Brazil Primed for Party

There are no free lunches in investing, but this might be as close as it gets. If a major stock market drops 10% in a day for reasons primarily political, it’s probably a buy.

That certainly proved to be the case three months ago in Brazil, after the country’s iBovespa index tumbled on revelations that President Michel Temer tried to obstruct a wide-ranging corruption probe. On recordings submitted to prosecutors by owners of the country’s largest meatpacking concern as part of their own plea bargain, Temer is heard discussing payoffs to keep a jailed associate quiet.  

The bombshell revelations appeared to bury not only Temer’s political career but his government’s economic reform agenda and for the economy’s chances of shaking off a steep two-year downturn.

Temer remains irredeemably unpopular, with approval ratings in the single digits. But the economy has weathered the political storm without sinking further. It remains on track for marginal growth this year ahead of a stronger recovery expected in 2018.

The economic liberalization push continues as well, despite Temer’s troubles. Brazil’s lawmakers recently overhauled labor law by a wide margin, making it easier to hire and to fire.

Brazil stocks have just about recovered all of their losses from May and June as investors’ worst fears failed to materialize. After all, Brazilian companies have coped with endemic political corruption for years.

The recent corruption conviction of former Socialist president Luiz Inacio Lula da Silva increased the odds that a pro-business candidate will win next year’s presidential election, which could provide a catalyst for stocks as well as the economy.

Endemic corruption has strengthened popular support for deregulating the economy. So too has the cautionary tale of neighboring Venezuela, where socialist rule has degenerated into a brutal and incompetent dictatorship.

In the meantime, Brazil has been helped by the improved economic indicators of key trading partner China, which is showing renewed appetite for Brazilian commodities like iron ore. Inflation has been dropping, allowing Brazil’s central bank to aggressively slash interest rates.

Despite those cuts, Brazil rates remain high. The central bank’s short-term target rate is a hefty 9.25%.

That’s a tempting yield for foreign investors coping with much lower interest rates at home. WisdomTree Brazilian Real Strategy Fund (BZF) is an exchange-traded fund speculating on appreciation of the real, Brazil’s currency. It claims an “embedded income yield” of 7.4% based on Brazil money market rates available to foreign investors.

But even if currency speculation is your thing, note that the BZF is a tiny and illiquid fund that doesn’t actually distribute its earned income. And of course it’s a currency-only play, so  will not benefit from any gains by Brazil equities that are now up 14% year-to-date but with no net gain over the last decade.

The iShares MSCI Brazil Capped ETF (EWZ) provides diversified exposure to the country’s largest companies. It has a trailing distribution yield of 1.8% and the underlying portfolio yields 2.5% annually, currently.    

The sibling iShares MSCI Brazil Small-Cap ETF (EWZS) has a 2.8% trailing distribution yield. Its 63 small-cap holdings are less exposed to the banking sector facing a headwind from the rate cuts, and more leveraged to business and consumer spending due to pick up as the economy emerges from recession.

Of course this is still Brazil, so the stock market remains at the mercy of political bombshells and subject to the whims of foreign investors. But the political and economic backdrop is promising.

In an increasingly dangerous world, buying into Brazil is starting to look less and less like a nutty idea.