Itaú BBA - Moving toward the new equilibrium

Brazil Scenario Review

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Moving toward the new equilibrium

February 10, 2017

Anchored expectations and widespread disinflation create an opportunity to reduce the inflation target.

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

Anchored expectations and widespread disinflation create an opportunity to set the 2019 inflation target at 4%, rather than the 4.5% in place since 2005. We lowered our IPCA forecast to 4.4% this year and to 3.8% in 2018

• Congress will begin debating Social Security reform this month. We expect the reform to be approved in 2Q17.

• Economic activity is presenting signs of improvement at the margin, in line with our scenario. 

• A drop in country risk has strengthened the BRL. We have revised the exchange rate forecast to BRL 3.35 per dollar for 2017 and BRL 3.45 for 2018. 

• Lower inflation supports further reductions in the Selic benchmark rate, which is likely to fall to 9.25% in 2017 and 8.25% in 2018.

Reduced target reinforces disinflation and likelihood of lower interest rates

Anchored expectations and widespread disinflation create an opportunity to reduce the inflation target. We have revised our inflation forecast to 4.4% this year (from 4.7%) and 3.8% in 2018 (from 4.0%) in light of better than expected inflation, a more appreciated exchange rate and the likelihood of the 2019 target being set at 4%, rather than the 4.5% target that has been in place since 2005.

Fiscal reforms will remain in the spotlight in 2017. Congress will begin to debate the Social Security reforms this month.This is a fundamental step needed to ensure spending-cap compliance over a prolonged period.We expect the Lower House to approve the reforms by the end of the second quarter.

Economic activity is presenting signs of improvement at the margin, in line with our scenario. We maintain our GDP growth forecast of 1.0% in 2017 and 4.0% in 2018.

We have revised our exchange-rate forecast based on a faster-than-expected reduction in country risk. We are now forecasting an exchange rate of BRL 3.35 to the dollar at end-2017 (previously 3.50) and BRL 3.45 to the dollar at end-2018 (previously 3.50).  

Falling inflation and the fiscal adjustments set the scene for a sustained reduction in interest rates. Alower inflation target for 2019 reinforces this trend.We now expect the Selic rate to drop to 9.25% by the end of 2017 (from 9.75%) and 8.25% in 2018 (from 8.50%).

Further reduction in inflation forecasts

We have reduced our Extended National Consumer Price Index (IPCA) inflation forecast for 2017 from 4.7% to 4.4%. The improved result for inflation at the margin and downward exchange-rate revision in the scenario were the main factors behind the decision to lower our inflation forecast for this year. For the 12-month reading, we expect inflation to fall back to 4.9% in February, 4.8% in March, 4.1% in June and 4.0% in September. We note that disinflation tends to trigger a welcome debate about a possible reduction in the inflation target.

On a disaggregated basis, we are forecasting a 4.1% rise in market prices (previously 4.4%) and a 5.4% increase in regulated prices (previously 5.5%) for 2017. Looking at market prices, we have reduced our forecast for food at home from 3.7% to 3.0% (compared with 9.4% in 2016) based on the revised exchange-rate scenario as well as positive results at the beginning of the year in both the wholesale and retail markets. The prospect of bumper farm crops from the world’s main producers as a result of favorable weather conditions is likely to ensure that food prices remain well behaved throughout the year. In the other segments, we are forecasting a 5.3% increase in service prices (compared with 6.5% in 2016) and 3.1% increase in industrial prices (compared with 4.8% in 2016). As the labor market and real estate sector continue to face adverse conditions, alongside a reduced inertial effect from past inflation and a smaller increase in the minimum wage, we expect this to have a moderating effect on wage and rent costs, thereby contributing to a further fall in service inflation this year. Looking at regulated prices, we are forecasting no variation for gasoline prices, a 2% increase for fixed-line telephony;,4% for drugs, 7% increase for urban bus travel, 8% for electricity and 11% for health plans.

