Can the next Brazilian president satisfy investors?

Lizzy Galbraith
Hello and welcome to the Macro Bytes podcast, the economics and politics podcast from Aberdeen Investments. My name is Lizzy Galbraith and this week I am joined by Tettey Addy, our emerging markets economic analyst within the Global Macro Research team. Welcome, Tettey.
 

Tettey Addy
Happy to be here. Thanks.
 

Lizzy Galbraith
So today we are going to discuss the Brazilian elections as well as their likely outcome and what the results could mean for Brazilian policy and assets prices. We're recording this episode on the 19th of October, so this is ahead of the presidential runoff which is scheduled for the 25th. That will see Flavio Bolsonaro go head-to-head against the incumbent president Lula. So Tettey, kick us off with an overview of these two candidates. It's a slightly unusual race in a lot of ways, in that the names are fairly familiar to any observers of Brazilian politics that we've had over the past few years or so. Although it's Flavio's first time running, he's from a fairly well-known Brazilian political dynasty, and Lula has been a presence in Brazilian politics now for quite a number of years. So give us a bit of an introduction to these candidates and the types of political philosophies that they are representing with their campaigns.
 

Tettey Addy
Sure. So for how we got here, it's worth going back to the 2022 election where Lula faced off and won against the previous president, Jair Bolsonaro. Now that saw Lula start his third term in office. He'd previously been president for two terms between 2003 and 2010. That was a time when Brazil was benefiting from a very strong backdrop of global commodity prices that helped Lula implement several major social spending programmes across Brazil. Now the 2022 election was also a comeback for Lula after we had this sweeping corruption and bribery investigation that led to several high-profile arrests, which included his own prison sentence from 2018 to 2019. Now after Lula's win in 2022, Jair Bolsonaro was banned from running for office for several years and put under house arrest based on charges of seeking to discredit the previous election and alleged involvement in a plotted coup. Now late last year, Jair Bolsonaro chose his son and Senator Flavio Bolsonaro to lead his right-wing movement in his place against Lula. Now at times, Flavio has tried to appear more moderate than his father, who was known for some very controversial rhetoric, while also at other times he has looked to more strongly emphasise their family ties. So even though we don't have the exact same candidates as in 2022, both the Lula and Bolsonaro brands, they entered the race with a lot of baggage in Brazil. The electorate also remain very highly polarised. Both candidates have very high rejection rates, meaning that they're basically competing over a very narrow portion of swing voters in Brazil, which has contributed to polling having been very tight at various points in the election season.
 

Lizzy Galbraith
So to take this a bit further forward then, as you said, polling has had both candidates within fairly narrow margins of one another, but in the first round of the elections, because Brazil, for those who aren't aware, does operate a two round presidential election system, Bolsonaro did end up slightly ahead of Lula, slightly surprised results relative to where polls were prior to that. So how did markets take that initial first round results and what do we then take from that in terms of our expectations for the runoff?
 

Tettey Addy
So yeah, the result was definitely an outperformance for Bolsonaro, with most polls having expected a slight Lula lead for round one, with the two of them being kind of neck and neck in various polls for the runoff. Now in terms of market sentiment, Bolsonaro is the investor favourite. For context, Lula's current term is ending with a fiscal deficit around 9.5% of GDP, while government debt is set to reach 97% according to the IMF. Now markets do see a shift to a Bolsonaro presidency as having better prospects for fiscal reform and yield compression, which they also hope could see more easing by the Brazilian central bank in the short to medium term. So the first-round surprise has seen rallies for the Brazilian Real, bonds and equities all alike. Now as for the runoff, we currently put odds of around 75% on Bolsonaro winning the presidency. Now votes for other right-leaning candidates that trailed behind the two frontrunners, most of that vote should be consolidated by Flavio in the second round to put him over the 50% mark to win. The polls are still very close and Lula comeback, that can't be ruled out, but it would be a shock in Brazil because since the country returned to presidential elections in 1989, there's not been a case where a runner up in the first round also went on to win with a comeback later on. Now if Bolsonaro does win, then we would expect the asset rally to have a bit further to go, whereas with Lula making a comeback, you would expect to see quite a reversal.
 

