The comeback of Luiz Inácio Lula da Silva in the Brazilian presidential elections has not only surprised the polls. It has also forced the markets to rethink a scenario that they took for granted, and has unleashed a historic collapse. Futures on the Bovespa index point to a 15% drop at the opening, according to the Bloomberg agency, the maximum expected. The Stock Exchange has expanded the market's trading range to 20% (that is, how much the index can rise or, in this case, fall) to accommodate the avalanche of paper. The drop may exceed the record of 14.7% recorded in 2020. You have to go back to the 1998 financial crisis, when the Bovespa plummeted 15.83% following Russia's decision to temporarily suspend payment of part of its debt, to find a drop of comparable magnitude. The currency, the real, also fell, which started the week with a fall of 8% against the dollar, to 5.43 reais per dollar. Interest rates on Brazilian debt are rising as investors demand more returns to compensate for the risk.
The advantage obtained by Flávio Bolsonaro in the first round had led investors to discount a more favorable economic turn for the markets and greater fiscal discipline: on October 5, the Bovespa index closed with a rise of 7.7%. For this reason, the signs prior to this Monday's opening already pointed in the opposite direction. The ETF on Brazilian shares listed in Tokyo plummeted by 15%, a record since 2008, while other financial assets linked to Brazil traded after hours anticipate strong sales on the stock market, debt and currency.
“The markets were broadly positioned for a Bolsonaro victory,” summarizes Eirini Tsekeridou, fixed income analyst at Julius Baer. The magnitude of the adjustment responds, above all, to the doubts generated by the fiscal course of the next mandate. In his opinion, Lula's victory points to an increase in volatility in the short term, in a context marked by uncertainties about the fiscal policy of the next Government. Once the initial impact has been absorbed, the market's attention will shift, according to analysts, to three fundamental issues: Bolsonaro's attitude towards the electoral result, Lula's ability to build majorities in a fragmented Congress dominated by center-right forces and, above all, the signals sent by the new Executive on fiscal matters. The composition of the economic team will be the first test to measure the extent to which the president is willing to combine his social promises with a credible debt containment strategy.
“Beyond the names, investors need a revised fiscal framework that generates sufficient primary surpluses to stabilize debt,” says Viktor Szabó, director of emerging market debt investments at Aberdeen Investments. In his opinion, this effort must be accompanied by measures on mandatory spending and fiscal expenditures, as well as a clear commitment to the independence of the central bank.
Tsekeridou shares a similar idea. The analyst believes that, if the Government demonstrates a clear commitment to debt stabilization and gradual fiscal consolidation, bonds, the Brazilian real and domestic equities could benefit from still high interest rates and valuations that remain attractive.
Risks and opportunities
Although Lula has committed to redirecting public accounts, analysts emphasize that he intends to do so at a more gradual pace than that advocated by Bolsonaro and with the explicit condition that the adjustments do not fall on lower-income households. The main focus of attention for investors will continue to be the evolution of public accounts. As ING analysts recall, the Achilles heel of the Brazilian economy has historically been its fiscal fragility. The country registers a budget deficit of between 7% and 8% of GDP and a public debt that exceeds 80%, figures that limit the next Government's room for maneuver.
“Brazil has little room left for this type of policy,” warns Szabó. The expert recalls that the country supports a deficit close to 10% of GDP and a debt of around 83%, a combination that forces the State to finance itself at costs much higher than those of other large economies despite having more robust fundamentals than those of a good part of the emerging markets. The yield on the ten-year Brazilian bond is around 6.5%, compared to 5% on the American bond for the same term, and is only surpassed in the region by the 12% that investors demand to buy Argentine debt. “It constitutes the very definition of an unsustainable trajectory,” he concludes. Unlike Argentina, which remains immersed in a process of correcting the imbalances accumulated during years of high inflation and recurrent exchange crises, Brazil has a larger and more stable economy, although it has a persistent problem of fiscal discipline.
However, analysts warn that reducing the Brazilian case to its fiscal problems would be a simplification. Szabó recalls that Brazil is an agricultural and energy superpower and is among the world's largest exporters of soybeans, beef, coffee, sugar and cotton. Experts agree that the key to the new mandate will be to regain investor confidence, something that Lula already achieved in his first two terms by combining strong economic growth with primary surpluses. This strategy allowed the country to recover the investment grade of the main credit rating agencies. “If his fourth term begins with debt on a downward path, interest rates could fall substantially, private investment could recover and public money could go to infrastructure and services instead of to creditors,” the Aberdeen analysts maintain. Brazil would then be in a good position to become the most prominent case in Latin America and all emerging markets. The challenge for Lula will be to convince the markets that this scenario is still possible.
