Itaú BBA - Falling inflation paves the way for marginally lower interest rates

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Falling inflation paves the way for marginally lower interest rates

October 5, 2017

Our forecast for the Selic rate in early 2018 was reduced to 6.5% from 7.0%

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

The increase in extraordinary revenues and the economic rebound should allow the government to meet its primary balance targets in 2017 and 2018.

• We revised our forecast for the exchange rate to BRL 3.25 per U.S. dollar by YE17 (vs. 3.35), given the recent behavior of foreign currency flows. Our call for YE18 remains at 3.50.

• We reduced our forecast for inflation to 3.0% from 3.2% in 2017 and to 3.8% from 4.0% in 2018.

• Well-behaved inflation and the latest central bank communications led us to reduce our estimate for the terminal Selic rate to 6.5% from 7.0%. 

• We lifted our forecast for GDP growth in 2018 to 3.0% from 2.7%, due to even-lower interest rates. Our estimate for 2017 remains at 0.8%.

Extraordinary revenues and the rebound in activity will help the government to meet its primary balance targets

Given the improvement in the extraordinary revenue and the economic rebound, the government should be able to meet its primary deficit target of BRL 162 billion (-2.4% of GDP) in 2017. Successful auctions in the Energy sector and the execution of  the judicial deposit withdrawals (the so-called “precatórios”) in September reduced risks regarding about BRL 44 billion in extraordinary revenues needed to meet the central government’s target of BRL 159 billion (-2.4% of GDP). A total of BRL 32 billion had already come through by September, up significantly from BRL 5 billion taken in as of August (see table). 

We expect that the 2017 primary deficit will be just marginally better than the annual target (BRL 157 billion or -2.4% of GDP). Positive surprises in terms of extraordinary revenues (such as premiums in upcoming auctions) and/or recurring revenues (due to a faster-than-expected recovery in activity) should be offset by relief in discretionary spending cuts (BRL 33 billion at the moment), thereby not leading to a better primary result.

For 2018, we still expect the deficit at 2.1% of GDP (149 billion reais) vs. a target of BRL 162 billion (or -2.3% of GDP). Expenses were set exactly at the constitutional spending cap level. Hence, positive surprises in revenues (with faster economic growth than the budget law assumes, of 2.0% vs. our 3.0% call) or faster progress in the asset sale agenda imply a better primary balance reading than the target. 

Additionally, the government announced plans to have development bank BNDES transfer BRL 180 billion (2.5% of GDP) to the National Treasury, as a way to cushion the impact of large primary deficits on gross public debt. A total of BRL 50 billion (0.8% of GDP) should be returned in 2017 and BRL 130 billion in 2018 (1.7% of GDP), implying an equal reduction in gross public debt each year. The actual transfer, along with the rebound in economic growth and lower interest rates, may allow gross public debt to be temporarily stable in 2018 (see chart).

However, in order to permanently reverse this (currently unsustainable) path for public debt, reforms must be approved. Without reforms, the government is less likely to meet the constitutional spending cap after 2019 and gradually attain the surpluses that would enable stabilization of public debt. In particular, the pension reform still needs greater political consensus before being voted on in two rounds on the main floor of the Lower House and then in the Senate. 

Less intense exchange-rate depreciation, for now

Late in September, the international scenario pressured emerging market currencies, including the Brazilian real. The exchange rate hovered around BRL 3.10 per dollar during almost the entire month. However, the greenback gained momentum after the U.S. Federal Reserve announced plans to reduce its balance sheet starting in October and signaled another hike in interest rates in December. Hence, the exchange rate finished the month close to 3.20.

We revised our YE17 forecast for the exchange rate to 3.25 (from 3.35). In the short term, we expect the real to depreciate at a slower pace thanks to the good outlook for microeconomic reforms and their impact on capital flows. Foreign demand for Brazilian assets was evident in late September, during the auction of four hydropower plants and in the 14th round of licensing for the exploration of oil and natural gas fields.

Our YE18 estimate, however, was unchanged, at BRL 3.50 per dollar, considering the international and domestic scenarios. The external background is set to remain relatively benign for risky assets, but hikes in U.S. interest rates (albeit gradual) and the removal of monetary stimuli in advanced economies justify a weaker exchange rate. Internally, uncertainty over adjustments and reforms will likely continue and pressure risk premiums.

