Itaú BBA - Political uncertainty and continued recession in 2016

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Political uncertainty and continued recession in 2016

December 8, 2015

The political and economic uncertainty will probably continue in 2016.

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

• Political and economic uncertainties in Brazil are intertwined and will likely continue in 2016.

• The deceleration has steepened. GDP fell by 1.7% in the third quarter and coincident and leading indicators suggest further contraction in the last quarter of the year. We have lowered our 2015 GDP forecast to -3.7% from -3.2%. For 2016, we now expect a contraction of 2.8% (vs. our previous forecast of -2.5%). In the labor market, the unemployment rate will likely continue to increase, reaching double-digits next year.

The fiscal deterioration continues, with declining revenues and rising mandatory spending. We have lowered our 2015 primary result forecast to -1.2% of GDP from -1.0% of GDP. For 2016 we have raised our primary result forecast to -1.3% of GDP from -1.5% of GDP after taking into account the revenues from the hydropower-plant auction, which are likely to affect the primary surplus only in 2016.

We have left our exchange-rate forecasts unchanged at 4.00 reais per dollar at the end of 2015 and 4.50 reais per dollar at the end of 2016. We believe that the economic and political uncertainties in Brazil are consistent with this exchange-rate level.

• The IPCA is expected to rise by 10.5% in 2015, just over 4 pp above last year’s result. For 2016 we have lowered our inflation forecast to 6.8% from 7.0% to reflect revised oil-price projections.

• We expect the Brazilian Central Bank (BCB) to leave the Selic rate at 14.25% throughout 2016. We believe that the BCB will not change its monetary policy stance unless there are significant changes in the economic scenario.

Goodbye 2015?

The year 2015 will probably be remembered as a particularly difficult one for the Brazilian economy. GDP is expected to shrink by 3.7%, and  IPCA inflation will end the year above 10%. Interest rates are ending the year at high levels, as is the value of the dollar against the Brazilian real. So what is the outlook for 2016?

The political and economic uncertainty will probably continue in 2016. An economic recovery largely depends on the approval of adjustment measures, which will require a political consensus.

Economic activity continues to contract; there are no signs of stabilization. GDP growth will probably be negative again in 2016 (we forecast -2.8%), largely because of the negative carry-over. It is still too early to talk about a resumption of growth.

The fiscal outlook remains challenging. The contraction in GDP and the wage bill will further reduce tax revenues. Due to the upward pressure from mandatory spending (e.g., pensions), the economy is likely to post another primary deficit in 2016 (we forecast -1.3% of GDP), despite the fiscal adjustment measures already underway.

Despite the difficulties, some major adjustments have been made. The currency depreciation, for example, has facilitated the adjustment in the external accounts. We believe that an exchange rate of around 4.00 reais per dollar is consistent with a narrower current account deficit for the coming years.

Another important adjustment was the realignment in regulated prices. The cost was high: inflation reached double-digit levels. But the consistently tighter monetary policy stance and the economic contraction, particularly in the labor market, are affecting price setting: IPCA inflation is expected to begin a long-term decline starting in the first quarter of 2016, although the pace of this decline is still uncertain. Our IPCA inflation forecasts stand at 6.8% for next year and 5.0% for 2017.

High inflation combined with contracting activity makes the monetary policy outlook more complex. We believe the BCB will opt to keep the Selic rate stable at 14.25% until the end of next year. Indeed, Brazil’s economic activity is already declining sharply and the exchange-rate dynamics are, at the margin, more related to the overall perception of risk than to domestic interest rates. Because of this risk, inflation expectations also tend to respond less intensely to monetary-policy decisions. Inflation convergence depends also on implementing the necessary economic adjustments.

However, judging from the Copom’s recent statement and minutes there is some possibility that the BCB will resume the rate-hiking cycle in January of next year.

Contraction in activity intensifies

The economic contraction has been steeper than expected. According to IBGE, Brazil’s GDP decreased by 1.7% qoq/sa in the third quarter. This was the third consecutive GDP drop on a sequential basis. The result was below our forecast (-1.0%) and the market consensus estimate (-1.2%). On the supply side, service-sector GDP continued to fall. On the demand side, domestic absorption posted another contraction, and it was also the ninth consecutive quarterly decline in gross fixed capital formation. Overall, the results confirm the scenario of a broad contraction in economic activity.

There are no signs of stabilization. Our diffusion index – which tracks the share of indicators with positive changes, based on a broad set of data, including business and consumer confidence, retail sales and demand for credit – will likely end October at a level compatible with a 4% (annualized) activity decline.

