Behind The Slump In Brazil ETFs [iShares MSCI Brazil Index (ETF), Market Vectors Brazil Small Cap ETF]

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March 3, 2014 10:58pm NYSE:BRAQ NYSE:BRF

brazil2Brazil ETFs have been going through a rough patch for over a year thanks to the nation’s structural problems, the Fed’s QE taper threats, and currency losses among other difficulties.

 The top Brazilian ETFs have bled in the range of 23% to 35% in the past one year and are showing no signs of healing. So far this year, these funds have shed as much as 8% to 12%.

Let’s delve a little deeper and find out what pushing the funds down even this year after massive losses in 2013:

Behind the Slump

Slowdown in China’s Manufacturing Sector: The prime reason for the latest crash can be the manufacturing slowdown in the world’s second largest economy China which is also the largest trading partner of Brazil.

As per Bloomberg, a gauge for activity in China’s manufacturing sector fell to the six-month low in January as export orders and output remained subdued. Investors should note that China is the largest buyer of Brazilian commodities like iron-ore and soybeans making the latter vulnerable to its economic growth.

Hard Hit Auto Industry: Car sales in Brazil skid 0.9% in 2013, for the first time in a decade. In Brazil – the world’s fourth-largest car market – new vehicle sales are expected to rise only 1.1% this year against the average annual growth of more than 10% for the past decade.

Deceleration in Argentina, one of the major purchasers of the Brazilian cars and also the third biggest export market, was also blamed for the malaise in the Brazilian auto industry (read: Falling Peso Undermines Argentina ETF).

Growth Outlook Spoils:  Double pressure from slower growth and heightened inflation has been crippling the country’s core. In a bid to cool off the stubbornly high inflation central bank resorted to aggressive rate hikes since last April.

The last hike of 25 bps to 10.75% on February 26, broke the record of six consecutive 50 basis points hikes that pushed up the benchmark rate to the highest point in over two years. A good number of private economists expect Brazil to finish 2014 with 11.25% in interest rate.

Quite expectedly, the eight straight rate hikes within less than a year cast a shadow on the nation’s growth. Confidence at both firm and consumer levels plunged substantially. Private sector economists reduced the Brazilian growth forecast for this year to 1.67% from 1.79%, according to a central bank survey. Economists also tapered their 2015 growth forecasts for Brazil from 2.1% to 2%.

The government forecasts Brazil’s GDP to grow 2.5% in 2014 and 4% in the next. The government at first projected 4% GDP growth for this year but finally adjusted it downward last week.  

Notably, Brazil’s GDP growth scored a whopping 7.5% in 2010 only to slacken to 2.7% in 2011 and just 1% in 2012. In 2013, Brazil’s economy grew 2.3% despite shrinking 0.5% in Q3 thanks to better-than-expected 4Q growth, but the scenario is likely to fade again this year.

Exports were the savior of Brazilian GDP in Q4 but prolonged under-investment and an imbalance caused by wage increases and lower productivity growth have undermined Brazil’s manufacturing sectors. Thus, analysts feel that inherent weakness in the industrial sector will put a lid on export growth in the coming days even if a more competitive exchange rate remains in place.

Overall, the lackluster growth scenario clearly explains why Brazilian ETFs are on a downhill ride since the start of the year. In fact, ironically, soon after Brazil came up with impressive GDP data for Q4, HSBC cut its 2014 forecast on Brazil’s economic growth from 2.2% to 1.7%, which is even worse than last year.

Inflation Outlook Raised: To add to the woes, a series of rate hikes could not fully contain the inflationary pressure so far.  Its last-recorded inflation rate of5.59% (in January) remains way above 4.5% center of the target range. Private sector analysts raised their 2014 inflation estimates from 5.93% to 6%.

Additional inflation risk might turn up from rising import bills and weakening of its currency, the real. Investors should note that Brazilian real has been among the worst performing emerging market currencies in 2013 thanks to the Fed QE taper concern.

With the Fed poised to scale down its QE program in the course of 2014, the Brazilian real might again underperform in the coming months (read: Is the Worst Over for These Emerging Market ETFs?).

Market Impact

For obvious reasons, this concerning outlook of the nation penalized the relevant ETFs. No fund focused on Brazil could stand to gain year-to-date with the ultra popular ETF, the iShares MSCI Brazil Capped ETF (NYSEARCA:EWZ), shedding 9.65% thus far in 2014 (as of February 26, 2014).

Some other hard hit names in the space include Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF), iShares MSCI Brazil Small Cap Index Fund (NYSEARCA:EWZS), Brazil AlphaDEX Fund (NYSEARCA:FBZ), Global X Brazil Consumer ETF (NYSEARCA:BRAQ) and EGShares Brazil Infrastructure (NYSEARCA:BRXX). Notably, two small-cap funds BRF and EWZS lost 8.44% and 10.19% while FBZ, BRAQ and BRXX dropped 11.05%, 10.17% and 13.27%, respectively.

Are There Any Rays of Hope?

While we are not sure of calling it a ray of hope, some small signs of improvement are cpeeping on the horizon. First of all, Brazil’s currency, the real, plunged 13% last year, bounced back 2% over the last month, representing the third-largest increase among 16 major currencies tracked by Bloomberg (read: Are Brazil ETFs Set to Take Off?).

In January, the inflation rate slowed to 14-month low level of 5.59%, though this might be just a short-term positive blip. Further, mounting pressure on growth resulting from a continued hike in interest rates will likely ease ahead as recessionary fears may hold back the central bank from more aggressive rate hikes.

Of late, the Brazilian government decided to cut 44 billion reais ($18.8 billion) in spending to meet the budget goal this year. The step came in the wake of the government’s efforts to reclaim investors’ confidence after lagging the target in the last two years. This along with some resilience in its currency (observed lately) might finish up the central bank’s prolonged tightening cycle earlier than expected.

Having said that, a lot still needs to be done to find long-term solutions for all the economic issues. Presently we have a ‘Strong Sell’ for EWZ and ‘Sell’ for FBZ, BRAZ and BRF while only EWZS gets a ‘Hold’.

This article is brought to you courtesy of Eric Dutram.

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