Itaú BBA - Step Ahead

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Step Ahead

February 8, 2013

In Brazil, the rebound has been slow, but there is no room for additional monetary easing. In Latin America, growth remains robust in most countries.

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
Balance of Risks Continues to Improve
Economic recovery outlook remains on track

Sluggish Confidence Recovery
Rebound in investments depends on confidence

A Farewell to High Growth
The gap between the parallel and the official exchange rate increased to over 50%. Conflictive wage negotiations have started. The economy is expected to record very sluggish growth and even higher inflation

Lower Interest Rates Ahead
The comfortable inflation outlook will likely lead to lower interest rates this year

Neutral for How Long?
Growth moderation amid low inflation in 2013 could soften the monetary policy stance

Confidence Spurs Growth
The economy continues to expand at a robust pace supported by a business-friendly environment, despite the reappearance of anti-mining protests

A Slight Bounce
We expect monetary stimulus to start spurring growth in the second half of this year

Stronger Demand
Lower price volatility

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Step Ahead

Another good month for the global economy. Without signs of vigorous growth, the world continues to leave behind the more catastrophic scenarios. It is an important step, but volatility has not faded and there will be eventual bumps in the road.

After avoiding the fiscal cliff, the U.S. is slowly negotiating an increase in the public debt ceiling. In Europe, peripheral countries have tapped the market in favourable conditions, which is a sign of confidence in the economic adjustments, while banks in the region are repaying funds borrowed at the peak of the crisis. The Chinese economy continues to gain traction, reducing hard landing fears, helped by incentives provided by the new political leadership.

The background is favorable for commodities. Metal and energy prices are on the rise. With strong demand, agricultural commodity prices are going up, despite larger supply.

In Latin America, growth remains robust in most countries. In Colombia, Mexico, Chile and Peru, inflation is receding more sharply, and is below the target range mid-point in some cases. Naturally, there are increasing expectations for interest rate cuts. The Colombian central bank has already reduced its benchmark rate, and Mexico’s will probably follow. The Chilean monetary authority may also signal a reduction. The Peruvian central bank has not indicated any cuts, but it is unlikely to lift its benchmark rate.

In Argentina, monetary policy is already quite expansionist, but inflation is on track to top 30%.

In Brazil, the rebound has been slow, but there is no room for additional monetary easing. Even with the drop in regulated prices, inflation is on the rise, imposing limits to further cuts in interest rates or significant currency depreciation. Tax breaks should continue, but the room for fiscal policy is also narrowing. The key to the recovery would be resumption in investments driven by infrastructure projects. Only the future will tell if this is the case.

Global Economy
Balance of Risks Continues to Improve
Economic recovery outlook remains on track

The balance of risks to the global economy continued to improve. With less chance of negative events, the world GDP could expand 2.9% in 2013, after 2.8% in 2012, and then accelerate to 3.5% in 2014.

The U.S. Congress avoided the fiscal cliff and extended the debt ceiling. We see some lingering fiscal risks to growth in 2013. Although important, the potential shocks are significantly smaller.

Europe still waits for growth to resume, but financial conditions continue to normalize, with capital flowing back to the periphery.Foreign investors’ demand for Spanish and Portuguese bonds was high last month. Banks started to repay the funds they borrowed from the European Central Bank (ECB) during the periods of stress.

Despite the stabilization, the euro area still faces donwside risk and we should expect periods of volatility. In February, the focus are the elections in Italy and a corruption scandal involving the Spanish Prime Minister.

China continues on a modest recovery path, as domestic demand remains resilient. Government investment, which usually accelerates after leadership transitions, is helping the economy.

With the balance of risks improving but the recovery still at early stages, we expect central banks to maintain eased monetary conditions but not act further at the moment. The Bank of Japan (BoJ) is the exception and is likely to keep increasing stimulus in response to political pressure.

U.S. – Fiscal policy still threatens growth in 1H13, but risks of a recession were avoided.

