Itaú BBA - Lower GDP but Higher Interest Rates

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Lower GDP but Higher Interest Rates

June 3, 2013

The Brazilian economy grew below expectation in 1Q13 but the Central Bank accelerated the pace of interest rate hikes due to inflationary pressures.

The Brazilian economy in May 2013

The Brazilian economy expanded less than expected in 1Q13, but the Central Bank’s monetary policy committee accelerated the pace of interest rate hikes due to inflationary pressures. The exchange rate weakened again, in part reflecting changes in the external scenario but also in domestic fundamentals. Unemployment remained low, supporting income gains. The approval of a temporary decree ruling ports and the resumption of auctions for concessions in the oil industry may boost capital investments, which increased during 1Q13. Prices for Brazilian assets declined during the month. The path of the exchange rate (and the government’s reaction) will be the main variable to watch.

The Brazilian economy grew below expectation in 1Q13...

GDP grew 0.6% qoq/sa in 1Q13, disappointing our call (1.0%) and market consensus (0.9%). Growth over four quarters climbed to 1.2% in 1Q13 from 0.9% in 4Q12. The favorable performance of the Agricultural sector (9.7%) supported the economy early in the year, while industrial GDP retreated 0.3%, and service GDP, the biggest negative surprise in the report, expanded 0.5%. Consumption growth slowed to 0.1%, and investments, the positive highlight in the report, advanced 4.6%. Expansion in the coming quarters is likely to be gradual. Incorporating the weaker reading for 1Q13 and the expectation of still-moderate growth ahead, we reduced our forecast for GDP in 2013 to 2.4% from 2.8%.

...but the Central Bank accelerated the pace of interest rate hikes...

The Central Bank’s monetary policy committee (Copom) lifted the benchmark Selic interest rate by 50 bps, to 8.0% p.a. in a unanimous decision. The hike was in line with our call and part of the market’s. The decision signals a more assertive stance in fighting inflationary pressures. In the statement that complemented the decision, the Copom reaffirmed its commitment to the goal of ensuring a downward trend for inflation. The unanimous decision strengthens this commitment and is consistent with our scenario of a total increase of 150 bps in the Selic rate, with another 50-bp hike in the next meeting and a final hike of 25 bps in August.

...due to inflationary pressures.

The mid-month consumer price index IPCA-15 rose 0.46% in May, slightly below our forecast and market expectations (both at 0.49%). Year over year, the IPCA-15 is up by 6.46%. The deviation in relation to our estimate is largely explained by the food group. Core indexes in the IPCA-15, which measure the underlying trend for inflation, increased somewhat. Year over year, core inflation in the IPCA remained at 5.9%.

The Brazilian currency weakened again...

The exchange rate depreciated again, ending the month at 2.13 reais per U.S. dollar. The move was partly caused by external factors. First, steadier growth in the U.S. suggests a stronger dollar. Second, the slowdown in China puts downward pressure on commodity currencies, such as the Brazilian real, the Australian dollar and the Chilean peso. But part of the depreciation in the real also reflects changes in domestic fundamentals, such as slower GDP growth. Late in the month, the Central Bank announced intervention in the derivatives market in an attempt to cushion the move.

...as the current account deficit widened.

The current account deficit reached $8.3 billion in April, as the gap over 12 months hit $70 billion (3% of GDP). On a positive note, foreign direct investment (FDI) topped our estimate and featured a benign composition, with inflows concentrated on equity capital transactions. We maintain our estimate that FDI will be smaller than the current account deficit in 2013 and 2014 (3% of GDP).

The unemployment rate remains low, supporting income gains.

The unemployment rate stood at 5.8% in April, a little higher than market expectations (5.6%) but still low by historical standards. The real average wage rose 0.3% and the real wage bill increased 0.4% during April. We maintain our view that labor market conditions remain favorable, though there is evidence of a cool-down in employment. Government-registered new jobs (according to the Labor Ministry’s CAGED registry) slowed down in the beginning of the year but stabilized in recent months. With the economy expanding at a moderate pace throughout the year, we believe conditions will remain favorable for employment and income.

Approval of the temporary decree regulating ports and the resumption of concessions in the oil industry may fuel capital investments.

After difficult negotiations, Congress approved the temporary decree for ports, which regulates and eases investment in private ports. Furthermore, auctions for oil-exploration concessions resumed, which is positive news for investments.

Stocks fall, risk spreads widen and the local currency weakens.

The benchmark Bovespa index extended its decline, falling 4.3% in May (-10.1% in dollar terms). The 5-year CDS spread rose 33% during the month, to 146, the highest since July 2012. The exchange rate weakened 6.5%, ending the month at 2.13 reais per dollar.

What’s next?

The path of the exchange rate (and the government’s reaction) will be the main variable to watch, given the depreciation move and the changes in the external scenario.



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