Itaú BBA - Bumpy Road but Not a Reverse in Direction

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Bumpy Road but Not a Reverse in Direction

March 8, 2013

This year optimistic mood is now being tested.

You can watch our LatAm Macro Monthly in video. Ilan Goldfajn, Itaú's chief economist, talks about the outlook for Latin America and the global economy. Watch the video here.

Global Economy
Bumpy Road but Not a Reverse in Direction
The political impasse in Italy increases volatility but does not alter our scenario for the global economy in 2013

On the Borderline
We believe interest rates will remain at historically low level

Good Morning, Your Honor!
Argentina faced a tough hearing at the New York Court of Appeals. The court requested a detailed proposal of payment to holdouts. The likelihood of a default increased

Stronger Hope for Reforms
Recent events make us more confident on a positive outlook for reforms. We now expect a single 50-bp interest-rate cut in June

Flying High
Chile’s economy once again surprised on the upside, and we have raised our growth forecast for this year, though we don’t expect interest rate moves

Expansion Amid Protests
Anti-mining movements are reappearing, but the government has been successful in containing the protests. Business confidence is high and the economy continues to expand at a strong and sustainable pace

Slower than Expected
Economic activity remains slow. Authorities have been worried about the appreciated foreign-exchange rate and its impact on the country’s tradable sector. A weaker peso would improve competiveness but would also bring costs for the economy

Falling Prices
Shipping delays in Brazil and Argentina affect short-term prices

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Bumpy Road but Not a Reverse in Direction

This year optimistic mood is now being tested. Political deadlock in Italy, stronger fiscal adjustment in the United States and measures to cool down the Chinese real estate sector have brought volatility to global markets. Commodity prices retreated. We believe that last year developments – especially the stance of the European Central Bank – have made the world economy more resilient and less prone to disruption. We continue to believe in the recovery trend, even though it is subject to eventual turbulence.

With the external environment under greater control, despite recent volatility, Latin American countries turn to local issues. In Mexico, the government moves forward with structural reforms and improves its prospects. In Argentina, a difficult hearing at the New York Court of Appeals led to higher risk of a technical default, adding even more risk to the mix.

In Chile and Peru growth remains robust, although anti-mining protests add some uncertainty to Peru’s outlook. In Colombia, however, growth slowed down, and the central bank has been reducing the policy rate, a process that will likely continue in coming months.

In Brazil, the focus is on monetary policy. After a few months indicating stable rates for a prolonged period, the central bank has now signaled interest rate increases in response to higher inflation. The decision to increase rates, in our view, will depend on upcoming inflation results. A retreat, even if helped by tax cuts, would cause the central bank to remain on hold for longer. If the pressure continues, the policy rate is likely to rise. Still, we don't believe in an intense or prolonged tightening cycle.

Global Economy
Bumpy Road but Not a Reverse in Direction
The political impasse in Italy increases volatility but does not alter our scenario for the global economy in 2013

The Italian political impasse increases volatility and poses risks for the global economy. However, But it does not change our scenario. We still see an improvement in the balance of risks and better global economic growth in the second half of 2013.

In the U.S., the Sequester spending cuts started on March 1. As a result, we expect a bigger fiscal drag and see an increase in downside risks to growth in the next few months. However, But we maintain our GDP growth forecast at 1.7% in 2013 as economic data have been relatively good this year.

After a worse-than-expected contraction in 4Q12, leading indicators point that the euro area economy is stabilizing, albeit at a slower pace than we had anticipated. We revised the GDP forecast to -0.5% from -0.2% in 2013. Volatility from the Italian stalemate increases downside risks.

In a world of loose monetary policies and talk of “currency wars”, the Japanese Yen and the British Pound have the weakest prospects among the major currencies. Both the Bank of Japan and the Bank of England switched to a more dovish stance, depreciating their currencies along the way.

Ben Bernanke re-affirmed that benefits of the U.S. Fed quantitative easing (QE) outweighs costs, confirming our expectation that the pace of QE will only be reduced in 2H13 with improvements in the labor market. The European Central Bank maintained rates unchanged in March, but re-affirmed monetary policy will stay accommodative. We expect the euro to depreciate against the dollar, given the worse economic outlook in the Eurozone.

