Itaú BBA - Activity Stalls; Inflation Wanes

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Activity Stalls; Inflation Wanes

August 13, 2014

The consumer price index posted a near-zero reading in July, but the year-over-year rate remained at 6.5%.

• We have lowered our 2014 GDP growth forecast to 0.6% from 0.7%, given the apparent slowness of economic activity recovery after the World Cup and the current low business confidence levels. For 2Q14, the published data are in line with our forecast of negative growth. We expect a modest expansion in 3Q14 and a slight pickup in 4Q14. For 2015, we have reduced our GDP forecast to 1.3%, from 1.5%.

• We have lowered our forecast for the IPCA consumer price index in 2014 to 6.3% from 6.5%, incorporating a lower-than-expected reading in July and the prospect of a more benign scenario for food prices in the second half. We have reduced our estimate for market-set prices to 6.5% from 6.8%, while leaving our forecast for regulated prices at 5.6%. For 2015, we have lowered our IPCA estimate to 6.4% from 6.5%, as we now expect a smaller adjustment in regulated prices due to greater increases this year and a slowdown in the rise of market-set prices.

• We believe that Brazil’s monetary policy committee (Copom) will leave the benchmark Selic interest rate at 11% until the end of 2015, given that there is little room to ease monetary policy. Naturally, this strategy depends on the evolution of the economy, particularly on the inflation front.

• Over the rest of this year, the external scenario should put downward pressure on the local currency. We maintain our year-end exchange rate forecasts of 2.40 BRL/USD in 2014 and 2.50 BRL/USD in 2015. 

• The downward trend in the primary budget surplus has continued, reducing the likelihood that the government will reach its fiscal target this year. We have kept our estimate for the 2014 primary surplus at 1.3% of GDP (target: 1.9%) and lowered our forecast for the recurring surplus to 0.6% of GDP from 0.7%.

We have lowered our IPCA forecasts to 6.3% in 2014 and 6.4% in 2015

The consumer price index posted a near-zero reading in July, but the year-over-year rate remained at 6.5%. The IPCA was up 0.01% in July, below our projection (+0.09%), the median market estimate (+0.10%) and the reading for the previous month (+0.40%). Market-set prices fell by 0.1%, while regulated prices increased by 0.4%. The slowdown in inflation from the previous month was driven by the reversal of the price increases for some tourism-related services (airfares and hotel rates) that occurred during the World Cup. Other important downward contributions came from fresh fruits and vegetables and fuels. The largest upward pressure came from electricity prices, reflecting annual tariff adjustments by some distributors. The IPCA is up 3.76% year‑to-date (vs. 3.18% for the same period in 2013), and the year-over-year change is virtually stable at 6.50% (vs. 6.52% in June). Our preliminary call for the IPCA in August is around 0.25%. In our view, somewhat lower-than-expected readings for services and durable goods prices (particularly in the auto sector) may be the first signs of the impact of weaker economic activity on inflation.

We have reduced our 2014 IPCA estimate to 6.3% from 6.5%, given the lower-than-expected result in July and the more benign outlook for food prices in the second half of the year. The sharper-than-expected deflation in agricultural prices in recent months has led us to lower our inflation forecast for food consumed at home to 5.5% from 6.0%. For market-set prices, we have lowered our inflation call to 6.5% from 6.8%. Drops in grain prices (corn, soybeans and wheat) have signaled a more benign scenario for protein and wheat products (breads and pasta) in the second half of 2014. For services prices – the largest component of market-set prices – we also anticipate some deceleration at the margin, forecasting an advance of 8.0% during the year, down from 8.7% in 2013. In our opinion, weaker economic activity may translate into a more favorable balance of risks for inflation in market-set prices until year-end. For regulated prices, our estimate remains at 5.6%, with most of the upward pressure coming from electricity, gasoline and health insurance prices. On the other hand, we expect negative readings for landline phone service and water and sewage tariffs during the year, which would help curb the advance in regulated prices.

For 2015, we have also lowered our IPCA forecast to 6.4% from 6.5%, reflecting an adjustment in our projection for regulated prices and the likely effect of weaker inflationary inertia on market-set prices. For regulated prices, we have lowered our inflation projection to 7.0% from 7.3%, due to an adjustment in our estimate for electricity tariff increase to 12% from 14%. We believe that the larger adjustments announced this year may lead to slightly smaller increases next year. In addition to an increase in electricity prices, our scenario for regulated prices next year contemplates sharp increases in water and sewage tariffs (14%) and urban bus fares (10%). Regarding water and sewage, we expect a price increase related to the reversal of a selective discount incentive granted by the São Paulo utility Sabesp this year under a program to curb water usage. For urban bus fares, we expect a correction for past inflation in some state capitals that have kept fares unchanged in recent years. For market-set prices, we have lowered our 2015 projection to 6.2% from 6.3% due to likely weaker inflationary inertia that will be inherited from this year. The deceleration relative to 2014 would be driven, we believe, by smaller increases in food and service prices. Regarding food prices, our forecast reflects the prospect of favorable weather conditions for agriculture. In the service sector, relief will likely be provided by some additional accommodation in the labor and real estate markets, with the result being a likely moderation in wages and rents.

