Markets unaffected by anti-Lula protests in Brazil

On Sunday 8 January, thousands of supporters of former President Jair Bolsonaro stormed the empty buildings of the Brazilian Congress, the Presidential palace, and the Supreme Court. They claimed, without evidence, that the 2022 election result had been rigged in favour of Lula, accused Supreme Court judges of favouring the socialist candidate, and demanded the army’s intervention to overturn the election result and reappoint Bolsonaro. Scenes resembled events in the US Congress when supporters of former President Donald Trump stormed into the US Capitol protesting against Joe Biden’s 2020 election victory. However, in contrast to events in the US, Jair Bolsonaro distanced himself from these violent protests despite failing to concede defeat after the election and refusing to attend Lula’s inauguration on 1 January.¹ The protests were rapidly contained by the police and condemned by most of the Brazilian population who accepted the results of the democratic election.

Market reaction

Despite the negative headlines that diverted attention away from budget negotiations and discussions over cabinet nominations, the protests had no effect on Brazilian financial markets. The Brazilian real (BRL) was largely unaffected. In 2022, positive real bond yields in Brazil and the improvement in terms of trade due to high commodity prices, favoured a strengthening of the BRL by 5.6% in the first six months of 2022. Since the start of 2023 the real has appreciated more than other currencies, as the BRL gained 4.0% against the US dollar, while the trade weighted dollar has weakened by 1.4% YTD.² Current USD/BRL levels reflect the strength of the Brazilian currency against the purchasing power parity estimate (see Chart 1). 

Chart 1. Brazilian real exchange rate with the US dollar and PPP estimate

Source: Refinitiv and EFGAM calculations. Data as of 01 February 2023.

Brazilian 5-year and 10-year credit default swap (CDS) contracts have also been unaffected by recent events, peaking at 300bps and 400bps respectively in the days before the first round of the Presidential election in October 2022. These resembled the dynamics observed ahead of the 2018 election when CDS spreads widened reflecting the uncertainty associated with a potential victory for Bolsonaro. Following the recent election, CDS spreads have narrowed to 235bps and 320bps for the 5-year and 10-year respectively, highlighting investor optimism about the outlook for Brazil and a reduction in the tail risks associated with Lula’s return to power (see Chart 2).

Chart 2. Brazil 5-year and 10-year CDS in USD (bps) 

Source: Refinitiv and EFGAM calculations. Data as of 01 February 2023.

Brazilian equities were among the best performing equities in 2022, rising almost 5%. The MSCI Brazil index is up by over 2% year-to-date (YTD), underperforming the broad Latin American index, which is up by over 8.5% since the start of the year. The weaker performance of the stock market YTD can be attributed to a catch-up effect from other markets following strong performance of Brazilian equities in 2022. Recent comments from various government officials about the need to review the independence of the central bank, uncertainty around when interest rates will be cut, the speed with which the tax reform will be implemented and concerns over defining a new fiscal anchor have also contributed to the weaker start to the year.

However, two factors could become a tailwind for the Brazilian stock market this year. Valuation is cheap: the EFG combined valuation score, which encompasses seven valuation metrics, currently reflects the cheapness of Brazilian equities compared to the average over three, five and ten years (see Chart 3). Additionally, the prospects of China reopening will favour those companies involved in production and export of commodities. The spot price of iron ore, Brazil’s second largest export to China after soybeans, has increased by over 7.0% YTD and by 60% since 1 November following the announcement of China’s reopening. 

Chart 3. Valuation of Brazilian stocks look attractive³ 

Source: Refinitiv and EFGAM calculations. Data as of 01 February 2023.

Conclusion

Recent political turbulence has done little to damage foreign investors’ cautious optimism with regard to Brazilian markets. The strengthening of the BRL, albeit as part of a global weakening trend of the US dollar, and the narrowing of Brazil’s CDS spreads are evidence of this. Brazilian equities had a strong 2022 and therefore it is not surprising they had a weaker start to the year given the recent political noise.

However, attractive valuations and expected increasing demand for Brazil’s exports from China may attract foreign investors again in 2023. Recent protests, although they created negative headlines, were not representative of most Brazilians. The priorities for the new government remain unchanged, the key challenges being consolidating the central bank’s efforts to control inflation with credible fiscal rules, and to deliver on a tax reform to simplify the tax system for companies and individuals.⁴

¹ In Brazil, as in many countries, it is customary protocol for the outgoing President to attend a ceremony to hand over power to the incoming President.
² The currencies included in the trade weighted dollar are the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc.
³ EFGAM’s Combined Valuation model incorporates seven valuation metrics: Price-to-Earnings, Price-to-Cash, Price-to-Book, Dividend Yield, EV-to-EBITDA, Price-to-Sales and EV-to-Sales. These metrics are normalised to allow for comparison over three, five and ten years.
4 See Infocus - Challenges and priorities for Brazil, December 2022.