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Persistent slowdown in China is weighing on global growth. But Brazil is also playing its role in damaging the broader economy, with its fundamentals getting from bad to worse. A sharp downturn and a deplorable political situation compelled Standard & Poor’s to cut the country’s credit rating from investment grade to a junk status with a negative outlook yesterday. The agency also warned of further downgrade if conditions do not improve.

Brazil is the second of the largest emerging countries that was stripped out of investment grade rating this year after Russia in January. The country had enjoyed the investment grade credit rating for the last seven years. The move is the latest setback to the efforts of president Dilma Rousseff to regain investors’ confidence and pull Latin America’s largest economy out of recession.

Reasons for the Downgrade

Numerous efforts taken by Rousseff, including spending cuts and tax increase, failed to arrest inflation and spur growth in the world's seventh largest economy. The country is still suffering from slower growth, lower consumption, weak investments, fiscal imbalances, stubborn inflation, high interest rates, labor unrest, a vast corruption scandal and prolonged political crisis (read: Rousseff Promises Big Changes: Is This Good for Brazil ETFs?).   

The Brazilian economy fell into recession in the second quarter, having contracted by 1.9% following a 0.7% decline in the first quarter. This marks the worst slowdown for Brazil in nearly three decades. Investment plunged for the eight straight quarters while household consumption saw the biggest drop since 2001. Unemployment has been rising sharply and reached a five-year high of 7.5% in July from 6.9% in June. Meanwhile, inflation climbed to a 12-year high of 9.56% year over year in July and more than doubled the central bank’s target of 4.5%.

Adding to the gloom is the government’s 2016 budget proposal, which forecast a deficit of 30.5 billion reais ($8.4 billion), representing about 0.5% of gross domestic product. This is well below the 2% surplus projected at the beginning of this year and a revised 0.7% surplus in July. In fact, this is the first time that the budget proposal has been made to account for a deficit. Additionally, the country’s debt climbed to 65% of GDP from 51% at the end of 2011.  

Market Impact

Though the downgrade did not come as a surprise, it came sooner than expected and dealt a huge blow to the Brazilian stocks and ETFs. In particular, iShares MSCI Brazil Small-Cap ETF (EWZS), Market Vectors Brazil Small-Cap ETF (BRF) and Global X Brazil Financials ETF (BRAF) stole the show, plunging 3.4%, 3.0% and 2.6%, respectively, on the day. The trio has a Zacks ETF Rank of 5 or ‘Strong Sell’ rating with a High risk outlook (see: all Latin American ETFs here).

Both EWZS and BRF target the small cap segment of the Brazilian equity market and trade in a moderate volume. EWZS has AUM of $26.1 million and expense ratio of 0.62% while BRF has a relatively higher AUM of $67.4 million and charges a fee which is lower by 2 bps. Coming to BRAF, this ETF offers exposure to the financial segment of the Brazilian stock market, charging investors 77 bps in annual fees. The fund is unpopular and illiquid with AUM of just $0.8 million and average daily volume of about 5,000 shares.

Apart from this, the Brazilian real also dropped nearly 3% to a 13-year low against the dollar though it recovered half of the losses at the close on Thursday. With this, the currency is down 31% against the greenback this year. Notably, WisdomTree Brazilian Real Strategy Fund (BZF) lost 1.2% on the day. This fund seeks to achieve total returns reflective of both money market rates in Brazil available to foreign investors and changes in value of the Brazilian real relative to the U.S. dollar.

Both AUM and average daily volume are paltry at $15.3 million and 15,000 shares, respectively. The product charges 45 bps in annual fees and has a Zacks ETF Rank of 4 or ‘Sell’ rating with a High risk outlook (read: Commodity Currency ETFs in Trouble as Dollar Resumes Rally).

Gloomy Outlook

The outlook for Brazil is bleak given the toxic mix of slow growth and a prolonged political gridlock that is thwarting the efforts of the Dilma Rousseff to shore up the economy. Higher interest rates (currently 14.25%) will continue to weigh on consumer spending and investments. This indicates that the economy will be on the downward trajectory in the coming months.

The central bank recently lowered the Brazilian economic growth forecast and raised the inflation outlook for this year. It expects the economy to contact 1.1%, more than the previous expectation of a 0.5% decline while inflation is expected to come in 9% instead of the previous expectation of 7.9%.

Further, Moody's Investors Service cut the country’s credit rating to the near junk status last month with a stable outlook while Fitch Ratings rates Brazil at BBB, two notches above investment grade, with a negative outlook.

What Should Investors Do?

Given the current turmoil, Brazilian stocks will likely see rough trading ahead and investors could easily tap this opportune moment by going short on them. There is currently only one way to play this trend with ProShares UltraShort MSCI Brazil Capped ETF (BZQ). The fund seeks to deliver twice (2x or 200%) the inverse return of the daily performance of the MSCI Brazil 25/50 Index. It has $30.1 million in AUM and average trading volume of nearly 30,000 shares per day. The product has gained 84.7% in the year-to-date timeframe (read: Gain From Market Correction via Inverse ETFs).
 
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ISHARS-MS BR SC (EWZS): ETF Research Reports
 
MKT VEC-BRZL SC (BRF): ETF Research Reports
 
GLBL-X BRZL FIN (BRAF): ETF Research Reports
 
WISDMTR-BRZ RL (BZF): ETF Research Reports
 
PRO-ULS MSCI BR (BZQ): ETF Research Reports
 
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