Lula overturns first-round deficit to win re-election, sending Brazil ETF down 27% pre-market

Brazilian President Luiz Inácio Lula da Silva defeated right-wing Senator Flávio Bolsonaro with 51.79% of the vote in Sunday's (25th) second-round presidential election, securing an unprecedented fourth term. The result ran counter to pre-election polls and prediction-market bets. Brazilian assets were sold across the board on Monday: IBOVESPA futures fell by nearly 20% at one point, while the cash market triggered a circuit breaker within minutes of opening. The US dollar briefly surged about 12% against the real to 5.60 reais.

According to B3, Brazil's exchange operator, the IBOVESPA cash index fell more than 10% at 10.03am Brazil time (9.03pm Hong Kong time), triggering a circuit breaker and suspending trading for 30 minutes. It was the first such halt since the market crash caused by the Covid-19 pandemic in early 2020, and the first time Brazil's market had triggered a circuit breaker after an election result. The index subsequently fell as much as about 17%. B3 widened the daily price limits for futures on Monday, raising the limit for IBOVESPA futures from 10% to 15% and then to 20%, while the limit for US dollar futures was increased from 6% to 8.4% and then to 12%.

Brazilian assets listed in the US began plunging before the Brazilian market opened. The iShares MSCI Brazil ETF (NYSE Arca: EWZ) fell more than 27% in pre-market trading at one point. American depositary receipts (ADRs) of oil giant Petrobras (NYSE: PBR) were down about 22%. Itaú Unibanco (NYSE: ITUB), Banco Bradesco (NYSE: BBD) and Nu Holdings (NYSE: NU), the parent company of digital bank Nubank, fell between 23% and 29%. E-commerce company MercadoLibre (Nasdaq: MELI) dropped 10.9%, while brewer Ambev (NYSE: ABEV) fell about 18%. By comparison, mining group Vale and aircraft manufacturer Embraer were down only about 3% to 4%.

The "Bolsonaro trade" unwound overnight

The scale of the sell-off was directly linked to the one-way bet that had built up over the previous three weeks. Flávio unexpectedly led Lula in the first round on October 4, securing about 47% of the vote against Lula's roughly 45%. Markets then began betting that a return of the right to power would bring tighter fiscal discipline, corporate tax reform and privatisation, helping to reduce government debt and borrowing costs. The positioning became known as the "Bolsonaro trade". By Friday's close, the IBOVESPA had gained nearly 7% from before the first round, the real had strengthened almost 5% against the US dollar, and interest-rate futures had already priced in room for rate cuts.

Citigroup analysts said in a report that Lula's victory should be viewed as negative for markets because it contradicted investor expectations and confirmed the "downside asymmetry" identified in the bank's pre-election survey: investors expected a larger fall if Lula won than the rise they anticipated if Flávio prevailed.

Pre-election polls showed Flávio with a narrow lead, while bets on prediction market Kalshi strongly favoured his victory. Lula ultimately gained more than 10 million additional votes in the second round and won by about 4.43 million votes. It was the first time since Brazil's return to democracy that a candidate who trailed in the first round went on to win the run-off.

Election challenge faces limited legal room

Flávio has so far refused to concede and said he would seek to have the election annulled. His challenge targets a decision by Supreme Federal Court Justice Cristiano Zanin, made at Lula's camp's request, to extend voting nationwide until 7pm. Flávio also questioned Zanin's previous role as Lula's personal lawyer.

However, Superior Electoral Court president Kassio Nunes Marques has confirmed Lula's victory and said the extension did not affect the result. Data from the electoral court showed that only about 35,000 votes were cast during the extended period, far below the gap of more than 4 million votes between the two candidates. Several electoral lawyers said overturning the overall result was not feasible. Flávio's camp had also sought an extension on the grounds of heavy rain in parts of cities in the states of São Paulo, Paraná and Santa Catarina. Although the legal challenge has little chance of succeeding, it could continue to add a risk premium to Brazilian assets until the dispute subsides.

Petrobras: markets fear not a "reversal", but "continuity"

Petrobras was at the centre of the sell-off. Markets fear that during Lula's new term, the government could increasingly use the state-controlled oil company as a tool to contain inflation amid pressure for higher social spending, selling fuel below international prices and eroding its earnings and dividend capacity.

