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Economy Playing Defense, Unchanged Interest Rates in 2015

July 11, 2014

Coincident indicators point to weaker activity in 2Q14.

• Faced with evidence of more weakness in current economic activity and deteriorating consumer and business confidence, we revised downward our forecast for GDP growth in 2014 to 0.7%. We expect negative GDP growth in 2Q14, followed by a recovery during the second semester, but slower than our previous estimate. For 2015, our GDP growth forecast was reduced to 1.5% from 1.7%. 

• We maintain our forecast for the consumer price index IPCA in 2014 at 6.5%, with market-set prices climbing 6.8% and regulated prices rising 5.6%. However, recent deflation in producer price indexes, in a context of weaker economic activity and a stronger exchange rate, may result in a more favorable balance of risks for inflation throughout the second half. For 2015, we also expect 6.5% IPCA inflation, with a sharper increase in regulated prices and some deceleration in market-set prices. 

• We believe that weaker growth will lead the Monetary Policy Committee (Copom) to keep the benchmark Selic interest rate at 11% in 2015 as well, even with inflation remaining at the upper-limit of the target range in 2014 and 2015. This path is consistent with the signaling from the latest Inflation Report. 

• The announcement of the extension of the Central Bank’s daily intervention program should help to support the Brazilian currency at a more appreciated level in the short term. However, we continue to expect the exchange rate to weaken before year-end, driven by changes in the international scenario and domestic uncertainties (in the fiscal sphere, for instance). We revised our year-end forecasts for the exchange rate to 2.40 reais per U.S. dollar in 2014 and 2.50 in 2015.

• The wide primary budget deficit posted by the public sector in May reduced further the likelihood of reaching the fiscal target this year. We maintain our forecast for the primary budget surplus this year at 1.3% of GDP (target: 1.9%).

• The latest poll shows some improvement in voter intentions for President Dilma Rousseff in the first round, but a more difficult victory in the second round.

Cut in our growth forecast for the year

Coincident indicators point to weaker activity in 2Q14. We observe sluggishness in both production and sales. Reports show lower sales in supermarkets and auto dealerships (with a sharp decline in June, going back to levels seen in mid-2010). Industrial production fell for a third consecutive month in May, with a widespread retreat which reached 15 out of 24 surveyed sectors.

In the short term, the outlook is for negative GDP growth. Business confidence levels fell in June, particularly among industrial entrepreneurs (-3.9% mom/sa). Industrial inventories remain high, despite the slowdown in output, while labor market figures already point to a retreat in formal employment. Furthermore, the industrial sector should be impacted in June by the reduction in working hours in several segments due to the Soccer World Cup. Our diffusion index, which contemplates other economic sectors from both the demand and supply perspectives, remains at a low level. In May, only 34% of indicators had gone up in the previous three months. Beside gauging the current situation, the diffusion index has predictive power for the following quarter, also pointing to lower growth (the month-over-month performance of 2Q14 contributes with a weaker statistical carryover). We estimate a decline in GDP of 0.3% qoq/sa in 2Q14.

We reduced our forecast for GDP growth in 2014 to 0.7% from 1.0%. In our view, some of the decline in confidence levels is related to temporary factors, such as fewer working hours due to the World Cup. Therefore we expect some recovery after this period, with 0.3% growth in both 3Q14 and 4Q14, still below potential. With a weaker statistical carry-over, we expect the economy to resume moderate growth in 2015, of 1.5% (1.7% in our previous projection).

Unemployment remains low. The unemployment rate for May was not published due to delays caused by a worker strike at the statistical agency IBGE. Anyhow, we estimate that, in the four metropolitan regions with published data (Belo Horizonte, Recife, Rio de Janeiro and São Paulo), the seasonally-adjusted rate stood at 4.4% in May vs. 4.3% in April. Despite the slight increase, the unemployment rate remains at a low level.

We understand that unemployment is sustainably low, despite weakness in job creation, because the labor force has been shrinking since October 2013 in a year to year basis. However, such dynamics will be exhausted at some point, and we expect a moderate increase in the unemployment rate (our year-end forecasts are 5.3% in 2014 and 5.6% in 2015). Sluggish growth in the working population limits growth in the real wage bill.

More rainfall and lower electricity usage contribute to lift reservoir levels at hydropower dams, but risks remain. Above-average rainfall combined with lower electricity usage led to higher reservoir levels in June, going in the opposite direction of the seasonal pattern of decline for that month. Hence, reservoir levels have moved away from the “Risk Aversion Curve,” which sets the minimum level in each sub-system that is necessary to meet the full load. Still, the scenario for 2015 is still marked by risks. First of all, the slide in electricity usage is temporary (caused by the World Cup). Second, the rise in reservoir levels is concentrated in the South basin, where reservoirs are close to 100% capacity. When they reach their limit, additional rainfall cannot be used. All in all, the scenario of high utilization of thermal power plants and rationing risks is still on, despite the favorable evolution observed in June.

