Itaú BBA - Fiscal challenge, volatile markets

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Fiscal challenge, volatile markets

October 6, 2015

There are no signs of a recovery in economic activity.

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

• The government announced new fiscal measures in an effort to improve the public accounts, but most of the impact will depend on congressional approval. We forecast a primary deficit of 0.7% of GDP for 2016 (previous scenario: -1.0%) and -0.3% of GDP (unchanged) for 2015.

• Domestic uncertainties have led to an increase in risk premiums and the depreciation of the BRL. In an attempt to contain excess volatility, the central bank intervened in the foreign exchange market through the sale of foreign exchange derivatives for the first time since March. We are maintaining our exchange rate forecast at 4.00 BRL/USD for year-end 2015 and at 4.25 BRL/USD for year-end 2016.

• There are no signs of a recovery in economic activity. Our forecasts indicate a contraction of 3.0% of GDP in 2015 (previously -2.8%). The continuing uncertainty in the domestic scenario led us to revise our 2016 GDP growth forecast to a 1.5% decline (previously -1.2%). Weaker activity is likely to drive the unemployment rate to 8.6% by the end of this year and 10.2% next year (previously 8.3% and 9.6%, respectively).

• We forecast IPCA inflation at 9.7% this year and 6.5% in 2016. The slower rise in regulated prices expected for next year will play a key role in the drop in inflation.

• The rapid exchange-rate depreciation put pressure on inflation expectations for 2016, leading markets to price in additional rate hikes. While acknowledging the deterioration in the balance of risks, the central bank continues to signal flat interest rates. This, coupled with the deepening recession, led us to maintain our Selic rate scenario stable at 14.25% until the end of 2016.

Rising uncertainty, more FX intervention

The government announced new fiscal measures following the downgrade of the country’s sovereign rating by Standard & Poor’s, and the consequent loss of investment grade status. However, most of the measures require congressional approval, which is uncertain. The deepening recession further reduces tax collection, which affects the fiscal result.

Thus, despite renewed efforts to adjust the public accounts, the perception of high uncertainty in the domestic scenario remains. In this context, asset prices remain volatile, the country risk has risen again, and the BRL has depreciated, prompting the central bank to step up its intervention in the FX market.

The decline in activity will probably be longer – and deeper – than we anticipated. Leading and coincident indicators show that the economic contraction trend is likely to extend until at least the end of this year.

Expectations of continuing fiscal problems are a major risk for future inflation.

In fact, inflation expectations have risen again, although so far moderately. Despite the worsening balance of risks for inflation, we believe that the central bank will opt to maintain the Selic rate stable at 14.25% until the end of 2016. However, in the event of a steeper deterioration in inflation expectations, we do not rule out the BCB to resuming a moderate hiking cycle.

New fiscal-adjustment measures do not ensure a positive primary result

While the government announced new fiscal measures, most of the impact will depend on congressional approval. The government’s intention was to reaffirm the primary-result target of +0.7% of GDP in 2016, after previously sending a budget proposal with a deficit of 0.34% of GDP. The main measure is the reinstatement of the CPMF tax (at a 0.20% rate), with revenues estimated at BRL 32 billion. On the expenditure side, the highlight is the postponement of the adjustment of civil servant salaries from January to August of next year. The government estimates that the proposed measures will result in a BRL 72 billion adjustment (1.2% of GDP), of which BRL 46 billion corresponds to tax increases and BRL 26 billion to spending cuts. The announcement shows an effort to improve the fiscal situation, but there are implementation risks. Most of the measures (80% of the expected adjustment) require congressional approval; only BRL 14 billion does not depend on congressional approval.

Given the challenges in implementing the proposed measures, our forecasts incorporate only BRL 35 billion (0.6% of GDP) to be generated by the new measures in 2016. This figure includes some additional tax increases (not yet announced) that require no changes in laws, such as the IPI tax on manufactured goods and the IOF tax on credit transactions, among others.

We also expect a further decline in economic activity compared with our previous scenario. The GDP contraction, and therefore the wage bill and consumption, will continue to have a negative impact on tax collection. The revision of our economic activity forecast is consistent with a negative impact of 0.3% of GDP on tax revenues (already incorporated in our primary result forecast).

Furthermore, mandatory expenditures, especially social security, tend to expand as a result of the minimum wage adjustment, which will be affected by the high inflation in 2015. These factors (declining revenue and rising mandatory expenditures) make it difficult to obtain a positive primary result next year.

We forecast a primary deficit of 0.7% of GDP for 2016 (previous scenario: -1.0%) and -0.3% of GDP (unchanged) for 2015. We have incorporated the fiscal measure’s (announced and others) net impact of 0.6% of GDP into our forecast for next year, which is partly offset by the -0.3% impact of the activity contraction.

Rapid BRL depreciation and increased central bank intervention

The exchange rate exceeded 4.00 BRL/USD. Economic and political uncertainties as well as the downgrading of Brazil to speculative grade by Standard and Poor’s affected the country’s FX market.

