Itaú BBA - Consumers and Businesses Step on the Brakes: Activity Decelerates

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Consumers and Businesses Step on the Brakes: Activity Decelerates

June 11, 2014

We revised our GDP forecast for 2014 to 1.0%.

• In the light of the release of 1Q14 GDP numbers and the economic slowdown in April and May, we reduced our GDP growth forecast for 2014 to 1.0%. The demand deceleration has been notable, and we expect negative GDP growth in 2Q14, followed by a slight recovery in the second half. We expect economic growth of 1.0% in 2014 and 1.7% in 2015.

• We forecast an exchange rate of 2.45 reais per U.S. dollar by year-end, pressured by a weaker-than-expected trade balance (our call is USD 1.5 billion), election-related uncertainties and our scenario of a moderate rise in U.S. interest rates. We see the exchange rate at 2.55 reais per dollar by the end of 2015. In the short term, we expect the exchange rate to remain within a range that is consistent with the monetary authority’s comfort zone – as implied by the announcement of the future renewal of the FX swap program.

• We reduced our forecast for the IGP-M general price index, to 6.0% from 6.8%, but maintain our estimate for the IPCA consumer price index at 6.5%. Our forecast for 2015 stands at 6.5%, with sharper increases in regulated prices and some deceleration in market-set prices.

• In this low-growth scenario, it will be difficult for the fiscal policy to achieve the primary budget surplus target of 1.9%. We maintain our primary surplus estimates of 1.3% for 2014 and 1.7% for 2015.

• The Central Bank’s Monetary Policy Committee (COPOM) kept the benchmark interest rate at 11%, but the meeting’s minutes indicate that concerns are equally balanced between inflation being uncomfortably close to the upper limit of the target range and the declining economic growth rate. We see the SELIC rate at 11% by the end of this year and 12% in 2015.

• Polls show a drop in the government’s approval ratings and a narrowing of the gap between President Dilma Rousseff and the other candidates.

Outlining a Lower-Growth Scenario

We revised our GDP forecast for 2014 to 1.0%. The 1Q14 GDP outturn and coincident indicators for April and May suggest a slowdown in domestic demand, and we expect negative growth in 2Q14. Depending on the intensity of this contraction, growth in 1Q14 could be revised downward to a negative reading as the seasonal adjustment to that series is updated. In that case, there would be two consecutive quarters with negative GDP growth. However, we expect a moderate economic recovery in 2H14 that will drive growth to 1.0% in 2014.

The 1Q14 GDP report showed a deceleration in domestic demand. Economic activity slowed in 1Q14, with GDP growing 0.2% qoq/sa (1.9% yoy). The deceleration reached investment, household and government spending, with the first two actually falling in the period. (For further details, please refer to the link). The 1Q14 GDP outturn and the revision of the 2013 GDP figure triggered a deterioration in the statistical carryover for 2014.

According to the available 2Q14 data, there was a retreat in industrial activity and a moderation in retail sales. Industrial activity declined and retail growth has been moderate. Industrial production fell 0.3% mom/sa in April, showing a sharper decrease in sectors in which demand is more dependent on business/consumer confidence and credit availability, such as capital and durable consumer goods. The positive highlight was semi-durable and non-durable consumer goods production, which rose 0.4%. Serasa Experian’s retail activity index showed a growth deceleration in May. The same occurred with vehicle sales, according to FENABRAVE, the auto dealers association.

Business confidence indices fell to exceedingly low levels. There was a decline in business confidence in the four largest economic-activity sectors in both April and May. Moreover, these indices remain low, indicating a cool-down in activity in the coming months. We believe, however, that part of the retreat is temporary due to the expectation of cuts in working days during the Soccer World Cup event.

We see negative GDP growth in 2Q14. The statistical carryover from 1Q14 and coincident indicators for April and May suggest a 2Q14 retreat in GDP (-0.2% qoq/sa). Given the revision in seasonal adjustment, growth in 1Q14 could be negative, thus setting the stage for a technical recession. However, we expect the economy to stabilize in 2H14, expanding by 0.5% in 3Q14 and 0.4% in 4Q14.

We revised our growth forecast for 2015 to 1.7%. Low growth in 2014 will provide a statistical carryover that is likely to be less favorable than we anticipated (our previous forecast for 2015 was 2.0%). We expect a moderate recovery, fueled by an improvement in domestic demand as election-related uncertainties are resolved and business and consumer confidence levels stabilize.

Despite the slowdown in economic activity, unemployment remains low. The unemployment rate stood at 4.9% (seasonally-adjusted) in April (vs. 4.8% in March), missing both our and market estimates. The recent decoupling of unemployment and economic growth has been partly due to successive year-over-year drops in labor force. We understand that the retreat is largely driven by young people who have left the labor market to return to school (please see our report titled “Macro Vision – Unemployment, Declining Participation Rate and FIES”).