Credit market remains weak. The daily average of new non-earmarked loans expanded 0.1% mom/sa in May in real terms. Real year-over-year growth in outstanding loans continues to cool down, moving to 6.0% in May from 6.7% in April. Growth in earmarked loans slowed to 14.9% (16.0% in April), while earmarked credit receded (-0.6% vs. -0.1% in the previous month). Overall delinquency, which stood at 3.0% for five months, advanced to 3.1%. The rise in delinquency was driven by non-earmarked loans (5.0% vs. 4.8% in the previous month), with higher rates for both households and non-financial corporations. Interest rates remain on an upward trend.

IPCA should remain on the upper-limit of the target range this year and next year

The consumer price IPCA slowed down in June, but the year-over-year change hit 6.52%. The IPCA rose 0.40% in June, slightly above our forecast (0.38%) and the median of market estimates (0.39%). Services related to tourism (airfares and lodging) provided the strongest inflationary pressure, reflecting the effect of the World Cup. On the other hand, foodstuff and fuel prices mitigated the rise in the IPCA. The year-over-year change in the IPCA accelerated to 6.52% from 6.37% in May. Our preliminary forecast for July points to a 0.15% lift. The drop in monthly inflation would be largely due to deceleration in the transportation and personal expenses groups, as airfare and lodging prices recede. On the other hand, the housing group must exert additional pressure, reflecting the adjustment in electricity tariffs in São Paulo. Even with inflation receding at the margin, the year-over-year change in the IPCA should pick up to 6.65% in July and remain around this level until November.

Our forecast for the IPCA in 2014 is unchanged at 6.5%, despite a small increase in our estimate for regulated prices. Our expectation for regulated prices was adjusted to 5.6% from 5.4%, as we incorporated a higher-than-anticipated increase of 18% in tariffs charged by utility company Eletropaulo. Our scenario for regulated prices still considers a lift in gasoline prices (5% at the pump) in 4Q14. Our forecast for market-set prices remains at 6.8%. Recent deflation in producer price indexes, in a context of weaker economic activity and a stronger exchange rate, may bring additional relief to inflation for market-set prices throughout the second half.

Our forecast for the IPCA in 2015 was also maintained at 6.5%, with a sharper increase for regulated prices and a smaller change for market-set prices. Our estimate contemplates lifts of 7.3% for regulated prices and 6.3% for market-set prices. The scenario for regulated prices includes substantial increases in important sub-items, such as electricity tariffs (14%), water and sewage tariffs (12%), urban bus fares (10%) and gasoline (6%). Yet, we cannot rule out the possibility of a more gradual correction of these prices. For market-set prices, the slowdown from the expected figure for 2014 will be caused by smaller increases in food and service prices. Regarding food, we are counting on more favorable weather for agricultural production. In the service sector, the relief should be enabled by some accommodation in the labor market and in the real estate segment, with a likely decompression on wages and rents. In a broader context, weaker economic activity may be translated into a slightly more favorable balance of risks for inflation in market-set prices later this year and early next year.

The General Price Index IGP-M ended June with larger-than-expected deflation of 0.74%, after dropping 0.13% in May. The producer price index IPA fell 1.44%, extending a 0.65% slide in the previous month, with deflation for both agricultural prices (-3.73%) and industrial prices (-0.55%). Hence, the year-over-year change in the IGP-M slowed to 6.2% from 7.8% in May. Deflation in the IGP-M in the past two months reflected the partial reversal of the shock in agricultural prices between March and April due to dry weather, as well as recent strengthening in the exchange rate. Current data signal another negative print for the IGP-M in July, keeping the year-over-year change on a downward path.

Faced with weaker producer prices data, we now expect the IGP-M to rise 5.0% this year. In our previous report, our forecast stood at 6.0%. The producer price index IPA-M — the heaviest weighted component in the IGP-M — should advance 4.1% this year, with increases of approximately 3.8% for industrial prices and 5.0% for agricultural prices. In the mining industry, iron ore should provide an important downward contribution, as prices are expected to drop 25% (impact of -1.0 p.p. on the headline index). For the other components, we anticipate increases of 6.5% in the consumer price index IPC-M and 7.1% in the construction cost index INCC-M.

Weak activity should lead the Copom to keep interest rates unchanged in 2015

Although we expect inflation at the upper-limit of the target range, low growth should lead the Copom to maintain the benchmark rate at 11% in 2015. In order to reduce risks and drive inflation back to the mid-point of the target range, it is our view that the Copom should resume the hiking cycle in interest rates in 2015. However, we now believe lower-than-expected growth will drive the Copom to maintain the Selic rate at 11% also in 2015.

