While developed markets have remained volatile, emerging markets have comfortably outperformed the MSCI World Index. Moreover, within the emerging markets space, the BRIC markets – that is, Brazil, Russia, India and China – have recorded very strong gains.

However, in the wake of exceptional returns from the BRIC markets, and concerns about a potential bubble in the China ‘A’ share market, a more cautious and selective stance towards BRIC economies is appropriate in our view. Within the BRIC arena, Brazil is our favoured market, while we are cautious on China and India. Our key reasons for this are:

1. Monetary policy should be supportive for equities in Brazil, but not so in China and India

An environment of solid (if unspectacular) economic growth and a generally flat inflation trend in Brazil suggest that current interest rates are excessively high. In real terms, interest rates remain close to ten per cent, a figure way above the level seen in most other emerging markets. Given steady inflation of around four per cent, a stable currency and reassuring measures of solvency and credit worthiness, the markets’ suspicion is that Brazilian interest rates could fall by at least 100 basis points over the next 12 months, with more cuts to come in 2008. By contrast, fears of overheating in China and India are intensifying, and the respective central banks have given successive warnings that further monetary policy action is very likely.

2. Earnings momentum has been quite strong in Brazil over recent quarters

In Brazil, the 12-month earnings per share forecast has increased from 17 per cent in January to 22 per cent at present. There are two factors driving positive earnings sentiment in Brazil. First, commodity prices (to which the market is heavily exposed) have moved higher this year, with solid gains for both energy and base metals prices. Second, domestic demand growth continues to strengthen, and analysts have upgraded their estimates of top-line sales growth in response.

Moreover, the depth of the Brazilian earnings story is reflected by the fact that if commodities are stripped out, profits are expected to advance by around 30 per cent. It is worth noting that there also appears to be an improvement in the quality of earnings on the back of de-leveraging. In contrast, earnings momentum has been pretty flat in both China and India this year, despite the continued strength of their economies.

3. Brazilian equities are attractively valued

Whichever way you look at it, Indian and Chinese equities do not look cheap. On a trailing price-to-earnings basis, the Indian and Chinese markets trade at approximately 20 times, compared with just 13 times for Brazil and Russia. Forward-looking price-to-earnings ratios tell a similar story, as do price-to-book ratios. Indeed, India’s current price-to-book ratio is well above its five- and ten-year averages.

Meanwhile, we believe there is a very real prospect of a re-rating of the Brazilian equity market over the coming years amid a material reduction in the country’s risk premium, which is currently at elevated levels. Historically, there may have been good reasons, both political and economic, for this risk premium.

However, the much improved macro performance and the stability of the current administration make it hard to justify a continuation of the elevated risk premium. Indeed, we believe there is a strong possibility that Brazil’s debt could be re-rated to investment grade over the next couple of years.

4. Rising oil prices are positive for Brazil and Russia

A high oil price will be a positive for Russia and, to a lesser extent, Brazil. Unlike India and China, Brazil is almost self-sufficient in oil and the energy sector accounts for around 23 per cent of the stock market. Over the last five significant oil price rallies since 2005, Brazil has been the top performer on two occasions, with Russia claiming the top spot on the other three. India and China tend to struggle with high oil prices, as both countries are significant importers of oil.

Outlook

Brazil is our favoured equity market over the next 12 months within the BRIC space. Economic growth is accelerating and disinflation means that rate cuts will coincide with stronger top-line growth. Brazil is also cheaply valued and offers good earnings momentum compared with its peers. By contrast, Indian and Chinese equities look expensive and are likely to be hindered by tighter monetary policy. The key risk to our favourable outlook comes from commodity prices – if prices fall, Brazil could struggle due to the importance of the energy and materials sectors. On a fundamental basis, however, Brazil is the most attractive of the BRIC markets.

Henk Potts is equity strategist at Barclays Wealth, a gathering of wealth experts from within the Barclays Group.

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