Itaú BBA - On hold domestically, amid a favorable external scenario

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On hold domestically, amid a favorable external scenario

April 1, 2016

The outlook for Brazil is a binary one. If the country takes the path of reform, there would be room for an economic recovery.

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

The outlook for Brazil is a binary one. Without reforms, the economy will likely continue to struggle as the fiscal situation deteriorates, confidence wanes and the recession continues. On the other hand, if the country takes the path of adjustment and reform, the fiscal outlook will look brighten, boosting confidence and opening room for an economic recovery. 

• Meanwhile, the country’s fiscal accounts continue to deteriorate. We have lowered our 2016 primary result forecast to -1.7% from -1.6% as a result of additional expenditure forecast, and held our 2017 forecast steady at -2.1%. 

• A better external outlook (less uncertainty, lower interest rates and a weaker dollar), along with the increasing likelihood of reforms/adjustments domestically, have boosted Brazilian asset prices. Taking this new environment partially into account, we now foresee a more appreciated trajectory for the Brazilian real. We now expect exchange rates at 4.00 reais per dollar at the end of 2016 (vs. 4.35 before) and 4.25 reais per dollar at the end of 2017 (vs.4.50 before). 

• A stronger real opens room for a faster decline in inflation. We have reduced our IPCA inflation forecast for this year to 6.9% from 7.0%. Our forecast for market-price inflation has dropped to 7.0% from 7.3%, and we now see regulated prices rising by 6.7% instead of 6.2%. Our inflation forecast for 2015 remains stable, at 5.0%. 

• Our GDP growth forecasts remain at -4.0% for 2016 and 0.3% for 2017. On the labor market, recent data indicate that the unemployment rate - as measured by the Continuous PNAD survey - will rise to 13% by the end of the year, and reach 13.4% in 2017. 

• Lower inflation and the ongoing recession will likely allow the monetary easing cycle to start sooner than previously expected. We now expect the central bank to start cutting interest rates in July instead of August. Thus, we now forecast the Selic benchmark rate at 12.25% at the end of 2016 (vs. 12.75% before) and 10.00% at the end of 2017 (vs. 10.50% previously).

Asset prices reflect a favorable global outlook, but also a greater likelihood of domestic adjustments/reforms

Adjustments and reforms (particularly fiscal reforms, to stabilize debt dynamics) could turn around Brazil’s macroeconomic scenario. The resulting reduction in country risk and stronger Brazilian real would push down inflation, allowing for deeper cuts in interest rates, improved confidence and a faster economic recovery.

We believe that the likelihood of this adjustment/reform scenario has increased recently. Financial assets tend to anticipate such changes. The Brazilian real, in particular, has been appreciating, likely reflecting not only better domestic prospects but also improvements abroad, as the dollar weakens against other currencies (with the Fed signaling fewer interest rate hikes this year than previously anticipated).

Inflation has started on a downward path, reflecting economic fundamentals. The slowdown in service inflation has been gaining momentum as the labor market deteriorates. Food and industrial goods inflation remain high. However, our projections imply that exchange rate pressures on these items will be milder going forward, due a less depreciated Brazilian real. Thus, we have lowered our 2016 IPCA inflation forecast to 6.9% from 7.0%.

Activity and the labor market continued to weaken in the first quarter. Leading and coincident indicators suggest that Brazil’s GDP will shrink over the first two quarters of 2016. There is likely to be some relative stabilization in the second half of the year. We maintain our forecast of a 4% drop in GDP this year.

Once the recession was confirmed, the government revised its forecast for tax revenues and proposed adjusting its target to allow a primary deficit of up to 1.6% of GDP, a level close to our ‑1.7% forecast.

Deep recession and the improving balance of risks for inflation led us to expect now an earlier and longer monetary easing cycle. We now expect the Central Bank to start cutting the Selic benchmark rate in July instead of August, taking the Selic rate to 12.25% at the end of 2016 and to 10% at the end of 2017.

The BRL strengthens, reflecting a better mood both at home and abroad

Emerging market currencies strengthened against the U.S. dollar in March. Monetary easing in Europe and more dovish Fed boosted emerging-market currencies. Higher commodity prices also helped. The exchange rate has retreated from 4.00 BRL/USD at the end of February to less than 3.60 BRL/USD, the lowest level since Brazil’s sovereign downgrade (by Standard and Poor’s, in September 2015).

