Itaú BBA - Recession continues

Brazil Scenario Review

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Recession continues

July 15, 2015

Indicators suggest new decline in the economy during the third quarter. We’ve revised downwards our GDP forecast in 2015 and 2016.

• Economic activity shows no signs of stabilizing. Leading indicators suggest further contraction of the economy in the third quarter. We revised our GDP forecast to a decline of 2.2% in 2015 (from -1.7%). The current conditions (statistical carryover), the deterioration in the labor market and high production costs indicate lower average growth ahead. We changed our GDP forecast for 2016 to -0.2% (from +0.3%). We expect unemployment to rise further. We changed our projection to 8.0% in December this year and 9.0% in 2016.

• We reduced our primary-surplus forecasts to 0.5% of GDP this year (from 0.7%) and 1.0% of GDP next year (from 1.2%). The revision results from the decline in economic activity, especially in consumption and the labor market, where the tax burden in Brazil is more concentrated.

• We raised the forecast for the IPCA this year from 8.8% to 9.1%, with an increase in the forecast for market prices, from 7.0% to 7.4%. The revision took into account the greater pressure on food prices in recent months. On the other hand, we reduced the forecast for the IPCA in 2016 from 5.5% to 5.3%, given the worsening scenario for economic activity. We reduced the forecast for market-price inflation from 5.3% to 5.0% in 2016, and maintained regulated-price inflation at 6.3%. The greater easing in labor-market conditions will likely contribute to a steeper slowdown in services inflation, which is expected at 6.0% next year. We expect inflation to decline to the center of the target, 4.5%, in 2017.

• We believe that the stabilization of the exchange rate at current levels promotes a gradual adjustment in the external accounts. The latest data have been corroborating our view. We maintained our forecasts for the exchange rate at 3.20 reais per dollar by the end of 2015 and 3.50 reais per dollar by the end of 2016.

• The short-term scenario remains challenging for monetary policy, but the balance of risks for inflation over longer horizons has improved. We expect a final increase of 0.50 pp in July, taking the Selic rate to 14.25%, but it is possible that the Copom chooses to slow the hiking pace to 0.25 pp. Low growth and inflation expectations approaching the target make room for sharper interest-rate cuts in 2016: We believe that the BCB will initiate an interest-rate reduction cycle starting in the second quarter of the next year, with the Selic rate reaching 11.25% by the end of 2016 (previously, 12.00%).

No stabilization, but smaller imbalances

Leading and coincident indicators suggest that the declining trend in economic activity may last longer – and be stronger – than we expected.Unemployment continues to rise. The slowdown in activity has an impact on government revenues, hindering the fiscal adjustment. Inflation seems unrelenting: The IPCA could reach 9.5% in the second half of the year.

However, there are signs that the economy is beginning to move toward better balances, consistent with the adjustments being implemented. The current account deficit has been declining and the trade balance posted a surplus in the first half of the year. The exchange rate has remained stable, enabling the central bank to reduce the stock of FX swaps. Lagged regulated prices were adjusted. Long-term inflation expectations have been converging to the target center, and the central bank indicated that the hiking cycle is nearing its end.

Thus, imbalances are being reduced. However, thereare still many challenges ahead.

In particular, the fiscal adjustment has become more difficult to achieve due to the weakening economy. 

No signs of stabilization

Leading indicators point to a decline in economic activity in the third quarter.In June, among the main sectors of economic activity, only confidence in the Construction sector posted an increase (0.8%), but it was not enough to reverse the decline in May (-5.1%). Business confidence in the industry posted the fifth consecutive decrease, reaching the lowest level of the series (begun in 1995). The result suggests further contractions in industrial output over the coming months. Consumer confidence also receded in June. The proportion of people reporting difficulty in finding employment increased for the sixth consecutive month, to 84.5%. Finally, planned purchases of durable goods declined for the fourth time and, combined with other indicators, point to a low level of retail sales ahead.

Despite a positive result in industrial production in May, all major economic categories posted retractions of more than 3% in the past 12 months.The production of durable consumer goods and capital goods posted a contraction of about 15%. On the demand side, there are no signs of recovery. Light-vehicle sales declined further in June, and are at the lowest level since 2009. As for heavy vehicles, the level of sales is the lowest since 2007 and reflects the low intention to invest in capital goods.

Our diffusion index (which measures the number of indicators with positive changes, based on a broad set of data) will likely end June below the level consistent with zero growth (estimated at 47%), for the fifth consecutive month.Over the past five months, the diffusion is expected to reach an average of only 24%. These results show that activity contraction is occurring at a steeper pace than was anticipated, and that there are no signs of recovery ahead.

