Smaller Brazil ETFs Dinged by Rate Hike

The beleaguered iShares MSCI Brazil Capped Index Fund (NYSE:EWZ), the largest ETF tracking Latin America's largest economy, is trading modestly higher Thursday, a day after Brazil's central bank raised its benchmark interest rate to 7.5 percent from 7.25 percent.

The move comes after Brazil's rate of inflation recently top the target range of 4.5 percent and at a time when Brazilian GDP is only expected to grow by around three percent this year. The rate hike also signals an end to two years of fairly loose monetary policy by Brazil's central bank, policy that did little to boost the fortunes of EWZ. The $7.28 billion ETF is down nearly 29 percent since April 18, 2011.

As has been duly noted, EWZ has its own problems. Specifically, EWZ has been hampered by dour performances by Petrobras (NYSE:PBR) and Vale (NYSE:VALE), the ETF's two largest holdings. Petrobras, Brazil's state-controlled oil company, has been exceptionally mismanaged by the government and Vale has suffered at the hands of investors' apprehension regarding the veracity of China's economic recovery.

For Thursday at least, EWZ is holding up well in the face of the rate hike news. Other ETFs tracking Brazil are not so fortunate.

The $442.5 million Market Vectors Brazil Small-Cap ETF (NYSE:BRF) is down nearly one percent as is the Global X Brazil Consumer ETF (NYSE:BRAQ). Although the volume is paltry, the Global X Brazil Financials ETF (NYSE:BRAF) is off nearly 2.7 percent.

Traders could be trimming positions in BRF and BRAQ on speculation the rate hike could adversely impact the Brazilian consumer. While BRF is not a consumer-specific ETF, the fund does allocate 34 percent of its weight to discretionary names, according to Market Vectors data.

BRAQ, as its name implies, is a consumer-oriented fund, though its focus its tilted heavily toward staples with an almost 47 percent allocation to food and beverage names.

Arguably, the Brazilian consumer is fine shape. Unemployment is near record lows, a factor that buoys the stunning popularity of President Dilma Rousseff, and wages have been rising. Recently, Rousseff's government has moved to lower electricity tariffs and taxes on staples and temporarily reduced duties on car purchases and home appliances, the Financial Times reported.

Still, Brazil's system of taxation is among the most punitive in the developing world and while some tax breaks here and there are nice, foreign investors believe more needs to be done to be alter the country's archaic tax policy. Now, with higher interest rates and expectations for slack economic growth this year, investors and Brazilian consumers, may become increasingly concerned about stagflation.

Those concerns could weigh on BRF, which is already down nine percent year-to-date. To BRAQ's credit, the ETF has held up remarkably well to other Brazil-specific ETFs this year. Even with Thursday's decline, BRAQ is off less than three percent year-to-date.

As for the Global X Brazil Financials ETF, the light volume could be viewed as deceiving, but the reality is Brazil's largest banks are not reacting favorably to the rate hike headlines. Itau Unibanco (NYSE:ITUB) is off 3.2 percent while Banco Bradesco (NYSE:BBD) is down 2.1 percent. Banco Santander Brasil (NYSE:BSBR) is lower by one percent. That trio combines for about 30 percent of BRAF's weight.

Amid the aforementioned slack growth, Brazilian banks are seeing waning demand for consumer loans, perhaps because Brazilian consumers are already heavily indebted. In theory, higher interest rates should help BRAF and its constituents, but some global investors think Brazilian banks need more than rate hikes to rebound.

Weak loan growth lead to a contraction in profits for Brazil's banks last year, the first time in 15 years that happened, but higher rates are also coming at a time when bank profits are more dependent than before on economic activity and demand for loans, Reuters reported.

For its part, EWZ has a 27.3 percent weight to financials, indicating that investors may want to take a cautious approach to equity-based Brazil-specific ETFs amid this rate tightening cycle.

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