Brazil ETF (EWZ) – Trade Idea

Brazil: A Safe Haven from U.S.-China Trade with a Potential Major Near-Term Catalyst According to J.P. Morgan

THESIS

  • As a relatively closed economy, Brazil may stand to be a relative winner despite the outcome of U.S.-China trade dispute. A stable political landscape also sets the stage for near-term pension reforms that could be a major positive catalyst for the country, and Brazilian equities. The investment bank sees upside in EWZ with House approval on pension reform. Equity strategist Emy Shayo believes that approval in the House will occur by mid-July.

  • While some reform delay is possible, the reform approval paves the way for significant market upside. This may then allow the government to move along with its macro policy agenda, which includes: 1) tax reform, 2) intensification of the privatization effort, 3) trade openness, and 4) federalism/de-centralization from the union, among others. J.P. Morgan strategists’ base case Dec-2019 price target for the Ibovespa (IBOV) is 108,000brl (~$46.80 in EWZ) with pension approval. Their bull case, which incorporates improved growth and a continuation of a favorable policy agenda, is 120,000brl (~$52 in EWZ).

  • JPM does not believe the option market is incorporating enough event premium for the upcoming reform vote. Volatility is cheap when considering trade & pension reform. Current 2M ATM implied volatility of ~30% ranks in its 50th %-ile over the last two years, and despite a small kink in the EWZ term structure, the option market appears to be pricing-in little event premium for pension reform.

  • The U.S.-China trade dispute may stand to be a win/win for Brazil. Within a global context, Brazil is well insulated from the U.S.-China trade dispute, allowing it to be an alternative thematic, especially with the Fed easing. While a negative U.S.-China trade outcome is likely to result in lower global growth and a decline in U.S. markets, which could hit Brazilian equities, Brazil may outperform on a relative basis, as a negative outcome should exhibit greater pressure on other more exposed markets. Brazil exports make up less than 15% of GDP, with the bulk of the country’s exports being Ag-related goods (e.g., soybean, beef, chicken etc.) and iron ore (where prices are benefiting from supply shortages), which China consumes. Thus, a negative U.S.-China trade outcome may still benefit Brazil’s Ag economy. Conversely, a favorable U.S.-China trade outcome is likely to benefit most EM economies, and combined with the possibility of favorable pension reform approvals, may pave the way for higher economic growth and lower country risk. In either scenario, we view Brazilian equities as a near-term safe haven set for limited relative downside, but the potential for significant upside.

Chart

Trade Idea

If you are bullishly disposed on Brazilian equities and believe the investment rationale from J.P. Morgan has merit, one might consider purchasing a near the money call option. For example:

SideQtyExpStrikeType
Buy115 Aug44Call

Break-even on Aug expiration:

  • Strike price of $44 plus the cost of the call $1.70. Making $45.70 the break-even point for Aug expiration.

  • Risk is limited to the premium paid for the call option.

  • There’s theoretically unlimited profit potential, if the stock goes to infinity 🙂 

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