Itaú BBA - We forecast a 4% drop in GDP and lower interest rates in 2016

Brazil Scenario Review

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We forecast a 4% drop in GDP and lower interest rates in 2016

February 5, 2016

Economic activity has not yet stabilized. In our scenario of falling activity and inflation, we see the Selic rate ending 2016 at 12.75%.

• Brazil’s economic activity has not yet stabilized. The economy shrank significantly at the end of last year and leading indicators suggest that it continues to retreat during the first part of this year. Looking only at last year’s carry-over, we would expect GDP to fall 2.6% in 2016. Adding in a probable 1% contraction during the first quarter, GDP for the year could shrink 3.6%. As we believe that the economy is likely to stabilize only in the second half of the year, we are now forecasting a 2016 contraction of 4.0% (previously -2.8%).

• In 2017, we expect a moderate economic recovery, depending on the economic policy reaction and international shocks, with GDP rising 0.3% (previously 0.0%).

• The labor market is likely to have a lagged reaction to negative GDP growth. Unemployment will probably continue to rise, reaching 13.0% in 2016 and 13.4% in 2017.

• Fiscal accounts are still Brazil’s core problem. At the end of 2015, the primary deficit was 1.9% of GDP (0.9% excluding delayed expenditure), after a deficit of 0.6% of GDP in 2014. We have revised our projection of the primary balance in 2016 to -1.5% from -1.4%, but we maintain our -2.0% projection for 2017.

• Brazil’s external accounts are adjusting fast, in line with current weaker exchange rate. The current account deficit fell to 3.3% of GDP in 2015 (compared with 4.3% in 2014). The current account deficit should continue to improve and end 2017 close to zero.  We are maintaining our dollar exchange rate projections at 4.50 reais per dollar at the end of this year and 4.75 per dollar at the end of 2017.

• With a stable exchange rate, inflation will probably present a long-term downward trend. Our inflation projections for this year (7.0%) and 2017 (5.0%) remain unchanged.

• The central bank has backed down and held interest rates stable, based on global risks and the domestic recession. In our scenario of falling activity and inflation, we now expect to see the Selic benchmark interest rate ending 2016 at 12.75%, with three 0.5 percentage point cuts from August onward.

Contracting activity and falling inflation create opportunity for interest-rate cut

Data on economic activity from the last quarter of 2015 were worse than expected. The first quarter of 2016 is also likely to reveal negative growth.

Fundamentals suggest difficulties moving forward. Domestic demand is set to weaken further, while any positive contribution from external demand is likely to be limited.

The fiscal situation worsens. Future stabilization of economic activity and resulting improvement in tax revenues will be insufficient to stabilize debt dynamics, because of a structural tendency for mandatory spending to rise faster than GDP. Without reforms to reduce these expenditures, gross public debt will continue to rise.

Brazil’s external accounts have been improving consistently, providing relative stability for the Brazilian real. The current-account deficit is converging to zero in 2017. However, the global outlook and deteriorating fiscal situation may lead to further depreciation. 

We believe that inflation has embarked on downward trend. Less pressure from regulated prices will help ease the IPCA this year. The impact of the economic slowdown on inflation, particularly in the Service sector, should become clearer later in the year. The main risk in this scenario is a stronger depreciation of the BRL.

We expect the Selic benchmark interest rate to fall in 2016. The central bank has communicated its concerns about global and domestic activity. We believe that inflation will fall throughout the year and push the central bank into a rate-cutting cycle in the second half of 2016.

A little light at the end of the tunnel. There are incipient signs of economic activity stabilizing in the second half of the year. The downward trend in business and consumer confidence has ended, and ticked up in January. Inventories are high, but they are being adjusted. Other leading indicators, such as our diffusion index, still suggest that economic activity will slow down, but the deceleration will be less dramatic.

Activity contracts at the end of 2015 and beginning of 2016

The contraction in economic activity was stronger than we expected at the end of last year. For example, real revenues in the Service sector fell 6.6% year over year in November. Industrial output disappointed in December, retreating 0.7%. In the fourth quarter, it fell 3.9%. Retail sales surprised to the upside in November, but coincident indicators pointed toward a reversal in December, suggesting a 2.2% reduction in sales during the fourth quarter of 2015. With GDP falling further in 2015, the carry-over for 2016 stands at -2.6%. In other words, this is the extent that GDP will fall if it remains stable throughout the year. However, economic fundamentals suggest that GDP will fall further in early 2016.

