Itaú BBA - The Elusive Quest for Growth

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The Elusive Quest for Growth

December 6, 2012

As the end of the year approaches, there is some positive news in the global landscape.

The Elusive Quest for Growth

As the end of the year approaches, there is some positive news in the global landscape. Although not accelerating, the world economy is at least stabilizing. Markets seem eager to join in the year-end celebrations.

We still see volatility on the horizon. The risk of a fiscal cliff in the U.S. continues to linger. And we doubt that investors will remain calm about Spain for much longer, without intervention by the European Central Bank.

Commodity prices have taken diverging paths. While a better-than-expected crop generated lower agricultural prices, energy prices have benefited from worsening geopolitics and metals have been sustained by a firmer outlook for China.

The Brazilian economy disappointed yet again. Investment spending is just not recovering as expected. In response, we will probably see a new round of policy stimulus, including interest-rate cuts and a weaker-than-expected exchange rate.

Elsewhere in Latin America, the scenario remains positive. Mexico’s reform agenda finally made progress, with the approval of a new labor-market bill that is expected to generate greater optimism about advances on other fronts. Chile and Peru’s economies remain on a fast track. Robust fundamentals continue to boost investment in Colombia, despite the cyclical slowdown in credit and manufacturing.

In Argentina, however, challenges continue to mount. Lower grain prices, protests against the government, and a possible new technical default are fresh additions to an already-cloudy outlook.

Global Economy
Be Careful with Year-End Cheerfulness
World growth will only be marginally better in 2013. Prospect of a quick resolution of the fiscal cliff in the U.S. appears exaggerated. And we doubt that investors will remain unworried about the waiting game in Spain for much longer

Financial markets appear eager to join in the end-of-the-year celebrations. The stabilization of the global economy and positive activity data in the U.S. and China provide support. However, we see the world growth at 3.0% in 2013, only marginally better than the 2.9% of this year. Not a slowdown, but definitely a low-growth environment.

We also fear that the chances of some bumps ahead are higher than markets are factoring in. Despite some optimism after the election, the risk of the fiscal cliff lingers on in the U.S. And we doubt that investors will remain calm with Spain much longer if the country doesn’t becomes eligible for the European Central Bank (ECB) bond-buying program.

Central banks have been in an ultra-active mode in the past year, won’t they give a further push and counterbalance any risk? Some will try, but alas, central banks in the developed world are at their limits. We are skeptical about the stimulating capacity of monetary policy ahead and see fiscal policy – balancing necessary adjustments without too much damage to activity – as the main game in town.

Finally, we are lowering our price forecasts for agriculture commodities because of lower-than-expected prices in November and a better supply outlook. As a consequence, we now expect the Itaú Commodity Index (ICI) to increase only 13.7% in 2012 (previously 19.2%).


Official creditors approved the disbursement of €44 billion ($57 billion) to Greece. The deal solves the country’s cash needs in the short term. However, the government debt remains unsustainable. Without a definitive solution for its debt problem – which depends on the currently politically unacceptable official loans haircut – Greece will occasionally return to the spotlight.

Spain continues to access bond markets at reasonable volume and cost. In November the treasury issued €8.6 billion at an average yield of 4.6%. As long as this situation persists, the government of Mariano Rajoy will probably keep suggesting that the country is ready to request aid from the ESM, but say it doesn’t need it and not ask for it.

The Spanish government points out that foreign investors returned to Spain after the ECB launched its new bond-buying program (called Outright Monetary Transactions – OMT). Indeed, preliminary data show that the share of sovereign debt held by nonresidents increased 2.3 percentage points in September.

However, in our view, this equilibrium is not sustainable and at some point the pressure will return. The fiscal adjustment, deleveraging and rebalancing of the Spanish economy to tradable sectors remain challenging. Giving the uncertainties and without actual ECB interventions, we don’t believe that foreign investors will keep increasing their holdings. Without their flow, domestic institutions are unlikely to absorb the €120 billion of bonds Spain will need to issue next year.

Therefore, as Spain moves into 2013 without being eligible for the ECB’s OMT, we could see sovereign yields trending up. But it might take some bond-auction failure to finally trigger an aid request.

France gained the media spotlight in the past month. An IMF paper and a special country report in The Economist warned about the country’s bleak prospects. Moody’s downgraded France's government bonds’ rating by one notch to Aa1 from Aaa.