Looking ahead, we forecast a moderate rise in unemployment. While our forecast is based on the slowing economy, we also believe that the recent dynamics of the declining labor force will eventually be exhausted. We expect the seasonally-adjusted unemployment rate to be at 5.3% by year-end and 5.6% by the end of 2015.

Dependence on thermal power plants and rationing risks persist. The rainfall levels in key regions for hydropower generation and storage were below average in May, but have been in line with the historical average since February 15. Power usage is showing some signs of cooling down, possibly due to the still-high prices in the free market. Reservoir levels started to recede in May, following the seasonal patterns, and should continue to drop slowly until November. In a nutshell, recent developments reinforce a scenario of intense thermal-power-plant usage and a continued risk of rationing going forward. Although precipitation levels that surpass the seasonal average during the dry season (until October) provide relief, they are not a definitive solution.

Poor credit performance in April. The daily average of non-earmarked loans fell 2.5% mom/sa, in real terms. Moreover, the expansion pace of the credit stock has slowed. The year-over-year real growth in total outstanding loans slid to 6.7% in April, from 7.1% in March. The deceleration in lending was widespread, reaching both earmarked credit (which slipped to 15.9% from 16.6%) and non-earmarked loans (down to 0.0% from 0.3%), as well as credit granted by state-owned banks (down to 13.3% from 14.2%) and private banks (down to 0.3% from 0.4%). Overall delinquency remained at 3% for a fifth consecutive month. The average interest rate was also unchanged, at 21.1%.

While Exports Huff and Puff, the Current Account Deficit Stands Firm

We revised our 2014 trade-balance forecast downward. We expect the falling prices for exported commodities and resilient imports (which continue to advance despite the economic activity deceleration( partly due to the fact that fuel prices are being held back) to have a negative impact on the Brazilian trade balance this year. We therefore revised our trade-balance estimate for 2014 to USD 1.5 billion, from USD 3 billion. A smaller trade balance widens the current account gap, which is likely to end 2014 at USD 82 billion (vs. USD 80 billion previously). For 2015, we maintain our expectation of a USD 16 billion trade surplus.

The current account deficit widened to USD 8.3 billion in April. Profit and dividend remittances were a positive surprise, in what seems to be a one-off event related to the recent exchange-rate appreciation. From a financing standpoint, foreign direct investment (FDI) remains robust, totaling USD 5.2 billion in the month. The FDI inflows stand at USD 19.4 billion year to date, 2.3% higher than in the previous year. We revised our FDI forecasts to USD 60 billion in 2014 (vs. USD 51 billion previously) and USD 57 billion in 2015 (vs. USD 49 billion previously).

The exchange rate has been fluctuating within the 2.20-2.30 range, which seems to be a comfort-zone for monetary authorities. A weaker level would increase the risk of breaching the upper-limit of the inflation target’s margin of error, while a stronger level, albeit positive for the inflation target, is perceived as costly to exporters and those holding dollar-denominated assets (such as the Central Bank itself).

The FX intervention program via swap contracts will be extended beyond June. As the end of June approaches, doubts regarding the continuity or interruption of the Central Bank’s daily intervention program in the foreign exchange market put pressure on the Brazilian real last week. Facing this movement, the monetary authority increased the rollover lot for contracts expiring in July, to 10,000 daily contracts, even after announcing the rollover of only 5,000 daily contracts in the first day of June. Moreover, the government reduced the IOF tax charges on foreign borrowing to 180 days, from 360 days. This set of measures signals that the government is uncomfortable with a weaker exchange rate because a weaker real makes the battle against inflationary pressures more difficult in the short-term. Thus the government will reach into its toolbox to maintain the exchange rate stable.

Our year-end exchange-rate forecasts are at 2.45 reais per dollar for 2014 and 2.55 for 2015. We regard the 2.25 vicinity as temporary, although it may last a little longer. The recent deterioration in external accounts, our expectation of a moderate increase in U.S. yields (2.90% for the 10-year Treasury by year-end) and electoral-related uncertainties in the second half of the year are likely to weigh on the real, which is set to weaken again during the year.

We Reduced Our 2014 IGP-M Forecast, but Expect the IPCA to Advance 6.5%

The IPCA slowed in May, but topped market estimates. The IPCA consumer price index rose 0.46% in May, beating our forecast (0.40%) and median market expectations (0.38%). The inflation slowdown from April (0.67%) was driven by smaller changes in the food and transportation groups; the year-over-year change in the IPCA advanced to 6.37% in May, from 6.28% in April. Our preliminary forecast for June indicates a 0.30% gain in the IPCA, with expected declines in food consumed at home and fuel costs.

