Itaú BBA - Dealing with a more uncertain world

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Dealing with a more uncertain world

November 16, 2016

We now expect a more depreciated exchange rata and a 25-bp rate cut in November, due to a more uncertain external scenario.

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

• The Lower House has approved the cap for primary spending growth, a structural change in Brazilian fiscal policy that will likely be voted on by the Senate before the end of the year. The government will probably send a Social Security reform bill to Congress this month or in December. We have marginally adjusted our primary result forecast for 2016 from -2.6% to -2.5% of GDP based on the results of the foreign asset repatriation program. For 2017, we have held our 2017 forecast at -2.2% of GDP.

• Economic activity disappointed in the third quarter. Although industrial output rose in September, this failed to offset the previous fall. The drop in 3Q16 GDP is likely to be stronger than suggested in the scenario (-0.5%). Although this creates a downward bias for our 2016 GDP forecast, we note that, when published, the third-quarter GDP figures will offer additional information, probably revising the historical series. Looking ahead, leading indicators and fundamentals continue to suggest an improvement in economic activity, led by industry. We have therefore maintained our forecast of a 3.2% fall in 2016 GDP and a 2.0% rise in 2017 – these figures may be revised when the aforementioned national figures are published at the end of November. Turning to the labor market, we have maintained our unemployment forecast of 12.5% for the end of the year and 12.2% in December 2017.

• We have changed our exchange-rate forecast to 3.40 reais per U.S. dollar at the end of 2016 (previous: 3.25) and to 3.60 reais per U.S. dollar at the end of 2017 (previous: 3.50). The result of the American elections pressured emerging market currencies, among them the Brazilian real. We believe that the domestic scenario, including approval of fiscal reforms and the international scenario, encompassing a still gradual interest rate rise in the U.S., are compatible with slight depreciation, near the inflation differential, next year.

• We are forecasting 6.8% inflation for the Extended National Consumer Price Index (IPCA), compared with 7.0% in the previous report. More benign food prices and lower fuel prices more than offset the increase in electricity prices. We continue to forecast that inflation will fall to 4.8% in 2017, with market prices rising 4.7% and regulated prices increasing 5.3%.

• The Central Bank cut the Selic rate by 25 bps in October. We believe that the domestic scenario will continue to evolve favorably in November. However, uncertainties related to U.S. policies will likely lead the CB to approach the easing cycle with greater caution. We now expect the Copom to cut the Selic rate by 25 bps in November, to 13.75%. As uncertainties dissipate, the pace of interest rate cuts could intensify throughout 2017, taking the Selic to 10.0% by year-end.

Progress on reforms, falling inflation and disappointing activity in a more uncertain environment

The constitutional amendment capping public spending increases was approved by the Lower House.  This bill is critically important in order to guarantee a sustainable public debt trend. The wide voting margin was good news, suggesting that the government has a solid majority in Congress and increasing the likelihood of other reforms, like Social Security, also being approved.

Current data on economic activity disappointed. The recovery in industrial output after August’s significant drop was small and suggests a stronger GDP contraction in the third quarter. Our preliminary forecast for October is for another decline. However, leading indicators remain positive: confidence and financial indicators remain on an upward path, suggesting a recovery for the quarters ahead.

In this cycle, the gap between leading indicators and industrial output may be significant, as industrial inventories are still high. However, we believe that the inventory adjustment cycle is near the end. In fact, industrial output may rise next year even without any additional increase in demand, given the outlook for inventory rebuilding.

Prospects for higher interest rates in the U.S. may pressure the real. We believe the BRL at around 3.25 to the dollar is compatible with the long-term balance of payments equilibrium (if the reforms are approved). However, the rise in long-term interest rates in the U.S. tends to strengthen the dollar. Accordingly, we believe the real will end the year at a slightly weaker level. The external account deficit is likely to grow over the next several years, but it should remain around or below 2% of GDP.

The fall in inflation is consolidating. Industrial prices, which put pressure on inflation during the first half of the year, have been slowing much faster in recent IPCA figures. This trend had already been captured in wholesale prices as a result of the BRL’s appreciation, but it has only more recently been passed on to consumers and offers a more solid basis for a further fall in inflation.

The Central Bank cut the Selic benchmark rate of interest by 25 basis points in October.  We reckon the domestic scenario will continue to evolve favorably in November. However, uncertainty related to the outcome of the U.S. elections will likely lead the CB to approach the easing cycle with greater caution. We now expect the Copom to cut the Selic rate by 25 bps in November, to 13.75%. As external uncertainty dissipates, the pace of interest rate cuts could intensify throughout 2017, taking the Selic to 10.0% by year-end.

