Itaú BBA - Copom reduces the Selic rate to 6% p.a.

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Copom reduces the Selic rate to 6% p.a.

August 1, 2019

Amid weak activity, well-behaved inflation and the first vote on the pension reform in Congress, the Copom cut the Selic rate by 50 bps.

The Brazilian economy in July 2019

After the social security reform was approved in a first round of voting in the Lower House, the Copom delivered a 50-bp rate cut, in a unanimous decision, despite the signs of market stress seen after the earlier Fed decision. Formal job creation announced for June continued at a moderate pace and the unemployment rate remained stable at historically high levels. The July’s year-over-year inflation measured by the IPCA-15 declined to 3.27% from 3.84%, underscoring its benign behavior at the margin. The government has announced new economic measures to stimulate consumption and investment, such as the withdrawals allowance from FGTS and PIS/Pasep accounts, and the disclosure of the New Gas Market Program.

Copom: 50-bp cut, signaling another 50-bp adjustment ahead

The Copom delivered a 50-bp rate cut, in a unanimous decision, despite the signs of market stress seen after the earlier Fed decision. This move was in line with our expectation, but was not the market consensus. Inflation targeting is actually inflation-forecast targeting, and the set of figures provided in the meeting statement suggests an overall easing budget of some 100bps. But that is also conditional on an envisaged resumption of the economic recovery, which is as of yet uncertain. The decision to start with a 50-bp move, as well as language used in the policy statement, indicates that, for now, another 50-bp downward “adjustment” of the benchmark rate needs to be the base case for the next meeting. So, we expect the Copom to take the Selic down to 5.5% at its September gathering. For now, given the weakness of the recovery and the benign inflation outlook, we expect the Selic to be trimmed to 5% by year-end. To summarize, it appears that external/internal factors dominate the upside/downside risk to said call (provided economic reforms stay on track). 

Lower House approves main text for the pension reform

The main text of the pension reform was approved in a first-round vote in the Lower House, with 379 votes in favor and 131 against. The victory margin was significantly larger than the 330 to 350 favorable votes that surveys indicated. According to our estimates, the approved text will yield BRL 865 billion in savings in the next 10 years.

We expect the pension reform to be fully approved by Congress in 3Q19, with no further dilutions. The proposal is likely to be approved in a second-round vote by the Lower House in early August and by the Senate in September. Our confidence in the approval of the bill is based on the existence of a notional majority in Congress that is not conceptually or ideologically opposed to the proposal, as well as on the existing consensus among opinion-makers and society about the need to restore the financial sustainability of the pension system.

Inflation behavior remains benign

In the latest inflation release, the midmonth consumer price index IPCA-15 was up 0.09% in July (from 0.06% in the previous month), printing below our estimate (0.14%) and the median of market expectations (0.13%). Notwithstanding the monthly increase, the year-over-year change decelerated to 3.27% in July from 3.84% in June. The headline IPCA also showed a benign path in June, rising 0.01% and printing slightly above our call (-0.01%) and the median of market estimates (-0.03%). The year-over-year change slid to 3.37% from 4.66% in May (vs. our 3.35% forecast and market consensus at 3.33%). Core inflation measures remain at comfortable levels. In particular. the core measure for underlying services  went up 0.2% during the month and its year-over-year change slowed to 3.7% from 3.9%.

Still-moderate improvement in job creation 

According to the Ministry of Labor’s CAGED registry, a net 48.4k jobs were created in June, beating our estimate (+28k) and the median of market expectations (+29.5k). Seasonally-adjusted figures show 26k jobs created, lifting the quarterly moving average to 30k from 15k in the previous month. Notwithstanding the improvement at the margin, the pace of formal job creation is still moderate. Moreover, current business confidence levels do not suggest a pickup in job creation in the coming months. 

The nationwide unemployment rate receded to 12.0% in the quarter ended in June from 12.4% one year earlier, according to national household survey PNAD Contínua. The reading matched our estimate and the median of market expectations. Seasonally-adjusted unemployment was unchanged at 11.9%, a high level by historical standards, caused particularly by the still-moderate recovery in economic activity. Importantly, the pace of formal jobs created in the private sector (as published by PNAD Contínua) had been faster than the pace suggested by CAGED but declined sharply in June.

