Itaú BBA - A challenging fiscal and activity scenario continues

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A challenging fiscal and activity scenario continues

January 19, 2016

Recession will persist in 2016. The depressed economic activity makes the fiscal adjustment even more challenging.

Please open the attached pdf to read the full report and forecasts.

• Brazil’s recent economic activity numbers surprised to the downside. We have lowered our forecast for 2015 GDP to -3.9% (previously: -3.7%). Fundamentals continue to indicate a challenging scenario. For now, we maintain our 2016 growth forecast at -2.8%, but with a negative bias. We remain on hold until the next round of data in order to define our estimates more precisely. For 2017, we forecast GDP growth at 0.0%.

• The fiscal situation remains challenging, with weak economic activity and growing mandatory expenditures. We have lowered our forecast for the 2016 primary balance to -1.4% of GDP from -1.3% of GDP (compared with -2.0% of GDP in 2015). 

• Over the course of 2015, the dollar rose by almost 50% against the Brazilian real. In the coming years, international and domestic uncertainties will probably continue to put pressure on the real. We maintain our forecast for an exchange rate of 4.50 reais per dollar by the end of 2016.

• The current account deficit will likely reach zero in 2017. A more-depreciated exchange rate and slowing economic activity led to a sharp adjustment in the external accounts in 2015, and point to even better results in 2016 and 2017. We have revised our current account deficit forecasts to USD 59.5 billion (from USD 66.5 billion) for 2015, USD 21 billion (from USD 35 billion) for 2016 and zero for 2017.

• We have increased our inflation forecast for this year slightly, to 7.0% from 6.8%, to reflect larger regulated-price adjustments and tax increases. For 2017, we continue to forecast inflation at 5%.

• Despite the complex scenario for monetary policy, the BCB has continued to signal that further interest-rate hikes are likely. We now forecast a 1.0-pp hiking cycle composed of two increases of 0.5 pp starting in January. For 2017, we see room for a gradual decline in the Selic rate, to 12.00%.

An even more-complex scenario

Economic activity disappointed again. Recently released leading and coincident indicators suggest that the contraction in activity at the end of 2015 was deeper than we anticipated. There are no signs of stabilization.

The drop in activity will have a significant impact on other macroeconomic variables. The fiscal adjustment needed to rebalance the economy will be even more challenging if government revenues continue to decline as a result of the deepening recession. In addition, the increase in unemployment will have a major social impact, despite the disinflation we expect for the year. A drop in imports, partly as a result of weaker activity, has been ensuring a prompt adjustment in the external accounts, reducing the need for more-volatile capital to finance the current account deficit.

Without reforms that reduce mandatory expenditures, the fiscal situation will remain challenging. Given the weakness in economic activity and the already-significant cuts in discretionary spending, the fiscal adjustment will require either a decline in mandatory expenditure or tax increases. Both options are difficult, since both would require approval from Congress, while the second option would also increase the country’s already-high tax burden.

Inflation will likely start the year under pressure before shifting to a downward path. Some of the fiscal difficulties faced by the public sector will translate into higher inflation, through the increase in some taxes and tariffs at the beginning of this year. However, with a more-stable exchange rate, a smaller increase in regulated prices and the impact of the recession, the IPCA inflation will likely enter a declining path starting in 2016.

Monetary policy has become even more complex. The BCB has been signaling that it will make further interest rate hikes to counter higher inflation. We expect two 0.50-pp hikes at the next two Copom meetings (January and March), with the Selic rate remaining stable at 15.25% from April onward.

Recession continues

Widespread recession. Our diffusion index – which shows the number of indicators with positive variations, based on a broad set of data, including business and consumer confidence, retail sales and demand for credit – will likely end November at a level compatible with a 3% (annualized) contraction of activity. On a 12-month basis, the diffusion index has reached the lowest level in the series.

A negative trend in industrial production. November saw the sixth consecutive monthly drop in industrial production. All 25 industrial activities posted contractions over the last 12 months. With a slowdown in the construction sector, our gross fixed capital accumulation proxy shrank by 2.3% in the month. These results suggest that 4Q15 will be the tenth consecutive quarter with a decline in investment.

The growth in retail sales seen in November will not be sustainable going forward. The result for November was driven by advance purchases made before year-end. We expect payback in December, consistent with the real wage bill deterioration. Recent leading and coincident indicators support our view. For instance, activity in the retail sector – as measured by Serasa Experian surveys and according to our own estimate, which weights segments according to their share of retail sales – declined by 1.9% in December.

Sales data released for December showed no improvement. Vehicle sales fell by 4.9% in December, according to Fenabrave (with our seasonal adjustment). Vehicle production came in slightly higher in December but did not fully recover from the poor result posted in November (-5.5%).