Kicking off the reforms: the spending cap advances through Congress.

In October, the Lower House approved a constitutional amendment that creates a spending cap (PEC No. 241/55). The bill now moves on to the Senate, where it will likely be voted on before the end of the year.

If the reform is approved, it will represent a structural change in Brazil’s fiscal policy management. The cap will help reverse the continuous increasing trend seen in primary federal spending for the past 20 years (see graph). Under the cap, if any expenditure rises in real terms, it will have to be offset by a real-term reduction in other expenditures. By controlling the increases in public spending, the reform will gradually reverse the structural fiscal imbalance. (See “Macro Vision: Frequently Asked Questions:The Spending Cap (PEC 241)”).

The government will send a Social Security reform bill to Congress by the end of the year to ensure the spending cap remains feasible in the years ahead. Social Security expenditure represents 40% of the federal government’s total primary expenditure (8.0% of GDP) and will increase in real terms over the next several years as the population ages. The government has signaled that, as part of its Social Security reform, it intends to set a minimum retirement age of 65. This would bring the federal budget into line with Brazil’s new demographic situation. It would also reduce the need for significant cuts to the rest of the budget and support spending cap compliance for a longer period of time.

In our view, if approved, these measures will be an important step toward stabilizing the public debt in the medium term.  We forecast that the federal government will achieve a primary surplus only by 2020. However, the return to growth and the structural drop in interest rates following implementation of the reforms will significantly reduce annual increases in public debt during this period. Specifically, we believe that as the spending cap is followed, public debt will roughly remain stable, at around 80% of GDP, until 2023, when rising annual primary surpluses will lead to a reduction in public debt year after year.

While the reforms await approval, short-term fiscal results will remain on an unfavorable trend and dependent on extraordinary revenues.

In 2016, due to the BRL 47 billion (0.8% GDP) in revenues from the repatriation program, we have marginally improved our primary deficit forecast, from 2.6% (BRL -163 billion) to 2.5% of GDP (BRL -158 billion). Of the funds raised from the repatriation bill, BRL 18 billion will be used to pay expenses from previous fiscal budgets  and BRL 12 billion will be automatically transferred to the states and municipalities. With more funding and better-than-expected current data, the primary result for the states and municipalities is likely to be higher than we had forecasted (a balanced result instead of a deficit of BRL 6 billion). Only BRL 17 billion (0.3% of GDP) of the repatriation bill will be used by the federal government to reduce the 2016 deficit.  This is BRL 2 billion higher than our previous scenario, but it will be partially offset by BRL 1 billion due to a shortfall in recurrent revenues and a higher-than-expected increase in mandatory expenditure. Hence the fiscal result of the federal government remains broadly the same.

In 2017, we expect BRL 37 billion (0.6% of GDP) in extraordinary revenues to meet our primary deficit forecast of 2.2% of GDP (BRL 142 billion). Most of these revenues will come from energy permit auctions, infrastructure concessions and IPO taxation, in line with the government budget. Furthermore, the government may implement a new asset repatriation program in light of disappointments with recurrent revenues, given the slightly delay in returning to economic growth. 

Activity: worse in the short term, but fundamentals remain stable

Industrial output rose 0.5% in September. This increase did not offset the drop from the previous month. As a result, third-quarter industrial output was, surprisingly, 1.1% lower than the previous quarter, weighed down by a 3.5% drop in August.

A weaker third quarter creates a downward bias for 2016 GDP. The negative surprise from third-quarter industrial output suggests that GDP is likely to fall further than expected in our current scenario (-0.5%). Furthermore, the first indicators for the fourth quarter failed to reveal a stronger recovery. Therefore, we have included a downward bias in our GDP forecast for this year (currently -3.2%). Given the additional uncertainty surrounding the third-quarter GDP figures, when, in addition to new data, revisions of the historical series are also presented, we are maintaining for now our current estimates.

In 2017, even if the statistical carryover is likely to be worse than our current scenario, fundamentals should remain unchanged (particularly interest rates, commodity prices and confidence). Consequently, we are maintaining our 2.0% growth forecast for the time being.