Lizzy Galbraith
I think it is fair to say there has been a lot of optimism from investors since we had that first round result about what potential policy changes we could see if we do get a different government following the second round. But I also think it is interesting that in the international context, this election is increasingly looking like it is part of a pattern that we've seen over the past couple of years now where incumbent governments are really struggling to retain their vote share and also retain power in elections. It's very rare now that you're seeing in any election, whether that is in an emerging market or a developed economy, you actually see the same candidate and the same party retain power going from election to election. And there are lots of reasons that could be behind this. Some of it could be cost of living pressures, some of it could be changing voter perceptions around issues like security, more fragmented political environments, possible that increased social media use is also accelerating the pace of political change and making people more willing to shop around between different parties, whereas previously we would have expected people to on average be more loyal to a particular ideology or political coalition between elections. So Brazil is certainly not alone in seeing incumbent leaders struggle and in potentially looking at a change election. But we've certainly got a few more twists and turns, I think, because of this two-phase system that Brazil operates, which is a similar type of structure to France. And I'm sure there will be future Macro Bytes episodes where we cover off that particular election in greater detail going into next year. But to keep us on track with Brazil for now, as you said, the public finances in Brazil are really where a lot of the investor scrutiny has been and where a lot of the optimism for some sort of turnaround or at least a change in trajectory under a potential Bolsonaro government is really coming from. But that's the investor perspective. So what are the issues that are mostly concerning voters themselves? Is it that fiscal trajectory or are there other issues where Lula is struggling to be able to sell his record to the electorate and that's driving what we think is going to happen on the 25th?
 

Tettey Addy
Sure. I mean, long story short, it's all connected. The economic backdrop was a very mixed bag for Lula heading into election season in Brazil. Now on one hand, you've seen in recent quarters very strong jobs growth, which is helping to keep Brazil's unemployment rates near historic lows. We've also seen quite strong nominal wage growth outpacing inflation for a while now. So real purchasing power has actually been increasing at a pace that's been above the trend that we saw before the pandemic. But despite those conditions that would normally be quite favourable in an election, we've had what's becoming increasingly prominent for households and voters is the backdrop of very tight financial conditions. Now for context, the Brazilian Central Bank, the BCB, it was pressured to raise interest rates quite sharply from late 2024 as market sentiment regarding the fiscal outlook soured and caused a very sharp spike in Brazilian bond yields. Now since then, or rather since the start of this year, the BCB has been cutting its benchmark Selic rate quite slowly. But real rates are still very high at around 9%, with yields still being quite stubborn and coming down over that period. So high rates have actually led to quite a sharp increase in households’ debt servicing costs, with the same also being true for businesses across Brazil. So that's been weighing on perceptions of the economy and the cost of living, despite the job market actually being quite strong. Now, on top of this, these economic strains, they have come alongside voter concerns about domestic and regional security. Now, this has been a trend in other elections in Latin America recently, which did see insecurity being a vulnerability for incumbents and led to several shifts away from previous left-wing leaders towards the right. But an extra issue in Brazil's case has also been corruption. Specifically, this has been tied to the more high-profile scandal tied to the collapse of Banco Master, a mid-sized Brazilian lender which happened late last year and it's had ripple effects across. Brazilian politics since then. Now that's a whole discussion in itself, but long story short, both Lula and Bolsonaro's camps, they have been caught up in the fallout due to varying levels and types of connections to people involved with it. But recurring coverage in the press and the media of the scandal looks to have weighed more on sentiment towards Lula and his handling of corruption in institutions. With that being again a vulnerability as an incumbent, but also a bit worse for him given his own history and coverage around it, tied to corruption and so on. So all that together, has created a fairly favourable backdrop for Bolsonaro and the broader right in these elections.
 

Lizzy Galbraith
So we're talking a lot so far about the outlook for the presidency itself, but of course the elections are broader than just deciding the president. They've also coincided with elections for the Senate and the Chamber of Deputies. Both houses have seen shifts to the right as part of that voter response that you've been discussing. It seems to be something that's not just tied to Lula personally, but is more broad brush than that. So what does a right-leaning Senate Chamber of Deputies actually mean for policymaking over the next presidential term? Is it going to affect the mandates that these presidential candidates are going to inherit?
 

