Brazilian Presidential Election: The next Event on our Radar

The market is rightfully focused on Argentina, Turkey and Russia at the moment, and so are we. However, there is another key event brewing in the background, and we see the next focus of investors to become Brazil with the October Presidential Election coming up.

 

The biggest question for Brazil this year is who will become the next president. This is not just any election for the country; it is the first one since the impeachment of the last elected president and the first one since Brazil entered a recession. The country is just overcoming a recession and government debt is on the rise (see Figure 1). Given this context, the next president will have an enormous influence on the success, or failure, of the country’s recovery. At Fisch, we are closely monitoring the situation given its importance within emerging markets, especially as Brazil accounts for 6.2% of the J.P. Morgan CEMBI Index, the largest weight of any country other than China.

 

 

 

 

 

 

At this time, we see three front-runners in the election: Geraldo Alckmin, Jair Bolsonaro and Fernando Haddad. Other possible winners include Marina Silva and Ciro Gomes, but although early to tell, we do not see them as real possibilities at the moment.

 

In our view, a victory by Alckmin would be the best case scenario for the market. We see Alckmin, a relatively center candidate, as the most predictable, and at this time, predictability would be exactly what investors need. Alckmin’s experience in Brazilian politics and relationships within the congress would increase the likelihood of key reforms, of which something Brazil is in dire need. Although supported by the markets, Alckmin has some key hurdles to overcome during the election as many Brazilians associate him with Temer and the current government. If he can overcome this association and make it to the run-off stage, we believe Alckmin has a real chance of winning.

 

After Alckmin, we see Bolsonaro as the next best case marketwise. A career military politician, Bolsonaro is positioning himself as the anti-left candidate and the only true opposition (despite having been in the congress for over 20 years). We see him as a positive candidate from an economic perspective, especially in the short-run, due to his intention of placing Paulo Guedes, an economist from the University of Chicago, as his Treasury Minister. However, we are concerned by Bolsonaro’s ability to pass reforms in the congress due to his lack of alliances. We also see Bolsonaro as a wild card, especially in the long-run, given his affinity with the military regime, debatable morals and unpredictable personality. Worth noting that he has a high rejection rate as many Brazilians view him as a questionable character, something that would be particularly concerning in a run-off round. Ultimately, Brazilians will have to weigh whether a change in government and economic improvement will be worth a possible reversion in social policies.

 

Finally, from the three likely outcomes, we see Haddad as the worst one among the three. Given the past track record of the Workers Party (Partido dos Trabalhadores; PT; the party of the impeached Rousseff and jailed Lula), we have some definite concerns over Haddad. Although he has publically supported the need for some reforms, we are concerned over PT’s willingness to pass certain reforms, especially given the short-term impact on its supporter base. Additionally, PT has a history of interfering with quasi-sovereigns and other corporates and using them to implement policies; for example, Rousseff controlled Petrobras’ prices at the pump to help curb rising inflation. Haddad did have a high disapproval rate as the former mayor of Sao Paulo; however, Lula’s supporters could back him providing a boost in a run-off scenario.

With that said, the elephant in the room remains Lula (Haddad is currently discussed as PT’s back-up plan). When included in polls, Lula comes out as a clear favorite. However, we are not currently entertaining a scenario where the former president would be allowed to run by the authorities. If this were to happen, we believe he would have a real chance of winning, something that we would definitely see as negative for the market. We will be following closely the electoral authority’s decision regarding this candidate, an overhang which we are hoping will be cleared still in August or September.

 

 

Regarding companies, the credits that would be most affected by the election outcome are the quasi-sovereigns, in our view. These include Petrobras, Banco do Brasil and Eletrobras, which together account for 2.4% of the EM index (note that 100% owned institutions such as BNDES and Caixa are not eligible for the corporate index). The role that these companies are to play in the next president’s policies will be crucial; for example, whether Petrobras is allowed to continue charging market prices at the pump is a game-changing question. Furthermore, further privatization of Eletrobras or at least less interference can help the company recover after a challenging period. We do not expect the market to respond positively at all to government interference. Ultimately, the biggest risk is a possible nationalization, or manipulation of operations, in addition to corruption, as experienced with the previous government. The candidates that we are most concerned about regarding such possible interference would be Haddad and Gomes.

 

Financial institutions in Brazil would also be affected by the outcome of the election. In addition to general domestic demand, banks would be impacted by possible distortions in interest rates and credit policies. In case a socialist candidate wins, private banks could be harmed by manipulation of interest rates, inflated public banks and liquidity problems, as we have seen in the past. It is worth noting that the private Brazilian banks within our space, such as Itau and Bradesco are among the largest and most established in the country and have experience navigating volatility, but risk re-pricing would likely occur if PT is elected. As a reference, banks account for 1.6% of the EM index (0.9% excluding Banco do Brasil).

 

We also expect private corporates to be affected, but to a smaller extent than the previous two groups. While domestic demand, FX and local regulation do impact corporates across the board, companies in Brazil are used to operating in a volatile economic environment, especially after the last couple of challenging years. Additionally, many companies within our universe are multi-nationals or exporters that depend on global demand. For example, protein companies like JBS, Marfrig and Minerva could benefit on the export side. Additionally, mining companies like Vale and Nexa depend on global commodity markets more than local demand. As none of the three likely candidates are using strong rhetoric regarding intervention in the private sector or pursuing an isolationist policy, we expect corporates in Brazil to survive these elections relatively unscathed after some volatility. This can create opportunities as an investor, as high-quality credits can be relative safe havens in such an uncertain environment.

 

 

Ultimately, Brazil has an important choice to make, and with such a wide range of candidates, the country is at a crossroads. Unfortunately, Brazil struggles to distance itself sufficiently from those political ideologies that have served it poorly in the past. The fact that Lula is even in the discussion, let alone being in the lead, is not only maddening but also incredulous to many. However, as a Brazilian, it can be understandable why a frustrated population experiencing high inequality may choose such a course. Having said that, we view that enough of the population has opened its eyes to the consequences of a long-running PT government, and are hoping that a change in government will take place.

 

 

 

 

The months leading up to the elections will provide plenty of opportunities in the face of what we expect to be heightened volatility. At the end of the day, Brazil remains a natural resource-rich country and an index heavyweight, and as such should be anything but ignored. We are currently market-weight in our portfolios, a positioning we expect to retain until we begin to get better visibility on which path Brazil will chose in the coming elections. The above graph shows that current valuations are appropriate and are pricing in a reasonable election outcome. However, the graph also shows what can happen if things were to go awry again when political risk spikes. Ultimately, we like idiosyncratic risks at Fisch, and these elections will bring exactly that.