Itaú BBA - A more complex scenario

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A more complex scenario

May 11, 2018

Lower GDP, higher BRL and inflation forecasts

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

We reduced our GDP growth forecasts to 2.0% from 3.0% in 2018 and to 2.8% from 3.7% in 2019, after incorporating weaker 1Q18 data and less room for a pick-up in activity due to uncertainties surrounding reforms.

We maintained our estimate for the primary budget deficit at 1.9% of GDP in 2018, but our outlook for 2019 worsened to 1.2% of GDP, from 0.9%. Fiscal rebalancing still depends on reforms.

We revised our exchange-rate forecasts to 3.50 reais per U.S. dollar by YE18 and YE19 (from 3.25 and 3.30, respectively), as interest-rate differentials reached all-time lows.

We lifted this year’s inflation estimate to 3.7% from 3.5%, while maintaining our call for 2019 at 4.0%. Our scenario now includes a weaker currency, rising oil prices and slower economic growth.

The latest developments put forth ambiguous signals for monetary policy, but the central bank’s Monetary Policy Committee (Copom) will likely follow the path recently signaled and cut the benchmark interest rate by 25 bps in its next meeting to an all-time low of 6.25% p.a., ending the monetary easing cycle.

Slower growth in 2018 and 2019

We reduced our estimate for 1Q18 GDP to 0.3% qoq/sa from 0.5%, due to weak figures in March. Industrial production fell 0.1% during the month, dragged by widespread weakness. In the labor market, both the national household survey (PNAD Contínua) and the Ministry of Labor’s Caged registry show disappointing gains in employment. According to our calculations, the quarterly moving average for formal job creation receded to 27,000 in 1Q18 from 43,000 in 4Q17.

In addition to weakness in 1Q18, a broad set of indicators suggests that underlying growth lost steam, slowing down in annualized terms to 2.0% in early 2Q18 from 3.0% in 2H17. This assessment is based on the decline of confidence readings in April and on the diffusion of key monthly indicators. The domestic demand indicator also cooled down, as temporary factors that supported consumer spending in 2017 (rising real wages as inflation receded, growing informal employment, and withdrawals from inactive accounts held under the FGTS employment-protection program) faded away, and formal job creation – which was supposed to be the biggest driver of further expansion in the real wage bill in 2018 – decelerated.

Going forward, monetary policy, corporate balance sheets, the external situation and uncertainties surrounding the evolution of reforms suggest that there isn’t much room for a pick-up in growth. We expect annualized underlying growth to speed up somewhat, to 2.5% in 2H18. 

Thus, we reduced our forecasts for GDP growth to 2.0% from 3.0% in 2018, and to 2.8% from 3.7% in 2019. The balance of risks is neutral, with the outlook for growth changing according to expectations about the progress of reforms. Importantly, recent the exchange-rate move hurts growth through the following channels:   i) harming economic activity in the short term (by making capital goods imports more expensive and increasing corporate leverage); and ii) reducing the central bank’s ability to stimulate growth (given evidence that interest-rate cuts have a greater marginal impact on the exchange rate). Eventual incentives to activity due to a boost to exports, and disincentives to imports, tend to materialize with lags, and their magnitude is limited. 

Our forecasts for unemployment increased, in line with slower GDP growth. Using models that contemplate our new GDP-growth scenario and the sensitivities of different kinds of occupations to the pace of economic activity, we lifted forecasts for our seasonally adjusted unemployment rate to 12.1% by YE18 (vs. 11.7% previously; 1Q18: 12.5%) and to 11.5% by YE19 (vs. 10.7% previously). Our forecasts for the average unemployment rate are now 12.3% in 2018 (12.0% previously) and 11.7% in 2019 (11.0% previously).

Waiting for reforms

Despite our downward revision to GDP growth, we maintained our expectation for the primary deficit in 2018 at 1.9% of GDP (or BRL 137 billion). Revenue losses of BRL 10 billion due to our lower expectation for economic growth (to 2.0%) should be offset by additional extraordinary revenues related to oil-field auctions to be held in June and September. In 2018, meeting the primary deficit target of BRL 161 billion (2.2% of GDP) and the public spending cap will be less challenging than in the recent past.

