More Bad News For Brazil ETFs: June Edition

Already in a tenuous technical spot because of a year-to-date tumble of 11.5 percent, the iShares MSCI Brazil Capped Index Fund (EWZ) could be facing more troubling times ahead. Late Thursday, Standard & Poor's lowered its ratings outlook on Brazil, Latin America's largest economy, to negative from stable.

The S&P downgrade comes barely more than a week after Brazil's central did the almost unimaginable in the current environment by raising interest rates by 50 basis points to eight percent. The 50-basis point increase shows the Brazilian central bank's resolve when it comes to fighting inflation.

However, that interest rate increase was not appease to S&P. The ratings agency cited slowing economic growth, weaker fiscal and external fundamentals "and some loss in the credibility of economic policy" among reasons for the lowered outlook. While S&P affirmed its BBB credit rating on Brazil, it warned the negative outlook implies a one-in-three chance Brazil's rising debt burden and fragile macroeconomic outlook could result in a ratings downgrade over the next two years, The Financial Times reported.

In addition to rising rates and inflation, Brazil is also dealing increasing unemployment, a plunging currency and concerns about its ability to host the 2014 World Cup. Those factors explain why EWZ is off 9.3% in just the past month,

What's Next For EWZ?
For the near-term impact that S&P's outlook change can have on Brazil ETFs investors need only to look to India. In April 2012, S&P cut its outlook on India to negative from stable while warning Asia's third-largest economy could lose its already tenuous grasp on the lowest investment-grade credit rating.

Obviously, there can be no guarantees that EWZ and other major Brazil ETFs such a the Market Vectors Brazil Small-Cap ETF (BRF) will follow a similar trajectory. However, over the 60 days following S&P lowering its outlook on India, the WisdomTree India Earnings ETF (EPI) lost almost 12 percent while the Market Vectors India Small-Cap ETF (SCIF) lost more than 15 percent.

On Friday, with U.S. stocks surging on the back of a strong May jobs report, EWZ is off two-thirds of a percent and struggling to stay above the important $50 area. BRF is down one percent.

Bonds
Already under pressure due to fears about the end of quantitative easing, rising yields on U.S. 10-year Treasurys and currency weakness, emerging markets bond ETFs, one of 2012's favorite yield destinations, have suffered this year.

Plenty of those ETFs are heavy on Brazil and that is not a good thing at a time when the yields on Brazilian 10-year sovereign bonds have surged 104 basis points in the past month, according to Bloomberg data. The yield spread between those bonds and the equivalent U.S. Treasurys is about 150 basis points.

With Brazil raising interest rates and now, a ratings agency there is a chance of a sovereign downgrade, select emerging markets bond funds could be in for more downside. The Market Vectors LatAm Aggregate Bond ETF (BONO) has 59 percent allocation to dollar-denominated holdings, but bonds denominated it Brazilian real account for 7.8 percent of the ETF's weight. Brazil is 20.8 percent of BONO's country weight.

BONO has lost almost seven percent in the past month. The iShares Emerging Markets Local Currency Bond Fund (LEMB) is another bond ETF to monitor. That ETF devotes allocates 12.3 percent of its weight real-denominated issues and is off almost eight percent in the past month.

BY The ETF Professor