The general price index, IGP-M, showed 0.61% deflation in July, after falling by 0.74% in June, marking a third consecutive month of negative readings. The producer price index, or IPA – the component with the largest weight in the IGP-M – slid by 1.1% (vs. -1.4% in the previous month), with declines in both agricultural prices (-2.7%) and industrial prices (-0.5%). Hence, the year-over-year change in the IGP-M slowed to 5.3% from 6.2% in June. The deflation in the IGP-M in the past three months, which adds up to 1.5%, reflected the partial reversal of the March-April shock in agricultural prices (which was caused by a drought), the effects of the drop in grain and iron-ore prices in international markets, and the appreciation in the Brazilian real that started in April. Current data suggest that the IGP-M is likely to remain tame this month, showing stability or minor deflation, which would keep the year-over-year change on a downward path.

With a string of lower readings at the margin, we have reduced our IGP-M forecast for this year to 4.2%, down from 5.0% in our previous report. We expect the producer price index, the IPA‑M, to be slightly lower than 3%, with industrial prices rising by 3.2% and agricultural prices up 2%. For the mining industry, we maintain our estimate of a 25% drop in iron-ore prices, with an impact of -1.0 pp on the IGP-M. As for the other components, we project increases of 6.4% for the consumer price index (IPC-M) and 7.4% for the construction cost index (INCC-M).

We have lowered our GDP growth forecast for 2014

The Brazilian economy decelerated sharply in June, partly due to the temporary reduction in the number of working days during the World Cup. We observed sharp declines in sales of high-value items, such as autos and major appliances; a severe drop in the number of hours worked in the manufacturing sector; and a widespread slide in industrial production (seen in 18 out of 24 sectors, with food, beverages, pulp, oil and mining, oil refining and tobacco being the exceptions). While factors such as high inventories, low business confidence and more expensive electricity in the free market detracted from growth, we believe that the slide in economic activity was mostly temporary and was generally expected.

However, even now that condition have normalized following the end of the World Cup, economic activity has not yet shown convincing signs of recovery. In the second fortnight of July, average electricity consumption (already adjusted for factors unrelated to economic activity, such as the weather, number of working days and seasonality) was not yet back to the levels seen prior to the soccer tournament. In retail, sales of passenger cars and light commercial vehicles, as recorded by the auto-dealer association FENABRAVE, had only a small recovery in July, sustaining their downward trend in the three-month moving average. This insufficient recovery in sales kept auto inventories high, according to data from the automakers association ANFAVEA. Finally, our diffusion index (based on a broad dataset including business and consumer confidence, retail sales and credit demand), a leading indicator of economic activity, is pointing to a slower growth recovery in the second half of the year than we previously anticipated.

Confidence indicators also point to a more sluggish rebound. Across the major sectors of the economy, only retail sector entrepreneurs showed an increase in confidence in July, but even after that uptick their confidence remains low. Consumer confidence has improved somewhat in the past two months, but that does not necessarily mean that more demand is ahead, as shown by the weak purchase intention of durable goods in the next six months. Low demand along with high industrial inventories will likely delay an industrial output rebound.

We have lowered our 2014 GDP growth forecast to 0.6% from 0.7%. Our forecast for 2Q14 growth remains -0.3% qoq. The slower activity rebound in July and the statistical carryover seen so far this quarter will likely hold back GDP growth in 3Q14. We now project growth of 0.1% for 3Q14. For 4Q14, we anticipate a slight pickup, to 0.3%. Our forecast for 2015 has been revised downward to 1.3% from 1.5%, given the deterioration of the statistical carryover.

Unemployment remains low but is likely to increase moderately. As in the previous month, the statistical agency IBGE did not publish the nationwide unemployment rate in June because of a labor strike. In June, the seasonally adjusted aggregate unemployment rate (comprising the four metropolitan regions for which figures were published) receded to 4.3% from 4.4% (the aggregate nationwide reading was 4.6% in April, the last complete monthly report presented by IBGE). Thus, unemployment remains at historically low levels.

We reiterate our evaluation that the unemployment rate has remained low because the labor force has been shrinking in year-over-year terms since October 2013. As these dynamics will ultimately come to an end, we expect unemployment to increase due to weaker economic activity. We forecast a moderate climb in the unemployment rate to 5.4% by the end of 2014 and 5.7% in December 2015.

