Itaú BBA - Easing cycle: another cut, followed by a pause

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Easing cycle: another cut, followed by a pause

March 9, 2018

We now expect the central bank to reduce the Selic rate to 6.5% in March and interrupt the cycle right after that.

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

We reduced our estimate for the primary budget deficit in 2018 to 1.9% of GDP from 2.0%, reaffirming our expectation that the government will easily meet its target.

GDP expanded 0.1% in 4Q17, consolidating the recovery, notwithstanding a seemingly weak reading. Our growth forecasts are for 3.0% in 2018 and 3.7% in 2019.

We maintained our exchange-rate forecasts at BRL 3.25 per USD for YE18 and 3.30 for YE19.

We maintained our inflation forecasts at 3.5% for 2018 and 4.0% for 2019.

We expect the Monetary Policy Committee to reduce the Selic rate to 6.5%, given surprises in the latest economic data, which are substantial enough to warrant a final rate cut in March.

Fiscal readings continue to improve, but their sustainability depends on reforms

Short-term fiscal results continue to improve 

We reduced our estimate for the primary budget deficit in 2018 to 1.9% of GDP (BRL 137 billion) from 2.0% of GDP (BRL 145 billion). This supports our belief that meeting the target of BRL 161 billion (2.2% of GDP) and the spending cap will be less challenging this year. Fiscal results in 2018 will benefit from larger extraordinary revenues, particularly those related to tax amnesty programs (Refis), and lower mandatory spending on subsidies. 

Debt dynamics and the “golden rule” will not be a source of concern this year. As development bank BNDES repays BRL 130 billion to the National Treasury, the government will be able to comply with the so-called golden rule this year. Notwithstanding still-negative primary results, this repayment, better economic growth and lower real interest rates will contribute to keep gross debt as a share of GDP virtually stable in 2018.

However, without reforms, fiscal results will slip back into a deteriorating trend from 2019 onward. The pension reform, a prerequisite for rebalancing public accounts, is no longer being pushed through Congress and, most likely, will only get back on the table in the next administration. If controlling public expenses (as set by the spending cap) is not made feasible, gradual convergence to primary surpluses that are compatible with public debt stabilization will be halted. If the currently unsustainable trend in public debt is maintained, the rebound in economic activity and sustainability of interest rates at historically low levels will be in jeopardy.

For 2019, we estimate the primary deficit at 0.9% of GDP (BRL 80 billion). Compliance with the spending cap will require an adjustment of about BRL 30 billion, which, in our view, will come in the form of discretionary spending cuts and a reversal of payroll tax breaks.

Activity: 4Q17 GDP consolidates the rebound

GDP expanded 0.1% qoq/sa in 4Q17 and 2.1% yoy, in line with our estimate (0.1%) and below the median of market expectations (0.3%).

Notwithstanding a seemingly weak reading at the margin, 4Q17 GDP led to 1.0% growth in 2017 and consolidated the rebound in economic activity. Importantly, weaker GDP growth in seasonally adjusted terms in the second half of 2017 is related to the accounting treatment of the huge crop in the first half. Consequently, GDP readings for the beginning of the year were much higher than underlying growth, while the opposite occurred in the second half.

The dynamics in domestic demand (consumption and investment) picked up in the second half, providing evidence that the rebound in economic activity is consolidating (see chart).

Additionally, our preliminary forecast for GDP growth in 1Q18 is 1.0% qoq/sa (2.4% yoy). If confirmed, this reading would reinforce our view that the seemingly weak result in 4Q17 merely reflects noise in the data rather than a change in trend.

Our growth estimates are 3.0% in 2018 and 3.7% in 2019, but we see downside in the balance of risks. These forecasts assume that reforms will continue in the future. If an interruption occurs or if there is a perception that the reform process is reversing, then the recovery in economic activity may be threatened.

According to the national household survey (PNAD Contínua - IBGE), Brazil’s nationwide unemployment rate rose to 12.2% in the quarter ended in January from 11.8% in 4Q17. Using our seasonal adjustment, unemployment rose 0.1 pp, to 12.5%, due to a 0.1 pp increase in the participation rate (ratio of the labor force to the working-age population).

The contribution coming from the self-employed has become less significant to the decline in unemployment. Informal employment was virtually stable in seasonally adjusted terms in the last two monthly reports, halting a sequence of eight increases during 2017. PNAD Contínua shows an additional modest decline in formal employment in the private sector, but another indicator, the CAGED registry, reveals a net creation of about 50,000 jobs per month. The chart below shows that such decoupling trends are being reversed and fall in line with CAGED figures.

Using models that take into account the sensitivities of different occupations to the pace of economic activity and our GDP scenario, we expect the unemployment rate (using our seasonal adjustment) to recede to 11.7% by YE18 and to 10.7% by YE19, as formal jobs generate an increasing contribution. Our forecasts for the average unemployment rate are 12.0% for 2018 and 11.0% for 2019 (2017: 12.7%).

Stable BRL despite global volatility

Notwithstanding the recent volatility in international markets, the Brazilian currency remained range-bound in the past month (BRL 3.20-3.30 per USD). Synchronized global growth and lower global risk aversion have supported the currency, even during a correction in some global asset prices.

We maintain our exchange rate forecasts at BRL 3.25 per USD by YE18 and BRL 3.30 by YE19. Stronger and more widespread global growth will continue to support risk assets, including emerging market currencies. Domestically, although uncertainty remains high (especially over the approval of fiscal reforms), meeting the fiscal target in 2018 will be less challenging, thanks to the rebound in economic growth. Risk premiums required for investment in Brazil (measured by CDS spreads) tend to remain at moderate levels, and the BRL will likely be somewhat stable over the next quarters.

