Itaú BBA - Tepid Activity, End of Tightening Cycle

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Tepid Activity, End of Tightening Cycle

May 9, 2014

IPCA surprised on the downside in April.

• We maintained our estimate for the 2014 IPCA inflation at 6.5%, taking into account adjustments in electricity and lottery games. Our forecast for the 2015 IPCA also remains at 6.5%.

• We regard the appreciation in the Brazilian currency as likely to be temporary, and we maintain our year-end exchange-rate forecasts of 2.45 BRL/USD in 2014 and 2.55 BRL/USD in 2015.

• Our GDP growth estimates have been left at 1.4% for 2014 and 2.0% for 2015, given the cool-down in economic activity in March and April. The fiscal figures for 1Q14 have drawn attention to the ongoing difficulties that are impeding fiscal adjustment. Our primary budget surplus forecasts remain at 1.3% for 2014 and 1.7% for 2015.

• The central bank’s monetary policy committee (Copom) reinforced its signal of an imminent end to the interest-rate hiking cycle, but inflation control may require additional increases in 2015. We expect benchmark year-end Selic rates of 11% for 2014 and 12.5% for 2015.

• Polls show a decline in government approval ratings and a diminishing gap in voter intentions between President Dilma Rousseff and the other candidates.

We maintain our 6.5% IPCA forecast for this year

IPCA surprised on the downside in April. The IPCA climbed by 0.67% in April, after a 0.92% increase in March, below our projection and the median of market expectations (both 0.80%). Foodstuff prices surprised on the downside, rising significantly less than expected (1.2%, while our expectation was 1.55%). The year-over-year change in the IPCA reached 6.28%, compared with 6.15% in March.

We maintain our 6.5% IPCA forecast for this year. Our estimate for regulated prices has been raised to 5.6% from 5.1%, after recent revisions to electricity tariffs (to 14%, from 10% previously) and lotto game prices. Our estimate for the year also assumes increases of 6% in gasoline prices and 2% in urban bus fares. For market-set prices, our 2014 forecast has been adjusted to 6.8% from 7.0% after we incorporated a smaller increase in food prices. If the exchange rate stays at its current levels for a longer period, it may bring some relief to inflation over the second half of the year.

Our 2015 IPCA forecast remains at 6.5%, as we lowered our estimate for regulated prices and raised our estimate for market-set prices. We have lowered our 2015 estimate for regulated price increases to 7.2% from 8.0%, as we expect some of the correction in electricity tariffs to be moved up to 2014. For 2015, we foresee increases of 15% in electricity tariffs, 10% in urban bus fares and 8% in gasoline prices. For market-set prices, we now forecast a 6.2% increase in 2015, up from 6.1% previously. The slowdown in expected inflation in market-set prices compared with our 2014 estimate (7.1%) is driven by our updated expectation of smaller increases in food and service prices. We assume an absence of new supply shocks in the agricultural sector, a cool-down in the labor market and some relief in service cost increases.

The general price index IGP-M rose by 0.78% in April, slowing sharply from March (+1.67%).The producer price index (IPA) climbed by 0.8% in April, after soaring by 2.2% in March, as agricultural prices rose by 2.0% (vs. 6.2% in March) and industrial prices went up 0.33% (vs. 0.76% in March). On a year-over-year basis, the IGP-M climbed by 8.0% in April. Our ongoing collection signals further deceleration in this index in May.

We maintain our 6.8% IGP-M forecast for this year. We expect the broad producer price index (IPA-M) – the component with greatest weight in the IGP-M – to increase by 6.7% as industrial prices rise by 5.5% and agricultural prices rise by 10%. As for the other IGP-M components, we estimate that the consumer price index (IPC-M) will climb by 6.5% and the construction cost index (INCC-M) will rise by 7.8%.

The currency strength is likely temporary, but may last longer

The exchange rate has been range-bound at 2.20-2.25 BRL/USD. The recent exchange-rate appreciation is related to a global strengthening movement in emerging-market currencies, to the interest-rate differential and to the perception by some international investors that some Brazilian assets are deeply undervalued.

A stronger currency may help in the fight against short-term inflationary pressures. The government seems comfortable with the current level of the exchange rate. The central bank reduced the pace of rollovers of swap contracts, signaling flexibility in its currency intervention policy.

We regard the current stronger level of the BRL as likely to be temporary, though it may last a while longer. We maintain our view that U.S. yields will resume their upward trend. Domestically, there is still a somewhat large current account deficit and uncertainty related to future economic adjustments. We thus believe that the currency will weaken again during the year.

We maintain our year-end exchange rate forecasts of 2.45 BRL/USD for 2014 and 2.55 BRL/USD for 2015. A weaker exchange rate is key to ensuring a downward trend in the current account gap in coming years.

In March, the last-12-month current account deficit narrowed marginally (to USD 81.5 billion (3.7% of GDP), confirming signs of stabilization. The deficit in the service account deteriorated from the previous month, driven by an increase in the deficit in equipment rentals.