The central bank intensified its intervention in the foreign exchange market. In an attempt to contain the excess volatility and avoid dysfunctionality in the foreign exchange market, the central bank resumed the sale of foreign exchange swaps and the offer of lines with repurchase agreements. New FX swap contracts had not been offered since March, and the stock of swaps was declining.

We maintained our exchange rate forecasts at 4.00 BRL/USD for year-end 2015 and 4.25 BRL/USD for year-end 2016. The worsening economic outlook is likely to have a significant impact on the availability of external financing, leading to a more depreciated exchange rate than in recent years.

We believe that above-cited FX forecasts (4.00 in 2015, 4.25 in 2016, and constant in real terms thereafter) are likely to lead to a current account deficit between 1.5-2.0% of GDP in 2017. We do not rule out a possible overshoot in the exchange rate in light of the high current uncertainty. In that case, it is possible that the Central Bank would step up its foreign exchange intervention, including on the spot market.

Ongoing current account adjustment. The widespread improvement reflects a more depreciated exchange rate and weaker economic activity. The sharp drop in imports has offset the decline in exports, ensuring a trade balance surplus. International travel spending, transportation and the remittance of profits and dividends also remain on a downward trend. On the financing side, however, both direct investment and portfolio flows continue to moderate on a month-over-month basis.

We increased our trade balance forecast after incorporating the latest data. We expect a USD 10 billion trade surplus in 2015 (from USD 8 billion previously) and USD 25 billion in 2016 (from USD 22 billion). Based on this trade balance revision, we also revised our current account deficit forecast to USD 69 billion in 2015 (from USD 71 billion previously) and USD 42 billion in 2016 (from USD 45 billion); these figures correspond to 4.0% and 2.8% as a percentage of GDP, respectively.

Activity: No relief expected in 4Q15

Economic indicators continue to disappoint. Our diffusion index – which displays the number of positive activity indicators based on a broad set of data that includes business and consumer confidence, retail sales and demand for credit – is likely to reach a level compatible with a 4% (annualized) activity contraction in September. The diffusion index is a leading indicator that suggests the continuation of a challenging economic growth scenario over the coming months.

Industrial production declined 1.2% mom/sa in August and remains on a downward trend. Production decreased in three out of the four main economic categories. Coincident indicators suggest further drops going forward.

We also expect a further contraction in both core (-0.6) and broad[1] (-1.3%) retail sales in August. Other activity sectors also continue to retreat. In July, real service revenues decreased 0.6% mom/sa, marking a fifth consecutive decline (according to our calculations based on the Service Monthly Survey).

Widespread deterioration in confidence. Business and consumer confidence receded again in September. The indicators for industry, services, trade, construction and consumer reached record lows. In industry, the surprise was the seventh consecutive increase in inventories, despite the lowest capacity utilization level since 1993. High inventories are likely to contribute to a further reduction in production going forward.

Lower GDP in 2015 and 2016. The economic activity contraction in the second half of 2015 is likely to exceed our previous expectations. Leading indicators, such as our diffusion index and business and consumer confidence, suggest a further deterioration in activity. We revised our GDP forecasts to -3.0% for 2015 (previously -2.8%) and to -1.5% for 2016 (previously -1.2%).

Higher unemployment due to worsening economic activity. The unemployment rate reached 7.6% in August. In seasonally adjusted terms, there was an increase to 7.4% in August from 7.2% in July, despite the drop in the participation rate, which is, in our view, unlikely to persist.

There was a reduction in formal employment (CAGED) of 87,000 jobs in August – a destruction of 170,000 jobs in seasonally-adjusted terms. The percentage of states that created jobs in the month was close to zero.

The percentage of the population reporting difficulty in finding employment increased by more than 3 pp in September, indicating that the upward trend in unemployment is likely to persist.

Given the weakening economic activity, we revised our unemployment-rate forecasts to 8.6% for year-end 2015 (previously 8.3%) and 10.2% for 2016 (previously 9.6%).

Credit remained weak in August. The daily average of non-earmarked new loans fell by 0.3% in real terms mom/sa. In the same comparison, earmarked new loans declined by 10.7%. Total credit outstanding continued to decelerate as the real annual growth fell from 0.3% to 0.1%. In the same comparison, non-earmarked outstanding loans continued to recede (-4.0%), while earmarked credit moderated from 5.2% to 4.7%. The system’s delinquency rose 0.1 pp, to 3.1%. Interest rates and spread increased.

Higher inflation due to higher fuel prices

We forecast a 0.52% advance in the September IPCA. The higher reading relative to the previous month (0.22%) is expected to be driven by a pick-up in transportation, housing, food and clothing items. In transportation, we highlight the sharp rise of airfare (23%), which reversed much of the reduction observed in August (-25%). Thus, the IPCA will accumulate an increase of 7.62% year to date, with the 12-month rate reaching 9.47%, against 9.53% in August and 6.75% in the same period of last year.

