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by Joseph Hogue CFA

Brazilian bank Itaú Unibanco (NYSE:ITUB) got rocked Tuesday after reporting disappointing third quarter results due to declining service fees and a drop in the net interest spread. The shares gave up 3.7% against losses of 2.5% in the broader iShares MSCI Brazil index (NYSEARCA:EWZ) and broader market losses across the globe.

Banking fees fell 4.4% from a year earlier to $2.47 billion as the government pressures the Brazilian bank sector to cut rates and fees to aid consumers. The bank's net interest spread -- the difference between loan rates and deposit rates- has also been under pressure after the central bank lowered the benchmark SELIC rate 5% in ten straight meetings.

Not all was bad news

I have been bearish on the Brazilian bank sector for the better part of this year as the government increased pressure despite surging default rates and lackluster growth. Tuesday's earnings release was not pretty, but there might be a silver lining -- and it may soon be time for investors to return.

Itaú saw a decrease of 0.1% in loan delinquencies to 5.1%, though the rate was higher than last year's 4.7%. Overall economic growth has improved recently, growing 0.4% in the second quarter against the first and on track for 1.5% growth over the year. Economic activity is forecast to pick up to 4% next year and should help to further moderate default rates. A slight increase in inflationary expectations should keep the central bank from lowering rates any more and will probably even start to raise rates in 2013. This will help improve profitability through fees and the spread on products.

The Brazilian bank sector may not be out of the woods yet, but I think you can slowly allocate into the quality names. Itaú trades at 9.6 times trailing earnings and just 1.72 times book. Despite a difficult environment, management is able to earn a return-on-investment of 19.3%. The shares are down 25% over the last year and are relatively cheaper than rivals.

Rival Banco Bradesco (NYSE:BBD) by comparison, is slightly more expensive. The bank trades for 10.8 times trailing earnings and 1.92 times book. Return-on-equity is slightly better at 20.1% and the shares are only down 13% over the last twelve months. Both banks pay a marginal dividend yield around 0.6%, fairly small for Brazilian stocks and well under the 2.74% yield on the iShares index fund.

Recent rebound was the rising tide, not a turn in sentiment

The Brazilian bank sector had started to rebound with the rest of the global markets in July before the recent selloff took everything back down. The recovery was not so much on fundamentals or a better macro environment in Brazil but more or less just a risk-on sentiment. This tells me that once the environment turns for the sector, on top of a pickup in global sentiment, then the shares could really take off.

Source: Brazilian Bank Sector: Hope For The Road Ahead