We maintain our full-year IPCA forecast at 6.5%, despite a slight reduction in our regulated price estimate (to 5.4% from 5.6%) after incorporating tariff reductions for landline phones (basic subscription with Telefônica) and water and sewage (related to discounts granted by Sabesp to consumers who cut their water usage). We maintain our estimate for market-set prices at 6.8%. An exchange rate that remains at the current levels for a longer period of time may help ease inflation throughout the second half of the year.

We also maintained our 2015 IPCA forecast, at 6.5%, but the balance of risks may be a little more favorable. We expect increases of 7.3% for regulated prices and 6.3% for market-set prices. In our scenario for regulated-prices, we include material price increases in important sub-items such as electricity tariffs (15%), water and sewage tariffs (12%), urban bus fares (10%) and gasoline (6%), but the correction of some of these prices may be more gradual. For market-set prices, the slowdown relative to 2014 is due to smaller increases in food and service prices. This scenario assumes no new supply shocks in the Agriculture sector and a slight slowdown in the labor market, which would help reduce the upward pressure on service costs. In a broader context, the weaker economic activity may translate into a slightly more favorable balance of risks for inflation on market-set prices later this year and early next year.

The IGP-M general price index decreased 0.13% in May. The IPA producer price index fell 0.65%, after rising 0.8% in April, with agricultural prices dropping 0.7% (vs. +2.0% in April) and industrial prices sliding 0.6% (+0.3% in April). Iron ore prices fell 6.1%, marking the largest downward contribution to the general index (-0.22 pp). IGP-M inflation dropped to 7.8% year over year. According to the current data, the IGP-M is also likely to remain subdued in June, probably with another monthly deflation as the year-over-year change sustains the recent downtrend.

We reduced our full-year IGP-M forecast to 6.0% from 6.8%, due to a revision of our agricultural items and iron ore forecasts. The IPA-M producer price index, which carries the greatest weight in the IGP-M, is expected to gain 5.6% this year, driven by a 4.6% increase in industrial prices and 8.2% increase in agriculture goods prices. In the Mining Sectors, iron ore prices are expected to post a substantial negative contribution, due to an estimated 25% decline that is likely to reverse most of last year’s 34.6% gain. For the other index components, we anticipate a 6.5% increase in the IPC-M consumer price index and a 7.5% gain in the INCC-M construction cost index.

Fiscal Balance: Postponement of Expenditures Influences Short-Term Result

The public sector’s consolidated primary fiscal budget surplus reached BRL 16.9 billion in April, or 4.0% of the monthly GDP. The result is higher than in April 2013 (2.6% of GDP) but below the average of the post-Lehman period (4.7% of GDP). April is usually a positive fiscal month, mainly due to income tax payments. The primary surplus from January to April stands at 2.6% of GDP, compared with 2.7% of GDP in 2013 and a 3.6% average for the post-Lehman period.

The year over year growth in the six-month moving average real federal spending slowed to 3.8% in April, from 7.3% in March. Although these numbers seem to indicate an adjustment in expenditures, we note that the slowdown was largely due to the postponement of mandatory expenses to the end of this year. Indeed, payroll expenses decreased 13.2% year over year and social security disbursements fell 10.6% year over year. These lines were affected by the government's decision to defer the payment of precatórios bonds, which usually occur in April, to the end of the year. We therefore expect these lines to rebound at the end of 2014. Moreover, for the first time this year, there were no transfers to the energy development account (CDE). Transfers to the CDE averaged BRL 900 million per month in 1Q14 and the government’s budget includes BRL 13 billion in payments to the CDE, which implies an average of almost BRL 1.1 billion per month.

Discretionary spending (such as investment spending and government cost) also slowed, but at a milder pace. The year over year growth in the six-month moving real investment expenditure slid to 8.1% in May, from 12.4% in April. In the same metric, government cost growth dropped to 7.2% from 12.2%. Although the growth rates remain high, these lines have the greatest short-term flexibility for adjustments. For the next few months (May to December), we forecast a 4.4% year-over-year real growth in total spending, which would imply a growth rate of 3.9% for 2014.

Non-tax revenue (especially dividends) remains high, while tax revenue is growing in line with GDP. Dividends from state-owned enterprises totaled BRL 2.3 billion in April. Year to date, dividends total BRL 8.2 billion, versus BRL 1.0 billion in the same period of 2013.

As a result, the gap between the conventional and recurring primary surpluses remains wide and the fiscal stance remains expansionary. In the last 12 months through April, the public sector’s conventional (non-adjusted) primary balance reached 1.9% of GDP (vs. 1.7% in March). The recurring primary surplus (excluding atypical revenues and expenses) rose to 0.8% of GDP (vs. 0.6% in March). According to our calculations, the primary surplus needed to stabilize the public debt in the long run stands at 2.0%-2.5% of GDP. Hence, a recurring surplus below this level reflects a still-expansive fiscal policy.