Our economic activity diffusion index continues to suggest the situation will improve as we move forward. The index – which shows the number of rising activity indicators, based on a wide dataset, including business and consumer confidence, retail sales and credit demand – has remained volatile in recent months, which is a typical pattern when the economy reaches an inflection point. In August, diffusion stood at 31%, after reaching 58% on the moving average for the previous three months. Preliminary figures for September and October show diffusion recovering at the margin, returning to above neutral territory (44%).

Industrial fundamentals continue to suggest an increase in output. In October, confidence showed signs of moderating in the main sectors of the economy. However, it was still higher than the levels seen during the first half of the year. In industry, confidence has improved in recent months due to falling inventories. This improvement will not necessarily be reflected by an immediate rise in output, as seen recently. On the other hand, lower inventories corroborate our view that demand is outstripping output (measured by the level of utilization of installed capacity – NUCI). In this case, we continue to see space for an increase in industrial output when inventories reach the desired level, even if industrial demand remains stable.

Formal employment was lower than expected in September. In September, a net 39 thousand formal jobs were destroyed (CAGED), compared with a consensus of 7 thousand. Without accounting for seasonal effects, the contraction affected 117,000 jobs, and the three-month moving average remained practically stable (reaching -107,000 from -106,000) – as the “neutral” CAGED is 35,000, there is a long way to a rebound in employment.

Unemployment close to 12%. In September, the nationwide unemployment rate rose to 11.8%. At the margin, the unemployment rate posted its 22nd consecutive increase and rose to 11.9% from 11.7%, using our seasonal adjustment. The labor market reaction lags behind economic activity, which means unemployment is likely to remain high through the first half of next year. We have maintained our unemployment forecast of 12.5% for year-end 2016 and 12.2% for December of 2017.

BRL: more volatility ahead

The BRL reached its all-year high (3.11) with capital inflows from the Repatriation Act. However, at the end of October and beginning of November, the currency lost steam, along with other risky assets.

Risk-aversion increased as a result of uncertainty generated by the American election results. Against the prospects of greater volatility in the exchange rate market, the Central Bank announced a halt in its FX swap auctions in order to assess current market conditions.

We revised our exchange-rate forecast to 3.40 reais per dollar at the end of 2016 (previous: 3.25) and our year-end 2017 forecast to 3.60 reais per dollar (previous: 3.50).  On the one hand, greater uncertainty regarding the economic policies to be adopted in the U.S. and the increase in interest rates (albeit gradual) in the U.S. justify a more depreciated exchange rate. On the other hand, the approval of fiscal reforms in Brazil and the prospect for higher metallic commodity prices provide some support to the exchange rate. These figures are also in line with a scenario of slightly increasing current account deficits, albeit at levels that will not compromise external sustainability.

External accounts show stability at the margin. The current account deficit has been settling at a higher level than observed during the first half of the year. Currency appreciation in recent months and some stability in domestic activity have helped explain these results. However, year to date, the current account deficit shrank 72% compared with the same period last year (USD 13.6 billion vs. USD 49 billion), the lowest cumulative deficit since 2007.

We have revised our external account forecasts for the next years. Higher metallic commodity prices next year coupled with a slightly more depreciated exchange rate justified the revision. We are forecasting a USD 47 billion trade surplus in 2016 and USD 46 billion in 2017 (previous: USD 42 billion). For the current account, we are forecasting a USD 21 billion deficit in 2016 and USD 29 billion in 2017 (previous: USD 33 billion).

The downward trend in inflation is consolidating

We are forecasting a 6.8% variation in this year’s IPCA, lower than the 7.0% forecast in our previous report. We expect a 7.1% increase in market prices (compared with 8.5% in 2015). Looking at the market price components, we estimate an increase of 10.2% for food at home (12.9% in 2015), 5.2% for industrial prices (6.2% in 2015) and 6.8% for services (8.1% in 2015). We forecast a 5.9% increase in regulated prices (compared with 18.1% in 2015). The lower forecast for foodstuffs and the decline in gasoline prices have more than offset the expected increase in electricity prices, taking into account the net effects of the so-called “yellow flag electricity rate surcharge” (introduced to account for an increase in marginal supply costs) and the lower tariffs from some utilities.

Food prices continue to show more benign behavior at the margin. Current figures indicate that food deflation in September and October may continue into November. The main reasons for this are falling bean and milk prices, which are retreating faster than expected, giving back some of the significant increases seen during the first half of the year.

