Why Brazil's markets fell after Lula won re-election

What happened

Brazil's stock market, currency and government bonds fell sharply on October 26th. The day before, voters had re-elected President Luiz Inácio Lula da Silva, of the Workers' Party, to a fourth non-consecutive term. The Bovespa, the benchmark stock index, closed down 13.9%, its largest daily percentage drop since March 2020. The real, Brazil's currency, fell more than 11% against the US dollar in early spot trading. Later in the session, Reuters put it down 8.1% at 5.415 per dollar.

Trading on the stock exchange stopped for 30 minutes after the index fell 10%. The Treasury cancelled its regular auctions of inflation-linked and fixed-rate government bonds, which were scheduled for October 27th and 29th. Longer-dated bonds fell hardest. The 2054 dollar bond lost 2.2 cents and yielded 7.45%. Brazil's 10-year government bond yield rose to around 15.45% in late October, a decade high, according to Trading Economics.

Why markets reacted so hard

Markets had bet on a different result. Senator Flávio Bolsonaro, the son of former president Jair Bolsonaro, unexpectedly finished first in the opening round of voting on October 4th. Investors expected a shift to the right and a tighter budget. Markets soared. By Friday, the Bovespa was almost 7% above its level before that vote, and the real was nearly 5% stronger against the dollar.

Lula's win reversed those bets. Dario Durigan, Brazil's finance minister, said on October 27th that the rout reflected investor positioning, not a change in Brazil's economic fundamentals.

Analysts point to a second cause: government debt. Mauricio Monge, a senior Latin America economist at Oxford Economics, wrote that Lula's biggest challenge is to convince markets he can deliver a credible, sustainable fiscal adjustment. That means a plan to slow the rise in public debt. Lula's team has said it aims for a budget surplus of about 1.3% of gross domestic product by 2030. Divya Singaravelu of the asset manager Meridian 1305 Capital said he has not detailed how the spending cuts would look.

Moody's, a credit rating agency, rates Brazil's external sovereign debt Ba1, one level below investment grade, with a stable outlook. William Foster, Moody's lead Brazil analyst, said that rising fiscal pressure without a credible plan could push the outlook to negative.

The main players

Two men stand on opposite sides of the dispute, pictured below.

Luiz Inácio Lula da Silva

President of Brazil, re-elected

Won a fourth non-consecutive term. His team aims for a budget surplus of about 1.3% of gross domestic product by 2030.

Flávio Bolsonaro

Senator and defeated candidate

Refused to concede and said he would seek to annul the election. His legal team now plans abuse-of-power cases against Lula's ticket, Jurinews reports.

Where it stands now

Markets recovered some ground on October 27th. The real strengthened nearly 2% to around 5.31 per dollar, and the Bovespa rose 1%, Reuters reports. Interest rate futures retreated.

JPMorgan analysts said markets had not yet developed a clear narrative for Lula's fourth administration. They expect investors to reassess the outlook in the weeks after the vote, as the new economic team and its plans take shape. Figure 1 sets out the dates.

What to watch

Two things decide whether the recovery holds. The first is whom Lula names as finance minister. Graham Stock of RBC BlueBay Asset Management told Reuters that the key signal for markets will be the next administration's commitment to fiscal discipline, starting with that appointment.

The second is whether the Treasury brings back the cancelled auctions. It kept its auction of bonds tied to the Selic, the central bank's benchmark interest rate, which stands at 13.75%.