Itaú BBA - A difficult reversal

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A difficult reversal

June 18, 2015

Inflation has increased and growth has worsened in Brazil, making it harder to conduct monetary and fiscal policy.

• Inflation has increased and growth has worsened in Brazil, making it harder to conduct monetary and fiscal policy.

• The country's economic activity indicators continue to deteriorate. Our diffusion index, which measures the number of broad indicators on the rise, remains near the levels registered during the financial crisis in 2008. We revised our GDP forecast for 2015 to a 1.7% decline (from -1.5% previously), which reduces the statistical carryover for next year.  We also revised our GDP growth forecast for 2016 to 0.3% (from 0.7% previously). We expect unemployment to continue to rise, to 7.6% by December and 8.0% in 2016 (from 7.3% for both years).

• The sharper decline in economic activity and other fiscal challenges have led us to reduce our primary surplus forecast to 0.7% of GDP for this year (from 0.8%) and 1.2% next year (from 1.5%).

• We raised our IPCA forecast for 2015 from 8.5% to 8.8%, following the increase in our forecasts for regulated prices (from 14.0% to 14.9%) and market prices (from 6.9% to 7.0%). Regarding regulated prices, we note the higher-than-expected adjustments in health plans and lotteries. The slight upward revision to our market-price assumption, on the other hand, was driven by the increased pressure from food prices in recent months as well as the more depreciated exchange rate expected for the end of the year. These effects more than offset the downward revision in our service forecast. For 2016, our IPCA forecast remains at 5.5%, with a 6.3% expansion in regulated prices and a 5.3% growth in market prices. In the case of market prices, we note the sharper slowdown in service inflation, to 6.2% in 2016 due to weaker labor market and more moderate wage increases.

• The latest data confirmed the gradual adjustment in external accounts. The prospect of lower commodity prices and reductions in the rollover pace of currency swap contracts by the Brazilian Central Bank (BCB) led to an upward revision of our exchange-rate forecast to 3.20 reais per dollar by the end of 2015 (from 3.10) and 3.50 reais per dollar by the end of 2016 (from 3.40).

• The BCB reinforced that it is fighting inflation with "determination and perseverance." Increased pressure on inflation and the BCB's recent communication led to the revision of our monetary policy outlook. We expect a final hike of 0.50 pp in July, taking the Selic rate to 14.25%. Interest rates are likely to drop again, but only from the middle of 2Q16 onward.

Worsening scenario poses a challenge for economic policy

The combination of higher inflation and lower growth makes for a more challenging scenario. The IPCA surprised again in the month, and the inflation accumulated over the last 12 months is likely to continue to rise (exceeding 9%). Leading and coincident activity indicators suggest a further contraction in production and rising unemployment ahead.

Because the deceleration in economic activity affects government tax collection, part of the deterioration will be reflected in a lower primary surplus. Another part will probably be offset by additional fiscal-adjustment measures.

The increased pressure on inflation is likely to lead the BCB to carry out further interest-rate hikes. The BCB's speech of "determination and perseverance" suggests that interest rates will remain high for some time.

Thus, worsening inflation and unemployment figures indicate a more complex scenario.

Economic activity worsening

We expect a 1.5% drop in GDP in the second quarter of 2015. In the first quarter, GDP fell by 0.2% qoq/sa. Although the drop was less severe than expected, the breakdown - a larger contraction in the more stable service data - suggests further weakness ahead. Moreover, the latest data continue to disappoint at the margin. Our latest diffusion index (which is based on a broad set of data that includes consumer and business confidence, retail sales and demand for credit) showed increases in only a few indicators - similar to the trend registered during the financial crisis in 2008 - underscoring the dissemination of the weakness in activity.

Industrial production fell 1.2% mom/sa in April, and the May indicators suggest a further decline. The industry's performance is highly correlated with trade and transportation services, and supports our expectation of a sharper decline in GDP in 2Q15.

Leading activity indicators show no signs of stabilization. Business and consumer confidence fell again in May. The confidence indicators remain near their historical lows. Business confidence, which is a key leading indicator of industrial production, posted a fourth consecutive decline, signaling a weak sector performance over the coming months. Inventories reached the highest level since 2009, likely restricting production in the short term.

We revised our forecast of a GDP contraction to 1.7% for 2015 (from -1.5%). The decline in economic activity in the second quarter will probably be greater than we anticipated. Moreover, the widespread weakness and statistical carryover for the third quarter indicate slower growth this year. The lower expected growth for this year affects the statistical carryover for 2016. Furthermore, a recovery is limited by the continuity of macroeconomic adjustments and weak consumption. We reduced our GDP growth forecast to 0.3% for 2016 (from 0.7%).