 In the capital account, inflows to the local capital markets picked up. FDI remains robust. Foreign investment in the local capital markets was positive in February and accelerated in March. The interest-rate differential was one of the drivers behind the recent pickup in inflows, although inflows to equities also increased. Foreign direct investment (FDI) is also robust, with few signs of a slowdown at the margin. In the 12 months through March, FDI amounted to 2.9% of GDP. We forecast 2014 FDI at 2.4% of GDP.

Latest data point to activity cool-off

The latest released figures show economic activity cooling off. The numbers are consistent with our expectation that economic growth will remain moderate, following positive surprises in the first two months of the year. Industrial production fell by 0.5% mom/sa in March. Sales in supermarkets (as reported by the Brazilian Supermarket Association, ABRAS) dropped by 1.8% mom/sa in March, pointing to declines of 1.0% in core retail sales and 2.0% in broad retail sales. Our diffusion index for economic activity remains at low levels, with just 46% of indicators going up in the last three months.

The methodologically revised industrial production series confirms stagnation of the industry since 2010. In the March release, IBGE revised the industrial production historical series, updating the basket of surveyed products and the weights of each sector in the headline index. The new series showed small changes in the industrial performance over recent years: the level of production in February was 0.9% below that observed in the average of 2010 (-0.5% in the old series). There were changes, however, in the cyclical movements. Growth in 2013 was increased from 1.2% to 2.3%, which should translate into a moderate upward revision of GDP growth last year. On the other hand, in the first quarter of this year industrial production fell 0.4% seasonally-adjusted. The decline was slightly steeper than the one indicated by the old series, creating a downward bias for growth in the first quarter of this year.

Confidence continues to slide. Business and consumer confidence levels continued to retreat in early 2Q14. The sharp decline in confidence among entrepreneurs in the service sector (-3.1% mom/sa in April) was remarkable. The historical series for this indicator is relatively short (starting in June 2008), but its changes are correlated with service GDP. Hence, the April reading points to weak service GDP in 2Q14.

Our forecast for GDP growth in 2014 remains at 1.4%. We expect quarter-over-quarter growth rates of 0.3% in 1Q14, 0.2% in 2Q14, 0.4% in 3Q14 and 0.5% in 4Q14. For 2015, our estimate remains at 2.0%.

Unemployment continues to decline. The unemployment rate reached 4.8% in March, in line with our estimate and sustaining the downward trend that started in the middle of last year. The main driver is the slower shrinking of labor force participation. In a recent working paper, we argued that youths who left the labor market to go to school are unlikely to return to it in the short term (see Macro Vision – Unemployment, Declining Participation Rate and FIES). Hence, the unemployment rate tends to remain at historically low levels, even as the economy and employment levels are expanding at a moderate pace. As for income, the scenario of recent months has sustained wage increases, but growth in the real wage bill has been moderate, as there is no longer a positive contribution from growth in the working population.

Despite the electricity auction and the loan from the electricity trade chamber known as CCEE, distribution companies are likely to need more cash support in 2014. The recent evolution of the electricity balance in Brazil confirms the risk of power rationing and the system’s heavy reliance on thermal power plants, at least until 2015. The volume of electricity sold in the so-called A-0 auction reached 2.05 GW, on average, topping market expectations but still less than the total exposure of distribution companies (3.2 GW, on average). The auction reduces costs related to low hydropower generation in 2014 by 5-10 billion reais. However, costs (23 billion reais) are still higher than the amount allocated in the government budget plus CCEE loans.

Credit growth is moderate. In march the daily average of non-earmarked new loans increased by 1.8% mom/sa in real terms. On a year-over-year basis, real growth in total outstanding loans slowed to 7.1% in March from 8.4% in February. There was deceleration in both earmarked loans (to 16.6% from 18%) and non-earmarked loans (to 0.3% from 1.6%). Overall delinquency remained at 3.0% for a fourth consecutive month. The average interest rate continued to rise, while the spread was stable.

Fiscal policy: waiting for an adjustment

The public sector’s primary budget surplus stood at BRL 3.6 billion in March, slightly above market consensus expectations (BRL 3.1 billion). The consolidated primary surplus for the month was equivalent to 0.9% of GDP, stable compared with one year earlier but below the March average for the period following the Lehman Brothers collapse (2009-2013: 2.3% of GDP).

With the primary surplus at 2.1% of GDP, the public sector posted the lowest result for a first quarter in the historical series. In 1Q13, the primary surplus for the first three months of the year was 2.8%, while the average for the post-Lehman period is 3.2%. The decline in fiscal performance this year is taking place especially at the federal level, as the result slid to 2.0% of GDP in 1Q14 from 3.1% in 1Q13. The budget performance of states and municipalities is also starting to show signs of weakness, after showing good results in the first two months of 2014 due to federal transfers being held back late last year.

