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Economy improves amid greater risks

December 8, 2017

Pension reform back on the table, but there is still uncertainty regarding its approval

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

We increased our forecast for GDP in 2017 to 1.0% from 0.8%, after incorporating the revision of the historical series and the results for 3Q17. We estimate growth at 3.0% for 2018 and 3.7% for 2019, but we see downside risks if the outlook for public accounts changes.

The government introduced a watered-down version of the pension reform, but there is still uncertainty regarding its approval by the congress.

We trimmed our forecast for inflation this year to 2.8% and maintained our call for 2018 at 3.8%. Our estimate for the consumer price index IPCA in 2019 stands at 4.0%.

Our year-end forecasts for the exchange rate are unchanged, at BRL 3.25 per USD in 2017, 3.50 in 2018, and 3.60 in 2019.

After cutting the Selic rate by 50 bps in early December, the Monetary Policy Committee (Copom) is set to further reduce the easing pace to 25 bps in its next meeting, in February 2018. We expect no increase in interest rates in 2018, with a rise only in 2019, when the Selic should reach 8.0%.

Activity: Revised path and strong demand in 3Q17 improve GDP outlook

The real GDP path since 2015 was revised upward. Census bureau IBGE incorporated 2015 annual accounts in its regular revision, lifting the real GDP change to -3.5% from -3.8% for 2015, and to -3.5% from -3.6% for 2016. Figures for 1H17 also improved (affected by adjustments in gross GDP as well as seasonal changes), as growth rates were revised to 1.3% from 1.0% for 1Q17 and to 0.7% from 0.2% for 2Q17.

GDP slows down in 3Q17, but domestic demand shows robust growth. In 3Q17, GDP rose 0.1% qoq/sa, in line with our call. Notwithstanding a weak reading, the breakdown reflected a pickup in domestic demand (see chart). Household spending climbed 1.2%, moving up despite the end of withdrawals from inactive accounts held under the FGTS employment protection program. Gross fixed capital formation rose 1.6%, after 15 negative quarters.

We forecast 0.2% qoq/sa growth for 4Q17 GDP (2.3% yoy). Our estimate is based on fundamentals, higher confidence levels (suggesting slightly stronger growth) and coincident indicators (which signal a slightly weaker evolution).

After we incorporated the revised numbers and adjusted our outlook for 4Q17, we increased our estimate for 2017 GDP to 1.0% from 0.8%.

Our forecast for 2018 is 3.0%, but the risks are tilted to the downside. Firstly, preliminary information regarding supply-specific conditions (lower agricultural GDP and possibly more intense use of thermal power plants) represents a downside to the scenario. Secondly, a deterioration of financial conditions might be triggered by greater uncertainty over reforms and/or worse liquidity for emerging markets, hurting activity.

In 2019, sustained financial conditions and better statistical carry-over should drive growth to 3.7%.

These forecasts assume continuity of the reform agenda. If this process is interrupted or reversed, the recovery could be jeopardized, especially if the reduction of global monetary stimuli becomes more pronounced.

Gradual recovery in the labor market continues. In October, 76,600 formal jobs were created (according to the Ministry of Labor’s CAGED registry). The seasonally adjusted moving average improved to 17,000 from -5,000, and it has been improving gradually since 2Q16. The national household survey PNAD Contínua shows that unemployment has been receding since March.

We expect the seasonally adjusted unemployment rate to decline to 11.8% by the end of 2018 and to 10.9% for 2019, compared with 12.5% in the quarter ended in October. In our view, the decline in unemployment will be increasingly driven by formal jobs rather than informal positions.

Thus, unemployment is set to remain higher than its neutral level (which we estimate at 10%, but that could recede to lower levels due to the labor reform; see “Macro Vision – Labor Reform: Potential Impacts”), at least until the end of 2019. Therefore, we do not anticipate inflationary pressures arising from the labor market during this period.

Pension reform back on the table, but there is still uncertainty regarding its approval

The government introduced a watered-down version of the pension reform and expects to bring it to a vote in the lower house before year-end. The new version focuses on establishing a minimum age of retirement of 65 for men and 62 for women, maintaining a 20-year transition rule from the current rules, in addition to the equalization of rules for public and private sector employees.

According to our calculations, the watered-down reform would have 60% of the original government’s proposal impact — 1.20 pp of GDP in 2025 on private sector pensions (see chart), and 0.20 pp of GDP on public sector pensions.

However, there is still uncertainty regarding its approval in congress. Without a reform, the government is less likely to meet its constitutional spending cap after 2019, negatively influencing the gradual return to a situation of primary budget surpluses that are compatible with public debt stabilization. If public debt remains on its current, unsustainable path, it increases the uncertainties about the consistency of the economic recovery and the maintenance of interest rates at historically low levels.

