Behind the Weakness in Brazilian Small Cap ETFs - ETF News And Commentary
November 18 2013 - 10:01AM
Zacks
Of late, Brazil small-cap ETFs have been hurt more than large
caps in the country like EWZ on slowing economic growth prospects.
The Brazilian economy which saw a turnaround following the Fed’s
‘taper hold’ decision in September, started faltering again
probably in anticipation of subdued growth ahead.
To add to the woes, taper fears have resurfaced as better job and
GDP data in the U.S. Although the Fed’s Vice Chairman Janet Yellen
recently made some dovish comments on this issue, it is quite
likely that the speculation about taper timing will persist and
foreign investors will pull out funds from the riskier emerging
market on worries over a ‘QE taper’.
History has shown that smaller companies generally bounce back in a
reviving economy faster than the larger ones and also fall faster
if the scenario reverses. Hence, we are likely to see a downturn in
small companies in a market that is crippled with structural
problems like rising inflation and slowing growth, such as what is
currently the case in Brazil.
Raging Rate Hikes Halter Growth
Although Brazilian inflation began to calm down since July on a
quarter-over-quarter basis, it still remains high at 5.84% in
October, well above the policy makers’ target of 4.5%. Also, this
downward trend in inflation has also been achieved through a set of
interest rate hikes.
Notably, at present, Brazil's benchmark interest rate is pegged at
9.50%, staying at the peak among the world's largest economies,
after five successive raises since April. If this is not enough, a
recent Reuters poll suspects inflation to flare up again in the
months ahead. Inflation is expected to finish 2013 at 5.83%, as per
a survey by Brazilian economists.
The rate is also expected to stay stubborn at 5.94% in 2014.
Finding no other way to contain the potential rise in inflation,
analysts expect monetary policy committee to go for another 50 bps
hike in their November meeting which is really not a healthy sign
for the country’s growth. Rampant rate hikes will likely mar the
business activity of the country and check the growth pace.
Brazil’s growth rate is lagging many of its emerging market
cousins. In fact, with growth projections falling below 2.5% for
2013 GDP, the country has now come in line with the developed
nations like the U.S. and lost its glory of its former 7.5%
growth rate in 2010. Notably, the U.S. economy posted around 2.8%
growth in the third-quarter 2013, beating out this once surging
nation (read: Short Brazil with These Inverse ETFs).
Since small caps are more exposed to domestic dynamics, these will
likely suffer more than the large caps. Moreover, many times larger
companies enjoy relatively lower interest rates than the smaller
ones as the latter always involves some credit risks thanks to its
lower scale of operation. In a rising rate scenario, this might
pose threats to the small-cap companies.
Market Impact
The recent pullback also signals the trend as both the small-cap
funds including
iShares MSCI Brazil Small Cap Index
Fund (EWZS) and
Market Vectors Brazil Small Cap
ETF (BRF) lost, respectively, 13.01% and 12.77% in the
last one–month period (as of November 12, 2013) while the largest
Brazilian ETF by assets,
iShares MSCI Brazil Capped
ETF (EWZ) lost just 6.89%.
Bottom Line
While small-caps are mostly beaten-down in Brazil, EWZ is bearing
the brunt of it as well. Some of its major holdings like
Petrobras (PBR) – the Brazilian state-run energy
giant-- have raised investors’ concern and haven’t been all-stars
either.
Another key holding –
Vale (VALE) – one of the
world’s largest producers and exporters of iron ore, is suffering
reduced production, with no visible sign of recovery.
Yet another important holding
AmBev – with 7.0% of
the total – is reeling under pressure as evident from the
lower-than-expected earnings posted in the recent past. Thus, we
refrain from being optimistic on not only small-caps but the
large-cap Brazilian ETFs as well.
As a matter of fact, Brazil’s recovery is tied with China’s fate to
a large extent with the latter being one of the largest importers
of Brazilian raw materials. China’s inclination toward West Africa
to source iron ore can prove a major setback for Brazil.
Thus, at this juncture, it is advisable to opt for a wait-and see
approach on Brazilian ETFs across the range of capitalization
levels and focus elsewhere for emerging market ETF opportunities
(read: Time to Buy These Top Ranked Latin America ETFs).
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MKT VEC-BRZL SC (BRF): ETF Research Reports
ISHARS-BRAZIL (EWZ): ETF Research Reports
ISHARS-MS BR SC (EWZS): ETF Research Reports
PETROBRAS-ADR C (PBR): Free Stock Analysis Report
VALE SA (VALE): Free Stock Analysis Report
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