Itaú BBA - Signs of a rebound amid fiscal deterioration

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Signs of a rebound amid fiscal deterioration

September 4, 2017

We revised upward our forecast for 2017 GDP growth, to 0.8% from 0.3%.

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

 The Brazilian government decided to change primary balance targets for 2017 and 2018 (to deficits of BRL 162 billion in both years), delaying the reversal of the currently unsustainable path of public debt.

• We revised upward our forecast for 2017 GDP growth, to 0.8% from 0.3%, while maintaining our call for 2018 at 2.7%. Our estimate for the average unemployment rate in 2018 was reduced to 12.4% from 13.3%.

• Our forecasts for the exchange rate remain at BRL 3.35 per U.S. dollar in 2017 and 3.50 in 2018, but we see upside for the currency.

• We revised downward our inflation estimate for 2017, to 3.2% from 3.4%, but maintained our 4.0% forecast for next year.

• We expect the Brazilian Central Bank’s Monetary Policy Committee (Copom) to decide on another 100-bp cut in the benchmark Selic rate in its September meeting.

Bigger deficits, bigger challenges

Facing disappointing revenues and limitations preventing deeper cuts in discretionary spending, the government changed its primary balance targets for 2017 and 2018. The new targets mean deficits of BRL 162 billion (-2.4% of GDP in 2017 and -2.2% of GDP in 2018) for the consolidated public sector, vs. previous targets of BRL 142 billion (-2.2% of GDP) in 2017 and BRL 131 billion in 2018 (-1.8% of GDP). For the central government, the new targets are BRL 159 billion for 2017 and 2018 (-2.4% of GDP in 2017 and -2.2% of GDP in 2018), vs. BRL 139 billion (-2.2% of GDP) and BRL 129 billion (-1.8% of GDP) previously.

Even after the revision, meeting the new targets will still depend on additional measures, illustrating the challenges set to fulfill fiscal rebalancing efforts. Recurring primary results point to deficits that are still wider than the new targets, at BRL 225 billion (-3.4% of GDP) in 2017 and BRL 170 billion in 2018 (-2.4% of GDP).

Nevertheless, we believe that the government will be able to meet the new targets. The government will likely use a combination of extraordinary revenues from concessions and asset sales, tax hikes and discretionary spending cuts. Furthermore, recent disinflation in the economy will have greater influence on the pace of spending growth.

We expect a primary deficit of BRL 157 billion (-2.4% of GDP) in 2017. The government should collect BRL 35 billion in extraordinary revenues (excluding automatic transfers to states and municipalities), and implement a BRL 35 billion budget cut in discretionary expenses to achieve the annual target.

We revised our call for the deficit in 2018 to 2.1% of GDP (BRL 147 billion) from 1.8%. The revision follows a reduction in estimated extraordinary revenues this year by approximately BRL 20 billion, reflecting a more conservative approach by the government in designing the annual budget. However, as expenses are set exactly at the constitutional spending cap, positive surprises - such as faster economic growth than the budget assumes (2.0% currently vs. our 2.7% estimate) or asset sales progressing more quickly - would imply a better primary result than the target. In particular, progress in asset sales has potential to generate up to BRL 113 billion in extra revenues in 2018, particularly in the Utility and O&G sectors (see table).

Deterioration in fiscal targets adds a degree of urgency to the approval of the pension reform, which is still waiting to move through Congress. The proposal needs greater political consensus before being voted on in two rounds in the Lower House and then proceeding to the Senate. Without reforms, the government is less likely to meet the constitutional spending cap after 2019, and public debt would then tend to remain on the unsustainable path seen in recent years (see chart).

Activity: Faster growth in 2017

GDP expanded 0.2% qoq/sa in 2Q17, topping expectations. On the supply side, the 0.6% hike in services more than offset stability in agricultural GDP and the 0.5% drop in industrial GDP. On the demand side, another contribution from net exports and improved consumer spending (influenced by withdrawals from inactive accounts held under employment protection program FGTS) offset the negative contribution provided by inventory changes, which reflects the agricultural crop in 1Q17.

