After the recent sell-off in Brazilian equities, the iShares MSCI Brazil ETF (NYSEARCA: EWZ) saw its dividend yield rise to 6.8%. At the same time, the return of the underlying MSCI Brazil index increased to 9.7%, which suggests that the EWZ will see its distributions increase further over the next few months, as it has historically. As uncertainty mounts ahead of the October general election, particularly with Brazilian President Jair Bolsonaro looking unlikely to accept defeat, the risk-reward outlook remains very favourable.

The EWZ ETF

EWZ tracks the performance of the MSCI Brazil Index and charges an expense fee of 0.59%. The ETF currently holds 50 companies and is heavily commodity focused. The materials sector makes up 21% of the index, with iron ore giant Vale holding an 18% share. The oil and gas sector accounts for an additional 18% due to oil major Petrobras. Due to the high degree of volatility of the Brazilian currency, the performance of the EWZ has tended to be driven as much by the BRL as by the stock market itself. However, the main underlying driver of both markets is commodity prices, as higher export prices benefit both local incomes and the appetite for local currency in dollar terms. EWZ’s dividend yield is currently an impressive 6.8%, which dwarfs the expense fee of 0.57%. Additionally, distributions are expected to increase over the coming months as ETF payouts track the underlying MSCI Brazil Index, which now has a dividend yield of 9.7%.

Extremely high dividend yield largely reflects undervaluation

The 9.7% dividend yield on the MSCI Brazil is largely the result of the two main stocks in the index – Vale and Petrobras. These two companies account for more than 6 percentage points of the 9.5% dividend yield, with Vale trading at a rolling yield above 17% and Petrobras at almost 24%. While these outsized yields partly reflect high dividend payout ratios that are unlikely to be sustained over the next few years, they also reflect extremely cheap valuations. Petrobras trades with a PE ratio of just 4.1x, while Vale trades at just 3.2x. These are not only cheap in absolute terms, but also less than half of their long-term averages. Although these earnings are highly sensitive to commodity prices, valuations are already pricing in a dramatic drop in earnings and dividends.

Excluding Vale and Petrobras, the dividend yield is around 5%, which is still considerably higher than the emerging market benchmark. The financials sector, which represents 19% of the EWZ, offers a return of 4.8%, 40% more than the MSCI EM index. Utilities are also paying a 4.8% return, 30% higher than the MSCI EM, while consumer staples are paying a 4.1% return, 70% higher than the MSCI EM. In each case, the higher dividend yield reflects lower current and future price-to-earnings ratios on Brazilian equities.

EWZ has yet to catch up with commodity prices

Over the long term, the performance of the EWZ has tended to track Brazil’s terms of trade index – the price of its exports relative to its imports. This reflects not only the performance of Vale and Petrobras, but also the impact of Brazil Real. When commodity prices rise, Real tends to strengthen, lifting the EWZ.

Brazil’s terms of trade improvement has yet to be reflected in the EWZ’s performance, despite exports and the trade balance at or near historic highs.

The recent weakness of Real partly reflects the recent surge we’ve seen in the US Real bond yields, as interest rate expectations have risen much faster than inflation expectations over the past month. However, despite rising US rate expectations, 10-year yields remain 944 basis points higher in Brazil relative to the US, while the trailing inflation rate is only 276 basis points higher. basis points. from Brazil Real yield differential is one of the highest in the world and strongly suggests that the Real should outperform over the long term, to the benefit of the EWZ.

Electoral risks increase

Besides the near-term risks of lower commodity prices and continued dollar strength, the most significant fundamental risk comes from the upcoming general election in October. Leftist former President Luiz Inacio Lula da Silva leads the poll ahead of incumbent President Jair Bolsonaro, who has shown several signs that he may not respect an election defeat. Late last week, the recently re-elected US consul in Rio de Janeiro, Scott Hamilton, published an opinion piece in the newspaper O Globo arguing that Washington should impress on Bolsonaro that any effort to undermine the his country would trigger multilateral sanctions. Hamilton wrote that “the Brazilian president’s intent is clear and dangerous: to undermine public confidence (in the electoral system) and set the stage for the effort to refuse to accept his outcome,” Hamilton wrote.

Having witnessed the devastating impact international sanctions have had on Russian actions, such risks cannot be ruled out, but a refusal to accept Bolsonaro’s victory would be unlikely to result in such a crackdown. US trade with Brazil is more than double that with Russia, and Washington will be reluctant to see Brazil move closer to China. Moreover, even if Bolsonaro refuses to formally accept an electoral defeat, there is no guarantee that the military will support him. Moreover, the strength of Brazilian institutions makes a coup and a return to dictatorship difficult to imagine. Recent Supreme Court decisions and rulings by state governors have contradicted Bolsonaro, and the president also lacks support from key players such as most of the media. Even under a successful military takeover of the country, the Brazilian stock market could still perform well. In the country of Thailand where I currently reside, the stock market has performed relatively well since the Thai generals took power in 2014, and valuations were nowhere near as cheap as they are now in Brazil.

Summary

After its recent correction, the EWZ again looks too cheap to ignore, as the MSCI Brazil index offers a dividend yield of almost 10%. Although this high yield is largely due to Vale and Petrobras, the still high prices of iron ore and oil suggest that it may remain high. Meanwhile, the Brazilian Real remains well supported by the improvement in the country’s terms of trade position and the level Real interest rate. The main risk comes from a contested election, with President Bolsonaro repeatedly saying he would refuse to accept defeat under current voting practices. However, at these valuations, the risk-reward outlook remains strongly positive.