What Lula’s election means for Brazilian assets
The relatively positive market reaction in the first days after his election indicates that a Lula presidency does not scare financial markets. Lula’s economic record during his two previous stints as president may explain why they are willing to give him the benefit of the doubt for now. It helps that Lula inherits an economy with relatively sound fundamentals. Despite the looming threat of a global recession, the Brazilian economy was still growing at an annual rate of 3.2% in Q2.
But leading indicators are pointing south and the Brazilian economy’s Achilles heel remains the chronic current-account deficit, which increased to -2.2% of GDP in the first nine months of 2022 from -1.7% in 2021). Brazil’s continued trade surplus is unlikely to fully compensate for the expected deterioration in income resulting from higher interest rates.
Although foreign investors have been reluctant to pile into Brazilian bonds this year, the end of the electoral cycle, elevated real yields (over 5% on government bonds after inflation), and a likely end to monetary tightening could prove strong tailwinds for foreign and local investors alike. Nevertheless, the new government will first have to prove that it is serious about ensuring Brazil’s large public debt remains sustainable over the long term. Given its limited fiscal room, the Lula administration’s first moves will be closely watched, with any deviation from orthodox policies likely to be sanctioned by capital outflows.
For the second time in a row, Brazil’s central bank kept its policy rate unchanged in October, leading to speculation that the rate-hiking cycle is over and that we could see rate cuts next year. We suspect that a fiscally responsible new government coupled with a halt in the US Federal Reserve’s hiking cycle in 2023 could even open the door for more rate cuts than are currently being priced in. But this largely depends on inflation continuing its downward trajectory and the real not depreciating significantly against the US dollar.
Brazilian stock indexes have outperformed emerging (EM) and developed (DM) equity market benchmarks by a wide margin this year, with the bulk of this performance coming from steadily rising earnings on the back of high commodity prices and financials benefiting from high local interest rates. Bu with Brazilian equities’ earnings yield comparable to the policy rate and only slightly higher than the 10-year sovereign local-currency yield, and with the BCB turning more dovish, we see local investors continuing to favour fixed income over equities.
Foreign investors’ appetite for Brazilian equities will likely be driven in part by the make-up of the new administration and its policy direction (of which we know little so far). But equally important could be the impact that a potential recession in the US and Europe has on risk appetite generally. All this explains our slightly cautious view on the Brazilian equity market at this juncture and we see limited further near-term upside. Apart from the new government’s policies, the timeline for an end to China’s zero-covid policies will be key to watch, especially when it comes to commodity prices.
The Brazilian real has outperformed all major currencies this year so far. But we also see limited upside for the Brazilian real as key factors such as the central bank’s monetary policy stance, commodity prices and the fiscal outlook may turn less supportive going forward. Externally, the strong signal sent by the Fed at its October monetary meeting that it will keep raising rates and that the terminal fed funds rate could be “higher than expected” should keep the US dollar strong. Overall, the real may find it hard to rise much further in the next few months from current levels (BRL5.10 on 3 November).