Tettey Addy
Sure, so yeah, October 4th, same day as the first round of the presidential vote. We also saw elections for 51 of the 81 seats in the Senate, alongside all the seats in the Chamber of Deputies. Now Bolsonaro's Liberal Party, they had the strongest result of any party in an election since the 90s, with them now being the largest single bloc in both of the fragmented houses. Now the Liberal Party's gains alongside just the broader right in general, now puts the combined shares of the right and centre-right parties at just over the 50% mark in the lower house and above the three-fifths supermajority in the Senate. And that second member for the three fifths is crucial because that's the threshold needed for making changes to the constitution in both houses. Now the very highly fragmented makeup of both these houses, you've got many, many parties in both of them. Now that's been the case since the last elections in 2022 and that was a hurdle for Lulu's government in passing legislation. Now the new splits in both houses mean that whoever does win the presidency will still need to do lots of cross-party deal making and appeal to what's known as the centrale or the big centre. Now that's a very large block of several transactional and very ideologically varied parties, but overall the gains made by the Liberal Party and the right mean that the Bolsonaro presidency would be expected to have an easier time in passing legislation and better odds of constitutional reform than Lula under the same makeup of the houses.
 

Lizzy Galbraith
So if we take all that together then, we take your base case assumption that we see a Bolsonaro government or a Bolsonaro-led government after the 25th of October. Looking at fiscal policy specifically, what do you think that he's actually aiming to achieve with his presidency and with that parliamentary makeup that you've just described? How does that actually affect the outlook for Brazil's finances and those investor expectations as well, which are pretty lofty, actually? There does seem to be quite a lot of optimism on the part of investors that a Bolsonaro presidency can result in meaningful and quite rapid change in some areas, particularly on this fiscal question.
 

Tettey Addy
Sure. So I guess before diving into comparing the candidates like for like on the fiscal side, we've got to maybe zoom out on the monetary side first. So we've sort of got this bit of a doom loop between the fiscal and monetary policy, which have been a bit in conflict in Brazil as of late. Now the BCB Selic rate to start off there, our base cases for it to be cut towards 13.25% by the end of this year and then gradually towards 11% over the course of 2027. We do still think that, you know, with high real rates that should weigh on the economy a bit more, allow for the BCB to cut very gradually. But the balance of risks is towards there being more cautious easing depending on yields or inflation. Now, I mentioned the Selic rate first because it plays a key role in public finances due to debt that's tied to the Selic rate now making up more than half of the total government debt stock. Now, even though the government's primary deficit is around 0.6, 0.5% of GDP, a very large debt servicing bill that's propped up by high interest rates has the overall budget deficit at around, again, 9.5% of GDP. So markets, they see a change of leadership to Bolsonaro as being more likely to see eventual spending cuts, yield compression and an improvement of the step trajectory than continuity under Lula. Now as for the fiscal plans of these two candidates, the 2027 budget bill that was proposed back in August, that showed that Lula's short-term targets would focus more on spending caps towards getting a primary surplus of targeted 0.5% of GDP for next year, but that's rather than there being more major spending cuts outright. So that would mean, to materially improve the budget balance, you have to raise revenue by quite a lot. Now the issue there in Brazil's case is that it already has quite a high tax bill compared to other EMs. You know, government revenue is close to 40% of GDP as of last year in Brazil, that’s well above the IMF's emerging market aggregate of around 25%. So the potential gains from further revenue raising measures in the short term are comparatively limited. Now, as for Bolsonaro, he's campaigned on fiscal tightening in the range of 1.5% of GDP over 18 months from coming into office. But beyond claims of a currently unspecified debt to GDP target, which could, if missed, trigger automatic spending curves, which again, the details are quite lacking on, his broader fiscal plan remains a bit unclear for now. Now Bolsonaro, he's also pitched himself as being more business friendly than Lula and open to potential tax cuts, but those would risk hindering the progress towards reducing the deficit if implemented at the same time. Now we estimate that Brazil's debt stabilising primary balance, so that's the amount that's needed to stop debt from rising, is around 2.7% of GDP or so. And that's above the targets of both Lula and Bolsonaro in the short term. Now this could decline, the debt stabilising level could decline and become more attainable over the medium term if we do see, again, this material decline in borrowing costs. But the key message is whoever wins the presidency will have their room for manoeuvre being limited by various challenges, chief among them as well, being mandatory expenses. Now these expenses which are required by the constitution, these include areas like pensions, healthcare, education, social spending and more. Together they account for around 90% of government spending in Brazil and that's been crowding out, you know, more growth supportive areas like public investment and so on. But also importantly, these mandatory expenditures have risen gradually over successive presidencies over the past few decades. So, multiple governments haven't done the job of being able to rein these in and markets are hoping that we could see some change. But, the constitutional hurdles, that's already won. But political pushback could be an extra constraint on short-term reform momentum. Now here, it's worth bringing in the comparison of Colombia, which just had its elections this past summer. It could be a sign of things to come for Brazil on the market side of things. Now there in the first round of the presidential race, we saw an outperformance from the right-wing candidate and now president, Abelardo de la Espriella. Following that, on the back of hopes for fiscal reform, very similar narrative here, we saw bonds rally and other assets doing quite similarly. But since then, the unfavourable fiscal realities have set in, the challenges that have been inherited have come to light. And with that, we've seen what in markets’ eyes was a fairly underwhelming budget for next year. So while bond yields did initially fall quite substantially, they have risen again. They've not lost all the ground they made, but you know, that rally has come to a bit of a halt. So, you know, long story short there, we could see if we, you know, in a Bolsonario win, if reform momentum doesn't materially increase once you're in office, you could see that initial rally pare back.
 

