Morgan Stanley Downgrades Brazil Stocks as Fiscal Risks Loom

(Bloomberg) — Morgan Stanley downgraded Brazilian stocks to underweight, warning that the country’s burgeoning fiscal deficit may overwhelm central bank attempts to control inflation, forcing interest rates higher. 

Concerns about the government’s commitment to control spending are making investors more skeptical about the investment outlook in Brazil even as valuations remain cheap, strategists Nikolaj Lippmann, Juan Ayala and Julia Nogueira wrote in a note.

“Funding the government is sucking the oxygen out of the room for local markets,” they said, adding that high interest rates are luring investors to park their money into fixed income instruments. “Local equity cannot compete with that.”

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Analysts have been lifting interest rate and inflation forecasts for Brazil as the central bank warns of more prolonged tightening cycle if consumer price expectations worsen further. Policymakers, which began lifting borrowing costs just as the Federal Reserve cut, have advocated for “structural changes” in fiscal policy to lower inflation forecasts. 

It’s not just Brazil that is worrying investors. The outlook for stocks remains gloomy across Latin America as the region struggles with populism and fiscal discipline, Morgan Stanley said. The bank remains underweight Mexico, citing the risk of populism.

“Politics got in the way of LatAm’s moment and multiple hurdles need to be cleared for the region to redevelop a clear investment narrative,” they wrote. “Cheap valuations are not enough.”

The strategists recommended digitalization, energy and agriculture stocks in Brazil, while avoiding cyclical domestics given the risks to earnings should fiscal stimulus be withdrawn amid a tight monetary policy. 

A more bullish view depends on fiscal austerity in Brazil and policy alignment with the US in Mexico, they said. But it’s still too early to become optimistic as “things could get worse before they get better.”

Across the region, Morgan Stanley is overweight in Argentina, Chile and Colombia on a higher probability of policy improvement. 

“The Andean markets are relatively small and not deep, but they offer good value and low correlation” with the rest of the world, they added. 

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