Itaú BBA - No signs of economic stabilization

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No signs of economic stabilization

November 12, 2015

Economic activity continues to decline. There are no signs of stabilization in production or demand.

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

• Economic activity shows no sign of stabilizing. Leading and coincident indicators continue to fall. Investment will likely be lower than we had anticipated. We revised our GDP forecasts to -3.2% for 2015 (-3.0% previously) and -2.5% for 2016 (-1.5% previously). Even if activity stabilizes from November onward, the average decline next year (compared with this year) would be -1.7% (i.e, the so-called statistical carryover). The unemployment rate is expected to reach 10.6% by YE16 (10.2% previously).

• The fiscal situation has deteriorated further. Falling revenues, reflecting economic activity, and rising mandatory spending (particularly social security) will continue to pressure public accounts despite the ongoing adjustment measures. We revised our forecasts for the primary budget balance to -1.0% of GDP for 2015 and -1.5% of GDP for 2016, including payment of past expenses.

• The local currency appreciated during the past month due to the international scenario and expectations about the repatriation bill approval by congress. However, fundamentals are still in line with our exchange rate forecasts, at 4.00 reais per U.S. dollar by the end of 2015 and 4.50 by the end of 2016.

• Our estimates for consumer inflation (IPCA) stand at 10.1% this year and 7.0% next year. A smaller advance in regulated prices in 2016 will contribute to lower inflation. Market-set prices are also expected decelerate, with relief coming from food and service prices.

• The central bank extended the horizon of inflation convergence to the target to 2017. This move allows more time for the central bank to reach its target and limits the chance of interest rate increases in the next monetary policy meetings. We believe that the Selic benchmark rate will hold steady, at 14.25%, until the end of 2016.

Waiting for the adjustment

Economic activity continues to decline. There are no signs of stabilization in production or demand. A growth rebound is conditional on the adjustment in public accounts, which is not happening.

Despite weaker activity, inflation remains under pressure. The realignment of relative prices has largely materialized, but it has driven inflation toward double digits. The trend ahead points downward, but inflationary inertia (due to formal and informal indexation mechanisms) and FX depreciation will keep inflation at high levels throughout 2016.

In this context, the central bank extended the convergence horizon to 2017. A longer convergence horizon reduces the likelihood of new interest rates increases in the near future, preventing further activity deterioration going forward. On the other hand, high inflation does not allow for rate cuts either. Hence, we expect the central bank to keep the Selic rate unchanged, at 14.25%, until the end of 2016.

The balance of payments has been posting favorable results. A weaker currency and slower activity are helping the trade balance, which will likely post surpluses of USD 12 billion in 2015 (previous forecast: USD 10 billion) and USD 30 billion in 2016 (previous forecast: USD 25 billion). Our latest forecasts incorporate recent figures showing larger trade surpluses. Thus, we now estimate smaller current account deficits, of 3.9% of GDP in 2015 (4% previously) and 2.4% of GDP in 2016 (2.8% previously).

Activity slows down even more

Economic indicators continue to point downward. 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 – will likely end 3Q15 at a level that is compatible with an annualized drop of 5% in activity. The index suggests weak activity through the end of this year and into the beginning of next year.

Industrial production fell 3.2% in 3Q15. Meanwhile, construction materials production dropped 4.4% (according to our seasonal adjustment) and points to another decline in investments, which, if confirmed, would mark the ninth consecutive quarterly drop.

We anticipate a further decline in retail sales. The real wage bill will likely continue to shrink next year. Higher inflation reduces real income, which means reduced household spending. In the short term, leading indicators continue to show sales declines, which are consistent with deterioration in the labor market.

The Service sector also reveals an unfavorable backdrop. In real terms, the sector’s revenues are close to the lowest levels since 2013, despite a slight increase in August (according to our seasonal adjustment).

High inventories, eroded confidence. In October, business and consumer confidence levels remained close to their all-time lows. Confidence in the Retail and Construction sectors and among consumers posted their lowest readings ever. Confidence among manufacturing entrepreneurs rose somewhat, but industrial inventories reached their highest level since 2001. High inventory levels point to falling industrial production in the near future.

Additional decline in activity going forward.  We anticipate a sharper contraction in GDP during the next few quarters. The real wage bill will shrink further, reducing household spending. Still-high unit labor costs (in local currency) and lower revenues due to weak domestic demand will hurt corporate profitability. Along with low business confidence levels, low capacity utilization and high inventories, this picture tends to dissuade investors even further. Hence, we have revised our GDP forecasts to -3.2% from -3.0% for 2015 and to -2.5% from -1.5% for 2016.

Unemployment rate still on the rise. Unemployment climbed to 7.5% in September (our seasonal adjustment) from 7.4% in August, marking the ninth consecutive increase. The latest increase materialized despite a low participation rate, which, in our view, will not be sustained. Faster elimination of formal jobs (according to the Labor Ministry’s CAGED registry) – marking the worst result in the historical series (-208K, according to our seasonal adjustment) – corroborates the additional deterioration in the labor market. The share of people who say that it is difficult to find a job reached 92%, reinforcing the upward trend in unemployment.

