Brazil’s equity market runs risk of overheating

The remarkable recovery in Brazil over the second half of last year has begun to raise concerns about the economy overheating and posing a risk to its asset markets, says James Lord, international economist at Capital Economics.

He notes that the real effective exchange rate is almost 50 per cent above its long-run average, the price-earnings ratio of the MSCI Brazil equity index is about 40 per cent above the long-run average and that sovereign credit default swaps are beginning to look pricey.

But Mr Lord believes that a correction is more likely than a collapse.

“While earnings multiples are high, this is not unusual in the early stages of an economic recovery, and in any case the price/earnings ratio is still 20 per cent below the peaks seen in late 2007,” he says. “Likewise, CDS spreads are still some way from the all-time lows seen at the same time.”

He acknowledges that there is a risk of overheating and asset bubbles if commodity prices continue to rise and risk appetite holds up.

“But we expect commodity prices to fall later this year as the recovery in the developed world fades. Coupled with a more general dip in risk appetite, this is likely to lead to a moderation in capital flows into Brazil.

“A plunge in share prices is unlikely, but we see the Bovespa [currently at 69,700] dropping to 65,000 by year-end, compared to an expected peak of 75,000 in the second quarter.”