Itaú BBA - The slowdown is spreading, but without recession. Costs are still on the rise.

OrangeBook

< Back

The slowdown is spreading, but without recession. Costs are still on the rise.

August 14, 2013

Segments related to consumer spending continue in the slowdown process observed since May.

With information through August 12, 2013

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    
Segments related to consumer spending continue in the slowdown process observed since May.     

Investment    
Investment may be losing the momentum it built up in the first half of the year. Business confidence has been retreating since May.    

Real Estate    
Activity in the residential real estate sector has continued at a moderate pace, sustained by medium-size properties targeted at the middle class. The commercial real estate segment is being hit harder by the economic slowdown.

Commodities    
Most sectors related to agribusiness continue to post good performance. The outlook is challenging for steel and mining. In contrast, the scenario is favorable for pulp and paper.

Labor Market, Production Costs and Prices    
Production costs in Brazil have remained high. There are inflationary pressures for the second half of the year.

Our View    
The drop in business and consumer confidence and worsening financial conditions point to a weak economy in the second half. High and persistent inflation is limiting the room for monetary policy actions that could help sustain growth.


Summary

Segments related to consumer spending continue in the slowdown process observed since May. Demand should remain cautious ahead. Falling consumer confidence, pressure on consumer prices (especially due to the pass-through of currency depreciation) and the risk of unemployment are all concerns for the sector. There is, however, no indication of a sudden halt in activity.

Investment may be losing the momentum it built up in the first half of the year. Business confidence has been retreating since May. The good performance posted by the capital goods sector is concentrated in agricultural machinery and heavy vehicles. Other segments have reported severe downturns in orders.

Activity in the residential real estate sector has continued at a moderate pace, sustained by medium-size properties targeted at the middle class. Sales to the upper and lower income classes are weaker. The commercial real estate segment is being hit harder by the economic slowdown.

Most sectors related to agribusiness continue to post good performance, with ample harvests and strong exports. The risk for the sector lies in oversupply. In the sugar-alcohol industry, results are being curbed by unfavorable domestic and external prices. The outlook is also challenging for steel and mining. In contrast, the scenario is favorable for pulp and paper.

Production costs in Brazil have remained high, with wages rising faster than productivity and additional exchange rate depreciation. There are inflation pressures for the second half. Fragile demand causes companies to seek productivity gains in order to avoid pass-through to prices.

Our view: The drop in business and consumer confidence and worsening financial conditions point to a weak economy in the second half. High and persistent inflation is limiting the room for monetary policy actions that could help sustain growth.

Consumption and Production of Goods and Services

The slowdown observed since May continues to affect segments related to consumer spending. Reports have become more heterogeneous, depending on the type of activity, the region of the country and even the company’s sales strategy. But the general perception is that consumer spending has lost steam in recent months and consumers are likely to remain cautious in the months ahead. Falling consumer confidence, consumer prices under pressure (especially due to the pass-through of currency depreciation) and the risk of rising unemployment are the biggest concerns regarding consumption-related sectors. However, there is no indication of a sudden halt in activity.

The segments that are being hit the hardest are those with high average prices, particularly for durable goods such as cars, white goods (major appliances) and brown goods (small appliances). Sales are losing steam and inventories are piling up. The inevitable rise in prices generated by the weaker Brazilian real (most of these products rely heavily on imported components) may further erode sales in the second half of the year. The exception are products directly related to government programs such as “Minha Casa Melhor” and electronic products such as smartphones and tablets, which continue to post accelerating sales.

The automobile sector had been a sales highlight among the retail segments. The extension of the lower IPI tax and favorable credit conditions for some lines boosted results in the first half of the year. The signs, however, are now hinting at a loss of momentum. Inventories at automakers are going up again, and there is a possibility of mandatory vacation for workers in auto manufacturing. Suppliers to this segment, such as auto parts makers, are reporting declining orders for the second half of the year.