Given the steeper decline in economic activity, we have revised our YE16 forecast for the unemployment rate to 10.6% from 10.2%. Our estimate for YE15 remains at 8.6%.

Credit was weak again in September. The daily average of new non-earmarked loans fell 1.1% mom/sa in real terms, while the daily average of new earmarked loans expanded 5.1%. The real year-over-year change in total outstanding loans switched to a 0.4% decline from 0.1% growth. Non-earmarked outstanding loans continued to fall (-4.2% yoy), while growth in earmarked credit slowed to 3.9% from 4.8%. The overall delinquency rate was stable, at 3.1%. Average interest rates increased, but average spreads narrowed.

Fiscal outlook worsens

The adjustments needed to rebalance the Brazilian economy are proving to be more challenging than anticipated. Last month, the government revised its 2015 primary budget balance target to -0.8% of GDP from +0.15%.

We revised our estimate for the primary balance in 2015 to -1.0% of GDP.  The revision in the government’s target suggests 9 billion reais in revenues less than we anticipated, and 25 billion reais more in public expenses. We also incorporated 10 billion reais in additional payments related to delayed expenses.

However, the primary balance could reach -2.0%. This risk arises mainly from the eventual payment of the full amount of delayed expenses (estimated at 57 billion reais by the Finance Ministry). But also, from eventual disappointments with the hydropower dam auctions extraordinary revenues.

Our forecast for the primary balance in 2016 now stands at -1.5% of GDP. We revised our estimate for payment of delayed expenses upward (to 39 billion reais from 24 billion). We also revised our forecasts for economic activity, implying a negative impact on government revenues. Finally, we revised our estimate for the primary balance of states and municipalities to -10 billion reais from +3 billion, given their perceived difficulties in extending spending cuts to offset falling revenues.

In a nutshell, falling revenues due to sluggish economic activity and rising mandatory expenses will continue to pressure fiscal readings. These factors outline a downward trend for primary results going forward, despite ongoing fiscal-adjustment measures. This situation reinforces the need for structural adjustments (click here to read our recent article – “The Art of Cutting Close to the Bone”).

Fundamentals do not support a stronger BRL

The exchange rate traded between 3.75 and 4.00 reais per U.S. dollar in October. After peaking at 4.20 in September, the FX market calmed down in the past month.

The international scenario provided support. Lower risks of a so-called hard landing in China and expectations of further monetary stimuli in Europe boosted emerging market currencies, including the real.

However, fundamentals in Brazil still do not suggest a stronger currency. The news flow on fiscal policy, unemployment and activity remains negative. Fitch Ratings has recently downgraded the country to BBB- from BBB, with a negative outlook, but maintaining the investment-grade status.

We maintained our exchange rate forecasts at 4.00 reais per dollar for year-end 2015 and 4.50 for year-end 2016. During the past month, amid the revision in the fiscal target and deterioration in the scenario for the next years, we revised our exchange rate estimate for the end of 2016 to 4.50 reais per dollar from 4.25. Domestic uncertainties will likely have impact on the external financing availability in the coming years. We believe these FX forecasts (4.00 in 2015, 4.50 in 2016, and constant in real terms later) will likely lead the current account deficit to 1.0% of GDP in 2017.

Current account figures continue to be favorable. The widespread improvement reflects a weaker currency and slower economic activity. The annualized seasonally-adjusted three-month moving average deficit, which neared USD 110 billion at the end of 2014, has been cut by half, to USD 55 billion in September. On the financing side, however, both direct investment and portfolio flows keep receding on a month-over-month basis.

We increased our trade surplus forecasts to USD 12 billion from USD 10 billion for 2015, and to USD 31 billion from USD 25 billion for 2016. We also revised our current account deficit to 3.9% of GDP for 2015 (4% previously) and to 2.4% of GDP for 2016 (2.8% previously). Our forecasts incorporate the latest readings of larger trade surpluses, a weaker currency and slower activity.

Inflation at 10.1% this year and 7% in 2016

The consumer price index IPCA climbed 0.82% in October, standing between the median of market expectations (0.80%) and our own estimate (0.84%). Hence, the index went up 8.52% year to date and 9.93% year over year. Transportation, food and housing provided the largest upward contributions during the month, led by fuels, which impacted the inflation reading by 0.30 pp. On the other hand, prices for fresh fruits and vegetables and passenger cars declined. 

Our preliminary forecast for the IPCA in November stands at 0.70%, with the year-over-year change picking up to 10.1%. Food and transportation will provide the biggest contributions to the increase. Still, the change for the transportation group is expected to be more moderate than in October, as the hike in fuel prices slows down.

