Itaú BBA - Delayed Recovery

Brazil Scenario Review

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Delayed Recovery

September 12, 2014

After weakness in 2Q14, the recovery in economic activity has been sluggish.

• We lowered our forecast for GDP growth in 2014 to 0.1% from 0.6%. The still-slow recovery in economic activity and unfavorable fundamentals continue to indicate weak activity in the near future. Considering the unfavorable statistical carryover and available data for 3Q14, we anticipate stagnation or slightly negative GDP in the current quarter. For 4Q14, we expect normalization in activity and, thus, moderate expansion in the economy, driving growth to 0.1% in 2014. For 2015, our GDP growth estimate remains 1.3%.

• We reduced our estimate for the general price index IGP-M in 2014 to 3.5% from 4.2%, in the face of a lower-than-expected reading in August and a downward revision in estimates for some commodity prices. For the consumer price index IPCA, our forecast for 2014 is unchanged, at 6.3% (6.5% for market-set prices and 5.6% for regulated prices in the index). For 2015, our estimate stands at 6.4%, with regulated prices advancing 7.0% and market-set prices increasing 6.2%.

• The central bank’s Monetary Policy Committee (Copom) reinforced the signal of stability in interest rates ahead. We thus project the benchmark Selic rate at 11% by year-end. There is more uncertainty in the scenario for 2015, but in the absence of a bias, our forecast also remains at 11%. 

• We lifted our estimate for the trade surplus in 2014 to USD 2.5 billion from UDS 1.4 billion, due to a weaker pace in activity. For 2015, in the face of price declines for key commodities exported by Brazil, we reduced our projection for the trade surplus to USD 10.3 billion from USD 12.6 billion.

• The primary budget surplus continues to shrink, and the public sector’s net debt is up by 1.5 pp of GDP year to date. We lowered our estimates for the conventional primary surplus in 2014 to 1.1% from 1.3% of GDP and for the recurring primary surplus to 0.4% from 0.6%.

• The most recent Datafolha poll shows Marina leading by 4 p.p. over Dilma in the second round simulation 

We reduced our forecast for GDP growth in 2014

After weakness in 2Q14, the recovery in economic activity has been sluggish. Activity decelerated sharply in June, largely due to a temporary reduction in the number of working days during the soccer World Cup. Thus GDP growth in 3Q14 was negative (-0.6%) and worse than our call and the market consensus (-0.4%). After the sports tournament ended, we saw some signs of improvement in the economy in early 3Q14, confirming our view that the slide in activity in June reflected an expected and temporary shock.

However, the rebound in activity so far does not seem enough to push 3Q14 growth into positive territory, due to a deeply negative statistical carryover. For instance, industrial production increased 0.7% mom/sa in June, not enough to reverse the 1.4% slide in June. Moreover, available figures for August do not suggest a reversal in this scenario of sluggish recovery. Auto production (according to the manufacturers’ association Anfavea) increased moderately during the month, but to a level that is still substantially lower than the seasonally-adjusted average for 2Q14. The same goes for vehicle sales (according to the dealers’ association Fenabrave).

Economic fundamentals suggest more adjustments ahead. Business and consumer confidence levels remain low. Confidence among executives in the manufacturing, retail and service sectors fell in August. Industrial inventories remain high and suggest further adjustments in production in the near future. Considering the largest economic sectors, confidence only increased among construction executives, but not enough to recover from the slide seen in the previous month. Among consumers, confidence also retreated, reversing two increases in previous months and reflecting a perception of deterioration in the labor market.

We cut our forecast for GDP growth in 2014 to 0.1% from 0.6%. The recovery in activity has been gradual and sluggish, following a contraction in 2Q14 sharper than our expectations and the market consensus. With more negativity in the statistical carryover, we forecast stagnation or a small retreat in growth in 3Q14 (-0.1% qoq/sa). For 4Q14, a more favorable statistical carryover and reduced uncertainty in the domestic scenario will contribute to a moderate growth of 0.5%. We now estimate annual growth at 0.1%. For 2015, we expect modest growth, of 1.3%, driven by the return to normalcy of some factors, such as investment.