The unemployment rate is likely to continue to rise in the coming months. Unemployment rose from 5.8% in March to 6.0% in April (our seasonal adjustment). In the formal market (CAGED), there was destruction of 158,000 jobs (seasonally adjusted) across all major sectors (industry, services and trade) in the month. Leading indicators, such as the percentage of people reporting difficulty in finding jobs, suggest the continuation of this scenario ahead.

We expect the unemployment rate to reach 7.6% by the end of 2015 and to remain on an uptrend in 2016, to 8.0% in seasonally adjusted terms (from 7.3% for both years previously).

Credit remained weak and delinquency rose in April. The daily average of non-earmarked new loans fell 1.0% mom/sa in real terms, while earmarked new loans grew 2.4%. Total outstanding credit continued to slow down: real annual growth fell from 2.8% to 2.1%. In the same comparison, non-earmarked outstanding loans continued to recede (-3.1%) and earmarked credit moderated from 9.5% to 8.2%. The system's delinquency increased 0.2 pp to 3% and the interest rate and spread also increased.

Growing fiscal challenges

Public spending has been declining this year, despite the payment of postponed expenses. Total federal spending (excluding RGPS compensation) has decreased 1.0% in real terms year to date, relative to the same period of last year. This rate compares with an expenditure growth of 5.2% in 2014 and 6.4% in 2013. The government started to pay the postponed interest-rate-equalization expenses related to the BNDES-PSI investment program (BRL 2 billion) in April. We had already factored in this expense for the month and for the remainder of 2015 (our fiscal scenario for 2015 assumes BRL 9 billion in interest-rate-equalization expenses).

The main expenditure cut occurred in investment (-34.7% ytd). Discretionary administrative costs continue to increase by 0.7%. According to the National Treasury, the government is working to reduce administrative costs, likely leading to lower figures in this line going forward.

We expect a significant drop in spending in real terms this year (-6.0%), as the payment of postponed expenses is reduced and a more favorable comparison base is taken into account (spending accelerated substantially in the second half of 2014).

The problem is that tax collection is also declining due to worsening economic activity, particularly in consumption and the labor market. Federal tax revenue has fallen 2.6% in real terms year to date, relative to the same period of last year. Dividend revenues from state-owned companies totaled BRL 2.2 billion from January to April (compared with BRL 8.2 billion in the same period of 2014). Royalty revenues totaled BRL 10.6 billion this year (vs. BRL 16.2 billion in the same period of last year).

The central government reported a primary surplus of BRL 10.6 billion in April, slightly below market estimates of BRL 11.3 billion and our forecast of BRL 13 billion. Year to date, the central government reached a primary surplus of BRL 15.5 billion. Given that the result from January to April usually represents about 50% of the full-year result, the BRL 15.5 billion accumulated so far underscores the challenge being faced by the central government to reach the fiscal target of BRL 55 billion.

Regional governments delivered a positive performance in April and year to date. The primary surplus of regional governments reached BRL 2.6 billion in April (vs. market consensus of BRL 2.0 billion and Itaú estimate of 0.0). Year to date, regional governments have accumulated a primary surplus of BRL 17.1 billion, surpassing the BRL 11 billion target for 2015. This does not mean, however, that the target has already been delivered. From May to December 2014, for example, regional governments posted a primary deficit of BRL 21.3 billion. The notably positive result in the first four months of 2015 is probably associated with the ICMS revenue from electricity, which benefits from higher prices. However, electricity ICMS represents only about 10% of total ICMS, and the other 90% will suffer from the contraction in economic activity. We therefore expect a moderate decline in the primary surplus of regional governments going forward, closing the year at BRL 11 billion (0.2% of GDP) - in line with the target.

We reduced our primary surplus forecast to 0.7% of GDP this year (from 0.8%) and 1.2% next year (from 1.5%). The revision for 2015 is due to lower tax collection (by about BRL 2 billion) and lower dividend revenues (by BRL 5 billion). The revision for 2016 is due to the following factors: (i) lower revenues from the bill that reduces payroll tax exemption; (ii) less tax collection due to downward revisions in economic activity; (iii) softer changes in the rules regarding the annual bonus for low-wage workers. Given these factors, an additional increase of BRL 40 billion in the tax burden would be required for the primary surplus to reach 1.5% of GDP. We believe that an increase of BRL 20 billion is more likely, and have therefore reduced our primary surplus forecast for 2016 to 1.2% of GDP.

