Itaú BBA - A More Hopeful Start

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A More Hopeful Start

January 10, 2013

World growth should improve throughout 2013. Despite recent volatility, a better outlook during the year should push asset prices up.

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Global Economy
Better Growth Outlook, Volatility Still On
World growth should improve throughout 2013. Despite recent volatility, a better outlook during the year should push asset prices up

Unsteady State
Intervention in the foreign-exchange market reveals that the economic policy goals and preferences may change, as could interest rates over the coming months

Growing, Nominally
Despite the lack of growth in 2012, inflation sped up and is likely to increase further in 2013

All Eyes on Structural Reforms
Inflation fell unexpectedly fast over the last months of 2012. While we have left our growth forecasts unchanged, we have reduced our inflation estimate for 2013

Low Inflation To Continue in 2013
Lower commodity prices, exchange-rate appreciation and “inflationary inertia” will likely keep inflation below the center of the target

Rising Sol
A market-friendly environment, robust growth and lower inflation are behind the rise of the sol

Weak Economy, But Advancing Reforms
Economic growth has disappointed and the Central Bank has cut the policy rate. We expect the weakness and rate cuts to continue. The government continues to focus on structural reforms to improve the country’s long-term outlook

Demand for Base Metals Rebounds
Expectations of a strong harvest in South America are leading to lower grain prices

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A More Hopeful Start

This year started on a more positive note, with an improved balance of risks. The U.S. managed not to plunge off the fiscal cliff, the Chinese economy has regained its momentum. Europe is still struggling, but nevertheless moving forward. The ECB is ready to draw on its new bond-buying plan, Greece completed a debt buy-back and received fresh cash from its official lenders, and Spain is accessing markets under reasonable conditions.

But threats remain. U.S. lawmakers look set for another battle over the country’s public finances – now about the debt ceiling. In Europe, the need for structural reforms will continue to make heavy demands on the political system – the uncertainty regarding the next elections in Italy is just the most recent example.

China’s stronger growth is pushing up the prices of metal commodities, and the stabilization of the global economy is raising energy prices. Grains, on the other hand, keep falling because of rising supply. On average, commodity prices increased over the past month.

In Latin America, Chile and Peru continue to be the top-performing countries, posting the highest economic growth and the lowest inflation rates. But they are also becoming more uneasy with the pace of exchange-rate appreciation and credit expansion.

Colombia and Mexico, on the other hand, have decelerated. Yet both continue to make efforts towards reforms that increase their long-term potential. The Colombian congress approved a tax reform that will improve its firms’ competitiveness and society’s income distribution. In a display of commitment to more sustainable fiscal accounts, the new Mexican president sent to congress a zero-deficit budget. The government is working on proposals for laws to diversify tax revenues away from oil and to allow for more private participation in the energy sector.

Argentina remains trapped in interventionist government policies, which are likely to inhibit the country’s growth prospects despite a good grain harvest and Brazil’s recovery.

In Brazil, a fragile economic rebound continues, with private-sector investment still posting lackluster performance. Economic policy also turned more complex in the short run. Authorities acted against the depreciation of the currency as a way to curb inflation. Months earlier, they had pushed for a weaker currency, aiming to help industrials weather internation.

Global Economy
Better Growth Outlook, Volatility Still On
World growth should improve throughout 2013. Despite recent volatility, a better outlook during the year should push asset prices up

World growth could reach 3.0% in 2013, only marginally better than the 2.9% of 2012. The picture during the year is more encouraging. We expect quarterly growth to improve from a 2.4% seasonally-adjusted annual rate (SAAR) in the fourth quarter of 2012 to 3.5% in the last quarter of 2013 (see graph).

Importantly, despite recent volatility, the balance of risks to this scenario continued to improve in the last month.

In the U.S., Congress passed a bill in the first minutes of 2013, avoiding the so called “fiscal cliff.” The current agreement represents a moderate fiscal contraction of 1.2% of GDP. Nonetheless, there is still some uncertainty ahead. Republicans and Democrats appear set for another debt-ceiling battle in the next couple of months. And the decision on some spending cuts – worth about 0.7% of GDP and part of the fiscal cliff – was only postponed until March 1 in this last-minute deal.

