Jumping On The ILF Bandwagon

Jan. 24, 2022 8:08 AM ETiShares Latin America 40 ETF (ILF)1 Comment
Dmitry Lifatov profile picture
Dmitry Lifatov
87 Followers

Summary

  • The bottom-buying traders will probably define the ILF performance throughout H1 2022. The rebound effect will be the key to explaining the dynamics of the index.
  • Negative factors that could cause this index to fall will come to the fore only starting from June-July 2022.
  • Other factors, including neutral/lower prices for metals and minerals, deceleration in oil prices, slower credit expansion, do not put downward pressure on the index.

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Sectoral analysis

The prospects for a recovery in the Brazilian stock market after a fall in the second half of 2021 are becoming increasingly apparent. At that time, the main reasons for this fall were the start of an aggressive monetary tightening in Brazil, the spread of the COVID-19 delta strain throughout the world, a new Chinese regulatory framework, and domestic fiscal problems in Brazil exacerbated by the adoption of a new social spending program.

The metals and mining companies, banks, oil and gas companies, and FMCG companies have the largest share in the NYSEARCA:ILF index.

iShares Latin America 40 ETF's Exposure Breakdowns by Sector

iShares Latin America 40 ETF

iShares

In 2022, the metals and mining sectors in Brazil will be hit hardest, according to the forecast by Santander. The oil and gas sector and the FMCG industry will also show a decrease in profitability. The only exception will be the banking institutions, which will show moderate growth this year.

Ibovespa Earning Mass YoY Growth 2022E by Sector

Santander

The main concern for the metals and mining companies (Vale (VALE), Grupo México, Gerdau (GGB), Southern Copper Corporation (SCCO)) will be a deceleration in growth or a decline in the price of metals and minerals this year. In the first half of 2021, the sharp rise in commodity prices was the main driver of their shares' growth. Now the situation may change. For example, Fitch gives a predominantly neutral outlook for most metals in 2022.

Metals and Mining Price Assumptions 2022

Fitch

The index's largest oil and gas companies, Petrobras (PBR) and Ecopetrol (EC), may also face slower oil price growth this year. Thus, according to the forecasts of the Brazilian Itaú Unibanco (ITUB), the energy subindex will more than halve in 2022.

Brazil Macro Forecasts 2022

Itaú

However, in addition to energy prices, other factors influence the stocks of these companies. Most of them are predominantly political. Last year, when Petrobras managed to make extraordinary dividend payments, the market perception was that the government was not yet going to cover its social obligations at the expense of this company. However, any attempts by Bolsonaro to meet social policy goals at the expense of Petrobras could destabilize the market. One such situation occurred in February 2021 when he decided to change the CEO of Petrobras amid the rising domestic prices of diesel fuel. Last year it was possible to avoid long-term negative consequences for the company. An additional destabilizing factor for Petrobras could be the victory of Lula da Silva in the October 2022 presidential election. He repeatedly criticized Petrobras' policy of raising domestic fuel prices. Still, we expect that in H1 2022, we can see some moderate growth of its shares.

The risk appetite will depend, among other things, on geopolitical factors. At the moment, we see how the Russian stock market is declining, reflecting the growing fears of investors about the start of a full-scale war in Ukraine. Should this happen, we will almost certainly see much higher energy prices.

Banking institutions included in the index, Brazilian Itaú Unibanco, Banco Bradesco (BBD), Banco do Brasil (OTCPK:BDORY), Mexican Banorte, and Peruvian Credicorp (BAP), are unlikely to face significant difficulties this year. Of course, with rising interest rates and inflation in Brazil, further credit expansion will be limited. The banks themselves acknowledge this. For example, according to Santander estimates, "the bank's consumer loan book is likely to expand between 9% and 12% [in 2022], a steep decrease from the roughly 20% growth [in 2021]". However, slower growth in consumer lending is unlikely to dampen the banking stocks in Brazil. In Mexico, the outlook for the banking sector is predominantly neutral. Fitch, for example, predicts credit expansion by 4% in 2022.

The FMCG companies included in the index - Mexican beverage company FEMSA (OTCPK:FMXUF), Brazilian brewer Ambev, and Brazilian cosmetics group Natura Cosmeticos (NTCO) - are facing rising inflation. High levels of household debt and weaker purchasing power caused by the recent BRL collapse are likely to limit private consumption growth in the near term.

