A Left-Wing Return in Brazil Is Investors’ Worst Nightmare

August 20, 2018 Updated: August 20, 2018

When investors say they are concerned about the outlook for Brazil’s election, they’re mostly talking about just one thing: The possibility of a comeback for the Workers’ Party.

The most dire warnings say Brazil may turn into the next Turkey if the left-wing party takes power again. Brown Brothers Harriman & Co. says the real could tumble more than 20 percent to 5 per dollar. Bank of America Merrill Lynch sees an even bigger drop to 5.5 under its worst-case scenario for the next government. The Ibovespa stock index may lose more than a third of its value, according to the local hedge fund Rio Bravo Investimentos.

All this pessimism reflects what’s really an intense distaste for the Workers’ Party, known locally as the PT, among investors and business executives. They see the government of former President Dilma Rousseff as largely responsible for bringing about the worst recession in a century before she was impeached, and her predecessor Luiz Inacio Lula da Silva as a crook. While the PT has put Lula forth as its candidate, it’s unlikely he will be allowed to run in October because of a corruption conviction. His probable replacement, former Sao Paulo Mayor Fernando Haddad, gets no more love from traders.

“Turkey and Argentina are examples of how disrupting it is for financial markets when investors lose confidence in policy direction and institutions,” said Tania Escobedo, a Latin America strategist at RBC Capital Markets in New York. “Lula’s PT party would represent this scenario unless it moderates its views significantly.”

Escobedo, who was the most accurate forecaster for Brazil’s currency in the first and second quarters of this year, according to Bloomberg rankings, says the real would go to 4.5 per dollar if the Workers’ Party candidate wins. It traded near 3.9 per dollar on Friday.

It’s not easy to estimate Haddad’s level of support as long as Lula technically remains a candidate. A CNT/MDA poll from May shows support for the PT at 33 percent, above far-right congressman Jair Bolsonaro with 17 percent. Others in the run include market-friendly candidate Geraldo Alckmin and leftist former Ceara Governor Ciro Gomes.

One specific concern is that a PT government might seek to unwind the efforts President Michel Temer made to shore up the budget after the country’s credit rating was cut to junk, including a push to overhaul the social security system. The moves by Temer, a centrist who took over after Rousseff’s ouster in 2016, boosted the real and stocks that year.

Haddad said last week that a government led by the Workers’ Party would immediately roll back Temer’s move to ease labor rules and implement a spending cap, policies that he says come with very little benefit while harming the poorest Brazilians. The campaign platform presented by the PT ticket also favors capital controls to reduce currency volatility and favor certain sectors of economy.

Haddad has signaled he supports a dialed-back version of the social security overhaul that economists and investors say is the most important measure needed to bolster fiscal balance sheets.

In an interview earlier this year, Workers’ Party chief Gleisi Hoffmann said investors didn’t have to fear a Lula comeback as “everyone won” when he was in office in the 2000s. Backed by a surge in commodities during his tenure, Lula oversaw a massive rally in Brazilian assets as the economy posted the fastest expansion in a quarter century. The tenure of his handpicked successor was less successful, marked by the loss of Brazil’s investment grade amid a ballooning budget deficit and a sinking economy.

You-Na Park, a currency strategist at Commerzbank AG in Frankfurt, says if Haddad or any other PT candidate wins the election, the real would probably depreciate as an initial reaction. But that would happen with almost every candidate—the sole exception being a victory by Alckmin, the right-wing former Sao Paulo governor. In the longer run, she thinks whoever wins will make efforts to restore fiscal balance, no matter the campaign rhetoric.

“Politicians in Brazil are well aware that the high fiscal deficit is not sustainable and that at least some kind of reforms are necessary,” she said. “Maybe the current lira crisis is a good and frightening example for what could happen if markets lose confidence in politics. I don’t think any of the candidates in Brazil would want this to happen.”

The real was the second-worst performing emerging-market currency in the second quarter, with only the Argentine peso faring worse, as election uncertainty and cuts to growth forecasts weighed on sentiment. It has slumped about another 1 percent this quarter.

An unfavorable outcome in the presidential election, as well as negative sentiment toward emerging markets globally, could send the real to 5 per dollar, according to Win Thin, a strategist at Brown Brothers Harriman in New York.

“Whoever Lula backs would be the worst scenario,” Thin said. “We can assume that a lot of Lula’s support will flow to whomever he chooses to be his proxy.”

Bank of America Merrill Lynch forecasts the real at 5.5 per dollar next year under its most bearish scenario, in which the new government has a market-unfriendly agenda (analysts don’t mention any candidates or parties by name). Inflation would accelerate past the top end of the country’s target range, forcing policymakers to raise interest rates from the current record low of 6.5 percent, according to economists David Beker and Ana Madeira.

Evandro Buccini, an economist at Rio Bravo Investimentos, which manages about $3 billion of assets, said he’d expect the real to fall as much as 30 percent following a left-wing victory in the election. He says the benchmark equity index could sink as low as 50,000 from current levels near 80,000.

“There’s still plenty of room for Brazilian assets to deteriorate,” he said.

By Aline Oyamada & Vinícius Andrade

From Bloomberg