In fact, the Inflation Report (RI) for 2Q14 indicated a scenario of stable interest rates ahead. In the report, the Copom stated that its scenario “contemplates resilient inflation in the next quarters, but, under stable monetary conditions, tends to enter a path of convergence to the target in the final quarters of the forecast horizon.” In other words, the Copom suggested that, with the Selic rate at the current level, the IPCA will begin to converge to the target in 2016.

According to the Copom, activity is going in a disinflationary direction. The Inflation Report stated that the output gap “has been moving in a disinflationary direction,” given that, at the margin, activity is growing below potential. The committee reduced its forecast for GDP growth this year to 1.6% from 2.0%.

Therefore, we maintain our forecast for the Selic at 11% by year-end and lower our estimate for 2015 to 11% from 12%.

Fiscal policy: primary budget deficit in June emphasizes difficulties to reach the target for 2014

The public sector posted a negative primary balance of 11.0 billion reais in May. The deficit equals 2.5% of GDP for the month. This performance is much worse than observed in the period from 2009 to 2013, when the average primary surplus for May stood at 1.0% of GDP. In fact, the latest figure is the only consolidated primary deficit for the month since the beginning of the historical series in 2002. Year-to-date, the public sector has a primary balance of 1.5% of GDP, the smallest in the series started in 2002. One year earlier, the primary surplus stood at 2.4%, while the average for 2009-2013 reached 3.1%.

The weakening of the fiscal effort this year is caused mainly by the federal government, whose result declined to 0.9% of GDP year-to-date vs. 1.7% between January and May 2013. But the primary surplus of regional governments also started to deteriorate, after increasing in the first few months of the year. The balance accumulated in 2014 stands at 0.7% of GDP, down from 0.8% in the same period of 2013.

In the 12 months through May, the conventional consolidated primary surplus (i.e., without adjusting for accounting changes or economic cycles) fell from 1.87% of GDP in April to 1.52%, the lowest level since October 2013. During the same period, the recurring primary surplus (i.e., excluding atypical revenues and expenses) declined from 0.84% of GDP in April to 0.53%, the lowest level in the series started in 2002. The public sector’s nominal deficit (a gauge of fiscal performance which includes interest expenses) stood at 3.5% of GDP in the 12 months through May (April: 3.1%). The recurring nominal fiscal deficit (i.e., adjusting for atypical primary revenues and expenses) widened 0.3 p.p. to 4.5% of GDP. Interest expenses were stable at 5.0% of GDP in the 12 months through May.

Tax revenues are slowing down, while total expenditures rise faster than potential GDP. Using the three-month moving average, administrated revenues fell 1.1% yoy in May, marking the weakest trend since April 2013. The deceleration reflects the downturn in economic activity in 2Q14, with our Monthly GDP proxy (PIBIU) headed to the poorest quarterly growth in over four years. Between January and May, total expenses (adjusted for inflation) by the central government increased 3.9% yoy, a slower pace than in the second half of 2013 (7.0%), but still faster than potential growth, estimated at around 2-3%. As a share of GDP, federal outlays climbed 0.4% this year to 18.7%.

Regarding expenses, fiscal policy remains expansionary, particularly in the so-called “discretionary” lines, such as investments (excluding the Minha Casa Minha Vida low-income housing program), which are up by 23% year-to-date in real terms, and in other administrative expenses, which are up by 25%. The execution of some mandatory expenses (such as judicial claims bond payments and subsidies to the electricity sector) has been postponed to the end of this year, temporarily offsetting the growth in some important lines, such as pensions, personnel expenses and subsidies. We expect federal expenses to expand 3.7% this year (vs. 6.4% in 2013 and 3.9% year-to-date). Although the current growth pace of expenditures is in line with our scenario, a delay in mandatory expenses (approximately 8 billion reais, according to our calculations) will require a sharp reduction in the pace of "discretionary" expenses later in the year.

Downside risks for revenues may be mitigated by extraordinary revenues. Our scenario contemplates real growth in tax revenues of 1.2% in 2014, up from zero year-to-date. Downside risks to our forecast for revenues from taxes and contributions are, to some extent, “mitigated” by a possible search for sources of extraordinary revenues this year (i.e., besides what is already incorporated into our forecasts, such as revenues from the Refis tax amnesty program, from the concession of the 4G band and dividends paid by state-owned banks).

All in all, budget numbers for May further reduced the likelihood of meeting the fiscal target this year, especially considering the adverse base effects expected for the end of the year: in November, for instance, the large atypical revenues obtained in 2013 (Refis and the Libra oil field, totaling 0.7% of GDP) will be excluded from statistics which encompass the previous 12 months. Add to that the need to execute mandatory expenses delayed in recent months (probably adding another 0.15% of GDP in expenses until year-end). Although we keep our forecast for the primary surplus in 2014 at 1.3% of GDP, this estimate is increasingly dependent on the capacity to generate extraordinary revenues this year. Our scenario also relies on somewhat of a grip in discretionary expenses in late 2014.