The first quarter of 2016 is also likely to see negative growth. The first coincident indicators for economic activity (vehicle sales and energy demand) fell in January. Industrial inventories remain high. Additionally, our Itaú-Unibanco monthly GDP index suggests a negative carry-over into 1Q16. Based on this, we are now projecting that GDP will shrink 1.1% during the first quarter. As a result, GDP would retreat 3.6% this year if it remained stable from the second quarter onward.

Economic fundamentals suggest that challenges remain. Uncertainties, pressure on production costs and high levels of idle capacity are likely to drive investment down further. The significant drop in commodity prices in international markets has reduced profitability in certain sectors, further discouraging investment.

Last year’s downward trend in spending is likely to continue. The deteriorating job market will continue to weigh on consumer decisions.

Following the currency depreciation, exporters are likely to continue making a positive contribution to growth, as in 2015. However, modest global growth will limit any impact.

Confidence shows early signs of stability. In January, business and consumer confidence indices surprised positively. Despite this improvement, it is not yet clear whether this represents a fundamental change in attitude – at the moment, it’s clear that confidence generally remains low. Still, these figures suggest relative stability for economic activity in the second half of the year.

We are now forecasting that GDP will fall 4.0% in 2016 (compared with -2.8%). On the demand side, the drop in GDP will be led by domestic consumption and investment, whereas the negative highlights on the supply side will be industry and services. We are forecasting a 0.3% rise in GDP (previously 0.0%) in 2017. A slight loosening in monetary policy should contribute some growth next year.

Fundamentals remain negative in the labor market. In December, there was a net loss of 596,000 formal jobs (CAGED). Removing seasonal effects, we calculate that 118,000 jobs were lost. Job destruction has lessened in recent months but remains close to historical minimum levels. The rate of unemployment in the six metropolitan regions surveyed by the Monthly Job Survey (PME-IBGE) also rose less than expected in December.

Weak economic activity is likely to continue driving up unemployment. Additionally, the proportion of people reporting difficulty finding a job, a leading indicator of unemployment, rose from 89.0% in December to 91.7% in January.

We forecast that the national unemployment rate reached 10.0% at the end of 2015 and will rise to 13% by the end of this year. We have reduced our 2017 projection slightly, to 13.4% (from 13.7%). We expect the rate of unemployment (PME-IBGE) to reach 11.4% by the end of this year, and we have revised our 2017 projection down to 11.8% (previously 12.4%).

Total outstanding loans fell 3.7% in real terms in 2015. The daily average of new non-earmarked loans fell 2.5% in December (mom/sa in real terms), while the daily average of new earmarked loans fell 4.3%. Total outstanding loans continued to decline in terms of real annual growth, falling 3.7% (-2.8% in November). The drop in non-earmarked credit intensified to -6.3% from -5.9%. Earmarked outstanding loans also shrank, falling 0.8% (0.6% in November). Overall delinquency remained stable, at 3.4%. Overall, interest rates and average spreads declined.

Fiscal deterioration continues

The primary deficit was 1.9% of GDP in 2015 (0.9% excluding delayed expenditure), compared with a deficit of 0.6% of GDP in 2014. The discretionary spending cuts and tax increases throughout the year proved insufficient to offset the drop in tax revenues and increase in mandatory expenditure. The central government registered a primary deficit of BRL 117 billion (1.9% of GDP), of which BRL 56 billion represented December payment of delayed expenses. Regional governments ended 2015 with a surplus of BRL 9.7 billion (0.2% of GDP). However, regional governments recorded a deficit of BRL 9.8 billion in December, confirming the assessment that positive news throughout the year was only temporary, partly reflecting delayed spending.

We forecast a primary deficit of -1.5% of GDP in 2016 (revised from -1.4%). Some of the pressure has been taken off government expenditure because delayed expenses were paid off in 2015; however, the downward trend in tax revenues and the rise in mandatory spending – especially on social security – will continue. We project that social security spending will rise from 7.4% of GDP in 2015 to 8.0% and 8.3% in 2016 and 2017, respectively.