Our 2018 inflation forecast has fallen to 3.8% from 4.0%. On a disaggregated basis, we are forecasting a 3.7% rise in market prices and a 4.3% increase in regulated prices. Our inflation forecast for next year fell, based on the revised exchange-rate scenario, less inertia from this year’s inflation and the likelihood that the 2019 inflation target will be set at 4% rather than the current 4.5%. As noted above, instances where inflation dips below the target center throughout the year create an opportunity to discuss reducing the inflation target for the years ahead. We believe that a lower target will be credible and help reinforce the process of reducing the level of inflation.

The main inflation-scenario risk factors are linked to external scenario uncertainties and domestic political issues. Despite the markets’ apparent tranquility at the beginning of the year, greater uncertainty abroad could see risk premiums increase, which may result in further exchange-rate depreciation. In the fiscal realm, any further difficulties in moving ahead with the necessary reforms and adjustments could put additional pressure on risk premiums and exchange rates and create an opening for alternative fiscal measures, with a greater focus on tax hikes. However, the signs of progress to date and approval of the fiscal reforms are positive factors.

The high level of idle capacity in the economy may also help push down inflation further. Albeit subject to uncertainties and errors of measurement, the negative output gap (the difference between potential GDP and actual GDP) could lead to faster market price disinflation over the next few months, particularly in areas that are more sensitive to the economic cycle, such as industrial products and services. The inflation surprises in recent months already contain evidence that there is a more widespread disinflation process across exactly these components. Similarly, progress on fiscal reforms could improve the outlook for inflation, either through exchange-rate and inflation expectations, or by gradually switching from expansionary to neutral or even contractionary fiscal policies.

More-solidly grounded expectations reinforce the scenario of falling inflation. According to the Central Bank’s (CB) Focus survey, median inflation expectations for 2016 retreated again last month to 4.6% from 4.8%, a level now very close to the inflation target. In turn, median expectations for 2018 and further ahead remain solidly at the center of the target (4.5%), reflecting economic agents’ increasing conviction that the CB will take steps to ensure the IPCA will indeed converge on the target.

Signs of improving activity

Sharp increase in industrial output. Industrial output rose 2.3% in December last year.Growth was observed in three of the four main economic categories and 16 of the 24 activities (across 67% of activities).Output rose for the second consecutive month, reaching its highest level since July 2016.

Diffusion index likely to reach its highest level since 2012. 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 December at around 41% (3-month moving average). At the margin, the trend is toward a more-accentuated improvement. Preliminary figures from January suggest that diffusion is set to reach around 60%, which, if confirmed, would be the highest level since October 2012.

Widespread increase in business and consumer confidence. Confidence improved at the beginning of the year. In January, business and consumer confidence increased. In industry, besides a sharp rise (5.7%), confidence showed a favorable makeup, with falling inventories and rising demand. We expect the cyclical inventory adjustment to continue as we move ahead, which will support the economic recovery.

We have maintained our GDP forecasts for 2017 and 2018. We forecast that fourth-quarter GDP in 2016 would drop 0.5% on a quarterly basis, after seasonal adjustments. However, leading indicators are improving and suggest a return to growth in the first quarter of this year. Additionally, fundamentals continue to signal that activity is improving. We are therefore maintaining our forecast that GRP will grow 1.0% in 2017 and 4.0% in 2018.

Lower-than-expected drop in formal employment. In December, a net of 462,000 formal jobs were destroyed (according to figures from Caged), the month’s best result since 2013. Stripping out seasonal effects, we estimate a contraction of 19,000 jobs and that the three-month moving average improved from
-114,000 to -81,000. We expect net destruction to ease over the coming months, although it is likely to continue into the second half of this year.

Unemployment remains high. In December last year, the national rate of unemployment hit 12.0%, three percentage points (p.p.) higher on an annualized basis. The rate of unemployment stripping out seasonal effects registered its 25th consecutive increase and rose from 12.3% to 12.6%. The (seasonally adjusted) rate of unemployment is likely to reach 13.2% by the end of 2017 and 12.9% in the fourth quarter of 2018.

