Brazil is facing a pivotal election next year—here's why investors are buckling up now

  • Brazil's election is set for October, but analysts are already warning of volatility.
  • Unpopular incumbent Michel Temer faces an uphill battle to win a mandate, with scandal-scarred former President Lula da Silva making a case of his own.
  • The country's continued reform is far from guaranteed, analysts say.
Brazilian President Dilma Rousseff with former president, Lula Da Silva.
Mario Tama | Getty Image
Brazilian President Dilma Rousseff with former president, Lula Da Silva.

Brazil's presidential election is 10 months away, but analysts are already warning of volatility after a dramatic impeachment opened fresh social divisions and has scrambled the political terrain.

Despite significant progress on the reform front lately, plenty of work is still needed, says Marcelo Carvalho, head of emerging market research with BNP Paribas.

"Whoever wins the elections will face formidable challenges, especially in advancing structural reforms, making sure the fiscal house is in order, and promoting long-term sustainable growth," Carvalho told CNBC.

Brazilian President Michel Temer
Igo Estrela | Getty Images
Brazilian President Michel Temer

The vote could be the most consequential since Lula da Silva's election in 2002, primarily because it will mark a turning point in Brazil's direction and, by extension, its long-term economic outlook.

Unpopular Brazilian President Michel Temer, who took over after the corruption charges drove Dilma Rousseff from office, has faced an uphill battle in trying to reform the economy. He is facing a stiff challenge in his bid for a four-year term from da Silva, who is supported by the leftist Workers Party.

Temer "has initiated a hugely ambitious effort to pull back the state's role in the economy, and this election will determine whether those efforts continue or are reversed," said Jeffrey Lamoureux, senior country risk analyst with BMI Research.

"Broadly speaking, the election of a pro-reform candidate would likely support the economy's nascent recovery from a three-year recession as it would encourage private investment, while an anti-reform candidate could scare off investors for years to come," he added.

Socially, the election is likely to be a demonstration of the country's broad disillusionment with the political establishment.

"The campaign looks set to bring bouts of increased market volatility" -Marcelo Carvalho, head of emerging market research, BNP Paribas

A far-reaching corruption scandal dubbed "Lava Jato" (Car Wash) has ensnared a vast swath of Brazil's political elite — including Temer, who currently holds single-digit approval ratings. The public's dissatisfaction may create space for outsider and anti-establishment candidates to mount competitive campaigns.

"It is far from clear that a strong, pro-reform candidate capable of building a broad electoral coalition will emerge," Lamoureux, said.

That means global investors should buckle up for a bumpy ride, Carvalho said. While elections typically bring uncertainty, Brazil's political instability suggests there's no shoe-in candidate, and the volatility of public opinion could swing in favor of either a far-leftist or an extreme rightist.

Brazilian markets are likely to be increasingly volatile as the election nears, with the potential for substantial downside. While markets have thus far proven willing to brush off concerns over the country's political direction, attitudes are likely to shift as the field of candidates comes into focus.

Opinion polls consistently show da Silva, who has been tainted himself by the corruption probe and is now campaigning on an anti-reform platform, currently has the lead. Right-wing populist Jair Bolsonaro is following closely behind.

A big risk to da Silva's candidacy looms in the form of a Brazilian appeals court, which will decide on Jan. 24 on an appeal by the former president against a corruption conviction that could bar him from running in the 2018 presidential race.

To the extent that this election will determine Brazil's growth outlook, it will also have ripple effects across the region. Brazil is the region's largest economy and remains a key trading partner for many of its neighbors. The election of an anti-reform candidate could undermine Brazilian demand for goods from its regional trading partners.

"A recovering economy should help candidates that support broad policy continuity," Carvalho said. Still, even if market-friendly policies prevail in the end, "the campaign looks set to bring bouts of increased market volatility," Carvalho said.

—Reuters contributed to this article.