Itaú BBA - Fundamentals improve, but fiscal progress is still lacking

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Fundamentals improve, but fiscal progress is still lacking

July 8, 2016

A stronger and sustainable economic recovery depends on the approval of fiscal reforms, especially on the expenditure side.

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

We have revised our exchange-rate forecast to 3.25 BRL per dollar at the end of 2016 (previously 3.65) and 3.50 BRL per dollar at the end of 2017 (previously 3.85). The likely postponement of a U.S. rate hike, greater consensus on fiscal reform and the central bank’s conservative approach should help the Brazilian real appreciate this year. 

We have maintained our IPCA inflation projection for this year at 7.2%. Recent pressure from food prices is likely to be offset by the effects of currency appreciation and the larger drop in electricity bills. We have lowered our 2017 forecast from 5.0% to 4.8% due to the stronger real.

Leading activity indicators have improved in recent months, but holding interest rates higher for longer (see below) may to affect demand in the short term. We are therefore maintaining our forecast of a 3.5% drop in 2016 GDP and a moderate 1.0% increase in 2017. 

The government has announced a target of -2.2% GDP for the consolidated primary sector result in 2017. We have reduced our primary result forecast to -2.2% from -1.5% of GDP in 2017, in line with the announced primary target. 

The central bank has reiterated its goal of achieving the center of the target in 2017, which may require tighter monetary policy over a longer horizon. We are now forecasting that the cycle of interest-rate cuts will begin in October (previously August), with an initial 0.25 pp cut. We expect the Selic to end 2017 at 10.00%.

Brazil shows resilience, but fiscal reforms are needed

The BRL outperformed other emerging currencies in June. The likelihood of a delay in U.S. interest rate hikes, more optimism about fiscal adjustments and the CB’s conservative approach have helped strengthen the currency. This movement does not pose a risk to the long-term balance of payments equilibrium, but the high country risk , and the outlook of lower interest rates next year could bring more pressure on the BRL in the future.

The IPCA remains on its downward trend. Service inflation is already more benign, and industrial goods inflation has been showing signs of slowing. Additionally, fundamentals are also improving: the currency has appreciated and inflation expectations are falling. However, food prices are likely to remain high in the short term, preventing a sharper drop in inflation in 2016.

Activity has shown signs of stabilizing. Indicators that precede economic growth have improved, which suggests activity could recover faster. Industrial production is likely to resume growth in the next quarter. However, the labor market might recover only next year.

The government sent a constitutional reform bill to congress, limiting annual public spending growth to the previous year’s inflation. Social security reform is critical for the spending ceiling to work. We believe these two measures are important structural reforms for the Brazilian economy, and together they are capable of reversing the deterioration in public accounts. However, there is no certainty yet that the reforms will be approved.

 The central bank has reaffirmed its goal of achieving the center of the target in 2017 and signaled there is no room for more flexible monetary conditions yet. The CB’s more conservative approach is helping to anchor expectations, but it may have a short-term impact on aggreagate demand. We believe that rising unemployment, currency appreciation, an improving outlook for inflation and progress on fiscal adjustments will create conditions for a gradual easing cycle, starting in October.

BRL appreciation

Emerging market currencies  appreciated, and the dollar tested this year’s lows against the BRL. Initially, the vote for the UK to leave the European Union generated risk-aversion in global markets. However, the likely postponement of interest rate hikes in the U.S. and the fall in long-term interest rates in advanced countries offset this effect, benefiting EM currencies.

The Brazilian real outperformed its peers this month, helped by domestic factors. The Central Bank (CB) highlighted its goal of inflation-convergence towards the center of the target in 2017 and restated that under current conditions, there is no room to cut the Selic rate. The outlook of higher interest rates for longer and the prospects of fiscal reform sustained the BRL’s relative performance throughout the month.

We have revised our exchange-rate forecast down to 3.25 BRL per dollar at the end of 2016 (previously 3.65) and 3.50 BRL per dollar at the end of 2017 (previously 3.85). Our revision for 2016 is justified by the CB’s conservative approach, the increasing consensus on fiscal reforms and lower interest rates globally. For 2017, the likelihood of lower domestic interest rates, the continuing high level of country risk (because of elevated public debt) and global uncertainties justify a more depreciated BRL than in 2016.

In May, the current account remained in positive territory with a USD 1.2 billion surplus. The current account adjustment has been under way since last year, as a result of the currency depreciation and slowdown in activity. The largest positive contribution comes from the trade balance, but other current account items have also improved.

However, over the next few months, we expect the trade balance to show more modest results as the currency appreciates and activity stabilizes. Therefore, despite the past two months’ current account surplus, we stand by our projection of a small deficit in 2016. On the financing side, direct investment in Brazil remains high (around USD 80 billion in the past 12 months), but portfolio flows (local stocks and fixed income), which are typically more volatile, continue to retreat.