GDP composition shows stronger underlying growth.  A lower contribution from agricultural GDP and the unfavorable statistical carryover of several GDP components due to weak March results offset gains accumulated by the key economic indicators throughout the quarter. Industrial production, broad retail sales and real revenues from services went up 2.5%, 3.7% and 3.1% (seasonally adjusted) in 2Q17, respectively.

Our forecast for 3Q17 GDP is a gain of 0.1% qoq ∕sa. This estimate is based on: 1) the positive evolution of coincident indicators in July and August; 2) the impact of the accumulated decline in consumer confidence since May; and 3) a partial reversal of the effect caused by withdrawals from inactive FGTS accounts. Importantly, the census bureau (IBGE) is likely to revise 2Q17 GDP growth upward, to 0.6% (vs. 0.2% original release) in the first release of its 3Q17 GDP estimate.

We increased our 2017 GDP growth estimate to 0.8% from 0.3%, incorporating a faster pace in activity in 2Q17 and a milder-than-expected impact from rising political uncertainties lately. Our call for 2018 remains at 2.7%.

The gradual rebound is bringing improvement to the formal labor market. In July, 17,400 formal jobs were created (according to the Ministry of Labor’s CAGED registry). The seasonally adjusted quarterly average swung to 2,000 from -11,000, marking the first positive reading since 4Q14, according to our estimates, and following a gradual upward trend since 2Q16 (see chart). Importantly, stabilization in the unemployment rate without expansion of informality historically requires net creation of about 40,000 formal jobs.

Beyond the private sector’s formal labor market, the expansion in self-employment and informal jobs caused the unemployment rate to peak much earlier. Unemployment receded to 12.7% in the quarter ended in July from 13.2% in the quarter ended in March (seasonally adjusted figures according to our estimates). The decline was driven by strong gains in informal jobs. Even if this trend cools down, the unemployment rate will not peak again in our scenario, which assumes a gradual rebound in activity.

We revised our estimated unemployment figure, extending adjustments carried out in the previous scenario review. In our new forecast, unemployment peaked in March 2017 and will remain stable at 12.6% until 1Q18, gradually falling from then on. The new estimate for YE18 is 12.2% (13.2% previously). The revision was called for by the increase in our GDP forecast as well as larger-than-expected gains in informal employment in recent months.

Current account: Moderation at the margin

The exchange rate remains range-bound amid domestic and international uncertainties, hovering at BRL 3.10-3.20 per dollar during the entire past month. Uncertainties related to the political scene and reform approvals remain elevated, but risk premiums have been at well-behaved levels (around 200 bps). The international background, despite recent tension between the U.S. and North Korea, remains favorable for risky assets, ensuring a good performance for emerging market currencies.

We maintained our year-end exchange rate forecasts at 3.35 in 2017 and 3.50 in 2018. Progress in the agenda of microeconomic reforms, particularly the privatization program, represents upside for the Brazilian currency this year.

Balance of payment figures show moderation in the current account at the margin. The strong trade surplus has helped to maintain low current account deficits, but a rebound in domestic demand and lower commodity prices tend to produce slightly weaker readings in the next months. July figures already point in that direction. The seasonally adjusted annualized three-month moving average reversed from a USD 1 billion surplus in June to a USD 9 billion deficit in July. In terms of financing, direct investment in the country remains robust, hovering at USD 80-85 billion since the beginning of the year and covering the current account deficit multiple times. Meanwhile, volatile capital flows (i.e. portfolio flows) are still negative over 12 months.

For the next years, we maintain our expectation of growing current account deficits, but not to the point of compromising Brazil’s external sustainability. We estimate trade surpluses[1] of USD 62 billion in 2017 and USD 50 billion in 2018. Our estimates for the current account deficit stand at USD 15 billion in 2017 and USD 34 billion in 2018.

