The day after tomorrow (election) - Update on Brazil (Late Oct 26)

It was amazing to watch how the market sold off Brazil after the unexpected result.

The index dropped 20%. Some stocks dropped as much as 30-50% overnight.

Why ? After the first round of election, many investors were expecting Bolsonaro to win. They were surprised by the election result and dumped their positions aggressively.

Lula is not trusted by investors. Under the current govt, not much efforts were made to control spending. Debt/GDP increased from 70% to 80% or so.

To support the currency and keep inflation in check, Central Bank hiked rate aggressively in recent years. Real interest rate in Brazil is probably the highest in the world @ 9%.

Given the lack of confidence in Lula, BRL and bonds were sold off as well. The belief is debt/GDP will grow and grow under Lula in the next few years. A debt crisis is more or less guaranteed.

What to make of all that ?

1.      Looking at the comments on Twitter, sentiment is very negative.

2.      While the market is looking for signal that the govt will be responsible (i.e. tracking who is going to be the finance minister closely), at the end of the day, Lula is the boss. Lula has demonstrated time and time again he doesn’t believe in fiscal austerity.

3.      The economy is in a strange spot. Overall, good enough. Unemployment is only a little over 5%. It has been trending down from as much as 9% a few years ago. Yet, household debt level (debt service to income ratio) is very high (almost 30%). External trade balance remains healthy (think about rising commodity prices).

4.      Not at all surprising considering interest rate has been around mid teens for quite some time despite inflation running at 4-5%.

5.      The situation sounds dire but also need to look at the details. Structural primary deficit is only around 1.5% in 2026… BUT throw in interest payment @ 14%, budget deficit balloons to much higher level (8% in 2025). On the other hand, as much as 90% of govt costs are “fixed” or indexed to inflation so hard to find easy savings.

6.      Lula will also struggle to ram through his agenda as he has lost control of the congress and the senate. Maybe the opposition will be able to “compel” more fiscally responsible policies from Lula.

7.      It is likely the the Central Bank will slow down its rate cut considering the BRL weakened after the election result.

This is my base case:

1.      Domestic economy will slow. Maybe even recession next year.

2.      Sentiment is negative enough so potential upside if Lula uncharacteristically decides to work on the fiscal situation.

3.      Debt crisis will still take time to “cook”. An important point is, despite high debt to GDP of 80% (by its standard but still quite low if we compare with say France or USA), per ChatGPT, over 90% of its debts are local currency denominated. Put it another way, the govt will not default on its bonds, it can just print when the time comes…. In that sense, domestic equities may do OK once the printing press gets going.

4.      FX is where the problem will show up. BUT my hypothesis is the currency will be a bit better supported in time. The secular trend is USD will weaken. Commodity prices will hold up/if not rise.

5.      Valuation is attractive. Sentiment is negative and fund flows have left Brazil following the election. Interest rate is crazily high so room to cut once things stabilise (see Pic 2).

6.      Net, too late to sell. I am inclined to hold onto my various positions in Brazil.

PS… Personal opinion. Not investment advice.