The current account deficit is likely to rise again in 2017 but remains at low levels. We have revised our external account forecasts based on BRL appreciation over the next several years. We forecast a USD 50 billion trade surplus in 2016 (previously USD 52 billion) and a USD 46 billion surplus in 2017 (previously USD 55 billion). For the current account, we forecast a USD 18 billion deficit in 2016 (previously USD 15 billion) and a USD 28 billion deficit in 2017 (previously USD 7 billion).

The CB once again intervened in the currency market, selling reverse FX swaps, albeit in smaller amounts (USD 500 million/day). According to Central Bank President Ilan Goldfajn, domestic and international factors have opened room to reduce the short position in FX swaps. We believe the central bank will act with parsimony and maintain the floating exchange-rate regime.

Lower inflation in 2017

The IPCA inflation forecast for this year remained at 7.2%, with additional pressure on food prices being offset by the effects of currency appreciation and the larger drop in electricity. The large increase in some wholesale agricultural prices, partially passed on to retailers, resulted in an increase in our forecast of food at home prices this year, from 10.0% to 11.0% (compared with 12.9% in 2015). We have reduced our projected increase in industrial prices to 5.8% from 6.0% (6.2% in 2015), in light of the currency appreciation. We have reduced the forecast for service price inflation to 7.2% from 7.3% (8.1% in 2015). The forecast for regulated prices was lowered to 6.0% from 6.5% (18.1% in 2015), mainly due to the larger-than-expected drop in Copel and Eletropaulo electricity tariffs.

Prices for food consumed at home are likely to rise 8.5% in the first half, ahead of the 7.1% increase in the first half of last year. Despite this, we expect the food-price increase to slow significantly in the second half, to 2.3%. As the repercussions from El Niño on fresh-fresh fruits and vegetables prices dissipate, one tends to see an above-average drop in prices for these products by the end of the year, something we are beginning to observe in current data. Alongside the supposedly better weather for fresh fruits and vegetables supplies, a stronger currency and more manageable fuel and energy costs, alongside more restrained domestic demand, is likely to  help mitigate pressure to price increases for other foodstuffs.

In our view, fiscal issues remain a major risk for inflation. Future attempts to increase government revenues could lead to fresh tax increases and/or sharper increases in regulated prices. On the other hand, favorable fiscal developments could improve the outlook for inflation, either through exchange rates and inflation expectations, or switching from looser to neutral or even tighter fiscal policies.

Based on a currency appreciation scenario, we have lowered our 2017 IPCA forecast to 4.8% from 5.0%. Next year’s drop in inflation will reflect the end of relative price adjustments (regulated prices and exchange rates); less inflationary inertia; lower inflation expectations; more favorable weather conditions; and the remaining impact of continued weakness in economic activity. On a disaggregated basis, we are working with a 4.7% rise in market prices and a 5.2% increase in regulated prices. Among market prices, we are forecasting a 4.5% increase for food consumed at home, as we expect a more stable exchange rate and weather conditions to be more neutral, which would make room to give back some of the increases seen in 2016. For the other segments, we are forecasting a 5.4% increase in service prices and a 3.8% increase in industrial prices in 2017.

Activity: signs of stabilization

Short-term data in line with our expectations. Compared with March, broader retail sales declined 1.4% (including vehicles and construction material) in April, after seasonal adjustment. This result is in line with our forecasts (-1.5%) and illustrates the sector’s weakness. The falling real wage bill and large proportion of family incomes that are already committed suggest the situation is unlikely to change, but with smaller reductions in the margin. On the other hand, industrial output was stable in May, close to expectations (-0.1%). The capital goods segment generated its fifth consecutive increase, and our proxy for gross fixed capital formation has shown stability in recent months, signaling that investment is likely near an inflexion point.

Diffusion index at its highest level since 2014. Our diffusion index – which shows the number of rising indicators, based on a wide dataset, including business and consumer confidence, retail sales and credit demand – should end May at around 44%, close to the neutral level (44%). Preliminary figures for June suggest diffusion heading above 50%, the best result since 2014 (see chart). As a leading indicator for economic activity, this result suggests a positive trend for economic activity at the end of this year.

Confidence indicators suggest industrial production will improve in the second half of the year. In June, industrial confidence rose significantly, according to data from both FGV and CNI. We continue to believe that industrial output is lower than demand. Consequently, we expect to see a continued decline in inventories, which should lead to a cyclical recovery in the second half, even without a pickup in demand. Over the medium term, approval for fiscal reforms that reduce uncertainty and a cut in interest rates are essential to stimulate a more vigorous and sustainable recovery in the sector.

We have maintained our GDP forecast for 2016 and 2017. Our leading indicators for economic activity suggest a faster recovery than we predicted. However, the prospect that interest rates will remain at their current level for longer (see monetary policy session below) may restrict a short-term recovery in demand. Thus, we maintain our forecast for a 3.5% decline in GDP this year. We continue to estimate a 1.0% increase in 2017 GDP.