The French economy in fact shows weakness. Unit labor cost increased significantly and the external current account turned negative in the past decade (see graph). And the French government spends 56% of GDP, more than any other country in the euro area.

However the country has time to adjust and President Hollande started to address some of these problems. Last month he announced €20 billion in tax rebates (1% of GDP) to firms so they can increase their competitiveness. And despite adopting some flagship campaign promises – like the 75% tax rate for income above €1 million – the socialist government has broadly maintained its fiscal targets.

It is true that a lot more needs to be done. The fiscal consolidation so far focuses on increasing revenues, which depend on rosy growth assumptions, and doesn’t attack the size of the government. The country’s impetus for structural reforms also appears limited by various taboo areas (the 35-hour work week is an example). In any case, France has more a medium- to long-term problem to deal with, rather than facing an immediate collapse.

GDP in the euro area declined 0.05% seasonally adjusted in 3Q12, in line with our 0% forecast. One-off factors – VAT increase in September and statistical issues with working days and seasonal adjustment during the European summer – provided a brief relief to output. We foresee the recession intensifying again in 4Q12, with GDP dropping 0.25%.

Looking into next year, we see some downside risks to our forecast. Purchasing managers’ indexes available to November show little sign of recovery and are compatible with GDP contracting around 0.4% per quarter (see graph.) This contrasts with our baseline scenario, in which output is already flat in the 1Q13 and turns slightly positive afterwards. If leading indicators don’t improve soon, we might need to lower our forecasts again.

Given the weak economic outlook, we expect the ECB to cut its main rate by 0.25% to 0.50% in the 1Q13.


Economic indicators in the U.S. surprised on the positive side to October. Hence GDP growth in 3Q12 was revised to a 2.7% seasonally adjusted annual rate, from 2.0% in the advance estimate. The revision lifted our growth estimate to 2.2% from 2.1% in 2012. We don't, however, believe that the better trend would persist, as most of the gains appeared to be transitory, stemming from higher inventory accumulation and exports.

More recently, hurricane Sandy has been distorting the activity data. Our surprise index has started to trend down as more economic indicators missed the consensus forecast (see graph.) Most data releases should continue to be negatively distorted until year-end, as energy supply remained significantly below normal levels during the first half of November. Only high-frequency weekly economic data – like initial jobless claims – should start to rebound in the coming month.

Nevertheless we had already discounted the impacts of the storm. Our economic outlook remains the same, with GDP expanding 1.8% in 2013.

Fiscal policy not monetary is the main game in town

Market participants vigorously discuss the next steps by the U.S. Fed. We do expect the FOMC to move in December and next year. However, the latest round of stimulus – the open-ended quantitative easing from September – had only short-lived effects. We don't believe that next time will be different.  With the fiscal cliff still unresolved, fiscal policy is by far more important at the moment.

Hopes for a quick resolution of the fiscal cliff increased as Congressional leaders publicly expressed their aim to reach a deal before the year-end. However the Republicans rejected the first proposal by President Obama, indicating that two parties are still far apart.

A middle ground on many contentious political interests still must be negotiated. Republican leaders say they would support raising revenues only through closing loopholes and limiting deductions, not raising tax rates. Obama claims that a balanced fiscal adjustment should include higher tax rates for the upper-income households. Republican leaders also demand that any increase in revenues should come together with Social Security and Health Care reforms. These entitlements reforms would impact disproportionately the low- and middle-income households, leaning against the balanced fiscal adjustment proposed by President Obama.

We continue to expect a hard-fought compromise deal to be reached only in 1Q13, avoiding retroactively the full impact of the fiscal cliff. The political uncertainty should remain a source of volatility for financial markets.

Monetary policy is not a game-changer, but the Fed will keep trying to further stimulate the economy with balance-sheet and communication policies. The last FOMC minutes revealed that they should announce the replacement of Operation Twist with Open-Ended Treasury Purchases in their next meeting on December 12.

The FOMC is also likely to replace calendar-based guidance with an outcome-based forward guidance for the Fed Funds rate. But we see its implementation only in 1H13, because the committee is sorting out some practical issues. Moreover we think the Fed will opt for a qualitative outcome-based forward guidance rather than quantitative targets. Setting explicit thresholds for inflation or the unemployment rate would reduce future policy flexibility more than the Fed appears to accept.


