Little distinction between left and right

IFR IMF/World Bank Report 2022
11 min read
Ben Edwards

Investors factor in overlapping populism ahead of Brazil's election

When Brazilians head to the polls in October, the race is likely to come down to a run-off between incumbent right-wing president Jair Bolsonaro and leftist former president Luiz Inacio Lula da Silva – two candidates that sit at opposites ends of the political spectrum.

In normal circumstances, that political divide would typically cause asset prices to move on any changes in voter intention.

This time round, however, investors are not pricing in any significant difference between the two candidates.

“The election campaign this year will likely have a much lower impact on asset prices than we’ve had in the past,” said Leonardo Porto, Brazil chief economist at Citigroup.

“First, we’ve never had such well-known candidates running for the presidential election in Brazil. That means many votes are more crystallised because people know what to expect. But even if the polls change, the expected value for Bolsonaro and Lula from a market perspective is not significantly different, so asset prices will not change too much.”

Investors say this is because both candidates have overlapping populist tendencies. Bolsonaro, for example, recently cut fuel taxes and increased social handouts in a bid to win over voters.

“Bolsonaro has been a little bit more populist over the past year and Lula’s moderated a little bit,” said Richard Hall, sovereign credit analyst for Brazil at T. Rowe Price. “The common view in the market is that there’s not a huge distinction between then, at least from a macroeconomic policy [perspective].”

Both also understand that financial markets will be unforgiving if either candidate strays too far from an orthodox economic path.

“They know that if they don’t have coherent economic policies, markets will penalise them and it would create a lot of potential stress and undermine their efforts on the policy front, so the election is less binary than people might think,” said Rodolfo Luzio, an emerging market fixed-income analyst at MFS Investment Management.

Lula – who spent almost two years in jail for corruption before his conviction was voided – was commanding an 11-point lead in the polls in mid-September and is widely expected to win in the second round of October’s general election.

“There are a number of reasons why Bolsonaro is trailing in the polls – the mismanagement of the pandemic impacted his popularity, as has the economic situation, especially the high unemployment rate and high inflation that has curbed the purchasing power of the population,” said Mauricio Nakahodo, senior economist at MUFG Brazil.

Part of the reason for Bolsonaro’s declining popularity is because a number of centrists who backed him in 2018 are not planning to vote for him again.

“He’s proven to be so extreme and just alienated a portion of moderate voters who did vote for him last time, which was mostly as a way to vote against the PT (Workers' Party) and the corruption that we saw during the last PT administration,” said Hall. “They kind of held their nose and voted for him but those people are no longer willing to hold their nose. And that’s a hard dynamic to reverse – it’s not about policies, it’s about him.”

Known unknowns

Despite Lula being a clear frontrunner, there remain a number of unknowns about what a third Lula term would look like.

“There’s evidence to indicate that, at least in the early stages of a Lula presidency, he’s likely to be forced to take a more pragmatic route than being an ideologue,” said Christine Phillpotts, an emerging and frontier markets portfolio manager at AllianceBernstein.

Market watchers say the lack of clarity is intentional.

“He has been deliberately vague about his economic proposals – he’s campaigning on the nostalgia ticket, and on the change ticket without really specifying what that change would be,” said Graham Stock, senior emerging market sovereign strategist at BlueBay Asset Management. “So, we do need more detail around his economic policies.”

Local debt investors are giving Lula the benefit of the doubt. Yields on Brazil’s 10-year local currency bonds narrowed by about 50bp in the month to mid-September, trading at around 11.75%.

“If you'd asked me four years ago, I’d have said the local investor base was much more wedded to a Bolsonaro victory because they were worried by what the PT would bring if they returned to power and thought that Bolsonaro had the answer to a lot of Brazil's problems,” said Stock.

“If you ask them now, local investors – like a number of Brazilians generally – are just tired of the confrontational aspects of Bolsonaro’s presidency. There’s a weariness with the culture war aspect, and a bit of nostalgia for the good old days when Brazil appeared to be growing strongly when Lula was president.”

The broader macro backdrop is encouraging investors to ramp up bets on Brazilian stocks. Annual inflation fell to 8.7% in August from 10% in July – its lowest reading in more than a year. Brazil’s benchmark stock index rose by almost a fifth between mid-July and mid-September.

“On the equity side, part of the reason why we are overweight in Brazil is because we see a macroeconomic backdrop that is actually relatively solid,” said Phillpotts. “Inflation has peaked and is showing signs of being on a declining path. Economic growth expectations are starting to be revised upward. So, also part of what’s different about this election cycle is the starting point and the directionality of where the economy is heading.”

Even so, equity investors are still being cautious about election risk by avoiding companies that are too closely tied to the government.

“We look to stocks whose earnings base isn’t necessarily as predicated on policy,” said Phillpotts. “Petrobras, for example, is clearly a company that’s extremely politically entangled. But if you take a local supermarket chain, it’s less so. So, that really helps us tease out the stocks that have greater or less exposure to the political backdrop.”

Spending question

Another unknown is the fate of the government’s spending cap, which was put in place by the Brazilian Congress in 2016 to limit budget expansion and reassure investors about the sustainability of public debt.

“There is a recognition that probably Lula and Bolsonaro are moving in the direction of increasing public spending permanently, which can potentially create a conflict with the survival of the spending cap,” said Porto. “So, that’s the main anxiety – if the spending cap is replaced, what will be the new fiscal anchor?”

That outcome could have diverging implications for financial markets.

“It could be that they tighten the spending cap, while making some items of spending more flexible, and that would be a good outcome,” said Stock. “But if they just scrap it and say there’s no need for these rules, that will be a big step backwards.”

While Brazilian financial markets are relatively calm compared to previous elections, some investors believe that tensions could ratchet up after the first round of voting ends on October 2.

“The issue with the second round is that it is essentially a new election, and we’ve seen that in the past candidates shift their platforms and messaging in a significant way,” said Luzio. “The second round is probably going to be tighter than people think. And that’s probably when we’re going to have more noise – the fireworks are going to come in the second round.”

Investors are also wary about Bolsonaro doubling down on the Trumpian tactics of casting doubt over the legitimacy of the election. Like Donald Trump, Bolsonaro has already claimed that electronic voting machines could be rigged against him.

“If Bolsonaro closes the gap with Lula, it’s more likely that he will moderate and control his more extreme tendencies,” said Hall. “I am more worried about after the first round. If you get a situation in the second round where it looks like Bolsonaro is way behind, does he then start criticising institutions and the election? That would be more of a concern.”

To be sure, if Bolsonaro does try to cling to power if he loses, investors are confident Brazil’s institutions will hold – even if it does deliver a jolt to asset prices.

“There’s no institutional support for Bolsonaro not giving up power, but the concern is more what does he do to try and disrupt the transfer of power to Lula,” said Hall. “For example, does he try calling for a potential trucker strike. That could lead to some volatility. So, while there will be a transfer of power in Brazil, will it be messy enough to create market disruption? That’s the bigger concern the market still has.”

Yet, while the contrast between Lula and Bolsonaro is considered slender for now, in the long term the distinction in economic policy is likely to become more conspicuous. If Lula wins, the pace at which that happens will hinge on who he picks as his finance minister – something that investors will not know until after the election.

“The market is underplaying the microeconomic differences between the two which will play out over a longer time period, but whoever Lula appoints as his finance minister, they will be less market-friendly than Paulo Guedes [Bolsonaro’s finance minister],” said Hall.

“Lula has said look at my past government, but there was a huge difference between his first and second administrations. That’s the unanswered question for financial markets if Lula wins, and we’re not going to know the answer until at least December.”

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