Europe – Italian election increases volatility but is not the return of the euro crisis

The Italian elections showed a deeply divided country. Pier Luigi Bersani’s center-left party secured a majority in the lower chamber. Former Prime Minister Silvio Berlusconi’s center-right coalition elected most senators, but no group controls the Senate. The anti-establishment Five Star Movement, led by ex-comedian Beppe Grillo, became an important political force. Mario Monti, who is highly regarded by financial markets, fared poorly.

The political impasse creates volatility but we don’t see a return of the euro crisis. First, we expect some composition of the different parties to form a government in March. With the political fragmentation, this will be a fragile arrangement, but worried investors will be relieved nonetheless.

If negotiations fail and Italy needs another election (most likely towards mid-year), sovereign yields, which have reacted already (see graph), will widen further. But in this case, Italy would likely seek to become eligible to the ECB bond buying mechanism, limiting the potential financial stress. The main risk is that the Italian caretaker government and main party leaders would need to agree to fiscal and reform targets with their European partners during an electoral campaign.

In the euro area, after GDP contracted 0.6% in the 4Q12, worse than the -0.5% in our scenario, leading indicators point the economy is stabilizing this year. However, the pace is slower than we anticipated. We lowered our GDP forecast to -0.5% from -0.2% in 2013.

We still believe growth will resume in the second half of the year and expect the Eurozone to expand 0.9% in 2014. However, the volatility from the Italian stalemate increases downside risks.

An Even More Dovish Bank of England

The latest inflation report showed that the Bank of England (BoE) accepts higher inflation than before. This marks a shift in the central bank policy reaction function towards giving higher weight to the (weak) growth outlook than to the (high) inflation prospect.  Governor Mervyn King has also highlighted the need to rebalance the UK economy towards the external sector. Finally, the UK government is considering a change in the central bank mandate that could allow more “monetary activism”.

The BoE remained on hold in its last meeting, but the movements above indicate to us more easing ahead. The pound depreciated 7.3% against the dollar this year to date, a trend we believe will continue.

U.S. – QE to continue until labor market outlook improves substantially

In the U.S., Congress is unlikely to reverse much of the Sequester spending cuts that started on March 1. As a result, we expect a bigger fiscal drag (1.6% of GDP vs. 1.4% in our previous forecast) and see an increase in downside risks to growth in the next few months.

We maintain our GDP growth forecast at 1.7% in 2013 and 2.3% in 2014. The 4Q12 real GDP was revised up to 0.1% QoQ SAAR from -0.1%. The higher base effect and relatively good activity data so far this year offset the slightly slower growth in mid-2013.

Ben Bernanke reiterated in his Congressional testimony that the asset purchase program benefits outweigh its costs and risks, reducing market concerns that the FOMC could reduce or stop QE before we see a substantial improvement in the labor market outlook.

His speech confirms our view that the FOMC will reduce the pace of the QE stop expanding it and stop QE in the second half of 2013 due to substantial improvements in the labor market outlook (see graph). The employment gains should occur after it becomes clear the U.S. economy has absorbed the fiscal drag in the first half of the year.

China – House prices increasing, restriction measures intensifying

New house prices climbed 0.54% in January, the fastest pace since January 2011. Around 80% of the cities surveyed posted gains. If home prices keep rising too fast, there’s a risk authorities will start a new cycle of monetary tightening, with consequent negative impact on growth outlook. This is not our base case. We kept our GDP growth forecast for 2013 at 8.0% and 7.7% for 2014.

To curb house prices, the State Council announced new restrictions and reinforced controls on speculative demand and property prices. These measures include a 20% profit tax on property transactions, raising down payment ratio and mortgage rates, the current expansion of the pilot program of property taxes and price restrictions in some provinces.

Japan – Regime Change

Since the end of last year, Japan has been experiencing an important regime change in its macroeconomic policies. Prime Minister Shinzo Abe is implementing ultra-easy monetary policy and fiscal expansion (labeled as “Abenomics”), to pull the economy out of deflation.

The government and the Bank of Japan (BoJ) have increased spending and loosened monetary policy with an open-ended Asset Purchase Program (APP). As a result, since October, the yen weakened about 15% against the dollar and stock prices soared almost 30%.

