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Copom ready to resume easing, conditional on reform

July 1, 2019

Central Bank’s forecasts indicate new easing cycle in 2019

The Brazilian economy in June 2019

The Copom minutes bring about a clear verbal indication that, conditional on concrete progress on the reform front, the BCB will resume easing shortly. Formal job creation was weak in May, consistent with still-low business confidence levels. Year-over-year inflation measured by the IPCA-15 decelerated, as pressure on volatile items began to dissipate. On the political front, discussions on the pension reform in the Lower House’s Special Committee took center stage in the month.

Central Bank’s forecasts indicate new easing cycle in 2019

The Copom’s decision to leave the base rate unchanged at 6.5% pa was widely anticipated. Its statement paved the way for resuming monetary easing, as early as in the July 30-31 meeting, provided there is “concrete progress” in the reform agenda. The June 2019 inflation report shows inflation forecasts consistent with Selic rate cuts in 2019, although they do not corroborate the view that interest rates can be maintained at new record-low levels in subsequent years. In fact, forecasts that consider the Focus survey trajectory for the Selic rate (which incorporate rate cuts in 2019 and increases in 2020 and 2021) show inflation slightly below the target in 2020 and slightly above the target in 2021. In all, we think recent communications reinforce our call that the Copom will resume easing with a 25-bp rate cut in its July 30-31st meeting, conditional on concrete progress in the reform front. It should be noted that the Copom decision will take place a few hours after the release of the July FOMC outcome, which may have some bearing on local deliberations.

National Monetary Council sets inflation forecast for 2022

The National Monetary Council (CMN) set a 3.50% inflation target for 2022 (with a 1.5 pp tolerance range, up or down), compared to 3.75% in 2021, 4.0% in 2020 and 4.25% in 2019. The decision is another step toward the convergence of Brazil's inflation target to international standards.

Labor market pace remains sluggish

According to the Ministry of Labor’s CAGED registry, a net 32k jobs were created in May, missing our estimate (+55k) and the median of market expectations (+66k). Seasonally-adjusted figures show only 3k jobs, reducing the quarterly moving average to 13k from 26k in the previous month. The still-weak pace in formal job creation is consistent with current business confidence levels, which point to cooling economic activity. 

Also in May, the unemployment rate receded to 12.3% from 12.7% one year earlier, matching our call and the median of market expectations. According to our seasonal adjustment, unemployment fell 0.1 p.p. to 11.8% in the quarter ended in May vs. the quarter ended in April. Notwithstanding the decline during the quarter, unemployment remains high by historical standards, caused particularly by the still-moderate recovery in economic activity. We note that the current pace of formal jobs creation in the private sector reported by the PNAD survey is faster than the pace suggested by the CAGED registry. Such divergence is common, but normally doesn’t last long, as the PNAD figures tend to converge toward CAGED’s. Finally, the real wage bill advanced 2.4% yoy and 0.2% on a quarterly basis. Importantly, the real wage bill is strongly correlated with core retail sales (excluding vehicles and construction material).

Confidence indicators advance in June, but not in the industrial sector

Most confidence indicators published by FGV increased in June, interrupting up a string of declines seen in recent months. The industrial sector was the exception, with a 1.5 p.p. drop that led it to its lowest level since October 2018, dragged by both the expectations and the current situation components. Industrial capacity utilization receded again in June (to 75% from 75.3% in May), reinforcing the slack in production factors. Meanwhile, consumer confidence rose 1.9 p.p. after four straight declines. Importantly, the current consumer confidence level is consistent with GDP growth related to household spending of around 0.5% in the quarter (1.9% annualized). In the same direction, confidence among retailers climbed 1.8 p.p. in June, while the indicator for construction increased 2.1 p.p. Confidence in the service sector expanded 2.2 p.p., boosted by both the expectations (+3 p.p.) and current situation component (+1.2 p.p.). We understand that, notwithstanding the June improvement, without further gains, current confidence levels are consistent with an interruption in the economic activity recovery process.

