As Brazil Economy Finally Gets Growing, Investors Worry About Lula 2018

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They’re baaa-aack. Wall Street: "Please God, no." Two ex-presidents both declare their intention of getting back in the game in October 2018. Only one, Luiz Inacio Lula da Silva, has a chance of winning the presidency once again. Lula is under investigation for orchestrating the largest corporate corruption scandal in Brazil’s history. Even if he had nothing to do with it, the ransacking of Petrobras happened for over a decade, and most of it on his watch. (AP Photo/Eraldo Peres, File)

Brazil’s economy is growing again. It’s not by much. But after nearly three years of recession and unemployment going from 4.5% to 12%, anything over zero is reason to celebrate. Brazil’s stock market as measured by the popular iShares MSCI Brazil fund (EWZ) is up 20% this year. No country can do it better for Wall Street.

"I recommend the topic of whether Brazil will grow or not be taken off the agenda, because we are already growing," Sergio Rial, president of Santander, told Folha de Sao Paulo newspaper on Tuesday. "What we have to ask ourselves now is whether this growth is enough, and where is it coming from," he was reported saying.

Brazil is largely an overweight these days in U.S. mutual fund world. But there is a spark of concern out there that has less to do with the rising prices of Brazilian securities and more to do with the talk of Luiz Inacio Lula da Silva returning to power in 2018. Lula is largely seen by the populous as the master mind behind the God awful Petrobras scandal: a contract rigging scheme that has Lula a yardstick away from a jail cell and saw his predecessor Dilma Rousseff ousted in an impeachment trial back in August.

The Workers Party that he created was kicked to the curb by voters in October. They’re a smaller opposition party. Still, Lula cannot be counted out. He is far and away Brazil’s biggest political star. And in the age of media driven personality cults, even a fallen hero like this guy can make a comeback…and win. His chances look better if Rial of Santander is wrong, and the economy does not grow enough to increase employment.

I asked Mike Reynal, a fund manager with Sophus Capital in Des Moines and a long-time Brazil investor, what he thought about a Lula return in 2018. In a word: bad. Sophus is overweight Brazil at the moment.

"A new Lula presidency would be tinged with memories of corruption, mismanagement and judicial red tape linked to Dilma’s presidency," Reynal says. "A Lula win would lead to a hike in sovereign risk. We would definitely be more skeptical." Brazil became investment grade under Lula and lost it under Dilma.

"The market is already speculating that Brazil can get a credit once we approve pension reform," says Fernando Bergallo, director of FB Capital in Sao Paulo. Pension reform is the next big policy to move in the congress. A Lula victory would end all that. "Lula would undoubtedly be a disaster for the country’s finances. It would bring panic to financial markets as soon as investors started to believe that a Lula win was possible," he says.

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Lula the metal shop worker represented the working classes of Brazil when he ran and won two-terms starting in 2002. For many, he was the "Brazilian dream" incarnate. He was the perennial underdog, whose critics claim he sliced off his own pinky finger in order to collect disability insurance and use the injury as a symbol for the worker’s fight against the uncaring, greedy owners of capital. He toned down his rhetoric over the years and became known as more pragmatic capitalist during his 8 years as president.

To his luck, he presided over a remarkable period in Brazil’s history, one not seen since the so-called Miracle Years of the dictatorship in the 1970s. Inflation collapsed, interest rates fell, prices for every major commodity that Brazil dominated — from soybeans to iron ore — all rose on Chinese demand, and unemployment dropped. Domestic workers whose futures seemed relegated to servitude got jobs in call centers and shopping malls, or as small shop owners themselves in the northern half of the country where social welfare programs gave the poor more money to spend. He was heralded the world over for these policies. But when the commodity super cycle ended, Dilma was unable to continue those policies. The government was running out of money. Indeed a number of Brazilian states have a credit ranking worse than that of Venezuela’s, the most fragile state in South America.

"The commodity cycle helped the poor, but that’s not what the poor believe. They believe Lula brought them out of poverty and now commodities are rising again," says Fernando Pertini, CEO of Millenia Asset Management International in Panama. "This wouldn’t change our view on Brazil. The stars are starting to align in terms of fundamentals," he says.

