Brazil election upset rattles markets as Lula clings to power

This was not the result investors had anticipated. Brazil markets have entered panic mode, with the iShares MSCI Brazil ETF (EWZ) plunging more than 27% in premarket trading, after President Luiz Inácio Lula da Silva clung to power in Sunday's runoff election. It'll mark Lula's fourth term as president and will cement his control of the country just before his 81st birthday on Tuesday.

Bigger picture: In the first round of voting three weeks ago, Senator Flávio Bolsonaro, the eldest son of former President Jair Bolsonaro, took the lead. Most polls also put him ahead in the run-off election, in line with the right-wing victories seen across Latin America in recent years. Complicating matters, Bolsonaro has not yet conceded defeat to Lula, citing an "unacceptable" decision by a Lula-appointed Supreme Court justice, who issued a nationwide blanket order to extend voting by two hours.

Since mid-August, Brazilian markets had been undergoing some election-cycle positioning, but things really took off in early October in what became known as the "Bolsonaro Trade." Fiscal discipline, corporate tax reform, and potential privatization programs were priced in, sending Brazilian ETFs like (EWZ) and (FLBR) soaring following Bolsonaro's first-round win. Another big force was the strengthening of Brazil's real (USD:BRL), which can help tame inflation, reduce debt, and attract foreign capital.

SA commentary: Brazil is the world's tenth largest economy, with a population of more than 200M people, though it's still "small regarding capital markets," SA analyst Kenio Fontes writes in Brazilian Elections 101: What Comes Next. "It's enough to say that in movements of euphoria, where a lot of foreign institutional investors want to buy a big Brazilian position, it can create kinds of distortions. High quality will always matter in Brazil; asymmetrical and high-beta positions can offer high upside, but for long-term total returns, I would prioritize more stable companies with wide moats and a very healthy balance sheet (not depending on much lower interest rates)."