Itaú BBA - Lower growth, higher risks

Brazil Scenario Review

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Lower growth, higher risks

December 9, 2016

We reduced our growth forecast for 2016 and 2017. Fiscal reforms continue to move ahead, but political uncertainty increased.

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

• Third-quarter GDP figures confirmed the weakness of economic activity. We have revised our 2017 growth forecast to 1.5% (down from 2.0%).

• Fiscal reforms continue to move ahead, however political uncertainty has increased.

• Inflation continues to fall. Our 2016 IPCA forecast has been revised to 6.6% but remains stable for 2017 at 4.8%. 

• The exchange rate remains close to its sustainable, or equilibrium value.

• The pace of interest-rate cuts is likely to increase (to 50 bps per meeting) in January.

Falling inflation creates an opportunity for larger interest-rate cuts

Economic activity seems to have weakened in the recent months. However, fundamentals (lower interest rates, higher commodity prices, reduced company leverage and falling inventories) continue to suggest a moderate rebound in economic activity.

Scenario risks have been increasing. In addition to a more complex external scenario, there has been a recent upswing in political uncertainty in Brazil. We maintain our view that the fiscal reforms (Social Security and the spending cap) will be approved by Congress, however there is a greater level of risk.

Fiscal reforms continued to make headway last month despite increasing political uncertainty. The spending cap was approved in the first round of Senate voting and the second round is scheduled for the end of this year.

Inflation continues to be better than expected. We have reduced our forecast for the Extended National Consumer Price Index (IPCA) to 6.6%, compared with 6.8% in the previous report.

We have maintained our exchange-rate forecast of BRL 3.40 to the dollar at the end of 2016 and BRL 3.60 to the dollar at the end of 2017. The outcome of the U.S. elections has pressured emerging currencies; however, approval of domestic reforms supports the BRL, which also benefits from higher commodity prices.

Interest-rate cuts likely to accelerate in January. Falling inflation and weaker activity are creating an opportunity for larger interest-rate cuts. We expect that the cycle will move to a pace of 50 bps per meeting, with a final cut of 25 bps, until the Selic rate reaches 10.00%.

Modest return to growth in 2017

GDP shrank 0.8% in the third quarter. This result shows further deterioration in economic activity.On the positive side, the drop in family consumption has decelerated[1]. Additionally, GDP remains below aggregate demand (-1.1% over the past four quarters) because of companies’ efforts to reduce inventories.

Diffusion worsened at the margin. 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 – remains volatile, which is characteristic of economic inflection points.The index’s three-month moving average will probably end November at around 41%, after reaching 56% in July.The index continues to suggest that activity will improve as we move ahead, but with less intensity.

A slight rise in industrial confidence. Industrial confidence rose slightly in November, remaining above the levels observed during the first half of the year. We estimate that demand remains higher than the output (measured by the capacity utilization). This situation should normalize when inventories achieve the desired level.

Weaker short-term GDP, but fundamentals are stable. Recent reports have shown a lower-than-expected level of activity. Incorporating the 3Q16 GDP figures and a review of the historic series, we expect GDP to remain broadly stable in the fourth quarter of 2016. We have therefore amended our 2016 GDP forecast to -3.3% from -3.2%. Although the statistical inheritance for 2017 will likely be worse than previously forecast, we believe the fundamentals continue to suggest moderate GDP growth next year. Commodity prices are likely to increase in 2017 after falling for the past two years. Monetary-policy easing and company deleveraging are likely to provide some relief for aggregate demand. Additionally, inventory normalization should contribute positively to GDP[2]. We have therefore revised our 2017 economic activity growth forecast to 1.5% (compared with 2.0% previously).

Formal employment shrank less at the margin. In October, a net 75 thousand formal jobs were destroyed (Caged). Without accounting for seasonal effects, the contraction affected 79,000 jobs, a milder decline at the margin than in 1Q16, when 145,000 jobs were destroyed (three-month moving average). Although widely spread across sectors, destruction of formal jobs appears to be slowing in the manufacturing industry and retail sectors.

Rising trend for unemployment continues. In October, the nationwide unemployment rate posted its twenty-third consecutive increase and rose from 11.8% to 12.1%, based on our seasonal adjustment. We have maintained our unemployment forecast of 12.5% for end the year and 12.2% in December of 2017. Since the PNAD Contínua series is relatively short, the forecasts are quite uncertain.

Reforms advance, but political uncertainty increases

Fiscal reforms continued to move ahead last month.