In the Lula years, investors watched a rapid expansion of the government’s role in the economy. It took the lion’s share of Petrobras deep water discoveries, and awarded billions of dollars in contracts to build hydroelectric dams to state owned power utilities. The sidekicks were the big construction firms, led by Odebrecht. Their executives are now in prison. Odebrecht, which built part of the Miami International Airport, is now a shadow of its former self. CEO Marcelo Odebrecht is serving a 19 year prison sentence.

If Lula, under investigation for his role in the Petrobras graft schemes, is allowed to run for office, some believe he has a serious chance of winning. This is especially true if the economy fails to impress. From a political narrative standpoint, all he has to do is appear the slightest bit humbled, and assure those that supported him years ago that the corruption that wiped out over 70% of Petrobras’ market capitalization is over; he is starting Brazil off on a clean slate. And he is coming to town with a pro-growth agenda. Instead of "Lula Peace and Love", it’d be "Lula Forgive and Forget". That could be his motto. The general election is not until October 2018 and there are no declared challengers at this time. In the meantime This is pretty normal in Brazil, however. The locals don’t think he wins.

"If he wins in 2018 it would be a huge backslide in fighting corruption and represent a pretty significant decline in business confidence in Brazil," says Joao Gabriel Barros, a partner in Libra Energia, an Brazilian energy trading firm. "You’d probably see some capital flight."

Continued from page 2

Foreign capital is slowly coming into Brazil. On Tuesday, multinational steel company Ternium spent $1.3 billion in a deal to buy CSA, a Brazilian steel maker, from Thyssenkrupp. It was a bargain price for Ternium, and stands as a testament to the flea market sales now taking place in Brazil. The market priced the CSA asset at $3 billion.

Brazil’s currency is also strengthening on hopes that the new government of Michel Temer will indeed pass a public pension reform bill. The Brazilian real is now trading at 3.10. It was over 4 a year ago. Word on the street is that Brazil has precisely 10 months left to get any real reforms out of the way, because starting in January 2018 congress will be in campaign mode.

Should Lula be allowed to run for office and lose, it would likely spell the end of the Workers’ Party. The party has been at the forefront of progressive politics for the last 20 years. Its spin off parties, socialist PSOL and the greens at Rede, remain marginal with diminishing star power. Marina Silva, an ex-Workers’ Party senator and Environmental Minister under Lula, is now with Rede and is seen as a potential candidate.

Jan Dehn, head of research at London-based Ashmore Group is betting that Lula’s days are done.

"My base case is a PSDB candidate wins," he says. According to polling firm Datafolha, Lula beats them all in the first round. That will not be enough. If all goes the way of the smart money here, Lula loses in the second round against a candidate from the business-friendly Social Democratic Party, or PSDB. "If I am wrong,‎ then markets will sell off. The market was able to overcome its suspicion about Lula once before, but it would struggle to overcome its suspicion a second time."

The first time the fear was policy, which turned out to be misplaced. Lula didn’t end up being Brazil’s Hugo Chavez, the Socialist Party of Venezuela president. But most observers in the market see him being a more angered version of Dilma this time around, owing nothing to the southern industrial hub states of Brazil which have largely called for his arrest for the past 12 months. Nobody knows if that would be the case. Say what you will about Lula, he is one of the most skilled politicians in Brazil.

But…

"The big concern is far more basic now: Lula is a crook," says Dehn.

They’re baaa-aack. Wall Street: "Please God, no." Two ex-presidents both declare their intention of getting back in the game in October 2018. Only one, Luiz Inacio Lula da Silva, has a chance of winning the presidency once again. Lula is under investigation for orchestrating the largest corporate corruption scandal in Brazil’s history. Even if he had nothing to do with it, the ransacking of Petrobras happened for over a decade, and most of it on his watch. (AP Photo/Eraldo Peres, File)

Brazil’s economy is growing again. It’s not by much. But after nearly three years of recession and unemployment going from 4.5% to 12%, anything over zero is reason to celebrate. Brazil’s stock market as measured by the popular iShares MSCI Brazil fund (EWZ) is up 20% this year. No country can do it better for Wall Street.