Activity in China continued to improve. The picture is of moderate growth compared with the past, but the risk of a hard landing appears to be behind us. In fact, we raised the GDP-growth forecast for China to 7.7% from 7.6% for 2012 and to 7.9% from 7.7% for 2013.

In the euro area, risks remain tilted to the downside, but the chances of a crash are smaller. The European Central Bank (ECB) is ready to use its new bond-buying plan. Greece completed a debt buy-back and received €34 billion ($45 billion) from its official lenders. Spain continued to access the bond markets at reasonable volume and cost. We note however that the region will continue to see volatility as the structural adjustments remain challenging. The abrupt end of Mario Monti’s government in Italy was the most recent example.

With lower tail risks and the prospect of an improvement in economic growth along the year, “risk-on” assets could perform well during the year.

U.S. – Fiscal cliff avoided, but some uncertainties remain

Congress passed the American Taxpayer Relief Act (ATRA) in the first minutes of 2013, a bill that deals with the tax issues of the fiscal cliff. The agreement implies a fiscal contraction of 1.2% of GDP in 2013, roughly in line with our assumption and market consensus.

However there are still some uncertainties regarding fiscal policy in the short and medium terms.

In the short term, note that ATRA only delayed the sequestration spending cuts for two months, until March 1. We believe that a new deal will replace the automatic cuts for this year with reductions in 2014 and 2015, at the same time that it maintains the total savings for the next 10 years. Republicans aim to reduce government spending, but avoid the reduction in the defense budget included in the sequestration. Democrats want to smooth the fiscal adjustment. Hence, both parties are likely to agree on another extension. Nonetheless, if lawmakers don’t reach a deal, the economy could suffer another fiscal drag equivalent to 0.7% of GDP in 2013.

The main risk is the debt ceiling. The Treasury estimates that it must be raised by early-March at the latest. Republicans lawmakers say they can raise the borrowing limit but demand in return an equal amount of spending cuts in the 10-year horizon, with a focus on entitlements (Medicare and Social Security). President Obama insists on more revenues through tax reforms to get a balanced fiscal adjustment. We expect another last-minute deal after a tough negotiation.

Finally, rating agencies say that Congress must increase the debt ceiling in an orderly fashion and act to stabilize the expected debt dynamics in order to avoid a rating downgrade.

Monetary policy also brought some important news last month, although with limited immediate impact.

First, as widely expected, the FOMC decided to purchase long-term Treasury securities at a pace of $45 billion per month to replace Operation Twist, which was completed at the end of the year. The Committee also pledged to continue its purchases of Treasury and agency mortgage-backed securities, until the outlook for the labor market improves substantially.

The minutes of the meeting showed however that the FOMC is more concerned about the costs of the Fed assets purchases. Several members thought it “would probably be appropriate to slow or to stop purchases well before the end of 2013”, due to concerns about the financial stability or size of the balance sheet.

With the US GDP expanding at a slightly below 2% annualized pace in the 1H13, the Fed is likely to continue asset purchases until about the end of 2013. But given the concern shown in the minutes, as downside risks to the economy decline, we see a higher change than currently priced in the markets that the Fed could indeed slowdown or stop its purchase program already in the 3Q13.

In another important change, the FOMC moved from calendar-based to outcome-based guidance to interest rates, a change that came earlier than expected.

Specifically, the FOMC anticipates that the current federal funds rate should be appropriate at least as long as the unemployment rate remains above 6.5%, the inflation forecast 1-2 years ahead is below 2.5%, and longer-term inflation expectations continue to be well anchored. These are thresholds; the Committee will also consider other information about the labor market, inflation and financial developments in order to decide when to start raising the federal funds rate

In the short term, the change did not add stimulus because it is consistent with the previous guidance, that rates should remain low at least at least through mid-2015.

