Itaú BBA - No Pleasure Cruise - July 2012

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No Pleasure Cruise - July 2012

July 5, 2012

The world economy risks losing more steam, as signaled by Central Bank’s renewed state of readiness. All eyes still stare at Europe’s woes.

Global Economy
Governments Reacting, Again
The world economy appears to be stalling again, adding risk to growth forecasts and pushing the main central banks back to easing mode

Brazil
Time to Adjust
The economy is still adjusting  to a less benign environment

Argentina
Only Uncertainty Flourishes
Activity continues dGlobal Economy
Governments Reacting, Again
The world economy appears to be stalling again, adding risk to growth forecasts and pushing the main central banks back to easing mode

Brazil
Time to Adjust
The economy is still adjusting  to a less benign environment

Argentina
Only Uncertainty Flourishes
Activity continues deteriorating, the government’s approval ratings fall, and uncertainty about future economic policies prevails

Mexico
PRI Returns to Power After 12 years
Enrique Peña Nieto was elected with 38% of the vote, campaigning in favor of the much-needed economic reforms

Chile
A Brighter Outlook for Inflation
Better-than-expected inflation numbers and global concerns led the central bank to remove its hiking bias

Peru
eteriorating, the government’s approval ratings fall, and uncertainty about future economic policies prevails

Mexico
PRI Returns to Power After 12 years
Enrique Peña Nieto was elected with 38% of the vote, campaigning in favor of the much-needed economic reforms

Chile
A Brighter Outlook for Inflation
Better-than-expected inflation numbers and global concerns led the central bank to remove its hiking bias

Peru
Signs of Economic Weakening
The economy continues to post good numbers, but GDP is slowing

Colombia
Growth Decline
Negative surprises led us to reduce GDP and interest rate forecasts

Commodities
Tail Risks Affect Prices
After another slump in June, driven by macro pessimism, commodity prices are rebounding, led by the supply-and-demand balance as well as an improving mood in the market  


No Pleasure Cruise

It’s been no pleasure cruise. The world economy risks losing more steam, as signaled by Central Bank’s renewed state of readiness.  All eyes still stare at Europe’s woes. The good news is that European leaders came up with a plan that was better than expected. But it is too early to celebrate.

To make the deal real, its architects must now beat legal, market, and political hurdles. It will probably be months before they get to anything concrete, such as a pan-European bank regulator.  Still, markets reacted with a nod of approval after the European summit. At least until the next emergency comes.

In Brazil, growth remains weak. While demand is improving, production struggles as businesses digest too optimistic plans made one or two years ago. We do, however, expect growth to pick up in the second half, even if moderately. 

The slow recovery is at least keeping inflation quiet. That will help the Central Bank cut the Selic rate deeper, and we now expect it to touch 7%.

Elsewhere in Latin America growth is decelerating. It remains good in Mexico, Chile and Peru. But Colombia appears to be slowing substantially. Argentina is very weak due to its economic policies. In Mexico, newly-elected president Enrique Peña Nieto has spurred hopes of progress on reform, especially in the oil sector. It remains to be seen how well he will be able to work with the opposition in Congress.

Global Economy
Governments Reacting, Again
The world economy appears to be stalling again, adding risk to growth forecasts and pushing the main central banks back to easing mode

The world’s main central banks are in a state of readiness – again. The European Central Bank announced a 25-bp cut interest rates and relaxed rules on what it takes as collateral when lending to banks. We expect another cut this quarter.

In the U.S., the Fed extended operation “twist”, the mechanism by which it swaps shorter- for longer-term Treasury bonds as a tool to promote growth. The Bank of England’s announced another 50 billion pounds of quantitative easing. There was also another cut in interest rates in China, and the Bank of Japan is expected to increase its asset purchase program further at next week’s meeting.

Is this easing inclination intended to prevent tail risk? Authorities may have sensed an increase in the risk of financial disruption and sought to reassure everyone that they will act if needed. 

But it could also be a response to weaker growth. Global growth looks less promising than a few weeks ago. Although the size of the recent actions is still limited, risk prevention and growth promotion are pushing monetary authorities to do more, and to promise to do even more if needed.

