Brazilian markets start eyeing elections

The last two Brazilian elections could hardly have been more different. In 2002, Brazilian markets went haywire. With the real and equity values tumbling, Brazil went cap-in-hand to the International Monetary Fund (IMF) to seek a bailout to the tune of $30bn. In 2006, markets remained preternaturally calm. Analysts think that this year’s election should not repeat the crisis scenario of 2002, but it will perhaps be trickier than in 2006. Crucially, they will usher in a new president as incumbent Luiz Inácio Lula da Silva has run through the constitutionally-permitted two consecutive terms. John Rumsey compares the two leading contenders for the country’s pre-eminent job.

In this year’s elections in Brazil, voters will probably be choosing between two authoritarian and competent bureaucrats, neither of whom has the charm and knack for political persuasion of outgoing president Luiz Inácio Lula da Silva. The two candidates do have much in common. They are from the centre left and are likely to have similar policies in key areas.

The first round will be held on October 3rd. It is likely to pit Dilma Rousseff, frontrunner for the incumbent Workers’ Party (PT), against José Serra, likely candidate for the opposition centrist Brazilian Social Democracy Party (PSDB) party. Rousseff is widely seen as authoritarian with a fiery temper and Serra is known as the kind of tough negotiator who gets just what he wants.

Even if, however, elections don’t have a high probability of tension, they will be an important event, says Rafael Cortez, political scientist at São Paulo-based consultancy Tendências. The elections are likely to be close and the outcome cannot be predicted, he notes. With campaigns only allowed from April onwards under Brazilian legislation, analysts need to second-guess candidates’ policies.

Although the PT as a party tacks well left of the PSDB, which has moved to the centre in recent years, the two leaders are similar in how they view the role of the government, says Mauro Cunha, head of equity at local asset manager Mauá Investimentos, based in São Paulo. Both candidates are likely to respect orthodox macro-economic policies, with some different leanings. Brazil has learned the importance of implementing reasonable monetary and fiscal policies and that is not likely to be jeopardised, market watchers say. Both candidates are also by instinct tied to the role of the state in development. Both would likely pursue a policy of big government and an activist industrial policy, which is likely to include the promotion of Brazilian “champions” in key industries, nurtured in the hope that they will become global players. This has been a pet project of outgoing president Luiz Inácio Lula da Silva and it is probable that the policy would be more actively pursued by Rousseff than by Serra.

The PT also takes a strong line with fully and partially state-owned companies. Those that let go of workers during the 2008-09 recession were chastised with vocal threats to replace Roger Agnelli, boss of Vale, through the company’s pension fund majority owners, although this did not transpire. The activist stance of both candidates will probably be good news for the country’s powerful national development bank (BNDES), which lent more money than the World Bank last year and received a R$100bn loan from the government to beef-up operations. As the recession wanes, the bank may lose some of its enormous clout but it will still be a very significant part of the financing mix for Brazilian companies under either presidential candidate.

Another institution that is likely to benefit is the ministry of planning, budget and management. The ministry will be strengthened and enter new areas, says Cortez. However, the statist thrust of industrial policy is likely to mean privatisation plans take a back seat, says David Fleischer, professor of political science at the university of Brasilia, and a political consultant at consultancy Brazil Focus. Discussions over the privatisation of electricity giant Eletrobras and the sale of more of Petrobras to the private sector are likely to be off the table, he believes. Serra did attempt to sell São Paulo’s state energy body, CESP, but backed off when no willing investors were found and seems to have little genuine appetite for selling crown jewels.

Hawks and doves

If the perceived role of the state under both has similar stripes, divergences are likely to appear in how fiscal and monetary policy is undertaken.

Rousseff is widely seen as continuing Lula’s policies which is likely to mean a relaxed fiscal stance, predicts Fleischer. Under Lula, current spending of the government has grown substantially thanks to a combination of hires, increases in wages for federal employees and inflation-busting increases in the minimum wage.

Cunha agrees that Rousseff would likely continue with the PT’s lax policies, which have involved using loopholes and accounting tricks to disguise the impact of spending on government finances. Last year, for example, the BNDES received a R$100bn loan from the government, which does not count as part of the country’s net debt. This sleight-of-hand keeps the most commonly looked at debt-to-GDP ratios down.