Domestically, the political and economic uncertainty remains high, but we see somewhat greater odds of adjustments and reforms taking place.

We have revised our exchange rate forecast to 4.00 BRL/USD at the end of 2016 (from 4.35 previously) and 4.25 BRL/USD at the end of 2017 (from 4.50 previously), driven by the dollar’s weakness globally and by the higher likelihood of domestic adjustments .

The current account deficit continues to shrink, despite February’s worse-than-expected figures. The seasonally-adjusted annualized three-month moving average of the deficit reached USD 15 billion in February. In terms of financing, direct investment in the country has been resilient, and is more than enough to fully cover the current account deficit. Typically more volatile flows (such as a foreign investment in fixed income and equity), however, continue to recede.

We revised our current account deficit forecasts to USD 13 billion in 2016 (from USD 10 billion) and to a zero deficit in 2017 (from a USD 5 billion surplus) as a result of our revised exchange rate projections.

Inflation likely to fall a little further

We have lowered our IPCA inflation projection for this year to 6.9% from 7.0%. The main reason for this revision is our new, stronger exchange rate scenario. Our market price inflation forecast has been revised downward to 7.0% from 7.3% (compared with 8.5% in 2015). On the other hand, we have increased our forecast for regulated prices, which we now expect to rise to 6.7% instead of 6.2% (compared with 8.1% in 2015). Most (around two-thirds) of this year’s inflation slowdown will likely be due to lower regulated prices, particularly for electricity and gasoline.

We are forecasting a 2.6% first-quarter increase in the IPCA this year (compared with 3.8% in 1Q15), with the 12-month rate dropping to 9.4% (vs. 10.7% at the end of 2015). In the first quarter, we see inflationary pressure stemming mainly from higher food prices (particularly for natural foodstuffs affected by El Niño), rising public transportation costs in several state capitals, tax hikes and school fee increases. On the other side, we project that electricity bills, which registered a massive 36% increase in the first quarter of 2015, will fall almost by 4% as dependence on thermal power plants is reduced. This means that regulated price inflation is likely to slow to 1.8% in the first quarter, compared with 8.5% over the same period of 2015, reducing quarterly inflation by 1.6 pp. For the rest of the year, we are projecting a 1.6% second-quarter increase in the IPCA (vs. 2.3% in 2Q15), followed by increases of 0.9% in the third quarter (vs. 1.4% in 3Q15) and 1.7% in the fourth quarter (vs. 2.8% in 4Q15).

Our 2016 inflation forecast for market prices has been lowered to 7.0% from 7.3% in light of the new exchange rate situation. We have revised our forecast for home food price inflation downward to 8.2% from 8.5% (compared with 12.9% in 2015) and our forecast for industrial price inflation to 6.0% from 6.3% (compared with 6.2% in 2015). Prices of industrial products have risen faster at the start of this year as manufacturers pass on costs and tax hikes take effect, but the price hikes are likely to slow in the months ahead. Our basic scenario for foodstuffs includes better weather conditions than we have seen in recent years. The effects of El Niño, which have been putting upward pressure on natural foodstuff prices since November of last year, appear likely to diminish in the second half of 2016, easing the inflationary pressure from food products by the end of the year. It is important to note that in 2015, almost two-thirds of the 25% increase in natural foodstuff prices occurred in the last two months of the year. Alongside predictions of better weather for crops, expectations of a more stable BRL and more manageable fuel and energy costs will likely help to hold down food price increases throughout the year. We have slightly reduced our forecast for the annual increase in private sector service prices, to 7.1% from 7.3% (vs. 8.1% in 2015). Despite service inflation showing greater persistence last year, we are forecasting continued deterioration in the job market and real estate sector, both of which are facing particularly adverse conditions, and this dynamic will likely have a moderating effect on wage and rent costs and continue to hold down service inflation in the months ahead. In fact, we have already noted a slight slowdown in major service sector inflation components, such as residential rents, condominium costs, prices for personal and medical services, and even school fees, which rose less than expected at the start of the year.

