Brazilian assets plunge after Lula's surprise election victory

The risk of depending on prediction markets for capital-market investment becomes apparent on Monday as Brazilian assets are being hammered.

The EWZ Brazil ETF has fallen 25% in premarket activity after incumbent President Lula defeated Flavio Bolsonaro in a surprising result. Betting platforms had given Bolsonaro a better than 75% chance following his lead in the first round of voting earlier this month.

Opinion surveys had pointed to a tight contest, but a late push by Lula proved sufficient as he secured 51.79% of the vote versus 48.21%, a margin of over 4 million ballots. Bolsonaro has not conceded, meaning some of the market weakness may stem from uncertainty over the outcome, though the primary driver is the prospect of continued left-wing governance in Brazil. The result also stalls the trend toward populism in Latin America, an unexpected turn that could generate spillover effects in neighbouring economies.

In currency markets, USD/BRL has climbed to 5.60 from 4.97 on the eve of the election, accounting for a significant portion of the decline in the dollar-denominated ETF.

The drop in the Brazilian ETF on Monday erases the entirety of the market's year-to-date gains.

It is worth noting that Brazilian stock markets have essentially delivered no returns for years. The EWZ ETF has been flat since 2014, though it currently trades at roughly 8 times earnings as the commodity-heavy index benefits from elevated global prices. As a result, today's sell-off could represent a buying opportunity once conditions stabilise.

The market was clearly caught off guard by the election result and is now experiencing a squeeze. In May, when Lula was the favourite to win, the ETF traded at $39; by contrast, in premarket trading it stands at $30.89, even with better global commodity prices.

Eamonn earlier noted how the market is pricing in an extreme scenario, drawing on Goldman Sachs' Monday playbook:

The bank said the dollar could rise as much as 10% against the real, long-term government bond yields could climb by about 200 basis points, credit spreads could widen by 30 to 40 basis points and Brazilian equities could fall around 15%. Goldman framed these as an extreme case rather than its central expectation, but the figures underline the scale of the repricing risk. 

In short, the premarket is reflecting Goldman's tail scenario — and beyond.

Investors are now watching for Lula's cabinet picks. The quickest way to establish a floor here would be a credible finance minister announced this week.