October data reinforced the growth-stabilization trend. Industrial production was 9.6% higher than one year ago, an improvement from the 9.2% pace in September. Investment, pushed by infrastructure, and consumption remained firm. Nominal fixed-asset investments were up 22.2% yoy in October, similar to the previous month. Infrastructure growth went up to 23.9% from 23.4% and retail sales picked up to 14.5% from 14.2%. Inflation slowed to 1.7% from 1.9%, and should remain below 3% in the next few months.

The new Chinese leadership was unveiled in November. Xi Jinping emerged as the new leader and consolidated his position. He succeeded Hu Jintao both as General Secretary of the Communist Party and Chairman of the Central Military Commission, posts usually occupied by the main Chinese Leader. Note that, similarly to arrangements in the past, Hu Jintao could have stayed on as the military chairman for a couple more years. The fact that Xi Jinping has already assumed this position helps to solidify his political power. The perception is reinforced because the Politburo Standing Committee, the highest governing body, has been shrunk from 9 to 7 members, with most of them politically close to Xi.

Looking forward, the transition process should proceed smoothly without disruption of economic policies in the short term. Some of the new leaders already belonged to the party’s political core. Additionally, the current transition was in the Communist Party but not in the government. Hence, we do not expect major policy changes, at least until the new leaders take their government positions in March of next year.

With activity data broadly in line with our scenario and a well-coordinated political transition, we maintain our GDP growth forecast of 7.6% in 2012 and 7.7% in 2013.


Japanese economic growth continues decelerating. The economy contracted 0.9% in the third quarter, worse than our -0.5% forecast. Net exports contributed -0.7 percentage points, reflecting the sluggish external demand and hurt by political dispute with China in September. With weak corporate sentiment, capital expenditure declined 3.2% in the quarter. Personal consumption fell 0.5% qoq, compared with a drop of 0.1% in the second quarter, because of the end of the eco-car subsidies in September. On the positive side, public-sector demand provided some support, with government spending and public fixed investment contributing together 0.2 percentage points.

After two consecutive months of additional easing, the Bank of Japan (BoJ) stayed on hold in November, as expected. However, the political pressure on the BoJ to take bolder monetary action in the next meetings could rise substantially.

In November, Prime Minister Yoshihiko Noda dissolved the Lower House and called elections for December 16. The earlier election was a demanded by the opposition parties, in order to pass a bill to allow the issuance of deficit-covering bonds for the remaining of this fiscal year. Shinzo Abe, the main opposition leader and frontrunner to lead a new administration after elections, has called for bolder monetary action and more government intervention in the BoJ decisions.

Notwithstanding the recent additional stimuli and the possibility of more to come, we expect the weakness in activity to persist. We see GDP contracting 0.1% in the fourth quarter, down from our previous forecast of a 0.1% expansion. We revised our GDP forecast to 1.6% from 2.0% in 2012, mainly reflecting the fourth-quarter revision and the weaker-than-expected third quarter. For 2013, we lowered the output expansion to 0.4% from 0.7% in 2013, due to carry-over effects.


After falling 4.2% in October, commodity prices remained flat in November, but with a mixed performance across different groups.

Agricultural prices fell 2.4%, driven by better supply outlook. Soybean had the sharpest decline, with the upward revision to the crop’s production in the U.S. and favorable weather conditions in Brazil and Argentina. We still expect low inventories to lead to a price recovery in December. But the rebound will be smaller than we previously expected. We revised our price forecast for the end of the year to 1500 cents per bushel from 1750. For next year, prices should remain relatively high until exports from South America resume by the end of the first quarter.

Despite better supply prospects, the violence in the Gaza Strip kept oil prices firm in November. Following the cease-fire, we expect tension over Iran’s nuclear program to return to the media and sustain high prices, offsetting sector fundamentals and worries about the fiscal cliff in the U.S. We maintain our forecast of crude price (Brent) at $112 by the end of 2012 and at $115 by the end of 2013.

Base metal prices rebounded mildly, rising 4.0% in November. Supply prospects for copper improved, but growth stabilization in China pushed prices up. China’s stockpiling of aluminum and zinc also contributed to the movement.