Nevertheless, the change in communication is important. First it increases the transparency of the Fed reaction function, thereby reducing the risk premium embedded in long-term rates, which is associated with the uncertainty regarding future path of the Fed funds. Moreover, the Fed can change the thresholds as it considers appropriate to stimulate the economy more (or less). Finally, as highlighted by Ben Bernanke, the new formulation makes more explicit the FOMC’s intention to maintain accommodation as long as needed to promote a stronger economic recovery.

Economic indicators were surprised positively in November, probably reflecting some payback from Hurricane Sandy. We increased the GDP quarterly growth estimate in 4Q12 to 1.8% SAAR from 0.8%. In addition, the GDP expansion in 3Q12 was revised upward to 3.1%, from 2.7% in the previous official release. As a result, we revised our GDP forecast up to 2.3% from 2.2% for 2012 and to 2.0% from 1.8% for 2013.

Europe – Euro breakup risk declined, but volatility remains

Risks in the euro area are still predominantly to the downside. But since the ECB announced its new bond-buying program in September, the euro breakup risk has declined significantly.

December saw some further, although small, advances. Greece completed a debt buy-back and received €34 billion from its official lenders. European leaders agreed on the outline of a banking union. And Spain continued to access bond markets at reasonable volume and cost.

We note, however, that the region still faces important structural challenges. At the same meeting in which they agreed on the banking union, leaders decided to postpone any discussion on fiscal integration and better economic monitoring at the EU level to a summit next June.

In the periphery, countries have advanced in their external adjustment. Exports in Spain and Portugal are increasing and both countries could near a current account balance in 2013. But fiscal imbalances and/or debt overhang problems remain high. The Greek debt is unsustainable. Debt sustainability in Portugal is also tricky, and the Spanish fiscal deficit remains close to 6.0%.

With significant structural challenges, the region will continue to face moments of volatility. The latest example was the abrupt end of Mario Monti’s government and the ensuing uncertainty regarding the February election in Italy.

We don’t see widespread support among the Italian population for a radical shift in the EU-oriented policies. A large part of the fiscal adjustment has already been made and economic growth might improve in 2013. Therefore, the next government will likely maintain the country’s fiscal targets. But since Berlusconi withdrew his party’s support for Monti, the situation has become more uncertain. At the moment, there is no clear coalition to form a new government and we could face some volatility before one is formed.

Growth, or the lack of it, is another major issue in the region. Recent data points to a bleak picture in 4Q12 but gives glimpses of hope for 2013.

Retail sales declined 1.2% seasonally adjusted in October. Industrial production also fell 1.4% in the month after a 2.3% drop in September. The weak data led us to expect GDP to fall 0.4% (previously -0.25%) in 4Q12.

In contrast, business surveys improved in November and in December (see graph).The Purchasing Manager’s Index (PMI) of the euro area gained 1.6 points in the two months. The PMI remains in recessionary territory. But if it keeps moving up, the euro area could, in line with our scenario, move out of recession as early as in the first half of 2013.

China – Modest recovery

China’s overall activity kept improving in November, confirming a modest recovery. Industrial production was 10.1% higher than one year ago, up from 9.6% in October, continuing its recent moderate upward trend (see graph).

On the demand side, consumption remained robust. Retail sales were up 14.9% yoy in November, accelerating from 14.5% in the previous month. Investment was slightly weaker. The expansion in fixed-asset investment declined to 20.7% yoy from 22.2% in October. Infrastructure investment was the negative highlight, weakening to 13.8% from 26.8%, after several months in an upward trend. Finally, real estate improved in November. Growth of housing starts turned positive, property sales accelerated and prices rose marginally, remaining at high levels.

Following the slightly better-than-expected data in November and our view that the ongoing recovery extended into December, we revised our 4Q12 GDP forecast to 7.8% yoy from 7.5%. Hence, our GDP forecast increased to 7.7% from 7.6% for 2012 and, due to carry-over effects, to 7.9% from 7.7% for 2013.

