- "Apocalyptic" headlines out of Brazil have pressured risk appetite and sentiment towards investing in the country.
- We have a more constructive view with an expectation that the economy can recover as the COVID pandemic ends.
- A favorable global macro environment including strong commodity prices supports a positive forward outlook for Brazil stocks which offer attractive value and significant upside.
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If you do a news search for Brazil, the headlines aren't pretty. From the ongoing pandemic to weaker than expected economic activity in recent months, the media has had a field day pushing the narrative that the situation is a "nightmare". That said, we are taking a more constructive view that the outlook going forward is positive setting up an attractive buying opportunity in Brazil stocks ahead of a post-pandemic recovery.
The iShares MSCI Brazil ETF (EWZ) has lagged global benchmarks in part given the weakness of the local Brazilian Real currency. Our take is that an improving global macro backdrop including strong commodity pricing which has supported sentiment towards emerging markets can be an upside catalyst for Brazil this year. We are bullish on the region which offers a combination of attractive value and significant upside as the pandemic ends.
COVID - Light at the End of the Tunnel
The main challenge for Brazil right now is to control the COVID outbreak as it remains in the middle of its most serious wave since the start of the pandemic. Current data shows that Brazil is, unfortunately, leading the world with the highest daily rates of COVID mortalities while lagging other countries in its vaccine rollout.
Stepping past the political angles, we believe it's important to place the data into context. Brazil with a population of 213 million people and 333k confirmed COVID deaths has overall faced comparable statistics to many other countries which goes against any narrative that the situation is an outlier or a catastrophic exception. The current 1,559 COVID mortalities per 1 million in population rank Brazil below countries like Portugal at 1,660, Italy at 1,843, and even the United States at 1,712. Even in a scenario where the official numbers are systematically undercounted by 20%, which we don't believe to be the case, Brazil would still be at a level below the United Kingdom.
While we're not suggesting one country performed better or worse, we bring this up because regardless of how devasting COVID has been as a global public health crisis, the general messaging in regards to "Brazil's response" has been aggressively negative. In our view, publications of record from the Washington Post to the Guardian have framed Brazil to a different standard compared to the outcomes in other countries.
(source: Google News screenshot)
As it relates to the stocks we're looking at, the implication is that media messaging may be indirectly pressuring Brazil's asset prices through lower business confidence and investor sentiment that in our opinion is unjustified. This creates the potential for an upside catalyst once the proverbial dust settles and the COVID pandemic ends. There are some encouraging signs that the trend is already turning.
Even as concerns have been raised regarding new coronavirus variants found in Brazil that are potentially more contagious, the 7-day rolling average of case infections has declined by 17% from 10 days ago. The bet here is simply that Brazil has passed its worst stage and the metrics will improve going forward. We make the case that the current wave in Brazil is simply 1-2 months behind the similar situation the U.S. observed in late January when the case count peaked in that country.
Ending the pandemic will likely come down to vaccinations which Brazil has been slow to roll out. As a developing economy, there was always an assumption that Brazil would be behind the U.S. and wealthier European nations in terms of access to the leading vaccines which were the first approved in the U.S. at the end of 2020. Brazil data shows that 8.1% of the population has received at least 1 does with the pace accelerating in recent weeks and set to gain momentum going forward.
(source: Google Vaccination Tracker)
While the level is far below the U.S. at 33%, Brazil is more comparable to the 12.9% vaccination rate in Italy and above the 6.4% reported for Mexico. A target to administer 1 million vaccines per day going forward means over 50% of the population can receive a dose over the next 3 months. It's been reported that one dose of the vaccines are 80% effective at preventing COVID infections while Pfizer has said its vaccine neutralizes the "Brazilian variant". We assume that as levels of vaccinations climb particularly among at-risk groups, mortalities will decline with a lag against the current case count. We see the stage set for the end of the pandemic in Brazil by Q3 which can support accelerating economic activity levels as COVID restrictions are relaxed.
Stable Economic Outlook
The story in Brazil has been weaker than expected economic activity to start 2021 amid worsening COVID metrics through March. Measures like retail sales and industrial production have underperformed which inflation statistics trending higher forced the Central Bank to hike its "SELIC" monetary policy rate. Compared to a 4.1% real GDP contraction in 2020, the current forecast from the economics team at local Brazilian Bank Itau Unibanco Holdings SA (ITUB) is forecasting a 3.8% rebound this year.
(source: Itau Economics Research)
The group makes the case that the country is still positioned to benefit from broader global growth as it relates to exports and trade. While local interest rates have climbed from record lows last year, the current levels are still supportive of credit expansion and investment demand. There is an expectation that the economy can gain momentum as the pandemic ends.
What we are highlighting are the overall solid "external accounts" considering an ongoing record trade surplus and positive current account balance estimated to reach 0.3% of GDP this year. This is important as it provides a backstop against external vulnerabilities while limiting a situation such as a "capital flight" or currency collapse observed in other emerging market countries like Turkey and Argentina in recent years. Brazil at the country level is benefiting from elevated prices for key trade products like soybeans, iron ore, and even crude oil which has been positive for macro stability indicators.
In some ways, the surge in commodities over the past year from the lows of 2020 has been something of a windfall for Brazilian exporters in the context of the Brazilian Real currency trading at a record low against the Dollar. The Real currency is trading at 5.60 per USD which is near a record weakness for the pair, being more Reals are needed to purchase 1 Dollar. The weaker currency has helped Brazil remain competitive in the current environment.
While exchange rate levels from the past decade closer to BRL3.00 are likely out of reach in the near term, we argue that the currency can strengthen from its current level and appreciate towards BRL5.00 to the Dollar implying about 10% upside as our year-end target. This would be driven by the consensus turning more positive as the market recognizes Brazil will emerge out of the pandemic into a strengthening global economic recovery. Narrowing credit spreads towards Brazil country risk would be positive for the currency.
