Luiz Inácio Lula da Silva's unexpected win in Brazil's presidential election on Sunday sent financial markets into a tailspin. On Monday, Brazil's main stock index took a nosedive, dropping 13.9%—its worst single-day fall since the early days of the COVID-19 pandemic. The Brazilian real wasn't spared either, plummeting nearly 8% against the U. S. dollar, marking its steepest fall since 1999. Yields on Brazil's 10-year government bonds also surged, climbing 2.46 percentage points to reach their highest level in over ten years.
The market upheaval wiped out the gains Brazilian assets had made following the first-round election in early October. The candidate seen as more market-friendly due to support for fiscal discipline was initially favored. Now, Lula, who previously governed from 2003 to 2011 and took office again on January 1, 2023, is facing a significant challenge. He must steer policy through a heavily right-wing Congress that stands against many of his initiatives, all while dealing with a skeptical White House.
Brazil's economy, the largest in Latin America, is dealing with slowing growth, high inflation, and elevated interest rates. Lula's campaign pledges are now under the microscope. These include protecting existing benefits, raising the minimum wage above inflation, expanding housing and education support, cutting taxes on essential foods, and reducing the workweek to 40 hours without pay cuts.
A senior analyst at Signum Global Advisors, specializing in Latin America and emerging markets, noted that Lula's ability to fulfill these promises hinges on a central tension. Voters expect real improvements in their finances, interpreting the election result as a demand for increased social spending. However, bond markets are jittery about Brazil's rising debt-to-GDP ratio and may seek higher premiums if public spending grows too much.
In response to these market anxieties, the Brazilian Treasury canceled two planned bond auctions this week, citing concerns over demand and soaring yields. An analyst noted that an inadequately funded fiscal expansion could impede the central bank's ability to cut interest rates, which would offset some of the relief Lula aims to provide. He suggested that Lula might manage this delicate balance by initially reassuring markets, capturing the benefits of monetary easing, and later pursuing greater fiscal flexibility to achieve his long-term goals.
Reassurance could come from measures to increase the 2027 primary surplus, possibly involving a constitutional amendment to expand spending freezes and appointing a finance minister with market savvy, the analyst added. A key issue is whether markets will view any fiscal discipline as temporary and whether Lula might go on a spending spree ahead of the 2030 elections if support for the left wanes.
Elizabeth Johnson, managing director of Brazil research at TS Lombard, said Lula is facing a potential fiscal crisis largely of his own making. She expects that market-calming measures will be rolled out soon. Johnson also noted that Lula would likely rush to approve reforms before the new legislature convenes in February, contingent on his willingness to cut spending.
Johnson's base case is that Lula will push through a modest fiscal reform, helping to stave off a major fiscal crisis in 2027. However, in the short term, Brazilian stocks are likely to suffer. Russ Mould, investment director at AJ Bell, pointed out that the 10-year bond yield is likely to rise first, posing questions later, which could make Brazilian equities less appealing.
Brazil's Ibovespa had been the top-performing major stock market index this year, buoyed by Bolsonaro's expected win and the country's benefit from higher commodity prices. Mould noted that the recent decline might not bode well for broader pan-Latin American indices, which are easily accessible to investors. The MSCI Latin America index hit a 12-year high this year, driven by the political rightward shift that Brazil was expected to join.