Confidence remains low

Confidence indicators published by FGV were mixed in July. Confidence in the industrial sector fell for a third consecutive month, by 0.9 p.p. Industrial capacity utilization went up 0.5 p.p. to 75.5% but still reflects substantial slack in production factors. Consumer confidence dropped 0.4 p.p., as the slide in the component addressing future expectations (-2.0 p.p.) offset the 1.9 p.p. gain in the current situation component. On the other hand, confidence among retail sector climbed 2.3 p.p. to 95.5 in July. In the same direction, the indicator for the construction sector increased 2.6 p.p. to 85.4 — this reading, however, is still much lower than neutral (near 100). Confidence among service entrepreneurs also advanced in July, by 2.2 p.p. Notwithstanding the improvement in a few sectors, we understand that the recent performance of confidence indicators is consistent with a moderate pace in economic activity at the margin.

Weak economic activity in 2Q19

The industrial production declined 0.6% mom/sa in June, a qoq/sa decrease of 0.7% in the 2Q19. Year-over-year, the industrial production receded 5.9% in June. Among the data release for May, the retail (PMC) and services (PMS) related activity indicators as well as the industrial production also showed weakness at the margin. Despite the slide in sector indicators, the Central Bank's monthly activity index (IBC-Br) suggested 0.5% economic growth that month, marking its first improvement in 2019. On a year-over-year basis, the indicator climbed 4.4%, boosted by the slide in activity that same month in 2018 due to the truckers' stoppages. Nevertheless, the figure is still timid and reinforces our expectation that growth will remain weak in 2019.  

 Primary deficit of BRL 12.7 billion in June 

The consolidated public sector posted a primary deficit of BRL 12.7 billion in June, slightly disappointing our forecast and market consensus (-11.6 billion and -11.1 billion, respectively). The consolidated primary deficit over 12 months remained at 1.4% of GDP. 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 oil auction from the transfer-of-rights area (‘cessão onerosa’), expected in November, 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 55.2% of GDP in June from 54.7% in May, while the general government’s gross debt remained at 78.7% of GDP. Over 12 months, the nominal deficit excluding FX swap transactions retreated to 6.6% of GDP from 6.8%. 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.

Government allows withdrawals from FGTS and PIS/Pasep programs

The government allowed withdrawals limited to BRL 500 from active and inactive accounts in the workers' severance fund FGTS this year, increased the fund's profit distribution, and gave the option, starting in 2020, of annual withdrawals proportional to the worker’s amount allocated at the fund. Another round of withdrawals from PIS/Pasep accounts was also announced. According to the Economy Ministry, these measures should inject BRL 30 billion in the economy this year and ensure additional economic growth of 0.35 p.p. over 12 months.

New Gas Market is launched by the government

In another set of measures to support the economy, the government launched the New Gas Market program, seeking to reduce natural gas prices. According to the Economy Ministry, it is possible to reduce the product's price by about 40% in the next two years, impacting power generation costs as well as the costs of some basic industrial input. In that sense, the government believes that cheaper natural gas will contribute to the rebound in economic activity, encourage investments and ensure competitiveness for the industrial sector.

Financial assets

In July, the Ibovespa rose 0.8% in local currency and 2.6% in U.S. dollars. Country risk measured by the 5-year CDS declined 23 bps and finished the month at 127bps. The exchange rate appreciated 1.8% to BRL 3.76 per USD by the end of the month.

Upcoming events

In Brazil, the pension reform proposal is due to be voted in a second round of the Lower House in early August and, if approved, will be forwarded to the Senate. In addition, discussions on tax reform should continue to advance.

Overseas, attention remains focused on the progress of US-China trade negotiations. In the US, the annual Jackson Hole meeting will take place on August 22-24 to discuss the challenges for monetary policy worldwide.

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