We revised our 2017 inflation forecast to 3.2% from 3.4%

We reduced our forecast for the consumer price index IPCA to 3.2% from 3.4%, due to a new estimate for food consumed at home. We expect year-over-year inflation to bottom at 2.6% in August and rise to 2.8% in September.

Breaking down the index, we expect market-set prices to rise 2.2% and regulated prices to advance 6.2%. Among market-set prices, we anticipate a decline of 1.6% for food consumed at home (previously 0%), after a 9.4% increase last year. Plentiful crops — amid favorable weather in Brazil and other major global producers — have caused declines in producer prices since September 2016, with favorable impact on retail food prices. From January through July, costs for food consumed at home in the IPCA fell 1.9%. We expect an additional slide to -3.4% by August. We expect industrial prices to rise 1.2% (4.8% in 2016). Service prices are estimated to advance 4.7% this year (6.5% in 2016). Adverse conditions in the labor market and in the Real Estate sector, a lower inertial effect from past inflation and a smaller adjustment in the minimum wage prompted moderation in wage and rent costs. These factors will continue to contribute to a drop in service inflation throughout 2017. As for regulated prices, we have the following forecasts for the main components: 4% for gasoline, 4% for medication, 6% for urban bus fares, 8% for electricity tariffs, and 13.5% for health insurance premiums.

Our 2018 inflation estimate remains at 4.0%. Breaking down the index, we expect market-set prices to rise 3.7% and regulated prices to climb 5.0%. Our below-target inflation estimate for next year will be driven by a still-negative output gap, along with less inertia from 2017 inflation and anchored inflation expectations in relation to the targets.

The main risk factors for the inflation scenario are still tied to domestic politics. Rising political uncertainty has hindered progress in reforms and needed economic adjustments, and may cause additional impact on risk premiums and the exchange rate. However, so far the net short-term effects of rising uncertainty on inflation have been neutral. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as new tax hikes and/or reversal of tax breaks. As for the external situation, despite more favorable levels at the margin, there are still policy risks in central economies which could eventually lift risk premiums and weaken the local currency.

Substantial slack in the economy may contribute to a sharper decline in inflation. The negative output gap (difference between potential and effective GDP) and the corollary high level of unemployment for a longer period may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months have indicated a broader disinflation process, which has been hitting exactly these segments. As for food consumed at home, given the benign supply shock and the recent path of wholesale agricultural prices, we cannot rule out an even more favorable behavior than we currently anticipate in 2017.

Inflation expectations remain anchored, with breathing room in relation to the targets in 2017 and 2018. The median of market expectations for inflation, as per the central bank’s Focus survey, receded to 3.38% from 3.45% in 2017 and to 4.18% from 4.20% in 2018, while the median estimates for 2019 and 2020 remained at 4.25% and 4.00%, respectively.

Monetary policy: 100-bp cut expected in September, but the Copom should signal a slower easing pace soon

We expect the Copom to announce another 100-bp cut in the Selic rate in the September 5-6 meeting. The post-meeting statement and the minutes of the July meeting indicated that the baseline scenario for September is a 100-bp reduction in the Selic, as long as economic conditions remain unchanged — i.e., activity stabilization followed by a gradual recovery, with substantial slack in the labor market and tame inflation. The 2Q17 GDP report reinforced that economic conditions did not deviate much from the baseline scenario, so that the easing pace should be sustained.

The committee should change its communication soon to prepare for a slower monetary easing pace starting in the October 24-25 meeting. In fact, the Copom has been stressing that, for a given expectation of extension in the cycle, the pace will depend on the stage of the cycle, signaling that, from now on, changes will be inclined toward slower monetary easing. In recent speeches, committee members have also pointed out that real interest rates fell near their all-time lows, tending to boost the economy. Furthermore, the committee has stressed that recent evidence suggests that the economic stabilization process is consolidating. In our view, such statements indicate that the committee will likely slow down the monetary easing pace to 50 bps per meeting starting in October, taking the Selic to 7.25% by year-end.


 


[1] As per the Ministry of Trade (MDIC)


 

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



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