High inventories in the industrial sector will likely constrain activity. In December, the outlook for consumers and businesses remained gloomy. Consumer and business confidence in the trade sector reached record lows. In the industrial sector, despite the fact that capacity utilization was close to its lowest level since 1993, inventories remained high. Still-high inventories and declining demand suggest that adjustments in production will probably continue over the coming months.

Recession should continue. Released indicators suggest that the contraction in activity deepened in the fourth quarter. The decline in GDP in 2015 will probably be even sharper than we anticipated. We have lowered our 2015 growth forecast to -3.9% (previously: -3.7%).

We maintain for now our GDP forecast for 2016 at -2.8%, but expect to lower our estimates in the future. The sharper decline in economic activity in the fourth quarter of 2015 worsened the statistical carry-over for 2016. In addition, the fundamentals point to a persistently difficult situation ahead: the degree of uncertainty in the domestic scenario remains high, monetary policy remains contractionary and businesses still face high costs. At the same time, the drop in the wage bill will likely continue to contribute to lower household consumption. All suggest a downward bias in our current forecast.

We remain on hold until the next round of data, in order to define our estimates more precisely. For 2017, we forecast GDP growth of 0.0%.

Recession in economic activity weighs on the labor market

No relief in the labor market, job destruction continues. In November, the net balance of formal jobs reached -131,000 (CAGED). In seasonally adjusted terms, we calculate a decline of 156,000 jobs. Regional diffusion (the percentage of states that created employment) is at its lowest level since the beginning of the series in 1998.

We maintain our estimate that the unemployment rate reached 8.6% in the six metropolitan regions that compose the PME and 10.0% nationwide (“PNAD Contínua”) by year-end 2015 (with our seasonal adjustment). In November, the unemployment rate in the six metropolitan regions that make up the Monthly Employment Survey (PME-IBGE) was 7.5%. With our seasonal adjustment, unemployment rose to 8.2% from 7.9%, the eleventh consecutive increase. For the quarter ended in October, the nationwide unemployment rate was 9.0%. Using our seasonal adjustment, the unemployment rate rose to 9.3% from 9.0% in September, marking the tenth consecutive increase. Moreover, the proportion of people reporting difficulty in finding employment is getting closer to 100%; in December, it increased to 93.8% (from 92.8% in November). We have raised our year-end unemployment rate forecasts (PME-IBGE) to 11.4% for 2016 (previously: 10.6%) and 12.4% for 2017 (previously: 11.2%). For the national unemployment rate, we expect 13.0% at the end of 2016 and 13.7% at the end of 2017 (previously: 12.0% and 12.3%, respectively).

Credit remained weak and the delinquency rate rose in November. The daily average of new non-earmarked loans fell by 0.3% mom/sa in real terms, while the daily average of new earmarked loans declined by 2.1%. Total credit outstanding continued to decline in November in terms of real annual growth, down 2.7% (vs. -1.6% in October). For non-earmarked credit, there was a sharper drop in outstanding loans, to -5.8% from -5.1%, in an annual comparison. There was also a slowdown in earmarked credit growth, which rose by 0.6% (vs. +2.3% in October). The overall delinquency rose by 0.1 pp, to 3.3%. Overall interest rates and average spreads receded slightly.

Fiscal deterioration due to weak economic activity and rising mandatory spending

We have revised our forecast for the 2016 primary balance to -1.4% of GDP from -1.3% of GDP previously (vs. -2.0% of GDP in 2015). The government decided to pay the totality of delayed expenses in the last days of 2015, reducing our public-expenditure forecast for 2016 by BRL 20 billion (our previous hypothesis was that the delayed expenses would be paid in installments between 2015 and 2018). However, we have reduced our forecast for tax collection by about BRL 30 billion due to a deep contraction in economic activity. Tax collections have retreated more strongly than GDP because the wage bill and retail sales – together, the basis for more than 70% of the federal government’s tax revenues – have also retreated more strongly than GDP.

For 2017, we forecast a decline in the primary result to a deficit of 2.0% of GDP. The main reasons for the additional deterioration next year are an increase in social security expenses (from 8.0% to 8.4% of GDP), a drop in extraordinary revenues (from 0.7% to 0.3% of GDP) and a decrease in recurring revenues (from 20.7% to 20.5% of GDP), due to the fact that the wage bill and retail sales will likely continue to underperform GDP.

There is possibility of parafiscal expansion. The payment of delayed expenses to state-owned banks and FGTS could make room for an increase in subsidized credit, which would constitute a parafiscal stimulus.