The BoJ’s balance sheet, already bigger than those of other major central banks, is set to expand even further (see graph).  However, the average duration of the bonds purchased by the BoJ is about 2.5 years, significantly less than, for example, the 7.8 years of the U.S. Fed. Hence, if we adjust for duration, the monetary easing in Japan remains smaller than in the U.S.

We expect more stimuli ahead. In the end of February, Abe appointed Haruhiko Kuroda, an advocate of aggressive monetary easing, as the next BoJ governor. Thereby, we believe the BoJ will expand the APP and extend the maturity of government bonds purchased to 5 years, from the current 3 years, further increasing the monetary stimulus.

Looking ahead, Abenomics will support the economic recovery for the rest of this year and 2014. Recent data supports this view. Industrial production increased 1.0% in January, retail sales expanded strongly by 2.3% in the same month and business surveys are consistently improving this year.

Commodities: Falling Prices

Commodity prices fell 3.2% in February, with grain prices reversing the slight increase from January and base metals and energy prices falling in the second half of the month. Compared to the end of January, the agricultural, base metals and energy sub-indexes fell 2.3%, 5.8% and 3.4%, respectively. If we look at average prices, the fall throughout February is offset by the upward trend in January, bringing our Itaú Commodity Index (ICI) to average 0.8% above January. We expect the ICI to increase 0.4% (previously 0.8%) in 2013, after we revised some agriculture and base metals prices downward.

Further measures to cool property markets in China and a less dovish tone in the FOMC minutes explain the decline in base metal prices (and partially, in energy). Energy prices also fell because the current tightness in global oil balances has relied on lower, and possibly unsustainable, OPEC supply in the last three months. Weak coordination among the OPEC members will probably lead to higher oil output ahead.

Finally, fundamental indicators for agricultural prices were mixed. The highlight was the improvement in conditions for the next winter wheat crop in the United States. At the same time, prices were affected by shipping delays in Brazil and Argentina, leading to an increase in demand for the U.S. crop.

On the Borderline
We believe interest rates will remain at historically low level

The change in the central bank’s message has made for a less certain interest rate path. In our view, even if rate hikes take place, the Selic will rise to around 8.25%. Despite the signals of stronger growth in 1Q13, the economic rebound under way is moderate and in line with our forecasts for both GDP growth (3.0% in 2013 and 3.5% in 2014) and inflation (5.7% this year and 6.0% next year).

We revised our exchange rate estimate to 2 reais per U.S. dollar until the end of 2014 (from 2.10 for both the end of this year and the next), in line with the current economic fundamentals and the central bank inflation concerns. We widened our current account deficit estimate, given the recent above-expectation numbers, but maintained our trade balance forecast ($14 billion this year and $15 billion in 2014). We now project a current account gap of 2.6% of GDP this year and 2.5% in 2014 (from 2.5% and 2.4%, respectively). Our primary budget surplus estimate remains at 1.9% of GDP in 2013 and 0.9% of GDP in 2014, reflecting the continuity of the current fiscal policy.

Copom: tighter, but not for now

Brazil’s monetary policy committee kept the Selic rate at 7.25% p.a. The decision was unanimous and in line with market expectations and our view.

In the statement that accompanied the decision, the Copom removed the indication that the Selic rate should remain stable for a “sufficiently long” period, as it had reiterated in the previous statements. In our view, the change in the statement is in line with the latest speeches of Copom members, aiming to gain flexibility for an eventual rate hike.

The language used (“follow the evolution of the macroeconomic scenario”) indicates that the Copom considers the possibility of hiking the rate in coming months. However, it is not strong enough to signal a hike already in its next meeting, in April.

Our assessment is that the Copom’s strategy is to gain flexibility to observe current inflation, before deciding if it will indeed deliver the tightening cycle. If monthly inflation comes in line with our scenario, the decision will be a close call. On the other hand, if the government accelerates tax breaks and short-term inflation declines more, the Copom may opt to remain on hold.

Therefore, rate hikes in coming months are possible, but not certain. For now, we maintain our forecast that the Selic rate will remain at its current level until year-end. But we see the possibility of a short tightening cycle (around 100bps through 25-bp hikes), starting in May.