Japan – BoJ under pressure

The Liberal Democratic Party (LDP) swept into power in Japan, winning a landslide victory in the parliamentary elections held in December. With more than a two-third majority, the new elected government, led by Prime Minister Shinzo Abe, is acting to implement their campaign promises of additional monetary and fiscal stimuli, putting pressure on the Bank of Japan (BoJ) to ease policy more aggressively.

In response to the still-weak economy and under rising political pressure, the BoJ eased again in December. The purchasing target in the Asset Purchase Program was expanded with an additional ¥10 trillion ($118 billion), equally split into Japanese government bills and bonds. The program now totals ¥101 trillion.

The central bank also agreed to discuss its medium- to long-term price-stability goal in January. Currently, the BoJ aims at a positive range for inflation of up to 2%, with a target of 1%. Mr. Abe is pushing for a 2% target and threatened to revise the central bank independence law if the BoJ refuses to change.

We believe that the BoJ will concede and adopt the 2% inflation target at the next meeting. Although we are skeptical that the central bank will achieve its new target, we already incorporate a loose monetary and fiscal stance in our 0.4% GDP growth forecast for 2013.

We also revised our forecast for 2012 GDP to 2.0% from 1.6%. This reflects a revision in the past data going back into 2011.

Finally, although still fragile, the Japanese economy seems to have bottomed out. We foresee an output contraction of 0.1% in the last quarter of 2012, after a 0.9% decline in the third. Then the economy should gradually recover during 2013.

Commodities – Demand for base metals rebounds with better economic outlook

Base metals led the Itaú Commodity Index (ICI) to increase 0.4% in December over the previous month. The increase was less than we expected (4.0%) because of lower grain prices. As a result, ICI in 2012 expanded 7.8% versus our forecast of 11.7%. For 2013, we revised the ICI growth to 1.0% from -4.1%, mostly due to a lower base at the end of 2012.

Grain prices extended their losses for the 5th consecutive month and fell 0.9% in December. A strong crop in South America and cancellation of soy contracts from China pressured prices down. We also reviewed our forecast for grain prices. Major consumer regions seem to be postponing imports, which should lead to lower prices than we previously expected.

Average energy prices were down 1.1% in December, amid lower geopolitical risks and concerns over the fiscal cliff in the U.S.

In contrast, base-metal prices have posted a strong performance since mid-November. Average prices in December were 6.4% higher than the previous month. Solid economic indicators from China are leading the recovery.

Unsteady State
Intervention in the foreign-exchange market reveals that the economic policy goals and preferences may change, as could interest rates over the coming months

We have revised the path for the exchange rate throughout 2013, but have not changed our year-end forecast of 2.15 reais per dollar. We continue to expect interest-rate cuts in March and April, with the benchmark SELIC rate at 6.25% by year-end. However, we acknowledge the increased likelihood that the exchange and SELIC rates will remain unchanged throughout 2013. The recent advance in inflation and government signals (as well as actual moves, in the case of foreign exchange) point in that direction.

A less-depreciated exchange-rate path caused us to lower our trade-balance estimate for 2013, to $18 billion from $20 billion. We raised our consumer price index (IPCA) estimate for 2013, to 5.6% from 5.5%, due to the withdrawal of the IPI tax break on automobiles. We maintained our GDP growth estimates at 0.9% in 2012 and 3.2% in 2013. Our forecast for a primary budget surplus in 2013 also remains unchanged, at 2.1% of GDP.

The exchange rate: a change in signals and actions

In December, policymakers changed again their signals regarding the desired path for the exchange rate. Given likely concerns about inflation, the government and the central bank acted against further depreciation, easing controls on foreign capital inflows (see Macro Vision: U-Turn) and resuming sales in the derivatives market (swaps). These moves prompted a 4% gain by the Brazilian real against the U.S. dollar, despite the largest outflow of foreign currency since 2008 ($6.8 billion). This behavior indicates that economic policy actions and the desired level for some variables are not in a steady state.