Moderate activity in 2Q19

Industrial production rose 0.3% mom/sa in April, printing below the median of market expectations (0.7%) and close to our call (0.2%). Manufacturing advanced 1.2% mom/sa, while mining/extraction decreased 9.7%, possibly reflecting lower iron ore production following the dam collapse in Brumadinho. Broad retail sales were stable in seasonally-adjusted monthly terms in April, missing market expectations (0.3%) and our estimate (0.4%). In year-over-year terms, the indicator advanced 3.1%. Core retail sales (excluding vehicles and construction material) declined 0.6% mom/sa, also disappointing market estimates (-0.1%) and our call (-0.4%). Compared to April 2018, core sales climbed 1.7%. Meanwhile, revenues in the service sector (PMS) went up 0.3% in April, after three consecutive declines. In year-over-year terms, the indicator receded 0.8%, slightly worse than the median of market expectations (-0.6%) and our forecast (-0.5%).

Year-over-year inflation recedes to 3.84%, according to IPCA-15 

The mid-month consumer price index IPCA-15 moved 0.06% in June, in line with our estimate. The main highlight was deflation in food items, with price drops for food consumed at home (-0.82%) and away from home (-0.33%). The year-over-year change decelerated to 3.84% from 4.93% in May. All core inflation measures remain on a comfortable path. In May, the headline IPCA increased 0.13% during the month and 4.66% yoy. Considering the latest IPCA-15 report, we expect the year-over-year change in the IPCA to slow down to 3.35% in June from 4.66% in May. Some of the deceleration is explained by the low reading expected for the month (-0.01%) but also because the base effect influenced by the May 2018 truckers’ stoppage will slip out of calculations. Overall, recent inflation reports reinforce our view that, after short-term pressures in 1Q19, consumer inflation remains on a benign path due to substantial slack in the economy, favorable inertia and anchored expectations.

Primary deficit of BRL13 billion in May 

The consolidated public sector posted a primary budget deficit of BRL13 billion in May, somewhat better than our forecast and market consensus (both at -14.4 billion). The central government experienced a deficit of BRL 14.7 billion (close to our -15 billion estimate). The consolidated primary deficit over 12 months remained at 1.4% of GDP, matching the April print. In our view, meeting the public sector’s annual primary deficit target of BRL 132 billion requires discipline, but shouldn’t be so challenging, especially in case of a successful auction of oil from the transfer-of-rights area (‘cessão onerosa’), expected in October, which could improve this year’s primary result by about BRL 52 billion (0.7% of GDP).

The public sector’s net debt widened to 54.7% of GDP in May from 54.4% in April, while the general government’s gross debt declined at the margin to 78.7% of GDP from 79.0%, thanks to reimbursements by development bank BNDES to the National Treasury. Importantly, a favorable fiscal scenario depends strictly on the approval of reforms, such as the pension reform, that signal a gradual return to primary surpluses that are compatible with structural stabilization in public debt.

Current account posts $664 million surplus in May

The current account posted a surplus of $664 million in May, printing close to our forecast ($850 million) and market estimates ($700 million). The deficit accumulated over 12 months remains at a historically low level: 0.7% of GDP. For the next years, we maintain our expectation of a gradual increase in the current account deficit, but not to the point of compromising the sustainability of Brazil’s external accounts. Direct investment in the country is still the main source of financing for the current account deficit.

Mercosur and European Union reach free trade deal

Brazil’s Ministry of Foreign Affairs announced that Mercosur and the EU reached a free trade deal. According to news reports, the agreement addresses tax and regulatory issues, including services, government purchases, trade facilitation, technical barriers, sanitary/phytosanitary measures, and intellectual property rights. According to the joint statement, “the agreement's conclusion highlights the commitment of these two blocs to economic openness and the enhancement of competitiveness.” 

Financial assets

In June, the Ibovespa rose 4.1% in local currency and 7.0% in U.S. dollars. Country risk measured by the 5-year CDS declined 31bps and finished the month at 150bps. The exchange rate appreciated 2.8% to 3.83 reais per dollar by the end of the month.

Upcoming events

In Brazil, the pension reform text will possibly be voted in the first week of July by the Lower House’s Special Committee. The next step would be the presentation of the proposal to the Lower House floor. According to news reports, representatives, including House Speaker Rodrigo Maia, are working to move the proposal forward and get a first-round vote before the congressional recess, scheduled for July 17-31.

Overseas, attention remains focused on the progress of US-China trade negotiations. Although the trade truce agreed at the latest G20 meeting brought some relief at the margin, there is no set deadline for both countries to reach an agreement.

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