One week / one topic: Half-time lead

What happened?

Back in February, ahead of carnival, I said that political noise would probably drown out fundamentals in Brazil before the October election, and that the outcome would be close to unpredictable.

Eight months on, voters have proved the second part right: Flavio Bolsonaro won 47% of the vote in the first round against about 45% for the incumbent, Lula.

The right also did well in the Senate, Congress and governors' races, echoing recent results in Colombia, Chile and Peru.

As most investors had expected the opposite result, the market's reaction was quick and strong. Bolsonaro now goes into the 25 October runoff as a clear favorite (~85% Polymarket odds).

Thankfully – going into the event – we already owned significant positions in local assets for fundamental reasons, in the form of very high real yields on bonds and attractive valuations for equities.

On Monday, Brazilian equities rose 8%, their biggest gain since 2020.

The Brazilian real gained as much as 5% against the dollar.

Swap rates fell by more than 130bp, and local government bonds rallied hard.

Volumes exploded, too: more than $8bn of the largest Brazil ETF changed hands in a single day, the most since it launched in 2000.

The central narrative can be clearly articulated:

• The nominal fiscal deficit is close to 10% of GDP, public debt is above 80%, and the policy rate is still 13.75%.

• Investors see Bolsonaro as more likely to deliver fiscal consolidation, which would give the central bank room to keep cutting rates.

• Lula, by contrast, expanded social spending and subsidies in the final weeks of the campaign.

Now, never mind that Flavio has said little about how he would actually cut spending, beyond a promise of a ‘big cut’… (This is 2026 after all, and all business is show business).

So, with one round still to go, is this the start of a structural re-rating for Brazil?

What should we do with our positions after the recent gains?

Our observations

• Fundamentals: The fiscal arithmetic has not changed overnight. What has changed is the perceived chance that someone will fix it.

  A right-leaning Congress would indeed make it more plausible, but a promise to cut spending is not a budget – and Brazil’s rigid spending rules have defeated better-prepared reformers many times.

• Price action: The one-day move was large, but real yields remain high and equity valuations are still inexpensive.

  Credible fiscal signals might spur further monetary easing, but let’s take this one day at a time…

• Investor beliefs: Positioning was light, and ‘emerging markets’ continue to offer a meaningful risk premium.

  As the gap vs so-called ‘developed markets’ continues to shrink from both sides, there is perhaps a structural case for maintaining exposures.

So what?

In February, we saw good potential in Brazil and maintained our positions over the following months while being careful not to bet the fazenda on this view.

Arguably, that restraint matters even more now that the election has paid out a large part of the (implicitly) expected returns.

The balance of risks also looks different, since the market has now largely priced in a Bolsonaro win:

• If he wins, the upside is smaller than it was a week ago.

• If Lula pulls off an unprecedented comeback, the downside is larger.

On the other hand, it would be easy to take profits too early... Real yields are still high, equities are still inexpensive vs global peers, and investors are still underweight Brazil.

If the polls confirm Sunday's result, there is room for others to buy in and – as previously noted – the structural case for EM assets doesn't rest on any one election.

On balance, I think the position has earned a review rather than a rethink, and we’ll keep watching this closely between now and the second round on October 25th.

The party has started early this year… but carnival never lasts forever.

Mood music: Prince – Let’s Go Crazy

By popular demand, here is the One week / One topic playlist

The information provided should not be considered a recommendation to purchase or sell any particular security.