Brazil is heading into the second round of a consequential presidential election that could shape the direction of fiscal policy, economic reform, and investor confidence for years to come.
Incumbent President Luiz Inácio Lula da Silva is seeking a fourth nonconsecutive term, while Senator Flávio Bolsonaro, son of former President Jair Bolsonaro, is running on a more market-oriented platform. Neither secured a majority in the October 4 first round, setting up a runoff on October 25.
Bolsonaro’s stronger-than-expected showing—47% of the vote versus 45% for Lula—also coincided with gains for the political right in Congress, increasing the potential significance of the result for the next government’s ability to pursue its agenda.
For investors, the election comes at a particularly important point in Brazil’s economic cycle. Fiscal concerns have weighed on Brazilian assets, government debt remains high, and the central bank has maintained exceptionally restrictive monetary policy, leaving the policy rate around 14%. At the same time, signs of weakness are becoming more visible in the domestic economy and credit cycle.
These conditions had already created an interesting investment setup before the first ballots were cast, and the election could meaningfully alter it. A Bolsonaro victory would likely be interpreted by markets as increasing the prospects for greater fiscal discipline and a more market-friendly policy mix, while a Lula victory would imply greater continuity with the current policy framework.
The important question is whether the next government can restore enough confidence to allow interest rates to fall.
But the investment case for Brazil is not simply a binary political trade. In my view, the more important question is whether the next government can restore enough confidence—and whether inflation and economic conditions cooperate—to allow interest rates to fall.
The first-round result moved that debate forward quickly. Markets had generally expected Lula to lead Bolsonaro by zero to three percentage points. Instead, Bolsonaro finished ahead, materially changing perceptions of the October 25 runoff and triggering a sharp repricing across Brazilian assets.
That matters for markets. But in my view, the case for Brazil is broader than the election itself. Several factors are shaping the opportunity.
Credit Had Become Oversold Ahead of the Vote
Going into the election, we believed Brazilian credit had become too cheap relative to the underlying fundamentals.
Political uncertainty had weighed on the market, but some of the pressure was also technical. Investors with exposure to Brazilian corporates often hedge political risk through sovereign credit default swaps, which can push sovereign spreads wider even when external credit fundamentals remain relatively sound. We viewed that weakness in dollar-denominated bonds as an opportunity and entered the first round positioned long.
At the same time, the political backdrop was becoming less negative than market pricing suggested. In early August, consensus expectations still favored Lula by a considerable margin, but polling tightened meaningfully through September. By late in the month, some polls were effectively 50-50, with at least one showing a modest Bolsonaro lead.
In our view, that created an attractive asymmetry: credit had already absorbed considerable election risk, while the probability of a more market-friendly outcome was rising. The stronger-than-expected first-round result validated that view and helped drive the subsequent repricing.
Positioning Magnified the Market Reaction
The strength of the post-election rally cannot be explained by politics alone. Positioning also mattered.
Brazil’s domestic hedge fund industry has changed considerably. Historically, local hedge funds were an important source of risk-taking in Brazilian markets. But after sustained outflows and weak performance, many of those funds entered the election with limited capacity to add exposure.
Outflows across equity and fixed-income products had at times reached roughly $1 billion to $5 billion per week. As a result, even investors who believed Bolsonaro had an advantage were not necessarily positioned to express that view aggressively.
That created an asymmetric setup: sentiment was becoming more constructive, but positioning remained light. When the first-round outcome surprised the market, Brazilian risk assets rallied sharply.
Dollar Credit and Local Assets Tell Somewhat Different Stories
It is important not to interpret every move in Brazilian dollar bonds as a direct referendum on politics.
Brazil has several hundred billion dollars of international reserves and relatively little dollar-denominated debt compared with its overall debt stock. That gives its external credit profile a significant buffer.
As a result, dollar bonds tend to have less sensitivity to domestic political developments than local assets. Their tightening ahead of and after the election reflected both changing political expectations and the broader macro environment.
For investors looking to express a more direct view of the domestic outlook, local markets are therefore particularly important.
The Deeper Opportunity Is in Rates
The most compelling part of the Brazil story, in my view, is the level of real interest rates.
Brazilian assets sold off significantly in 2024 as fiscal concerns grew and the country moved against the global monetary trend by resuming rate hikes. That adjustment has left Brazilian real rates among the most attractive globally.
