By Claire Milhench and Rodrigo Campos
LONDON/NEW YORK (Reuters) - Mexican and Brazilian voters fed up with politics as usual could whipsaw investors this year, with a leftist consolidating his favourite status in Mexico's presidential race while Brazil's front-runner now sits in jail, leaving its October election wide open.
Corruption scandals in both countries have led millions of voters to abandon traditional parties in favour of more populist candidates. Bond markets are tightly priced after strong inflows, making them vulnerable to upsets.
Mexico and Brazil, Latin America's largest economies, have benefited from global economic growth and investor appetite for riskier, higher-yielding assets over the last two years.
But some Mexican assets, including stocks, have underperformed their Brazilian counterparts despite Brazil's long-running recession and ongoing political turmoil.
This is partly because investors fear leftist candidate Andres Manuel Lopez Obrador, the front-runner to win the Mexican presidential race on July 1, will roll back energy reforms and increase welfare spending.
Mexican hard currency bond spreads still trade wider than Brazil's on the JPMorgan EMBI Global Diversified index <11EMP>, though Brazil is a lower-rated sovereign credit.
The inclusion of bonds issued by Mexico's state oil company Pemex in the JPMorgan EMBI Global Diversified could be part of the reason, as these can trade wider than the sovereign, said Cathy Hepworth, co-head of the emerging markets debt team at PGIM Fixed Income.
Also, while Brazilian equities <.BVSP> have risen 10 percent year-to-date, Mexico stocks <.MXX> are down nearly 2 percent. Worries about negotiations to update the North American Free Trade Agreement have also taken a toll, although hopes for a deal are rising.
While Mexico's race seems sewn up, Brazil's is wide open after the Supreme Court rejected former President Luiz Inacio Lula da Silva's plea to avoid prison while he appeals a corruption conviction, likely ending his political career.
Lula had been leading in the polls, with a third of voters still undecided.
"You need more than a crystal ball to figure out what will happen," said Thierry Larose, a senior portfolio manager at Vontobel Asset Management.
MEXICAN WHIPSAW
In Mexico, investors may face increasing volatility going into the election. Fears about a leftist president have weighed on sentiment, although some argue Lopez Obrador may turn out to be more market-friendly than anticipated.
"He will have to moderate his views and if he wants to win he needs to reach out to the centre," said Raphael Marechal, a portfolio manager at Nikko Asset Management in London. "The market is too negative with Mexico and we could have a positive surprise even if AMLO wins," Marechal added, referring to Lopez Obrador by the nickname he takes from his initials.
In early April, Lopez Obrador sent an open letter to investors seeking to allay fears that he could damage the economy and promising to run a zero-deficit government.
Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle, said Mexico's recent fiscal rules and energy reforms, which ended a decades-long state monopoly, would be difficult to roll back, but there was still a chance investors could get spooked.
"As the probability of AMLO getting elected increases, there is the risk that local currency debt and the currency sell off more aggressively," he said. "The peso will be the release valve for any repricing of political risk."
The peso > has firmed almost 7 percent this year against the U.S. dollar, to a point where some say it is too expensive given the risks.
A Lopez Obrador adviser told Reuters last week that his government would aim to run a federal budget that was "more or less" in balance and downplayed fears that the energy reform would be overturned.
Yet some Mexican long-dated issues are trading cheap versus lower-rated credits such as Jamaica 30-year bonds.
"The market is wrong right now … the risk is that the market could miss out on a rally in Mexico," said Luc D'Hooge, head of emerging market bonds at Vontobel Asset Management.
MISPLACED OPTIMISM?
While Mexico's hard currency spreads to U.S. debt have tended to widen over the past two years, Brazil's have tightened, fuelled by optimism that critical pension reforms will happen regardless of who wins the election. But some say that the market is complacent.
Brazil's budget deficit is forecast to reach 6.2 percent of GDP for 2018, according to the Brazilian central bank, partly due to the generous pension system, which Vontobel's D'Hooge called a "time bomb."
"We mispriced Brazilian assets going into the impeachment (of President Dilma Rousseff), they got too cheap and now they have tightened so much they are probably a bit too rich," said Al-Hussainy.
Right now it is impossible to predict who will emerge as front-runner in place of Lula, but his ability to transfer votes to another candidate is seen as limited. Meanwhile market-friendly candidates are trailing in the polls.
"At this point there is not one name for people to get excited about," said Maarten-Jan Bakkum, a senior strategist at NN Investment Partners. "And some that have a chance of winning are certainly not reformists … it's a bit of a wild card."
(Reporting by Claire Milhench; graphics by Rodrigo Campos; editing by Christian Plumb and Tom Brown)
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