Analysis-Investors Confident In Brazil Staying The Course After Election

A leftist former union leader is on track to replace Brazil's right-wing president and tear up the most important fiscal rule in the world's 10th largest economy, but foreign investors are largely unfazed.

Their even-keeled outlook for Brazil, where the local currency and stock market have gained this year, reflects confidence that even a highly polarized election will not ruin the relative safe haven of Latin America's largest economy.

Polls suggest former president Luiz Inacio Lula da Silva will beat incumbent Jair Bolsonaro in October's election, possibly even in Sunday's first-round vote, and take office in January.

"We have a broadly positive medium-term view on Brazilian investment opportunities," said Amer Bisat, head of emerging markets fixed income at BlackRock, pointing to an attractive mix of strong corporate earnings, a healthy financial system, plus ample foreign reserves and a current account surplus thanks to strong commodity exports.

Lula, whose Workers Party trod a largely orthodox path while he was in office from 2003-2010, has decried Bolsonaro's policies but both are promising more generous welfare and more flexible budget rules.

Lula spent heavily on welfare programs first time around as a federal budget boosted by a commodities boom gave him room for maneuver. This time he will have less and he has already vowed to do away with a constitutional spending cap.

Yerlan Syzdykov, Amundi's head of emerging markets, said at a recent event that it was troubling to see Lula not respecting Brazil's current fiscal anchor.

"But during the last two years neither did Bolsonaro, so this is not something that's shocking investors."

He said Lula's track record on economic policy meant that any change of regime would not really be a radical one.

Brazil's real is one of the few emerging market currencies gaining against a dollar which more broadly is at multi-decade highs, while both local- and hard-currency bonds are among top performers in their asset class.

GRAPHICS: Brazil sovereign spreads to U.S. Treasuries

Stocks are also up for the year in the local market and barely down in dollar terms, banks have healthy balance sheets and the job market is on the rebound, while inflation is falling thanks to early and aggressive interest rate hikes.

"The central bank, as an independent institution, has proven its credibility by being one of earliest global central banks to combat inflation with vigor and determination," BlackRock's Bisat said.

Central bank chief Roberto Campos Neto, whose term runs through 2024 under a new law establishing the bank's formal autonomy, oversaw a string of rate hikes effectively front-running the U.S. Federal Reserve and helping to support the real.

Although Workers Party economists gripe about the central bank's newfound independence, Lula has offered assurances that he can work constructively with Campos Neto.

"It's important that he (stays), because otherwise what's the point in having a mandate for the central bank governor that's independent of the political cycle," said Graham Stock, senior emerging sovereign strategist at BlueBay Asset Management, noting the opportunity for Lula and his team to show they respect the bank's independence and inflation targeting regime.

Graphics: Emerging market currencies vs USD

In what Goldman Sachs called a "hawkish hold", the central bank paused last week after hiking the policy rate from a record-low 2% at the start of last year to 13.75%, with forward guidance hinting at a 'high for long' stance.

"We are seeing high real yields, which is unheard of in the market at the moment," Philip Meier, head of EM debt at Gramercy Funds Management told investors, calling Brazil a "great opportunity" into 2023.

Even with the dollar at 20-year highs against a basket of major currencies, Brazil's real is up 4% this year versus the greenback, the top performing free-floating emerging market currency.

Not all investors are so sanguine and JPMorgan, which cut foreign-denominated Brazilian debt to "underweight" earlier this month, says further upside for the country in global credit markets may be limited.

"Policy and political uncertainties are likely to persist ahead of the October elections, and fiscal/debt dynamics remain a concern," said Lupin Rahman, head of sovereign credit on the EM markets portfolio management team at Pimco.

Graphics: MSCI stock indexes YTD performance

Brazilian stock valuations, however, remain cheap - investors in the MSCI Brazil index pay some $6 for every $1 in earnings, compared to nearly $18 at a 2020 peak.

Investors will be looking for a calm political transition. Bolsonaro has laid the groundwork to contest a defeat but Brazilian institutions are closing ranks to guarantee the integrity of the vote.

Lula could make it hard for Bolsonaro to mount a challenge if he gets more than 50% of valid votes on Sunday, foregoing the need for a second-round runoff on Oct. 30. Several recent polls show the former union leader in striking distance of that threshold.