Investors Way Too Stressed Out About Brazil

&l;p&g;&l;img class=&q;dam-image ap size-large wp-image-3b7dfb75957c460ea745fb96af70087f&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; A protester holds up a poster with a picture of Brazil&s;s former President Luiz In&a;aacute;cio Lula da Silva during a demonstration in his support. Lula is in jail. Investors are pessimistic about Brazil&s;s elections, with or without Lula. (AP Photo/Armando Franca)

On balance, investors are much more pessimistic about Brazil due to pending elections this October than they are optimistic. The scales&a;nbsp;have clearly tipped in favor of a negative outcome, with a non-reformer taking the presidency.&l;/p&g;

Over the last three months, Brazil&s;s stock market&a;nbsp;has been getting beat by the benchmark emerging markets index.&a;nbsp;And by Mexico, a country facing its own election on July 1.

U.S. investors are almost always overly negative about Brazil&s;s elections. The currency heads to four-to-one (it&s;s now R$3.60 to a dollar); the stock market declines. Then the new president picks his cabinet, and even if the cabinet members are not guys like former banker Henrique Meirelles, the current Finance Minister and ex-Central Bank chief, the market always comes back. The Brazilian real will be back to R$3 (or stronger) in less than a year, barring a complete blowout in the global economy. In other words, foreign investors are pessimistic about Brazil, and that&s;s expected. They always overreact on this. Pessimism makes Brazil cheap, and that means it is becoming fertile ground for bargain hunters.&l;/p&g;

Brazil should be a buy.

Last week, Richard Turnill, chief investment strategist of BlackRock, said Brazil was one of three countries best positioned to weather a global trade war. Inflation is holding steady to falling. Interest rates are in decline. The domestic economy is finally rebounding, albeit slowly. Brazilians are still consumers. They are going to buy beer and gasoline and go grocery shopping at P&a;atilde;o de A&a;ccedil;&a;uacute;car regardless of Xi Jinping and Donald Trump trade spats.

What&s;s currently priced in?

Local debt and currency markets are pricing in a 75% pessimistic and a 25% optimistic scenario, says Nomura&s;s Latin America Strategist, Mario Castro. &q;The initial reaction would be stronger in the event of a positive development, but we expect the market to continue trading weakly until there is a meaningful increase in the likelihood of a reformist winning the election.&q;

Who is going to win?

Nobody knows.

&l;img class=&q;dam-image getty size-large wp-image-939266540&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;639&q; data-width=&q;960&q;&g; Congressman Jair Bolsonaro is a right-of-center, law-and-order type. He is the highest polling candidate, and his appearance on the scene comes at a time when Rio de Janeiro is being patrolled by the military to cut down on violent crime and the political class is embroiled in a years-long scandal involving state-controlled oil giant Petrobras.&a;nbsp; (Photo by HEULER ANDREY/AFP/Getty Images)

Barring a miracle, ex-president and now convicted ex-president Luiz In&a;aacute;cio Lula da Silva is still the chosen one, based on polling data. If elections were held today, some 30% of voters would pick him. But like Wall Street&s;s pessimism during Brazilian election seasons, Lula&s;s lead is not new. Lula is always in the lead, and 30% is not enough to put him over the top even if he could be a candidate. He cannot be a candidate. Even if he got out of jail before October.&a;nbsp; The country&s;s Clean Slate laws ban individuals convicted of crimes from running for public office for 8 years.&a;nbsp; Appeals courts and the Supreme Court all upheld a lower criminal court&s;s charge that Lula was on the receiving end of bribes in the massive Petrobras contract-rigging scheme.

The Petrobras scandal has pulled a rug out from under Lula and his once mighty Workers&s; Party. Not a single Workers&s; Party candidate polls more than 5% of voter intentions, based on Datafolha surveys, a S&a;atilde;o Paulo-based pollster.

The number one candidate&a;nbsp;that will run for office and is allowed to run for office is congressman Jair Bolsonaro from a small party with no real coalition. A Bolsonaro win would be compared to the Trump victory by everyone in the press, insofar as Bolsonaro looks and feels a lot like a traditional American Republican. He likes guns. He&s;s not too fond of gay marriage. He&s;s Brazil&s;s version of the law-and-order president.

The closest Brazil has to a free-trader, Bovespa type is Geraldo Alckmin. He doesn&s;t poll over 10% at this time, based on Datafolha&s;s polls.

&l;img class=&q;dam-image bloomberg size-large wp-image-34561562&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;629&q; data-width=&q;960&q;&g; Geraldo Alckmin, Governor of S&a;atilde;o Paulo, hasn&s;t cracked 10% in the polls yet. He is the market&s;s favorite. (Photographer: Steven Brahms/Bloomberg News.)

Brazil&s;s election season shifts into high gear after the World Cup in Russia in July. Investors will only get a better sense of who is in the lead and what their platform is heading into August. In the meantime, Brazil will likely follow the whims of international emerging market investors. If emerging markets are okay, Brazil will be okay. If emerging markets are not okay, Brazil will underperform until there is political clarity.

Keeping in mind that Brazil always recovers strongly after an election cycle, then Brazil is at least as good as Mexico, only not dependent on the U.S. And it has a more diverse local market.

The economy now has historically low interest rates, tame inflation, strong external accounts and it is growing.&a;nbsp;Their fiscal standing&a;nbsp;remains fragile and requires pension fund reform to help. (Or less tax evasion, but that&s;s complicated.)

&q;The incoming administration&a;rsquo;s willingness and ability to pass reform remain as key variables in the outlook,&q; says Castro. &q;The market appears to be biased towards a more pessimistic scenario… could be stronger in the event of positive developments.&q;

Expect foreign investors to trade Brazil on the bearish side. For those who believe a turnaround begins in 2019, regardless of the presidency, the lower Brazil goes, the bigger the opportunity. Not too long ago, Petrobras was trading at just $3 a share. It closed at $16.19 on Friday.&l;/p&g;