The U.S. Congress overcame the fiscal cliff and the debt ceiling, reducing the risk of a recession in 2013. Most tax breaks due to expire were permanently extended, overcoming the cliff. Republicans no longer see the debt ceiling as a piece in their current political bargaining. They agreed to suspend the ceiling until May and we expect them to increase it again in the future.

However, there still remain a couple of downside risks to growth in 2013.

First, Congress has to cut the federal deficit by an additional $1.3 trillion over the next decade to stabilize the debt-to-GDP ratio. Republican lawmakers might allow the sequestration spending cuts to occur if Obama insists on further tax increases. If the sequestration in fact happens as scheduled, in March 1, it would shave off an additional 0.5% from U.S. growth in 2013.

Second, law enacted on January 2 avoided most of the cliff, but allowed some tax breaks, worth 1.2% of GDP, to expire.

Beyond these short-term risks, fundamentals indicate that U.S. growth should accelerate in 2H13 and after. According to preliminary estimates, the U.S. economy expanded 2.3% in 2012. The fourth quarter was a bit weaker, due to temporarily slower inventory accumulation. For 2013, we expect growth to decelerate to 1.8% because we still have a significant fiscal drag in the year.

But these headwinds should gradually fade in 2014. Residential investment is set to expand as excess housing inventories appear to have finally been eliminated (see graph). And financial conditions will continue to boost growth over the coming years, helped by loose monetary policy. As a result, we forecast that real GDP will accelerate to 2.3% in 2014.

Europe – Financial conditions continue to normalize, with capital flowing back to the periphery.

Spain issued €17 billion ($23 billion)of bonds in January, 14% of the issuance planned for 2013. In the latest sale, the country placed €7 billion of a 10-year bond, 60% of it to foreign investors. Portugal also raised €2.5 billion of five-year debt, for the first time since official lenders rescued the country in 2011. Foreign investors acquired 90% of the sale.

Financial institutions started to repay the three-year funds they borrowed from the ECB in December of 2011 and February of 2012. Banks, most likely from core countries, have repaid €137 billion of the total €1 trillion borrowed. The amount is still small but we expect it to increase.

Despite the stabilization, the euro area still faces donwside risk and we should expect periods of volatility. In February, the focus are the elections in Italy and a corruption scandal involving the Spanish Prime Minister. We see risks in both cases, but our baseline scenario is these events will not change the normalization trend.

We believe that better financial conditions, as well as improving consumer and business confidence, will stimulate economic activity through the year. Fiscal consolidation remains a headwind, but less so than in 2012. The Purchasing Managers’ Index shows some signs of stabilization and has been increasing since last November (see graph.)

However, we are still waiting for better financial conditions to improve growth. The real economy in Europe has not yet shown signs of improvement. GDP likely tumbled 0.5% in 4Q12.

We revised our growth forecast for the euro area to -0.5% from -0.4% in 2012 and to -0.2% from ‑0.1% in 2013. In 2014, we see GDP expanding 0.9%.

Giving the outlook for economic recovery, the ECB signaled in its January meeting that it is on hold. Hence we changed our expectation of a 0.25% cut on the main rate to maintenance.

China – Modest Recovery Continues

China’s economy grew 7.8% in 2012, a bit higher than our 7.7% forecast. We estimate that consumption growth outpaced investment for the second consecutive year. We expect this trend to continue as China rebalances its economy towards higher domestic consumption.

Activity improved further at the end of 2012. Industrial production was 10.3% higher than one year ago, up from 10.1% in November. Nominal retail sales were up 15.2% yoy, compared with 14.9% in the previous month. Exports also picked up to 14.1% yoy from 2.9% in November. The exception was nominal fixed-asset investment, which weakened to 19.9% yoy from 20.7% previously.

We see the modest recovery extending into this year, with domestic demand remaining resilient, partly due to government investments, which usually accelerate after leadership transitions. Better world growth should also benefit exports. We revised our GDP forecast for 2013 to 8.0% from 7.9%.

For 2014, we expect the economy to slightly decelerate to 7.7%, in line with our view that long-term growth in China is declining.

