Quick View: Investors brace for an emboldened Lula 4.0

The recent electoral trend toward economic liberalization in Latin America suffered a setback on Sunday with the surprise reelection of Brazilian President Luiz Inácio Lula da Silva (Lula) in the region’s largest economy. Investors must now come to terms with the implications of this unprecedented comeback after Lula placed second in the election’s first round. Lula won by leaning heavily into his Bolsa Familia ethos of large-scale government programs aimed at providing economic support to his working-class base.

Having been rewarded with a victory, we have little doubt that Lula will seek to follow through on his wide-ranging campaign promise. We do not see this program as a recipe for success – a view likely shared by the market’s early reaction to his surprise victory. Brazil’s economy has largely muddled through two years of elevated interest rates, and investors began to pin optimism on a more reformist Flavio Bolsonaro administration taking steps to put the country on a more sustainable economic path.

With that off the table and an emboldened Lula likely to double down on economic populism, we believe Brazilian assets – equities, bonds, and its currency, the real – will quickly reprice to reflect the havoc that potentially four more years of roughly 15% sovereign interest rates would wreak on the country’s economy.

We are particularly cautious toward Brazil’s domestic cyclical sector. The country remains home to quality secular growth companies and world-class commodities firms that could potentially benefit from a weakening real. But the headwind presented by the cumulative deleterious effects of high interest rates is, in our view, a force that will likely further expose structural weaknesses in an economy at risk of becoming a low-growth, redistributive welfare state.

Past does not make precedent

A former union leader, Lula benefited by having his first two terms coincide with the global commodities supercycle of the early 2000s. The tax receipts generated by demand for Brazil’s vast natural resources likely gave Lula’s Workers Party false confidence that its Bolsa Familia agenda was viable. We view any economic and fiscal success from that period as unrepresentative of what would likely be the outcome during a high interest-rate, low-growth environment.

As seen in Exhibit 1, the bill started coming due during the administrations of Lula’s immediate successors in the form of higher public debt taking up a higher share of gross domestic product (GDP).

Jair Bolsonaro enjoyed some early success in taming government finances, but that largely ended with the onset of the Covid-19 pandemic. We see Lula’s third term as the precedent for his fourth term. Most octogenarians – especially those who’ve enjoyed an unprecedented political career – are unlikely to change their stripes. This is especially true for Lula, whose final electoral triumph was delivered by promises of an aggressive populist agenda.

One moderating influence on Lula’s worst fiscal impulses could be the rise of the conversative bloc in Brazil’s senate, as their votes, at least at the margin, could deprive the president of consensus on more substantive changes to the country’s economy governance.

An unfavorable backdrop

Lula’s economic strategy is premised on the concept of spend now, pay for it later, once economic growth arrives. Among the myriad problems with that approach is the country is running deficits not by investing in projects that could increase productivity but instead by funding subsidies to households. Lacking investment in the country’s capital stock, Brazil is likely mired in a real economic growth range of 2.0% to 2.50%. Meanwhile, with many of Lula’s handouts and pension costs indexed to inflation, deficits are likely to increase in a self-perpetuating cycle as the government seeks to maintain its base’s standard of living.

Furthermore, Brazilian households are already notoriously in debt. We believe it’s unrealistic for consumption to become a meaningful lever in generating economic growth. And even if an extension of the current period of elevated interest rates only modestly hampered consumption, the higher cost of capital represented by Brazil’s “risk-free” rate would eventually permeate though the economy and deprive the corporate sector of the oxygen it needs to invest in attractive projects. The market also cannot overlook the damage potentially incurred on the country’s banks should Lula seek to fulfill his campaign promise of renegotiating – or forgiving – consumer loans.

Living with the consequences

Elections have consequences. By doubling down on economic populism, Lula achieved the improbable. But markets – and especially bond investors – get to cast a vote, too. Two years of high interest rates have resulted in middling economic growth. That could continue into early parts of Lula’s fourth term. But with unemployment already relatively low and household finances already levered, we don’t see a realistic path to a higher growth trajectory.

Similarly, it’s highly doubtful that Lula 4.0 will champion many pro-growth reforms within the private sector. Without those, and with higher deficits and the cumulative pressure of a punitive cost of capital, we believe Brazilian financial assets will ultimately reflect what is likely to be an unfavorable economic outcome.

Brazil remains one of the world’s 10 largest economies and is home to many companies capable of compounding earnings. But we believe investors need to consider company and country when approaching emerging markets.

We think many Brazilian enterprises can grow even with an unfavorable macro backdrop. These, however, are largely concentrated within the secular growth category rather than in more vulnerable domestic, cyclical names. Brazilian assets are also likely to remain volatile – experiencing both downdrafts and recoveries – as the market gets a better grip on Lula’s forthcoming economic agenda.

Still, with the exception of high-quality companies exposed to secular growth themes, natural resource producers generating U.S.-dollar denominated revenues, and enterprises least exposed to high interest rates, this election’s outcome dims many of Brazil’s investment prospects as they are weighed down by the inescapable forces of high debt ratios and borrowing costs pushing the country further off a fiscally sustainable course.

Brazil’s external debt had largely priced a Bolsonaro victory following the post-first-round rally. Sunday’s surprise outcome therefore exposed a clear pricing asymmetry in bond markets.

 

Flavio Bolsonaro’s rejection of the result creates institutional and transition risk, reinforcing the immediate negative reaction across Brazilian assets. We see currency weakness as the critical transmission channel: Depreciation lifts inflation expectations and local rates, increasing the government’s interest burden and headline fiscal pressures. That deterioration may ultimately impose policy discipline on Lula, but markets are likely to demand a larger risk premium.

 

Attention now shifts to Lula’s team and its fiscal plan. The key signals will be whether he appoints a market-credible economic team, empowers it politically, and presents a quantified, expenditure-led adjustment with congressional support. Brazil’s external balance remains resilient, but durable bond recovery requires recurring spending reform and a credible debt-stabilisation path, not revenue measures, one-offs, or a simple post-election change in rhetoric.

 

Thomas Haugaard, Janus Henderson Emerging Market Hard Currency Debt Team

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