Divided Brazil set for growth

After a hotly contested race, one-time leftist former president (2003-10) Luiz Inacio ‘Lula’ da Silva and his PT Party won 50.9 per cent of the Brazilian presidential vote, the tightest margin in history. As of writing, his opponent Jair Bolsonaro has not formerly conceded, but agreed to a transition of power.

Economically, Lula’s election will likely see a move away from Mr Bolsonaro’s free market agenda to a more state-led approach of increasing public spending, expanding social welfare, and raising taxes. Lula also vowed to resume the fight against climate change and restore Brazil’s credibility as a steward of the Amazon, after Mr Bolsonaro publicly promoted illegal development of the resource-rich rainforest.

We’ll always have Paris

The president-elect has pledged to stop illegal mining, outlined proposals to subsidise sustainable farming, and plans to establish an agency to ensure Brazil is in line with its Paris Agreement goals.

As in many recent elections, the close result indicates how divided the country is and should act as an incentive for the new administration to adhere to more centrist policies. Initial signs are encouraging. In his first speech post-election, Lula talked about unifying the country and making a government for all 215m Brazilians, not just those who voted for him.

The polls correctly predicted the result, but there remains a question mark over which Lula will take charge. Will he be the pragmatist, who embraces economic orthodoxy as he did when he first took office in 2003, or will he increase state intervention and spending as he did in his second term, in response to the global financial crisis? The forthcoming appointments of his finance minister and broader cabinet should provide important clues to his economic policy.

Despite the uncertainty, the immediate impact of the result on Brazil’s economy is likely to be limited. Recent GDP growth has beaten other Latin American countries and unemployment has declined. Brazil also benefits from today’s macroeconomic backdrop; here there are similarities to Lula’s first term in power, when the country benefitted from significant commodity tailwinds, helping underpin state spending.

Keeping it real

Brazil has also been ahead of the curve in its efforts to combat inflation. The independent Brazilian central bank has raised the main policy rate to 13.75 per cent, which has supported the Brazilian real and made it one of the strongest emerging market currencies this year. This has allowed the central bank to signal an end to the hiking cycle, which should be supportive going forward. For these reasons, radical measures may not be necessary. In any case, given the more conservative composition of Congress, any aggressive economic agenda would likely face gridlock and need to be moderated.

As investors in emerging market corporate debt, one of our key concerns is the impact of the elections on Brazilian companies. Credit metrics for many Brazilian corporates are in robust shape.

However, Lula’s administration might take a more interventionist approach to business, particularly to large state-owned enterprises that play a major role in the Brazilian economy. We believe this risk should be somewhat mitigated by legislation passed in recent years. Typical of this approach is the ‘SOE Governance Law’ of 2016, which aimed to limit state interference and align business practices with the private sector, as part of a drive to attract more investment into key sectors of the economy. These measures should disincentivise intervention into banks such as Banco do Brasil, majority-owned by the government, and the oldest bank in the country.

It boasts a good-quality and diversified loan portfolio, stable low-cost funding, and strong capitalisation, positioning it conservatively to absorb an uptick in non-performing loans if the economy slows.

Reasons to be cheerful

Energy supply and fuel pricing is another key topic, with state-controlled oil and gas giant Petrobras maintaining prices in line with international markets. However, Mr Bolsonaro had put pressure on the company to artificially lower fuel prices and Lula may also try this. That is why we avoid direct interference risk in the energy sector and prefer companies with more diversified operations in biofuel supply chains as well as natural gas distribution and commodity logistics.

While much will depend on Lula’s next steps, there is reason to be optimistic about Brazil’s economy. We expect to see some relief in markets and moderation in risk premium as investors had been previously pricing in greater political and economic risks. The economy is still expected to grow, albeit more slowly, and underlying corporate fundamentals are in good shape. After all, the elections are behind us and the results are not being contested.

Charles Gélinet is portfolio manager of the J. Stern & Co. Emerging Market Debt Stars Fund