Industrial production posted its fifth consecutive monthly drop in October. Fifteen of the 24 activities that compose industrial production contracted. Our gross fixed capital formation proxy fell by 0.5% (our seasonal adjustment) and is pointing to a further decline in investment in the fourth quarter. 

Retail sales are also on a downward path. We expect the October figures to show a retail sales retreat, as coincident indicators such as trade activity (Serasa) and supermarket sales (Abras) fell for the month. Meanwhile, the real wage bill remains in negative territory and unemployment continues to increase. These factors point to a likely downward trend for retail sales over the coming months.

Confidence remains low. In November, business and consumer confidence indicators remained close to their historical lows. In the industrial sector, in particular, business confidence fell by 1.8% and capacity utilization showed a drop of 0.3 pp. Inventory remains in high levels, suggesting that additional adjustments in industrial production lie ahead.

Activity likely declined in all four quarters of 2015. Coincident and leading indicators point to further decline in GDP in the fourth quarter. If this expectation is confirmed, economic activity will have contracted in all four quarters of the year. We maintain our view that domestic demand will likely continue to fall in 2016, sapped by lower household consumption and reduced investment. We have lowered our GDP growth forecasts to -3.7% from -3.2% for 2015 and to -2.8% from -2.5% for 2016.

Persistent labor market deterioration. Formal employment continues to retreat. According to CAGED data, 169,000 formal jobs were destroyed in October. In seasonally adjusted terms, we calculate a loss of 177,000 jobs for the month. The pattern was widespread, visible across different sectors and regions of the country, as it has been in previous months. We expect to see a continuous decline in jobs over the course of 2016.

The national unemployment rate will reach 12% in 2016, according to our projections. We maintain our expectation that the unemployment rate in the six metropolitan regions of Brazil covered by the Monthly Employment Survey (PME-IBGE) will reach 8.6% by the end of this year and 10.6% by the end of 2016. For national unemployment (PNAD Contínua), we expect rates of 10.0% in December 2015 and 12.0% at the end of 2016.

In October, the unemployment rate reached 7.9% in the six metropolitan regions covered by the PME-IBGE. In seasonally adjusted terms (our adjustment), the PME rate rose to 8.0% from 7.6% in September, marking the tenth consecutive monthly increase. The national unemployment rate (measured by PNAD Contínua-IBGE) reached 8.9% in the quarter ended in September. This represented an increase at the margin to 9.0% from 8.7% (after our seasonal adjustment). The unemployment rates from both surveys have shown similar movement over the past 12 months.

Moreover, leading indicators suggest that unemployment will continue to rise over the coming months. The proportion of job-seekers reporting difficulty in finding employment is still increasing, climbing to 92.8% in November from 92.0% in October.

In October, the delinquency rate increased by 0.1 pp, to 3.2%. The total amount of non-earmarked new loans fell by 0.9% (daily average in real terms, mom/sa). In the same sequential comparison, earmarked new loans declined by 5.9%. Total credit outstanding continued to shrink in October in terms of real annual growth, falling by 1.7% (vs. -0.4% in September). For non-earmarked credit, there was an even sharper drop in outstanding loans, to -5.2% from -4.1% in an annual comparison. There was also a deceleration in earmarked credit, which grew by 2.3% in October, down from 3.9% growth in September. Average Interest rates and spreads both increased.

Fiscal deterioration continues

For the 12 months ending in October 2015, the consolidated public sector posted a primary deficit of 0.7% of GDP (vs. -0.4% in September) and a nominal deficit of 9.5% of GDP (vs. -9.3% in September). Excluding the BCB’s losses from currency swaps, the nominal deficit reached 7.4% of GDP (up from 7.0% in September). According to our calculations, the primary balance needed to stabilize public debt in the long term is close to 2.5%, which means that public debt will remain on an upward trend. Gross general government debt amounted to 66.1% of GDP in October, with net debt coming in at 34.2% of GDP.

The downward trend in the primary balance stems from the structural growth in mandatory spending, especially on pensions, and a decline in revenues. Total federal government revenue has fallen by 6.0% in real terms in 2015 through October. Expenditure has dropped by 4.0% in real terms over the same period, as a significant cut in investment (-40% in real terms) has offset mandatory spending growth. Investment can hardly be cut to the same extent next year, likely preventing a further decrease in total federal public spending, in real terms, in 2016. Meanwhile, revenues will very likely continue to decline due to the ongoing economic contraction, particularly as it affects consumption and the labor market, where the Brazilian tax burden is concentrated.

