Itaú BBA - External and Domestic Uncertainties Affect the Economy in 2014

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External and Domestic Uncertainties Affect the Economy in 2014

February 10, 2014

Spending on goods and services is slowing down as demand becomes increasingly selective.

With information through February 7, 2014

This report, published six times per year, summarizes anecdotal information on current economic conditions received from key business contacts, economists, market experts, and other sources outside Itaú. Apart from the “our view” section, it is not a commentary on the views of Itaú’s Macroeconomic Research team.

Contents

Consumption and Production of Goods and Services    
Spending on goods and services is slowing down as demand becomes increasingly selective.

Investment
Business leaders in many industries are expecting 2014 to be a year of uncertainty.

Real Estate    
Sales recovered in 2013, although the pace does not seem to have picked up this year.

Commodities    
Hot and dry weather is affecting agricultural production in Brazil.

Labor Market, Production Costs and Prices    
Elevated production costs are still worrisome. Companies in general are determined to reduce costs.

Our View
Fundamentals suggest that the activity will remain slow in the first semester.


Summary

Spending on goods and services is slowing down as demand becomes increasingly selective.

The period from late 2013 to early 2014 has been marked by decoupling among consumer-related sectors. On the one hand, manufacturers of durable consumer goods are reporting restrained demand, a slowdown in orders and high inventories at retailers. On the other hand, producers of non-durable consumer goods are reporting stronger activity, though there has still been a deceleration from 2013. Manufacturers of beverages and textiles have also been favored by high temperatures at the beginning of the year and by the run-up to the World Cup.

The World Cup is also giving a boost to industries such as beverages and textiles, in addition to service industries such as hospitality, tourism, events, media and executive transportation. However, the service sector as a whole remains on the downward path observed throughout 2013.

Despite this cautious mood, most sectors remain interested in investing in Brazil. The country is structurally attractive due to the size of its market and its credentials as a commodity producer.

Business confidence remains subdued, although there have been some signs of improvement early in the year. Business leaders in many industries are expecting 2014 to be a year of uncertainty, both domestically and globally, which in many cases is leading them to postpone large-scale investment decisions.

The heavy vehicle industry (buses, trucks and agricultural machinery) is experiencing a moment of particular uncertainty following changes in the investment support program (PSI) funded by the state development bank BNDES.

Even in sectors that have benefitted from the growth of the middle class in recent years, many companies are signaling an intention to slow down their expansion projects.

The real estate sector recovered in 2013, although the pace does not seem to have picked up this year. Despite better sales, the outlook for production is moderate.

Commodities are facing mixed prospects this year. Dry weather is affecting agricultural production in Brazil. As a whole, the 2013 14 crop should still be good, but there are likely to be differences among crops. The unfavorable weather could be particularly damaging to sugarcane and coffee plantations, due to their geographic location. In the steel and mining industries, exchange rate depreciation and the outlook for a recovery in global manufacturing activity feel encouraging.

Elevated production costs are still worrisome in many industries. Wages remain under pressure, with few signs of accommodation. Companies, determined to reduce costs, are avoiding new hires and automating processes.

Our view: The Brazilian economy ended 2013 at a slow pace. Domestic fundamentals for industrial production and consumer spending suggest that the activity will remain sluggish through the first half of 2014. On the external front, stronger growth in G7 nations may be positive for the Brazilian economy, but an unfavorable environment for emerging economies and a deteriorating economic situation in Argentina are causes for concern.

Consumption and Production of Goods and Services

The period from late 2013 to early 2014 has been marked by a decoupling between durable and non-durable consumer goods segments. On the one hand, durable consumer goods manufacturers are reporting restrained demand, a slowdown in orders and high inventories at retailers. Rising interest rates, higher prices (especially due to the weaker exchange rate), greater consumer indebtedness and fears of a slowdown in the labor market are some of the factors that, according to companies in these industries, are limiting demand. The auto industry faces a more complex challenge in this context. Inventories are particularly high, and the still-reduced IPI tax is no longer perceived by the industry as an incentive. The recent deterioration in Argentina’s economic situation is also worrying. Auto parts producers evaluate the beginning of 2014 as “difficult”.

On the other hand, producers of semi-durable and non-durable consumer goods – such as food, cleaning products and medication – report stronger activity, though still slower than in 2013. A still-heated labor market and less spending on durable goods have been mentioned as among the factors that are boosting sales. Manufacturers of beverages and textiles have also been favored by high temperatures at the beginning of the year and by the run-up to the World Cup.

The World Cup is also spurring service industries such as hospitality, tourism, events and executive transportation. However, the service sector as a whole remains on the downward path observed throughout 2013. There are fewer patrons at restaurants and customers at shopping malls. Corporate demand is more selective as companies seek more efficient management with tighter budgets. As mentioned in our previous Orange Book, even demand for essential corporate services, such as security and transportation, is being resized.

All in all, spending on goods and services is slowing down as demand becomes increasingly selective.

Investment

Business confidence remains subdued, although there are some signs of improvement early in the year. Our business confidence indicator, which is based on a broad client survey, advanced in January, following a retreat in the fourth quarter. However, the confidence index is still below its average for the first half of 2013 and considerably below the levels seen in 2010 and 2011.

Infrastructure concessions, the World Cup and specific government programs (to finance machinery and equipment purchases by municipalities) are boosting activity in the construction sector.

The fact that the currency is weaker than last year’s average level is serving to protect against competition from imports, improving the outlook for the capital goods sector.

