EWZ ETF: High Real Interest Rates Positive For Brazilian Stocks
EWZ tracks the performance of MSCI Brazil index and charges expense fee of 0.57%. See why I think the fund is highly likely to outperform over the coming years.
Brazilian real borrowing costs can be very high. This has some investors worried about the effect this might have on stock prices. The EWZ monitors the MSCI Brazil index performance and charges an expense fee (0.57%). The ETF currently holds 50 companies and is heavily weighted towards commodities. Thanks to Vale, an iron ore giant, 22% of the index is in the Materials sector. This sector has a 20% share. Petrobras, a major oil company, contributes an additional 15% to the Oil & Gas sector. It is partly a function real interest rates and commodity export prices. The EWZ has a 12.3% dividend yield and is highly undervalued by high commodity prices. The underlying MSCI Brazil yields 9.8%, so this is likely to decrease slightly in the future. Investors have been concerned over the years that low real borrowing costs for stocks are good for them, while high real yields can be bad for stocks. In a series of articles about the US market, I have demonstrated that there is no evidence supporting this. The situation for emerging markets is more complex. The chart below shows that Brazil's high real borrowing costs, measured in 10-year inflation-linked bonds yields, is highly correlated with equity prices. High real borrowing costs can be a positive factor for equity returns if you look ahead. They not only increase expected returns on equity by depressing values but also support the currency. This is also true for the high real yields in 2016, which led to the recovery. The EWZ's performance over these periods was influenced by the commodity prices. The willingness and ability of the central bank, to raise rates aggressively to maintain inflation anchored, is a key factor in securing international support for the currency as well as revenues and earnings in dollars terms. You could argue that further upside pressure on real borrowing prices could cause EWZ valuations to drop and further weakness in the near term. While this could be true, the equity market is still relatively cheap relative to real bond yields. Low Brazilian equity valuations are closely associated with high real borrowing costs. However, they also correlate with high subsequent returns. Brazil's strong external and fiscal accounts allows real bond yields, which are higher than the currency and debt crisis, to stay elevated. This will allow for a possible recovery in equity valuations. The EWZ is expected to outperform in the next five years with 5-year total returns of around 15%.