Itaú BBA - A slower recovery

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A slower recovery

June 19, 2012

A qualitative analysis of the Brazilian economy and its sectors. With information through June 15, 2012

Consumption and Production of Goods and Services
Consumer demand has recovered since the beginning of the year, but performance is mixed across products and regions.    
Investments
Many businesses are becoming more selective regarding capital expenditures. Investment plans for the medium term, however, are broadly maintained.
Real Estate
After strong growth in recent years, the housing sector is undergoing adjustments. Meanwhile, commercial real estate continue to grow at a solid pace.
Commodities
The situation is challenging for metallurgy and mining, which are more reliant on global economic activity. Among soft commodities, the balance between supply and demand remains tight.
Labor Market, Wages and Prices
The labor market is still tight. Despite the economic slowdown, there are no plans to lay off workers. The pass-through from wages and currency depreciation to consumer prices has remained quite limited.
Our View
The Brazilian economy has been recovering more slowly than anticipated. We expect economic policy stimulus to boost activity in the second half of the year. Domestic demand is already showing signs of rebound. Domestic and external risks remain.


Summary

The performance of the economy has been mixed from late April to early June. Companies in logistics and other services, and in some consumer goods, report steady growth. Others, such as those dedicated to vehicles and industrial investment, have not yet rebounded. On average, though, economic activity has disappointed, even in the best-performing sectors. There were some signs of recovery in late May and early June, and, in general, companies still expect that government stimulus will boost the economy as a whole in coming months. But skepticism has increased in many sectors.

Consumer demandhas recovered since the beginning of the year, but performance is mixed across products and regions. Overall, companies are carrying fewer inventories in May and June than in the previous two-month period, though the level of inventories is still above normal.

The most vigorous sectors were those buoyed by government measures (as household appliances), tied to current income (food, personal care products) and services linked to bottlenecks (technology, education).

Many businesses are becoming more selective regarding capital expenditures. Business confidence remains subdued, in the face of the external crisis and the slower local rebound. Some segments overinvested in the recent past and see no need to accelerate investment now. Investment plans for the medium term, however, are broadly maintained.

After strong growth in recent years, the housing sector is under adjustments. The focus this year has been on inventory reduction and cash generation. Sales are good (but not great), in line with 2011. Meanwhile, commercial real estate continues to grow at a solid pace.

On commodities, the situation is challenging for metallurgy and mining, which are more reliant on global economic activity. Currency depreciation partially offsets the decline in prices. Among soft commodities, the balance between supply and demand remains tight, particularly for soybeans. Corn, with a good out-of-season crop, is the exception.

The labor market is still tight. Despite the economic slowdown, there are no plans to lay off workers. Several sectors have been operating with suboptimal employment levels. Since domestic activity is still slow and there is competition from imports, the pass-through from wages and currency depreciation to consumer prices has remained quite limited.

Our view:the Brazilian economy has been recovering more slowly than anticipated. We expect economic policy stimulus to boost activity in the second half of the year. Domestic demand is already showing signs of rebound. Domestic and external risks remain.

Consumption and production of goods and services

Domestic demand in May and June continued to rebound, but performance varies across products and regions. The positive highlights are items more reliant on current income and segments favored by recent tax incentives. Among the regions, demand in the North and Northeast seems firmer than in the South. Overall, companies have fewer inventories in May and June than in the previous two-month period, though inventory levels are still above historical averages. Indeed, our proprietary survey of the business sector shows that, after a rise in May, inventories were down again in June. Additionally, the medium term plan is to work with tighter inventory levels than in the past.

Segments related to current income, such as personal care products, medication, food and beverage, reported strong sales in April and May. But sales are not exceeding expectations.

There is a perception that sales are concentrated among semi and non-durable items of higher aggregate value (premium lines) over cheaper lines. Increases in current income, along with lower demand at the margin for big-ticket durable goods (e.g., automobiles), may be stimulating consumption of better-quality products. As evidence of the effect of current income on consumption, regions with greater sensitivity to the monthly minimum wage, such as the North and Northeast, have seen higher sales volumes. Meanwhile, retailers in the South and Southeast have witnessed, in general, a weaker performance.

Government incentives to buy household appliances, extended through June, have kept strong demand in this sector. Businesses expect these measures to be extended again. However, as there was demand anticipation in the first quarter, results since April have been uneven. Mother’s Day was considered good for the segment, except for electric-electronic appliances, where Mother’s Day turned out to be disappointing in terms of sales, with a new accumulation of inventory.

In the vehicle sector, sales remained weak in April and May but improved after the reduction of the IPI tax for cars (implemented by the government in late May). Overall, however, the outlook for this sector is not so bright. Business perception is that demand is still cautious. Inventory levels remain high, so that the pickup in production is not immediate, even as sales improve. Thin orders for auto parts are additional evidence of weak output. Tax cuts are likely to be passed through to consumer prices, but maybe not completely.

As in previous editions of our Orange Book, the service sector has reported the best results, particularly for those businesses related to existing bottlenecks to economic growth. The highlights are transportation, lodging, technology and education (in-classroom and distance learning, with even faster growth). However, there are signs of accommodation in some segments. Air carriers, for instance, are experiencing below-trend growth.

In general terms, among all consumption sectors there is still the expectation that government stimulus will boost demand ahead. But skepticism has increased. The potential market in Brazil and favorable changes in income distribution are still attractive. Nevertheless, segments experiencing faster growth fear higher taxes to compensate tax cuts in other sectors. Many of the sector's participants are concerned over recent news of higher household indebtedness, and doubts over whether consumption can continue at its current pace.

