Market Views: Equities
Why Brazil’s election is so important
Brazil’s election looks set to be one of the closest in decades. We explain what is at stake and why Brazilian financial markets are so volatile.
Unstructured Learning Time
Brazil goes to the polls on 7 October to elect a new president. In the National Congress, two thirds of the 81 seat Federal Senate and all 513 Chamber of Deputies seats are up for election. Polls for state governors and legislative assemblies will also be held on the same day.
The outcome of these elections will have a major bearing on Brazil’s economic policy framework for the next four years. Consequently, the elections have significant implications for Brazil’s financial markets.
Brazil’s economic recovery remains young, following a deep recession in 2014-16, during which GDP declined a cumulative 10%. Low inflation has enabled the central bank to maintain easy monetary policy to support growth and GDP recovered by +1% in 2017, with a further +1.4% expected in 2018. However, unemployment remains high and the economic outcome of recent years, in combination with a widespread corruption scandal, has discredited the established political class. Many Brazilian voters want change.
How did we get to this point?
Brazil’s current leader, President Michel Temer from the Brazilian Democratic Movement (MDB), came to power in 2016 following the impeachment of second term president Dilma Rousseff of the Workers’ Party. As vice-president under Rousseff, he was elevated to president, as prescribed by the constitution without the need for a general election.
With Brazil experiencing a major recession at the time, Temer initiated a reform programme to return the country to a path of sustainable economic growth. The key reforms included the implementation of a spending cap and labour reform. However, despite some initial success, progress stalled amid allegations of corruption. Austerity is not often popular and although financial markets applauded Temer’s reform efforts, his approval ratings are in single digits and he is not running to retain office.
Who are the main candidates?
Jair Bolsonaro – Social Liberal Party (PSL)
Former army captain and right-wing candidate, Jair Bolsonaro, leads opinion polls, campaigning on a nationalist conservative ticket with a popular emphasis on law and order. He was hospitalised following an attack at a campaign rally in early September. Despite his inability to campaign in recent weeks, his support in opinion polls has continued to rise. A major feature of his success so far has been attributed to his use of social media to push his message out to voters.
Fernando Haddad – Workers’ Party (PT)
The Workers’ Party initially registered former President Luiz Inácio Lula da Silva, or “Lula” as he is widely known, as its candidate. Lula led opinion polls by a wide margin until, as expected, the country’s electoral court ruled him ineligible to run due to his criminal conviction for money laundering (he is currently serving a 12 year prison sentence). Former Sao Paulo mayor, Fernando Haddad, replaced him as the Workers’ Party candidate in September. Supported by Lula’s endorsement, and together with TV and radio airtime, he has gradually built up momentum in the past month and sits in second place in most opinion polls.
Ciro Gomes – Democratic Labour Party (PDT)
Ciro Gomes is an experienced politician on the left of the political spectrum who has held ministerial positions under presidents Lula and Itamar Franco. He ranks third in most opinion polls but has struggled to gain the momentum required to reach a potential second round run-off.
Geraldo Alckmin – Brazilian Social Democracy Party (PSDB)
The highest polling market friendly candidate is Geraldo Alckmin, of the Brazilian Social Democracy Party (PSDB). He is backed by a group of eight other centrist parties, creating a bloc known as the “Big Center”. This provides Alckmin with the largest share of TV and radio airtime of any candidate. However, despite this benefit, he has seen little pick-up in opinion polls through September.
Sustainability Network (REDE) candidate, Marina Silva, had performed well in early opinion polls but her support has waned in recent months. Henrique Meirelles, Minister of the Economy under President Temer and the MDB’s candidate, has low levels of support in surveys, and has not been able to boost his ratings by any meaningful degree.
The chart below reflects the evolution of voting intentions in the past month. Fernando Haddad’s momentum is striking, as is the wide gap to Jair Bolsonaro.
Where do the candidates stand on the crucial issue of pension reform?
From a macroeconomic perspective, Brazil’s key weakness is its large fiscal deficit, which ballooned to over 10% of GDP under former President Rousseff. The Temer administration was able to pass measures that helped to ease this deficit to 7.8% of GDP in 2017. However, the key pension reform, required to put public finances on a long-term sustainable path, has been delayed until after the election.