Business leaders in many industries are expecting 2014 to be a year of uncertainty, both domestically and globally, which is driving them to postpone large-scale investment decisions. On the external front, the U.S. Federal Reserve is likely to continue to tighten monetary policy in the U.S., and some emerging-market countries are being compelled to make macroeconomic adjustments. Domestically, rising interest rates, exchange-rate volatility and the expected withdrawal of some tax incentives are leading to questions about the strength of demand going forward.

Supply factors such as high production costs (labor, transportation and rent) and complexity in the tax system are also making entrepreneurs less confident about expanding production capacity. Even in sectors that have benefitted from the growth of the middle class in recent years (including healthcare, education, personal care and beauty), many companies are signaling an intention to slow down their expansion projects.

Despite this cautious mood, most sectors remain interested in investing in Brazil. The country is structurally attractive due to the size of its market and its credentials as a commodity producer. The infrastructure projects offered by the government through its concession program do have return potential and help to tighten production bottlenecks. The World Cup may leave a legacy of internationalization, which is relevant for an economy like Brazil’s that is still largely closed and has few globalized companies.

Hence, any signs that the country is making progress toward correcting its structural deficiencies could lead to a rebound in large, long-term investments once the short-term uncertainties are resolved.

The heavy vehicle industry (buses, trucks and agricultural machinery) is experiencing a moment of lower sales, following changes in the credit conditions of the investment support program (PSI) funded by the state development bank BNDES. Sales were moved up to be carried out before the end of 2013 - when the exceptional favorable conditions of the program were expected to finish (and indeed finished) - so demand has been moderate at the beginning of this year and inventories are high. Some recovery is expected for February and March, as PSI conditions are still relatively favorable and the expectation of an abundant crop is helpful. However, there are questions about the sustainability of demand throughout the year.

Real Estate

The real estate sector recovered in 2013, although the pace does not seem to have picked up further in recent months. Sales speed is considered good, but there are signs that higher interest rates are affecting demand, particularly for investment properties such as offices and small residential apartments. In some regions, especially the South and Southeast, vacancy rates remain relatively high. The high-end luxury segment is still quite heated and immune to short-term volatility, driven essentially by limited supply.

Despite better sales, production is likely to remain modest, due to still-high inventories, the high price of land for new projects and the uncertainties surrounding future demand. In fact, manufacturers of real-estate supplies such as wood panels, metal fittings and sanitary wares are reporting a modest beginning of the year, with “calm” demand.

Commodities

Hot and dry weather is affecting agricultural production in Brazil. The 2013-14 crop should still be good as a whole, but with differences among crops. Soybean and cotton production will probably be higher than last year, while the corn and coffee crops are likely to be smaller. More limited output and falling prices in international markets – due to a favorable crop in the U.S. – are compressing margins for grain producers. On the other hand, a weaker exchange rate is beneficial for Brazilian producers, even in the face of the resulting increase in prices for fertilizers and compost.

The unfavorable weather could be particularly damaging to sugarcane and coffee plantations, due to their geographic location. This cyclical problem comes on top of a more structural one, namely the low investment levels of recent years, putting these producers in a relatively tough situation. Investments in sugarcane farms have been low because profitability is limited by regulated prices for gasoline. Regarding coffee, the problem is related to rising production costs in recent years, as this crop is more labor-intensive than the others.

For producers of fertilizers and crop-defense chemicals, a still-large overall crop and unfavorable weather are a positive combination. When rainfall is scarce, insects become more attracted to plants, and a heavier use of chemicals is required to fight them. The segment has no trouble passing through currency depreciation to farmers.

Two external facts worry Brazilian agricultural producers: the potential for a decline in demand from China due to high inventories, and the depreciation of the Argentine Peso, what could improve Argentina's competitiveness.

In the steel and mining industries, exchange rate depreciation and the outlook for a recovery in global manufacturing activity feel encouraging. But as mentioned in our previous Orange Book, there are no concrete investment plans in the segment. The situation is mixed for internal demand. On the one hand, infrastructure projects are gaining some momentum. On the other hand, production of durable consumer goods, particularly passenger cars and household appliances, will likely be restrained by high inventories and modest growth in consumer spending.

Labor Market, Production Costs and Prices

The hike in production costs is still a worry in several sectors of the Brazilian economy. Wages remain under pressure, with few signs of accommodation. Tough wage negotiations are expected for this year. On the one hand, the unemployment rate remains historically low and the preparations for the World Cup are giving a boost to some service segments that are particularly labor-intensive. On the other hand, companies are determined to reduce costs, and they are doing so by avoiding new hires and automating processes. As we emphasized in the last Orange Book, many industry observers report that, in the absence of surprising growth forecasts for 2014, there will be some slack in the labor force this year, with even skilled workers being affected.

Companies in some segments of the consumer goods industry report plans to pass through costs during the first quarter, although selective demand may prevent a full pass-through.

Our View

The Brazilian economy ended 2013 at a slow pace. Industrial activity fell severely in December, and the fundamentals – higher interest rates, undesired inventories, still-subdued business confidence and greater volatility in financial markets – do not suggest a rebound in the short term. As for consumer spending, retail sales remain relatively strong, but here the fundamentals also point to a deceleration ahead. Slower growth in the real wage bill, lower confidence levels among consumers, rising real interest rates and moderate credit expansion are compatible with more modest growth in retail sales this year.

Stronger growth in the G7 nations may be positive for the Brazilian economy. On the other hand, a worse environment for emerging economies at the beginning of the year and the deteriorating economic situation in Argentina are causes for concern.

In structural terms, infrastructure and productivity bottlenecks are still weighing down Brazil’s economic potential. An acceleration of concessions to the private sector should help, though the positive impact will only be clearly felt starting in 2015.



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