Morgan Stanley upgrades Brazil to overweight, predicts 10% further upside in equities and real

Brazil experienced a sharp rally on Monday, and Morgan Stanley is not betting against the move. Late on Monday, the firm's Latin American equity strategy team raised Brazil to an overweight rating. They described it as the start of the market's "honeymoon stage" with Flavio Bolsonaro, forecasting an additional 10% gain in equities and a 10% rise in the real by year-end as risk premiums narrow.

The MSCI Brazil index surged 12.5% in dollar terms on Monday. The MSCI Emerging Markets index rose 1.6%, Mexico's index added 1.1% and the S&P 500 gained 0.7%.

The core argument focuses on structural factors rather than the election itself. Morgan Stanley contends that Brazilian investors have been crowded out of equities for years by historically high real interest rates. Domestic equity allocations are currently around 5%, just above the all-time low of 4.6%. That compares with an 8.5% historical average and a peak of 15%. If fiscal consolidation brings rates down, the bank sees a multiyear rotation from fixed income into stocks.

The bank's flow estimates:

• Brazil's free-float market capitalization stands at roughly US$500bn
• Potential new demand: US$30-40bn from domestic investors, US$10-20bn from EM funds, and US$30-40bn from global funds
• That translates to up to US$100bn in potential inflows for a US$500bn free float

These flows are substantial for a market trading at about 9.5 times forward earnings. Strong commodity prices provide an additional tailwind for Brazil's resource-heavy economy, which is rapidly expanding oil production.

On a regional level, Brazil's election follows similar shifts in Chile, Argentina, Peru and Colombia away from left-wing populism. Morgan Stanley argues this trend should reduce the region's cost of capital and tighten alignment with the US.

What are the risks? Morgan Stanley lists them. The election still requires a second round. Bolsonaro led the first-round vote 47-44%, but his victory is far from certain, and fiscal consolidation is described as "a must." Brazil has a history of markets pricing fiscal discipline before it materializes. The investment-to-GDP ratio is only 17%, among the lowest in the region, and Morgan Stanley concedes the transition "will likely take years."