Consequently, the issue of greatest concern for financial markets is the next president’s commitment and ability to implement the necessary structural reforms, specifically pension reform, in combination with an ongoing commitment to orthodox economic policy. With regards to pension reform, all of the main candidates recognise that action is needed, but the degree and speed at which each is likely to act is diverse.
Jair Bolsonaro has appointed Paulo Guedes, who holds a PhD in economics from University of Chicago, as his economic adviser. In terms of the pension reform, he favours a fully funded system, moving away from the current pay-as-you go model. Meanwhile Bolsonaro’s plans would also involve a broad privatisation programme in order to reduce government debt, in addition to simplification of the country’s tax system. The key issue for Bolsonaro is that his party is comparatively small, with fewer congressional deputies and no senators. This would make it harder to pass legislation without the support of other parties.
Fernando Haddad and the Workers’ Party are not in favour of current proposals for pension reforms and may initially propose a more diluted version, focusing the changes on the public sector pension system. While his tone has recently moderated, in the past Haddad has suggested he would consider repealing the government spending cap along with recent labour reform and legislation which liberalised the exploration of deep water oil reserves. Haddad has indicated that he believes the state should be a driver of growth and he favours cutting interest rates and increasing the supply of credit to boost activity. He would consider seeking a dual mandate for the central bank to target not only inflation but also job creation. In the short-term, he has also raised the prospect of capital controls to help limit the impact of currency fluctuations.
Ciro Gomes has stated support for a fully funded capitalisation scheme with a unified social security system that is controlled by risk ratings agencies. However, he would revoke the spending cap. These changes would be funded by increasing taxes. Like Haddad, he would seek changes to the central bank’s mandate. While he is not against privatisation per se, he would block the sale of strategic companies such as Petrobras.
Geraldo Alckmin’s plans include the most orthodox measures. He has committed to close the fiscal deficit within two years by passing pension reform and through privatisation of some state companies. While the opinion polls reflect little support among voters, one factor in Alckmin’s favour is his party’s support in the Chamber of Deputies. Together with other parties in his coalition, he would have the largest bloc in both houses of congress.
Marina Silva has tabled plans which seek to offer voters an alternative option. Her economic plans are viewed as relatively orthodox and Silva is committed to pension reform, including unification of public and private sector regulations and the introduction of elements of a capitalisation system. In addition, she has stated plans to cap spending at 50% of GDP growth, which is tougher than current legislation and so has led to concern that this policy could drag on growth in the future. Similar to Bolsonaro, however, her party has little representation in congress which would complicate passing the required legislation.
A solution will likely be found, one way or another
The prospect of a single candidate achieving more than 50% of the vote in the first round seems remote. As a result, a second round run-off between the two leading candidates from the first round is likely and would be held on 28 October. With Jair Bolsonaro and Fernando Haddad now the favourites to participate in the second round, this would be a choice between right and left wing candidates offering vastly different outlooks. Simulated second-round opinion polls have seen mixed results meaning uncertainty remains elevated.
Nevertheless, pension reform and ongoing fiscal discipline is deemed to be critical to medium term fiscal sustainability. Consequently, the performance of Brazilian assets is likely to depend on the extent to which the next administration delivers appropriate policy measures. Should the government fail to pursue sufficiently conventional economic policies, it is likely that the bond and currency market reaction would pressure the government to consider a more orthodox policy framework. As a result, we have conviction that fiscal sustainability will be addressed in the medium term, but both the path and timeframe are likely to be dependent on who wins the election and could have material implications for short term market volatility and macroeconomic outcome.
From an investment perspective, we have a cautiously positive view on Brazilian equities. The market is trading at attractive valuations, with a forward price-to-earnings ratio of around 10x, which is a discount to wider emerging markets and to its history, with above average earnings growth. We believe that pension reform is likely to be approved by the new government, regardless of which of the leading candidates wins, although its form and scale will potentially differ. The market may be vulnerable if the new government does not commit to presenting and passing pension reform at the beginning of its administration. We aim to take advantage of market volatility to add to high quality Brazilian companies at discounted valuations if our base case scenario plays out.