Itaú BBA - Clearer recovery signs

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Clearer recovery signs

August 11, 2016

Activity has been showing signs of a recovery. However, any recovery will be sustainable only if fiscal reforms are approved.

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

Business and consumer confidence surprised positively in July, rising across the board. Other leading indicators suggest that activity in the second half of the year could be better than expected. Our proprietary indicators of economic activity, which are based on diffusion and momentum indexes, support the view that the economy is close to starting a recovery. For the moment we keep our forecast of a 3.5% drop in 2016 GDP and a 1.0% increase in 2017, pending the release of 2Q16 GDP figures and waiting for additional high frequency data. As fiscal reforms move ahead, we will incorporate the positive trend suggested by recent data into our scenario. Despite better current activity data, the labor market continues to deteriorate. We expect unemployment to end this year at 12.5% and 2017 at 13.0%.The combination of widely diverse positive and negative activity indicators across sectors is typical in this part of the cycle. 

Public accounts are still deteriorating and this trend will only be reversed if structural reforms are approved. We have adjusted our primary result forecast from -2.4% to -2.5% of GDP in 2016 based on lower-than-expected current revenues, but we have held our 2017 forecast at -2.2% of GDP.

After a significant improvement in current accounts throughout 2015, the external adjustment is losing steam. This change mainly reflects the better economic activity (particularly investment) and, to a lesser extent, the stronger currency. We have maintained our exchange-rate forecast of 3.25 reais per dollar at the end of 2016 and 3.50 reais per dollar at the end of 2017. These forecasts are in line with wider current-account deficits over the next several years, albeit at still comfortable levels.

We have held our 2016 IPCA inflation forecast at 7.2%. There has been higher pressure from foodstuff prices recently, but we believe this will weaken during the second half of the year. In 2017, the improving inflation expectations reinforces our scenario of the IPCA slowing to 4.8%, with market prices rising 4.7% and regulated prices climbing 5.2%. 

The focus on inflation convergence in 2017 means no room for interest rates cuts now. However, as the monetary-policy focus switches to 2018, we believe the central bank will find space to start a gradual easing cycle. We have maintained our forecast that the Selic benchmark rate will fall to 10% by the end of 2017.

Activity could surprise, but the fiscal adjustment needs to move ahead to achieve consistent growth 

Economic activity, particularly in industry, has been showing increasing signs of a recovery. Business and consumer confidence have risen in recent months. Asset prices usually react ahead of an economic recovery and have been performing well recently. Furthermore, our diffusion indices, which usually anticipate GDP shifts, show a significant improvement in the industrial sector.

This means that second-half economic growth could be stronger than expected. However, the labor market will continue to deteriorate for several months because it lags economic activity. 

Any recovery in economic activity will be consistent only if the proposed fiscal reforms such as the spending ceiling and social security reform are approved. These adjustments are critical for two reasons: first, controlling the dynamic of public accounts means improving long-term economic predictability. Second, this would increase exchange-rate stability, which is needed to ensure that inflation – and, subsequently, interest rates – are brought down.

Uncertainty and interest rates need to fall in order to trigger a consistent return to investment, which will be the first step for an economic recovery. 

The external account adjustment will lose traction, but the balance of payments remains comfortable. A reaction in activity, particularly investment, alongside a stronger currency will mean more-modest balance-of-trade results going forward. The current-account deficit is likely to rise again, but will remain at low levels. 

Declining inflation expectations reinforce a better IPCA outlook. Anchored inflation expectations, high unemployment and the recent exchange-rate appreciation suggest that inflation could fall significantly in 2017.

We believe that the CB will start a cycle of interest-rate cuts in October. The central bank (CB) has been focusing on inflation convergence in 2017, which means that there is currently no room to cut interest rates now. Moving ahead, we believe that the monetary-policy focus will naturally switch to 2018, opening room for a gradual easing cycle beginning in the fourth quarter of this year.

Leading and current indicators suggest higher growth in 2Q16

Industry shows signs of consistent improvement. Industrial output rose 1.1% in June. This was an across-the-board increase with growth in every economic category and 75% of activities. The result was slightly ahead of our forecast (0.7%) but consistent with the upward trend we expect for the industrial sector, which should extend into the second half. We note that this marks the fourth successive monthly expansion, the first time this has occurred since 2012.

Investment rises again. June saw the sixth consecutive monthly increase in capital goods production – something not seen since 2007. This improvement and the significant increase in capital goods imports in June drove up our measurement of capital goods absorption. Our indicator suggests that gross fixed-capital formation rose during the quarter after 10 consecutive quarters in negative territory.

Diffusion index remains high. Our diffusion index – which shows the number of rising indicators, based on a wide dataset, including business and consumer confidence, retail sales and credit demand – should end June at around 54% (3-month moving average), above the neutral level (44%). Although we have little data for July, this month’s diffusion index is expected to beat 60%, the best result since 2010. This is a significant leading indicator for GDP, and this behavior suggests a positive trend as we approach the end of this year.