Meanwhile, Serra has built a reputation in his current position as governor of São Paulo state, the country’s most populous and wealthiest, as a fiscal hawk and parsimonious in hiring. This has allowed him to boost the state’s investment budget and leads analysts to believe he will be more fiscally cautious.

Even these differences in the area of fiscal policy may be less than thought, speculate some analysts. Recently, Rousseff has appointed Antonio Palocci to head her campaign. He was Lula’s first minister of finance and steered Brazil through the turbulent waters of the 2002 post-election period with surprisingly tough fiscal policies before losing his job in the 2005 Mensalão payment-for-votes scandal. His appointment could mean Rousseff will prove tougher on fiscal policy than expected, says Cortez.

On the flip side, Rousseff may prove to be tougher in monetary policy and maintaining a hands-off attitude to the Central Bank, as Lula has done. Serra, who is seen as being in hock to the São Paulo industrial base, has been a fierce critic of the Central Bank’s tight monetary policy, believing it to be a cause of the high valuation of the real, which is seen by many industrialists as stifling Brazilian competitiveness.

In this tight-run race, a couple of more minor candidates could alter the final result. Ciro Gomes of the Brazilian Socialist Party (PSB) has announced his candidacy. He has run for president twice before and could draw votes away from Rousseff. However, the PT and PSB are allies and may cut a deal if Gomes agrees to withdraw, says Fleischer. Marina Silva, an ex-environment minister, will represent the Green Party and might just put the issue further up the political agenda than it would otherwise be.

Markets and elections

The impact of elections is likely to be muted in the long term as the main planks of both candidates are similar. However, in the short-term, the elections could cause spikes in volatility, especially if candidates present more populist ideas on the campaign trail.

Cortez thinks that Brazil country risk could spike up to 300 basis points on an EMBI basis and might even reach 420 points with the dollar gaining to a maximum of 2.06. He sees inflation subdued at 4.2%, comfortably inside the official target rate of 4.5%, and growth at 5.2%.

For capital markets, the effects are also likely to lead to some wobbles this year, although most investment banks still see upside for the Bovespa. Citigroup and HSBC Asset Management have an 80,000 target for the Bovespa index and Goldman and Itaú BBA have 85,000 with the index closing at the end of January 29 at 65401.

Many are more concerned by external events. Global uncertainties and commodity price weakness stemming from the decision by Chinese authorities to put a brake on growth through tighter credit and higher banking reserve requirements contributed to a terrible first month of the year. In January, the Bovespa index fell 4.6% and the real tumbled 7.9% against the US dollar.

Most investment bankers remain hopeful, however. There is still the warm glow of 2009’s excellent performance, when the Bovespa index leaped 148% in US dollar terms. Moreover, a growing number of global and Asian funds are eyeing Brazil for its relatively strong economic growth and consumer market.

For Latin American funds, the country has become pivotal. “Whenever we talk to anyone, they just want to talk about Brazil. It’s just Brazil, Brazil, Brazil,” says Nicolas Aguzin, head of Latin America investment banking at the US bank.

These investors are scouring the market for domestic consumer stories as the theme of an emergent middle class comes to dominate thinking on Brazil. Higher salaries and easier access to credit are particularly helping the low-to-middle-income class C and D consumers up their spending.

The focus may be on those sectors, but the wider market should benefit, partly as there are so few consumer plays to be had. Commodity stocks still represent some 40% of the total index and retail names just 4%, although the retail sector accounts for 13% of GDP. That is seeing banks emerge as proxies for the consumer story, for example.

For some investors, however, there are questions about current valuations. There is less room for capital gains than there were in the past, notes Roberto Serwaczak, head of equities at Citigroup in São Paulo. Pedro Bastos, chief executive officer at HSBC Asset Management, thinks that the fast growth in earnings will quickly reduce multiples to more reasonable levels. His own estimate is for an increase of earnings of 28% this year. “History does not reflect what this country is about to experience in terms of growth and formation of the middle class,” he says.