Semi- and non-durable goods such as clothing and food, and building materials report that sales are still running at a relatively good pace, although they are slower than at the beginning of the year. The street protests across Brazil in June had an passing impact on sales, but did not induce a change in trend. Regionally, the Northeast and Midwest regions are still showing demand levels above the national average. For the full year, most segments expect real sales levels similar to 2012.

Sales are also good in other segments, including those of essential goods or goods with lower average prices, such as cosmetics, pharmaceuticals and housekeeping supplies. Service segments such as entertainment, restaurants and lodging also continue to report good results, although demand in these segments is more resistant to price increases. Segments that provide services to industry and trade, such as outsourced labor, consulting and information technology, have been failing to renew all of their contracts.

In brief, the slowdown in consumer spending persisted in recent months. There is no indication of a sudden halt in sales, but buyers have been even more selective and price-sensitive. High inventories in different segments suggest that industrial production of consumer goods will lose steam in the coming months. In this environment, the challenge is to keep rising costs – due to wages, currency devaluation and other factors – from translating into higher prices for consumers. Investment in operations has become an important differential, as companies that improve productivity have been able to sustain results. In some instances, however, price adjustment is inevitable, which may lead to a drop in traded volumes.

Investment

Business confidence has retreated significantly since May. Our indicator, built from a broad customer base, fell in June and July, reaching lows not seen since the second half of 2011. In addition to concerns that had been identified in previous research – production costs, inflation, uncertainty about fiscal policy – higher interest rates and the volatility of financial assets (especially the exchange rate) also affect confidence.

The capital goods segments continue to post the good performance observed in the first half of the year, but the strength is now concentrated in agricultural machinery and heavy vehicles (trucks and buses). Sectors supplying these segments continue to report rising orders, although the cost increases generated by the exchange rate depreciation (which will be felt only later) has raised concerns. The remaining lines of machinery and equipment have seen relatively severe downturns in orders in recent months, including the suspension of orders that had already been submitted. The costs of machinery increase with higher interest rates and a weaker Brazilian real. And demand is already feeling the fall in business confidence. Still, companies’ need for automation and the low interest rates of BNDES financing should sustain overall demand for machinery and equipment in the second half of 2013.

Sectors related to infrastructure – steel, cement and other building materials – have been sustained by a fragmented consumption market composed of small players, particularly individuals. Depending on the sector, retailers represent up to 50% of sales. However, demand for large projects, both public and private, is weaker, especially now that the most intensive phase of World Cup-related infrastructure projects is over.

The investment prospects of the commodities sector had been improving with the devaluation of the Brazilian real (which directly benefits the industry’s revenues), the government’s plan involving concessions to the private sector, and the prospect of accelerating infrastructure works. In recent months, however, the slowdown in China and the perception that infrastructure works could be deferred have tempered this optimism. Moreover, idle capacity can still be found in many industries, especially steel and mining. Thus, the acceleration in investments described as a potential scenario in the previous edition of the Orange Book is no longer expected.

From the point of view of foreign investment, Brazil is still a significant destination, especially because of the size of the market. The country’s low growth is perceived more as a result of bottlenecks in supply than as a lack of demand. However, doubts have been increasing in light of high production costs, falling business and consumer confidence and the street protests that have been taking place since June. At the margin, some multinational companies have been postponing investment decisions or have been choosing to invest in other countries in the region, such as Mexico and Colombia.

Real Estate

Activity in the residential real estate sector has continued at a moderate pace. Sales of intermediate-size real estate properties targeted at the middle class continue to grow. However, real estate properties targeted at the upper and lower income classes have been facing more difficulty, due to the high price of projects (especially in the upper income segment) and the reduction in the purchasing power of buyers (due to indebtedness or unemployment risk among low-income buyers).

Overall, inventories remain high, and the expected acceleration of launches over the course of 2013, which was discussed in the previous edition of the Orange Book, has not materialized.