Production costs remain high.We estimate that the unit labor cost in the industry stands around 15% above the 2010 average. These costs tend to restrict supply and will probably hinder the economic recovery.

We changed our GDP-contraction forecast to 2.2% in 2015 (previously -1.7%).The decline in activity in the second quarter is proving deeper than we expected. Leading indicators show no signs of stabilization in the third quarter. In our assessment, the beginning of the recovery will be postponed to the end of the year.

We revised our GDP forecast to a contraction of 0.2% in 2016 (we previously anticipated 0.3% growth).A moderate recovery over the next year will likely not be enough to offset the statistical carry-over in the 2016 average growth. Production costs remain under pressure, limiting growth in the medium term.

The unemployment rate will likely continue to rise over the coming months.Unemployment increased from 6.0% in April to 6.3% in May (our seasonal adjustment). In the formal market (CAGED), job destruction reached 125 thousand jobs, considering the three-month moving average (seasonally adjusted). The decline in activity affects employment across various sectors, including the most resilient ones such as trade and services.

The participation rate (ratio of the economically active population to the working-age population) will probably increase over the coming months.In the recent past, real-income gains probably contributed to the decline in the participation rate, as growing family income enabled other household members to leave or postpone their entry into the labor market. With the drop in real wages and rising unemployment, we expect a reversal of this process.

We changed our forecast for the unemployment rate to 8.0% by the end of this year (previously 7.6%) and to 9.0% in 2016 (previously 8.0%).The increase in the participation rate represents greater demand for jobs, and will likely contribute to a faster increase in the unemployment rate.  

Credit remains weak in May.The daily average of non-earmarked new loans grew by 0.9% mom/sa in real terms. In the opposite direction, earmarked new loans fell by 11.5%. Total outstanding loans continues to decelerate: real annual growth fell from 2.1% to 1.5%. In the same comparison, non-earmarked outstanding loans continued to recede (-3.5%) and earmarked credit moderated from 8.2% to 7.4%. The system’s delinquency rate remained stable at 3.0%. The system’s interest rate and spread increased.

Fiscal Policy: Headwinds intensify and gross public debt continues to rise

The exchange-rate depreciation continues to widen the difference between net debt and gross debt.Net debt of the public sector decreased by 0.5 pp this year to 33.6% of GDP (-0.1 pp between April and May). On the other hand, the general government’s gross debt increased by 3.6 pp of GDP this year to 62.5% (+0.9 pp between April and May), only partially due to the cost of FX swaps (0.7% of GDP this year). The FX depreciation reduces the net debt due to the positive effect on the BRL-value of international reserves. In our view, both gross and net debt will show an upward trend ahead, as the primary surplus remains below the level that would be consistent with the stabilization of debt dynamics.

The public sector posted a primary deficit of BRL 6.9 billion in May, a weak result for the month, but in line with expectations (market: BRL -7.0 billion, Itaú: BRL -8.1 billion).The positive surprise relative to our estimate came from regional governments, which posted a surplus of BRL 2.0 billion. The central government posted a primary deficit of BRL 8.9 billion.

Regional governments have accumulated a surprisingly positive result this year, but we expect a decline going forward.Year-to-date, states and municipalities this year reached a primary surplus of BRL 19.2 billion (0.3% of the expected GDP for the full year), higher than their target for 2015, of BRL 11 billion (0.2% of GDP). The positive performance reflects the National Treasury’s more-rigid stance in terms of financing and higher collection of ICMS on energy (driven by the increase in energy prices). We expect the result of regional governments to recede moderately ahead, and we forecast a primary surplus in line with the target at year-end.

The central government’s results, on the other hand, have been weak.Year-to-date, the central government’s primary surplus reached BRL 6.6 billion. Considering that the period between January and May historically represents 52% of the annual result, the BRL 6.6 billion this year underscores the difficulty for the central government to achieve the 2015 target of BRL 55 billion (0.9% of GDP).

Federal spending declined 1.1% year-over-year in May and 1.3% year-to-date, in real terms.This is a significant change from previous years (spending grew 5.2% in 2014 and 6.4% in 2013 in real terms), which underscores the tighter fiscal stance on the spending side. The main cutting occurs in investment (-37.6% year-to-date), while discretionary administrative costs are still growing, by 0.8% in the same period. The expansion of mandatory spending (especially with pensions: +4.3% year-to-date in real terms) shows the difficulty of implementing a significant fiscal adjustment on the expenditure side. There was no payment to BNDES’ Investment Support Program (PSI) in May, after a BRL 2 billion disbursement in April.

However, the expenditure reduction is still insufficient to offset the drop in tax collection.Administered revenues declined 3.0% year-to-date in real terms. The weakness results from the contraction of economic activity, especially in consumption and the labor market, where the tax burden in Brazil is concentrated. Revenues from dividends and royalties have also posted a significant decline this year.