A small increase in unemployment, with another drop in the labor force. For a third consecutive month, the national unemployment rate was not published by IBGE due to a labor strike at the census bureau. In the four metropolitan regions whose numbers were released, the dynamics in the labor market were little changed from previous months, with another decline in the labor force preventing a sharper increase in the unemployment rate in July, despite a drop in the working population. We still hold the view that weaker economic activity and a possible draining of the dynamics of declines in the labor force should cause a moderate increase in unemployment. We forecast the unemployment rate at 5.4% by year-end and at 5.7% in December 2015.

Lower hydropower generation is offset by thermal power plants and wind mills. Rainfall levels 48% below average in August affected hydro power generation, but that was offset by the usage of thermal power plants and wind mills and by lower electricity consumption (-2.5% yoy). Hence, the aggregate level of water reservoirs in August fell 6.4 pp, close to its seasonal pattern. Looking ahead, a seasonal recovery in rainfall levels may interrupt the decline in reservoir levels and ease operations for the National System Operator (ONS). Anyhow, we continue to see intense usage of thermal power plants for a prolonged period and risks of electricity rationing in 2015.

Decline in new loans. The daily average of non-earmarked new loans dropped 5.0% mom/sa in July, in real terms. Growth in outstanding loans continues to cool down, receding to 4.6% yoy in July from 4.9% in June, in real terms. Growth in new earmarked loans slowed to 12.5% in July from 12.9% in June, while the change in non-earmarked loans was negative by 1.4% (-1.0% in the previous month). Overall delinquency remained at 3.0%, favored by a widening share of earmarked loans, which have lower delinquency levels and posted no change in July. However, delinquency rates for non-earmarked loans edged up to 4.9% from 4.8%, with increases for both households and non-financial corporations.

We reduced our forecast for the IGP-M this year to 3.5% while maintaining our estimate for the IPCA

The consumer price index IPCA climbed 0.25% in August, after posting no change in the previous month, while the year-over-year rate remained around 6.5%. The result was slightly lower than our call (0.27%) and in line with the median of market expectations. Market-set prices in the IPCA rose 0.18%, while regulated prices increased 0.51%. The main upward contribution came from housing (0.14 p.p.), pressured by rentals and fees and electricity tariffs. Food prices receded for a third consecutive month. Transportation posted a small increase (0.3%), following a steep slide in the previous month (-1.0%). The IPCA is now up by 4.02% year to date (3.43% one year earlier), and the year-over-year change advanced slightly, to 6.51% (6.50% in July). Our preliminary forecast for September indicates a 0.37% increase in the IPCA.

Our forecast for the IPCA in 2014 is unchanged, at 6.3%. For market-set prices (weighing 77% in the IPCA), we estimate a 6.5% advance, down from 7.3% in 2013. Breaking down its main components, we estimate increases of 5.5% for food consumed at home (7.6% in 2013) and 8% for services (8.7% in 2013). Food and services represent nearly two-thirds of the weight attributed to market-set prices and a little over half of the IPCA. For regulated prices (weighing 23% in the IPCA), we forecast a 5.7% advance (1.5% in 2013), driven by electricity tariffs, health insurance premiums and gasoline. On the other hand, tariffs for landline phone, water and sewage services should decline, bringing relief amounting to 0.5 pp to regulated prices this year.

Our forecast for the IPCA in 2015 stands at 6.4%. We estimate a 7.0% increase in regulated prices, driven by substantial adjustments in electricity, water and sewage tariffs and urban bus fares. For electricity, we consider the financial impact of loans granted to power distributors this year, of the non-renewal of concessions for some generators (with cheaper energy entering the market), as well as other parameters used to calculate annual readjustments and tariff reviews (beginning of the fourth review cycle). Regarding water and sewage tariffs, we anticipate the end of discounts granted by São Paulo utility Sabesp this year, under a program to encourage lower water consumption. Urban bus fares, which had been frozen for a few years in some state capitals, especially in São Paulo, should increase to compensate for inflation. Market-set prices should climb 6.2% in 2015, thanks to lower price increases for food consumed at home and services. Still-favorable conditions for agriculture will likely impact food prices. Regarding private services, the cool-down process should be driven by the accommodation in the labor market and in the Real Estate sector, with a likely moderation in wage and rent costs. Weaker economic activity and the sharp slide in producer price indexes recently may translate into a slightly more favorable balance of risks for inflation in market-set prices late this year and in early 2015.

