The peril of relying on prediction markets to invest in capital markets will be laid bare today as Brazilian markets are torn apart.
The EWZ Brazil ETF is down 25% premarket following the surprise win by incumbent President Lula over Flavio Bolsonaro. Betting markets had Bolsonaro over 75% after he led in the f irst round of voting earlier this month.
Polls showed a close race but a final push by Lula appears to have done enough as he won 51.79% to 48.21%, which translates into more than 4 million votes. Bolsonaro is refusing to concede so some of the weakness in markets might be about an uncertain outcome but it’s mostly about a continuing left wing government in Brazil. The move also halts the march towards populism in latin America in a surprise turn for the region that could lead to some knock-on market effects in neighboring countries.
In the FX market USD/BRL is up to 5.60 from 4.97 on the eve of the election and that’s a big part of the drop in the USD-priced ETF.
The drop in the Brazilian ETF today wipes out the entire year-to-date rally in the market.
Notably, Brazilian stock market have basically been dead money for years. The EWZ ETF is flat since 2014, though I’d note that it’s now trading at around 8x earnings as the commodity-heavy index benefits from elevated global prices. With that, today’s drop could be a buying opportunity (once the dust settles).
The market was clearly caught off guard by the results and getting squeezed. Note that back in May, the ETF was trading at $39 when Lula was favored to win; compare that to $30.89 in the pre-market with better global commodity prices now.
Eamonn earlier highlighted how the market is pricing in an extreme scenario, via Goldman Sachs’ playbook from Monday:
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 other words, the premarket is pricing Goldman’s tail case — and then some.
The next thing to watch is Lula’s cabinet. The fastest way to put a floor in here is a credible finance minister signal this week.
This article was written by Adam Button at investinglive.com.