Behind the Weakness in Brazilian Small Cap ETFs

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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