Investors are bracing for heightened volatility across Brazilian financial markets after leftist President Luiz Inácio Lula da Silva secured a surprise victory over right-wing challenger Flávio Bolsonaro in Sunday’s presidential runoff, overturning expectations of a shift towards fiscal austerity and deregulation.
Lula won 51.8% of the vote, securing a fourth term in office and dealing a setback to the conservative movement gaining ground across Latin America.
It was the first time since 1989 that a candidate who finished second in the first round had come from behind to win Brazil’s presidential runoff.
However, Bolsonaro refused to accept the result, alleging foul play and raising concerns about potential unrest following the election.
The iShares MSCI Brazil ETF (EWZ) fell more than 27% in premarket trading on Monday, while the Tokyo-listed Nomura NF Ibovespa Link ETF plunged 15%, reflecting the abrupt reversal in investor expectations.
“Important for local financial markets will be how quickly Bolsonaro accepts the result – or at least allows the constitution to run its course. That is what his father did 44 hours after losing to Lula in 2022, a move that provided some calm to markets,” wrote Chris Turner, global head of markets and regional head of research for UK & CEE at ING Think.
Investors unwind bets on a conservative shift
Brazilian assets had strengthened ahead of the election as investors anticipated a potential victory for Bolsonaro, the son of former president Jair Bolsonaro.
The benchmark Bovespa index closed on Friday almost 7% above its level before the first round of voting, while the Brazilian real had gained nearly 5% against the US dollar.
Interest-rate futures also reflected expectations that tighter public finances under a conservative administration could create room for borrowing costs to decline.
The election result has unsettled those positions, with investors reassessing the prospects for spending restraint and structural reforms under Lula.
"We expect a sharp market reaction on Monday, with aggressive repricing, a selloff in assets and interest rate futures likely to hit their upper limit shortly after the open."
Turner had previously forecast gains in Brazil’s currency and bond markets if Bolsonaro won.
Following Lula’s victory, Turner warned of a sharp reversal in investor positioning.
“Expect Brazilian markets to be hit hard,” Turner wrote ahead of Monday’s trading.
“USD/BRL gapping 5-7% higher at the open to the 5.20/25 area should be no surprise, while the local Bovespa equity index looks set for double-digit losses. The moves could turn out to be larger if the external environment deteriorates again and US Treasury yields spike,” he said.
“The fiscal side has always been Brazil’s Achilles heel, and a 7-8% budget deficit and 70% net debt-to-GDP ratio leave Brazil vulnerable in a global bond sell-off. Instead of fiscal consolidation under Bolsonaro, Brazilian assets are instead going to have to contend with Lula’s campaign pledges, including a shorter working week,” he added.
Public debt and interest costs pose major challenges
Over the next four years, Lula faces the challenge of slowing the growth of Brazil’s public debt while protecting social programmes and investment.
Investors will be watching whether his gradual approach to fiscal adjustment can restore confidence and eventually reduce borrowing costs.
Without a credible plan to stabilise government finances, lenders could demand higher interest rates, increasing the cost of servicing public debt and making credit more expensive for businesses and households.
Viktor Szabó, investment director for emerging market debt at Aberdeen Investments, said the pace and scale of Lula’s proposed fiscal consolidation were a key concern for bond investors.
Lula’s campaign pledged to improve public finances, but at a slower pace than his rival and with the condition that spending cuts should not disproportionately affect lower-income Brazilians.
Government projections show the primary balance improving gradually, reaching a surplus of 1.3% of gross domestic product by 2030.
Lula’s running mate, Geraldo Alckmin, identified campaign funding and excessive public-sector salaries as potential areas for savings.
However, Szabó argued that such measures would not be sufficient to address the scale of Brazil’s fiscal challenges.
“Brazil has little room left for this kind of politics,” he said.
“Gross public debt has climbed to around 83% of GDP, up more than 10 percentage points during this administration, and a deficit close to 10% of GDP is now almost entirely interest.
“Brazil pays one of the highest real interest rates in the world on a debt that keeps growing, which is the definition of an unsustainable path, and the bill falls on companies and households as much as on the Treasury.”
Investors demand a credible fiscal plan
Alejo Czerwonko, chief investment officer for emerging markets at UBS Global Wealth Management, said investors would need clear evidence that Lula’s administration intended to stabilise the country’s debt trajectory.
“Investors want a clear and credible commitment to fiscal discipline,” Czerwonko said.
“We expect the rally that followed the first round to be largely priced out, and sentiment to stay weak until a clear fiscal plan emerges.”
He said investors were looking for an end to campaign-related spending and a believable path towards stabilising public debt.
“It also means a working relationship with an opposition-leaning Congress, because no fiscal plan passes without it,” he said.
Lula’s administration is expected to pursue a gradual approach, building on the existing fiscal framework while attempting to preserve public investment and social spending.
Goldman Sachs analysts expect “modest measures” to contain government spending growth, alongside further increases in an already high tax burden, while major structural reforms remain unlikely.
That prospect could leave investors concerned about whether Brazil can reduce its debt burden quickly enough to ease pressure on interest rates.
The market outlook will also depend on global financial conditions.
A rise in US Treasury yields or a renewed deterioration in risk appetite could amplify pressure on Brazilian assets, particularly given the country’s high debt and borrowing costs.
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