EWZS As The Most Attractive Investment Bet In LATAM

Dmitry Lifatov profile picture
Dmitry Lifatov
87 Followers

Summary

  • EWZS, usually showing wider fluctuations and being less politically affected, is currently one of the most promising indexes for investment in the LATAM region.
  • Brazil appears to have passed peaks of economic, electricity, and, probably, political crises, which should be a good signal for further purchases of EWZS.
  • External factors, such as interest rate hikes in the US, geopolitical tensions, and an economic slowdown in China, have not significantly influenced the index's performance.

Brazil Country Numbers Death Tolls Unemployment Growth

themotioncloud/iStock via Getty Images

In January 2022, Brazil became one of the most attractive investment destinations. The EWZ index, which tracks the performance of the largest Brazilian companies, rose by 24.3% from the local low recorded on January 5. The ILF index, made up primarily of Brazilian and Mexican companies, showed a 16.7% growth from the December 20's low. Along with this, we recommend paying closer attention to another index consisting of the Brazilian small-cap companies - NASDAQ:EWZS. Since the beginning of the year, it has grown by 24%. Under our estimates, it should surpass both EWZ and ILF in terms of return over H1 2022.

Why EWZS?

Unlike large enterprises in EWZ, Brazilian small-cap companies are experiencing less pressure from the forthcoming October 2022 presidential election in Brazil. Of course, in the immediate run-up to the election date, investors may prefer to take profits and withdraw some of their funds from the Brazilian assets. But in general, throughout this year, political issues will play a lesser role for EWZS.

However, the political factor itself can significantly influence the direction of the stock market in Brazil. At the same time, this contribution can be both negative and positive. The news about the probable alliance between the leftist Lula da Silva with the centrist Geraldo Alckmin, who should become a vice president if Lula wins the presidential race, was positively perceived by the market as it moves him away from the left economic agenda.

It reduces the likelihood that Lula’s program will be radical,” said Juan Prada, a currency strategist at Barclays Capital. “If he is looking for alliances with centrists, not-market-unfriendly people, that is positive.

- Source: Bloomberg

Two other Latin American countries, Chile and Peru, where last year's presidential elections brought left-wing politicians Boric and Castillo to power, can serve as an example of the negative influence. Comparing the indexes of the four leading economies in South America, AGT (Argentina), ICOL (Colombia), ECH (Chile), EPU (Peru), and the Brazilian EWZ and EWZS, we can note that last year only ECH and EPU experienced the same problems as EWZ. All other indices did not have a well-defined bottom, which would have marked a signal to enter the market.

iShares AGT, ICOL, ECH and EPU Indexes

iShares AGT, ICOL, ECH and EPU Indexes

TradingView.com

iShares MSCI Brazil Small-Cap ETF

iShares MSCI Brazil Small-Cap ETF

TradingView.com

In general, the market is already familiar with Lula's economic approach during his two previous presidential terms in 2003-2010. This period witnessed an impressive multi-year rally in the Brazilian stock market, so this time we should not expect from Lula any radical changes in social and economic policies.

Although EWZS moves almost in sync with EWZ, the former typically exhibits wider fluctuations. It happens not only due to the smaller volume of assets of EWZS ($115 mln vs. $5.6 bln) but also to political factors that have a more profound impact on the value of large companies. Therefore, we expect that EWZS outperforms EWZ in terms of return.

EWZ’s Performance Relative to EWZS

EWZ’s Performance Relative to the EWZS

TradingView.com

The main reason for the rise in EWZS is the same as for EWZ and ILF: bottom-buying. The majority of market participants decided that most of the negative news, which caused the fall in the Brazilian stock market in H2 2021, has already passed, so they are increasing their purchases.

Sectoral Analysis

While the iShares website provides a general sector breakdown of the index, we have revised it for our analysis. The largest share in the index has companies associated with consumer goods trading (29.6%), electric grid companies (13.23%), as well as companies in the transportation and logistics industry (10.32%), including those providing vehicle rental and leasing services.

