By Jamie McGeever
BRASILIA (Reuters) - Having surged ahead of anticipated congressional passage of a pension reform in recent months, Brazilian financial markets find themselves at a crossroad.
Investors now have to figure out how much of the long-awaited leap on the fiscal and economic reform front, which lawmakers resoundingly signaled last week, is factored into the price of Brazilian stocks, bonds and the currency.
All have posted stunning gains since mid-May. But with a historic and major overhaul of the country's bloated social security system all but sealed, do Brazilian assets continue rising, pause for breath, or is this as good as it gets?
The pace of gains and huge shift in investor positioning suggests a pause for breath might be the most likely scenario, particularly in the currency and interest rate markets.
Take the real, which has surged 10% since mid-May to a five-month high around 3.72 per dollar (BRBY).
In early June, hedge funds and other speculators on U.S. futures markets had built up their largest net short position in the currency since December 2014. That bet on the real falling has now been completely unwound, and investors' positioning on the currency is now essentially neutral.
(For a graphic on 'Brazilian real positioning CFTC net' click https://tmsnrt.rs/32ynnX2)
In some ways this is unchartered territory, as funds have held an almost unbroken net short position since March last year. The unwind this month has put July on course for the second biggest reversal of short positions since CFTC real futures contracts were launched eight years ago.
(For a graphic on 'Brazil real positioning - CFTC change' click https://tmsnrt.rs/2O9dKL0)
RATES FAIRLY PRICED?
There has been a similarly rapid change of view in interest rates and fixed income markets. Two months ago rates futures anticipated no change in the central bank's benchmark Selic rate by June 2020. Now, they imply 100 basis points of cuts.
Benchmark 10-year sovereign bonds have jumped around 10% in price since mid-May, driving the yield down almost 200 basis points to 7.20%, the lowest since early 2006.
Paul McNamara, investment director at GAM in London, says he is comfortable owning short-dated Brazilian bonds, but warns against owning longer-dated paper if there is a likelihood of the central bank embarking on an aggressive rate-cutting cycle.
"I'm not saying the central bank won't cut, but there's a danger of over-cutting, and I think they'll regret it if they do. Inflation is low, but looks unlikely to fall further," he said.
Bank of America (NYSE:BAC) Merrill Lynch's latest fund manager survey showed that most investors agree that there is little value to be had in Brazilian dollar-denominated sovereign bonds due to their "somewhat tight valuations."
Inflation is running at a 3.4% annual rate and expected to remain well contained given how tepid economic growth is. The central bank's 2019, 2020 and 2021 targets of 4.25%, 4.0% and 3.75%, respectively, do not look to be under any threat.
But they might be if interest rate cuts are too aggressive and the currency tumbles. Policymakers, businesses and ordinary Brazilians remember that only a few years ago, with the economy in the depths of one of its deepest ever recessions, inflation still topped 10%.
ALL ABOARD
If this gives the central bank pause for thought, the scope to price in further rate cuts may be limited. Barclays (LON:BARC) analysts closed their trade recommendation to buy January 2022 interest rate futures after their target of 6.0% was reached, while their counterparts at Standard Chartered (LON:STAN) say the "substantial" easing cycle discounted this year is "too ambitious."
"We believe positioning is stretched and therefore vulnerable to a sudden unwinding," they wrote in a note on Monday.
The one market that might have room to rally further, even though it jumped 20% in barely two months on its way to a record high of 106,650 points last week, is the Bovespa stock index (BVSP), because foreign investors are not yet on board.
In the last three months the Bovespa has risen 10%. Of the index's 66 constituent companies 39 have risen even more, led by beaten-up names like steelmaker Cia Siderurgicia Nacional (SA:CSNA3) and meatpacker JBS (SA:JBSS3), while 27 have underperformed the index.
This suggests the rally has been fairly broad-based and could be hitting a ceiling soon. But if foreigners pile in, the upside potential suddenly opens up again.
Fund flow data from the Washington-based Institute of International Finance shows that Brazil equity funds posted a cumulative net outflow of $1.3 billion in the second quarter, and a cumulative outflow of $954 million in January-June.
Taking equity and bond flows together, the IIF reckons Brazil is one of the emerging markets foreign investors are least exposed to this decade, meaning there is plenty of room for them to buy.
The latest figures from fund flow analytic firm EPFR show that Brazil equity funds have posted outflows in each of the last seven weeks, culminating in an outflow of almost $1 billion.
($1 = 3.76 reais)