Europe

Greece finally has a government, and the risk of it leaving the euro zone now has diminished. Its official creditors (the “Troika”) may now loosen some of conditions for lending, but the economic situation remains bleak, as negotiations with the Troika will likely show.

Greece’s elections may have been an obvious risk point, but it wasn’t the only one. European authorities continue to take shaky steps down a risky road, with bigger members in the spotlight: both Spain and Italy still face uncomfortably high borrowing costs, a sign of market concerns (see graph).

The Greek elections of June 17 delayed, for now, the “Greek exit” scenario that markets had anxiously monitored in the preceding weeks. Our own version of that story also moved to the sidelines. “Greece” was replaced by “Spain” as the embodiment of impending disaster. Spain looks stronger than Greece, but the fallout if Spain fell would have far wider consequences. Clearly, Europe’s troubles run deeper than the occasional fact that markets focus on.

We estimate that the region’s GDP fell by 0.4% in the second quarter after staying unchanged in the first quarter. We still expect the euro zone’s GDP to fall by 0.6% this year, recovering to 0.4% growth in 2013.

Europe’s purchasing managers’ index was unchanged in June. It stood on average at 46.2 in the second quarter, a clear drop from 49.6 in the first quarter. Production plans are becoming more modest, a trend confirmed by hard data. Industrial production, for example, fell by 1% in April.

Could policy uncertainty and low growth lead inevitably to a breakup of the euro? The answer is no. As the situation deteriorates, policymakers can always react with new measures, as the ones announced after the European Summit. The latest idea is to use for the first time the ESM fund to buy bonds from Spain and Italy and to surrender the seniority of its loans to Spanish banks.. In fact, the volatility in 10-year European Treasury bonds is proof that markets are not 100% sure that the situation will spiral out of control (see graph).

None of these steps would alter the course of Europe’s crisis, but they could buy time: markets would cherish even a few months of peace.  Last week’s euro zone summit confirmed this pattern. Leaders did agree on growth measures and indicated some building blocks for further integration. But a roadmap has to wait until December.

The meeting was tense. Italy and Spain blocked the agenda until Merkel accepted short-term measures.  A single banking supervisor could be established by the end of the year, allowing the ESM to lend directly to banks. For now, the ESM will not ask more austerity of countries when the fund buys their sovereign bonds. Loans from the ESM to recapitalize Spanish banks, but just these loans, will not be senior to other creditors.

The German position on debt-sharing still prevailed. Any serious discussion about eurobonds – or euro bills or a European redemption fund – will have to wait until Germans get more visibility on (and a degree of control over) fiscal decisions in other countries.

Spain and Italy

The recent rescue of Spain’s banks with up to €100 billion ($126bn) in EU funds may stretch Spain’s public debt. This sovereign debt increase could be partially reversed once the ESM is allowed to lend directly to banks.  Although not certain, this possibility eased concerns about Spain losing access to bond markets. But the country is still likely to miss its fiscal targets and is in a prolonged recession. If concerns about debt returns, the Treasury could be shut out of markets and need its own bailout money, which could easily reach €200 billion.

What about Italy? The government will likely succeed in increasing the primary surplus to 2.8% of GDP in 2012. The parliament finally approved Prime Minister Monti’s labor reform, and privatization is under way. Public debt, however, remains at 120% of GDP, and, worryingly, public support for Mario Monti’s cabinet dove from 70% in March to around 35% today. Markets will not like to see an anticipation of elections, now expected to happen next year.

U.S.

In its June 20 meeting, the Federal Open Market Committee decided to continue, until the end of the year, to extend the maturity of its holdings of securities, adding $267 billion to its “twist” program. The move was a reaction to weaker growth prospects.

The committee lowered its GDP growth forecasts for 2012 and 2013 by about 0.5 pp, reflecting worse financial conditions, frustrating growth in the first quarter, and greater risk from Europe. The Fed now expects the U.S. to grow by 2.2% this year and 2.5% next year (see table).

In the statement, the committee vowed to “take further action as appropriate,” leaving the door open for more stimulus – probably more quantitative easing. Despite a recent worsening of financial conditions, we kept our GDP growth forecast at 2.1% for 2012 and 1.5% for 2013. Given that our 2013 forecast is much lower than the Fed’s, we believe that the FOMC is likely to start QE3 probably in late 2012 or early 2013.