Inflation remains high despite lower electricity tariffs

Inflation remained high at the beginning of the year and the year-over-year results are expected to fluctuate between 6.2% and 6.6% until the end of 3Q13, when inflation should start to retreat. The drop in inflation has failed to meet expectations despite the reduction in electricity tariffs, which had a significant impact on the consumer price index (IPCA) in February. Although the current food-price pressure is expected to be partially reversed, the price increases have been broader. A heated labor market, the lagged effects of exchange-rate depreciation and higher inflation expectations are boosting inflation and its resilience.

Which inflation effect is most likely to prevail in the coming months, lower food prices or greater resilience and more widespread price increases? We expect some reversal of the perishable food prices, albeit smaller than the increases. In fact, the drop in February was already less steep than anticipated, suggesting the greater resilience of these prices.

Another driver that could benefit consumer inflation is the decline in agricultural commodity prices in international markets. For instance, the recent slide in soybean prices already reversed the substantial increase registered in the middle of last year. However, the impact tends to be stronger on producer prices (measured by IGPs) than on the IPCA, on which the effect is indirect.

Together, these effects create a lower (but still-high) inflation-reading scenario in the coming months, with the year-over-year result slightly topping the upper limit of the target range by mid-year. We therefore expect a downward path for inflation. We maintain our expectation that the IPCA will end 2013 up 5.7%. We also maintain our 6.0% forecast for 2014. A stronger exchange rate than in the previous scenario reduced the upside risks to our forecast for 2014, but did not change our basic scenario, which had a (upward) bias in the balance of risk for inflation.

There are both downside and upside short-term risks. On the one hand, food inflation – which has been more resilient in the short term – could present a sharper decline. New tax breaks may be announced and inflation may drop. On the other hand, a disappointing drop in food prices and higher industrial-product prices could pressure short-term inflation even further.

A still-moderate rebound

The economy expanded 0.6% in 4Q12, close to our 0.7% expectation, which was included in our projection after the publication of 3Q12 GDP report. While the data reinforced a gradual rebound scenario, the good news was the return of investments to positive territory.

Over the past month, there have been increased signs that GDP growth in 1Q13 may be stronger. In addition to robust agriculture and livestock activity, the expansion in Industrial sector seems more vigorous. We adjusted our 1Q13 GDP growth forecast, to 1.2% from 0.8%, with continued upside risk, but wonder about the February figures. After a strong January, there is evidence of weakness in the middle of the quarter, which, depending on the intensity, could eliminate the upward risk for quarterly growth.

In our view, the strong economic growth in 1Q13 is related to short-term factors. Inventory increases in some segments, such as trucks, temporarily contributed to stronger industrial activity. While fundamentals continue to indicate a moderate economic acceleration, signs of broader-based economic activity growth remain scarce. Business confidence has virtually stalled over the past two months, and consumer confidence is falling. Once again, there is more uncertainty surrounding the evolution of the global economy, possibly affecting investment decisions. Thus, a stronger advance in one quarter should be followed by a cool-down in the next period. As a result, we lowered slightly our forecast for GDP growth in 2Q13 and 3Q13.

The effects of upward surprises in economic activity have offset the impact of the disappointments. Hence, our GDP growth forecast remains at 3.0% in 2013 and 3.5% in 2014.

The unemployment rate remains low despite the low growth; however, there are signs of moderation in the labor market, with a substantial deceleration in the pace of formal employment expansion. In the last two quarters, there has been a notable decoupling between the IBGE’s (census bureau) monthly-employment household survey data, which affects the unemployment rate, and formal employment data (Caged). Hiring has picked up in the former and continues to slow down in the latter. Which reflects the true conditions of the labor market? The surveys complement each other. However, economic conditions explain the deceleration in formal employment, but not the working population acceleration shown in the IBGE survey.

Both surveys show a tight labor market and sharp real-wage increases. We believe that the favorable conditions will be maintained over the next few quarters. With the economy gaining momentum (albeit at a moderate pace), the number of new formal employment tends to accelerate and the unemployment rate tends to remain low.

The January credit report showed significant changes in statistics for the sector, providing greater detail and a wealth of information (please refer to “BRAZIL – Credit: Change in Methodology Shows Lower Spread and Delinquency Levels”).

