Financial market forecasting President Dilma's win in Brazil on sunday, turns to post-election scenarios

The market is now forecasting that incumbent Dilma Rousseff will be re-elected president in a squeaker on Sunday. Although rival Aécio Neves could pull off an upset if enough of Marina Silva's voters choose him or opt-out of voting for anyone, his victory would now be seen as a surprise. Downside risks remain in Brazilian equities.

Neves came from polling in third place behind Marina Silva to clobbering her in the first round on Oct. 5, thus guaranteeing him the No. 2 contender spot against Dilma. Polls have suggested that at least 60% of Marina's voters would chose Neves on Sunday, but he needs a little more than 65% providing the rest of Marina's voters choose Dilma. So far, that has not been the case as only around 20% of Marina's voters said they would vote for Dilma on Sunday, meaning the current crop of undecided voters will call the shots. Recent polls show a technical tie.

It is worth noting that the market's forecast is not exactly the market's preference. At this stage, investors are broadly looking for change in Brasilia, even more so than the average Brazilian.

Post-election prospects for macro policy, structural reform and economic performance have been well chewed-over.

"We think the new president will face a challenge to improve Brazil's GDP, investment and productivity, especially with the economy barely growing," says Geoff Dennis, a strategist for UBS in Boston.

Key reform initiatives include reform to state owned enterprises - namely Petrobras; re-balancing fiscal and monetary policy; cutting the size of the public sector; reducing taxes permanently rather than Dilma's short-term fixes; lower interest rates and secure a cheaper real from getting even cheaper. Disappointment is almost a certainty during this process, no matter who wins.

Social Democrat Aécio Neves (left) is the market favorite over incumbent Dilma Rousseff (right) of the Workers' Party. However, the market is now betting on a Dilma win on Sunday.

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Social Democrat Aécio Neves (left) is the market favorite over incumbent Dilma Rousseff (right) of the Workers’ Party. However, the market is now betting on a Dilma win on Sunday.

Post-Election Scenarios

The Bovespa stock exchange is trading around 10.6 times forward earnings, 25% higher than its average in 2000, Dennis noted in a report to clients on Thursday. UBS's downside scenario is based on unchanged macro policies under a Dilma 2.0, led by limited structural reforms. This brings the Bovespa to hover between 48,000-50,000 points if the Brazilian real weakens to R$2.70. The Bovespa index is currently trading at 51,588 points with a real at R$2.50.

For value hunters in emerging markets, Brazil begins to look like a long-term buy if it falls to 45,000 with a low price to earnings multiple of just under 8 times.

The upside scenario is dependent, in part, on some structural reforms and better macro policies being led by a new Finance Minister. Dilma hinted that Guido Mantega would not return as Finance Minister if re-elected, but it is unclear who would replace him. A business friendly, market favorite, would help bring serious money to Dilma's side. The upside to this is a Bovespa at 65,000 and a R$2.25 exchange rate, which is a sell, by the way, according to Dennis.

There is little in the Dilma policy proposals that excites the equity investor today. There is no commitment to tax reform or to a change in the current 'policy mix' lorded over by Mantega since 2010. Government spending will continue to grow strongly under both Dilma and Neves, but Dilma doesn't promise anything on the tax front.

However, the market will likely force some change on Dilma. The second version should be better than the first, at least this is what investors are hoping for. This would include some tightening of fiscal and monetary policy, less forex market intervention via taxes on foreign bonds and a gradual reduction in energy subsidies like gasoline, something that Petrobras investors could get excited about.

Dilma will have a lot to prove in January if she wins. Although there is more downside to Dilma than newcomer Neves, there is a solid wooden floor under her.

Downside:Given unchanged macro policies and limited structural reforms, we expect the Bovespa to fall into the 48,000-50,000 range.. This range is up 10% from the mid-March Bovespa (44,965) on the view that, whatever the election result, there will be some policy changes and some reforms will be passed in the next four years compared to the 2010-14 period. However, the real issue over how low the market and valuations could go is likely to be driven by the post-election performance of the currency. On unchanged leadership and polices, we would expect the real to fall much further, to an overshooting level of around R$2.70, perhaps exacerbated by liquidity shortages. Our current end-2015 remains R$2.55 so, in time, a post-election collapse in the real will trigger a buying opportunity.

Upside: Our upside scenario for the Bovespa of some structural reforms of the state owned enterprises and moves towards a true re-balancing of macro policy, as expected from an Aécio presidency, is 65,000. Assuming global conditions are calm at the time, this upside scenario is also likely to be accompanied by a strong rally in the real as remaining currency shorts are covered and there are significant inflows of new foreign money. On an Aécio victory, we would expect the real to rally to around R$2.25. Again, such a rally would take the currency into overshoot territory, not least because a key plank of a new policy framework in Brazil may well be a lower currency as a policy tool to support stronger growth over the long-term. Our end-2014 real forecast of R$2.45 assumes that a post-Aecio victory surge in the Brazilian real will, in time, be followed by another pullback.