Commodities

Pessimism over global growth swept through commodity markets in June, driving prices sharply down again. Oil and energy led the drop, reacting to a pickup in OPEC and U.S. production, as well as to skepticism about future demand. Brent prices were down by around 10% since the end of May. After last week´s Euro Summit prices picked up, recovering to May levels.  Agricultural prices held on as unfavorable weather conditions hurt  the prospect for optimal grain production in the U.S. In Brazil, heavy rains are damaging sugar, coffee and orange crops. Given low inventories, climate risk will likely continue to pressure food prices upward in the coming months.

Overall, we expect commodity prices to move up again in the second half of the year. We still expect our index of commodity prices (the ICI) to gain 8.6% in 2012 (at this point it is at the same level as in December 2011) and 3.9% in 2013.

Brazil
Time to Adjust
The economy is still adjusting  to a less benign environment

We trimmed our 2012 GDP estimate to 1.9%, from 2.0%, and our inflation forecast to 4.9%, from 5.0%. We continue to expect the currency at 1.90 real to tGlobal Economy
Governments Reacting, Again
The world economy appears to be stalling again, adding risk to growth forecasts and pushing the main central banks back to easing mode

Brazil
Time to Adjust
The economy is still adjusting  to a less benign environment

Argentina
Only Uncertainty Flourishes
Activity continues deteriorating, the government’s approval ratings fall, and uncertainty about future economic policies prevails

Mexico
PRI Returns to Power After 12 years
Enrique Peña Nieto was elected with 38% of the vote, campaigning in favor of the much-needed economic reforms

Chile
A Brighter Outlook for Inflation
Better-than-expected inflation numbers and global concerns led the central bank to remove its hiking bias

Peru
he dollar at yearend 2012 and 2013. Although the forecasts revisions were small, the risk of lower growth is still present, and the Central Bank will likely seek to mitigate it. Our scenario now takes the Selic rate to 7.0% (from 7.5%) in three rounds of half a percentage point.

Brazil has received much praise in recent years. Growth has been faster than in the old days of macro instability, and income is now more fairly distributed. The economy recovered fast after the Lehmann collapse, posting growth of 7.5% in 2010. In a world of low growth and high risk, the country still offers a balanced macro picture and many consumers. Its new oil promise is bolstering an already large investment pipeline related to Brazil’s infrastructure backlog – not to mention the mega sports events of 2014 and 2016.

All of that is true. But the economy may have moved too fast in 2010 – especially considering it is part of a risky world where demand is, and will remain, weak. Having slowed down considerably in the second half of 2011, Brazil still seems to be adjusting on many fronts as it digests excessively optimistic plans. It appears that manufacturers still hold too much inventories, retailers too much capacity, homebuilders too many projects, and so on.

This is part of the reason why, although demand is gradually picking up, investment still struggles. Another reason is, of course, that the world continues to be a source of risk and weak growth.

In spite of this longer-than-expected adjustment and the risks still present, we expect a recovery in the second half of the year.

Economic activity: small changes, large risks

Recent data shows activity recovering at a moderate pace. Sectors touched by government stimulus, such the auto industry, picked a good speed in June. Elsewhere, demand is rising too. However, industrial production has not seen a broad reaction so far (it fell again in May), partly reflecting a prolonged inventory adjustment.

A business survey from FGV, a think tank, found uncertainty regarding future demand to be a key factor holding back capital spending in the private sector. The government is trying to mend that. The latest step was a new program of public spending, mainly on capital goods for transport and agriculture. If the government manages to deploy it quickly, fiscal spending will rise in the short term and GDP growth will likely pickup temporarily.

In the short term, after May’s weak industrial production we expect GDP to grow by 0.6% in the second quarter compared to the previous three months (from 0.8%). We slightly lowered our 2012 GDP growth forecast to 1.9% (from 2.0%), and kept 2013 at 4.5%.

It is a small revision to forecasts, but risks now appear to be higher. The world economy is still a threat. Even if a major disruption doesn’t happen, prolonged uncertainty may hold private investment down in coming quarters.

Another risk is that low growth finally hit the labor market. Until now, low unemployment and rising incomes have been a key factor supporting consumer demand. In May, however, formal job creation fell to 64 thousand, according to the Labor Ministry’s CAGED report (our seasonal adjustment). This is the first relevant indication of weakness: will the labor market cave in before the rest of the economy strengthens? The next few months will provide an answer.