Confidence indicators surprise positively. In July, there was a widespread increase in business and consumer confidence. Confidence rose for the third consecutive month among consumers and service and retail businesses, although the indicators have yet to make a clearer impact on service-sector revenues and retail sales. We expect industry to continue the cyclical recovery in the second half of the year. Service-sector confidence has risen more than expected, with an average monthly increase of around 3% over the past five months.

We have maintained our GDP forecasts for 2016 and 2017. Leading and current high-frequency indicators suggest an upward trend. We expect a 0.6% contraction in 2Q16 compared with the previous quarter, after seasonal adjustment. GDP is likely to shrink further than it did in the first quarter, but this does not mean that the recession is getting worse. In fact, leading indicators for the second half of the year suggest that economic activity will move into positive territory. However, uncertainty still shrouds the reforms and adjustments needed for a return to growth. Besides, service-sector revenues and retail sales continue to decline and have yet to mirror the improvement in leading indicators. Finally, second-quarter GDP figures will be released at the end of the month, bringing additional information on the speed of economic growth.

We are therefore maintaining our forecast of a 3.5% drop in 2016 GDP and a 1.0% increase in 2017. 

Slump in the formal sector labor market. In June, a net 91,000 formal jobs were destroyed (CAGED). The three-month moving average shows that 130,000 jobs were destroyed (stripping out seasonal effects). Job destruction was widespread, affecting 6 out of 7 sectors of economic activity. We have maintained our assessment that job losses will continue into the second half of next year, because the labor market lags behind market activity. Even if we see a faster recovery in activity, job losses are likely to continue for some time. We note that the “neutral” CAGED, i.e., compatible with a stable rate of unemployment, is 35,000.

Unemployment rises for the 19th consecutive month. In June, the national unemployment rate rose to 11.3%. At the margin, unemployment rose from 10.8% to 11.1% (our seasonal adjustment). The number of people at work continues to shrink, falling 1.5% compared with 2Q15. As a result, we continue to expect unemployment to end this year at 12.5% and 2017 at 13.0%.

Unlike other areas of the economy, the labor market has yet to show any sign of improvement, or even stabilization. 

Fiscal: awaiting structural reforms 

Fiscal results continue their downward trend. In June, the 12-month cumulative primary deficit reached 2.5% of GDP. Over the same period, the nominal deficit remained high (10.0% of GDP), under pressure from high interest costs. As a result, gross debt remains high: it reached 68.5% of GDP in June, compared with 66% of GDP at the end of 2015 and 57% of GDP in 2014 (see graph).

We have reduced our primary result forecast for 2016 from -2.4% to -2.5% of GDP (BRL 155 billion) based on a fiscal target of -2.6% of GDP (BRL 164 billion). This revision includes lower-than-expected tax revenues linked with consumption and household incomes. These taxes represent 70% of the federal tax burden and have been particularly affected by the slowdown in economic activity, due to the rise in unemployment and shrinking real wage bill.

Our scenario includes BRL 9 billion (0.10% of GDP) in extraordinary revenues from IPOs for Caixa Seguridade and IRB (the reinsurance company), as well as withdrawals from the sovereign wealth fund in 2016.

We have maintained our forecast for a primary result representing -2.2% of GDP in 2017 (BRL 143 billion), in line with the government target. One important sign is that 2017 spending will comply with the proposed cap on spending growth (i.e., nominal spending will grow in line with 2016 inflation).

For this target to be feasible, the government will have to make an effort of 0.9% of GDP (BRL 55 billion) in additional revenues; details will be released at the end of August. These revenues may come from asset sales, concessions or targeted tax increases.

The primary deficit remains high in the short term, and approval of the spending-corset is a necessary, although not sufficient, condition for improving the medium-term fiscal outlook – successful implementation of the corset will require additional reforms, such as that of Brazil´s wasteful social security system.

Social security reform will be fundamental. The reforms will reverse the past 20 years’ upward spiral in public spending (see graph). Even with these reforms, primary results will remain in negative territory for several years and public-debt stabilization will result from higher economic growth and lower interest rates.

External adjustment loses steam, but current-account deficit will likely remain at comfortable levels for the next few years

External adjustment has lost traction as domestic activity has stabilized and the exchange rate has appreciated. We believe that after significant improvement throughout 2015, external accounts have reached their inflection point. Imports of capital goods and intermediate goods have improved in recent months, reflecting a slight recovery in activity. The seasonally adjusted annualized three-month moving average grew to a USD 19 billion deficit in June 2016 from USD 5 billion in May.

The current-account deficit is likely to rise again in 2017, but remain manageable. We have maintained our forecast of a USD 50 billion trade surplus in 2016 and USD 46 billion in 2017. We forecast a USD 18 billion current account deficit in 2016 and USD 28 billion deficit in 2017. The current-account deficit should therefore remain below 2.1% of GDP, the historical average since 1995.

The exchange rate traded around 3.30 reais to the dollar throughout July. The outlook for a further U.S. interest-rate hikes has been pushed back until December or even 2017, supporting the BRL and other emerging currencies. Domestically, greater consensus on reforms (alongside proposed reforms to control public spending) also helped. The Central Bank continued to intervene in the currency market. Since July 1, USD 13.5 billion in reverse swaps have been sold (until August 10).