Falling IPCA inflation also reflects the slower increases in industrial goods prices. The BRL appreciation throughout the year has resulted in slowing inflation for tradable goods, particularly industrial goods. This movement had been captured by wholesale prices some time ago, but has only been passed on to consumers more recently. We expect this trend to continue or even gain traction throughout 2017.

We continue to forecast that IPCA inflation will fall to 4.8% in 2017. Next year’s drop in inflation will reflect the dissipating effects from relative price increases (regulated prices and exchange rates), less inflationary inertia, a lower inflation expectations, more favorable weather conditions and the high level of idle capacity still seen throughout the economy.

On a disaggregated basis, we are forecasting a 4.7% rise in market prices and a 5.3% increase in regulated prices.  Among market prices, we forecast a 4.0% increase for food at home, as major agricultural producers are expected to see bumper crops, reflecting improved weather conditions as the effects of El Niño taper off. In the other segments, we expect a 5.5% increase in service prices and a 4.0% increase in industrial prices. Among regulated prices, we have reduced our forecast for electricity from 7% to 5% – based on the expected return of the green tariff flag, when supply conditions normalize throughout the year – and from 6.5% to 5% for urban buses, as price increases are likely to be delayed in some state capitals. On the other hand, we have increased our forecast for gasoline prices, from 0% to 3%, based on the recently announced change in fuel pricing policy, as well as our scenario for the exchange rate and external gasoline prices.

The fiscal issue is still a major risk for inflation.  Future attempts to increase government revenues could lead to fresh tax increases, including at the state level. They could also entail the elimination of tax breaks and a greater increase in regulated prices.  However, progress on fiscal reforms could improve the outlook for inflation, either through exchange rates and inflation expectations, or switching from the current expansionary to neutral or even contractionary fiscal policies.

The high level of idle capacity in the economy is also likely to drive inflation down further as we move ahead.  Although it is subject to some uncertainty and errors in measurement, the negative output gap could lead to faster market-price disinflation over the next few months, particularly for industrial products and services.

Better-behaved expectations strengthen the scenario of falling inflation. According to the Focus survey of market analysts, inflation expectations for 2016 and 2017 retreated again last month and currently stand at 6.8% and 4.9%, respectively. IPCA inflation expectations for 2018 and further ahead have been at the center of the target (4.5%) for some time, reflecting an increasing conviction that the Central Bank will take steps to ensure that the IPCA will indeed converge toward the target over longer horizons.

Policy monitor – CB to cut interest rates by 25 bps in November in the face of external uncertainties

The Brazilian Central Bank cut the Selic rate by 25 bps in October, the first interest rate cut since 2012. According to the Central Bank, “inflation convergence towards target for 2017 and 2018 is compatible with a moderate and gradual loosening of monetary conditions.”Indeed, the weak economy, recent exchange-rate stability and the end of regulated price realignment has resulted in a downward trend for inflation and inflation expectations in recent months.

The debate now concerns the pace of the easing cycle. The CB’s communication suggested preference for sticking to a 25bps pace. However, the CB also left the door open for a more intense easing cycle, depending on the "combination" of a few factors, particularly service inflation resuming its downward trend (which is more sensitive to the economic cycle and monetary policy) and the fiscal adjustment’s approval and implementation.

We believe that the domestic scenario will continue to evolve favorably in November. First, the spending ceiling was passed by a large majority in the Lower House. Additionally, until the next Copom meeting, the government will likely approve the spending ceiling constitutional amendment in a first round vote in the Senate. Second, activity data for the month of September remained weak, suggesting no reversal of August’s negative results (highlighted by the CB in its communication from the last meeting). Expectations for an even more intense recession reduce inflationary risks. Third, inflation is likely to remain well-behaved in its various components, even if the services subgroup – whose inflation has already fallen significantly this year – does not further retreat in the short term. Fourth, the lag in the transmission mechanism of monetary policy will lead the Copom to add greater weight to 2018 inflation over time, instead of 2017. All these factors, in our opinion, increase the likelihood of acceleration in the easing cycle of monetary policy.

However, uncertainties related to the outcome of the U.S. elections should lead the CB to approach the easing cycle with greater caution. Donald Trump's victory and ensuing doubts over future economic policies have generated greater external volatility, which is likely to lead the Copom to a less-intense rate cut than we had expected at its November meeting.

We now expect the Copom to cut the Selic rate by 25 bps in November, to 13.75%. As uncertainty dissipates, the pace of interest rate cuts should intensify throughout 2017, taking the Selic to 10.0% by year-end.


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

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