This week, we saw the clearest proof yet that Brazil’s extraordinarily unpredictable 2018 presidential election is going to be a wild ride for investors.
A poll by the National Transport Confederation (CNT, in Portuguese) put leftist former President Luiz Inácio Lula da Silva in the lead in all possible scenarios – assuming that his legal woes don’t prevent him from being a candidate. In just 10 minutes after the poll was published, Brazil’s stock market index tumbled 250 points, or around a third of a percent. The market later bounced back, and is still up over 25 percent this year, near record highs on optimism that the economy is finally emerging from its worst crisis on record.
Nevertheless, the reaction to recent polls has raised questions about how investors should play Brazilian markets over the next 12 months, following a period in which they have been subjected to one dramatic political event after another.
The “Car Wash” investigations, the impeachment of Dilma Rousseff, the ascension to the presidency of Michel Temer, the subsequent accusations of corruption involving Temer, and the arrests and jailings of a number of top political figures have also introduced volatility to asset prices.
Temer recently survived a vote in Congress that might have brought about his own removal, although his position now appears relatively safe. Investors are now likely to focus their attention on the prospects for pension reform and an ambitious privatization program, which includes the state’s utility giant Eletrobras.
But the election is arguably the most important factor of all.
Concern about a populist turn – whether with Lula, or another candidate – is creeping into many investors’ minds, and Brazil possesses many of the prerequisites for a radical political shift. Recent polling shows that the president’s approval rate is a historically low 3 percent. More austerity is coming, popular disgust over corruption runs high, and most Brazilians have yet to experience any economic recovery.
However, a leftist platform is really one of three apparent paths to victory next year. While the field of potential candidates is vast – more than 10, by some counts – all of them are likely to break down into one of these categories. Here they are, along with thoughts on what various outcomes might mean for financial markets:
1. The Left
This is embodied by Lula, or if he is unable to run due to his legal troubles, a proxy. While Lula is embroiled in a series of scandals related to Car Wash, he still garners strong support from the economically disadvantaged segments of society, which view him favorably thanks to some of the achievements of his eight years in the presidency, such as the Bolsa Familia social program. However, Lula would likely fail to garner the 50 percent needed to win in round 1, and in Brazil’s run-off system, his rejection rate is so high that most observers feel he would be unlikely to prevail in a second round.
Lula’s chances however remain a worry for the markets, even though he presided over a period of relatively strong economic performance during his two terms from 2003-2011. The “paz e amor” version of Lula from his presidency is less likely to be evident should his campaign gain further traction. Since Rousseff’s impeachment and his subsequent legal troubles, Lula’s speeches have been more incendiary and his platform is likely to revolve around traditional leftist principles, including rejection of the pension reform and other policies favored by orthodox economists. The market clearly fears a Lula return to power. If legal troubles prevent Lula from running, the left could potentially coalesce around names such as former São Paulo Mayor Fernando Haddad (of Lula’s PT party) or Ciro Gomes (who at one point led presidential polls in 2002 and is member of the populist PDT).
What it would mean for markets:
With the prospects for structural reforms decreasing under this scenario, look for stocks to fall significantly, the currency to again test 4 versus the dollar, and important widening in credit spreads.
2. Centrist Moderates
In lane 2 are the most centrist moderates, led by São Paulo Governor Geraldo Alckmin and São Paulo Mayor João Doria, both of the PSDB party of former President Fernando Henrique Cardoso. Both are viewed as more market-friendly names who would advance Temer’s current agenda. Currently there are two power struggles within the PSDB: 1) Whether to officially break with the Temer administration due to the scope of the current scandals and 2) Who the party wishes to advance as its leader next year, Alckmin or Doria. Alckmin was Lula’s run-off opponent in 2006, and has been positioning himself to be the party’s name next year. Doria is a new political face in Brazil, and his recent travels through the Northeast suggest he is positioning himself for a run at the Planalto presidential palace. As Alckmin’s protégé, some feel Doria should wait his turn, and the battle within the PSDB will be important to watch.
A recent interview with Doria in Estado de Sao Paulo also implied he might consider leaving the PSDB if his candidacy was blocked. There are other names outside of the PSDB that may also emerge as contenders in lane 2, any of which will have to assemble a coalition of support from other centrist parties and the DEM of House Speaker Rodrigo Maia. Current Finance Minister Henrique Meirelles’ name is often mentioned as a possible candidate. Marina Silva, from the Rede party, has won approximately 20 percent of the vote in the last two presidential elections, and straddles lanes 1 and 2. She is capable of another strong run as well, with her platform favoring an emphasis on environmental issues.
What it would mean for markets:
This is the scenario increasingly priced in by Brazilian markets. Consequently, a rally in asset prices would be less dramatic than the fall in stocks, bonds and the currency, should scenario 1 come to fruition. That said, should one of these names blaze a path toward the presidency, expect continued strong performance, assuming that global markets stay calm.
3. Far-Right Populism
In lane 3 is far-right populist Jair Bolsonaro. He has been surging in polls and actually ran second to Lula in various simulations including this week’s CNT poll. Similar to Lula, however, his rejection rate is extremely high, which limits his chances in a run-off against a more moderate name. Bolsonaro has very extreme views on public security, human rights and other areas, and less developed opinions on economic policies. Fans of a return to a military style of rule in Brazil are attracted to Bolsonaro, who would run as a law-and-order candidate. Indeed, with street crime in certain segments of the country rising, there is a segment of the population that favors a more authoritarian figure leading the country – personified in Bolsonaro. Given his extremist tendencies, and habits of making outrageous comments about a host of social issues, markets also fear his rise in the polls.
What it would mean for markets:
Lanes 1 and 3 could illicit similar market reactions, although much will depend on what kind of economic platform Bolsonaro unveils in coming months. The uncertainty that would ensue from a right-wing populist winning the presidency would be significant, as under democracy, Brazil has never been governed by a leader with such a platform, and prospects for the passage of reforms would likely be low.
Due to how splintered the political system is, the range of outcomes for 2018 is vast. Conventional wisdom suggests that someone from lane 2 will emerge, with backing from the business elites and media – and indeed this is the outcome priced in by markets. Important to monitor is whether lane 2 can unify behind a particular name. Indeed there is a risk that Doria could run under the banner of another party, which would split the vote further in lane 2.
The market’s worst case would be run-off that could pit someone from lane 1 versus a candidate from lane 3. Under this scenario look for a 20 percent depreciation in the real, from current levels, and a significant drop in stocks. On the flip side, should lane 2 consolidate behind one name, with a deep coalition of parties behind it, optimism will surge that Brazil can move forward with a president that backs further structural reforms, creating the conditions for a return to moderate economic growth in the next four years.
Rosen has 20 years of experience in the Latin America financial markets, at both leading investment banks such as Goldman Sachs, and asset managers including Trust Company of the West. He has lived and worked in both Argentina and Brazil.