Japan – New Fiscal and Monetary Stimuli Improve Growth Outlook

Since Shinzo Abe became Prime Minister of Japan in the end of December, the new government has announced a new round fiscal stimulus and, in a coordinated action with the central bank, more monetary easing.

The fiscal package increased central government spending by 10 trillion yen ($ 110 billion or 2.1% of GDP). The BoJ formally introduced a 2% inflation target, replacing the previous 1% goal. It also announced that its Asset Purchase Program will become open-ended next year.

In our view, the BoJ will tend to ease further in the next few months. The Council on Economic and Fiscal Policy, led by the Prime Minister, will now regularly monitor monetary policy until the 2% target is reached. Additionally, Abe is likely to choose a new BoJ governor who is more aligned with his expansionary views, in April when the current governor’s term expires.

As result of this expansionary stance, we raised our GDP growth forecast to 0.8% from 0.4% in 2013. Macro policies should remain supportive next year, so we see the economy expanding 1.0% in 2014. We also increased the forecast to 2.1% from 2.0% for 2012 due to better data in 4Q12.

Commodities: Better Demand and Low Volatility

Better demand indicators helped keep prices roughly flat in January (and December), despite improvements in the supply outlook. The Itaú Commodity Index (ICI) was unchanged in January. Looking ahead, we maintain our year-end forecasts, and still expect the ICI to increase by 0.8% yoy in 2013.

Grain prices were heavily affected by the U.S. Department of Agriculture’s (USDA) January report. It showed better-than-expected demand for corn in the U.S., more than offsetting upward revisions to global production. As a consequence, agricultural prices have recovered 4.3% since January 9.

Base metal prices were up 1.2% in January, still driven by the better outlook for the Chinese economy. The strong increase in iron-ore spot prices, due to a new restocking cycle by mills in China, should be reversed throughout 2013 as higher prices provide an incentive for inefficient Indian and Chinese mines to increase production.

Energy prices rose 2.2%, driven by better demand and prospects of decreased infrastructure bottlenecks in the U.S. Taking both current data and the better outlook into account, the International Energy Agency (IEA) revised upward its demand scenario for 4Q12 and 2013. In the U.S., a cold winter is leading to an increase in heating-oil demand compared with last year, which had milder temperatures.

Sluggish Confidence Recovery
Rebound in investments depends on confidence

The economic recovery continues more modest than expected. We lowered our forecasts for GDP growth to 3.0% from 3.2% in 2013 and to 3.5% from 4.0% in 2014. We raised our estimate for consumer inflation (measured by the IPCA) to 5.7% from 5.6% this year. For 2014, we expect the inflation at 6.0%. Following the central bank’s release of the minutes ofits Monetary Policy Committee (Copom) meeting in January, we now expect the benchmark interest rate to remain at 7.25% p.a. until the end of 2014, rather than 6.25%.

We now expect the exchange rate to end December at 2.10 reais against the U.S. dollar (from 2.15 previously), the same level we anticipate for 2014. We cut our forecast for the trade surplus this year to $14 billion from $18 billion, mainly due to rising imports of gas and fuels and a stronger path for the exchange rate. We reduced our estimate for the primary budget surplus this year to 1.9% of GDP from 2.1%. We forecast 0.9% of GDP for 2014.

Weakness in the industrial sector and slow improvement in confidence suggest lower growth in 2013

Economic activity continues to provide negative surprises. Industrial production stood flat in December 2012 and declined in 4Q12, reversing part of the advance of the previous quarter. After growing by 1.0% in 3Q12, largely due to the auto sector, industrial activity fell by 0.3% in 4Q12. With a low carryover from late last year, only a strong recovery in the first months of 2013 could ensure growth in industrial activity in 1Q13.

There are mixed signals in the industrial sector. The Industrial Survey by FGV shows that inventories are better adjusted and expectations of future production have advanced steadily. However, the same survey shows that the increase in confidence is the slowest of all recovery cycles of the past 20 years. Low confidence results in less investment; and without a pickup in investment, the expansion cannot strengthen. Even an immediate improvement in purchases of machinery and equipment would not quickly boost the production of capital goods, as inventories in this sector are still high.

