Itaú BBA - New Year Challenges

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New Year Challenges

February 1, 2013

Consumer spending dynamics are still favorable, but companies remain cautious in their investment decisions.

The Brazilian economy in January 2013

Consumer spending dynamics are still favorable, but companies remain cautious in their investment decisions. The government continues to try to boost the economy. A pickup in inflation reduces room for further stimulus through lower interest rates and currency depreciation, but tax breaks are likely to continue. Foreign direct investment remains strong. Low rainfall in December has drawn attention to the levels of reservoirs that supply hydroelectric dams.

Consumer spending dynamics are still favorable...

Consumer spending continues to grow, boosted by income and full employment. Retail sales increased 7.2% year over year in November. The unemployment rate went up slightly in December but remained close to all-time lows. The workforce continues to grow at a solid pace.

...but companies remain cautious in their investment decisions.

Greater risk aversion is still affecting investment decisions. In most sectors, moves to increase capacity have been delayed and, overall, cut back. A survey of industrial entrepreneurs by CNI, the national industrial association, shows that uncertainty regarding future conditions remains high. The Itaú Unibanco monthly GDP proxy posted a 0.2% monthly increase for November, which is consistent with a 0.7% expansion in the final quarter of 2012.

Inflation pressures have increased...

The mid-month consumer price index (IPCA-15) went up 6.0% year over year, nearing the 6.5% upper limit of the target range. Food and service prices are rising more rapidly. Higher inflation for durable goods, partly a result of foreign-exchange depreciation in 2012, is also behind the higher inflation. Underlying inflation indicators (core measures, diffusion indexes) have accelerated, showing that the pressure is not just temporary. On the other hand, regulated prices remain subdued.

...reducing room for further monetary and exchange-rate stimulus in the short term.

In the minutes of its last monetary policy committee meeting, the central bank signaled its intention to keep the benchmark interest rate at 7.25% for an extended period. The committee acknowledged a deterioration in the balance of risks for inflation and stated that additional monetary policy actions would not be effective to stimulate the economy, due to “supply-side limitations”. Furthermore, the central bank, concerned with inflation, allowed the Brazilian currency to appreciate below 2 reais to the U.S. dollar for the first time in seven months.

Tax breaks are likely to continue.

The public sector posted a high primary budget surplus in December and met its annual target. To accomplish this, the government used atypical revenues, executed a sharp temporary restraint on spending and reclassified expenditures in the Growth Acceleration Program (PAC) to allow for higher deductions. The target surplus of 2.4% of GDP was achieved – though, when it is adjusted for atypical revenues and expenses, the ratio falls to 1.8% of GDP. Still, the result is consistent with stability in public debt. Therefore, tax breaks aimed at boosting growth are likely to continue in 2013.

Foreign direct investment remains robust.

Foreign direct investment (FDI) amounted to 2.9% of GDP in 2012, topping 2011’s level of 2.7%. The service sector is still the main FDI recipient, with 52% of intakes in the form of equity capital transactions. The current account deficit ended 2012 at 2.4% of GDP ($54 billion). Hefty outflows of interest, profits and dividends and the gap in the service account more than offset the $19 billion trade balance surplus.

Auctions for toll operators on two federal highways have been postponed.

The government postponed auctions for toll operators on two federal highways. The postponement took into account requests by investors. Given that the lack of infrastructure has become one of the main bottlenecks in the Brazilian economy, the success of the concession program in the transportation sector will be vital to ensuring sustainable growth for the country.

Low reservoir levels have drawn attention.

Reservoirs hit very low water levels in 2012 due to insufficient rainfall and strong electricity usage last year (despite the low GDP growth). The reduction in electricity tariffs announced by the government (18% for residential users and up to 32% for industrial users) may stimulate demand even further this year. Thus, even with reasonable levels of rainfall in January – which lifted reservoir levels somewhat – the balance between electricity supply and demand should remain tight throughout the year.

Stocks fall, the real strengthens.

After strong gain in December, the Bovespa benchmark index fell by 2.0% in reais (+0.8% in dollars) in January. Over 12 months, the index lifted by 5.2% in reais (-17.1% in dollars). The 5-year CDS spread ended December at 118, up by 8.4% from the previous month. The real strengthened in January, finishing at 1.99 real per U.S. dollar.

What’s next?

The focus will be on the pace of economic recovery. GDP data for the fourth quarter of 2012 will be released on March 1. Rainfall volumes should also be monitored.

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