For 2017, we estimate the primary budget deficit at 2.3% of GDP (or BRL -150 billion), compared with its target of BRL -163 billion (-2.5% of GDP). Due to positive surprises in terms of extraordinary and recurring revenues, lower-than-expected mandatory expenses and better results for states and municipalities, the government should post a primary result that is slightly better than the target set for the consolidated public sector — even if it reverses BRL 20 billion in spending freezes announced throughout the year.

For 2018, our expectation is a deficit of 2.1% of GDP (BRL -150 billion), compared with the target of BRL -161 billion (or -2.3% of GDP). As spending is fixed exactly at its constitutional cap, positive surprises in terms of revenues – such as better economic growth than contemplated in the budget law (our 3.0% call vs. the government’s 2.0%) – or faster progress in the schedule of asset sales would imply beating the target. On the other hand, non-compliance risks involve not compensating for the loss of at least BRL 20 billion after the judicial decision that removed the ICMS tax from the PIS/Cofins base and the rejection of adjustment measures sent to Congress, such as taxing closed-end funds and delaying wage adjustments for public servants. 

For 2019, our call for the primary deficit is -1.0% of GDP (BRL -80 billion). Compliance with the spending cap for the year requires an adjustment of approximately BRL 30 billion, which, in our view, will be executed through additional reductions in discretionary spending and a reversal of payroll tax breaks.

BRL depreciated amid pension reform uncertainty

The BRL depreciated again in November amid uncertainties over the pension reform. Political uncertainties around the voting of the reform remained high and pressured the exchange rate during the month, reaching its weakest level against the U.S. dollar since June. Nevertheless, the currency remains range-bound (between BRL 3.20 and BRL 3.30 per USD), as does the country risk premium, which remained well-behaved, at around 175 bps.

Our year-end forecast for the exchange rate is unchanged, at BRL 3.25 per USD, depreciating to 3.50 in 2018 and 3.60 in 2019. The increase in interest rates in the U.S. (albeit gradual) and tighter financial conditions will likely reduce global risk appetite, supporting a weaker exchange rate in the coming years. Domestic uncertainties surrounding adjustments and reforms tend to persist. 

The biggest risk to our call is the progress of the reform agenda, particularly the adjustment in public accounts. If the agenda advances more quickly or deeply than we anticipate, there may be a swift appreciation of the Brazilian real. On the other hand, a reversal may trigger a depreciating trend.

The strong trade surplus has helped to maintain low current account deficits. The seasonally adjusted annualized three-month moving average for the deficit receded again, to USD 4.5 billion in October. Recovery in domestic demand and lower (average) prices for the main commodities exported by Brazil should produce weaker readings next year. In terms of financing, direct investment in the country remains robust, hovering at USD 80-85 billion since the beginning of the year and covering the current account deficit multiple times. Meanwhile, volatile capital flows (i.e., portfolio flows) are still negative over 12 months, although outflows are substantially thinner now.

For the next few years, we maintain our expectation for a gradual increase in the current account deficit, but not to the point of compromising Brazil’s external sustainability. We estimate trade surpluses[1] of USD 65 billion in 2017, USD 55 billion in 2018 (from USD 50 billion previously, after we incorporated a revision in exported and imported quantities), and USD 50 billion in 2019. Our estimates for the current account deficit stand at USD 15 billion in 2017, USD 34 billion in 2018 and USD 46 billion in 2019.

We trimmed our inflation forecast for 2017 and maintained our call for 2018 at 3.8%

We reduced our forecast for the consumer price index IPCA in 2017 to 2.8%, slightly below the lower bound of the inflation target range (3.0%). The forecast was revised (3.3% in the previous report) due to lower-than-expected readings lately for food and services, as well as the definition of the red tariff flag system for electricity prices at Level 1 in December (we had assumed Level 2). Hence, the extra charge on electricity bills in December will be BRL 3.00 per 100 kWh used instead of BRL 5.00 (impact of -0.14 pp on the IPCA).

Breaking down the index, we expect market-set prices to rise 1.2% (1.7% in the previous report) and regulated prices to advance 7.9% (8.4% in the previous report). Among market-set prices, we anticipate 5.0% deflation for food consumed at home, after a 9.4% increase last year, providing a relief of 2.4 pp to annual inflation. Plentiful crops — amid favorable weather in Brazil and other major global producers — have caused significant declines in producer prices since September 2016, with a favorable impact on retail food prices. We expect industrial prices to rise 1.0% (4.8% in 2016). For service prices, we forecast a 4.4% gain this year (6.5% in 2016). The slide in inflation of industrial and service prices — which are more sensitive to the economic cycle (output gap) — is set to provide a 1.7 pp relief to headline inflation this year. Regarding regulated prices, the estimated 7.9% hike (5.5% last year) will provide an additional contribution of 0.6 pp to 2017 inflation. Breaking down the estimate, we have the following forecasts for the main components: -5.4% for landline phone service, 4.0% for urban bus fares, 4.4% for medication, 9.6% for gasoline, 10.3% for electricity tariffs, 10.4% for water and sewage tariffs, 13.5% for health insurance premiums and 17.5% for bottled cooking gas. As for gasoline, about 8.0 pp of the annual result will be driven by tax hikes (PIS/Cofins). As for electricity, 6.0 pp of the estimated increase will be caused by the extra charge under the tariff flag system, due to more intense use of thermal power plants.