Agricultural and livestock activity should help GDP in 1Q13. There is a positive outlook for crops with relevant weight in the first three months of the year. Soybeans stand out, with estimates by the census bureau IBGE pointing to a 25% yoy increase in 2013. For corn and tobacco, which are also relevant at the beginning of the year, forecasts point to gains of 7.2% and 5.8%, respectively.

However, agricultural and livestock activity cannot prevent GDP growth in 1Q13 from being slightly lower than we expected previously. We lowered our estimate to 0.8% qoq/sa from 0.9%. With confidence recovering slowly, investments should expand with less vigor. Additionally, our scenario no longer contemplates any cuts in interest rates this year.

Hence, we now estimate that the pace of GDP growth during the coming quarters should be closer to 0.8% than to 0.9%. We revised our forecast for GDP growth in 2013 to 3.0% from 3.2%. For 2014, we lowered our estimate to 3.5% from 4.0%, as a large part of the additional reduction in interest rates that we expected previously had an impact on GDP growth in 2014.

In the credit market, new loans granted to consumers and corporations have increased. New loans to consumers rose by an inflation-adjusted 3.5% mom/sa in December, in a second consecutive month of gains (1.1% in November). The three-month moving average for consumer loans grew by 1.0%, the most since June. New loans to companies increased by 4.6%, rebounding from the drop accumulated in the two previous months (-4.8% in October and November). The three-month moving average for new corporate loans remains virtually stable.

Delinquency rates have not fallen as we expected. The seasonally-adjusted rate for consumer loans more than 90 days past due rose by 0.1 p.p. in December to 7.9%, while the same rate for corporations was stable at 4.1%. Interest rates and spreads declined again, particularly in the corporate segment.

Exchange rate: shifting goals

In late January, the exchange rate broke the barrier of 2.00 reais per dollar for the first time since July 2012, after the central bank rolled over currency swaps. The decision to roll over when the exchange rate stood at 2.03 reais per dollar induced further appreciation.

In our view, exchange rate policy is still seeking to promote more competitiveness in the industrial sector and a higher trade surplus. However, in the short term, fighting inflation is an additional goal. Consumer prices accelerated between late 2012 and early 2013, and should push yoy inflation close to the upper limit of the target range. However, monthly inflation should recede in coming months, providing space for a weaker exchange rate ahead.

Hence, we maintain our forecast of a weaker currency by the end of 2013, at 2.10 reais per dollar, which is a slightly stronger level than in our previous scenario (2.15).

Gas and fuel imports reduce forecast for the trade balance in 2013

The current account deficit reached $8.4 billion in December, with a relevant contribution from the service account. The current account gap in 2012 stood 2.4% of GDP, easily financed by foreign direct investments, which hit 2.9% of GDP or $65.3 billion. For this year, we maintain our call that foreign direct investments will stay strong, adding up to $64 billion (2.8% of GDP).

January ended with a trade deficit of $4 billion, influenced by fuel import transactions done in 2012, but only accounted for this year, due to a change in legislation. According to official sources, this effect should last until March. However, there is an upward trend in fuel imports due to growing demand. This effect, along with our expectation of thermal power plants running at full capacity this year and demanding gas from abroad, as well as a somewhat stronger currency, led us to revise downward our forecast for the trade balance in 2013.

Therefore, we now expect a surplus of $14 billion ($18 billion previously). Thus, we changed slightly our forecast for the current account deficit to 2.5% of GDP from 2.4%. For 2014, we see the trade surplus at $15 billion.

Fiscal policy: a smaller primary budget surplus in 2013

The public sector’s primary budget surplus stood at 2.4% of GDP in 2012, down from 3.1% in 2011. The December reading prevented an even smaller annual surplus. In the last month of 2012, the public sector posted a primary surplus of 22.3 billion reais, the highest monthly result since September 2010. The figure was influenced by a high volume of atypical revenues, used to ensure the achievement of the adjusted target proposed by the 2012 Budget Law. The government also put a sharp (albeit temporary) restraint on spending, in addition to re-classifying expenses related to the Growth Acceleration Program (PAC, in its Portuguese acronym), thus allowing greater deductions of the fiscal target.