EWZS Exposure Breakdowns by Sector

EWZS Exposure Breakdowns by Sector

iShares

The retail and consumer industry

Currently, we can observe some improvement in the Brazilian retail and consumer industry. The retail sales index, which reflects the nominal sales revenue in retail trade, in December 2021 accelerated its growth, which started from September last year.

Nominal Sales Revenue in Retail Trade in Brazil in 2021

Nominal Sales Revenue in Retail Trade in Brazil in 2021

IBGE

In terms of the retail sales volume, in December 2021, 6 sectors witnessed their growth, while four others experienced a decrease (including vehicles and construction materials included in the extended retail sales). At the same time, a reversal trend started in November, when, contrary to the forecasts, the rate of decline in sales volumes became noticeably lower. Of course, the more expensive goods - computers, cars, and construction materials, which purchase means costly repairs - still face adverse factors. Still, such durable goods as furniture and household appliances, which previously also showed substantial declines, in December 2021 demonstrated recovery in demand. Additional downward pressure on the retail sector comes from higher water and electricity prices, traditionally having a sizable meaning for consumer expenditures.

Brazil Retail Sales in December 2021, Sector Breakdown

Brazil Retail Sales in December 2021, Sector Breakdown

IBGE

Brazil Retail Sales in 2021 YoY

Brazil Retail Sales in 2021 YoY

TradingEconomics.com

The consumer confidence index in Brazil has stabilized, showing values in the range of 74-76 points from September 2021 to January 2022.

Brazil FGV Consumer Confidence

Brazil FGV Consumer Confidence

TradingEconomics.com

The appreciation of BRL since the beginning of 2022 could secure further growth in retail sales, both in terms of revenue and volume. Commonly, this happens with a time lag of about 2-3 months. In this case, the USD/BRL exchange rate could serve as a leading indicator of consumer confidence, with markets already pricing in the improvement in the retail sector.

USD/BRL, 1W

USD/BRL, 1W

TradingView.com

Rising inflation also affects retail sales since it has eroded consumer income. That is why the profitability of FMCG companies will depend on its future figures. Inflation in Brazil since September last year reached a plateau in the range of 10-11%. Some economists point to the possible peak of inflation in November 2021. In our view, since the situation in the Brazilian economy in late 2021 and late 2015 has many similar features, this year's inflation will probably follow the same trajectory as in 2016. A further increase in the interest rate in Brazil should also help reduce inflation, which, according to various estimates, will rise in March 2022 to 11.75% or 12.25%.

Brazil Inflation Rate

Brazil Inflation Rate

TradingEconomics.com

The electricity sector

Among utility companies included in EWZS, electric grid companies have the largest share (10 out of 13).

EWZS utility companies

iShares, Bloomberg, Reuters

EWZS electricity companies

iShares

The Brazilian electricity sector should show good results this year. Thus, in June and December 2022, two auctions are planned for the production and transmission of electricity.

The Schedule of Auctions for the Concession of Public Service for the Transmission of Electric Energy in Brazil in 2022

The Schedule of Auctions for the Concession of Public Service for the Transmission of Electric Energy in Brazil in 2022

MME

Only the first auction in June this year will feature 13 lots for the construction and maintenance of power lines and transformer substations, which can attract R$15.3 billion of investments ($2.9 billion). Compared to the same auctions in 2021, which amounted to R$1.3 billion and R$2.9 billion ($817.9 million in total), this year, we are seeing a 3.5-fold increase in the June lots alone.

Regarding the current energy crisis in Brazil, partly caused by a drop in hydro generation in 2021, in January 2022, hydro generation showed an increase of 11.4% due to the more considerable rainfall. Thermal generation, on the contrary, decreased by 27% over the same period, which should have a positive impact on consumers. About 66% of Brazil's electricity comes from hydroelectric power. When in 2021, the country faced its worst drought in 90 years, Brazil used thermal power plants to cover electricity shortages. For Brazilian consumers, the growth in fuel prices led to a substantial increase in the cost of electricity and, as a result, an additional acceleration of inflation. Therefore, the recovery of hydro generation should support both energy consumers and grid companies in Brazil.