Water reservoir levels receded in July, in line with seasonal patterns. Rainfall levels topped averages for another month, energy consumption did not return to pre-World Cup levels and the average utilization of thermal power plants exceeded the levels seen in March and April. Still, reservoir levels fell to 40.4% of total capacity from 43.2%, in line with the seasonal pattern. The recent evolution further raises the prospect of intense usage of thermal power plants for a prolonged period and the risk of power rationing in 2015.

The credit market had a weak month in June. The daily average of new non-earmarked loans was stable on a seasonally adjusted monthly basis, in real terms. Growth in total outstanding loans continues to cool down, moving to 4.9% in June from 6.0% in May (year over year, in real terms). Earmarked-loan growth slowed to 12.8% in June (from 14.9% in May), while non-earmarked loans declined by 1% (vs. -0.6% in the previous month). On the other hand, overall delinquency dropped by 0.1 pp, going back to the 3.0% level seen consistently in recent months.

Copom: No rate cuts

The Brazilian Central Bank’s monetary policy committee (Copom) left the benchmark Selic interest rate unchanged at 11% p.a. at its July meeting. The decision was unanimous and in line with expectations.

In the minutes of the meeting, the Copom stated its view that given “unchanged monetary conditions”, inflation should converge towards the target “in the final quarters of the forecast horizon” (i.e., in 2016). The Copom was explicit, indicating that its strategy “does not contemplate a reduction in the monetary policy instrument”. Therefore, the minutes signaled a stable Selic rate, at 11%.

The Copom’s strategy of stable interest rates is ultimately dependent on the evolution of the economy, particularly the inflation dynamics. In that sense, weak activity and temporarily low monthly inflation readings until August may prompt some market participants to believe in a rate cut in the coming months.

However, our view is that the inflation outlook for 2015 leaves little room for monetary policy easing. The realignment of regulated prices, the effects of a likely depreciation in the Brazilian real and persistent inflation will likely keep 2015 inflation close to the upper bound of the central bank’s target range (6.5%).

We thus maintain our forecast that the Selic rate will remain at 11% p.a. until the end of 2015.

Fiscal policy: We reduced our forecast for the recurring primary budget surplus in 2014

The downward trend in the primary surplus was sustained in June. The public sector posted a primary deficit of BRL 2.1 billion in June. The central government had a primary deficit of BRL 2.7 billion, while regional governments and state-owned companies posted surpluses of BRL 113 million and BRL 518 million, respectively. In last-12-month terms, the primary surplus receded to 1.4% of GDP in June from 1.5% in May, while our estimate of the recurring primary balance (excluding atypical revenues and expenses) declined to 0.4% of GDP (from 0.6%), the lowest level of our series, which started in 2002.

The reduction in the primary surplus has been driven by the impact of deteriorating economic activity on tax revenues, coupled with expenditures increasing in line with expectations. This year through June, total revenues collected by the central government have risen by 0.4%, slightly below our projection for the full year of 2014 (+1.1%). This largely reflects a decline in tax revenues to the Treasury (-0.7%), but non-tax revenues are also sliding (-0.2%). Social security revenues are up 1.7%. Spending growth is somewhat in line with our scenario: year-to-date growth stands at 3.3%, while our year-end forecast is 3.7%. During the first half of 2014, mandatory expenses (payroll, pension benefits) grew at a slower pace than discretionary spending (government costs, investment), partly due to the postponement of the so-called “precatórios” (judicial claims) to the end of the year. This composition of spending growth will likely reverse in the second half.

The reduction in the primary surplus has been driven by the impact of deteriorating economic activity on tax revenues, coupled with expenditures increasing in line with expectations. This year through June, total revenues collected by the central government have risen by 0.4%, slightly below our projection for the full year of 2014 (+1.1%). This largely reflects a decline in tax revenues to the Treasury (-0.7%), but non-tax revenues are also sliding (-0.2%). Social security revenues are up 1.7%. Spending growth is somewhat in line with our scenario: year-to-date growth stands at 3.3%, while our year-end forecast is 3.7%. During the first half of 2014, mandatory expenses (payroll, pension benefits) grew at a slower pace than discretionary spending (government costs, investment), partly due to the postponement of the so-called “precatórios” (judicial claims) to the end of the year. This composition of spending growth will likely reverse in the second half.