We raised our IPCA inflation forecast for 2015 to 9.7% from 9.5%, due to the adjustment in gasoline prices. We now forecast a 16.0% increase in regulated prices this year, with a 3.6 pp impact on the IPCA. We adjusted our gasoline price forecast to 14% from 10%, due to the 6% adjustment in refinery prices. The adjustment is likely to result in an additional 3.6% increase in the price of gasoline at the pump and also have an effect on the price of hydrous ethanol. Diesel fuel was adjusted by 4% at the refinery, but the direct impact on official inflation is small given its low weight in the index. We also revised our bottled-gas price forecast to 18% from 14% to incorporate the higher-than-expected impact of the adjustment in the refinery price. The largest contribution among regulated prices will come from electricity (1.4 pp). We forecast the following changes for other regulated prices with high contributions to inflation in 2015: health insurance (12%), urban bus fares (13%), water and sewage rates (14%), medicine (6.5%), and fixed-line telephone services (-3%).

The forecast for market-set prices remains at 7.8%. Higher market-set prices will account for 6.1 pp of the full-year IPCA. In disaggregated terms, we now forecast an 11.2% increase in food consumed at home (from 10.8% previously and 7.1% in 2014). The increased pressure on food items this year reflects the impact of various cost shocks (exchange rate, energy and fuel) as well as the effect of climate –related issues on the supply of some products, particularly meats and fresh fruits and vegetables. For services, we expect an 8.0% increase in 2015 (from 8.3% in 2014). For prices in the industrial sector, we forecast a 5.5% increase (from 4.3% in 2014).

We maintained our 2016 IPCA inflation forecast at 6.5%. In disaggregated terms, we forecast increases of 5.5% in industrial prices, 7.0% in food consumed at home, and 7.0% in services. Despite the growing resilience observed in service inflation this year, we maintain the view that the worsening labor market conditions and weakening real estate sector – which tend to generate consequent moderation in wages and rent – are likely to contribute to the drop in private service inflation next year. In the case of foodstuffs, our baseline scenario assumes more favorable weather conditions than in previous years, which is likely to imply good grain harvests for major global producers such as the U.S., Brazil and Argentina. In addition to the more benign climate for crops, lower BRL depreciation and more contained increases in energy and fuel costs will probably lead to a reduction in food inflation next year. In this context, we anticipate more moderate increases in prices of meat, wheat products and fresh fruits and vegetables. We also maintained our 6.5% forecast for regulated prices. The contribution of regulated prices to inflation will decrease to 1.6 pp in 2016, from 3.6 pp in 2015, implying a 2.0 pp easing in headline inflation.

In addition to the weak economic activity, other factors will contribute to the drop in inflation next year. Among them we highlight the prospect of better weather conditions and significantly lower increases in regulated prices (particularly electricity), given that much of the relative price-adjustment process (between regulated and market-set prices and domestic and international prices) will have already taken place in 2015. On the other hand, a risk for inflation next year is the possibility of additional tax hikes, given the need to increase tax collection, which may directly or indirectly affect the prices of some goods and services (market-set and/or regulated). The recognition of liabilities in the electricity sector, if translated into higher residential electricity bills, also represents a risk for inflation in 2016.

The impact of fiscal-policy-related risks on inflation expectations may be a key risk factor going forward.

We raised our inflation forecast measured by the IGP-M to 9.0% for this year (from 8.3% previously), due to the higher impact of FX depreciation and the readjustment in gasoline and diesel prices. In disaggregated terms, we now project increases of 9.1% for the IPA-M, the highest weight component in the IGP-M (60%); 9.5% for the IPC-M, with a share of 30% in the IGP-M; and 7.2% for the INCC-M, with a 10% weight in the IGP-M. For 2016, we maintained our IGP-M inflation forecast at 7.2%.

Stable Selic despite risks

The BCB continues to signal its intention to maintain the monetary rate stable for an extended period, while acknowledging a worsening balance of risks. According to the latest Inflation Report (IR), “the scenario of inflation convergence to 4.5% by the end of 2016 has been maintained, despite some deterioration in the balance of risks, recently exacerbated by the effects of the downgrade in the sovereign credit rating.”

The rapid depreciation of the BRL in recent months has added pressure to inflation expectations for 2016 and beyond, leading futures markets to price in additional rate hikes. According to the BCB’s Focus Survey, inflation expectations for 2016 have risen to 5.94%, from 5.50% in July (see chart). Longer term expectations have also been rising, but remain closer to the target center, probably influenced by the strong recession that limits the second-round effects of exchange-rate depreciation.

The BCB’s strategy to cope with FX pressures seems to be a scaling up of interventions, which could include the spot market, as opposed to rate hikes (at least as the first line of defense). This is, in our view, the message given by BCB Governor Alexandre Tombini following the publication of the IR. However, we do not rule out the BCB resuming a moderate hiking cycle if inflation expectations deteriorate significantly (particularly for longer maturities).

Thus, despite the worsening balance of risks, the BCB's signaling and deepening recession led us to maintain our scenario for a stable Selic rate of 14.25% until the end of 2016.


[1] Includes vehicles and construction material.

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


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