The commercial real estate segment seems to be feeling the economic slowdown more intensely. Sales are weaker than in previous years, and vacancies of commercial properties for lease are on the rise. The slowdown in retail has reduced demand for leased spaces in shopping malls, changing the balance of leverage in negotiations between retailers and shopping malls.

On the production side, as in many sectors of the economy, there are cost pressures. Wages continue to rise faster than the productivity rate estimated for the sector, albeit at a slower pace than in the last few years. The prices of some raw materials such as metal hardware, steel plates and finishing materials have been affected by the currency devaluation. The price of land is more stable, but at higher levels.

Commodities

Most sectors related to agribusiness continue to post good performance: ample harvests, strong exports (despite logistical bottlenecks) and a depreciated currency are offsetting the fall in international prices. The risk for the sector lies in excess supply, since well-capitalized producers invested heavily in this year’s crop. If excess supply also materializes in other regions of the world, international prices may fall further, offsetting some of these sectors’ gains.

The good harvest has kept up high demand for pesticides. Currency depreciation has put pressure on costs, as most of the inputs are imported, but has benefitted agricultural producers. Results remain positive.

The sugar-alcohol sector continues to face difficulties. As Brazil is a major global producer, the country’s larger crop and the depreciated Brazilian real opened up room for a decline in international sugar prices. On the ethanol side, regulated domestic prices curb returns. Thus, the overall results are modest and investment in the sector is small. Some players in the sector have dollar-denominated debt, making the current scenario even more complex.

In the steel and mining sectors, the outlook is also challenging. The fall in external demand, especially from China, is now accompanied by a less favorable outlook for domestic demand, especially if the production slowdown in the auto sector is confirmed. The depreciation of the currency favors this sector, but not enough to stimulate investment, especially given the global oversupply and the still-high level of idle capacity in local production.

In contrast, the scenario is favorable for the pulp and paper segment. Brazilian players in this industry have their costs denominated in local currency and their revenue denominated in dollars, with diversified demand from around the world. In recent months, pulp and paper exports have maintained the good pace seen at the beginning of the year.

Labor Market, Production Costs and Prices

Despite the slowdown in economic activity, production costs continue to increase in Brazil. Nominal wage increases in various sectors this year returned to the 8%-10% range. A number of different sectors, such as fertilizers, durable consumer goods and commercial aviation, have a significant portion of their costs in dollars and are already feeling the effects of a cheaper Brazilian real.

Regarding labor, high wages have reduced hiring, and some companies have included headcount reduction targets in their projects to improve efficiency. But there are no signs of widespread layoffs. On the contrary, many industries are still understaffed and see the eventual weakening of the labor market as an opportunity to resume hiring.

High costs are being passed along the pricing chain. Purchase managers have been reporting marked increases in the prices of services hired for their companies, such as transportation, outsourced staffing (cleaning, security) and healthcare. Where possible, services are being canceled.

There are also inflation-related pressures. Many sectors – particularly consumer-goods producers – are still selling inventories produced when the exchange rate was close to 2.05 reais per dollar. Over the second half of the year, prices will have to be adjusted. The same goes for the pass-through of additional wage increases and prices for other contracted services.

On the other hand, competition and more reticent consumer demand have hampered the pass-through to prices. In this context, sectors can be divided into those that will adjust prices even if it means accepting a drop in volumes, and those that will try to step up cost cuts and productivity gains to avoid new margin squeezes.

Our View

Falling business and consumer confidence and worsening financial conditions point to a weak economy in the second half of the year. The volatility of financial assets, street protests, stubbornly high inflation and uncertainty about fiscal policy are all contributing to the loss of confidence. Investments are becoming less attractive and sources of funding more restricted. Risk premiums have also increased, and long-term interest rates are higher.

We do not expect the Brazilian economy to fall into recession, but we do see investment retreating in the second half of 2013. Consumption, especially of durable goods, will also likely decelerate.

Brazil’s persistently high inflation limits room for monetary policy changes aimed at sustaining economic growth.



< Back