There is more uncertainty regarding the evolution of the exchange rate. On one hand, the fundamentals suggest a stronger rate than now (in the absence of additional domestic savings) and an additional weakening of the currency could put further pressure on inflation. On the other hand, there have been signals that a weaker exchange rate is considered part of the policymakers’ toolbox for increasing competitiveness and boosting growth.

Therefore, our scenario now forecasts the exchange rate holding at around 2.05 reais per dollar throughout the first half of 2013, before it tips into gradual depreciation to 2.15 by the end of 2013. We previously assumed that the rate would be 2.15 by the beginning of 2013.

We believe that the signals and actions related to the currency market have been intense, increasing the chances of a scenario in which the exchange rate stays around the current level for longer than we assume in our base-case scenario.

Regarding the balance of payments, the trade balance ended 2012 at $19.4 billion, consolidating a year of decline in the trade surplus, which fell from $29.8 billion in 2011. A drop of 4% in the terms of trade in 2012 stood out as one of the key drivers for the slowdown in the trade balance last year. For 2013, we have lowered our trade balance estimate to $18 billion from $20 billion, due to a stronger average exchange rate and a worse outlook for soybean prices than in our scenario.

We estimate that foreign direct investment ended 2012 at $63 billion. Despite the positive surprise of the November figure ($4.4 billion), a weaker preliminary reading for December FDI ($2 billion through December 14) suggests that our estimate is still valid. For 2013, we stand by our forecast of $64 billion in FDI. As for the current account deficit, we have adjusted our forecast for 2012 to 2.3% of GDP from 2.2%; for 2013, we have also adjusted our call slightly, to 2.4% of GDP from 2.2%, based on forecasts of a lower trade surplus and a wider deficit in services and income.

Rebound in economic activity remains moderate

The economy continues to grow, but at a moderate pace. After rising in October (the Itaú Unibanco monthly GDP index rose by 0.5%, and the central bank’s economic activity index, the IBC-Br, climbed by 0.4%), the data point to weakening economic activity in November and a pick up in December. There was a broad-based reduction in economic activity in November: a broad dataset showed that more indicators were going down than going up. For December, early signs show improvement, with broader-based growth.

Industrial production fell by 0.6% in November, and growth was probably slower in 4Q12 than in the previous quarter. The drop in investment stood out. Domestic absorption of machinery and equipment slid by 3.6% mom/sa in November, influenced by the fourth consecutive decline in the production of capital goods and by a contraction in imports of these items. Our estimates point to a 2.8% drop at the margin in gross fixed capital formation and a decline of 1.9% in the quarter ended in November. In other words, there is still no rebound in investment.

Available data suggest that the economy resumed growth in December. The withdrawal of the IPI tax break for autos starting in January prompted higher sales in December (5.8% mom/sa). Electricity usage and confidence among industrial entrepreneurs also advanced. But weakness in November and the pick up in December are in line with our scenario. Therefore, we have maintained our GDP growth forecast for 4Q12 at 0.7% qoq/sa. Our GDP growth forecasts for 2012 and 2013 remain at 0.9% and 3.2%, respectively.

There is one risk for GDP growth in 4Q12 which is unusual. For statistical reasons, a slightly positive surprise in the year-over-year growth rate may cause a leap in growth compared with 3Q12. The inclusion or exclusion of an outlier in 4Q08 produces a significant change in the seasonal adjustment for GDP (for instance, if the economy grows 1.6% yoy the outlier is included in the seasonal-adjustment model, but if GDP grows 1.8% the outlier stays out of the model). These seasonal-adjustment changes would drive 4Q12 growth to a level of 1.2% qoq/sa in the event of a small upward deviation from our yoy growth forecast (1.6%). Thus, the natural perception would be of a much stronger rebound in economic activity than contemplated in the 0.7% forecast. However, this figure would possibly be revised downward later, thus leaving unchanged the scenario of a moderate recovery in economic activity.