Our 2014 primary-surplus estimate remains at 1.3% of GDP (below the target of 1.9% of GDP). A slowdown in discretionary spending is required in order to come closer to reaching the primary surplus target this year, particularly given the weak economic activity and the consequent impact on tax revenue. Given the slowdown in tax collection, efforts are being made to increase non-tax revenue, which include the reopening of the Refis fiscal amnesty program. This reinforces our view that the recurring primary fiscal surplus will remain below 1% of GDP this year (our forecast is 0.7% of GDP by year-end). The conventional primary surplus should continue to hover at around 1.7%-1.8% of GDP until the last two months of the year. By year-end, we expect a drop in the 12-month cumulative primary surplus to 1.3% of GDP, due to a tough comparison base – a large primary surplus at the end of 2013 caused by extraordinary revenue.

For the coming years, we anticipate a fiscal adjustment particularly driven by an increased tax burden (i.e., reversal of tax breaks and increases in other taxes). We see the conventional primary surplus rising gradually to 2.0% of GDP in 2016, from 1.3% in 2014. According to our calculations, this implies an increase in the structural primary balance, to 1.8% of GDP in 2016 from 0.5% in 2014 (i.e., zero momentum this year). The average fiscal contraction in 2015-16 would be 0.6% of GDP. A less-favorable economic cycle requires a greater fiscal effort to boost the conventional primary surplus, increasing the downside risk to our fiscal forecasts for 2015-16.

Brazil: The End of the Rate Hikes, at This Moment

The Monetary Policy Committee (COPOM) maintained the SELIC benchmark interest rate at 11.00% pa at the May meeting. The decision was unanimous and in line with our call and most market estimates. The post-meeting statement included the phrase “at this moment”, leaving the door open for future monetary policy actions.

In the meeting’s minutes, the COPOM expressed heightened concerns about the drop in economic growth and greater ease with the stability of the exchange rate. The minutes offered insight into the elements that supported the decision to interrupt the hiking cycle. The COPOM argued that growth is likely to be “less intense” this year than in 2013, and did not include the paragraph that cited currency depreciation and volatility as a source of short-term inflationary pressure in the minutes for the April meeting.

We expect stable interest rates until year-end. The COPOM will probably wait to assess the effects of the monetary policy adjustments implemented through April. The Central Bank continued to indicate that some of the effects of monetary policy on inflation “have yet to materialize” and that such effects “tend to be leveraged” in light of the low confidence levels.

Still, the COPOM acknowledges the importance of remaining vigilant. There are specific concerns about the secondary effects of two relative price changes: the realignment of regulated and market-set prices (driven by the need to adjust gasoline, electricity tariffs and transportation fares) and international and domestic prices (due to a weaker exchange rate).

We maintain our year-end SELIC rate forecast at 11.0%, and revised our projection for 2015 to 12.00% from 12.50%. The COPOM’s May decision and the minutes that followed reinforce our call of a stable SELIC rate until the end of 2014. In 2015, we continue to expect the COPOM to create a new tightening cycle to ensure stable inflation. However, weakening activity has led us to reduce the size of the cycle expected for next year. We revised our SELIC rate forecast to 12.00%, from 12.50% pa, by the end of 2015.

Falling Approval Ratings and Worsening Perceptions About the Economy Make for a More Competitive Electoral Race

An Ibope poll ahead of the presidential elections showed a drop in voting intentions for President Rousseff. The President’s voting intentions dropped to 38% from 40%, while Aecio Neves rose to 22% (from 20%) and Eduardo Campos to 13% (from 11%). The sum of the other candidates rose to 7% (from 5%) and the percentage of blank/null/undecided fell to 20% (from 24%). Since Dilma has less votes than all the other candidates combined, the election, if held today, would go to a second round.

In runoff simulations, the gap between Rousseff and her main opponents shrank. In the simulation between the President and Neves, the difference narrowed to 9 pp from 19 pp; against Campos, the gap narrowed to 11 pp from 20 pp.

The approval ratings for the administration and confidence in the economy decreased. Approval for the Rousseff administration (share of participants who regard her administration as "excellent/good") fell to 31% from 35%, the lowest reading since the wave of popular protests last June. A poll by Datafolha shows that perceptions about the economy deteriorated. The share of people expecting higher unemployment rose to 48%, from 42%, while 64% of the participants expect higher inflation, from 58% previously.

Party conventions scheduled for June. From June 10 to 30, political parties will gather to formally decide on their candidates and party alliances. The TV air time granted to each party alliance, starting in August, will be allotted according to the number of seats held by the alliance parties in the House of Representatives. The next step is the formal registration of the candidates and alliances in the Supreme Electoral Court until July 5, when the official campaign season kicks off.



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