Likewise, debt dynamics and the “golden rule” will not cause concern this year. As development bank BNDES repays BRL 130 billion to the National Treasury, the government will be able to comply with the so-called golden rule this year. Notwithstanding negative primary results, this repayment, better economic growth and lower real interest rates will contribute to keep gross debt as a share of GDP virtually stable in 2018.

However, our outlook for the primary deficit in 2019 worsened to 1.2% of GDP (or BRL 90 billion) from 0.9% of GDP (or BRL 80 billion). The revision followed our expectation of slower economic growth. In 2019, compliance with the spending cap will demand an adjustment of about BRL 30 billion, which, in our view, will come in the form of discretionary spending cuts and reversal of payroll tax breaks.

Without reforms, fiscal results will go back to a deteriorating trend from 2019 onward. The pension reform, a prerequisite for rebalancing public accounts, most likely will only get back on the table in the next administration. If controlling public expenditure (as set by the spending cap) is not made feasible, gradual convergence to primary surpluses that are compatible with public-debt stabilization will be halted. If the currently unsustainable trend in public debt is maintained, the rebound in economic activity and sustainability of interest rates at historically low levels will be in jeopardy.

A weaker currency

The Brazilian real continued to depreciate against the U.S. dollar in the past month and reached its weakest level since June 2016. After trading around 3.25 reais per dollar since 2H17, the exchange rate weakened beyond 3.50. The international and domestic scenarios became more volatile and uncertain. Normalization of U.S. inflation toward its 2% target fueled concerns of sharper interest-rate hikes by the Federal Reserve, pressuring emerging-market currencies. Domestically, uncertainties surrounding the approval of reforms remain high, and the narrowing interest-rate differential to all-time lows also seems to impact FX dynamics. 

Our exchange-rate forecast is now 3.50 by YE18 and YE19 (from 3.25 and 3.30, respectively). Uncertainties arising from the international and domestic scenarios (especially as the pension reform was not approved) remain high. Thus, there is growing demand for hedging against a weaker BRL, encouraged by the low cost of carrying these positions (the interest-rate differential). Our new outlook includes a narrowing interest-rate differential to historical lows and rising demand for FX protection, leading to a weaker currency than we previously anticipated. 

There are relevant risks to our call. 

The first risk involves the internal and external macro scenario. In Brazil, there are persistent uncertainties regarding reforms, especially on the fiscal side. Overseas, more intense tightening in U.S. interest rates or an escalation of the trade war between China and the U.S. could trigger corrections in some assets, including the Brazilian real.

The second risk is specific to the FX market operation. The very thin interest-rate differential is something quite new, and there are doubts about its full impact on the FX market.

At the margin, data continue to show healthy external accounts. For the next few years, we expect larger current-account deficits, but not to the point of compromising Brazil’s external accounts. Our outlook now incorporates a weaker currency, but we continue to expect a rebound in domestic demand to produce somewhat wider current-account deficits. Trade surpluses, which were behind low current-account deficits in recent years, are set to weaken in the future. We estimate trade surpluses[1] of USD 62 billion in 2018 (USD 57 billion previously) and USD 50 billion (USD 42 billion previously) in 2019. For the current account, we anticipate deficits of USD 25 billion this year (USD 30 billion previously) and USD 47 billion next year (USD 51 billion previously).

We lifted our 2018 inflation estimate to 3.7% from 3.5%, but maintained our call for 2019 at 4.0%

For 2018, our forecast for the IPCA consumer price index climbed to 3.7% from 3.5%, due to our adjusted estimates for oil and the exchange rate. Headline and core inflation measures remain at low levels, with the IPCA rising just 0.9% ytd (1.1% one year ago) and 2.8% year-over-year. We expect year-over-year readings to accelerate to 3.5% in June and 3.9% in September, largely reflecting the upward pressure in food prices and the fact that negative changes registered last year will no longer enter calculations.

