Lula wins Brazilian presidency, faces polarised Congress

Key takeaways

• Former President Lula narrowly wins Brazilian election. In a divided Congress, he will need centrist support, limiting fiscal policy changes
• In the interim, the country will negotiate 2023’s budget to address the country’s spending cap and keep welfare payments in place
• A slowing Brazilian economy should see disinflation and higher debt in 2023; we expect the central bank to start cutting interest rates from Q2 2023
• We are neutral Latin American hard currency debt, and prefer corporate to sovereign bonds. We see USDBRL trading in a 5.10 to 5.40 range over the next three months. 

Luiz Inacio Lula da Silva has won Brazil’s presidential vote, promising state investments, tax reforms and to end hunger with a programme that depends on forging allies in a polarised Congress. Lula’s 50.9% victory margin, narrower than polls indicated, has been confirmed by Brazil’s Superior Electoral Court.

As we publish President Jair Bolsonaro, the right-wing incumbent, has not yet conceded. Throughout election campaigning, he cast doubt on the integrity of Brazil’s electronic voting machines and the court. While Brazil’s political institutions and the international community have endorsed the election result, the risk of political unrest can’t be dismissed. Markets are closely watching Bolsonaro’s response.

Investors will pay close attention to the list of ministers that Lula appoints in the coming weeks for his third presidential term, and negotiations with other parties to build a working majority in Congress, before taking office on 1 January 2023. He has already said that he will name Geraldo Alckmin, a former governor of Sao Paulo, considered sympathetic to business and markets, as his vice-president. Elections on 2 October for the Chamber of Deputies and Senate produced an even more polarised, right-leaning Congress with more seats for Bolsonaro’s allies, making it difficult for Lula to enact his agenda. Lula will have to draw support from the influential centrist block to fend-off any impeachment proceedings and pass laws (see table). Constitutional amendment will be even more difficult in the new Congress for Lula and his allies as it would require support from some of the right-wing parties who supported Bolsonaro.

Even before the new government takes office, the existing administration under Bolsonaro and Congress must work together to add new modifications to the country’s constitutional spending cap to keep delivering welfare payments worth BRL 600 (USD 113) per month for each household. While the extension of these payments, branded as ‘Auxilio Brasil’, have broad-based support in Congress, Lula’s Worker’s Party (Partido dos Trabalhadores or ‘PT’) may resort to temporary workarounds such as delaying the final 2023 budget. Without these measures, the welfare payments will fall back to BRL 400, putting Lula in a difficult political position at the start of his new term.

Lula, who served two presidential terms through 2010, has criticised the spending cap. The ceiling is widely seen by investors as economically reassuring, as it constrains a government’s fiscal response during a crisis. He has not spelled out how his policies would be funded. Lula may be considering targeting a budget surplus range as an alternative to the cap. Whether Congress will support such a constitutional amendment remains an open question.

Disinflation and BCB independence

Despite a punitively high interest rate of 13.75% since August, around 6% in real terms, Brazil is set to enjoy a second consecutive year of above 2% growth in 2022 thanks to the global commodities boom and solid consumption buoyed by welfare payments. The tone will be different in 2023. With the negative impact of high real rates filtering into the economy and global demand slowing for raw materials, Brazil will likely see its growth rate fall below 1% in 2023.

The expected economic slowdown will contribute to material disinflation in the country. Consumer price inflation decelerated from 12.1% in April to 7.2% in September, significantly impacted by falling fuel inflation. We expect this trend to continue in 2023, bringing inflation within Banco Central do Brasil’s (BCB) target range of 3%, plus-or-minus 1.5%. If this happens, Brazil will be one of few emerging markets to reach its inflation target.

We see only limited scope for a monetary policy misstep. Stronger legal provisions for the BCB’s independence mean that Lula cannot appoint new directors for his first two years in office, leaving the current central bank President Campos Neto free to defend its inflation target until 2024. Even then, limited economic room for manoeuvre and a fragile hold on Congress will constrain Lula’s appointments. We therefore remain cautious on how quickly the BCB will drop its benchmark Selic rate next year. Gradual cuts starting in the second quarter of 2023 would be in line with market consensus, especially if Congress agrees to keep distributing Auxilio Brasil cheques.

Fiscal risk focus

The risk watched by markets is primarily fiscal. After imposing a stringent constitutional spending cap in 2016, Brazil’s Congress has steadily introduced greater flexibility since the Covid pandemic. Gross government debt still declined as a share of gross domestic product, despite these modifications, thanks to the country’s commodity exports that lifted revenues for local governments.