In the credit market, new bank loans were relatively stable in November, amid signs of a retreat in consumer delinquencies. New consumer loans rose by 1.2% mom/sa in real terms, recovering from the drop in the previous month (-1.9%). New corporate loans fell by 2.3% during the month, in a second consecutive decline (-2.1% in October). The three-month moving averages for new consumer loans as well as corporate loans are virtually stable. Total outstanding loans are still expanding (1.5%), particularly earmarked credit transactions.

The consumer delinquency rate for loans over 90 days past due fell by a seasonally-adjusted 0.1 pp, to 7.8%, marking the first slide since March. The corporate delinquency rate was stable at 4.1%. Interest rates and spreads went down again for consumers and companies. The prospect of a retreat in delinquencies is favorable to credit expansion ahead.

In December, the central bank authorized the use of a share of reserve requirements on deposits to finance purchases of machinery, equipment, trucks, buses and other items. The decision formalized the expansion of resources available to the Investment Support Program (or PSI, in its Portuguese acronym) to 100 billion reais, out of which 85 billion reais will come from state development bank BNDES and 15 billion from freed reserve requirements. The measures seek to boost investment.

Labor market data remain positive, with the unemployment rate remaining at a historically low level that is below our estimated equilibrium rate. Thus, real average income and the real wage bill have remained on a steady upward path, a trend which we expect to continue in 2013, though at a somewhat slower pace.

Expansionary fiscal bias creates downside risks to the primary budget surplus in 2013

The public sector posted a primary budget deficit of 5.5 billion reais (1.4% of GDP) in November, the worse reading for the month in the series calculated by the central bank (since 2002). The fiscal target for 2012 was threatened, even after deductions for expenditures within the Growth Acceleration Program (PAC). A strong result, around 25 billion reais (close to 7% of monthly GDP), would be needed in December to meet the adjusted target for the year.

The signs are that this strong result will materialize through extraordinary revenues (such as new dividend payments by state-owned banks, following new capital injections by the Treasury, in addition to money withdrawn from the Sovereign Wealth Fund). The volume of atypical inflows in the last days of 2012 is estimated at about 21 billion reais (0.5% of GDP), ensuring an accounting primary budget surplus close to 2.5% of GDP (vs. 3.1% in 2011). The recurring result, which excludes only atypical budget transactions, should be around 1.8% of GDP (vs. 2.7% in 2011).

New tax cuts for 2013 were announced in December. The break on payroll taxes was extended to construction and retail companies, in addition to other fiscal benefits granted to the construction sector. A gradual return of the IPI (tax on industrial products) was announced for automobiles and other durable goods, as well as a reduction in personal income taxes on profit-sharing. The government also included in the budget bill exemptions from new tax rates that will be implemented by the new legislation for PIS/Cofins.

In order to ensure the legal viability of recent and future tax breaks, the government submitted to Congress a bill to change the Fiscal Responsibility Act (2000) and allow tax benefits to be granted based on “excess” revenues forecasted for the year. Previously, the law dictated that tax exemptions could only take place through spending cuts or increases in other revenues.

Overall, there will be an additional volume of 18 billion reais (0.4% of GDP) in revenue losses in 2013, totaling about 50 billion reais (1.0% of GDP) for the year (we had already contemplated this assumption in our scenario). Our calculations indicate that there is no more room for new tax breaks. From now on, further tax reductions should be accompanied by lower spending (possibly on investments, where there is more room for adjustment) or by a lower fiscal target (for instance, with more room for PAC-related deductions).

Our estimates for the structural primary budget surplus also suggest that there is little room for new stimulus measures, in case the fiscal targets in the budget law are not changed. We estimate that the fiscal result, adjusted for the economic cycle, asset prices and non-recurring transactions, was around 1.0% of GDP in 2Q12 and 3Q12, compared with about 2.0% throughout 2011. This implies that the fiscal policy stance became more expansionary starting in 2Q12, which would be consistent with a primary surplus below the adjusted target throughout the cycles.