The public debt and nominal deficit continue to deteriorate. The nominal deficit rose from 6.0% to 10.3% of GDP between 2014 and 2015. Even excluding currency-swap expenses (totaling 1.5% of GDP in 2015), the nominal deficit rose from 5.7% to 8.8% of GDP, reflecting an increase in interest expenditure from 5.2% to 7.0% of GDP, excluding income from swaps. Interest expenses excluding swaps are likely to remain under pressure because of the growing size of the debt. We believe that interest expenditure excluding swap losses will represent 7.6% of GDP in 2006, increasing the nominal deficit to 9.0% of GDP.

Rapid external accounts adjustment

The current account deficit fell from 4.3% of GDP in 2014 (USD 104 billion) to 3.3% of GDP in 2015 (USD 59 billion), driven by the positive contribution from the trade balance, which swung from a 2014 deficit to a 2015 surplus. The income and services deficit also decreased in 2015.

Foreign investment is consistent with the current adjustment. Direct investment in Brazil (USD 75 billion in 2015) should be more than sufficient to cover the entire current-account deficit.

We have maintained our foreign exchange projection of 4.50 reais per dollar at the end of 2016 and 4.75 reais per dollar at the end of 2017. This exchange rate trend is consistent with the current, swift adjustment to external accounts.

The currency depreciation and weaker economic activity will help to improve the balance of trade in 2016 and 2017. We are maintaining our forecast of a USD 42 billion trade surplus in 2016 and USD 56 billion surplus in 2017. In turn, the current account deficit should drop from 1.4% of GDP in 2016 to 0% of GDP in 2017.

We project 7.0% inflation this year and 5.0% in 2017

We believe that inflation will fall to 7.0% this year. We are projecting a 7.0% increase for both market and regulated prices. Regarding the latter, we reduced our forecast for electricity but upped our projections for new-vehicle registrations fees.

We forecast a 2.5% increase in the IPCA inflation during the first quarter (compared with 3.8% in 2015), with the 12-month rate falling back to 9.3% (10.7% at the end of 2015). At the beginning of the year, inflation comes under pressure from foodstuffs (particularly price increases for fresh fruits and vegetables, reflecting the climate effects of El Niño), rising public-transport costs in a number of cities, tax hikes in several states and higher school fees. On the other hand, electricity prices rose 36% in the first quarter of 2015, but they will not rise this year and should fall by March. As a result, regulated price increases should slow to 1.9% in the first quarter, compared with 8.5% during the same period last year, resulting in a 1.5 percentage-point drop in inflation. For the remainder of the year, we are projecting a 1.4% increase in the IPCA for 2H16 (2.3% in 2015), rising 1.0% in the third quarter (1.4% in 2015) and 1.9% in the fourth (2.8% in 2015).

Projection for market-price inflation stays at 7.0%. Projected inflation for the various market-price components includes a 5.5% increase in industrial prices (6.2% in 2015), a 7.4% rise in services (8.1% in 2015) and 8.5% hike for food at home (12.9% in 2015). Despite last year’s stronger resistance to inflation from services, we stand by our assessment that the deteriorating job market and real estate industry, which mitigate salary and rent costs, should help to drive down service inflation this year. However, the inertia from the higher rate of inflation in 2015 may restrict expected service disinflation following the 11.7% increase authorized for the minimum salary and the likelihood of higher school fees at the start of the year. Our basic scenario for foodstuffs is based on better weather conditions than in previous years, despite the risks associated with El Niño, which could reduce supplies of certain agricultural products. Apart from a supposedly more-benign climate for crops, particularly grains, relative exchange-rate stability and lower cost variations for energy and fuel will likely help reduce foodstuff price increases during the year.