We have maintained our exchange-rate forecast of 3.25 reais per dollar at the end of 2016 and 3.50 reais per dollar at the end of 2017. Interest rates will remain low in the U.S. (even if the Fed resumes policy normalization in December) and high in Brazil for some time yet, and greater consensus on fiscal reforms should contribute to a more appreciated BRL.

Inflation forecasts for 2016 and 2017 remain stable

We have kept our IPCA inflation projection for this year at 7.2%. We are forecasting a 7.7% increase in market-set prices (compared with 8.5% in 2015). Looking at the components in the market-set prices group, we estimate an 11.7% increase for food-at-home prices (12.9% in 2015), 5.8% for industrial prices (6.2% in 2015) and 7.0% for service prices (8.1% in 2015). We are forecasting a 5.9% increase in regulated prices (compared with 18.1% in 2015). Most (around 2/3) of this year’s inflation slowdown will be driven by regulated prices, particularly relief from electricity and gasoline results. After rising 51% last year, electricity bills should fall 8% this year. We continue to expect a 1% hike in gasoline prices this year, following the 20% increase in 2015.

Despite higher short-term pressure from foodstuff prices at the margin, we believe that increases will slacken during the second half. We estimate a 2.7% increase in food-at-home prices between July and December after rising 5.4% over the same period last year and 8.8% in the first half of the 2016. In the second half of the year, our forecast indicates that fresh fruit and vegetable prices will fall, while beans and milk are also likely to move lower, giving back some of the significant price hikes seen in recent months. In any event, we believe that a large part of these products’ price corrections will only be seen next year, after supply conditions have fully normalized.

The fiscal issue remains a major risk for inflation. Despite the rosier outlook for public accounts, future attempts to increase government revenues could lead to fresh tax increases and/or larger increases in regulated prices. However, favorable fiscal developments could improve the outlook for inflation, either through exchange rates and inflation expectations, or a switch from an expansionary to a neutral or even contractionary fiscal policy.

Ample economic slack could help reduce inflation even further as we move ahead. The negative output-gap measurement could lead to faster market-set price disinflation in the second half of the year, particularly for industrial products and services.

Our IPCA inflation forecast for 2017 is stable at 4.8%. Next year’s drop in inflation will reflect the reduced effect of relative price increases (regulated prices and exchange rates), less inflationary inertia, lower inflation expectations, more-favorable weather conditions and the remaining impact from the high level of idle capacity still seen throughout the economy. A reversal in food prices could signal a major drop in inflation during 2017.

Improving inflation expectations reinforces the disinflation scenario. According to the Focus survey, inflation expectations retreated during the month. The median of projections for the 2018 IPCA and further ahead are at the center of the target (4.5%), reflecting the market’s increasing conviction that the IPCA will indeed converge to the target. Forecasts for 2017 remain slightly above 5%, but this is based on strong inflationary inertia inherited from previous years and this figure fall some more.

On a disaggregated basis, we are working with a 4.7% rise in market-set prices and a 5.2% increase in regulated prices next year. Among market-set prices, we are forecasting a 4.5% increase for food at home, as we expect the exchange rate to behave better and weather conditions to improve, which mean that a large part of this year’s price increases would be reversed throughout 2017. In the other segments, we are forecasting a 5.3% increase in service prices and 4.0% increase in industrial prices in 2017.

Monetary Policy: focus on 2017 means no rates cuts now

The economic outlook continues to suggest room for a cycle of monetary easing ahead. Despite signs of improvement in business and consumer confidence, aggregate demand remains weak – especially on the consumption side – and unemployment continues to rise, resulting in a wide output gap. Current inflation is coming under temporary pressure from foodstuffs, but core inflation measures remain on a downward path. The inflation expectations have fallen and are around the target from 2018 onward.

However, the central bank continues to signal that conditions are still not there for lower interest rates. In its official communication, which has been overhauled since the most recent Copom meeting, the CB indicated it is unlikely to start an easing cycle while its forecasts are above the target over the “relevant horizon” for monetary policy. Based on past CB reports, this expression refers to the next 18 to 24 months – i.e., between the end of 2017 and the first half of 2018.

The CB maintained its conservative stance in an attempt to ensure that inflation convergence occurs within the relevant horizon. As the central bank’s 2017 forecasts show inflation still above the target, the CB is reinforcing its position that there is no room for a short-term cut in interest rates.

Over time, the relevant horizon will gradually shift from 2017 to 2018. In our view, monetary policy decision will start giving greater weight to the 2018 inflation forecasts from October onward. Additionally, lower inflation expectations should help drive the CB’s forecasts down to a figure close to or even below the 4.50% target. We therefore understand that the central bank will start a gradual and careful cycle of interest-rate cuts in the fourth quarter of this year. Naturally, this will depend on the data, particularly current inflation, and on the progress of fiscal adjustments.

We forecast that the Copom will make an initial 25 bps rate cut in October, followed by  50 bps in November, leading the Selic benchmark rate to 13.5% by the end of the year.

We believe the cycle will continue in 2017 until the Selic falls to 10.00%.


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



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