrial sector compared to Brazil, using the Industrial Select Sector SPDR (NYSEARCA:XLI) fund as a proxy, but could easily have used materials.

As we can see, the degree of co-movement here is very close in the last two months. Note that the relationship did actually change at that point in time: Previously the two were slightly inverted to one another, but still trended quite closely together for the most part, until the crisis accelerated at the end of July this year. Then the two converged far more closely.

On a fundamental basis it isn't surprising to see that Brazil and the U.S. industrial sector would be closely related. Brazil's economy is driven largely by materials, energy, and industrial production. What may prove to be a useful clue is whether the two assets can continue to co-move but resume their more typical, slightly inverted correlation. If that divergence reasserts itself, we might well be at a point of trend change.

(Click to enlarge)

(Chart courtesy of tradeMONSTER)