Finally, we are revising down our year-end forecasts for the ICI. We now expect an increase of 13.7% in 2012 (previously +19.2%) and a decline of 4.1% in 2013 (previously -7.7%).

The Elusive Quest for Growth
GDP disappointed in the third quarter and growth in 2012 and 2013 is bound to be weaker. More stimuli may follow, including lower interest rates

We have reduced our forecasts for GDP growth to 0.9% from 1.5% in 2012 and to 3.2% from 4.0% in 2013. The negative surprise with GDP in 3Q12 and the expectation of slower expansion in capital expenditures have affected forecasts for growth this year and next. In a scenario of weak economic activity, we believe that the government will opt for lower interest rates and a weaker exchange rate to stimulate growth. We incorporated a 100-bp cut in the benchmark Selic interest rate in 2013 (ending the year at 6.25% vs. 7.25% in our previous call). Our year-end forecast for the exchange rate for 2012 was revised to 2.10 reais per U.S dollar and for 2013 moved to 2.15 (from 2.02 previously). We raised our estimate for the consumer price index (IPCA) for  2013 to 5.5% from 5.3%, considering a weaker currency and an increase in fuel prices, despite weaker activity. We revised our forecast for the trade surplus in 2012 to $19.5 billion from $20.5 billion, and to $20 billion from $18 billion in 2013, with the current-account deficit at 2.2% of GDP (from 2.3% previously) in the next year. We revised our forecast for the primary budget surplus to 2.3% of GDP from 2.4% in 2012 and to 2.1% of GDP from 2.2% in 2013.

Investment does not take off and GDP forecasts drop

GDP grew by only 0.6% qoq/sa in the third quarter, at half the pace that was expected. Previously it was the industrial sector which was not growing, now the service sector is the disappointing one. Private consumption remains solid, but the retreat in investments was sharper than expected, and exports and government spending were also weak.

With a disappointing third quarter and an outlook for tepid growth in the fourth, total growth in 2012 will be lower. The rebound which could have fostered more optimism, boosting business confidence, did not happen as expected. Worries about the future remain, leading to lower investments – and that will affect growth in 2013.

More stimuli are bound to be announced. In addition to more tax breaks, lower interest rates and a weaker exchange rate may be part of the toolbox in 2013, as was the case this year. Such stimuli may help the economy, but reducing domestic uncertainties in order to take advantage of incentives to growth is crucial, particularly in a still very uncertain world.

In the credit market, new consumer loans fell by 1.9% mom/sa in real terms in October, while new corporate loans retreated by 2.0%. Interest rates and spreads declined. Seasonally adjusted delinquency rates for loans more than 90 days past due are stubbornly stable at high levels. But the performance of new loans continues to suggest a drop in future delinquency.

Outstanding loans rose more strongly during the month (1.4%). Earmarked credit, particularly housing and farm credit, continues to take the spotlight. State-owned banks continue to increase their market share. Favorable conditions in the labor market and the expectation of lower delinquency suggest moderate credit expansion in the next few months.

Given the current outlook for economic activity, we cut our forecasts for GDP growth in 2012 and 2013. The expansion in 2012 was directly impacted by the weaker result in the third quarter. Signs for the fourth quarter already point to a more moderate expansion. We therefore lowered our forecast for GDP growth in 2012 to 0.9% from 1.5%.

The statistical carryover to 2013 GDP is declining. A more moderate expansion in the economy in 3Q12 and the pace expected for 4Q12 reduce the outlook for 2013. Furthermore, we believe that this uncertainty about the domestic rebound will have negative consequences for investment decisions. Therefore, we also reduced our forecast for GDP growth in 2013 to 3.2% from 4.0%, already taking into account the additional stimuli.

A weaker currency, but high FDI

After another quarter trading in the range of 2.01 to 2.05 reais per U.S. dollar, the exchange rate broke the dynamic of low volatility in November and reached over 2.11. Behind this move, there was an increase in global uncertainty, intensified by technical movements that are triggered when the exchange rate breaks certain levels. However, in contrast to what we have seen previously, the Central Bank acted in the market only at levels above 2.10 reais per dollar. Given weakness in growth and economic policy signals toward raising competitiveness through a weaker exchange rate, we revised our year-end estimates for the exchange rate to 2.10 reais per dollar in 2012 and to 2.15 in 2013, from 2.02 in both years.