We have increased our 2016 inflation forecast for regulated prices to 6.7%, as drug prices and water and sewage fees are now expected to rise faster than initially projected. According to available information, drug prices are likely to rise by 12% this year, reflecting the higher inflation rate (10.4% through February), the need to account for energy and foreign exchange costs (a 2.1-p.p. impact) and the industry’s failure to make productivity gains. We have therefore raised our forecast for drug-price increases this year to 12% from 10%. Concerning water and sewer fees, we are now working on the assumption that SABESP’s Consumption Reduction Incentive Program will be ended later this year, since the company has already put in a request for its termination with the regulatory agency; we estimate that terminating the program would result in a nearly 20% year-over-year average increase in fees. We continue to forecast an average 3% cut in electricity tariffs this year, after a 51% increase in 2015. This is because we foresee some cost relief in a number of components that had put significant upward pressure on industry costs in 2015. These include: the Itaipú plant tariff reduction; a smaller deficit in the Energy Development Account (Conta de Desenvolvimento Energético, or CDE), an industry charge; and the elimination of electricity bill surcharges – which had been implemented with the tariff flags – as Brazil reduces its dependence on thermal plants. For gasoline, we are forecasting a 1% price increase driven by a number of state tax increases, following the 20% price hike in 2015. We are not working on the assumption of an increase in the Contribution for Intervention in the Economic Domain (Contribuição de Intervenção no Domínio Econômico, or CIDE), which remains an inflationary risk factor. Among other regulated-price components which have a relatively heavy weight in inflation, we are forecasting price increases of 13% for private health plans, 10% for urban bus transportation, 5% for bottled gas and -1% for fixed-line telephony. Overall, most of the slowdown we expect in in regulated price inflation, from 18.1% last year to a projected 6.7% this year, comes from lower prices for electricity and gasoline.

Fiscal issues pose a major inflationary risk. Worsening public accounts could cause a more intense and prolonged realignment of relative prices than initially considered in our inflation forecasts. Inflation could be passed on via further currency depreciation, a rise in risk premiums, further tax hikes and/or increases in regulated prices, or worsening inflation expectations.

Weaker economic activity could contribute to a steeper drop in inflation during 2016. The significant economic slowdown could lead to faster market price disinflation in the second half of this year.

We have held our 2015 IPCA inflation projection stable at 5%. According to our forecasts, next year’s drop in inflation will reflect the dissipation of relative price increases (regulated prices and exchange rates), less inflationary inertia and the impact of continued weakness in economic activity, with no clear signs of a recovery.

Activity: prolonged weakness

Family spending continues to drop. In January, broad retail sales declined by 1.6% (including vehicles and construction material). This was a widespread contraction that affected 8 of the 10 segments analyzed. Sales remain at their lowest levels since 2010. In the service sector, real revenues fell in January for the sixth consecutive month. Revenues from services for families, in particular, declined by 4.1% compared with January of last year.

GDP will likely be relatively stable in the second half of the year. We expect 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 – to end February at around 42% (three-month moving average). Although the index has risen in recent months, it remains below the neutral level (44%) and is compatible with an (annualized) 0.5% decline in activity. The index is a leading indicator for economic activity, so this reading is consistent with an outlook for relative stability in GDP in the second half of this year. This means that we expect to see prolonged weakness in activity, unlike in other recessions when rapid growth began after activity had dropped.

Confidence remains weak. Business and consumer confidence remained at low levels in March. Confidence indicators have indeed shown some stabilization over the last few months - for instance, industrial confidence has increased by 0.4 pp in March - but it remains close to its record low.

Activity is likely to weaken further. Coincident indicators suggest that Brazil’s GDP fell in the first quarter of the year, in line with our forecasts. We anticipate some stabilization later this year, but not until the second half. We are maintaining our forecast for a 4.0% drop in GDP in 2016 followed by a slight 0.3% increase in 2017.

The national unemployment rate rose again in January. Based on data from the Continuous PNAD, unemployment hit 9.8% in December and rose to 9.9% in January (with our seasonal adjustment). This was the 13th consecutive monthly increase in unemployment. Nationwide figures show a rate of participation close to the historical average and a decline in the working population. The Continuous PNAD is now the IBGE’s benchmark survey of short-term job market indicators, replacing the Monthly Employment Survey (PME – IBGE), which was discontinued this month.