Our 2018 inflation estimate stands at 3.8%. Breaking down the index, we expect market-set prices to rise 3.4% and regulated prices to climb 5.1%. Our below-target inflation estimate for next year will be driven by less inertia from past inflation, anchored inflation expectations and a negative output gap. As for market-set prices, the decline in food prices is set to be reversed (given the low comparison base and less favorable weather conditions than in 2017), a sharper increase in industrial prices after a low reading expected for 2017 and another drop in service inflation due to less inertia.

Our 2019 forecast points to the IPCA around 4.0%, with market-set prices advancing 3.9% and regulated prices climbing 4.3%. 

The main risk factors for the inflation scenario are still tied to domestic politics and the evolution of the international scenario. Rising political uncertainty has hindered progress in reforms and adjustments required for the economic rebound — particularly the pension reform — and may at some point cause risk premia to increase and impact the exchange rate. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as new tax hikes and/or a reversal of tax breaks, with greater risks in 2019. As for the external situation, despite still-favorable signs at the margin — with sustained risk appetite for emerging market assets — there are policy risks in central economies which could eventually cause deterioration in risk premia, impacting the local currency and domestic inflation.

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 — notwithstanding some recent improvement — may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items. 

More favorable inflation inertia also imparts downside risk to 2018 inflation. Prices for food consumed at home have been more favorable than anticipated. The downside to 2018 inflation refers to possible second-round effects of the supply shock seen this year, not only on services tied to food consumed away from home, but especially through the inertial effect of past inflation. Importantly, food deflation throughout this year has contributed to lower readings in the INPC, a consumer price index focused on a tighter income bracket (up to five minimum wages), where food expenses weigh more on the household budget. The INPC guides not only the adjustment in the monthly minimum wage, but also a substantial share of private sector wages. Hence, results for the INPC that are lower than for the IPCA – we expect the INPC to rise 2.0% in 2017, the lowest in the historical series for a full year – may produce an even more favorable inertial effect on 2018 inflation.

Inflation expectations remain anchored, with comfort in relation to the targets in 2017 and 2018. The median of market expectations for inflation, as per the central bank’s Focus survey, slid to 3.03% from 3.08% in 2017 and remained at 4.02% for 2018. The median estimates for 2019 and 2020 remained at 4.25% and 4.0%, respectively, anchored on the targets set for these years.

Monetary policy: As slow as possible

In early December, the Copom delivered a widely expected 50bps rate cut, taking the Selic to 7.0%, an unprecedented low. The Copom noted that the evolution of economic conditions as expected and the stage of the easing cycle warranted such reduction in the Selic rate at this meeting, as previously signaled.

In the post-meeting statement, the Copom indicated, quite clearly, that it will likely cut the Selic by 25bps, to 6.75% in its next policy meeting, in February 2018. It seems the economy would have to surprise in a major way to change the Committee´s view on such movement. The statement also hints that the end of the easing cycle is very close.

For now, we expect  the Copom will cut the Selic to 6.5%, in two 25bps increments, in February and March, rather than in a single 50bps move. But we reckon that absence of progress on the fiscal adjustment and reform agenda would make the second 25bps cut less likely, and hence increase the likelihood that the cycle ends with the Selic at 6.75%. We will know more about the thinking of the monetary authority with the release of the minutes, next Tuesday, at 08:00 Brazil time.

Interest rates will not be increased in 2018. Although the recovery in activity gained momentum, the output gap is set to remain open, and inflation tends to remain below its target. The greatest risk to this outlook is sharper exchange rate depreciation due to a reversal in reforms or harsher removal of global monetary stimuli, which could put pressure on inflation and demand a timely response from the Copom.

Interest rates will rise moderately in 2019. As unemployment approaches neutrality, interest rates are set to normalize at their long-term levels, which, in turn, depend on the reforms. Hence, we expect the Copom to lift the Selic to 8% by the end of 2019. We see a single-digit Selic rate as sustainable in the long run, as long as the country manages to return its public accounts to a sustainable path for an extended period of time.


 


[1] As per the Ministry of Trade (MDIC)


 

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



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