After the second-round election in S茫o Paulo on October 25, supporters of Lula (Luiz In谩cio Lula da Silva) celebrated at Workers' Party camps as he pulled off a stunning comeback, defeating right-wing candidate Fl谩vio Bolsonaro, who had been favored by most investors.
Traders are preparing for a sharp sell-off across Brazilian markets on Monday.
Early signals already point to a major decline: an ETF tracking Brazilian equities fell as much as 16% during Japanese trading hours, the largest intraday drop since 2020; foreign exchange derivative contracts on the Chicago Mercantile Exchange (CME) show the real trading at 5.55 per dollar. While that quote is not an official fixing, it implies the real could depreciate by more than 10% compared with Friday's close.
Several trading desks in S茫o Paulo said Monday morning selling could be extremely intense and steep, potentially triggering circuit breakers. Brokerage Monte Bravo had previously estimated that if Lula won, the benchmark Ibovespa index could plunge 11% in the first hour of trading.
A Citi survey of 73 investors released Friday showed that most expect the outcome to weaken the real by at least 5%, with swap rates rising more than 1 percentage point; after Bolsonaro overtook Lula in the first round, the market had aggressively bet on rate cuts, and those positions will now be unwound en masse.
"Today will be tough. The market has to reprice all assets," said Bruno Funchal, CEO of Bradesco Asset Management, which manages 1.1 trillion reais ($221 billion). "Everyone was caught off guard, and everyone is trying to make sense of the situation."
According to data from Brazil's electoral court, with the vast majority of votes counted, Lula won 51.8% in the second round, while Bolsonaro received 48.2%.
The market widely believes Lula is unlikely to pursue the fiscal austerity needed for Brazil to cut interest rates. Earlier this month, after Bolsonaro's surprising lead in the first round, Brazilian assets rallied sharply, with billions in foreign capital flowing in as the market bet the government would implement the fiscal tightening investors had been hoping for, opening the door to rate cuts.
UBS, Morgan Stanley, JPMorgan, Citi and other institutions turned bullish on Brazilian assets. Subsequent polls consistently showed a tight second-round race, and as Lula rolled out a series of populist policies, many institutions began adding hedges to protect their portfolios, though the market's base case remained a Bolsonaro victory.
"The market was not prepared for this outcome. What we saw in Tokyo was a concentrated unwind of election trades: the post-first-round rally was given back almost all at once," said Anna Wu, founder of Floodlines Research and investment strategist. "In my view, this is not just a short-term knee-jerk reaction. Local markets now face real risks from government debt and a weakening currency."
Circuit breaker mechanism
When the Ibovespa falls 10% or more, a circuit breaker is triggered, halting trading for 30 minutes; if losses widen to 15% after trading resumes, it halts again for one hour; if it drops to 20%, exchange operator B3 has discretion over the length of the halt.
Brazil's derivatives market is one of the most liquid in Latin America and has no circuit breakers, but it does have price limits: swap rates can move 90 basis points in either direction, and FX futures have a 6% upper and lower limit. Once limits are hit, trading essentially pauses until the exchange approves widening the range.
The last time Brazilian stocks triggered a circuit breaker was in early 2020, when the pandemic hit global markets.
Deep-rooted fiscal problems
The 80-year-old leftist leader Lula, after returning to office in January 2023, improved the lives of Brazil's working class by stimulating consumption and continuing the pandemic-era approach of expanding credit, but did little to address the ever-rising fiscal deficit. Investors see the large deficit as the core reason Brazil's real interest rates remain stubbornly high.
Brazil's fiscal problems are deeply entrenched, with pressure visible across the economy: household delinquency rates are at record highs, millions of businesses are behind on payments, and farmer default rates have reached unprecedented levels.
The government has limited room to maneuver, with public debt exceeding 80% of GDP and a large share of the budget consumed by mandatory spending.
Doubts about Lula's determination to control the fiscal deficit erupted late in 2024: a sell-off drove the real to historic lows and pressured stocks, local-currency bonds and dollar bonds across the board. Still, during Lula's third term, Brazilian markets have been volatile but ultimately ended higher overall.
Although high interest rates weigh on the economy, they attract carry-trade capital in an environment of a weaker dollar, outflows from U.S. markets and tailwinds for emerging markets, supporting Brazilian assets.
Repricing
Li Haomin, a strategist at Lombard Odier in Singapore, said the reversal of the Bolsonaro trade is now "inevitable," and investors are bracing for it.
Wells Fargo strategist Alvaro Vivanco predicted before Sunday's second round that if Lula pulled off an upset, the real would weaken to 5.30 per dollar after Monday's open.
Guilherme Abbud, CEO of Persevera Asset Management, believes the currency could depreciate 7% and that a stock market circuit breaker is possible.
"The actual decline could be deeper, as sell-offs are often accompanied by panic and emotional stop-losses," Abbud said. "At least in the short term, the major economic policy shift the market expected will not materialize. Lula may adopt more restrained spending policies in the future, but the market will not give him the benefit of the doubt right now."
Cathy Hepworth, head of the emerging-market debt team at PGIM, which manages $1.5 trillion, said that after Lula's victory, "everyone will choose to sit on the sidelines." She said before the vote: "Rates had already risen a lot, and this repricing will be quite significant and may last a while. But this is Brazil after all, Lula knows politics well, and the market will eventually stabilize."
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