Interest expenses will likely continue to rise. The nominal deficit reached 9.3% of GDP in the 12 months ending in November 2015. Excluding the BCB’s losses from currency swaps, the nominal deficit reached 7.6% of GDP. Interest expenses excluding the swap losses reached 6.7% of GDP in November and will likely continue to grow, due to the increase in the average interest rate over 12 months and a larger amount of debt outstanding. We forecast that interest expenses excluding swap losses will total 7.7% of GDP in 2016, bringing the nominal deficit to 9.1% of GDP.

External accounts: a fast and intense adjustment in 2015

The exchange rate ended 2015 at close to 4.00 reais per dollar. We maintain our forecast for exchange rates of 4.50 reais per dollar at the end of 2016 and 4.75 reais per dollar at the end of 2017. The economic and political uncertainties in Brazil will likely affect the availability of external financing in the coming years, pressuring the real.

In 2015, the trade balance posted a surplus of USD 19.7 billion[1], after posting a deficit in 2014. Exports fell sharply, to USD 191 billion from USD 225 billion, penalized by lower prices for Brazil’s main exported commodities. The positive result for the trade balance stemmed from an even sharper drop in imports, which receded in all categories of use, totaling USD 171 billion (compared with USD 229 billion in 2014). There was a significant reduction in Brazilian trade flows, to USD 362 billion from USD 454 billion.

Intense adjustment in the external accounts in 2015. The current-account deficit accumulated over 12 months decreased to USD 68 billion (3.7% of GDP) in November from USD 104 billion (4.3% of GDP) at the end of 2014. The improvement was widespread, due to successive trade surpluses and the decrease in the service and income deficits.

On the financing side, direct investment in the country accumulated over 12 months reached USD 70 billion (equivalent to 3.8% of GDP) in November. This amount was sufficient to cover the entire current account deficit, reducing dependence on more-volatile capital. Foreign portfolio investments (fixed income and equity) started to show net inflows in November after four consecutive months of outflows. For next year, however, we forecast a smaller inflow to the local capital market.

The current account deficit will likely reach zero in 2017. Recent data, along with our expectations of a more-depreciated currency and weak economic activity, point to even better results in 2016 and 2017. We now forecast trade surpluses of USD 42 billion in 2016 (compared with our previous estimate of USD 31 billion) and USD 56 billion in 2017. Incorporating these larger trade surplus estimates, we have lowered our current account deficit forecasts to USD 59.5 billion in 2015 (from USD 66.5 billion), USD 21 billion in 2016 (from USD 35 billion) and zero in 2017.

Raising our 2016 inflation forecast to 7.0% from 6.8%, but leaving our 2017 forecast at 5.0%

The IPCA index ended 2015 with a variation of 10.67%, well above the rate posted in 2014 (6.41%). The IPCA increased by 0.96% in December, slightly below our estimate and the median of market expectations. With this result, market prices rose by 8.5%, contributing 6.6 pp to full-year inflation (vs. 5.2 pp in 2014), while regulated prices increased by 18.1%, with an impact of 4.1 pp on the IPCA result (vs. 1.2 pp in 2014).

Our preliminary forecast for the IPCA in January is for an increase of 1.0%, with the 12-month rate receding to 10.4%. In addition to the seasonal pressure from food prices at the beginning of the year, in January inflation will be under pressure from increases in public transportation fares in some state capitals, as well as from tax increases on consumer prices for some goods and services.

For this year, we have increased our IPCA forecast slightly, to 7.0% from 6.8%. Compared with our previous report, we have reduced our forecast for the readjustment of electricity prices but increased our forecasts for other regulated prices such as urban transportation fares and water and sewage rates. We have also incorporated the effect of tax increases, most notably the increase in the ICMS, which will likely affect both market and regulated prices. On the other hand, the ongoing economic recession this year should help mitigate the pressure on market prices, especially for services, durable goods and semi-durable goods.

Our 2016 inflation forecasts rose to 7.0% from 6.9% for market prices, and 7.0% from 6.5% for regulated prices. Among market prices, we anticipate increases of 5.5% in industrial prices (vs. 6.2% in 2015), 7.4% in services prices (vs. 8.1% in 2015) and 8.5% in prices for food consumed at home (vs. 12.9% in 2015). Despite the higher inertia observed in services inflation last year, we remain of the opinion that the worsening in labor market conditions and in the real estate sector, with the consequent moderation in wages and rents, will likely contribute to a drop in services inflation this year. However, the disinflation in services will be slow, due to the authorized increase of nearly 12% in the minimum wage, as well as the steep increases in tuition fees expected for the beginning of this year. In the case of food prices, our base-case scenario assumes more favorable weather conditions than in previous years, despite the risks associated with the El Niño phenomenon, which could affect the supply of some agricultural products. In addition to the presumably more-benign climate for crops, especially in the case of grains, lower exchange-rate variation and more-modest increases in energy and fuel costs will likely contribute to reducing food inflation over the course of the year.