Exchange rate generates volatility in nominal results and public debt. The nominal deficit accumulated over the last 12 months fell from 7.8% of GDP in March to 7.5% in April. The decline was mainly attributable to the favorable result of the Central Bank's FX swaps, which totaled BRL 31.8 billion in April, compared with negative BRL 34.5 billion in March. Interest expenses fell from 7.1% of GDP in March to 6.7% in April, while the primary deficit increased from 0.7% to 0.8%. The net debt for the public sector rose from 33.1% of GDP to 33.8%. The gross debt for the general government declined from 62.4% to 61.7%. The net effect of the exchange-rate depreciation is favorable for net debt, because the government has more assets than liabilities in foreign currency, but unfavorable for gross debt. Given the exchange-rate appreciation in April, net debt increased and gross debt fell. We expect the uptrend in both net and gross debt to continue, as the primary surplus is likely to remain below the level required to stabilize public debt as a percentage of GDP (around 2.5%).

Raising our IPCA inflation forecast for 2015 from 8.5% to 8.8%, but maintaining our forecast for 2016 at 5.5%

The IPCA increased 0.74% in May, surpassing both our forecast and the upper limit of market expectations. The largest contributions came from foodstuffs, housing, health and personal care and personal expenses. The results from foodstuffs and some regulated prices, such as electricity and lotteries, exceeded our estimates. Thus, the IPCA has accumulated a 5.34% expansion year to date, compared with 3.33% in the same period of 2014. Over the past 12 months, the IPCA has risen 8.47% - the highest level since 2003 - compared with 6.37% in the same period of last year.

Our preliminary forecast for June indicates an increase of 0.65%. The monthly result will be pressured by foodstuffs, water and sewage tariffs as well as by lotteries and airfare. If the estimated result for June is confirmed, the 12-month IPCA rate will rise to 8.7%.

We raised our IPCA forecast for 2015 from 8.5% to 8.8%, with an additional increase in the forecast for regulated prices, from 14.0% to 14.9%. The main corrections in our regulated price forecast were related to health plans and lotteries. For health plans, the change included the 13.55% increase authorized by the National Health Agency (ANS) for individual and family plans hired from 1999 onward. The increase - which is usually included in the IPCA calculation from August to July of the following year - surpassed both our estimate (9.0%) and the percentage defined by the ANS last year (9.65%). We therefore raised our forecast for health plans in the IPCA from 9.3% to 11.3% for this year. We also revised our forecast for lotteries, given that the initial IPCA results also showed an above-expectation average increase in this line. For the other regulated prices with the greatest weight on inflation, we forecast a 51% hike in the electricity tariff, 10% in gasoline, 12.8% in urban bus fares, 12.3% in water and sewage and a drop of 1.5% in fixed-line telephone bills. A significant risk factor for regulated-price inflation this year could come from gasoline prices, which once again lagged international prices. If the misalignment in prices persists over the next few months, we cannot rule out an increase in refinery prices this year (not yet contemplated in our scenario), which would have a direct impact on the price of gasoline at the pump and an indirect impact on the price of ethanol.

For market prices, we raised our forecast for this year from 6.9% to 7.0%, with some adjustments among groups. We reduced our forecast for services from 7.9% to 7.7% (compared with 8.3% in 2014), due to the more stable results of items related to wages (domestic workers and repair services) and airfare. We therefore maintain our view that the worsening conditions in the labor market and the Real Estate sector (with the moderation in wage and rents) are likely to contribute to the decline in private-service inflation this year and even more so in 2016. On the other hand, we raised our forecast for food at home from 7.4% to 8.0%, due to the increased pressure on results at the margin as well as the revision of our year-end exchange-rate assumption.

For 2016, we continue to forecast a 5.5% variation in the IPCA, with a stronger hike in regulated prices than in market prices. The higher-than-expected adjustment authorized for health plans this year also led us to increase our forecast for regulated prices in 2016, from 6.0% to 6.3%. However, we lowered our inflation forecast for market prices in 2016 from 5.4% to 5.3% to account for the downward revision in our economic-activity scenario, which more than offset the effect of higher inflationary inertia. In disaggregated terms, we expect increases of 3.8% in industrial prices, 5.5% in food at home and 6.2% in services. The slowdown in service inflation is likely to be more intense than expected this year due to expectations of weaker labor market and more moderate wage growth. In the case of foodstuffs, prices may ease following the confirmation of the El Niño weather phenomenon, which should lead to better grain harvests for major grain producers such as the U.S., Brazil and Argentina, where the overall prospects are already favorable. In this sense, the hydrological risk also tends to be lower than in recent years.

In addition to the weak economic activity, other factors are likely to cause significant disinflation in 2016, such as the prospect of better weather conditions, lower exchange-rate depreciation and a significant reduction in regulated price hikes (particularly electricity). On the other hand, new tax hikes due to the government's need to increase tax revenue may have a direct or indirect impact on the prices of some goods and services (market and/or regulated prices).

