(Adds outlook for the real, analyst comment, updates prices)
By Asher Levine and Walter Brandimarte
SAO PAULO/RIO DE JANEIRO, Oct 27 (Reuters) - Brazilian financial markets plunged on Monday with stocks falling to their lowest level in nearly seven months, as leftist President Dilma Rousseff’s re-election victory dashed investor hopes of significant policy changes over the next four years.
Market sentiment going forward will likely depend on whether Rousseff signals policy tweaks to boost Brazil’s flagging economy, as hinted in a conciliatory first speech she gave after defeating pro-business challenger Aecio Neves on Sunday.
After the most divisive and tightest campaign since Brazil returned to democracy three decades ago, Rousseff won 51.6 percent of votes in a runoff against Neves, who won 48.4 percent support.
“While Rousseff’s victory speech carried a conciliatory tone and invitation for debate and change, her ability to regain credibility will require more than just words,” said Flavia Cattan-Naslausky, a strategist with RBS Securities.
Brazilian markets will only stabilize, RBS added, once Rousseff announces “concrete policy initiatives” and appointments to key government positions in the finance ministry and the central bank.
The Bovespa index lost as much as 6.2 percent in early trade but later trimmed losses to about 4.7 percent as bargain hunters swooped in.
The real lost about 2.7 percent to 2.525 per U.S. dollar. Investors bet the Brazilian currency will weaken over the next few years as U.S. Treasury yields rise and Brazil tries to boost industry competitiveness.
“Without an acceleration in productivity, a further correction of the real seems highly probable in the near future,” Santander economists led by Mauricio Molan said. They forecast the real will overshoot in the short term, later converging to 2.55 per dollar at the end of the year.
Other analysts warned, however, that under a second Rousseff term the central bank is likely to extend its intervention program to cushion any currency losses that would further fuel inflation.
The tight and fast-changing election campaign had sent Brazil’s financial markets on a wild ride with big gains whenever Rousseff lost ground in polls and drops whenever her odds looked stronger.
Rousseff’s economic policies have been roundly criticized by investors for tipping Brazil into a recession while damaging state-run companies such as oil producer Petroleo Brasileiro SA , known as Petrobras, and lender Banco do Brasil SA along the way.
Preferred shares of Petrobras fell as much as 15.6 percent at the open, while shares of Brazilian sugar and ethanol company Cosan SA dropped over 6.0 percent.
Petrobras’ share price has suffered under Rousseff’s government due to a policy that holds down domestic fuel prices in order to help relieve inflation. Sugar and ethanol companies like Cosan have also suffered from that policy because it makes gasoline, a direct competitor to ethanol, cheaper.
Shares of Banco do Brasil fell about 8.0 percent. The bank has seen pressure from Rousseff’s government to lower lending spreads in order to juice consumption in a sputtering economy.
Yields paid on long-dated contracts for interest-rate futures surged, with the Jan. 2023 maturity shooting 44 basis points higher. Those yields had fallen sharply recently on bets that stricter fiscal and monetary policy in a Neves’ government would make room for lower interest rates in the future.
Brazil’s debt insurance costs also rose in the credit default swaps (CDS) market. Data from Markit showed that five-year CDS were up 10 basis points versus the closing level on Friday to 172 bps.
Any stanching of the losses in future sessions will most likely come on bargain-hunting and signals of more market-friendly policies and cabinet appointments from the Rousseff administration, analysts said.
“The current path is not sustainable without a big adjustment of the policy mix, but in the short run, as long as markets are willing to finance Brazil, this stagflationary scenario could continue for a few more quarters,” said Arthur Carvalho, an economist with Morgan Stanley.
“Unfortunately, we also believe that if the administration avoids the hard choices, sovereign downgrades will arrive at some point over the next 18 months, creating a new set of challenges for Brazil,” he added. (Editing by W Simon and Nick Zieminski)