On September 22, 2009, credit rating agency Moody’s became the last of the big three rating agencies to grant Brazil the coveted investment-grade status. The assumption among emerging market investment strategists was that since Brazil now hit its trifecta, institutional investors would start trickling money into the country’s stocks and bonds. A year later, however, foreign investment into Brazilian equities has been trickling out, not in.

In 2009, foreign investors accounted for 34% of direct investments into stocks in Brazil’s Bovespa index. It looked like history was repeating itself — in 2005, 32% of the money flowing into Brazilian stocks came from foreign funds and, for the first time, made foreigners the single biggest class of investor in the Bovespa, beating local retail, corporate investors and government pension funds on volume. But this year, foreigners are expected to account for 28% of volume on the exchange, below retail and institutional investors for the first time in five years, according to the BM&FBovespa exchange.

A year after going fully investment grade, the country has been placed on hold. What was supposed to be the continuation of 2009’s bull market — when it rose more than 55% in local currency terms — is turning out to be a cow, with 3% losses year-to-date as of September 8. Despite Brazil’s solid economy, it’s the economies of the U.S. and Europe that will dictate what happens next, analysts predict.

A Bucket of Cold Water

"Brazil makes up about 16% of the US$105 billion we have in emerging market investments," says Corin Frost, San Francisco-based global head of index strategy at asset manager BlackRock. "It’s definitely been on the rise over the last two years since getting the upgrade." The company owns the iShares family of exchange traded funds (ETFs). The MSCI Brazil fund (EWZ), the largest Brazil-only ETF, had nearly US$1 billion dollars flow out of it this year, according to Frost. "The big institutional investors are definitely focused on emerging markets and are still underweight in those markets as a group. When you look at them as a group, Brazil is an overweight for us," he says.

When Moody’s upgraded Brazil’s sovereign debt rating to Baa3, it gave it its lowest investment grade category. The move came 16 months after Fitch upgraded Brazil to BBB- on May 29. A month earlier, on April 30th, 2009, Standard & Poor’s (S&P’s) took Brazil out of its long-time speculative status and qualified its debt as investment grade. Investment-grade status matters for countries just as it does companies because many deep-pocketed investment funds, like U.S. and European pensions, can only invest in assets that are rated investment grade. With the regulatory guidelines met, Brazil’s upgrade meant it gained a new, multi-billion dollar audience for its publicly traded companies. In 2010, however, aversion to stocks by U.S. and European money managers, coupled with slow growth in those economies, has thrown a bucket of cold water on what was once considered one of the hottest, stable growth markets in the world.

It was around six years ago when all main types of institutional investors had discovered Brazil. Sovereign wealth funds, college endowments, non-profit research foundations and some public pensions, like the California Public Employees’ Retirement System (CalPERS), have been increasing their holdings in Brazil equities steadily. Amid the drivers fueling their high expectations: growing personal incomes; demand from Europe and China for Brazil’s raw materials, like sugar, oil and iron ore; and the likelihood of it becoming investment grade. CalPERS says it had a market value of US$981 million in Brazilian equity investments by the second quarter of 2010. That was up from the US$628 million it had in Brazilian equities as of June 30, 2009, and US$1.2 billion a year earlier in June 30, 2008, a few months before the derivatives fiasco claimed its first victim in Bear Stearns.

The decline in 2009 reflects the overall devaluation in the index funds CalPERS owned, which include Brazilian stocks. CalPERS doesn’t directly buy and sell Brazilian shares, which would be unworkable considering the size of its global equity portfolio of more than 9,000 companies. It hires third-party money managers to meet the fund’s investment objectives. All told, it has more than US$3.5 billion in emerging market investments with six external money managers, over US$1 billion less than last year.    

The market has gone sideways for the most part. Funds have not been able to recover from the losses of 2008. Global equity investors have their doubts and that will affect Brazil, regardless of sound economic fundamentals, says Daniel Kelly, director of global marketing at Batterymarch, a quant fund in Boston that has CalPERS as a client.

By mid-December, the CalPERS board of directors is expected to adopt a new asset allocation plan for the next three years. That would determine a target for the US$200 billion CalPERS sets aside for global equity and emerging markets. As of June 30, CalPERS has held steady with its 49.5% allocation to global equities like Brazil, down from a previous target of 56%. Its fund managers have turned to global fixed income, like Brazilian bonds, raising their allocation to 24.5% over their initial target of 20%.

Savvy institutional investors have been globally focused rather than country focused, chasing growth outside mature developed markets. However, "as a practical matter, most institutional investors in the U.S. are looking to allocate even less to equity, or only passively through index funds, including emerging markets," says Kelly. "Brazil will get a share of the bounty when the big institutions truly come back to global equities. No one is considering Brazil these days just because of the upgrade," he says.

A Wild Ride

While the Bovespa index has moved like a wild rollercoaster over the last two years, it has been moving more slowly in 2010. In May of 2008, the index hit over 73,000 points, an historic high for Brazil. It wasn’t because the economy was doing better than expected — 5% GDP growth was still in the forecast. In the meantime, bigger and more popular emerging markets — China and India — were forecasted to grow at 10% or more.