The budget policy keeps fueling aggregate demand and giving little contribution to reduce inflation in the medium term. Our estimates for the underlying gauges of the fiscal effort (structural or recurring primary surplus) are below 1% of GDP, despite a recent slowdown in the implementation of new fiscal stimuli (measured by the fiscal momentum, characterized by the change in the structural surplus).

Extension of the Central Bank’s swap program should support a stronger currency in the short term

Central Bank actions have contributed to support the Brazilian real at a stronger level. The Central Bank announced that its intervention program via currency swaps will be maintained at least until the end of the year, with daily offers of $200 million from Monday through Friday, the same amount it had been offering. The announcement helped to sustain the real at appreciated levels in recent weeks. We expect the exchange rate to remain range-bound in the coming months, while authorities should adjust the monthly amount for swap rollovers so as to avoid sharp depreciation moves which may jeopardize the fight against inflationary pressures in the short term.

We revised our year-end forecasts for the exchange rate to 2.40 reais per dollar in 2014 (2.45 previously) and to 2.50 reais in 2015 (2.55 previously). Even if the real remains at a stronger level in the short term, we expect the U.S. economy to start showing signs of recovery in the second half, translating into higher Treasury yields until the end of the year, making them more attractive to investors. We see the real weakening in late 2014, due to smaller inflows to Brazil and due to internal events (including the elections) which should increase market volatility.

The trade balance in June was positive by $2.4 billion, but is still negative by $2.5 billion on the year-to-date basis. Exports continue to decline on a year-over-year basis, but the reduction in imports offset part of this move in June. In our view, the trade surplus will be slightly smaller in 2014 than our previous estimate ($1.4 billion vs. $1.5 billion). For 2015, however, we lowered our forecast for the trade surplus to $13 billion from $16 billion, due to a less depreciated exchange rate and the revision in our international price projections for some agricultural products, including soybeans, corn and coffee.

The current account deficit is stable at 3.6% of GDP. The current account gap stood at $6.6 billion in May, with negative contributions from the service and income accounts ($4.5 billion and $2.9 billion, respectively). Foreign direct investment (FDI) flows remained robust at $5.96 billion, an all-time high for May. The composition of FDI also remains quite benign, with intercompany loans representing only 23% of the total amount.

We maintained our forecast for the current account deficit in 2014 at 3.7% of GDP, but revised our estimate to 3.2% in 2015 (2.9% previously), incorporating the effects of a smaller trade surplus and the lagged effects of a milder exchange rate depreciation than we previously anticipated.

The electoral race takes off

Party conventions wrap up and the campaign starts. Party conventions to choose candidates and alliances were held throughout June and turned out as expected: PT confirmed President Dilma Rousseff as a candidate for reelection, while PSDB confirmed Aécio Neves and PSB confirmed Eduardo Campos. There are other eight candidates in the race. President Dilma was able to attract support from many parties, including PMDB, PSD and PR, but lost PTB to Aécio Neves, whose candidacy also relies on SDD and DEM. The campaign officially started on July 6.

Dilma will have most of the free air time. One of the reasons why party alliances are so important is that free air time is allotted according to their footprint in the House of Representatives. The alliance behind Dilma accounts for nearly two-thirds of the seats in the House. We estimate that she will have about 11 out of the 25 minutes of air time, compared to about 4 minutes for Aécio and 2 minutes for Eduardo Campos. The remaining time will be distributed among the other candidates. The electoral program will air three times a week, twice a day, on TV and radio stations starting on August 19.

The latest poll shows some improvement for Dilma in the first round, but a more difficult victory in the second round. After registering lower numbers in June, the poll by Datafolha in July showed more favorable figures for Dilma in terms of government approval ratings (35% vs. 33% previously) and voter intentions in the first round (38% vs. 34% previously). However, the improved figures did not top those seen in May. In an eventual second round, Datafolha keeps pointing to a reelection for the President, who could beat both Aécio Neves (46% vs. 39%) and Eduardo Campos (48% vs. 35%), but with the lowest margin so far for her in polls.

Dilma’s biggest lead is in the Northeast, and Aécio’s in the Southeast. In the Northeast, Dilma would win with 66% of votes vs. 21% for Aécio Neves in a second round, according to Datafolha. The President also has a lead in the North, where the estimated score is 54% vs. 34%. Aécio Neves would win in the Southeast (48% vs. 36%), Center-West (47% vs. 41%) and South (43% vs. 39%).

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