Fiscal: focus on reforms

Fiscal results continued to worsen in 2016. The consolidated primary deficit reached -2.5% of GDP, the worst result in the historical series and only slightly better than the annual target of -2.6% of GDP. Gross debt advanced from 66% of GDP in 2015 to 70% of GDP in 2016 (see graph), despite the return of 1.6% of GDP (BRL 100 billion) from the National Bank for Economic and Social Development (BNDES) to the Treasury and the 1.2% of GDP (BRL 76 billion) gain with FX swap transactions last year.

The worsening trend reinforces the need to approve reforms in order to stabilize public debt over the medium term. We are forecasting that a return to primary surpluses will be achievable again only in 2020; however, we believe a return to growth and structural drop in interest rates following adoption of reforms will significantly reduce the speed that public debt increases each year. We expect public debt will remain stable at around 80% of GDP from 2018 on.

Social Security reform is likely to be approved (albeit with some amendments) by Congress in the second quarter of 2017. The bill 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. As Congress has now returned from its recess, the bill will be debated by the newly created Lower House Special Committee over the next few months.

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 are working on the assumption that there will be BRL 60 billion in extraordinary revenues, which should come from the tax regularization program, an extension of the asset repatriation program, energy auctions, infrastructure concessions and taxes raised from IPOs.

In 2018, we expect a primary deficit representing1.6% of GDP (BRL 116 billion). This forecast takes into account the spending cap (approved in 2016) and BRL 35 billion (0.5% of GDP) in extraordinary revenues, which is compatible with a gradual reversal of Brazil’s fiscal imbalance.

More modest BRL depreciation as country risk premium falls

The BRL continued to make gains against the dollar over the past month and reached its highest level since last October. The more-favorable external environment for emerging economies, with rising commodity prices and lower risk aversion, helped to explain why the U.S. dollar has lost strength against other currencies, including the BRL.

We have revised our exchange-rate forecast down to BRL 3.35 per dollar at the end of 2017 (previously 3.50) and BRL 3.45 per dollar at the end of 2018 (previously 3.50). On the domestic front, the improving outlook (of approval for fiscal reforms) that has reduced country risk premium and increased capital inflows is likely to continue, pressuring for a more-appreciated BRL than we expected.

The current-account deficit fell to 1.3% of GDP in 2016 (USD 23.5 billion)from 3.3% of GDP in 2015 (US$ 59 billion), mainly driven by a positive contribution from the trade balance, which posted a USD 45 billion surplus. The services and income deficits were also lower throughout the year. On the financing side, direct investment in Brazil remained resilient (4.4% of GDP) and were enough to fully cover the current-account deficit (multiple times), reducing dependency on more-volatile types of capital. 2016 was also marked by strong outflows of local fixed-income investment (-1.5% of GDP).

For the coming years, we have revised our current-account deficit forecast, but not enough to compromise external sustainability. The combination of a slightly more-appreciated exchange rate and a recovery in domestic demand will likely result in larger current-account deficits. We forecast a trade surplus[1] of USD 46 billion in 2017 and USD 34 billion in 2018 (previously USD 37 billion). We forecast a USD 33 billion current account deficit in 2017 (previously USD 30 billion) and USD 50 billion deficit in 2018 (previously USD 43 billion).

Monetary Policy: lower interest rates in 2017 and 2018

The monetary-policy scenario is now more favorable. Inflation continues to fall and inflation expectations remain anchored to the target over longer horizons. Activity remains weak, in spite of signs of improvement at the margin. Fiscal adjustments continue to progress and the external scenario remains positive for emerging markets, despite uncertainties surrounding future U.S. policy.

This environment enables a sustained reduction in interest rates. In our view, the likelihood of a lower target reinforces this trend. We now expect a Selic rate of 9.25% by the end of 2017 (previously 9.75%). We consider three additional cuts of 75 bps at the February, April and May meetings and three further cuts of 50 bps in July, September and October. In our assessment, the Central Bank should and will pause during the monetary-easing process in order to monitor the impact of its decisions on the economy.

We currently expect the Selic rate to end 2018 at 8.25% (compared with 8.50% in our previous scenario).


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