"I recommend the topic of whether Brazil will grow or not be taken off the agenda, because we are already growing," Sergio Rial, president of Santander, told Folha de Sao Paulo newspaper on Tuesday. "What we have to ask ourselves now is whether this growth is enough, and where is it coming from," he was reported saying.

Brazil is largely an overweight these days in U.S. mutual fund world. But there is a spark of concern out there that has less to do with the rising prices of Brazilian securities and more to do with the talk of Luiz Inacio Lula da Silva returning to power in 2018. Lula is largely seen by the populous as the master mind behind the God awful Petrobras scandal: a contract rigging scheme that has Lula a yardstick away from a jail cell and saw his predecessor Dilma Rousseff ousted in an impeachment trial back in August.

The Workers Party that he created was kicked to the curb by voters in October. They’re a smaller opposition party. Still, Lula cannot be counted out. He is far and away Brazil’s biggest political star. And in the age of media driven personality cults, even a fallen hero like this guy can make a comeback…and win. His chances look better if Rial of Santander is wrong, and the economy does not grow enough to increase employment.

I asked Mike Reynal, a fund manager with Sophus Capital in Des Moines and a long-time Brazil investor, what he thought about a Lula return in 2018. In a word: bad. Sophus is overweight Brazil at the moment.

"A new Lula presidency would be tinged with memories of corruption, mismanagement and judicial red tape linked to Dilma’s presidency," Reynal says. "A Lula win would lead to a hike in sovereign risk. We would definitely be more skeptical." Brazil became investment grade under Lula and lost it under Dilma.

"The market is already speculating that Brazil can get a credit once we approve pension reform," says Fernando Bergallo, director of FB Capital in Sao Paulo. Pension reform is the next big policy to move in the congress. A Lula victory would end all that. "Lula would undoubtedly be a disaster for the country’s finances. It would bring panic to financial markets as soon as investors started to believe that a Lula win was possible," he says.

Lula the metal shop worker represented the working classes of Brazil when he ran and won two-terms starting in 2002. For many, he was the "Brazilian dream" incarnate. He was the perennial underdog, whose critics claim he sliced off his own pinky finger in order to collect disability insurance and use the injury as a symbol for the worker’s fight against the uncaring, greedy owners of capital. He toned down his rhetoric over the years and became known as more pragmatic capitalist during his 8 years as president.

A demonstrator holds a banner supporting former Brazilian President Luiz Inacio Lula da Silva, during a rally in Sao Paulo, Brazil. Despite facing several corruption charges, Silva is a leading candidate for the 2018 presidential race. (AP Photo/Andre Penner, File)

To his luck, he presided over a remarkable period in Brazil’s history, one not seen since the so-called Miracle Years of the dictatorship in the 1970s. Inflation collapsed, interest rates fell, prices for every major commodity that Brazil dominated — from soybeans to iron ore — all rose on Chinese demand, and unemployment dropped. Domestic workers whose futures seemed relegated to servitude got jobs in call centers and shopping malls, or as small shop owners themselves in the northern half of the country where social welfare programs gave the poor more money to spend. He was heralded the world over for these policies. But when the commodity super cycle ended, Dilma was unable to continue those policies. The government was running out of money. Indeed a number of Brazilian states have a credit ranking worse than that of Venezuela’s, the most fragile state in South America.

"The commodity cycle helped the poor, but that’s not what the poor believe. They believe Lula brought them out of poverty and now commodities are rising again," says Fernando Pertini, CEO of Millenia Asset Management International in Panama. "This wouldn’t change our view on Brazil. The stars are starting to align in terms of fundamentals," he says.

In the Lula years, investors watched a rapid expansion of the government’s role in the economy. It took the lion’s share of Petrobras deep water discoveries, and awarded billions of dollars in contracts to build hydroelectric dams to state owned power utilities. The sidekicks were the big construction firms, led by Odebrecht. Their executives are now in prison. Odebrecht, which built part of the Miami International Airport, is now a shadow of its former self. CEO Marcelo Odebrecht is serving a 19 year prison sentence.