Labor market continues to contract. In May, a net 72 thousand formal jobs were destroyed (CAGED). Seasonally adjusted, the three-month moving average stood at -140,000. Payroll cuts remain intense, even with the milder GDP recession. This occurs because the labor market lags economic activity.

Unemployment likely to continue rising. In May, the national rate of unemployment rose from 10.7% to 10.8% (our seasonal adjustment). Unemployment has been on an upward trend in recent months, and we expect this situation to continue. We expect unemployment at 12.5% by year-end 2016, and at 13.0% by the end of next year.

Fiscal: awaiting structural reforms

The government sent a constitutional reform bill to congress that would limit annual public spending growth to the previous year’s increase in inflation. The measure is key, as it should help to reverse the 20-year uptrend in real public spending.

Social security reform is critical for the spending ceiling to work. A reform that increases the minimum retirement age and decouples benefits from the minimum salary, reducing the rate at which these expenditures increase, would lessen the need to make cuts in other areas of the budget.

We believe these two measures are important structural reforms for the Brazilian economy, and together they are capable of reversing the deterioration in public accounts. With a ceiling for public spending growth and social security reform, we estimate that public debt could be held at less than 80% of GDP and start falling through 2025 (see Marco View report: “Spending ceiling could stabilize debt below 80% of GDP”).

Current fiscal results, however, continue to deteriorate. In May, the 12-month cumulative primary deficit reached 2.5% of GDP, compared with 2.3% of GDP in April. Over the same period, the nominal deficit was 10.1% of GDP, with continuing pressure from high interest expenses (7.8% of GDP). As a result, gross debt remains on a less-than-favorable track (see image), reaching 68.6% of GDP in May.

The government announced a target for the primary deficit of 2.2% of GDP (BRL 143 billion) in 2017. The target is better than in 2016 (BRL 164 billion, -2.6% of GDP) and establishes that total primary spending growth for the year will be equal to 2016 inflation, in line with the proposed ceiling for public spending increases. To achieve the target, it is necessary an additional effort of BRL 55 billion in revenues that can come from asset sales, concessions or tax rises.

We have maintained our forecast for a primary result in 2016 at -2.4% of GDP, but we have reduced our 2017 forecast to -2.2% from -1.5% of GDP, matching the new target. Compared to our previous scenario for 2017, we don’t consider the reinstatement of the payroll taxes anymore (impact of 20 BRL billion or 0.4% of GDP) and we reduced our expectation of non-recurring revenues by BRL 16 billions (0.3% of GDP)

We believe that the perspective of high primary deficits in the short term does not mean that the government is relaxing the fiscal adjustment. More important is to address the fiscal outlook in a longer term with the approval of structural reforms that will allow the primary results to improve year after year as the economy resumes growth.

We forecast that gross debt could reach 71% of GDP in 2016 and 76% in 2017. Our estimate takes into account this year’s BRL 40 billion (0.6% of GDP) and 2017’s BRL 30 billion (0.5% of GDP) BNDES debt payment to the National Treasury. We have also included BRL 63 million in gains (1.0% of GDP) from currency swaps in 2016.

Monetary policy: Tight stance for longer

Timely convergence. Ilan Goldfajn, the new head of Brazilian Central Bank, has reiterated the goal of reaching the midpoint target of 4.50% in 2017. Goldfajn said this is a feasible but challenging convergence path.

Based on this goal, the central bank continued to signal that the current scenario “leaves no room for one to work on the hypothesis of easier monetary conditions.” In fact, the central bank’s forecasts published in its 2Q Inflation Report and those collected from market analysts (Focus survey) do not indicate that inflation will reach the midpoint target by 2017, in scenarios that include interest rates cuts.

Conditions for improved forecasts depend on the fiscal adjustment and other factors. Goldfajn said conditions could be created so that market forecasts converge on the target, making room for monetary policy easing. Among other factors, these conditions depend on the progress of the fiscal adjustment, which would help reduce country risk and anchor inflation expectations.

The recession and exchange rate are likely to contribute to continued disinflation. Unemployment is likely to rise further, which should maintain the disinflation scenario, despite some future growth recovery. Currency appreciation should also help to slow inflation ahead, particularly in tradable goods.

There is room for interest rate cuts in the second half of the year, but the cycle is likely to start later and more gradually. We believe the CB will hold interest rates stable for longer, to ensure that the conditions for a monetary easing (clearer progress in fiscal reforms and falling inflation expectations) are met. We now expect the cycle of interest rate cuts to start in October, with an initial cut of 0.25 pp (compared with 0.50 pp in August). In this scenario, the Selic rate will fall to 13.50% by the end of 2016.

More conservative approach in the short term is compatible with a longer easing cycle. We believe that Selic rate will reach 10.00% at the end of 2017.


 

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


 

 



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