In November, the Senate approved the constitutional amendment for the spending cap (PEC 241/55) in its first round of voting. The second round, the final stage in bill’s passage through Congress, is scheduled for the end of the year.

If the spending cap is approved, it will represent a structural change in Brazil’s fiscal management. If implemented, the cap will reverse the 20-year trend of uninterrupted real increases in primary federal expenditure and will gradually correct the fiscal imbalance as the economy returns to growth[3] .

Continuing the structural fiscal adjustment, the government has sent its Social Security reform bill to Congress. The bill is likely to be debated throughout the first half of 2017. It sets a minimum retirement age of 65 and unifies the rules on access to Social Security benefits for men and women, public-sector and private-sector workers and residents in urban and rural areas.

Changes to Social Security are essential in order to comply with the spending cap over the next several years. Social Security expenditure represents 40% of the federal government’s total primary expenditure (8.0% of GDP) and will increase in real terms over the next several years as the population ages. The proposed reforms would bring the federal budget into line with Brazil’s current demographic situation. It would also reduce the need for significant cuts to the rest of the budget and support spending-cap compliance for a longer period.

We believe that, if approved, these measures will be critical for stabilizing medium-term public debt. We are forecasting that the federal government will only be able to achieve a primary surplus again in 2020. However, a return to growth and structural drop in interest rates following implementation of the reforms will significantly reduce the speed of annual public-debt increases over this period. More specifically, we believe that by complying with the spending cap, public debt will remain stable at around 80% of GDP until 2023, when it should start to fall as the government achieves larger primary surpluses.

We have marginally improved our primary deficit forecast for 2016 from 2.5% (BRL -158 billion) to 2.4% of GDP (BRL -151 billion). The revision results from spending BRL 4 billion less than we had previously expected and a result from the states and municipalities that should be 3 billion BRL higher than we had anticipated. The primary result should beat the annual target of -2.6% of GDP (BRL -164 billion), despite the expected BRL 16 billion in payments from previous fiscal years (“restos a pagar”), due to the BRL 64 billion in extraordinary revenues raised from asset repatriation and hydroelectric auctions.

We have maintained our forecast for a primary deficit representing 2.2% of GDP in 2017 (BRL 142 billion), in line with the government target. We have included BRL 10 billion raised under the new foreign-asset repatriation program, which is likely to offset the shortfall in revenues from worsening growth forecasts. In addition to the repatriation revenues, we expect BRL 37 billion in additional extraordinary revenues from energy-permit auctions, infrastructure concessions and IPO taxation, in line with the government budget.

The inflation scenario remains positive

We are forecasting a 6.6% variation in this year’s IPCA, below the 6.8% forecast in our previous report. We are forecasting a 7.0% increase in market prices (compared with 8.5% in 2015). Looking at the market-price components, we estimate an increase of 10.0% for food at home (12.9% in 2015), 5.2% for industrial prices (6.2% in 2015) and 6.8% for services (8.1% in 2015). We are forecasting a 5.6% increase in regulated prices (compared with 18.1% in 2015). The announcement that the “green tariff flag” will be activated in December – which means there will be no additional charges on electricity bills – will have a -0.1 pp impact on December’s IPCA. Food-at-home prices have also reacted more favorably than previously expected.

For the time being, we are forecasting an increase of around 0.55% in the December IPCA. Inflation in the last month of the year will come under pressure from the transportation (reflecting higher airline ticket and fuel prices), food and personal expenses groups. On the other hand, the housing group should post a negative rate as electricity bills fall.

We continue to forecast that IPCA inflation will fall to 4.8% in 2017. Next year’s drop in inflation will reflect less inflationary inertia, lower inflation expectations, more favorable weather conditions, the high level of idle capacity still seen throughout the economy and a smaller effect from tax increases.

On a disaggregated basis, we are forecasting a 4.6% rise in market prices and a 5.6% increase in regulated prices. Among market prices, we are forecasting a 4.0% increase for food at home as major agricultural producers are likely to see bumper crops, reflecting improved weather conditions as the effects of El Niño taper off. In other segments, we are forecasting a 5.4% increase in service prices and a 3.7% increase in industrial prices. Among regulated prices, we are forecasting an increase of 8% for electricity, 3% for gasoline, 11% for health plans, 5% for urban bus and 5% for medicinal drugs.