If Lula, under investigation for his role in the Petrobras graft schemes, is allowed to run for office, some believe he has a serious chance of winning. This is especially true if the economy fails to impress. From a political narrative standpoint, all he has to do is appear the slightest bit humbled, and assure those that supported him years ago that the corruption that wiped out over 70% of Petrobras’ market capitalization is over; he is starting Brazil off on a clean slate. And he is coming to town with a pro-growth agenda. Instead of "Lula Peace and Love", it’d be "Lula Forgive and Forget". That could be his motto. The general election is not until October 2018 and there are no declared challengers at this time. In the meantime, the man leads every single candidate. This is pretty normal in Brazil, however. The locals don’t think he wins.

"If he wins in 2018 it would be a huge backslide in fighting corruption and represent a pretty significant decline in business confidence in Brazil," says Joao Gabriel Barros, a partner in Libra Energia, an Brazilian energy trading firm. "You’d probably see some capital flight."

Foreign capital is slowly coming into Brazil. On Tuesday, multinational steel company Ternium spent $1.3 billion in a deal to buy CSA, a Brazilian steel maker, from Thyssenkrupp. It was a bargain price for Ternium, and stands as a testament to the flea market sales now taking place in Brazil. The market priced the CSA asset at $3 billion.

Brazil’s currency is also strengthening on hopes that the new government of Michel Temer will indeed pass a public pension reform bill. The Brazilian real is now trading at 3.10. It was over 4 a year ago. Word on the street is that Brazil has precisely 10 months left to get any real reforms out of the way, because starting in January 2018 congress will be in campaign mode.

Should Lula be allowed to run for office and lose, it would likely spell the end of the Workers’ Party. The party has been at the forefront of progressive politics for the last 20 years. Its spin off parties, socialist PSOL and the greens at Rede, remain marginal with diminishing star power. Marina Silva, an ex-Workers’ Party senator and Environmental Minister under Lula, is now with Rede and is seen as a potential candidate.

Jan Dehn, head of research at London-based Ashmore Group is betting that Lula’s days are done.

"My base case is a PSDB candidate wins," he says. According to polling firm Datafolha, Lula beats them all in the first round. That will not be enough. If all goes the way of the smart money here, Lula loses in the second round against a candidate from the business-friendly Social Democratic Party, or PSDB. "If I am wrong,‎ then markets will sell off. The market was able to overcome its suspicion about Lula once before, but it would struggle to overcome its suspicion a second time."

The first time the fear was policy, which turned out to be misplaced. Lula didn’t end up being Brazil’s Hugo Chavez, the Socialist Party of Venezuela president. But most observers in the market see him being a more angered version of Dilma this time around, owing nothing to the southern industrial hub states of Brazil which have largely called for his arrest for the past 12 months. Nobody knows if that would be the case. Say what you will about Lula, he is one of the most skilled politicians in Brazil.

But…

"The big concern is far more basic now: Lula is a crook," says Dehn.

As for Brazil’s political credibility, perhaps such a thing doesn’t exist anywhere. Nor does predictability. In a world of Brexit and Donald Trump, up is down, down is up. Circumstances conspire to produce a particular type of leader. Whether that leader turns out to be good or bad is largely a crap shoot. For long-term, reliable Brazil investors like Ashmore, Lula’s return is bad news. "We would trade accordingly: sell," Dehn says.

Then again, everybody has a price. The sell-off would eventually make Brazil too cheap to ignore, and money would flow back in. Brazil’s government and its companies shouldn’t count on it flowing in in spades, especially if Lula turns Trumpian and pushes for domestic content in things like merchant marine vessels and oil and gas equipment. That will take a lot of money off the table, and keep Brazil dependent on its local market at a time when its local market is struggling to find buyers. Where it does, discounts are hefty. Off record, a number of projects in Sao Paulo state in particular are stuck because companies cannot find financing, numerous Brazilian private equity firms say.

Pertini in Panama City wouldn’t mind a stock market correction. "If an economy of 200 million people gets its engine started again…you better be on board."

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