There is historical precedent for the concern. During Lula's second term, from 2007 to 2010, domestic fuel prices were frozen for two years and seven months. His successor, Dilma Rousseff, adopted a similar approach, contributing to a deterioration in Petrobras's finances before the company became embroiled in the "Operation Car Wash" corruption scandal. Under Michel Temer's government in 2016, Petrobras adopted import-parity pricing, linking domestic fuel prices to international oil prices and the exchange rate. Bolsonaro largely maintained the system, and the company posted record profits of 106.7 billion reais and 188.3 billion reais in 2021 and 2022 respectively.

It is important to note that market-based pricing was already under threat before Lula returned to office. In May 2023, his government prompted Petrobras to abandon the import-parity mechanism and adopt a new pricing strategy based on "customer alternative costs" and the company's "marginal value". International oil prices were no longer the sole benchmark for price adjustments. In other words, investors are not afraid of a policy reversal this time, but of the continuation of a more flexible and less transparent pricing system for another four years — and its possible further use as a policy tool under fiscal pressure. The market had been betting that a right-wing government would tighten the mechanism again.

The fiscal arithmetic

Data from Brazil's central bank showed that general government gross debt rose to about 11.1 trillion reais in August, equivalent to 82.9% of gross domestic product (GDP) and the highest level since October 2020. Market forecasts compiled by Brazil's finance ministry indicate that the ratio could rise to 83.4% for the full year, while the national treasury's own forecast puts it at 89.6% by 2029.

Lula's economic team aims to deliver a primary surplus equivalent to about 1.3% of GDP by 2030 — a budget surplus before interest payments. But constitutionally protected spending, including pensions, accounts for most of the federal budget. With limited room to cut rigid expenditure, markets remain sceptical about the credibility of the commitment.

Interest-rate transmission puts banks on the front line

Under the "Bolsonaro trade", Brazilian interest-rate futures had been pricing in room for rate cuts resulting from tighter fiscal policy. Lula's victory has broken that narrative. Interest-rate futures surged on Monday, while Brazilian dollar-denominated sovereign bonds also came under pressure, with longer-dated debt suffering the biggest losses. Bonds maturing in 2056 fell by nearly 3 US cents.

Brazil's benchmark Selic rate currently stands at 13.75%. After five consecutive cuts of 25 basis points each, the central bank has not indicated its next move. Its next policy meeting is scheduled for early November. William Jackson, chief emerging-markets economist at Capital Economics, said that amid rising fiscal risks and a weaker real, the rate cuts previously expected at the remaining two meetings this year now appeared unlikely.

Bank stocks suffered the steepest falls, reflecting this transmission chain. If a loss of government credibility pushes up sovereign bond yields, financing costs for companies and households will rise, credit spreads will widen and expectations of bad debts will increase. Brazil's banks, which are highly dependent on the domestic credit cycle, would face a double blow. If fiscal pressure prevents the central bank from cutting rates freely, a high-interest-rate environment would amount to a continuing "hidden tax" on businesses, increasing the risk of a contraction in credit.

Bond auctions suspended as treasury launches buyback

The shock also spread to government financing. Brazil's national treasury said on Monday morning that it had cancelled the inflation-linked bond auction scheduled for Tuesday (27th), as well as the fixed-rate bond auctions scheduled for Thursday (29th) for LTN and NTN-F securities. It retained the auction of floating-rate LFT bonds, which are linked to the Selic rate and less sensitive to long-term interest-rate volatility. The treasury also announced a special buyback operation of up to 15 billion reais (about HK$21 billion) to stabilise the market. Tesouro Direto, the government bond trading platform for retail investors, also suspended trading on Monday because of excessive yield volatility. Local media said this was standard practice during periods of severe market turbulence.

What to watch next

Monday's losses had a clear element of panic, but they also exposed Brazil's long-standing structural fiscal tensions. Three indicators will determine whether Brazilian assets revert towards their previous mean or enter a prolonged slump:

First, appointments to the new administration, particularly the finance minister and other key economic posts. If the new team demonstrates firm fiscal discipline and presents a concrete deficit-control plan at an early stage, the market may find support after the oversold conditions.

Second, Petrobras's fuel-pricing policy. Whether the gap between domestic prices and international import parity continues to widen, and whether the dividend policy changes, will be the clearest signals of governance risks at the state-controlled company.

Third, the yield curve in the secondary government bond market. Although primary-market auctions have been suspended, yields and credit spreads on existing government bonds in the secondary market will provide the clearest gauge of sovereign credit risk and long-term inflation expectations.

Whether policy decisions continue to disappoint the market or sentiment recovers after an overreaction, Brazilian assets will not return to the pricing seen a week ago.