Lizzy Galbraith
Yeah, it does always seem like the prospects for reform are usually greatest when parties aren't in government. And often you'll find that, yeah, political reality can really hit quite early on in the term of a new government and with it, take investor expectations, a little bit of time to settle beyond the point of the election result itself. So Tetty, just touching on the comparisons to Colombia that you mentioned, another one is I think on foreign policy. So Brazil's election is part of a series that we've seen across Latin America over the past 12 months or so, which have seen shifts to the right almost in every instance actually and largely pro-US leaders being elected, largely a shift away from leftist presidents that had been in power under previous administrations. Now these votes have also taken place at a time where the Trump administration is looking to expand its influence over the Americas. It's been very clear that they're looking to adhere to this new Donroe doctrine, as we call it, a kind of revised Monroe doctrine where they're looking to enhance the influence that the US government has over Latin American policy trajectory and the political trajectories of the countries that make up the region. So what would the Brazilian presidential election and its likely results mean for the outlook with the US. In particular, I'm thinking about both foreign policy relations, but also trade as well, which has been such a big part of the way in which the Trump administration interacts with its neighbours.
 

Tettey Addy
Yeah, it's an interesting one to think about. So Brazil's ties with the US, they have been strained a fair bit since the beginning of Trump's second term last year. We had Washington's implementation of quite steep tariffs targeted at Brazil alongside various sanctions on individuals. And those were tied to last year's trial against Jair Bolsonaro, who previously when he was in office was Trump's, you know, biggest ally in Latin America. And you've had Lula being quite hawkish towards Trump for, you know, the tariffs and broader perceptions of interfering in Brazilian politics. And yes, with the Regional elections as of late, you have seen this shift to the right. Brazil has been a major left-wing holdout under Lula. Now, you know, if we do see Flavio winning, then that would be Latin America's largest economy having a sharp shift to the right and being much more US friendly. The son of a former Trump ally, you know, Trump and his administration would be very happy to have that unfold. But that wouldn't come at the expense of Brazil's very entrenched economic ties with China. In fact, over the past year, increased trade with China and the rest of the world has more than offset the drag on Brazilian exports caused by those US tariffs. Now, that might remain a source of contention with Washington. But either way, we wouldn't expect Brazil or other parts of LATAM, which remain very dependent on Chinese trade and investments to, you know the rhetoric might become more pro-US, but it won't be a breaking off of trade and economic ties with China itself. More broadly, in terms of other points on Brazil's foreign policy agenda will be, you know, trying to figure out how to leverage its resource abundance. You know, a key word that's been catching headlines as of late has been rare earths and critical minerals. Those have become of greater geopolitical importance and leverage. And as the US and other markets are looking to break China's chokehold in this area, Brazil has the second largest reserves globally of rare earths, but they remain largely untapped due to issues with the extractive sector, just the broader business environment. Now there have been some moves in the past year or so to try and establish more of a coherent domestic plan for how to handle this sector, but also for Brazil to move up the critical mineral value chain. So just beyond just exporting, but rather maybe moving into refining. But these are, you know, multi multi-year agendas. But yeah, whoever wins the presidency, that will be another priority to dig into over the coming years.
 

Lizzy Galbraith
And that is all we have time for this episode. Tettey, thank you so much for joining us and walking through the outlook for Brazil. Thank you to everyone for listening. Please like and subscribe to Macro Bytes on your politics platform of choice and we will see you on the next episode.

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