Banks Defy Woes To Drive Brazil ETF Higher

The iShares MSCI Brazil Index (ETF) EWZ is up nearly 68 percent this year, easily making it one of 2016's best performing single-country exchange-traded funds, emerging markets or otherwise.

Commodities And Politics

Among the catalysts often cited for EWZ's resurgence are rebounding commodities prices and the removal of President Dilma Rousseff from office. Rousseff is nearing impeachment and was replaced in May by interim president Michel Temer. Financial markets have cheered Temer's cabinet appointments, cementing the “anyone but Rousseff” undertone previously surrounding Brazilian equities.

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EWZ is also more than adequately levered to rebounding commodities prices, as energy and materials names combine for 20.7 percent of the ETF's weight. Additionally, EWZ is not a currency hedged ETF, meaning the fund is benefiting as Brazil's real climbs higher, while ranking as one of this year's best-performing currencies.

Surprise Headwinds

Arguably, the biggest surprise when it comes to EWZ is the strength of Brazilian bank stocks amid a myriad of headwinds. Challenges for Brazilian stem from what is becoming a familiar issue from Illinois to Greece: public pensions. Cash-strapped Brazilian states are now delaying doling out benefits to pensioners, potentially crimping banks that previously rushed to lend to this segment of the Brazilian population.

Add to that, banking issues are starting to creep up again. As Benzinga reported late last year, a 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 36 percent, or about double the ETF's second-largest sector allocation, consumer staples.

Operating Environment

“The operating environment for banks has become increasingly difficult since 2014 and challenges are likely to persist, as suggested by the Negative Outlook on the sovereign's 'BB' rating and on several bank ratings. Performance indicators in the sector are down: net returns on average assets reached 0.9 percent in March 2016, against 1.3 percent in 2015; and the sector's impaired loans are rising, albeit slowly, to 3.5 percent of total loans at end-June 2016, against 3.3 percent at end-2015 and 2.7 percent in 2014,” said Fitch Ratings in a recent note.

While the environment for Brazilian banks is not perfect, equity performance tells a different. The U.S.-listed shares of Banco Bradesco SA (ADR) BBD and Itau Unibanco Holding SA (ADR) ITUB are up 109 percent and 73.2 percent, respectively, year-to-date. Those stocks are two of EWZ's top three holdings, combing for nearly 19 percent of the ETF's weight.

“Bradesco's liquidity position is strong, held up by extensive and stable retail deposits and it operates with ample cash. In times of macroeconomic turbulence, Bradesco tends to see an inflow of deposits as it benefits from flight to quality. Its funding sources increased 10 percent in the 12 months ended June 2016. Media reports indicate that changes on the executive board are being considered but in our opinion, the bank's management team is deep. The tax investigations should not disrupt either the bank's day-to-day operations or the implementation of its strategy,” added Fitch.

Full ratings data available on Benzinga Pro.