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Brazil ETFs Crushed by Downgrade, Currency Woes

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Brazil was once the South American star performer, but over the past two years, the economy has been suffering from slower growth and heightened inflation. With these twin attacks, Brazil is currently one of the weakest performing nations among the four BRIC (Brazil, Russia, India and China) countries (read: Three Country ETFs Struggling in 2013).

Inside the Slump: Credit Outlook Downgrade

Part of the reason for this slump is due to an S&P downgrade of the nation’s credit rating outlook to negative from stable. This was largely due to sluggish economic growth prospects and an expansionary fiscal policy, which the rating agency believes are likely to raise the government debt burden.

This move is also a threat to the decade long streak of rating upgrades for the biggest country in Latin America, possibly suggesting that the country may be nearing its peak.

Rate Hikes

Beyond the downgrade, there have also been some interesting developments on the central bank front as the country recently raised rates. This is quite surprising as the nation is one of the only ones to take a hawkish stance as much of the developing world like Europe, Australia, and South Korea, and major emerging countries such as India, Thailand and Turkey are lowering their borrowing cost to boost economic growth (read: 3 Emerging Market ETFs Still Going Strong).

The central bank of Brazil increased the benchmark interest rate by 50 bps to 8% in order to pull back the inflation rate that is stalling economic growth. High inflation remains a matter of huge concern for the nation.

Inflation currently stands at 6.49%, which is very close to the 6.5% ceiling of the nation's inflation-targeting band. However, many fear that a rise in the rate would bring a stage of stagflation in the short term.

Other Concerns

This is not the only worry for the country by any means. The Brazilian real has depreciated by 8.9% against the dollar in the trailing three-month period, further adding to the country’s woes. This marks the biggest drop among 16 major currencies and signals bearish growth prospects for the nation.

In addition to rising rates and inflation, tension has started to mount regarding unemployment and the country’s ability to host the 2014 World Cup. Unemployment in Brazil rose to 5.8% in April from 5.7% in March, indicating pressure in the labor market (read: Brazil ETFs in Trouble?).

The S&P warned that rising inflationary pressure, increasing debt burden and a worsening fiscal situation may compel yet another downgrade in the next two years. The rating agency expects the country’s GDP to grow a modest 2.5% this year after growing 2.7% in 2011 and 0.9% in 2012.

This lackluster growth along with declining private sector investment and deterioration in the government’s credibility could result in higher public debt in the next three years.

Impact on ETFs

The news of the downgrade by the S&P has crushed the Brazil ETFs overall. The ultra-popular MSCI Brazil Index Fund (EWZ - Free Report) , which tracks the MSCI Brazil 25/50 Index, is now down 11.9% in the past month, slumping far more than U.S. markets in the time frame. .

With holdings of 82 securities in total, the product charges 60 bps in fees and expenses. The ETF focuses on the large cap segment that accounts for 84% of EWZ, while mid cap takes the remaining portion. The fund has amassed $6.3 billion in total assets while lost roughly 15% in the year-to-date time frame (read: Is It Time to Buy the Brazil ETF (EWZ - Free Report) ?).

The EG Shares Brazil Infrastructure Index ETF has lost about 10.2% in the last month, pacing its large cap counterpart’s performance. The ETF tracks the Indxx Brazil Infrastructure Index and holds 30 securities in its portfolio. Utilities take the top spot with one-third share closely followed by industrials, telecommunications, basic materials and financials. The fund has $68 million in AUM and charges investors a higher annual fee of 85 bps.

The two popular small cap funds recorded the largest declines, both immediately following the S&P report, and in the past month. The iShares MSCI Brazil Small Cap Index (EWZS - Free Report) was down 2.54% followed by Market Vectors Brazil Small-Cap ETF (BRF - Free Report) which lost 2.38%, while the funds lost double digits in the last one month time period. 

EWZS tracks the MSCI Brazil Small Cap Index, holding 85 stocks while BRF tracks the Market Vectors Brazil Small-Cap Index, holding 74 securities. Both charge a fee of 60 bps a year from investors (see more in the Zacks ETF Center).

The other unleveraged Brazil ETFs – Global X Brazil Consumer ETF (BRAQ), db X-trackers MSCI Brazil Hedged Equity Fund (DBBR), First Trust Brazil AlphaDEX Fund (FBZ) and Global X Brazil Financials ETF (BRAF) were also down 1.68%, 1.92%, 0.73% and 2.02%, respectively, on the day. These have also largely seen the same level of declines over the past month too, suggesting that Brazil is facing some severe weakness and could encounter more trouble in the months ahead as well.

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