Watch out! Brazil markets slide after elections

Can a new government allay Brazil's economic woes?
Can a new government allay Brazil's economic woes?   

Brazilian markets plunged more than 5 percent to seven-month lows after the open on Monday as investors expressed disappointment over Dilma Rousseff's victory in Sunday's runoff vote.

Rousseff triumphed against opposition leader Aecio Neves with 51.6 percent of votes in what has been called one of the closest campaigns in Brazil's history.

"Growth in Ms. Rousseff's first term in office was already the weakest under any president since the early 1990s and, in the absence of a major shift in policy in her second term, we expect more of the same over the next four years," said Neil Shearing, chief emerging markets economist at Capital Economics, in a report ahead of the open. He expected stocks, bonds and the currency to fall.

Brazilian stocks were on track for their worst day in three years, with state-run oil company Petrobras down 13 percent, and banks' shares falling 4-6 percent. Brazilian 5-year credit default swaps rose 10 basis points and bond yields rose too. The Brazilian real traded above 2.5 per dollar.

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On Friday, the Brazilian real closed at 2.15 per dollar, its weakest level since April 2005 while the benchmark Bovespa index fell over 3 percent, bringing its year-to-date losses to 1.5 percent.

"Attractive valuations might limit the downside for equities, but the real looks more vulnerable. Our 2015 forecast is for the real to hit 2.6 per dollar. Meanwhile, above-target inflation means that interest rates could rise further in the short-term, despite the weakness of growth," Shearing said.

The Next Funds Ibovespa Linked ETF, an exchange-traded fund on the Tokyo Stock Exchange that tracks several heavyweight Brazilian stocks, dropped over 7 percent on Monday—an early indication of how bad the selloff in Brazil could be.

Read MoreProspect of Rousseff re-election spooks Brazil markets

Rousseff's administration has been criticized for hurting the economy. Its interference in macroeconomic policies and attempts to control the private sector are factors in declining foreign direct investment (FDI). In September, FDI fell 38 percent on year. Meanwhile, subsidized gas prices and capped electricity rates have contributed to Brazil's current recession.

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Investors hoped that a Neves victory would yield much-needed reforms on the welfare, fiscal and labor fronts, and see Brazil shift from consumption-led growth to investment-driven growth.

Will Rousseff change?

Capital Economics doesn't expect Rousseff to make any breakthroughs in tackling high inflation and Brazil's deteriorating fiscal position. This could result in 2 percent annual growth, roughly half of what the group believes economies at Brazil's stage of development should be able to achieve.

"A big shift in policy seems unlikely under Dilma...The reforms that are needed means shifting income from ordinary workers - which form Dilma's core support - to companies. This in turn will require her to take on vested interests within her political base. All of this seems a tall order," said Capital Economics' Shearing.

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Investor confidence is key to Brazil's economic recovery, and Rousseff's administration may alter administrative practices to improve investment appetite, according to Societe Generale. However, the bank doesn't expect any overwhelming changes unless strong market moves or external events, such as Federal Reserve policy action, sway the government.

Rousseff wins second term - what that means for Brazil
Rousseff wins second term - what that means for Brazil   

"The failure to initiate reforms—particularly in sectors like infrastructure, fiscal and labor market—could keep the economy in a low growth and high inflation regime for a prolonged period. The pressure on Brazilian assets and the real would only worsen," said Societe Generale Latin America analyst Dev Ashish in a report.

On the bright side, reports that Finance Minister Guido Mantega is due to step down in December and will be replaced by a more pro-business personality are expected to help ease concerns over the country's fiscal plight.

Read MoreBrazil reforms unlikely…whoever wins election

Forget about politics?

Investors are exaggerating the impact of Rousseff's re-election on the economy, Bill Adams, senior international economist at PNC Financial Services, told CNBC on Monday.

"Brazil is coming out of a recession that was due to high inflation, low commodity prices and general industrial uncompetitiveness. I don't think there's very much a government could have done to affect that," he said.

Moreover, Adams added that politicians will have little control over declining global commodity prices, which are expected to cause major trade shocks to the South American economy.

Reuters and CNBC's Evelyn Cheng contributed to this report.