We continue to project a 7.0% increase in regulated prices this year, with changes in its composition. We have revised our projection of a 2% increase in electricity prices down to zero, following the reduction in the tariff-flag prices issued by the National Electrical Energy Agency (Aneel). Accordingly, we continue to expect a switch from the red-flag to the yellow-flag tariff from March onward, as demand on thermal power plants is expected to ease. Based on the new price for the yellow-flag tariff – BRL 1.50 per 100 kWh (kilowatt-hour) (previously BRL 2.50) – electricity bills should fall by 5.5% when the current red-flag tariff switches to yellow, instead of the 3.6% improvement we previously estimated. Additionally, our simulations indicate that as reservoir levels recover more quickly, there is an increasing likelihood of green-flag tariffs being adopted by the end of the year, which could further lighten electricity bills and have an impact of -0.1 percentage points on the IPCA. Some of the items that put significant pressure on industry costs in 2015 will now help stabilize electricity bills this year, after last year’s 51% increase: the Itaipu tariff will fall; we expect a smaller deficit in industry charges for the Energy Development Account (CDE); and there will be less demand on thermal plants, which will feed through to tariff-flag colors and prices. On the other hand, we have revised our forecast for vehicle registration fees upward, based on increasing IPVA rates (motor vehicle ownership tax) in some states. This means that we expect to see this item rise 9% in 2016, compared with our previous 2% forecast. This year, we are projecting the following changes for other regulated prices that have a significant influence on inflation: water and sewage fees (16%); health plans (12%); city buses (9.5%); medicines (8%); bottled gas (7%); gasoline (4.5%); and fixed-line telephony (-1%). The 16% price increase forecast for water and sewage fees reflects changes in the incentive program intended to reduce water consumption in São Paulo, which are likely to make it difficult to reduce tariffs. The 4.5% rise in gasoline prices includes a 5% price increase at refineries at the end of the year and some state tax increases. For the time being, we expect no increase in the Contribution for Intervention in the Economic Domain (Cide) that applies to gasoline, which remains a risk factor for inflation.

The fiscal accounts pose a risk for inflation this year. As government finances deteriorate, we could see an even more intense and prolonged price realignment than forecast by our inflation projections. Further currency depreciation, the need to raise taxes and/or further increase regulated prices, or worsening inflation expectations, could all have an impact on inflation.

Weaker economic activity, however, should help drive inflation down in 2016. The other side of this coin is the deepening economic recession, which, despite easing inflationary pressure on the demand side, will also delay any recovery for tax receipts, which may worsen the balance-of-risk uncertainties for inflation.

We are projecting 5% inflation in 2017, measured by the IPCA. A drop in inflation next year is expected as the effects from relative price adjustments (regulated prices and the exchange rate), lower inflationary inertia and the impact from weaker economic activity dissipate, albeit with no sign of a recovery.

We have also held our projections for the General Price Index – Market (IGP-M) stable, at 7.0% for this year and at 5.0% for 2017.

Monetary policy: interest rate cuts on the horizon

Global uncertainty has increased, and the Brazilian Central Bank (BCB) has held interest rates stable.  Concerns over the global economy have led to volatility in financial markets, worrying central banks in developed countries. Against this backdrop, the BCB decided to hold the benchmark Selic rate stable at its January meeting. In the post-meeting statement, the BCB mentioned an increase in "external uncertainties.” In the minutes of the meeting, the central bank added that “in light of the reduced level of activity, we would highlight growing concerns about the Chinese economy and its repercussions for other economies.”

The BCB is also concerned about the domestic recession. In a statement, BCB chairman Alexandre Tombini said that that the reduction in the International Monetary Fund’s projection for GDP growth in Brazil, now at -3.5% for 2016, was significant. In the minutes, the BCB noted the worsening labor market. These are signs that the central bank is increasingly concerned over the slowdown in economic activity.

In this scenario, we expect the benchmark Selic rate to remain stable for now…  Based on the current high levels of inflation, we believe that the BCB will opt to keep the Selic rate where it is, to ensure that the current level of inflation does not extend into the future.

 ... but it is set to drop in the second half. In our assessment, the unemployment rate will continue to rise, and central bank projections will point to a deeper recession this year. As a result, when 12-month inflation begins to retreat and seasonal inflationary pressures from foodstuffs dissipate, we believe that the BCB will cut rates. This would occur in the second half of the year.

Overall, we now believe that the Selic rate will end 2016 at 12.75%, with three 0.5 percentage point cuts coming from August onwards.  The cycle of interest rate cuts should continue in 2017, with the Selic falling to 10.5%.

The most important risk for this scenario is the exchange-rate dynamics. There are substantial external risks (global deceleration) and internal risks (fiscal) that could drive a more significant depreciation of the Brazilian real, putting pressure on inflation. If this alternative scenario materializes, we believe that the BCB will not likely cut interest rates.


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


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