3 Reasons iShares MSCI Brazil Index ETF (EWZ) Shares Could Fall

Brazil may be a popular stomping ground for investors seeking international exposure, but the iShares MSCI Brazil Index faces three big headwinds that could send its share substantially lower.

Aug 29, 2014 at 3:07PM

Source: Diego Torres Silvestre via Flickr.

When it comes to overseas investment opportunities, few countries seem to attract investors as strongly as Brazil.

The Brazilian economy offers investors a nice blend of natural resources that supply businesses with much-needed cash flow, while an ongoing infrastructure build-out around Brazil's major cities continues to fuel Brazil's GDP expansion. It's the seventh-largest economy in the world, yet it has decades of infrastructure improvements to make, which could make it the perfect investment opportunity.

However, for investors who aren't too familiar with the Brazilian economy or don't have the time to filter through annual reports from the nation's top companies, discovering the best way to invest in Brazil may not be easy. This is why so many investors have turned to the iShares MSCI Brazil Index ETF (NYSEMKT:EWZ) throughout the years.

As we examined last week, there are quite a few reasons to believe this ETF could head even higher, including accommodative domestic policy from Brazil's government, the aforementioned blend of growth and stability, and Brazil's abundant natural resources.

Could this fund head lower?

Yet there's another take on this ETF -- one that could see the iShares MSCI Brazil Index ETF head markedly lower. Today, we'll take a closer look at three specific headwinds that could stand in the way of optimists and the prospect of long-term stock gains.

Of course, before we dive into our analysis, I'd be remiss if I didn't remind investors that the stock market is a two-way street, and it's the collective opinions and trades of millions of investors around the globe that send stocks up or down. In other words, just because you're reading a bearish thesis on the iShares MSCI Brazil Index ETF doesn't mean that it will necessarily fall.

I'd also be doing you a disservice if I didn't briefly describe what investors are buying into when they invest in this Brazilian fund. The purpose of the fund is to provide investors with investment exposure solely to Brazil. It covers about 85% of the Brazilian stock market through various mid-cap and large-cap stocks, per iShares' prospectus. As you can see below, of the 74 holdings currently in the fund's portfolio, financial stocks hog the allocation of the nearly $5.3 billion in assets under management, and its expense ratio of 0.61% is actually lower than that of many peers.

Source: iShares. 

Now that you have a better understanding of the fund itself, let's look at why it could be headed lower.

Inflation is a big concern

The primary headwind that has the potential to push the iShares MSCI Brazil Index lower is persistently high levels of inflation.

Inflation is a tricky problem for countries to tackle because they need the prices of goods and services to rise modestly in order to put extra wealth in the hands of businesses. A deflationary environment might be welcomed by shoppers for a short period, but it usually leads to the oversupply of goods and services as businesses try to make up for falling prices and reduced profits. If that happens, companies may have trouble expanding their businesses and hiring.

However, too much inflation can be just as bad. This is the current problem in Brazil, where the annual inflation rate is 6.52% as of June, up from 6.37% in May. Inflation rates in Brazil have remained above 4% for nearly seven straight years because production is not stepping up to meet the demand ofa burgeoning middle class that suddenly has the wealth to buy goods and services.

The easy solution to inflation is to raise lending rates in order to cool lending -- and thereby spending -- and allow supply to catch up with demand. The problem with that is that Brazil already sports a high interest rate of 11%, which is up from just 7.25% about a year and a half ago. If Brazil gets too aggressive with its rate hikes, it could send the economy tumbling into a recession.

Long story short, the Brazilian central bank's response to inflation will signal what Brazil's economy may do next. Given that inflation is remaining stubbornly high despite aggressive recent interest rate hikes, I'd suggest that bank lending capacity and consumer buying power could take a substantial hit sooner rather than later.

Commodity prices remain weak

Another big concern for those investing in Brazil is that the country's ties to its natural resources can also be a hindrance if commodity prices and/or demand don't cooperate.

Brazil's vast reserves of copper, platinum, coal, and iron ore are great when the global economy is firing on all cylinders, but a steep drop in a number of natural resources can mean less cash flow generation and the potential for Brazil's mining industry to drag down GDP growth prospects.

Iron ore operations. Source: Peter Craven via Flickr.

Iron ore prices, for instance, have fallen to about $96 per dry metric ton in July 2014, a level that hasn't been seen since September 2009, during the height of the Great Recession. Similarly, platinum, after bottoming at less than $800/oz. following the recession and rebounding to more than $1,900/oz. in 2011, has once again found itself in a downtrend and is valued at a little over $1,400/oz. 

Though traders have certainly played their part in pushing commodity prices lower, China, the world's largest buyer of a number of natural resources, has been demanding less as it grapples with its own slowing growth. With one of Brazil's largest buyers suddenly not buying as much, and many commodity prices stymied, it would appear that many of Brazil's natural resource industries are adrift.

A possible housing bubble

Lastly, investors should keep a close eye on Brazil's housing market, which has seen a rapid appreciation in prices over the past six years. According to the FIPE-ZAP Index, which measures home property values, Rio de Janeiro and Sao Paolo have seen home prices skyrocket by more than 250% and 200%, respectively, since 2008.

View of Sao Paolo, Brazil. Source: Rodrigo Soldon via Flickr.

On one hand, this move makes some sense. We've seen a corresponding increase in Brazil's inflation over this time as its middle class's wealth has grown. In other words, it would imply that at least some of this increase is due to an imbalance in demand. There aren't enough homes on the market to meet citizens' demand to buy them, so prices are going up in response.

However, we in the United States are also uniquely familiar with the idea of not relying on real estate as an investment because we recall what happened when the U.S. housing bubble burst. It's quite possible that rising lending rates could stymie future housing-sector growth prospects in major cities like Rio de Janeiro and Sao Paolo. If that were to happen, and mortgage loans and real estate investments dried up, Brazil's economy would certainly take a hit.

Tying things together

Brazil is a large and diverse economy that has, for years, offered investors above-average growth potential due to its abundant natural resources and its free-spending government. However, macroeconomic factors like inflation, commodity weakness, and the potential for a housing bubble all loom over the iShares MSCI Brazil ETF as possible reasons why it could head sharply lower. Regardless of where you stand as an investor with regard to this ETF, you need to closely examine both sides of the coin before making your decision to invest in this Brazil-focused ETF.

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