Others, however, are tapping on the brakes. Markets such as Mexico are looking more attractive, not because economic growth will be as high as Brazil, but because Mexico is now deeply discounted and a seemingly-fast US recovery should help the country. Nicholas Morse, Latin America fund manager at Schroders Asset Management in London, has added to his underweight position in Mexico at the expense of Brazil because valuations in the latter look full.

It’s not just Brazil’s elections that are worrying the market. Economic growth is likely to put pressure back on interest rates, which are likely to trend up this year with the market predicting a 200-300 basis point increase, from current levels of 8.75%.

That may not be enough to completely rattle the stock market and cause an exodus into fixed-income markets. After all, Brazil has gone through periods of much higher rates. It may, however, give food for thought to investors interested in buying consumer stocks and real estate companies, where mortgages are just starting to become more popular.

The real estate sector, along with infrastructure and logistics, are likely to dominate the market in terms of new deals, this year. A government sponsored programme to help families buy a home called My House My Life is underpinning interest in companies that specialise in lower income families, and a couple of deals from Inpar and PDG Realty were due to test the market as this magazine went to press.

Infrastructure boom

Infrastructure is also seen as a likely boom sector this year. That’s only in very small part to the World Cup, which Brazil will host in 2014, and the Olympics, where Rio de Janeiro will be showcased in 2016. It is more a reflection of the growing number of bottlenecks, from ports, airports, roads and public transport, that afflict Brazil and which have pushed the issue close to the top of the political agenda, where it will stay under either a Rousseff or Serra administration.

Banks including JPMorgan see the total number of deals from the infrastructure sector in the multi-billion dollar level. Asian investors, in particular, are interested in infrastructure stories, recognising this to be one of Brazil’s weak points. BNY Mellon ARX has launched a dedicated infrastructure fund to Japanese investors which raised $200m within weeks of opening.

Amid the flurry of deals in these sectors, two megadeals stand out. Petrobras needs a lot of money for its five-year $175bn investment plan and aims to raise capital later this year. The amount of capital and format of the deal remain undecided as congress scrutinises the issue. That, and the government’s decision to buy 5bn barrels of petrol from the state-owned company at an as-yet undetermined price, has rattled many investors. They say that Petrobras has become a more complex and a more politicised stock in which to invest. “Petrobras has become a lot more complicated thanks to the pre-salt issue and how the government intends to derive benefits from that,” thinks Morse. The other issue is likely from state-owned Banco do Brasil, which has said it would like to raise up to R$10bn in equity to bolster its reserves and help scout for new opportunities.

With the imminence of elections and rates trending higher, this year is likely to be marked by a busy primary issuance calendar in the first half followed by a very quiet second half, investment banks estimate. Companies have just a short window of opportunity to tap markets, with the end of July seen as one of the last possible dates.

The nightmare scenario is that the recent volatility from global markets will continue to make deals hard to place in coming months and the rest of the year will be a wash-out thanks to elections and higher rates.

The countdown to the elections in Brazil

On October 3rd this year, Brazilian voters will choose the successor of current President Luiz Inácio Lula da Silva, leader of the country’s Workers’ Party, who will serve for a four year term. Lula da Silva will not be able to stand again, as he has already served two terms, the maximum allowed under the country’s constitution.

As well as the role of president; all of the 26 Brazilian state and federal district governors will be up for election All 26 Brazilian states and the Federal District governors will be up for election. If none of the candidates receives more than a half of the valid votes, a run-off will be held on October 31st.

Like the president, governors are elected directly to a four-year term, with a limit of two terms. Aécio Neves (Minas Gerais), Blairo Maggi (Mato Grosso), Eduardo Braga (Amazonas), Ivo Cassol (Rondônia), Luiz Henrique da Silveira (Santa Catarina), Marcelo Miranda (Tocantins), Paulo Hartung (Espírito Santo), Roberto Requião (Paraná), Waldez Góes (Amapá), Wilma de Faria (Rio Grande do Norte) and Wellington Dias (Piauí) were all elected in 2002 and re-elected in 2006 and thus are not allowed to run again.

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