The recurring primary surplus (i.e., excluding atypical revenues and expenses) remained at 0.9% in the 12 months through March. The recurring primary balance is close to the lowest level in the series, which started in 2002. The conventional consolidated primary surplus (i.e., not adjusted for accounting issues or economic cycles) remained stable over the last 12 months (1.75% of GDP in March, vs. 1.76% in February).

At the central government level, tax revenues increased by 2.0% in real terms in 1Q14, slower than the pace estimated by the government for 2014 as a whole (which was 4.2%, using our own IPCA forecast of 6.5%). Tax revenues are growing in line with economic activity, which we expect to remain moderate, indicating downside to official forecasts. Given this scenario, there has been intense early booking of non-tax revenues, which are expanding 32% in real terms this year (higher dividends from state-owned banks stand out), helping to prevent a sharper decline in the fiscal result.

The pace of federal spending remained brisk last month. Real growth in central government expenses reached 6.1% yoy. In 1Q14, spending sustained the pace seen last year, having increased at an annual real rate of 7.4%, exceeding our estimate for potential GDP growth (2%-3%). The fiscal stance has been expansionary in terms of outlays and there is upside risk to estimates (ours and the government’s) for federal expenses this year.

The biggest contributions to the increase in federal spending this year have been from administrative expenses, investments and personnel costs. On the other hand, there has been a slowdown in transfers to households early in the year. However, the recently announced 10% increase in benefits for the poor paid under the Bolsa Família program and, particularly, news of postponements in pension expenses and other mandatory outlays suggest the possibility that this trend will be reversed in coming months.

Given the unfavorable situation on the revenue side, the difficulty of implementing a sharp adjustment in expenses in the short term and the likely reduction in the fiscal performance of regional governments, achieving this year’s fiscal target (consolidated primary balance of 1.9% of GDP) still looks like a challenge. In our scenario, federal tax revenues expand by only 1.0%-1.5% in real terms, around BRL 30 billion below the official projection. Such a disappointment would likely force the government to slow down spending to a real annual pace of 2%-3% until year-end (wrapping up 2014 with 4% growth, vs. 6.5% in 2013), which would not be enough. We understand that the fiscal figures so far are consistent with our call that the primary budget surplus this year will drop to 1.3% of GDP (2013: 1.9%).

For the next two years, we expect a fiscal adjustment driven by an increase in the tax burden (i.e., reversion of tax breaks, hikes in other taxes), with the consolidated primary surplus at 1.7% of GDP at the end of 2015 and 2.0% of GDP at the end of 2016. According to our estimates for the structural primary balance, these numbers imply an average annual fiscal decline of 0.6%-0.7% of GDP over this two-year period.

Our calculations suggest that a less expansionary fiscal stance is ahead. Alternatively, these estimates also imply that, starting from a less favorable cyclical position, a considerable fiscal effort (i.e., tax hikes and spending controls) will be required to bring the primary budget surplus to a level closer to what is needed to stabilize public debt in the long run (2.0%-2.5% of GDP).

Government approval ratings continue to decline; chances of second round increases

The government’s approval ratings are trending downward. Polls have been showing a declining trend in approval ratings for the Dilma Rousseff administration. In mid-April, an Ibope survey showed that 34% of participants assessed the administration as “good” or “great”, versus 36% one month before. The Datafolha poll showed the approval rate falling to 35% in May, from 36% in April.

Rousseff still leads voter intentions, but the gap between the candidates has narrowed, indicating higher likelihood of a second round. According to the Datafolha poll, Dilma’s voting intentions fell to 37%, Aecio rose to 20%, Campos had 11% and the sum of all the others rose to 7%. Since Dilma’s voting intentions are now smaller than the sum of all the other candidates (38%), the presidential election could require a second round of balloting. 

After PSB (in March) and PSDB (in April), PT will have the right to free air time on TV and radio stations in May. The party is expected to use the air time to try to reverse the trend seen in the latest surveys.

Copom: end of a cycle, even with inflation still under pressure 

In April, the Central Bank’s monetary policy committee (Copom) lifted the benchmark interest rate by 25 bps and signaled the end of the tightening cycle. In both the post-meeting statement and the minutes published the following week, the Copom suggested, in our view, that the monetary tightening that was already implemented should be enough to control inflation. In the minutes, the Copom reminded readers that “the effects of monetary policy actions on inflation are cumulative and materialize with lags.”

The Copom regards the hike in inflation as likely to be temporary and further rate increases as unnecessary. Higher food and regulated prices led to an increase in market inflation expectations for this year and next. The Copom’s view is that the recent lift in food prices is “localized and, at first, temporary.”

Hence, we maintain our forecast that the Selic rate will remain unchanged, at 11%, until year-end. Current inflation may accelerate again, convincing the Copom of the need for an additional increase in the Selic. However, this does not seem to be the most likely scenario.

In 2015, we believe that an additional adjustment in monetary policy will be necessary. Curbing high inflation in 2014 and next year is likely to require a greater monetary policy effort. We project a Selic rate of 12.5% by the end of next year.

Forecasts: Brazil



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