Our estimate for the recurring primary budget surplus – which excludes atypical revenues and expenses – points to a balance of 1.8% of GDP in 2012, down from 2.7% in the previous year. The numbers point to a looser fiscal stance, a conclusion reinforced by our (still-preliminary) estimates for the structural primary surplus – the latter is running around 1.0-1.5% of GDP in 2012.

Further reduction in the fiscal effort should occur during 2013-14. The policy focus should remain on tax breaks. So far, the tax cuts announced or budgeted for 2013 add up to about 1.0% of GDP this year. We now forecast the primary budget surplus at 1.9% of GDP (2.1% previously). For 2014, our call remains at 0.9% of GDP, a decline due to new tax breaks. The recurring primary budget surplus will probably stay between 1.0% and 1.5% of GDP.

Our revision for the fiscal result this year incorporates a slower rebound in government revenues, due to the most recent figures for economic activity and tax intakes. We also expect somewhat higher expenditures at the beginning of the year to compensate for the sudden restraint in spending in December.

Tax cuts will limit the room for expansion in spending. Therefore, we expect real growth of 5% for central government outlays in 2013, a similar pace to 2012. Between 2004 and 2010, a fast expansion in revenues allowed expenditures to grow by 8-9% a year.

Lower adjustments in the monthly minimum wage expected for 2013 and 2014, due to the rule of real increases based on GDP growth of two years before (the rule holds until 2015), should create room for a qualitative improvement in spending. We believe that there is room for a slower pace of growth in transfers and administrative expenditures, and faster growth in public investment.

Inflation begins the year under pressure, but should recede starting in February

Inflation came in above expectations in December and remained under pressure at the beginning of the year. In January, the IPCA climbed 0.86%, even though some price adjustments were postponed (bus fares in Rio de Janeiro and São Paulo) and the drop in electricity tariffs was anticipated. Over 12 months, the IPCA advanced to 6.15%.

We expect some relief soon. Inflation should slow down in February. Despite pressure coming from adjustments in school tuitions and gasoline, we expect relief from food prices and the incorporation of the largest part of the discount in electricity tariffs (estimated contribution of -0.50 p.p. to the IPCA in February). Still, for 1Q13, we expect the IPCA to rise by 1.8%, up from 1.2% one year earlier.

For this year, we slightly raised our forecast for the IPCA to 5.7% from 5.6%, after including the expectation of thermal power plants running all throughout the year (See Macro Vision - Rationing: risks depend upon rain and prices), partly offsetting the initial reduction in electricity tariffs (-18.4%). We forecast market-set prices to rise by 6.6% (6.6% in 2012 as well) and regulated prices by 2.9% (3.7% in 2012).

We expect smaller increases in food prices this year, given the outlook for a good crop and the likely drop in grain prices. On the other hand, we should see pressure coming from the transportation group, reflecting the end of the IPI tax break for auto purchases, as well as increases in gasoline prices and bus fares in São Paulo.

We adjusted our forecast for the general price index (IGP-M) to 4.7% from 4.8%. Agricultural prices should post little change this year after rising sharply last year (19%). A large part of this movement will come from the reversal of price increases for soybeans (67%) and corn (27%) that were observed in 2012.

Cutting interest rates is not the solution anymore

The benchmark interest rate should stay at the current level for a long period of time. In the minutes of its last meeting, the Copom recognized the deterioration in the balance of risks for inflation and that additional monetary policy stimuli would have a limited effect on the economy (due to “supply-side limitations”). On the other hand, the Copom reinforced its view that the nature of the decline in real interest rates was structural and that recent inflationary pressure is to be short-lived.

After the minutes were published, we revised our forecast for the benchmark rate in the coming months. The Copom acknowledged that the low growth is related to supply factors, with implications for the effectiveness of tools to boost demand, including monetary tools. Therefore, along with higher-than-expected inflation this year, we now expect the Selic rate to remain unchanged at 7.25% p.a. until the end of 2014.

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

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