Breaking down the IPCA, we anticipate increases of 3.0% in market-set prices (1.3% in 2017) and 5.5% in regulated prices this year (8.0% in 2017). We expect inflation to remain below the target due to lower inertia from past inflation, still-favorable agricultural crops (albeit smaller than last year) ensuring good inventory levels, anchored inflation expectations and a negative output gap. As for market-set prices, we anticipate a 4.0% hike in costs for food consumed at home, after a 4.9% slide in 2017. Although the change in costs for food consumed at home early in the year was much milder than the seasonal pattern (0.6% in January-April), we anticipate stronger upward pressure during 2H18, due to rising grain prices and recent exchange-rate fluctuations. We expect industrial prices to climb 2.0% (following an unusually low reading of 1.0% in 2017). Service prices are expected to slow down again, to 3.3% from 4.5%, largely because of lower inflationary inertia and still-high unemployment. Regarding regulated prices, we now expect gasoline costs to rise 5% rather than 1% (10% in 2017), given our new outlook for the exchange rate and oil prices throughout the year. For electricity, we continue to expect an 8% increase this year (10% in 2017), assuming that the tariff-flag system will be in yellow mode in December. For other regulated items that are relevant to inflation calculations, we forecast increases of 12% in health-insurance premia, 5% in urban bus fares, 4% in water and sewage tariffs, and 3% in medication prices.

For 2019, our forecast for the IPCA remains at 4.0%. The slower narrowing of the output gap – which is behind our downward revision in GDP-growth estimates – virtually offset the effects arising from greater inflationary inertia and a weaker exchange rate. We expect market-set prices to rise 3.8% and regulated prices to climb 4.5%. 

The main risk factors for the inflation scenario are tied to both domestic and international scenarios. Uncertainties surrounding reforms and needed economic adjustments in 2019 may put further pressure on risk premiums and the exchange rate going forward, affecting the inflation path. As for the external situation, there is evidence of some reversal in the favorable landscape for emerging economies, reflecting greater risks of economic-policy changes in the developed world and tighter global financial conditions, in addition to geopolitical tensions. The increase in such risks, along with the historically low interest-rate differential, is already pressuring the Brazilian currency. 

Substantial slack in the economy may contribute to better behavior of market-set prices. The slower narrowing of the negative output gap as economic momentum decreases and the unemployment rate remaining above historically normal levels for a longer period may engender more favorable behavior in market-set prices, particularly those that are more sensitive to the economic cycle, such as services and industrial items. In that sense, the spare capacity in the economy may contribute to cushion eventual inflationary pressures arising from a weaker exchange rate.

Inflation expectations remain anchored, with breathing room in relation to the targets for 2018 and 2019. The median of market expectations for 2018, according to the central bank’s Focus survey, slid to 3.49% (1.0 p.p. below the 4.50% target) from 3.53%. The median estimate for 2019 receded to 4.03% (somewhat below the 4.25% target) from 4.09%, and remained anchored at the 4.00% target for 2020.

Monetary policy: End of the cycle

In the post-meeting statement and minutes of the latest monetary policy decision, in March, the committee signaled that a final interest-rate cut in the May 15-16 meeting would be appropriate, in order to minimize risks of inflation converging later to the target. Policymakers emphasized that this would be the flight plan if the scenario evolved as expected, but repeated that this assessment could change if the balance of risks to inflation was altered. They stressed that they could stop the monetary-easing cycle in May, if it became clear that the risks of later convergence to the inflation target had receded. 

Since the Copom meeting in March, there have been significant changes, but with ambiguous signs for monetary policy. On one hand, activity figures – namely industrial production, the monthly services survey and labor market data – disappointed this year, possibly favoring another cut. On the other hand, recent exchange-rate fluctuations and the FX outlook reduce the risks of inflation converging later to the target, and that could decrease the need for more easing. 

In our view, the central bank will follow the path outlined in its last post-meeting statement and announce a final 25-bp cut in the next meeting, taking the Selic benchmark rate to an all-time low of 6.25% p.a. and ending the easing cycle. In recent communications, committee members pointed to two aspects of recent economic developments: i) there were no significant changes in the balance of risks for inflation, in their view; and ii) FX policy is independent from monetary policy, so the recently announced net offering of swap contracts does not represent a change in plans for monetary policy. Thus, we believe that the Copom will follow the path presented in the March meeting and announce a final 25-bp reduction in the Selic rate in May.



[1] As reported by the Ministry of Trade (MDIC).


 

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



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