The main risk in the inflation scenario is posed by the external scenario and domestic political uncertainty. Greater uncertainty abroad could see risk premiums increase, which could result in exchange-rate depreciation. Besides any further difficulties moving ahead with the necessary reforms and adjustments could also put additional pressure on risk premiums and exchange rates.Additionally, this situation could also trigger attempts to adopt alternative fiscal measures, such as tax hikes and removal of certain tax breaks, which would slow down the disinflation process.

The high level of idle capacity in the economy is also likely to drive inflation down further. Albeit subject to a level of uncertainty and errors of measurement, the negative output gap could lead to faster market-price disinflation over the next few months, particularly for industrial products and services. Similarly, progress on fiscal reforms could improve the outlook for inflation, either through exchange-rate and inflation expectations, or switching from the current expansionary policies to neutral or even contractionary fiscal policies.

Anchored expectations strengthen the scenario of falling inflation. According to the Focus survey of market analysts, inflation expectations for 2016 retreated again last month to 6.7% while inflation expectations for 2017 remain unchanged at 4.9%. Median expectations for 2018 and further ahead remain solidly at the center of the target (4.5%), reflecting an increasing conviction that the central bank will take steps to ensure that the IPCA will indeed converge on target in a timeframe that will allow monetary policy to have a greater effect.

The BRL depreciates following the U.S. elections

Over the past month, higher U.S. interest rates have pressured emerging-market currencies, including the BRL. The exchange rate reached an intraday peak of BRL 3.54 to the dollar, its highest rate since July this year, but fell back as November progressed.

The central bank intensified its interventions in the FX market. The monetary authority announced a pause in its reverse-FX swap auctions to assess market conditions and rolled over the entire batch of USD 6.5 billion maturing in December.Additionally, a further USD 2.45 billion in new FX swaps were offered. At the end of November, the central bank’s short position in FX swaps stood at USD 27 billion. In December, the CB has already begun the process of rolling over contracts maturing in January.

We have maintained our exchange-rate forecast of BRL 3.40 per dollar at the end of 2016 and BRL 3.60 per dollar at the end of 2017. On one hand, higher U.S. interest rates may maintain pressure on the BRL ahead.On the other hand, our scenario is based on approval of the fiscal reforms, a gradual increase in U.S. interest rates and the outlook for higher average metal commodity prices than last year.This exchange-rate trend is in line with a scenario of slight growth in current-account deficits, albeit at low levels, not compromising external sustainability. 

External accounts are stable at the margin. The current-account deficit has settled at a higher level than observed during the first half of the year. In October, the seasonally adjusted, annualized, three-month moving average was stable at a deficit of around USD 25 billion. Currency appreciation in recent months helps explain the more-modest results. However, in 2016, the current-account deficit is already down 68% from the same period last year (USD 17.0 billion compared with USD 53.5 billion), the lowest year-to-date deficit since 2007.

Recent results are consistent with our outlook of a small current-account deficit in 2016. We have maintained our forecast of a USD 47 billion surplus in 2016 and a USD 46 billion surplus in 2017. For the current account, we are forecasting a USD 21 billion deficit in 2016 and a USD 29 billion deficit in 2017.

BCB opens the door to faster cuts

In November, the central bank delivered its second rate cute, another 25-bp move, taking the Selic to 13.75%. In the minutes, the BCB did not pre-commit to trim the Selic by 50 bps in the January meeting. But it makes quite clear that this is now the base case. In fact, some elements of the text hint that the central bank could have opted for a faster pace of easing, had it not been for the surprise in the U.S. election and its market aftereffects,

We believe the domestic scenario continues to support monetary policy easing… First, the fiscal reforms are still making progress, despite rising uncertainty. Second, economic activity remains weak, reducing inflationary risks. Third, inflation is likely to continue falling. And finally, the lag in monetary policy effects will encourage the CB to switch its focus to 2018 instead of 2017 inflation. In our opinion, all of these factors tip the scales toward speeding up the easing cycle.

... and developments abroad are unlikely to change this. According to the CB, “there is no direct relationship between the external scenario and domestic monetary policy.” External uncertainties may result in exchange-rate depreciation, which could hamper the disinflation process. However, the favorable evolution of commodity prices and possible impacts on domestic activity could mitigate the negative outcomes.

We believe that the CB communication and our expectations for the economy over the next few months are consistent with our scenario of a faster cycle of interest-rate cuts, starting at the January meeting. We forecast 50-bp cuts throughout 2017 and a final 25-bp cut, with the Selic ending the year at 10.00% p.a.


 

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



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