We increased our full-year forecast for the IPCA to 10.1% (9.7% in our previous report), given greater pressure from fuels and other regulated prices. We now estimate a 17.3% hike in regulated prices in 2015 (16% previously), causing an impact of 3.9 pp on the IPCA. We calibrated our estimate for gasoline to 17% from 14% due to a bigger increase in prices for ethanol at sugarcane-processing mills, as ethanol is part of the gasoline mix. We also revised our estimates for bottled cooking gas (to 21% from 18%), electricity tariffs (to 50% from 48%) and urban bus fares (to 15% from 13%). Electricity will see the biggest increase among regulated prices, which will have an impact of 1.5 pp on the IPCA. For the other regulated prices that are more relevant for inflation, we anticipate the following changes in 2015: health insurance premiums (12%); water and sewage tariffs (14%); medication (7%); and landline phone fares (-2.5%).

Our estimate for market-set prices this year was revised to 8.0% (7.8% in our previous report). The upward pressure exerted by market-set prices on the IPCA reading in 2015 will be 6.2 pp. We anticipate a 11% increase for food consumed at home (7.1% in 2014). The greater pressure on food prices this year reflects several cost shocks (exchange rate, electricity and fuels) as well as weather issues that affected supply, especially for meats and fresh fruits and vegetables. Service prices are expected to advance 8.1% (8.3% in 2014), while industrial prices will likely rise 5.9% (4.3% in 2014).

We increased our forecast for the IPCA in 2016 to 7.0% from 6.5% due to a weaker currency and greater pressure from regulated prices. We raised our estimate for market-set prices to 6.8% from 6.5%. We anticipate advances of 6.0% in industrial prices, 7.0% in service prices and 7.5% in costs for food consumed at home. Despite greater resilience in service inflation this year, we maintain our assessment that worsening conditions in the labor market and in the real estate market, with ensuing moderation in costs related to wages and rent, will contribute to a slowdown in service inflation next year. Our basic scenario for food prices assumes that weather conditions will be more favorable than in past years, while risks related to the El Niño weather pattern may affect the supply of some agricultural items. In addition to more benign weather for crops, particularly for grains, and more moderate exchange-rate fluctuations, smaller increases in electricity and fuel prices will also help to hold back food inflation in 2016. Given that backdrop, we anticipate smaller price hikes for meats, wheat byproducts and fresh fruits and vegetables.

We increased our forecast for regulated prices in 2016 to 7.4% from 6.5%. We adjusted our estimates for electricity (to 10% from 7%) and gasoline (to 8% from 7%). The revision involving electricity tariffs took into account legal decisions, the effect of a weaker currency on the cost of energy produced in the Itaipu plant and the inclusion of regulatory liabilities. On the other hand, and cushioning some of these effects, we now project some relief in electricity bills because of a change in the warning level under the so-called flag system, given the expectation that the use of thermal power plants will be less intense. We forecast price increases for gasoline of 10% at refineries and 8% at the pump. Right now, we do not project any increases in the CIDE tax on gasoline prices. The revision for electricity and gasoline prices also assumed the effect of higher rates for the ICMS tax in the state of Rio Grande do Sul. Anyhow, the contribution of regulated prices to inflation in 2016 (1.8 pp) will likely be much smaller than the expected contribution for this year (3.9 pp), with half of the relief coming from electricity tariffs.

The fiscal issue is a key risk factor for inflation next year. A further deterioration in public accounts could mean an even sharper and more prolonged realignment of relative prices than our inflation forecasts assume. Impacts may come from a weaker exchange rate due to higher risk premiums, from the need to hike taxes and/or adjust regulated prices more steeply or from a deterioration in inflation expectations related to this context.

On the other hand, weaker economic activity could contribute to a sharper retreat in inflation next year. However, although the slowdown in activity may smooth out inflationary pressures through the demand channel, it also creates a delay in the recovery of fiscal results, giving rise to uncertainty over the balance of risks.

We increased our forecast for inflation measured by the general price index IGP-M in 2015 to 10.5% from 9.0%, mostly due to the impact of FX depreciation. Breaking this down by component, we now estimate increases of 11.2% for the producer price index IPA-M (which has the greatest weight in the IGP-M, at 60%), 10.0% for the consumer price index IPC-M (30% weight), and 7.5% for the construction cost index INCC-M (10% weight). We also raised our forecast for the IGP-M in 2016 to 7.5% from 7.2%.

A longer convergence horizon gives the central bank more time, but it does not guarantee the target will be met

The central bank extended the convergence horizon of inflation to the target. The central bank now seeks convergence toward the “relevant horizon for monetary policy.” More recently, Economic Policy Director Altamir Lopes explained that the goal is "to bring inflation to the 4.5% target in 2017.”

The extension of the convergence horizon to 2017 gives more time to the central bank. This extension to meet the target reduces the likelihood of rate increases in the next meetings. Weaker demand will help push inflation downward, even if the process takes longer than anticipated.

The central bank maintained some parameters for 2016. There are indications that the central bank will not be comfortable with inflation topping 6.5%, the upper limit of the target range, in 2016. The authority has been warning that it will "remain vigilant" and "adopt the necessary measures to meet the goals of the target regime." Inflation expectations for 2016, according to the Focus survey, are still on the rise (we forecast 7.0%). We do not see room for rate cuts in 2015 or 2016.

Hence, we expect the Selic rate to remain stable, at 14.25%, until the end of 2016.




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


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