The outcome of Brazil’s first-round presidential election sent domestic financial markets soaring on October 5, producing one of the biggest single-day rallies in the country’s history. With the initial excitement fading, investors are now debating whether the extraordinary gains simply reflected a sharp adjustment to an unexpected election result or marked the beginning of a sustained rise in Brazilian asset prices, similar to the cycle that followed the country’s first investment-grade rating.

Sovereign risk indicators suggest investors may already be positioning for a more prolonged period of optimism. Brazil’s five-year credit default swap (CDS) spread plunged 22 basis points after the election, reaching 108 basis points on Tuesday (Oct. 6), its lowest level since February 2020, before the pandemic. CDS contracts are derivatives that provide protection against default and serve as a gauge of the credit risk associated with a country or asset.

Brazil’s CDS spread is now below that of some investment-grade countries, including Colombia, whose five-year spread stands at 164 basis points. Colombia retains its investment-grade rating from Moody’s but has been downgraded to speculative grade by Fitch and S&P Global.

The gap between Brazil and Mexico, which holds investment-grade ratings from all three agencies, has narrowed to just 14 basis points in recent days. A similarly small difference of 15 basis points separates Brazil from investment-grade Indonesia.

Brazilian sovereign risk is also trading below that of countries with comparable credit ratings, including South Africa, whose five-year CDS spread currently stands near 135 basis points.

A possible regime shift

A strategist at a major financial institution, speaking on condition of anonymity, said investors would have to look back to 2008, when Brazil first secured investment-grade status, to find a similarly remarkable simultaneous rally in stocks, bonds and the currency.

“Even that day fell far short, but the comparison is worth more than a good headline,” the strategist joked. “The significance of investment grade was never the rally on that particular day. It was the fact that Brazil’s equilibrium risk premium had changed. Suddenly, Brazil belonged to a different category. Its investor base was expanding, the cost of capital could fall structurally, and asset prices needed to adjust to a new regime.”

The strategist acknowledged that Brazil did not receive a sovereign rating upgrade on Monday. Still, the market may have begun trading as though a conceptually similar shift had taken place.

“If this were merely an election surprise, a move of five to seven standard deviations would be screaming: take profits, trade against the excess and move on. But if Sunday marked the beginning of a regime shift, Monday’s trading session may not have been the end of the trade. It may have been the repricing that started it,” the strategist said.

Markets have given back some of Monday’s gains in subsequent sessions, but several developments continue to support the bullish case. They include a record single-day inflow of foreign capital into Brazilian stocks and one of the largest auctions of fixed-rate government bonds in the National Treasury’s history, held on Thursday (Oct. 8).

Potential inflows

An Itaú BBA sensitivity analysis suggests Brazilian stocks could attract R$270.2 billion if foreign and domestic investors returned to their historical average allocations.

“Of that total, 45% would come from foreign investors and 55% from domestic investors. Foreigners tend to initiate this movement, while domestic investors may increase their exposure as interest rates decline,” the bank said.

The bank’s strategy team estimates that every 1-percentage-point increase in Brazil’s weight in the MSCI Emerging Markets Index could generate R$79.3 billion in inflows. A return to the country’s historical average weighting of 5.6%, compared with 4% currently, would represent R$123 billion.

“Among domestic investors, every 1-percentage-point increase in equity allocations would represent an additional R$113.2 billion. Equity funds currently account for 7.6% of total assets under management in the fund industry,” Itaú BBA said.

Despite Monday’s sharp gains, the bank remains bullish on Brazilian stocks.

Grounds for caution

Not everyone is convinced that Brazilian assets are poised for an extended rally.

In a recent investor letter, Azul Wealth Management examined the gains seen in Latin American markets following transitions to right-wing governments. The firm found that stock returns tend to be lackluster once the initial euphoria subsides.

“Notably, Argentina experienced the biggest break from the previous administration, which helps explain why it has so far enjoyed the longest-lasting rally in hard-currency terms. Yet even with all of [Javier] Milei’s reforms, local markets have already begun delivering mediocre returns in dollars,” said João Henrique da Fonseca, an economist and partner at the asset manager.

“If we assume that Argentina is the country undertaking the deepest reforms and that it started with the most depressed valuations, it is reasonable to presume that there is unlikely to be more hidden value in Brazil, Chile or Colombia than there was in Argentina,” he said.

Fonseca believes that even if Flávio Bolsonaro (Liberal Party, PL) wins the presidency, investors should cautiously unwind their positions in Brazilian stocks unless significant institutional reforms materialize. A reelection victory by President Luiz Inácio Lula da Silva would warrant a faster exit, in his view.

“In both cases, the ultimate destination is the same: increasing positions in companies and markets that are more dynamic and better at creating equity value,” he said, referring primarily to the United States.

The economist also warned that a correction in Brazil’s public finances, which he considers necessary, could narrow the interest-rate differential with the United States and put pressure on the Brazilian currency.

Fiscal adjustment could also delay a recovery in earnings per share among Brazilian companies, particularly those focused on the domestic market.

“Indeed, if there is a change of government, we expect asset prices to rise primarily because of a shift in the valuation multiples of listed companies, rather than an actual increase in average earnings,” Fonseca said.

Fiscal constraints

Canada-based BCA Research, which has maintained a bearish stance on Brazil for an extended period, dropped its negative recommendations following the first-round election result but continues to warn of significant risks.

Strategists Max Malak, Arthur Budaghyan and Matt Gertken argue that Flávio, the eldest son of former President Jair Bolsonaro, would be unable to deliver the fiscal adjustment needed to stabilize Brazil’s debt trajectory.

“The expansion of government spending under Lula has been the main force keeping Brazil out of recession. Fiscal tightening that goes beyond symbolic measures could push the economy into recession,” they said.

The strategists also pointed to the gap between expectations and results during Jair Bolsonaro’s presidency. Investors had anticipated sweeping structural reforms, but relatively few materialized, ultimately leading to disappointment.

“Brazilian financial markets did not perform well under the previous two right-wing governments. Therefore, even if Flávio follows an orthodox neoliberal approach, that does not guarantee strong market performance,” they said.

BCA’s strategists believe Brazil would need an unlikely multiyear commodity boom, particularly in oil, agricultural products and iron ore, to materially improve its fiscal outlook.

Without such a boost, “Brazil’s nominal GDP growth will remain well below the government’s borrowing costs,” they said.

Under those conditions, Malak, Budaghyan and Gertken argue, a modest fiscal adjustment would not be enough to stop the public debt-to-GDP ratio from rising.

*By Gabriel Roca and Victor Rezende — São Paulo

Source: Valor International

https://valorinternational.globo.com/