The greatest risk to our forecast is the domestic environment, particularly the fiscal reform agenda. If this agenda advances more quickly than we anticipate, the local currency could appreciate suddenly. On the other hand, a reversal or expected setback could lead to a falling trend in the exchange rate.

External accounts remain benign. February data showed a stronger trade surplus at the margin. Exports increased, led by the pro forma export transaction of an oil-drilling rig. Imports picked up in recent months but remain at historically low levels. Excluding the rig, the quarterly moving average of the trade surplus points to stability at the margin.

For the next few years, we expect larger current account deficits, but not to the point of compromising Brazil’s external accounts. In our view, the rebound in domestic demand will produce wider current account deficits. Trade surpluses, which were behind low current account deficits in recent years, are set to weaken in the future. We estimate trade surpluses1 of USD 55 billion in 2018 and USD 42 billion in 2019. For the current account, we anticipate deficits of USD 32 billion in 2018 and USD 51 billion in 2019.

We maintain our inflation forecasts at 3.5% for 2018 and 4.0% for 2019

For 2018, our forecast for the consumer price index IPCA remains at 3.5% Throughout the year, we expect increases of 0.8% in 1Q18 (2.7% yoy), 1.2% in 2Q18 (3.7% yoy), 0.6% in 3Q18 (3.8% yoy) and 0.9%  in 4Q18. 

Breaking this down further, we anticipate increases of 3.1% in market-set prices (1.3% in 2017) and 4.7% in regulated prices this year (8.0% in 2017). We expect the following: inflation still to track below the target due to lower inertia from past inflation; a relatively stable exchange rate; a still-favorable agricultural crop (albeit smaller than last year), ensuring good inventory levels; anchored inflation estimates; and a negative output gap. As for market-set prices, we anticipate a 3.7% hike in costs for food consumed at home, after a 4.9% slide in 2017. We project that industrial prices will climb 2.1% (following an unusually low reading of 1.0% in 2017), with some cost pressure due to higher steel prices (already reflected in producer prices), especially in the automotive and appliance segments. Service prices are likely to slow down again, to 3.4% from 4.5%, largely because of lower inflationary inertia. Regarding regulated prices, the main products are set to post smaller increases than in 2017, particularly gasoline, bottled cooking gas, electricity, and water and sewage tariffs. Looking at electricity in particular, we assume that the tariff flag system will be in yellow mode by December 2018. For gasoline, we expect it to be impacted by a decline in oil prices from current levels, to USD 58/bbl for Brent crude by year-end.

For 2019, our forecast for the IPCA remains at 4.0%. We expect market-set prices to rise 3.7% and regulated prices to climb 4.6%. 

The main risk factors for the inflation scenario are still tied to domestic politics and the evolution of the international scenario. Uncertainties over the political/election scenario may disappoint expectations regarding the approval of reforms and other adjustments needed to revive the economy. This could trigger deterioration in risk premiums and impact the exchange rate and the inflation path. A setback in reforms, despite the negative effect on economic activity, could also require alternative fiscal measures in the future, such as tax hikes and/or a reversal of tax breaks. As for the external situation, there are promising signs, including the outlook for stronger and synchronized global growth and sustained risk appetite for emerging market assets, but one cannot rule out economic policy changes in the developed world and tighter global financial conditions eventually.

Substantial slack in the economy may contribute to a sharper decline in inflation in 2018. The negative output gap and, consequently, unemployment above its equilibrium level for a longer period (despite some recent improvement) could cause more persistent disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items.

More favorable inflation inertia also presents downside risk to 2018 inflation. The sharp slide in agricultural and retail food prices last year, thanks to a favorable supply shock, contributed to a 2.9% increase in the IPCA, which came in below the lower bound of the inflation target range, as well as to even-lower readings for other inflation indicators, particularly the INPC (2.1%) and IGP-M (-0.5%). The INPC – whose basket is focused on a tighter income bracket of households earning up to five monthly minimum wages – is used to calculate adjustments in the minimum wage and is also a benchmark for most wage adjustments in the private sector. Certain favorable effects are also likely to arise from low readings for the IGP-M, used to adjust some regulated prices and home rental contracts. Hence, year-over-year inflation readings below those captured by the IPCA, which should prevail at least until mid-year, may cause an even more favorable inertial effect on headline inflation in 2018.

Inflation expectations remain anchored, with breathing room in relation to the 2018 target. The median of market expectations, as per the central bank’s Focus survey, slid to 3.70% from 3.94% in 2018 and remain well below the 4.50% target. The median estimate for 2019 receded to 4.24% from 4.25% and remained at 4.00% for 2020, and both were anchored on the targets set for these years.

Monetary policy: Another cut, followed by a pause

In February, the Central Bank’s Monetary Policy Committee (Copom) signaled that the end of the cycle is near, after it reduced the benchmark Selic rate to a new all-time low of 6.75% p.a. The main message of the minutes from the meeting was that the Copom had the intention to keep the rate unchanged in its next decision (on March 21), unless inflation readings are continually lower than anticipated. 

Data released since then seem to have provided enough surprise to convince the Copom to move away from its flight plan and add a final boost in its next meeting. Hence, we revised our call and we now expect the central bank to reduce the Selic rate to 6.5% in March and interrupt the cycle right after that. While weaker-than-anticipated inflation and activity figures justify this final cut, we do not expect the monetary policy rate to fall below 6.5%, as the Copom will likely continue to see convergence toward the target in 2019 (which gradually becomes the meaningful horizon for monetary policy). This decision is also likely to be based on the recovery in economic activity, the lagged effects of monetary policy (which will continue to provide a boost to the economy) and the balance of risks in the international scenario, which became less favorable recently due to the outlook for additional interest rate hikes in the U.S. and election-related uncertainties in Europe.

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