New bank loans continued to expand at a moderate pace in January. In real terms and adjusted for the number of working days, the total volume of new loans rose 7.8% yoy, topping the average for the second half of last year (3.3%).

Influenced by weak seasonality, total outstanding loans remained unchanged on a monthly basis. The year-over-year growth in total outstanding loans was also stable in January, at 16.4%.

Delinquency in consumer loans (more than 90 days past due) fell from 5.6% in December to 5.5% in January, marking the fourth consecutive month of declines. Consumer delinquency for earmarked and non-earmarked loans retreated, while delinquency in corporate loans (more than 90 days past due) was stable at 2.2%. Interrupting the recent downtrend, interest rates and spreads increased for both companies and consumers.

A stronger exchange rate 

In the foreign exchange market, the heightened concerns about inflation resilience expressed in speeches by authorities led to a currency appreciation. After the central bank’s sale of U.S. dollars in the derivatives market in late January, the exchange rate remained below 2 reais throughout February, reaching 1.95 per U.S. dollar. At this level, the central bank purchased dollars (also through derivatives) to partially curb the strengthening movement.

The speeches by authorities and the currency market interventions suggest that a stable exchange rate of around 2 reais per dollar (closer to macroeconomic fundamentals) is the current desired level. We therefore revised our expected exchange-rate path, with the dollar stable at 2 reais throughout 2013 and 2014 (vs. 2.10 previously).

Trade balance deficit reaches $5.3 billion in the first two months of 2013

The trade balance in February was negative by $1.3 billion, with still-incipient soybean exports and strong fuel imports. Adding January’s $4 billion deficit, the balance for the first two months of the year is negative by $5.3 billion. Still, we maintain a more optimistic view on the balance for the rest of the year (we forecast a $14 billion surplus), boosted by the record-high soybean crop and higher international iron ore prices.

The current account deficit reached $11.4 billion in January, disappointing expectations. The above-expectation figures for service and income accounts are not expected to be offset in the next few months, leading us to revise our accumulated deficit forecast for 2013, to 2.6% from 2.5% of GDP. For 2014, an increase in the profit and dividend-remittance forecast also led us to raise our estimate, to 2.5% of GDP.

Foreign direct investment reached $3.7 billion, less than in previous months. The flow over the last 12 months reached 2.8% of GDP, enough to comfortably finance the current account deficit. Furthermore, the flow to the stock market stood out, sustaining the high December levels (above $3 billion) after registering very small or negative flows throughout 2012.

Fiscal policy: January’s strong primary budget surplus unlikely to be repeated

The public sector reported a high primary budget surplus in January: 30.3 billion reais, or 8.1% of GDP for the month, marking the second best result for the month in the historical series starting in 2002. The consolidated primary balance over the last 12 months equals 2.46% of GDP (2.38% in December), the strongest reading since August. Our series for the recurring primary surplus (which excludes atypical or temporary revenue and expenditures from the conventional result) shows a balance of 1.99% of GDP (1.82% in December).

The fiscal performance in January is due to a strong increase (20% yoy in real terms) in revenue from corporate profit taxes. Overall, revenue from the IRPJ (income tax for corporations) and CSLL (tax on net earnings) accounted for about half of the growth in federal government revenue. Given the gradual rebound in activity, the higher tax revenue in early 2013 probably does not reflect a pickup in corporate profits. We expect the situation to be counterbalanced in the coming months, negatively affecting both tax revenue and the primary budget result.

We continue to expect a reduction in the fiscal effort throughout 2013 and 2014, due to tax breaks and a relatively-high sustained growth rate for federal government expenses of 5% in real terms (vs. an estimated trend GDP of 3%). We maintain our forecast for the consolidated primary budget surplus at 1.9% of GDP in 2013 and 0.9% of GDP in 2014. These figures are consistent with an expansionist stance on fiscal policy.

Our scenario also contemplates a greater expansion in federal investments, which could reach close to 2% of GDP by the end of next year (vs. 1.4% in 2012), considering the room created by the moderate adjustments in monthly minimum wage (limiting transfer outlays) and the likely control of personnel expenses.

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

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