We have adjusted our forecast for the 2015 primary result to -1.2% of GDP (previously -1.0% of GDP). Revenues from the auction of hydroelectric power plant concessions were in line with the government’s expectations (BRL 17 billion), but it is now expected that the corresponding tax collections will contribute to the primary surplus only in 2016 (there had previously been an expectation that some BRL 11 billion would go to this year’s primary surplus). There is still uncertainty about the final result for 2015: the government has yet to announce when and how postponed expenses (amounting to BRL 57 billion) will be paid. We assume only BRL 10 billion in additional payments this year, with the remaining BRL 47 billion being paid over the next three years.

For 2016, we have adjusted our primary forecast to -1.3% of GDP (previously -1.5% of GDP). The revision is due to the hydropower auction revenues discussed above, which will be received as extraordinary revenues next year. We expect a total of BRL 40 billion of extraordinary revenues in 2016, coming from the hydropower auction, the repatriation project and asset sales. This means that the recurring primary result in 2016 will likely be close to -2.0% of GDP. The result in 2016 would be more negative if it weren’t for the spending restraints announced in the latest fiscal adjustment package, which included discretionary spending cuts and the postponing of annual raises for civil servants to August from January. The main measures considered in our 2016 scenario that still need approval from Congress are: i) the repatriation project; ii) the postponement of civil servants’ salary adjustments; and iii) the elimination of wage bonuses for continued services, currently granted to federal civil servants who continue to work after qualifying for retirement. The most important measure that is not considered in our scenario but will likely be discussed in Congress is a reinstatement of the CPMF tax. We have also not incorporated in our scenario any increase in the CIDE tax rate.

Short term relief for the real

In November, the real-dollar exchange rate fluctuated between 3.70 and 3.90 reais per dollar. The Congress’ upholding of presidential vetoes on important fiscal measures and the repatriation law approval by the lower house helped stabilize the currency last month.

The economic fundamentals in Brazil, however, continue to point to an exchange rate of around 4.00 reais per dollar.  Although the real is already sufficiently depreciated for the adjustment of the current account to proceed, more pressure on the currency will enable an even faster and more intense current-account adjustment.

We have left our exchange-rate forecasts unchanged at 4.00 reais per dollar at the end of 2015 and 4.50 reais per dollar at the end of 2016, in line with the economic deterioration and political uncertainty dominating the Brazilian scenario. 

The current-account figures continue to improve. The improvement has been broad-based, reflecting both the more depreciated currency and the slowdown in economic activity. On the financing side, despite having diminished, direct-investment flows into the country have been sufficient to cover the entire current account deficit in 2015. Between January and October, direct investment in Brazil totaled USD 55 billion, while the current account deficit stood at USD 53 billion. Thus, the dependence on typically more volatile capital inflows to cover external financing needs has decreased.

Better data at the margin and still-sluggish activity point to a lower current account deficit ahead. The revisions to our commodity price estimates have increased the risks to this positive trend.  Nevertheless, we have raised our forecast for the 2015 trade surplus to USD 13.5 billion from USD 12 billion but are maintaining our 2016 trade surplus forecast of USD 31 billion. As a result, we project current account deficits of 3.7% of GDP in 2015 (compared with our previous projection of 3.9% of GDP), and 2.4% of GDP in 2016.

Reducing our 2016 inflation forecast to 6.8% from 7.0%

Our forecast for November IPCA inflation is for a 0.93% increase, with the year-over-year rate rising to 10.4%. We project that the major upward contributions in the month will come from food and transportation prices – particularly prices for fresh fruits and vegetables, and fuel.

For the full year of 2015, we forecast a 10.5% variation for the IPCA, 4.1 pp above last year’s inflation rate (6.4%). For market prices, we anticipate an 8.3% increase (vs. 6.7% in 2014), with a 6.4-pp impact on the IPCA (vs. 5.2 pp in 2014). For regulated prices, we forecast a 17.9% gain (vs. 5.3% in 2014), with 4.1-pp contribution to the IPCA (vs. 1.2 pp in 2014).

Among regulated prices, the largest contribution to inflation this year will come from electricity prices (1.5 pp of the IPCA), given the 51% average increase in electricity bills. Among other regulated prices with a significant weight in inflation, we forecast the following variations for the year: gasoline, 20%; health insurance, 12.2%; urban ​​bus fares, 15.1%; bottled gas, 22%; medicines, 6.8%; water and sewage rates, 14.6%; and fixed telephone services, -1.6%.

For market prices, we anticipate an 8.0% increase in prices for services, similar to the result posted last year (8.3%). The rise in services prices will probably have a 2.9-pp impact on inflation this year, almost the same as the impact last year. For food consumed at home, we expect a 12.4% price gain this year (vs. 7.1% in 2014), with a 2.0-pp contribution to the IPCA. The extra pressure on food prices was due to various cost shocks (exchange rate, energy and fuel) and the effect of inclement weather on the supply of some products, especially meats and fresh fruits and vegetables. Finally, for prices of industrial products, we forecast an increase of 6.0% (4.3% in 2014), with a 1.5-pp contribution to full-year inflation.