We have revised our forecast for the 2014 recurring primary surplus to 0.6% of GDP from 0.7%, but we have kept our forecast for the conventional primary budget at 1.3% of GDP. Following our downward revisions in growth estimates for the year, we lowered our forecast for tax revenue growth to 0.5% from 1.3% (representing a reduction of BRL 6 billion). On the other hand, there are signs that non-recurring revenues (from the Refis tax amnesty program, concessions, dividends) are above initial forecasts, offsetting the effect of a sharper-than-expected slowdown in cyclical revenues. We have thus raised our estimate for atypical revenues this year to BRL 36 billion from BRL 30 billion and left our estimate for the primary balance unchanged at 1.3% of GDP. This volume of atypical revenues would still be lower than in 2013, when they amounted to BRL 50 billion, according to our calculations. Due to our expectation of a larger contribution from atypical revenues in the composition of the primary surplus, we have reduced our estimate for the recurring result to 0.6% of GDP from 0.7%. These results indicate an actual fiscal performance below 2.0%-2.5% of GDP, which we regard as the minimum level for the primary surplus that is consistent with the stabilization of the public debt as a proportion of GDP in the long term.

For 2015, we still expect the primary surplus to increase, but to a level below our previous estimate. The prospect of slower economic growth in 2015 and the recent fiscal performance has led us to reduce our forecast for the primary surplus in 2015 to 1.5% of GDP from 1.7%. In the midst of an economic and financial cycle that is less favorable for the production of strong fiscal results, our forecast implies a negative fiscal impulse (defined as the change in the structural primary surplus as a percentage of GDP) for next year.

External scenario will likely put pressure on the Brazilian real until year-end

Our year-end exchange rate forecasts are unchanged at 2.40 BRL/USD in 2014 and 2.50 BRL/USD in 2015. Geopolitical factors and stronger signs of recovery in the U.S. economy put pressure on the real and other emerging-market currencies in recent days and will likely to continue to drive the currency downward until year-end. In the short term, however, we expect the central bank to continue to adjust its swap rollover program so as to avoid sudden moves in the currency market. The monetary authority recently quickened the rollover pace for FX swap contracts expiring in September to 10,000 contracts per day (up from 8,000 per day, as announced early in the month). If this pace is sustained until the end of the month, the central bank would allow the expiration of USD 1.1 billion, or 11% of the total batch maturing in September.

The trade balance surprised on the upside in July, at USD 1.6 billion, due to higher exports and lower imports, which were consistent with the moderation in economic activity. Sales of crude oil and the pro forma export of an oil-drilling rig contributed to a much better result than in July 2013. Hence, the year-to-date trade deficit receded to USD 916 million.

The balance of payments was more favorable in June, and the current account deficit narrowed to USD 3.3 billion. The stronger reading was driven by a significant surplus in the trade balance, along with lower deficits in the service and income accounts.

The reduction in the service deficit was due to temporary effects of the World Cup, namely higher revenues from spending by tourists and lower travel spending by Brazilians, possibly because Brazilian residents took fewer trips abroad during the tournament.

In terms of financing, foreign direct investment inflows moderated to USD 3.9 billion in June, and to 2.8% of GDP over 12 months (vs. 2.9% over the 12 months through May).

We have left unchanged our forecasts for the trade and current account balances. Despite more favorable results for both metrics, we regard these improvements as a product of temporary factors that will not recur in the coming months. We project trade surpluses of USD 1.4 billion in 2014 and USD 12.6 billion in 2015. We expect the current account deficit to reach 3.7% of GDP in 2014, narrowing to 3.2% of GDP in 2014.

Polls indicate that Dilma Rousseff is leading in voter intentions, but by a narrower margin in a second round

In the run-up to the October presidential elections, the latest polls continue to put President Rousseff in the lead for the first round of voting, with 38% of voter intentions, followed by Aécio Neves, with 23%, and Eduardo Campos, with 9%, while the other candidates together have 6%. The still-high proportion of voters who intend to cast blank or null votes (13%) or are still undecided (11%) is noteworthy. The sum of intended votes for other candidates is equivalent to the intended votes for Dilma, so there is as yet no telling whether there will be a second round. The numbers show little change from the previous month and are similar to those in the Datafolha survey, released in mid-July. The government’s approval rating (the proportion of participants who regard the government as “great or good”) improved slightly in the latest Ibope survey, by 1 pp, to 32%.

The gap between Dilma Rousseff and Aécio Neves in a notional second round has been narrowing. According to Ibope, if a second round of voting were held today, the President would be reelected with 42% of the vote, compared with 36% for Neves, a difference that is 2 pp smaller than in the previous survey. Against Eduardo Campos, the President would win 44% to 32%, the same difference as in the July poll. However, the July survey by Datafolha showed smaller gaps between Rousseff and her adversaries: 4 pp vs. Neves and 7 pp vs. Campos.

Airtime and debates. The presidential candidates’ media exposure will continue to increase. Starting on August 19, all candidates get free airtime on radio and TV stations. President Rousseff will likely have nearly half of all airtime minutes. The first debate between the candidates will take place on August 21. As candidates get more exposure, the share of voters who intend to cast blank or null votes and the share of undecided voters both tend to decrease.



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