Given the downward revisions in economic activity, we reduced our estimates of primary surplus to 0.5% of GDP this year (from 0.7%) and 1.0% of GDP next year (1.2% previously).We assess that the impact of the decline in economic activity on the primary surplus this year will amount to BRL 43 billion, or 0.7% of GDP (from a previous estimate of BRL 28 billion, 0.5% of GDP). On the other hand, we increased our expectation of extraordinary revenues in 2015 from BRL 10 billion to BRL 15 billion. In 2016, the scenario of a primary surplus increase to 1.0% of GDP counts on new revenue measures adding to BRL 25 billion.

We raised our forecast for the IPCA this year from 8.8% to 9.1%, but reduced the 2016 forecast from 5.5% to 5.3%

The IPCA went up 0.80% in June, close to our estimate and slightly below the median of market expectations.The largest upward contributions came from food consumed at home, lotteries, airfare, and water and sewage rates. Thus, the IPCA grew 6.17% in the first half (3.75% one year earlier), led by a hike of 11.9% in regulated prices. The year-over-year change in the IPCA increased to 8.89% (8.47% in May and 6.52% in June 2014).

For July, our preliminary forecast indicates an increase of 0.55%.The main upward pressure in the month will come from electricity, reflecting Eletropaulo’s (distributor for the São Paulo metropolitan region) 17.3% tariff increase, effective since July 4. On the other hand, we expect lower readings for transportation, personal expenses, food, apparel, healthcare and personal care. If the result estimated for July is confirmed, the year-over-year IPCA rate will increase to 9.5%.

For 2015, we raised our forecast for IPCA inflation from 8.8% to 9.1%, given the higher pressure from the food group.The 7.1% increase in food consumed at home in the first half led us to revise the forecast for the subgroup this year from 8% to 10%. The higher pressure on food prices likely reflects the impact of various cost shocks (exchange rate, energy and fuel) as well as the effect of the drought on the supply of some products, especially meats (worse pasture conditions) and fresh fruits and vegetables (late planting). For services, we continue to expect a 7.7% increase this year (compared with 8.3% in 2014). We maintain our view that the worsening in labor-market conditions and in the real estate sector, with consequent moderation in wages and rents, will likely contribute to a decline in private-services inflation this year, and a further decline in 2016. For the industrial prices under the IPCA, we forecast a 5.4% increase in 2015 (4.3% in 2014). Thus, the forecast for market prices increased to 7.4% (previously 7.0%), with an impact of 5.7 pp in the IPCA result.

For regulated prices, we slightly raised the forecast for this year from 14.9% to 15.0%.The largest upward contribution in regulated prices will come from electricity (1.5 pp), with an expected hike of 51%. For the other regulated prices with significant weight on inflation, we forecast increases of 10.5% in gasoline prices, 11.3% in health insurance, 12.8% in urban bus fares, 12.5% in water and sewage rates, 6% in medicine prices, and a drop of 1.5% in fixed-line telephone-service tariffs.

A risk factor for regulated-price inflation this year may come from gasoline, which shows a small lag against the international price.Should the price misalignment remain over the next few months, we cannot rule out an increase in refinery prices this year – not included in our baseline scenario – with direct impact on the price of gasoline at the pump and, indirectly, on the price of ethanol. A 5% adjustment in the price of gasoline at the refinery would raise the IPCA by 0.17 pp.

For 2016, we reduced our IPCA forecast from 5.5% to 5.3%, due to the revision in the forecast for market-price inflation, from 5.3% to 5.0%.This change took into account the effect of the downward revision in the scenario for economic activity, especially in the labor market, which more than offset the effect of higher inflationary inertia in 2015. In disaggregated terms, we expect increases of 3.5% in industrial prices, 5.0% in food consumed at home and 6.0% in services. The slowdown in services inflation tends to be steeper than expected this year, given the prospect of worsening labor-market conditions. In the case of food, we continue to work with more favorable weather conditions than in previous years, which will likely provide good grain harvests in major global producers such as the U.S., Brazil and Argentina. The expectation of lower variation in the exchange rate and in the cost of energy will likely also contribute to the reduction in food-price inflation in 2016. On the other hand, the reopening of the U.S. market for fresh beef – mainly due to the potential impact created by the opening of new markets – may eventually exert additional pressure on domestic prices and, thus, represent a risk factor for food-price inflation.

