(Adds comments by Rousseff, Aecio Neves and Fitch Ratings)
By Brian Winter
SAO PAULO Aug 29 Brazil fell into a recession in the first half of the year as investment dropped sharply and the country's hosting of the World Cup suffocated economic activity, a major blow to President Dilma Rousseff's already fading hopes for re-election in October.
Latin America's largest economy has suffered stagnant growth for more than three years under the economic policies of the left-leaning Rousseff, which have dented consumer and business confidence and caused heavy losses for financial investors.
The economy took an even bigger downturn in the second quarter, with gross domestic product contracting 0.6 percent from the first quarter, government statistics agency IBGE said on Friday. It also revised lower its estimate for first-quarter activity to a 0.2 percent contraction, meaning the economy entered a recession.
The data that confirmed the recession, Brazil's first since the global financial crisis of 2008-09, gives a powerful weapon to Rousseff's opponents in the Oct. 5 election at precisely the moment that her candidacy is at its most vulnerable.
Polls over the last week have shown Rousseff falling behind centrist candidate Marina Silva in the event of a second-round runoff, which appears likely.
Silva and the other main opposition candidate, Senator Aecio Neves, have strongly criticized Rousseff for being weak on inflation and ruining the economic momentum that made Brazil a Wall Street darling last decade.
"Today is a sad day for Brazil," Neves told reporters. "The truth is that this government failed, and it failed principally in its steering of Brazil's economy."
Brazil's economy grew an average 4 percent under Rousseff's predecessor, Luiz Inácio Lula da Silva, from 2003 to 2010. Growth under Rousseff's watch is set to average less than 2 percent.
Brazil's stock market rose as investors focused less on the bad economic report and more on the increasing possibility that Rousseff might not be re-elected. One equities investor on Wall Street e-mailed simply: "Hallelujah."
In comments to reporters in the northeastern state of Bahia Friday, Rousseff promised that economic performance during the second half of the year would be "better." The comments were broadcast via social media by Rousseff's campaign.
Despite efforts by Rousseff to win back business confidence in recent months, though, investment slid 5.3 percent in the second quarter, its worst performance since early 2009. Manufacturing suffered its fourth straight quarterly decline, down 1.5 percent.
Business activity also slowed as Brazil hosted the World Cup soccer tournament in June and July. Many cities declared public holidays on game days to prevent traffic problems and other logistical issues. Some factories began ramping down production before the tournament started in anticipation of disruptions.
Rousseff and her economic team have blamed the slowdown on continued problems abroad.
"I want to emphasize that even really organized countries are having problems getting better growth," Finance Minister Guido Mantega told reporters.
He said gross domestic product data suffered because of unique, seasonally related statistical effects, and stressed the unemployment rate has been low and stable. As a result, he said he believed Brazil's situation did not really constitute a recession.
COMMODITIES DEMAND SLACKENS
Global demand for Brazil's major commodities such as iron ore, sugar and corn also slackened, compared to the glory days of last decade, when the economy often grew more than 5 percent a year, lifting some 35 million people out of poverty.
However, economists and business leaders said Brazil's recent problems are mostly home grown, and run far deeper than any short-term considerations such as the World Cup.
They have repeatedly complained of what they describe as Rousseff's heavy-handed management of the economy, such as alternately raising and lowering certain taxes.
Other Latin American countries such as Chile or Colombia, where trade accounts for a bigger percentage of the economy and the business climate is perceived as better, have enjoyed much stronger growth in recent years.
Economists said Brazil's next president - whoever it may be - would need to undertake deep reforms. Failure to do so could hurt Brazil's debt rating, according to Fitch Ratings.
"Medium-term economic prospects will depend greatly on measures taken by the next administration to restore confidence," the agency said in a note.
Other data released on Friday showed Brazil posted a primary budget deficit in July for a third straight month. Brazil's faltering growth has hurt tax revenues and was a key reason behind a debt downgrade earlier this year by rating agency Standard & Poor's.
Following the data, some economists said they would revise down their forecasts for full-year economic growth to zero.
Brazil's central bank raised interest rates earlier this year to counter a spurt in inflation, which contributed to the slowdown in the second quarter.
The second-quarter GDP drop was worse than expectations of a 0.4 percent contraction, according to the median forecast of 47 analysts polled by Reuters. (Additional reporting by Silvio Cascione; Editing by Kieran Murray, Chizu Nomiyama and Jeffrey Benkoe)