The general price index IGP-M posted deflation of 0.27% in August, marking a fourth consecutive month of negative changes. The producer price index IPA – the component with the largest weight in the IGP-M – fell 0.45%, with drops in agricultural prices (-0.9%) and industrial prices (-0.3%). Hence, the year-over-year change in the IGP-M receded to 5.3% in July from 4.9%. Deflation in the IGP-M in the past four months (-1.7%) was caused by the partial reversal of the shock in agricultural prices in March and April, due to a local drought, in addition to the effects of the drop in grain and iron ore prices in international markets, combined with a stronger exchange rate starting in April. Current data signal a moderate increase in the IGP-M in September, with the year-over-year change falling below 4%.

We reduced our forecast for the IGP-M this year to 3.5%, due to a lower-than-expected reading in August and the downward revision in some commodity prices. Our previous forecast was 4.2%. For the producer price index IPA-M, our forecast is slightly less than 2%, with increases of 2.2% for industrial prices and 1.3% for agricultural prices. We cut our forecast for iron ore prices to a 31% slide during the year, with an impact of -1.2 pp on the IGP-M. For the remaining components, we estimate advances of 6.3% for the consumer price index IPC-M and 7.0% for the construction cost index INCC-M.

Copom: no changes, for now

The Brazilian Central Bank’s Monetary Policy Committee (Copom) maintained the benchmark Selic interest rate at 11.00% p.a. in its September meeting, in a unanimous decision that was in line with expectations.

The Copom continued signaling that the Selic rate will remain stable ahead. The post-meeting statement was similar to the previous one, except for the removal of the expression “at the moment”. This expression has been used in the past to indicate the possibility of a change in the path for interest rates in the short term. The minutes of the meeting reinforced that sign, reaffirming that the committee’s strategy "does not contemplate a reduction in the monetary policy instrument”.

We thus maintain the scenario of stability in the Selic rate, at 11% p.a. until year-end.

For 2015, the scenario is uncertain and depends on the evolution of the economy. There are factors which could lead to either an increase or a decline in interest rates. Weaker economic activity is already causing some slack, which, over time, may translate into lower inflationary pressure. On the other hand, inflation being close to the upper bound of the central bank’s target range, additional adjustments in regulated prices and a possible depreciation in the exchange rate may require a bigger monetary policy effort so that inflation converges to the target.

In the absence of a clear bias, we maintain our forecast that the Selic rate will also be stable in 2015. We acknowledge that stability in the benchmark rate for so long is a rare event in Brazil, but we do not have enough visibility to anticipate the direction of the next move in the Selic rate.

Fiscal accounts: we reduced our forecast for the primary surplus in 2014

The primary surplus continues to shrink. The consolidated public sector posted a primary deficit of 4.7 billion reais in July, resulting from deficits of 1.9 billion reais for the central government, 2.2 billion reais for regional governments and 603 million for state-owned companies. The conventional primary surplus accumulated over 12 months receded to 1.2% of GDP in July from 1.4% in June. Our estimate for the recurring primary surplus was revised downward, to 0.3% from 0.5%.

The net debt of the public sector is up by 1.5 pp of GDP year to date. The net debt of the public sector advanced to 35.1% of GDP in July, vs. 34.9% in June and 33.6% by the end of 2013. The nominal deficit accumulated over 12 months expanded to 3.8% of GDP in July from 3.6% in June. In addition to the decline in the primary surplus, this move was also driven by an increase in interest expenses, to 5.1% of GDP from 5.0%. We see an upward trend in interest expenses ahead due to a steady increase in financing costs for public debt, implying that, for the same level of primary surplus, the nominal deficit will be larger, putting more upward pressure on the trend for public debt.

Federal revenues continue to slow down, due to weak activity. Total central government revenues are down by 0.1% year to date in real terms. Tax revenues fell the most (-1.2%), while pension intakes are up by 1.3% and other (non-tax) revenues are down by 1.0%. As economic activity decelerated more sharply than expected this year, we reduced our forecast for real growth in tax revenues to 0.0% from 0.6%, meaning an impact of 5 billion reais.

