For years, global investors have made continued bullish bets on Brazil’s equity market, but in 2021 they are coming to terms with an adverse reality: a second year of negative performance. Measured in U.S. dollars the MSCI Brazil index has fallen 24% year-to-date, underperforming the regional MSCI Latam index and emerging peers, and even with this sizable decline Morgan Stanley considers the market is not offering yet “an attractive risk reward equation.”

Despite that corporate earning growth has been “actually supportive”, analysts Guilherme Paiva,  Juan P. Ayala and Julia M. Leao Nogueira argue in a report that the “poor performance” of the Brazilian equity market this year can be attributed to a multiple de-rating and the Brazilian real depreciation.

“The recent price action reflects investors’ concerns about the sustainability of the current level of profits of Brazilian corporates, especially against an increasingly challenging macro backdrop,” the analysts wrote in a 26-page report to investors dated November 2.

In late September, Morgan Stanley warned that Latin America’s largest economy is facing the adverse scenario of stagflation and lowered its GDP growth forecast for 2021 and 2022. The investment bank lowered its growth estimate for this year to 5.2% vs an original 5.5% expectation and applied an even more drastic reduction for 2022. The bank sees Brazil’s economic growth at 1.2% for next year compared with the initial 2.5% projection.

But locals banks, such Itau Unibanco, are even more pessimistic. Economists at Brazil’s largest bank revised their 2022 economic growth forecast to -0.5% from 0.5%, adding that they expect Brazil’s benchmark interest rate will climb to 11.25% as the central bank attempts to keep a cantankerous inflation in check, Reuters reported Oct. 25. Complicating the economic outlook, Brazil will hold elections in October 2022 with President Jair Bolsonaro aiming to be reelected.

Attractively Valued, But

At the country level, Brazilian equities appear be attractively valued on an absolute price to forward consensus earnings basis, the Morgan Stanley analysts argue in the note. The country currently trades at 8.5x forward earnings, or close to -1.7 standard deviation below its 11-year historical average, of Morgan Stanley valuation models. “However, the current valuation multiple for the country is materially influenced by the historically high profitability of commodity producing sectors such as energy and materials.”

Brazil’s inflation reached in September its highest level since February 2016, rising to an annual rate of 10.25%. And if the index that measures the cost of living in Latin America’s largest economy entered double-digit territory a month ago, many specific items were already there, Associated Press reported October 8. In the 12 months through September, electricity prices jumped 28.8% and cooking gas 34.7%, while chicken surged 28.8% and red meat 24.8%, the news agency posted on its website.

Additionally, Morgan Stanley expects that earnings forecasts for Brazil “will likely go through additional rounds of negative revisions over the next few months, which should make the valuation story less compelling.”

In fact, the consensus of analysts expect a more muted earnings expansion for Brazilian equities over the next couple of years, after a sharp initial rebound this year, from the pandemic lows last year. USD earnings for the overall Brazilian equity market should grow 182% this year, to then contract 8% in 2022, and gain only 4% in 2023, the Morgan Stanley analysts said in the report.

“We believe there is also downside risk to USD earnings growth estimates for domestic oriented stocks amid a more challenging macro outlook for Brazil in 2022-23 because of the ongoing monetary tightening cycle and rising inflationary pressures,” the added in the study.

Brazilian stocks and the real currency took a beating in late October the government moved to raise the nation’s constitutional spending cap, sending four key Treasury officials responsible for the fiscal area to leave their jobs, Reuters reported. And at the mines and energy ministry, oil and gas secretary José Mauro Ferreira quit on the same day Bolsonaro announced a BRL3.6 billion, USD637 million, 12-month package for 750,000 self-employed truck drivers to compensate for the increase in diesel prices, according to BNAmericas.

“We believe Brazilian equities still don’t offer an attractive risk reward equation despite the recent sell-off based on our normalized earnings analysis,” the analyst concluded.

According to Trading Economics, the Brazilian real trades slightly below 5.60 per USD at the beginning of November, close to its highest in near a week, as traders welcomed a more hawkish monetary policy stance from the nation’s central and the BCB minutes showed that a higher than 150 bps rate hike was weighed during the last meeting. Concerns over Brazil’s fiscal credibility and the pace of economic recovery alongside political woes continued to weigh on the currency’s appeal.