Investments

Business confidence remains subdued. Our confidence indicator, based on business-sector surveys, has been slowly improving since the beginning of the year; however, the index is still about 15% below the average for the first half of 2011.

Subdued confidence is related to both the deepening external crisis and the slow rebound in domestic demand. Different industrial sectors report a contrast between the fast-paced capital expenditures through mid-2011 and the weak demand since then.

Another relevant factor is the recent exchange-rate volatility, which reduces predictability, particularly for global corporations. While a weaker currency benefits exporters, it makes imported machinery and inputs more expensive. In some cases, the weaker currency generates a (nominal) drop in the domestic content of final products, to the point of having a negative impact on the financing granted by the state development bank (BNDES).

Still, more favorable credit conditions (low interest rates, BNDES programs) have started to have an effect. Sectors that supply manufacturers, for instance, report signs of new orders to replace depreciated equipment.

Signs are also mixed for infrastructure investments, given that government spending in the sector has not yet rebounded. Meanwhile, investments in logistics have sustained the vigorous pace of recent years.

The environment remains challenging for heavy vehicles. In addition to the effects related to the adaptation to the new engine technology (which is less pollutant and has a higher production cost), the sector reports still weak domestic demand. With still-high inventories, forced vacations continue to be frequent in the sector. There are early signs of a rebound in May and June, focused in some regions (e.g. the Center-West), particularly driven by government incentives (the "Procaminhoneiro" program).

Overall, government incentives feed sector expectations related to investment. And the structural pillars of economic growth in Brazil - a growing consumer market, large upcoming sporting events, and a still-high housing deficit - are still valid. Thus, the investment plans for the medium term are broadly maintained. Nevertheless, investments selectivity has increased on the back of the higher uncertainty in recent months.

Real Estate

Following the strong growth in recent years, the housing sector has undergone some adjustments. The focus this year has been inventory reduction and cash generation. Consequently, real estate prices are also expected to rise less this year than in the previous year, only tracking the increase in costs (still pressured by labor).

Sales are good (but not great), in line with 2011. Overall, sales are more focused on existing inventories than new launchings, whose volume is expected to be equal to or lower than last year’s. A sign of deceleration in housing comes from suppliers, who report a decline in orders from April through June (following an already weaker first quarter than in 2011).

Housing mortgages continue to decelerate. Market participants expect that the extension of mortgage terms to 35 years by state-owned Caixa Econômica Federal and the decline in interest rates announced by financial institutions would boost the sector. However, these factors have not yet generated a pickup in new loans. Delinquency in the sector is generally low and under control.

Meanwhile, the commercial construction market continues to grow briskly. In addition to demand for office space, market players expect the lodging sector to expand 25% in 2012 relative to 2011, with about 80 resorts being planned. There is also demand for industrial facilities and room for shopping malls to advance, although recent launchings have been somewhat below expectation.

Commodities

The global economic slowdown has impacted negatively commodities linked to construction and manufacturing, such as metallurgy and mining. But weaker exchange-rate provides some relief. Overall, investment plans on these sectors are being maintained, but are more focused on keeping the existing infrastructure than expanding it.

The Agriculture sector is still feeling the impact on prices of the crop decline early in the year. With higher soybean prices, the crop has occupied the room formerly dedicated to other crops, such as cotton. The supply-and-demand ratio is also tight for beans, rice and wheat. The decline in corn price is the exception, following a good out-of-season harvest, as the export infrastructure is unable to deal with excess volumes.

In the Sugar & Ethanol segment, the excessive rain in May in the country’s Center-South region has delayed crushing, affecting the sugarcane productivity. Forecasts of a more humid winter are a source of concern. In general, sugarcane volume and quality are expected to remain stable relative to last year. The production mix tends to be heavier on sugar this season, as ethanol sales remain weak and inventories are still high.

Companies in the Cellulose sector expect a tougher scenario in 2012 and 2013 in light of the slowdown in China (its main buyer), new plants starting production (boosting potential output), and high global cellulose inventories.

Labor Market, Wages and Prices

Notwithstanding the economic deceleration, there is no overall plan to lay-off workers (except in specific manufacturing segments). Due to the tight labor market in recent years, many sectors operated at below-optimal employment levels, a situation that is currently being normalized. The lack of skilled workers and high labor costs remain important concerns for many sectors.

The issue is more evident in service segments related to the FIFA World Cup™ (such as restaurants and lodging), particularly among small- and medium-size businesses. There are doubts about the capacity to properly meet prospective demand.

In the previous Orange Book (published in April), we described the intention of businesses to recover margins and to pass-through exchange-rate depreciation to prices. However, moderate domestic demand and growing competition have frustrated these expectations. Our business survey shows that, until May, there was indeed the prospect of higher pass-through of costs to final prices, a trend that was reversed in June, suggesting lower inflationary pressure ahead.

Due to the tight supply-and-demand balance, food prices seem to be the main short risk for inflation. Meanwhile, the drop in used cars prices, due to weaker demand and incentives to purchase new cars, has been larger than initially expected.

Our View

The economic recovery in Brazil has been slower than expected. The economic stimulus already in place is expected to generate a pickup in activity throughout the year (particularly during the second half), as domestic demand is already showing signs of a rebound.

The slower-than-expected rebound is largely explained by the inventory adjustment process, which is taking longer than expected. Companies are reporting plans to keep smaller inventories, which may be a consequence of the increased uncertainty regarding the international scenario.

The most significant risks to our scenario are (i) deterioration in the international outlook and (ii) impact of low growth on the labor market. In the first case, exports, investments and durable-goods consumption would be affected, thereby worsening the economic-growth outlook. In the second case, layoffs resulting delayed recovery would remove a key growth support: expansion of the real wage bill and consumer spending.



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