Expenditures, despite having decelerated, remain growing faster than the estimated potential GDP growth. The pace of expenditures, therefore, implies a still-expansionary fiscal stance. Total expenditures increased 3.2% year to date in real terms, slowing down from 2013 (+6.4%). Discretionary expenses picked up in July, sustaining year-to-date growth at high levels. Investments climbed 14.3%, and other administrative expenses advanced 5.5%, using the same metrics. We still expect investment expenditures to slow down in coming months, but we have revised our estimate for real growth upward this year, to -0.3% from -7.0%, meaning an impact of 4 billion reais.

We reduced our forecast for the conventional primary surplus this year to 1.1% of GDP (target: 1.9%) from 1.3%. Our estimate for the recurring primary surplus was lowered to 0.4% from 0.6%. In the next months, the primary surplus will probably benefit from a high volume of atypical revenues, particularly from dividends and the tax amnesty program known as Refis. On the other hand, in the face of weak economic activity, a substantial recovery in tax revenues is unlikely. Furthermore, some mandatory expense lines tend to pick up in the next months, due to disbursements of expenses that were postponed early in the year.

For 2015, we expect the primary surplus to widen to 1.5% of GDP. In an economic and financial cycle that is less favorable to stronger fiscal results, this forecast implies that the fiscal impulse (defined as the change in the structural primary surplus as a percentage of GDP) will be negative next year.

As imports decline, the trade balance turns to a surplus year to date

The trade balance reached USD 249 million in the first eight months of the year, becoming positive for the first time in 2014. In 2013, the year-to-date trade balance only posted a surplus in December. Despite a stronger balance in 2014, exports are down by 1.7% this year due to the decline in international prices for key exported commodities and lower sales of manufactured items, particularly to Argentina. Imports are also down (-4.1% year to date), in the face of weakness in economic activity, partly offsetting the negative effect of lower shipments to other nations.

We revised our forecast for the trade balance upward in 2014, to USD 2.5 billion from USD 1.4 billion, largely because of the slower pace of economic growth, which has curbed demand for imports. However, we reduced our forecast for the trade balance in 2015 to USD 10.3 billion from USD 12.6 billion, due to a revision in forecasts for international prices of some exported commodities, particularly soybeans and iron ore.

The current account deficit narrowed to 3.5% of GDP, after nearly one year steady at 3.6% of GDP. In July, the current account gap reached USD 6 billion, despite a positive contribution from the trade balance. The service deficit advanced, pressured by equipment rentals (related to increases in crude oil output and pro forma exports of oil-drilling rigs last year). In terms of capital flows, foreign direct investment remains at high levels (2.8% of GDP), offsetting the decline in portfolio investment flows to the local market.

We revised our forecasts for the current account deficit to USD 82.3 billion from USD 83.4 billion in 2014, and to USD 74.4 billion from USD 72.1 billion in 2015, following revisions in estimates for the trade balance.

Our year-end exchange rate forecasts are unchanged, at 2.40 reais per U.S. dollar in 2014 and 2.50 in 2015. With stronger signs of recovery in the U.S. economy, portfolio flows to emerging markets tend to decline, putting pressure on the Brazilian real and its peer currencies. However, the central bank continued to act in the currency market so as to prevent excessive volatility. In August, the real fluctuated between 2.23 and 2.30 to the U.S. dollar.

Marina leads by 4 percentage points in the second round simulation

In the first round, Dilma is the leader. According to the latest Datafolha released on September 10, Dilma leads with 36%, while Marina has 33% and Aécio has 15% of total votes. The other candidates sum 3%, while the percentage of undecided voters is 7% and those who say they would vote blank or null are 6%. The government’s approval rate (percentage of good/great evaluations) is stabilized at 36%.

But in the second round, Marina is ahead. Marina has an advantage of 4 percentage points over Dilma: 47% to 43%. In a poll at the end of August, this gap reached 10 percentage points. In the simulation against Aécio Neves, Dilma wins by 49% to 38%. Marina leads in the Southeast, in the South and in the Center-West; among those with high school and university degree; among those that earn more than 2 minimum wages; and in the cities with more than 50 thousand inhabitants. Dilma leads in the North and in the Northeast; among those with basic education; those that earn up to 2 minimum wages; and among those living in cities with less than 50 thousand inhabitants. The first round of the election is scheduled for October 5 and the second round, October 26.

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