Balance of payment figures show moderation in the current account at the margin. The strong trade surplus has helped to maintain low current account deficits, but a rebound in domestic demand and lower commodity prices tend to produce weaker readings in the next months. July and August figures already point in that direction. The seasonally adjusted annualized three-month moving average deteriorated to a deficit of USD 18 billion in August from USD 9 billion in July. In terms of financing, direct investment in the country remains resilient — in the USD 80-85 billion range throughout the whole year — and enough to cover the current account deficit multiple times. Volatile capital flows (i.e., portfolio flows) are still negative over 12 months, although the outflow became less intense.

For the next years, we maintain our expectation for slightly wider current account deficits but not to the point of compromising Brazil’s external sustainability. We estimate trade surpluses[1] of USD 62 billion in 2017 and USD 50 billion in 2018. Our estimates for the current account deficit stand at USD 15 billion in 2017 and USD 34 billion in 2018.

We expect inflation at 3.0% in 2017 and 3.8% in 2018

Our forecast for the consumer price index IPCA this year is now 3.0% (3.2% previously). The revision follows lower forecasts for food and service prices, which more than offset the hike in our estimate for regulated prices. Year-over-year headline inflation is set to reach 2.5% in September and climb gradually to 2.7% in October and 2.8% in November.

Breaking down our estimate, we expect market-set prices to rise 1.8% and regulated prices to advance 6.7%. Among market-set prices, we anticipate a 2.6% drop for food consumed at home (after a 9.4% increase last year), contributing 2.0 pp to the expected decline in inflation in 2017. Plentiful crops — given favorable weather in Brazil and for other major global producers — have caused significant declines in producer prices since September 2016, with a favorable impact on retail food prices. Costs for food consumed at home fell 5.2% yoy in August (while soaring 16.8% in the year-earlier period), contributing 3.6 pp to the slowdown in inflation in the period (to 2.5% from 9.0%). We expect industrial prices to rise 1.0% (4.8% in 2016). Service prices are estimated to advance 4.3% this year (6.5% in 2016). As for regulated prices, we assume the following forecasts for the main components: -4% for landline phone service; 4.5% for medication; 5% for gasoline; 5%  for urban bus fares; 8.5% for electricity tariffs; 9% for water and sewage tariffs; 12% for bottled cooking gas; and 13.6% for health insurance premiums.

For 2018, we lowered our forecast for the IPCA, to 3.8% from 4.0%, due to less inflationary inertia and improved expectations. Breaking down the index, we expect market-set prices to rise 3.5% and regulated prices to climb 4.6%. Our below-target inflation estimate for next year will be driven by less inertia from past inflation, anchored inflation expectations, and lingering effects related to a still-negative output gap. As for market-set prices, we expect a reversal of the decline in food prices (given the expectation of normal weather conditions), a faster increase in industrial prices (following the low reading estimated for 2017) and another drop in service inflation due to lower inertia.

The main risk factors for the inflation scenario are still tied to domestic politics and international developments. Rising political uncertainty has hindered progress in reforms and needed economic adjustments, and it may have an additional impact on risk premiums and the exchange rate. However, so far, the net short-term effects of rising uncertainty on inflation have not been seen. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as new tax hikes and/or reversal of tax breaks next year. 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 reverse the improvement in risk premiums, impacting the exchange rate and domestic inflation.

Substantial slack in the economy may contribute to a sharper decline in inflation next year. The negative output gap and the corollary high level of unemployment for a longer period (notwithstanding some improvement in the latest figures) may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. The very favorable behavior of inflation in recent months, with low readings for underlying inflation, already indicated a broader disinflation process, which has been hitting exactly these segments. 

The benign behavior of food prices may also represent a downside risk for inflation. Costs for food consumed at home have behaved more favorably than anticipated, so there is downside to our 2018 inflation call related to potential secondary effects of the supply shock seen this year — not only related to services but mostly through the inertia effect of past inflation. Importantly, food deflation during 2017 has contributed to lower results in another consumer price index, the INPC (which addresses a stricter income bracket of up to five minimum monthly wages and is overweight in food expenses). Given that the INPC is the benchmark for adjustments in the minimum wage as well as wages in the private sector, results that are lower than those of the IPCA may generate an even more favorable inertia effect for 2018 inflation. We expect the INPC to advance 2.3% this year.

