Investor Darling Brazil Back on Ropes as Election Fears Sink in

(Bloomberg) -- Brazil investors hoping the jailing of former President Luiz Inacio Lula da Silva would add fuel to a rally have been sorely disappointed.

The arrest of the front-runner in election polls all but eliminated the possibility Lula returns to the presidency in the October general elections, easing concern he would upend efforts to overhaul the economy. But the celebration in markets lasted less than a day. Since Lula’s arrest warrant was issued on Thursday afternoon, the real and stocks have lagged behind global peers.

Brazilian markets had already been underperforming, with the real weakening more than 4 percent in the past month while an index of emerging-market currencies lost around 0.2 percent. The Ibovespa stock benchmark, which earlier this year was hitting fresh records almost daily, has dropped more than 7 percent in dollar terms in the span, one of the world’s worst performances.

With Lula out of the picture, the election is wide open. There are at least a dozen potential candidates, whose policy proposals vary widely or are completely unknown. The field could still change amid widespread corruption allegations.

"There is no use in only taking Lula out, with that cancer that Brasilia is," said Bernardo Rodarte, a money manager at Sita Corretora, which has 1.5 billion reais ($439 million) under management. "They arrested Lula, but nothing was solved. The outlook for the elections is still very bleak."

Conservative Jair Bolsonaro, who leads polls excluding Lula, has enlisted a radical privatization proponent as his top economic adviser. On the left, Ciro Gomes -- who has said he would tax the rich and undo government spending caps -- is the only candidate that polls above 5 percent. The middle ground, pro-reform group includes Henrique Meirelles, the market’s dream Finance Minister, former Sao Paulo Governor Geraldo Alckmin and even President Michel Temer. All are struggling to gain ground.

While the external mood hasn’t helped Brazilian assets, with sell offs being sparked by global trade war fears and Russia concerns, much of the weakness can also be attributed to domestic drivers, according to Mauricio Oreng, a senior strategist at Rabobank in Brazil. Investors may be starting to worry more about the election, he said.

“We are driving with a very low visibility,” he said from Sao Paulo.

While some still think it will all work out in the end -- Moody’s Investors Service raised its outlook on Brazil’s sovereign debt to stable on Monday, saying whoever wins October’s elections will pass fiscal reforms -- some are beginning to raise alarms about the election not going investors’ way.

Political risk consulting firm Eurasia Group, which has become a key reference for Brazil investors since it was one of the few that correctly predicted Dilma Rousseff would be re-elected in 2014, isn’t so confident a reformist will win. The wide-open election comes as a consequence of broad popular rejection to anyone who looks like a traditional candidate, Eurasia co-founder Ian Bremmer wrote in a note to clients. While “most elites” apparently think voters will move toward a more traditional candidate like Alckmin, there’s too much controversy around his team to make him a strong bidder, he wrote.

"After Lula’s imprisonment, some market participants realized that it was not as simple as simply taking him out of the race, that the electoral process is much longer and less clear," said Rodrigo Borges, the Sao Paulo-based head of fixed income at Franklin Templeton’s Brazil investment unit. "The center that, in theory, would be pro-reform, has been pulverized and the perception is that this vote will be divided."

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