The deterioration of the formal job market continues. In February, a net of 104,000 formal jobs were closed, according to CAGED data. Applying our seasonal adjustment, we calculate that 189,000 formal jobs were lost, which is close to the worst result since the data series began (in 1995). This comes after a positive surprise in January, with fewer jobs lost than expected. Because the job market is out of step with economic activity, we expect jobless rates to rise throughout 2016, with national unemployment reaching 13% at the end of the year and 13.4% in December 2017.

Fiscal accounts are still deteriorating 

The consolidated public sector posted a BRL 21 billion deficit in February. The central government recorded a high BRL 26.4 billion deficit, led by expenses on bonuses paid to low-wage workers, pensions and discretionary expenditures. Regional governments produced a BRL 2.7 billion surplus, remaining in positive territory, albeit temporarily. The primary result remains on a downward trajectory, reflecting the acute drop in revenues, increasing mandatory expenditure and a limited capacity to cut discretionary spending.

The Ministry of Finance has announced that it wants to change the central government’s primary result target to allow a deficit of up to BRL 97 billion (-1.6% of GDP) in 2016. The proposal, which has yet to reach Congress, includes a BRL 21 billion reduction in official government revenue forecasts. Furthermore, in addition to the BRL 84 billion in deductions announced in February, the change would allow the government to deduct an extra BRL 16 billion (BRL 10 billion in the event that revenues fall further and BRL 6 billion to cover additional priority expenditure). However, the proposal does not include changes to state and municipal targets, which would be held at BRL 6.6 billion (0.1% of GDP) until their debt restructuring proposals are approved. We expect the central government to post a deficit amounting to 1.6% of GDP, with the states and municipalities recording a deficit of ‑0.2% of GDP in 2016 (see table in the next page).

We have adjusted our 2016 primary result forecast to -1.7% from -1.6% and maintained our -2.1% forecast for 2017. This revision reflects the inclusion of the additional spending laid out in the proposal to make the central government’s target more flexible.

Public debt and the nominal deficit remained on the rise in February. The general government’s gross debt increased to 67.6% of GDP in February from 67.4% in January, while the public sector’s net debt rose to 36.8% of GDP from 35.8% in the same period. Over 12 months, the nominal deficit narrowed to 10.7% of GDP from 10.9%, but excluding expenses related to FX swap contracts, the nominal deficit widened to 9.4% of GDP from 8.9%. Interest expenses will remain under pressure, reflecting a larger stock of debt and a higher average interest rate in 2016 compared with 2015.

We are projecting that, as percentages of GDP, gross debt will reach 73% in 2016 and 78% in 2017, with net debt rising to 44% in 2016 and 49% in 2017. We expect a nominal deficit of 9.5% of GDP in 2016, with interest costs amounting to 7.8% of GDP (excluding swap results).

Monetary policy: inflation slows, and interest rate cuts are likely to come sooner

The scenario is getting less complex. For a long time, the monetary policy scenario was ambiguous, with inflation under pressure and the economy in recession. However, inflation has finally started to recede, making the scenario less complex.

Given the risks, it is still too soon to cut interest rates. In its 1Q16 Inflation Report, the Central Bank stated that there are still uncertainties around the balance of risks for inflation, and emphasized its view that current conditions “do not allow the Committee to work with the possibility of monetary flexibilization”.

Interest rates are likely to fall in the second half of the year. The downward trend in inflation and the likelihood of a prolonged recession were already featured in our baseline scenario, supporting our belief that interest rate cuts will come in the second half of this year.

Easing cycle could come sooner than expected. The downward trend in inflation has started to consolidate. Additionally, a stronger Brazilian real creates space for a more benign IPCA trajectory. Thus, we now believe the central bank will start an easing cycle in July, rather than in August, as we previously expected.

We forecast that the Selic benchmark rate will be lowered to 12.25% by the end of this year (vs. 12.75% before), through four 0.50-pp cuts starting in July. The easing cycle is likely to continue in 2017, with the Selic rate reaching 10.00% (vs. 10.50% before).


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


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