Brazil Stocks Turn Cold as Lula Fourth Term Dashes Hopes for Government Change

Brazil ETF in Japan Plunges 15%

Concern Grows Over Bigger Losses for Sovereign Bond Investors

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President Luiz Inacio Lula da Silva's fourth term is proving negative for investors in Brazilian stocks and bonds.

On Oct. 26, TIGER Latin 35 dropped 7.62% to close at 6,000 won ($4.33) in Seoul. The exchange-traded fund invests in 35 American depositary receipts of large Latin American companies listed in the US, including major Brazilian names such as Vale SA, Petroleo Brasileiro SA and Itau Unibanco Holding SA. In Tokyo, an ETF that directly tracks Brazil's Bovespa index plunged more than 15%.

That contrasted with the first round of the presidential election, when stocks rose and government bond yields fell, lifting bond prices, after right-wing Sen. Flavio Bolsonaro led President Lula. Bolsonaro had pledged to cut fiscal spending. Markets took the prospect of a shift to a right-leaning government as a positive, sending stocks to a record high before that expectation premium evaporated.

Stocks began to lose momentum after the gap in support between Lula and Bolsonaro narrowed following the first-round vote. In a Citigroup survey released on Oct. 23, respondents projected the Bovespa would fall more than 5% if Lula prevailed. Felipe Tavares, chief economist at local asset manager Monte Bravo, calculated the Bovespa's fair value at 15% below its Oct. 23 close in that scenario. He also put the probability of a circuit breaker on the first trading day after the election at 55%.

In South Korea, exposure to a sharp equity selloff is limited because investment in Brazil-focused ETFs is relatively small. The bigger concern is for holders of Brazilian government bonds. The securities have attracted wealthy investors as a tax-efficient product because they offer coupon rates of about 10% a year, tax-free interest income under the Korea-Brazil tax treaty, and exclusion from South Korea's comprehensive taxation on financial income.

If fiscal spending continues to rise under Lula, Brazil will probably issue more government bonds, pushing prices lower and increasing losses. In Citigroup's survey, 67% of respondents said yields on bonds due in January 2029 would rise by more than 1 percentage point if Lula won. Respondents also worried that depreciation of the real tied to fiscal expansion could deepen mark-to-market losses for bond investors.

Kang Jin-kyu, Korea Economic Daily reporter josep@hankyung.com