The Other Issue For The Brazil ETF No One Is Talking About

It has been eventful year for the iShares MSCI Brazil Index (ETF) (NYSE:EWZ). The largest exchange-traded fund tracking equities in Latin America's largest economy has tumbled 35.6 percent and there is a myriad of issues to blame for that startlingly poor performance.

Brazil's Mounting Issues

There is the sweeping corruption probe into Brazil's state-controlled oil giant Petroleo Brasileiro SA Petrobras (ADR) (NYSE:PBR), which is one of EWZ's largest holdings. That probe has ensnared Brazilian President Dilma Rousseff.

Then there is Vale SA (ADR) (NYSE:VALE), another large EWZ holding, trading at levels that auger a reverse split. Add to all that the tumbling real, one of the emerging world's worst performing currencies.

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In September, Standard & Poor's downgraded Brazil's sovereign credit rating to BB+ from BBB-, becoming the first of the major ratings agencies to slap a junk rating on Latin America's largest economy. S&P may not be done downgrading Brazilian debt. All of those factors and more have contributed to one of the deepest recessions in Brazil's history and EWZ's struggles.

Another problem for EWZ is weakness in Brazilian bank stocks, which is particularly problematic when considering the sector's issues against the backdrop of some of the developing world's highest interest rates. EWZ's financial services weight is about 33 percent, or more than 1,200 basis points larger than the ETF's second-largest sector allocation, consumer staples.

Brazil's challenging operating environment and economic recession are driving Fitch Ratings' negative outlook on the country's banking sector. Higher interest rates and inflation, combined with further economic slowdown and rising unemployment will materially pressure asset quality metrics, credit costs and, ultimately, overall earnings.

Local banks will likely further constrain risk appetites in 2016. Together, these factors will increase credit pressure across each of Brazil's bank segments, said Fitch Ratings in a recent note.

Any Silver Lining?

In fairness, it should be noted that EWZ has not taken out its late September low, which was posted following the S&P downgrade. The ETF now resides more than 15 percent above its 52-week low, and for fans of seasonality, December is usually a great time to own EWZ.

EWZ jumped 2.5 percent Wednesday on news that Brazil's congress is moving forward with impeachment proceedings against Rousseff, a catalyst that has been previously highlighted in this space. However, EWZ's performance on the back of this news should remind seasoned Brazil investors of the scenario seen in 2014 when the ETF would surge when the media reported Rousseff was in danger of losing her reelection bid. Obviously, she won, and EWZ has tumbled since then.

Translation: An impeachment attempt is a near-term catalyst for EWZ upside, but if the effort fails and Rousseff remains in power, the ETF and its holdings are likely to tumble.

Related Link: Brazilian Industry Saw Largest Decline Since 2009, But It's Not As Bad As Anticipated

The Non-Performing Loan Issue

Getting back to the banks, there is a non-performing loan problem, too, a common theme in many emerging markets.

Asset quality in the Brazilian banking system remains stronger than its last peak weakness in 2011; however, the deterioration of Brazil's economy, especially during second-half 2015, is driving up nonperforming loans (NPLs) in many portfolios. Lower corporate cash flow generation and cautious retail borrowers will continue the weakening trend in asset quality, added Fitch.

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