For 2016, we have lowered our IPCA inflation forecast to 6.8% from 7.0% to reflect revisions in our oil-price scenario. Accordingly, our 2016 inflation forecast for regulated prices has fallen to 6.5% from 7.4%, while our inflation forecast for market prices has remained at 6.9%. Among market prices, we anticipate increases of 5.8% in industrial prices, 7.0% for services and 8.0% for food consumed at home. Despite the notable persistence of services inflation this year, we remain of the view that the worsening in labor market conditions and in the real estate sector, with the consequent moderation in wages and rents, will likely contribute to a drop in private services inflation next year. On the other hand, inflationary inertia may retard the expected disinflation for services, particularly considering that steep adjustments in the minimum wage and school fees are expected at the beginning of 2016. In the case of food, our baseline scenario assumes more favorable weather conditions than in previous years, despite the risks associated with the El Niño phenomenon, which could affect the supply of certain agricultural products. In addition to the supposedly more benign climate for crops, especially in the case of grains, the lower FX variation and more contained increases in energy and fuel costs will likely contribute to reduce food inflation throughout 2016. In this context, we continue to expect tamer price increases for meats and fresh fruits and vegetables.

In the case of regulated prices, the downward revision in our forecast for the price of oil and its derivatives has led us to assume a smaller gasoline price adjustment in 2016. Thus, we reduced our forecast for the readjustment of gasoline in the refinery to 5% from 10%, with the increase at the pump dropping to 4% from 8%. For now, we are not assuming an increase in the CIDE on gasoline, but this tax remains a risk factor for inflation. For electricity prices, we forecast an average increase of 9%. In this calculation, we are already considering the effect of a change from red to yellow in the tariff flag (-3.6 pp on electricity bills), given the expected reduction in thermal-plant usage. For other regulated prices with a significant weight in inflation, we forecast the following increases next year: health insurance, 12%; medicines, 7%; bottled gas, 6%; water and sewage rates, 6%; urban bus fares, 5%; and fixed-line telephone services, 0%.

The fiscal situation is an important risk factor for inflation next year. A more widespread perception that Brazil’s the public accounts are deteriorating could translate into an even steeper and long-lasting realignment in relative prices than is contemplated in our inflation forecasts. This  effect could come by way of: i) a more depreciated currency, due to the increase in risk premiums; ii) a need for tax increases and/or further increases in regulated prices; and/or iii) a  deterioration of inflation expectations.

On the other hand, weaker economic activity may contribute to a further decline in inflation in 2016. The counterpoint to this vector is that the slowdown in activity, although mitigating inflationary pressures through the demand channel, also delays the improvement of fiscal results, which in turn tends to increase uncertainty about the balance of risks for inflation.

The IGP-M will probably close this year with a 10.7% increase, 7.0 pp above last year’s result (3.7%). In disaggregated terms, we forecast increases of 11.5% for the IPA-M, the component with the largest weight in the IGP-M (60%); 10.2% for the IPC-M, with a 30% weight in the IGP-M; and 7.4% for the INCC-M, with a 10% weight in the IGP-M.

For 2016, we have lowered our IGP-M forecast to 7.0% from 7.5%. The revision was due to the downward revision in our commodity price estimates, especially for iron ore, soybeans and oil.

Monetary Policy: an unstable equilibrium for 2016

We expect the BCB to keep the Selic rate at 14.25% throughout 2016. There are forces pushing in opposite directions, suggesting that this is equilibrium (although unstable).

On the one hand, the political and fiscal uncertainties are putting pressure on inflation expectations. Since early September, the median of analysts’ projections for  2016 IPCA inflation has risen to 6.70% from 5.50%. Forecasts for 2017 have also started to show a slight increase, climbing to 5.10% in November (from 5.00% in September). This increase in inflation expectations worsens the balance of risks for inflation, which could prompt the BCB to resume the tightening cycle. In fact, at the last Copom meeting, two members of the committee voted for a 0.50-pp increase in the Selic rate.

On the other hand, the recession has intensified, which will help contain the second-order effects of currency depreciation and regulated price adjustments. The deterioration in labor market conditions – which we expect to continue in 2016 – has potential disinflationary effects in labor-intensive sectors (namely services). In the industrial sector, capacity utilization is at its lowest level since the 1990s

These factors lower the odds of additional monetary tightening in the short term. Besides, political uncertainties generate volatility and should tend to make decision-makers more cautious.

In short, we believe that the BCB will not change its monetary policy stance, given the existing countervailing forces on inflation.

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


 



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