In October, foreign direct investments (FDI) hit $7.7 billion, topping the most bullish of expectations. The current-account deficit, on the other hand, widened to $5.4 billion, due to a smaller trade surplus, more profit and dividend remittances and greater spending on international travel. For other flows, we continue to observe robust borrowing abroad and an outflow from the local stock market. We maintain our FDI forecast at $63 billion in 2012. Trade balance stood below our forecast in November. As a result, we revised downwards our projection to $19.5 billion from $20.5 billion in 2012.

A weaker exchange rate and lower economic growth impacted our forecasts for the trade and current account balances. Our call for the trade surplus in 2013 climbed to $20 billion from $18 billion, and our estimate for the current-account gap in 2013 slid to 2.2% of GDP from 2.3%.

Falling fiscal performance

Budget trends and outlook have changed little last month. Tax collection still loses steam, as activity remains sluggish and the impact of tax cuts begins to show. Moreover, federal spending is moving in high gear, at a pace of 6% from year-ago levels in the six months to October. The current speed of government spending exceeds estimates of potential GDP growth, which confirms an expansionary fiscal policy stance on the expenditure side.

The public sector's trailing twelve-month balance continues to downtrend. In October, it reached the lowest level since the end of 2011 (around 2.2% of GDP). Monthly budget results point to an increasing risk that the government will have to resort to deductibles on top of the 25.6 billion reais projected in the last budget review. For this year, spending on the PAC (infrastructure) program may deduct up to 0.9% of GDP from the 3.1% primary surplus target. We forecast a primary budget surplus of 2.3% of GDP for 2012 (previous forecast: 2.4%). Our estimate still counts on a temporary improvement in fiscal performance in the fourth quarter.

For 2013, we are revising down our primary surplus projection to 2.1% of GDP, from 2.2%. Signs of a slower than expected recovery, imply a less pronounced rebound in cyclical revenues (i.e., those strongly influenced by activity). A weaker tax collection reduces the room for future tax cuts, and limits somewhat the expansion of public spending (especially investment). According to our estimates, if the government maintains the fiscal target written in the 2013 Budget Law Guidelines (LDO) - allowing fiscal deductions of up to 1.0% of GDP in PAC expenses – there will be little room for additional stimulus. In this case, the decision to make is: more tax breaks or more public investment?

A weaker exchange rate and future fuel price increases maintain inflation high in 2013

We maintain our IPCA forecast at 5.5% in 2012. Current data indicate that the slowdown in food prices and the decline in agricultural prices have run their course. December data should already show more pressure on food prices at the retail level and a pickup in producer prices for agricultural items. According to our forecasts, market-set prices will rise by 6.2%, while regulated prices will increase by 3.4%. Among market-set prices, we expect gains of 4.3% for tradable goods and 7.9% for non-tradable goods.

We raised our forecast for the IPCA in 2013 to 5.5% from 5.3%. Even with the downward revision to our growth forecasts and more benign commodity prices, we anticipate high inflation due to a weaker currency and a possible 5% hike in gasoline prices next year, with a 0.2 p.p. impact on the IPCA.

We revised downward our forecast for the general price index (IGP-M) in 2012 to 7.5% from 7.9%, due to the postponement of fuel-price increases to next year. As a result, we revised upward our forecast for IGP-M in 2013 to 4.8% from 4.2%. We also took into account in this forecast the BRL depreciating to 2.15 at the end of 2013.

Interest rates: a change in direction, given headwinds to growth

The monetary policy committee (Copom) maintained the benchmark interest rate unchanged at 7.25% p.a. in its November meeting. The decision was unanimous and in line with our view and market expectations. The statement that accompanied the decision was the same as the one released in the previous meeting, in which the Copom indicated that the Selic rate will be stable for a “sufficiently prolonged” period (we dubbed it “flying at a cruise level”).

The signal shows confidence in a lower equilibrium real-interest rate, but also that current rates maintain economic stimuli. But we believe the cruise level of interest rates will be changed. There are now more headwinds to economic growth. We expect the Selic rate to go down again in March, with a 50-bp cut, and another cut of the same magnitude in the following meeting. Therefore, we expect the Selic rate to end 2013 at 6.25% (from 7.25% previously).

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


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