Behind Brazil’s stock market bubble were the speculative funds, which bought in after S&P’s upgrade and quickly cashed out after Fitch’s upgrade. By July 2008, the Bovespa index was holding steady until there was talk of a housing crash in the U.S. followed by the collapse of major investment banks. The Bovespa tumbled below 40,000 points by October. So brutal was the hammering that the local securities and exchange commission shut down electronic trading twice in one day, when the market opened 10% lower and then when it reopened and fell another 10% as fund managers panicked at the thought of an apocalyptic scenario for U.S. and European banks.

In 2009, U.S., European and Chinese government stimulus spending sent Brazilian stocks into a full-blown recovery. Brazil would especially benefit from its commodities exports to China. Then, despite a lackluster market in developed economies, Brazil was home to two of the largest initial public offerings last year. Banco Santander, a subsidiary of the Spanish bank of the same name, raised more than US$8 billion when it listed its shares on the Bovespa for the first time, and Credit card services company VisaNet, now known as Cielo, raised US$4.3 billion. Goldman Sachs, Citigroup and a host of Brazilian brokerage houses expected the bull market to continue into 2010, albeit not as strong as before. News and economic data were all on Brazil’s side. Moodys’ upgrade was the last gift.

"Unfortunately for Brazil bulls, there is no appetite for an increase in global equity," says Olivier Ginguené, chief investment officer of Pictet Asset Management in Geneva. "I don’t see any rebalancing in the big pension funds, and right now we are a little overweight in equities and could conceivably see a reduction. The risk appetite today is for high yield fixed income, like emerging market government debt and corporate bonds. For us, Brazil has been more of an asset class for bonds," he says.

Economy Grows, Market Slows

The stock market is an indication of the shape of future corporate earnings. While the Bovespa peaked at over 70,000 points last year with 5% GDP growth, a higher forecasted GDP growth this year has kept stocks moving sideways. The U.S. and European funds simply aren’t buying, despite the International Monetary Fund’s forecast for 7.1% economic growth in Brazil this year beats out the average 3.7% growth among countries rated BBB- by Fitch and S&P. There could also be a traditional cooling off because of Brazil’s presidential elections in early October. The reigning party is expected to win.

After the election news passes, Brazil’s economy might very well start to look good by comparison to the rest of the world. World GDP is expected to grow 4.5% in 2010, led by China, India, smaller Asian nations and Brazil, according to the IMF’s July Global Outlook report.

"Strong foreign demand for domestic Brazilian debt made up for a choppy equity market so far in 2010," says Alexander Gorra, head of international sales at BNY Mellon ARX in Rio de Janeiro.

For instance, mining company Vale announced sold over $1.7 billion in bonds in early September. On the equity side, oil major Petrobrás plans to raise US$65 billion in a mega-share offering to fund the first tranche of its deep-sea oil drilling program. Most of that will be purchased by the government and local institutions, however. So an avalanche of dollars into Brazil’s stocks, in this case Petrobras, is not expected.

Gorra says that BNY has seen more money flow into Brazil since it went investment grade — perhaps not as a direct result of the upgrade, but of lackluster growth in developed markets, Brazil’s higher than average interest rates that attract investors from low interest rate nations like Japan, and a stable economic and political landscape. Five years ago, foreigners accounted for less than 1% of all investments in locally priced government bonds, compared with around 10% today, Gorra says.  In 2007, BNY didn’t have any foreign institutional investors in its Brazil portfolio. Now, US$1.8 billion of the US$6.8 billion it has in Brazilian assets comes from sovereign wealth funds and university endowments.

"The pension funds are slowly coming around," Gorra says. "You have to go out and talk with the major consulting firms like Mercer and Cambridge so they can in turn convince the Michigan Teachers Association or something similar to allocate a portion of their pension money into Brazil. The big endowment funds that have been here for some time are increasing their holdings steadily," he says.

Nevertheless, the IMF says that downside risks have risen in developed markets. In the near term, the main risk is an escalation of financial stress and contagion prompted by rising concern over sovereign debt. This could lead to higher funding costs, weaker bank balance sheets, a return to tighter lending conditions and volatile currencies that will impact business and consumer confidence. Given trade and financial linkages, the ultimate effect could be substantially lower global demand, the IMF says. Money managers know that economic growth is happening in the emerging market giants like Brazil. But when their mainline domestic portfolio’s shrink, they will follow the mass of funds out of more profitable markets in an attempt to wrap duct tape around them.

The general consensus among global economists is that Brazil has handled the chaos in the developed world exceptionally well. On September 8, a blog from the Financial Times noted that Brazil, Russia, India and China could even account for as much as 41% of the global stock market value in the years ahead after showing their relative buoyancy as U.S. and Europe sank. China could see its share of global equity increase from 1% a decade ago to 11%. The top stock markets could be China, the U.S. and India, while Japan shares fourth place with Brazil. The country’s BM&FBovespa exchange has been preparing for that day, partnering with the Chicago Mercantile Exchange and Argentina’s securities market over the last few years, and opening offices in China.

"We never changed our thoughts on Brazil after the Moody’s upgrade," says Ginguené. "People were a little frightened by the incredible performance of the Bovespa last year. A poor U.S. economy and expensive stocks made Brazil equities less interesting. When the U.S. economy seems headed for a recovery, pension funds will come out of their comfort zone and Brazil will benefit," he predicts.