(source: XE.com/ annotation by BOOX Research)
Overall, in the context of the historically difficult economic environment amid the pandemic disruptions over the past year, Brazil's macro indicators suggest it remains positioned to recover going forward. We see value in the Brazilian Real Beyond trends in "the Dollar", our take is that the Brazilian Real can outperform based on country-specific factors which can add incremental returns for foreign investors buying Brazilian stocks.
How to Trade It
Overall, we believe a repricing higher for Brazil assets in the coming months can offer significant upside from the current levels. The following points summarize our bullish case for Brazil stocks into the second half of 2021.
- Extreme pessimism regarding COVID situation and economic outlook, setting up better than expected result.
- Early indications that the worst of the pandemic has passed in Brazil (cases trending lower/ vaccinations accelerating).
- Strong commodity prices support macro stability (record trade surplus in Brazil limits external vulnerabilities).
- Brazilian Real currency appears undervalued ahead of looming recovery.
- Brazil can benefit from the broader strength in the global economy.
- Country stocks have corrected lower in recent months and now offer more attractive entry levels to buy the dip.
The iShares MSCI Brazil ETF is an easy way to capture exposure to a diversified group of the largest and most important Brazil stocks. The fund is down about 8% year to date amid the macro weakness and COVID uncertainty which we discussed above. This represents a significant underperformance to global equity benchmarks including the broader iShares MSCI Emerging Markets ETF (EEM) and the S&P 500 Index (SPY), up 5.4% and 9% each respectively. The contrarian trade right now is to buy Brazil with the potential that it can outperform going forward which is our base case.
EWZ includes companies like Petrobras SA (PBR) and Vale SA (VALE) among top holdings. Vale as one of the world's largest iron ore producers has outperformed climbing nearly 80% in just the last 6-months given its exposure and record iron ore pricing and strong demand from China. We think both PBR and Vale can perform well as commodity prices remain robust.
Another option to trade Brazil is to look at the iShares MSCI Brazil Small-Cap ETF (EWZS) which may have more upside given its higher exposure to companies operating in the local market versus the large-cap fund that is concentrated in the big exporters and commodity players. If our thesis is correct in that the Brazilian Real can appreciate against the Dollar, small-cap companies which generate more of their revenue in the local currency appear more attractive being leveraged to the upside in a macro improvement in the region.
EWZS includes 87 equity holdings including more consumer discretionary, staples, and utilities compared to the exposure in EWZ. Brazilian airline carriers Azul (AZUL) and Gol Intelligent Airlines Inc (GOL) may become attractive as the outlook of travel improves in the region with an end to the pandemic.
Taking a look across Brazilian ADRs and over-the-counter shares available for trading in the U.S., the performance for the group has been mixed. The data shows that companies focused on exports have outperformed including Vale, up 13% year to date along with steel names like Gerdau SA (GGB) and Companhia Siderurgica Nacional SA (SID) each up 11% and 12% each respectively. Other "global" names including chemicals manufacturer Braskem SA (BAK) and beef giant JBS SA (OTCQX:JBSAY) also have positive returns in 2021.
What we want to highlight here are the more significant declines from each stock's 52-week high, which in many cases reflect levels reached earlier in 2021. The setup has been a deep correction since January corresponding to broader volatility in the global financial markets particularly in emerging markets and further pressured by the COVID situation in Brazil.
The attraction here is the companies that operate primarily in Brazil. Utilities like Centrais Eletricas Brasileiras SA (EBR) and Energy Company of Minas Gerais (CIG) will benefit from a broader economic recovery and strengthening Brazilian Real currency. Brazilian banks like ITUB, Banco Bradesco SA (BBD), and Banco Santander Brasil (BSBR) which have also underperformed now appear compelling at current levels.
One of our top picks is PagSeguro Digital Ltd (PAGS) which is off about 24% from recent highs although the company maintains a positive growth outlook. The company can be described as a local fintech player focusing on payment solutions for small and medium-sized businesses with a growing portfolio of e-commerce tools. The company reported Q4 results highlighted by total payments volume climbing 61% year over year and positive net income despite the economic challenges in the country. We are bullish on the stock and expect the operating and financial trends to continue.
Recognizing that Brazil is likely two or three months behind the curve in terms of controlling the COVID pandemic, we see light at the end of the tunnel. Investors that recognize the country maintain solid economic fundamentals with significant growth opportunities among major corporations can capture value by buying into the recovery story ahead of the crowd. We are bullish on Brazil as a contrarian idea and believe the Brazilian equities can outperform with 20-30% upside in ADRs shares as group on average through the end of 2021 driven by a stronger-than-expected rebound.
The main risk to watch is the potential that the global macro outlook deteriorates which would likely be a concerning development for the broader financial market. A tail risk scenario would be the emergence of a COVID variant that is simply resistant to existing vaccines or more dangerous which would force a reassessment of the risk appetite. Investors should be aware that Brazil as an emerging market represents a higher level of risk with some instability associated with the political climate which can add to volatility. Monitoring points in the year ahead include inflation statistics and monthly economic activity indicators that can gauge the trends in business and consumer confidence as it relates to the investing environment.
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This article was written by
Dan Victor, CFA is a market professional with more than 15 years of investment management experience across major financial institutions in research, strategy, and trading roles.
Dan leads the investing group Conviction Dossier, where his focus is on helping investors stay ahead of market trends and inflection points. Dan’s investing vehicles of choice are growth stocks, tactical exchange-traded funds, and option spreads. He shares model portfolios and research to help investors make better decisions, via his Investing Group’s active chat room.
Analyst’s Disclosure: I am/we are long PAGS, PBR, ITUB. 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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