We maintain our forecast for a primary surplus of 2.1% of GDP for 2013, which is consistent with a structural result of 1.0% of GDP. On one hand, we are lowering our estimate for the primary surplus of regional governments (to 0.5% of GDP from 0.7%), incorporating faster execution of investments by some states, thanks to the replacement of the index that adjusts their debt with the federal government (which could free up 15 to 30 billion reais to the states). On the other hand, we are forecasting a larger volume of extraordinary revenues which, as in 2012, could be used to meet the adjusted target in 2013.

We note that there are downside risks for government intake, whether due to a slower rebound in activity or to a bigger-than-expected impact from revenue losses. Therefore, there are downside risks to the fiscal result this year.

The end of the IPI tax break for autos leads to small adjustment in the inflation forecast for 2013

We have slightly increased our forecast for the IPCA in 2013, to 5.6% from 5.5%, due to the end of the IPI tax break for autos. The IPI tax will come back gradually, with the rate for vehicles with 1.0 engines rising to 2% in January, 3.5% in April and 7% in July. Our previous scenario assumed a partial resumption of the tax, but only over the second half of the year. Downward-pushing drivers for inflation in 2013 will come from food prices (contained grain prices) and housing prices (discount on electricity tariff). The main upward-pushing driver will come from transportation prices, with expected pressure from public transportation, vehicle ownership and fuel.

Following a pick up in December, the IPCA is likely to remain under pressure in January. Starting in February, the effect of the decline in electricity costs (-0.5 pp impact on the IPCA) should create some relief. Upward pressure throughout 1Q13 (from adjustments in urban bus fares, gasoline, new cars, cigarettes and school tuitions) will likely prevent a deeper cool-down in inflation. We also expect sharper increases in food and clothing prices compared with early 2012. On the one hand, monthly inflation should show some improvement throughout 1Q13; on the other hand, inflation over 12 months will likely remain on the rise, reaching about 6.3% by the end of the period.

For the general price index known as IGP-M, we have maintained our 2013 forecast of 4.8%, vs. 7.8% in 2012. Significant relief on the IGP should come from lower producer prices, particularly agricultural prices. Better behavior on the part of the exchange rate and grain prices, amid favorable weather conditions, should enable a smaller change in the IPA agricultural price index, following a hike of 18.8% in 2012.

An upside risk to our inflation scenario is a full dispatch of energy from thermal plants for a longer period than expected (a year instead of two months). Regarding this assumption, energy prices would decline less than considered in our scenario, which would add between 0.1 pp and 0.2 pp to our IPCA forecast in 2013.

We continue to expect a drop in the benchmark interest rate, but the odds of stability have increased

Even with weak results for 3Q12 GDP, members of the monetary policy committee (Copom), in official speeches and in the December Inflation Report, reiterated their signal of “stability in monetary conditions for a sufficiently-prolonged period”. The current inflation pressure and heated labor market are helping to support the assertive and conservative stance by the Copom.

In fact, there are more risks to our scenario of a reduction in the benchmark rate in 2013. The government has signaled some comfort with the pace of rebound in economic activity (despite its expansionary reaction on the fiscal and credit sides following the publication of the 3Q12 GDP figure) and there were no significant surprises in the growth figures. The news was more inflation pressure, as well as a shift in activity in the foreign exchange market towards showing greater concern with the inflation picture. Externally, the risks of a greater negative effect from fiscal policy on U.S. growth have receded.

These elements suggest lower downside risks to domestic economic activity, higher inflation in the short term and less reaction from economic policy.

However, we understand that the Brazilian economy is still recovering at only a moderate pace. Even in our base-case scenario, in which there is a rebound, growth would still be fragile and any negative surprise may push expansion in 2013 to below 3.0%. Furthermore, though inflationary pressures are currently higher, we expect some relief in the monthly readings starting in February. As it was the case with the exchange rate, the signals and the desired level of interest rates may change, and the Copom may choose to lower the SELIC rate again. Our forecast is for two 50-bp cuts, in March and April, driving the SELIC to 6.25%, and then a stable rate until at least the end of 2013.

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

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