In addition to the weakness in economic activity, other factors will likely lead to significant disinflation in 2016.Among these factors, we highlight the prospect of better weather conditions, lower exchange-rate depreciation and a significant reduction in regulated-price inflation, especially electricity. On the other hand, there is an upside risk for inflation next year, based on the possibility that, given the need for increased tax collection, new tax increases directly or indirectly impact prices of some goods and services (market and/or regulated prices). The recognition of liabilities in the electricity sector, if translated into electricity bills increases, also represents a risk factor for inflation next year.

We expect the disinflation trend to continue and inflation to reach the center of the target, 4,5%, in 2017.

The IGP-M rose 0.67% in June, growing by 4.3% year-to-date and 5.6% year over year.The IPA-M – the component with the largest weight in the IGP-M (60%) – rose 0.4% in the month, with a drop of 0.6% in agricultural prices and an increase of 0.7% in industrial prices. Thus, the variation of the IPA-M in 12 months went up to 4.3% (compared to 2.3% in May). The IPC-M – which makes up 30% of the IGP-M – posted a variation of 0.8% in June, with the year-over-year rate rising to 8.8% (compared to 8.3% in May). But the INCC-M – with a 10% weight in the IGP-M – increased by 1.9% in the month, pressured by wage increases in the construction sector, in Rio de Janeiro and São Paulo, increasing 6.6% over the past 12 months (compared with 6.0% in the previous month).

For this year, we increased our forecast for the IGP-M from 7.0% to 7.3%, with adjustments in the forecast for the IPA-M and IPC-M.In disaggregated terms, we forecast increases of 6.7% for the IPA-M, 9.2% for the IPC-M and 7.1% for the INCC-M. For 2016, we reduced the forecast for the IGP-M from 5.8% to 5.5%.

More-depreciated exchange rate and weaker activity have been reducing the current account deficit

We maintained our forecasts for the exchange rate at 3.20 reais per dollar by the end of 2015 and 3.50 reais per dollar by the end of 2016. Over the last month, the BCB reduced the rollover pace of FX-swap contracts. In addition, lower commodity prices and stronger data from the U.S. economy reinforce our exchange-rate scenario for this year and the next.

Year-to-date, the trade balance is in positive territory for the first time in 2015.In the first half of the year, the trade surplus stood at USD 2.2 billion, a better result than the deficit of USD 2.5 billion posted in the same period of 2014. We have emphasized that the improvement in the external accounts in recent months is the result of both the more-depreciated exchange rate and the slower pace of activity. We maintain our forecast of a trade surplus of USD 4 billion in 2015 and USD 8 billion in 2016. However, if the drop in commodity prices (especially iron ore) observed in the last couple of days persists, we can reduce our trade-balance forecast.

The current account balance is also showing more favorable results.With a higher trade surplus and a lower services and income deficit, the current account deficit totaled USD 3.4 billion in May. In the first five months of the year, the current account deficit receded 20.3% year over year (USD 35.8 billion vs. USD 44.9 billion). The seasonally adjusted and annualized quarterly moving average of the deficit, which came close to USD 120 billion at the end of 2014, has already receded to USD 72 billion in May 2015. The latest data reinforces our scenario of gradual adjustment of the external accounts. For 2015 and 2016, we forecast a reduction in the current account deficit to 4.1% and 3.7% of GDP, respectively.

Monetary policy: Tightening cycle near the end, better balance of risks in the medium term

The short-term scenario remains challenging for monetary policy.We revised the forecast for the IPCA upward and reduced the forecast for GDP in 2015.

However, the balance of risks for inflation over longer horizons has started to improve.The assessment that economic activity will remain weak for longer led us to reduce our inflation forecast for 2016 and 2017.

In this environment, the BCB has been indicating, in our view, that the monetary tightening cycle is not over, but is near the end.In most of its official communications, the BCB has been continuously stating that advances in the fight against inflation “have not been sufficient yet.” However, the BCB has highlighted that the effects of the current monetary-policy strategy have already started to appear, as “inflation expectations are close or at the target of 4.5% pa in the medium and long-term horizons.” Thus, the BCB seems to signal that the monetary policy mission is almost (but not yet) accomplished.

We expect the Copom to end the monetary tightening cycle with the Selic rate at 14.25%.We expect a final hike of 0.5 pp in July, taking the Selic rate to 14.25%. It is possible, however, that the Copom chooses to slow the hiking pace to 0.25 pp, signaling an additional hike in September, if demanded by the scenario. Thus, it is possible that, depending on the data, this last hike does not occur and the cycle ends with the Selic rate at 14.00%

Growth still at low levels and inflation expectations around the target center from 2017 onward open room for further interest-rate cuts in 2016.We believe that the BCB will initiate an interest-rate reduction cycle starting in the second quarter of next year, reaching 11.25% by the end of 2016 (we previously expected 12.00%).


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