The transportation and logistics industry

Within the industrial category in EWZS, most companies, 7 out of 18, operate in the transportation and logistics industry, 3 produce cars, commercial vehicles, and auto parts, and 3 are car and commercial vehicle rentals. The remaining companies, namely Embraer (ERJ), Gol Linhas Aereas Inteligentes (GOL), Ambipar Participacoes e Empreendimentos, Aeris and Boa Vista Servicos, operate in other industries.

EWZS industrial companies

iShares, Bloomberg, Reuters

EWZS logistics and transportation companies, auto parts manufacturers, car rental and commercial vehicle rental companies

iShares

Let's take a closer look at the Brazilian transportation and logistics market. In general, its indicators are closely related to consumer and business sentiment. Its growth is driven mainly by the e-commerce industry, which encourages many companies, such as MercadoLibre (MELI), Amazon (AMZN), Magazine Luiza (OTCPK:MGLUY), to invest in new logistics hubs to reduce the delivery time.

Due to its low base, analysts estimate that the e-commerce sector will continue to grow in 2022, with a 22.2% annual increase in Brazil compared to the global average of 12.2%. This growth should come from greater use of more convenient payment methods, such as the Pix instant payment system, and the increasing popularity of mobile payments.

Top 10 Countries, Ranked by Retail Ecommerce Sales Growth, 2022

LABS

The recovery of consumer demand should also support the transportation and logistics industry.

Another major factor that will appear next year will be the gradual recovery of the logistics industry and the easing of supply chain bottlenecks. For example, Santos Brasil has already shown growth in profits and container traffic volumes since the third quarter of last year. After releasing this data in November 2021, its shares went up. Vamos, which provides vehicle and special equipment rental services based on long-term contracts, has already ensured revenue growth in 2022 by 40% above the previous year.

Impacts

Considering the improvement of the sectors essential for EWZS - the strengthening of BRL and the recovery in the consumer sector, the easing of the electricity crisis, and optimistic forecasts for the transportation and logistics industry - we expect the largest EWZS companies will strengthen their positions.

Increased capital inflows in the Brazilian stock market, which began at the beginning of this year, also signal that most negative events, which caused a massive drop in the index in the second half of 2021, have passed. Despite EWZS being less politically sensitive, the market welcomed the first steps of a likely winner of the 2022 presidential election, Lula da Silva. A considerable part of the populist measures taken by the incumbent President Jair Bolsonaro also fell into the second half of 2021 (in particular, the Auxilio Brasil program).

We discussed the impact of other factors, for example, the US interest rate hikes, on the Brazilian stock market in more detail in the previous article ‘Jumping On The ILF Bandwagon’. Overall, we assume the country's cross-border capital flows are unlikely to be adversely affected by the US interest rate hikes in the first half of this year, as an increase in the Brazilian interest rate should support its financial markets.

A slowdown in economic growth in China, which is the largest export market for Brazilian goods, could also be a potential problem for EWZS. Theoretically, this could cause a decrease in Brazilian exports, especially if future Chinese economic indicators continue to show deterioration of its economy. Considering the monetary policy easing in China and a considerable fall of the Brazilian stock market last year, this factor has not halted EWZS's growth so far. However, if the Chinese monetary authorities fail to speed up economic growth, or in case of further regulatory tightening in China, this factor may have a more profound impact on EWZS, especially if it grows above its current values losing the low base effect.

We assume EWZS, as well as ILF and EWZ, will continue their growth in H1 2022. Among the most important upcoming statistics, it is worth highlighting the retail sales data for January (to be released on March 11) and inflation figures for February (to be released on March 11). Should we see a disinflation, which is a preferable option, or an increase in retail sales, investors may build up their EWZS exposure, as this will support the thesis that the peak of the crisis has passed at the end of 2021.

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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