Inflation expectations remain anchored, with breathing room in relation to the targets in 2017 and 2018. The median market expectations for inflation, as per the central bank’s Focus Survey, slid to 2.95% from 3.38% in 201, and to 4.06% from 4.18% in 2018. Median estimates for 2019 and 2020 remained at 4.25% and 4.0%, respectively, anchored in the targets set for these years.

Monetary policy: Our forecast for the Selic rate in early 2018 was reduced to 6.5% from 7.0%

Well-behaved inflation and the latest central bank communications show room to reduce the benchmark Selic interest rate to 6.5%. Its 3Q17 Inflation Report (RI) updated forecasts, as usual, putting inflation at 4.3% by YE18 and 4.2% for 4Q19 in the market’s scenario (based on exchange and interest rate forecasts from the Focus Survey). In the hybrid scenario (with constant exchange rate and Selic from the Focus survey), estimates are 4.1% by YE18 and 3.9% for 4Q19. These below-target estimates for 2018 (4.5%) and 2019 (4.25%) suggest that the Monetary Policy Committee (Copom) sees room to cut the Selic rate below 7.0% by the end of the easing cycle. Our new inflation forecast for 2018, at 3.8%, indicates that the central bank forecasts may go further down, reinforcing the implementation of additional monetary stimulus. We expect cuts of 75 bps in October, 50 bps in December and 50 bps in February 2018, taking the Selic to a final level of 6.5%.

The central bank has been communicating that current monetary policy is stimulating economic activity, with the interest rate below its structural level. The real ex-ante interest rate (nominal one-year rate minus inflation expectations one year ahead) is now close to 3%, which the central bank understands to be below the structural level. For interest rates to remain at such levels in the long run, the structural interest rate must also continue its decline. This situation will only materialize if the reform agenda — particularly in the fiscal realm (the pension reform above all) — continues to advance.

Activity: Faster growth in 2018 thanks to lower interest rates

Recent data is consistent with GDP growth of 0.1% qoq/sa in 3Q17. Industrial production expanded 0.7% in July and declined 0.8% in August, but it should rise in September (our preliminary projection is 0.7%) and sustain an upward trend. Retail sales were also stable in July, consolidating the strong increase seen in the previous quarter. Confidence indicators went up during the quarter and fully erased the drop related to rising political uncertainties.

From a demand standpoint, GDP composition should be more balanced in 3Q17, as both investment and consumption expand. We expect gross fixed capital formation to grow approximately 1% qoq/sa, driven by machinery and equipment purchases and stability in construction. Household consumption should increase at a slower pace than in 2Q17 (when influenced by withdrawals from inactive accounts held under employment protection program FGTS). Advances in both GDP components reflect improved fundamentals: falling interest rates, healthier corporate and households balance sheets, and higher real income due to lower inflation. 

Our forecast for 2017 GDP remains at 0.8%. Importantly, the 3Q17 report will likely revise 2Q17 GDP upward to 0.6% (vs. 0.2% in the first release).

We lifted our estimate for 2018 GDP growth to 3.0% from 2.7%. The revision incorporates our new scenario for monetary policy, with an additional cut in the Selic rate early next year.

The gradual rebound is bringing improvement to the formal labor market. In August, 35.4 thousand formal jobs were created in net terms (according to the Ministry of Labor’s CAGED registry). The seasonally adjusted quarterly average is near zero and has been improving gradually since 2Q16.

Improvement in the formal labor market was also captured by the national household survey (PNAD Contínua). The decline in unemployment in recent months is still influenced mainly by informal jobs, but formal jobs in the private sector contributed positively in the August report (see chart). 

We revised our forecasts for the unemployment rate, incorporating faster economic growth in 2018.  We now expect the seasonally adjusted figure at 12.0% by YE18 (12.2% previously), down from 12.6% in the quarter ended in August. In our view, the decline in unemployment will be increasingly helped by formal jobs creation.


 


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

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



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