The IGP-M rose 0.41% in May, 3.6% year to date, and 4.1% over the past 12 months. The IPA-M - the component with the largest weight in the IGP-M (60%) - gained 0.3% in May, following a 1.4% growth in April. The industrial IPA variation fell from 1.5 % to 1.0% in the month and the agricultural IPA dropped from 1.3% to -1.5%. Thus, the 12-month variation in the IPA-M variation rose to 2.3%. The IPC-M (with a 30% share in the IGP-M) - registered a variation of 0.68% in May, with the 12-month rate remaining at 8.3%. The INCC-M (with a 10% weight in the IGP-M) posted a variation of 0.45% in the month and 6.0% over the past 12 months.

We raised our forecast for the IGP-M from 6.5% to 7.0% for the year, with adjustments in the IPA-M and IPC-M. The adjustment in our IPA and IPC forecasts was based on the revision of our exchange-rate assumption for the end of this year. Furthermore, in the case of the IPA, the recent hike in iron ore prices incorporated into the FGV indexes beat expectations, while in the case of the IPC, we incorporated the increased pressure from regulated prices. In disaggregated terms, we forecast an expansion of 6.3% for the IPA-M in 2015, 8.8% for the IPC-M and 7.1% for the INCC-M. For 2016, we maintained our forecast for the IGP-M at 5.8%.

External accounts show clearer signs of improvement

The trade balance ended the first five months of the year with an accumulated deficit of USD 2.3 billion, improving from the USD 4.9 billion reported for the same period of last year. Although exports continue to suffer from the drop in commodity prices, imports have posted a steep decline in recent months.

The more depreciated exchange rate and slower activity have already begun to affect imports. Moreover, the drop in oil prices contributed to a lower deficit in the fuel account. We maintained our trade surplus forecast for 2015 at USD 4 billion and for 2016 at USD 8 billion.

The current account balance also showed favorable results in early 2015. The current account deficit declined 12.4% yoy in the first four months of the year, to USD 32.5 billion (from USD 37.1 billion). The seasonally-adjusted, annualized quarterly moving average deficit retreated from USD 90 billion in March to USD 87 billion in April 2015. The service and income deficits also declined 5.9% and 19.9%, respectively, between January and April 2015, relative to the same period of 2014 - in line with the weak economic-activity scenario and depreciated exchange rate. We note the persistent deficits in international travel as well as profit and dividend remittances. We forecast a gradual adjustment in the current account deficit, to USD 80 billion in 2015 and USD 69 billion in 2016.

On the financing side, we note the continued portfolio flows to local capital markets, both fixed income and equity. Between January and April, these flows totaled USD 27.3 billion, compared with USD 18.5 billion in the same period of last year. Direct investment, on the other hand, continues to recede on a yearly basis, to USD 19 billion in 2015 (from USD 30 billion in 2014). A larger share of the current account deficit has therefore been financed by portfolio flows, which are typically more volatile and dependent on global liquidity conditions.

Over the past month, the BRL has hovered at more depreciated levels due to domestic and international factors. Domestically, the behavior was fueled by the uncertainties surrounding the approval of the proposed fiscal-adjustment measures and the slowdown in the rollover of swap contracts by the BCB. Internationally, the stronger economic data from the U.S. has strengthened our expectation of on interest-rate hike by the Fed in 2H15.

We revised our exchange-rate forecast to 3.20 reais per dollar by the end of 2015 (from 3.10 previously) and to 3.50 reais per dollar by the end of 2016 (from 3.40 previously). The BCB recently reduced the rollover pace of the contracts maturing in July. If the new pace is maintained until the end of the month, the monetary authority will roll over 70% of the total batch. This reduction in the rollover pace, coupled with the drop in commodity prices, supports our scenario of a more depreciated exchange rate.

Continued tightening of monetary policy

The deterioration of inflation and growth in Brazil makes the implementation of monetary policy more difficult.

The 2015 inflation forecast has increased, while activity continues to deteriorate. 

The BCB continues to stress its goal to bring inflation to the 4.5% target by the end of 2016. In light of the increased pressure on inflation in 2015, the Central Bank has been underscoring the need for "determination and perseverance" to prevent the trend from becoming persistent.

Further pressure on inflation and recent signs from the BCB led to the revision of our monetary policy outlook. Initially, we believed that the substantial weakening of economic activity this year would lead the BCB to end the hiking cycle after the June increase, with the Selic at 13.75%. However, the significantly above-expectation May IPCA reading and the latest Copom minutes (published on June 11) convinced us that the monetary-tightening cycle will probably continue in July.

We expect a final hike of 0.50 pp in July, taking the Selic rate to 14.25%. We believe that the Selic will remain at this level until the second quarter of 2016, which is consistent with the BCB's speech of "determination and "perseverance". With the 12-month IPCA back within the target range, the BCB is then likely start to lower the monetary rate toward 12.00%.


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