Itaú BBA - "Surprises of 2012 and Their Implications", by Ilan Goldfajn

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"Surprises of 2012 and Their Implications", by Ilan Goldfajn

January 3, 2013

In Brazil and around the globe, the feeling is in fact one of transition between long economic cycles

Happy New Year, dear reader. I am vacationing in Southern Mexico, land of the Maya. From here I can assure you that a new cycle – named “baktun” by the Maya – is just beginning. No end of the world in sight.

In Brazil and around the globe, the feeling is in fact one of transition between long economic cycles. Surprises are even more common within these transitions. I list below the surprises of last year, as well as their implications for the New Year.

1.    Disruption risk in the euro zone has receded. Volatility, however, won’t likely disappear.

Thanks to Super Mario (European Central Bank President Mario Draghi), disruption risk in the euro zone retreated. The promise of doing “whatever it takes” to keep the euro zone functioning has produced results. The willingness to purchase sovereign bonds (from Spain, Italy, and others), when and if necessary, lowered financing costs for the peripheral nations. The improvement in financial conditions, however, may lead authorities to further postpone the harsh adjustments that are needed and bring back uncertainty. On the other hand, the long adjustments may still create fatigue, leading to new protests in the streets. European troubles have not ended, but the end of the euro is further away.

2.    No global recession, but lower growth to continue.

A lot was said about a double-dip in the U.S. and around the globe. But none of that happened. We saw more of the same: neither a recession nor a pickup, just the consolidation of a low-growth scenario. The world has completed a half-lost decade (2007-2012) since the beginning of the subprime mortgage crisis, which led to the global financial crisis. Everything points to a few more wasted years.  Deleveraging (reduction of debt) is a slow process, which is not over yet. In the U.S., the private sector has found relief (as signaled by the improvement in stock markets and in the real estate sector) but has left it all in the hands of the public sector, which must still adjust. Difficult negotiations related to the fiscal cliff and to the debt ceiling are signs of the huge challenges ahead.

3.    Fears of hard landing in China, but growth stabilized around 7.5%-8.0%.

While China was slowing down, the feeling of a free fall determined most expectations. The fear of losing one of the global growth drivers caused anxiety, especially in emerging economies, and in Latin America in particular. But the hard landing did not materialize, and in the second half growth stabilized and even recovered toward the end of the year. Signs point to lower but still strong growth in China in the coming years.

4.    Commodity prices resisted global troubles. We expect them to remain at this relatively high level.

With the risk of rupture in Europe, low growth in the U.S., and fears of a hard landing in China, commodity prices could have adjusted sharply, threatening the performance of many Latin American countries. The region breathed a sigh of relief and has maintained sound growth, apart from a few notable exceptions.

5.    Brazilian growth disappointed in 2012 (around 1%). A moderate rebound seems likely.

Despite lower interest rates, a depreciated exchange rate, and fiscal, quasi-fiscal and monetary stimuli, the eagerly expected rebound in Brazil did not come to pass. Some argue for the persistence of current policies, hoping for the return to last decade’s “normal” growth. Others are already looking for the structural causes of lower growth (absence of reforms, end of commodity boom and low global growth, uncertainty regarding policies in Brazil, etc). The fact is that the investment rate went down again last year, instead of rising, which would be a necessary condition for sustainable growth. Meanwhile, a rebound, although slow and still disappointing, is in the making: annualized growth of 2.5% in the third quarter, and 3.0% (expected) in the fourth quarter. But the risks are high. Structural problems may weigh on growth in the medium term.

6.   Despite the GDP slowdown, unemployment is at an all-time low, and wages are on the rise in Brazil – a fragile equilibrium.

A weaker GDP normally leads to a weakening in the labor market. This has not taken place yet in Brazil. Strong growth in labor-intensive sectors explains the employment trend. Labor hoarding (reluctance of companies to layoff, as they may have to re-hire people later, which is costly) explains the solid labor market in the current cycle. But one should have no doubts here. The weak GDP and the strong labor market contrast cannot last forever. Something will have to give. The rebound in GDP, even a moderate one, could still support employment and wages. But a persistently weak GDP threatens the strong labor market and what I consider its by-products: the new Brazilian middle class and its strong consumption, and social improvements such as lower poverty and better income distribution.

7.   The benchmark interest rate reached 7.25% p.a., and the Brazilian real weakened to around 2.00 reais per U.S. dollar. Weak growth will likely prompt the government to keep these stimuli in the economy. Inflation remains high.

Surprisingly weak growth last year led to an unexpected low Selic benchmark rate (real interest rates are currently around 1.5%) and an approximate 20% depreciation of the real. The outlook calls for only a moderate rebound, and we don't expect interest rates to rise, or exchange rates to appreciate in any notable way. Furthermore, high inflation (5.7% in 2012 and about the same this year) creates a limit for exchange-rate depreciation. Excess depreciation could lead to even higher inflation.

Ilan Goldfajn is chief economist at Itaú Unibanco and a partner of Itaú BBA.

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