As for regulated prices, the upward revisions in our forecasts for publictransportation fares, water rates and sewage rates, among others, have more than offset a downward revision in our inflation forecast for electricity. In the case of electricity, we have reduced our inflation forecast for 2016 to 2% from 9%. Most of this reduction is due to the announcement by the National Electric Energy Agency (ANEEL) of a reduction in the Itaipú tariff, as well as a lower deficit forecasted for the Energy Development Account (CDE). As for the impact of tariff flags, we continue to foresee a change in color from red flag to yellow flag (-3.6 pp in the electricity bill) around mid-year, given our expectation of lower thermal power plant usage. On the other hand, we have increased our inflation forecast for urban bus fares to 9% from 5%, given the adjustments authorized for the beginning of this year in some state capitals that account for a significant share of the IPCA. We also have raised our inflation forecast for water and sewage rates to 16% from 6%, due to changes in the incentive program for reducing water consumption in São Paulo, which will make it more difficult to obtain discounts in the rate. For gasoline, we continue to estimate price increases of 5% at the refinery and 4.5% at the pump. For now, we are not considering an increase in the CIDE on gasoline, but this tax remains a risk factor for inflation. For other regulated prices with a high weight in inflation, we forecast the following variations for the year: health insurance, +12%; medicines, +8%; bottled gas, +6%; and fixed-line telephone services, 0%.

The fiscal situation is a major risk factor for inflation this year. The deterioration of public accounts could translate into an even steeper and more-extended realignment in relative prices than that envisaged in our inflation forecasts. The effect could come by way of: i) a more depreciated currency, due to the increase in risk premiums; ii) a need for tax increases and/or further increases in regulated prices; and iii) a possible deterioration of inflation expectations.

However, weaker economic activity may contribute to a further decline in inflation in 2016. The counteracting vector for inflation is the slowdown in activity, although the deceleration also affects the fiscal results, which in turn tends to affect inflation expectations.

For 2017, we forecast an inflation rate of 5%. According to our forecasts, the drop in inflation next year will come from dissipating inflationary pressures from relative price adjustments (regulated prices and the exchange rate), less inflationary inertia and the ongoing impact of weak economic activity.

For the IGP-M inflation, we have maintained our forecast for a 7.0% this year, following a 10.5% in 2015. For 2017, we forecast 5%.

Monetary policy: the BCB continues to signal interest rate hikes, but we expect a short tightening cycle

The current trade-off is unfavorable for monetary policy.

On the one hand, the recession is deepening. GDP forecasts for 2016 have continued to drop since the beginning of the year, with much weaker data at the margin (e.g., industrial production in November). The median of market forecasts points to a 3.0% decline in GDP in 2016, with some projections already approaching a decline of 4.0%.

On the other hand, inflation expectations remain high. According to the Focus survey of market participants, IPCA expectations for 2016 rose again this week, to 6.93%. Inflation expectations for 2016 have been steadily rising since August of last year, influenced initially by the currency depreciation, and more recently by the expectation of a steeper adjustment in regulated prices. Expectations for 2017 have also risen recently, to 5.20%. In its December Inflation Report, the BCB forecasts the 2017 IPCA at 4.80%, above the 4.50% midpoint of the target range.

In this scenario, the BCB has continued to signal that further interest-rate hikes are likely. In an open letter to the Finance Minister released this month, BCB deputy governor Alexandre Tombini said that “despite the monetary policy efforts already undertaken, it is worth reiterating that, under the current circumstances, monetary policy must remain vigilant.” Tombini repeated the signals expressed in the last Copom minutes and the Inflation Report, that “regardless of other policies, the BCB will adopt the necessary measures in order to (...) circumscribe inflation to the limits established by the CMN in 2016, and converge inflation to the target of 4.5% in 2017.”

Given the BCB’s signals, we have recently revised our expectations for the Selic rate, which we previously expected to remain stable throughout 2016. We now expect the BCB to resume hiking interest rates in January. We estimate that an increase of 1.0 pp in the monetary rate would be necessary for the Copom model to forecast inflation reaching the target of 4.5% in 2017. We expect two 0.50-pp hikes at the next two Copom meetings (January and March), with the Selic rate remaining stable at 15.25% from April onward.

Room for interest rate cuts in 2017. For next year, we understand that the disinflationary effects of the economic recession and the prospect of greater stability in the exchange rate will make room for a gradual decline in the Selic rate, to 12.00%.


[1] According to the MDIC release.



Please open the attached pdf to read the full report and forecasts.


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