Negative impacts will increase in H2 2022

The interest rate in Brazil is likely to continue rising this year. Most experts agree that at the next meeting on February 1-2, Copom will raise the Selic rate to 10.75%. In March 2022, it will raise it again, to the level of 11.75% or 12.25%, after which it will remain unchanged until the end of the year.

SELIC Policy Rate Forecast

Santander

Such a forecast does not look very attractive, especially considering the upcoming increase in US interest rates. Still, in H1 2022, the interest rate hikes in Brazil should offset the effect of higher interest rates in the US. But in H2 2022, we can see an enhanced outflow of capital from Brazil.

According to the CME FedWatch Tool, most traders expect the Fed to announce an interest rate hike from the current 0-0.25% to 0.25-0.5% at its meeting on March 16, 2022. By the end of the year, most traders expect the rate to rise to 1-1.25%. One of the direct consequences of tighter monetary policy in the United States will be the appreciation of the US dollar.

"I think the most direct impact will be [felt] in the depreciation of the Brazilian real against the dollar," said Ricardo Mendes, managing partner at Prospectiva Consulting.

- Source: CNBC

Commonly, the BRL weakness accompanies big falls in the Brazilian stock market. Therefore, a weaker real could trigger a sell-off in shares of Brazilian assets. But as for now, we expect the real to continue depreciation in the second half of 2022.

The situation with interest rates in Mexico is more favorable than in Brazil. While Banxico raised its interest rate to 5.5% in December 2021, when the Fed starts raising rates this year, Banxico will have enough room to raise rates to avoid capital flight out of the country.

"Without a doubt, the Mexican economy would experience financial volatility whenever the Federal Reserve decides to raise interest rates. This is because there will be a return of capital from around the world back to the U.S., considering U.S. interest rates have been near zero for so long," said Carlos Serrano, chief economist at BBVA Bancomer. [Nevertheless], "the Mexican economy has very strong fundamentals, especially when you compare it with other emerging-market economies".

- Source: CNBC

Concerns about the spread of the omicron strain in Brazil and Mexico could also be a negative factor for the ILF. We have seen how the spread of the delta strain in mid-2021 led to risk reduction and investors shifting to defensive assets. However, the omicron strain did not cause the same reaction. Therefore, we can assume that the impact of this strain on the index performance will remain limited, at least until health systems in Brazil and other Latin American countries can cope with the number of hospitalizations. The only potential problem may be the low vaccination rate in Mexico (59.84% as of January 23, 2022, according to JHU). Should we see a dramatic increase in hospitalizations and deaths, the government may opt for a lockdown or other restrictions. These measures can negatively affect the Mexican economy.

The political factor has a great significance for the ILF performance. Under the data from opinion polls, the former Brazilian president Lula da Silva, who holds leftist views, is currently ahead of the incumbent president Bolsonaro.

2022 Presidential Vote Intention (%)

2022 Presidential Vote Intention

IPESPE

Therefore, investors will closely monitor the economic agenda of Lula da Silva. Moreover, investors are enthused neither by Bolsonaro nor da Silva and may prefer to shy away from Brazil. This risk will increase as the election date approaches.

Other factors, such as the comparative performance of the Latin American economies with other emerging markets, and China's regulatory tightening, so far do not come to the fore.

Conclusion

The growth of ILF, which we are seeing now, is possible due to a low base and a cheap but stable real. Foreign investors may have taken advantage of the cheap BRL to buy Brazilian assets. Thus, in H1 2022, we expect the ILF will rebound from the bottom it achieved in 2021. Negative factors such as interest rate hikes in the US and the probable outflow of capital from the Latin American countries, further depreciation of BRL, and the approaching presidential elections in Brazil will play a more significant role in the second half of the year. Even a neutral forecast for the metals and minerals in 2022, coupled with a deceleration in oil prices, will not cause a further decline in the index. Compared to the Brazilian EWZ, the ILF gives more stability to investors, as it does not depend on fluctuations in the stock market of one country. At the same time, it fully provides an opportunity to profit from the growth of shares of Brazilian companies since Brazil contributes more than 58% to the index.

This article was written by

Dmitry Lifatov profile picture
87 Followers
Dmitry is a trader, research analyst and forex trading coach with over 13 years of experience trading financial markets. His primary fields of interest include international monetary relations, currency trading and PM investing.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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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