At the same time, the economy is showing signs of strain. We see that particularly in credit, where nonperforming loans among domestic businesses are increasing.
I do not view this as a systemic banking problem. Lending rates remain high enough that banks should be able to absorb some deterioration. But it reinforces the argument that monetary policy is restrictive.
The probability of eventual easing is increasing.
With the policy rate around 14% and the central bank becoming more dovish, the probability of eventual easing is increasing. That creates an attractive setup for local rates.
Brazil may also benefit from a broader institutional desire to diversify portfolios away from concentrated exposure to the U.S. dollar. I would not overstate that theme—the dollar remains the world’s dominant reserve currency—but it is another potential source of demand for local assets.
Politics Could Add a Confidence Shock
A Bolsonaro victory would likely reinforce the rates story by generating an additional improvement in business and investor confidence.
The first-round result has already produced some of that effect. The Brazilian real, for example, strengthened materially as markets repriced the election probabilities. Under a Bolsonaro win scenario, market participants have discussed the currency moving toward roughly BRL 4.50-BRL 4.80 per dollar, compared with approximately BRL 4.95 around the time of our discussion and about BRL 5.20 before the repricing began.
That also means part of the opportunity is already behind us. My rough assessment is that perhaps 60% to 70% of the currency move associated with a Bolsonaro victory has already occurred.
The opportunity today is therefore different from the one that existed before the first round. Valuations are no longer as depressed, and investors should not assume that a favorable electoral outcome has not been discounted.
Fiscal Policy Ultimately Comes Back to Interest Rates
The fiscal debate is also more complicated than simply comparing one administration’s expected budget balance with another’s.
Some analysts estimate that a Bolsonaro government could run a fiscal balance roughly one to two percentage points better than under Lula. That would matter. But Brazil’s fiscal structure makes the interest-rate channel particularly important.
A large portion of government spending is constitutionally mandated, while revenue is already high relative to gross domestic product (GDP). That leaves policymakers with relatively few easy ways to adjust the fiscal position.
At the same time, the government relies heavily on the domestic market for financing, and much of that debt is sensitive to short-term interest rates.
That creates a potentially pro-cyclical dynamic. When the central bank raises rates aggressively, the government’s own interest expense rises. Higher rates can therefore weaken fiscal dynamics even as monetary policymakers are attempting to restore confidence.
A durable improvement in confidence could have an unusually large effect.
For that reason, a durable improvement in confidence that allows interest rates to decline could have an unusually large effect on both the fiscal position and the broader economy.
Even a reduction in the policy rate from roughly 14% to 10% would represent around 400 basis points of easing. Rates would still be high, but the reduction in financing costs could be meaningful.
I see three fundamental constraints shaping Brazil’s fiscal outlook: the level of interest rates, the rigidity of constitutionally mandated spending, and the government’s heavy reliance on domestically financed debt linked to short-term rates.
Duration Remains Scarce
Brazil has a long-term local bond market, but extending the yield curve remains challenging.
When yields are historically high, the government has little incentive to lock in expensive long-term financing if it believes rates will eventually decline. Issuers naturally prefer shorter maturities under those circumstances.
Brazil’s history of political and market volatility also limits investor willingness to extend duration. Compared with markets such as Mexico, investors have fewer opportunities to gain long-dated exposure.
The issue is not that Brazil’s yield curve is inverted. Rather, there is simply less duration available than investors might expect in a market of its size.
What Matters From Here
I remain constructive on Brazil, particularly local assets.
The election has clearly changed the near-term backdrop. The first-round result materially increased perceived odds of a Bolsonaro victory, the legislative elections shifted further to the right than expected, and domestic positioning allowed that surprise to translate into a powerful market reaction.
But the investment case does not depend solely on who wins the presidency. The more durable story is the combination of exceptionally high real rates, a weakening credit cycle, and the potential for eventual monetary easing. Because Brazil’s fiscal accounts are unusually sensitive to domestic interest rates, a sustained improvement in confidence and inflation that allows rates to decline could improve both debt dynamics and economic activity.
A Bolsonaro victory could reinforce that process by strengthening expectations for fiscal discipline and a more market-friendly policy mix. But markets have already priced a meaningful portion of that outcome.
From here, the key questions are whether the improvement in confidence can persist, whether inflation allows the central bank to cut rates, and whether the next government can translate its political position into durable economic reform.
Lewis Jones, CFA, FRM is a portfolio manager on William Blair's emerging markets debt team.