In the meantime, credit conditions have improved. Having moved sideways until March, bank lending rose moderately. In May, new corporate lending rose by 2.6% after adjusting for seasonality and inflation. New consumer loans fell by 0.7%, although conditions are improving. State-owned banks continue to gain market share. Lending rates fell again to both consumers and businesses, and the rate of non-performing loans stabilized. The exception is the share of consumer loans more than 90 days past due, which is still rising.

Fiscal policy

Revenues continue to slow, and spending is picking up. Taxes on domestic spending, corporate profits and labor continue to prop up federal revenues, while the settling of tax debt still brings in good cash. Those intakes help smooth the trend, but tax collection should continue to slow. It is now up 3.8% from last year, the slowest pace since the fourth quarter of 2009.

Spending is picking up, as expected. The central government is disbursing 8% more than a year ago (after adjusting for inflation), the fastest pace since late 2010, and close to the rate we project for the year. Growth has been faster in transfers (due to the new minimum wage), subsidies (especially for agriculture), administrative, health & education costs, and investment.

With administrative hurdles still holding down infrastructure spending, the pickup in public investment has happened mostly in the Minha Casa Minha Vida home subsidy program. This is, unfortunately, a line of investment with less impact on productivity.

What else? The finance ministry recently unveiled an 8 billion reais program of government purchases, part of which brings forward spending that would happen later in the year. Also, the much-needed increase in gasoline and diesel prices at refineries was offset, at the consumer end, by a reduction in the CIDE tax – that’s some five billion reais in lost tax revenues.

We already factored in an expansionary fiscal policy this year. As a result, we maintain our forecast for the 2012 primary surplus at 2.9% of GDP. This implies that the government will use “deductibles”, an allowance to reduce the target. But weaker-than-expected activity in the second half could hurt revenues and prompt more fiscal stimulus, and eventually lead to an even smaller surplus.

Balance of payments: better in June

The month of May saw a $2.4 billion outflow from equity markets, and lower rollover of medium and long term loans. On net, financial outflows reached a high $6.3 billion as global and domestic uncertainty upset investors. Foreign direct investment, however, held strong with a $3.7 billion inflow that kept the 12-month total at a solid 2.7% of GDP. The trade balance also stood out, helped by a record-setting 7 billion tons of soybean shipments.

June data shows a reversal, with financial inflows of $1.3 billion in the month. Equity flows are back, even if modestly, with $340 million until June 20, according to the Central Bank. In that month, the trade surplus was weak, $807 million. Despite the currency weakening, the global demand deceleration seemed to have a bigger impact, which led the country to the worst June since 2002.

Inflation, behaving well

Numbers so farshow a drop in consumer inflation in June. Lower prices of autos are a major factor, but other prices are going up less fast too. Core inflation is quiet, and services prices are going up less, suggesting that weak activity is, to some extent, slowing inflation. The 2012 outlook now looks easier, although much results from tax breaks on autos and home appliances. After the June surprise, we slightly lowered our forecast for the 2012 IPCA to 4.9% (from 5.0%).

No doubt, June’s lower-than-expected IPCA, and a weak global economy (risking turning even weaker) point to easy inflation ahead. But a strong labor market, a constant flow of growth-promoting initiatives and bigger increases in regulated prices still suggest higher inflation next year. The recent increase in agricultural commodity prices, if persistent, represents an upward risk to inflation. We have kept our 2013 IPCA forecast at 5.4%.

Monetary policy: less growth, less inflation, lower rates

While our growth and inflation forecasts fell only slightly, current conditions suggest those numbers are more likely to go down than up in the future. The Central Bank is also alert to the risk of weaker growth ahead, and may seek to prevent it by cutting rates more. Easy inflation is making that option even more attractive.

We thus lowered our forecast for the Selic rate and now expect it to reach 7.0% this year in three rounds of 50 basis points (previously 7.5%). In 2013, we expect the Selic to go up by 150 basis points, beginning in the third quarter. Before that, we expect the government to use other instruments (para-fiscal, macro-prudential, etc.) to moderate growth, when necessary.

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