Itaú BBA - Weaker Consumption, Slightly Better Investment

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Weaker Consumption, Slightly Better Investment

October 30, 2013

Business confidence remains subdued.

With information through October 29, 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
The slowdown in consumption-related segments and the service sector has continued in recent months.

Investment
Business confidence remains subdued. The scenario for investment-related sectors, however, is more favorable, as public investment picks up.

Real Estate
Sales are gradually recovering. On the production side, the expectation is of relatively low growth.

Commodities
In Agricultural Commodities, the 2013-14 crop should hit a new production record. In Steel and Mining, currency depreciation has fostered a more optimistic outlook.

Labor Market, Production Costs and Prices
Production costs have remained high throughout the second half. The margin squeeze leads to efforts towards more efficiency and cost reduction, which in some cases means reduction in the workforce.

Our View
The latest data suggest that GDP might have shrunk less than we had forecasted. The improvement in financial conditions points to a recovery starting this quarter.


Summary

The slowdown in consumption-related segments has continued in recent months. Reports suggest lower growth or stability compared with last year. In general, Retailers are experiencing a slower-than-expected pace in store openings. The slowdown also affects the Service sector. Restaurants and hotels indicate increased idleness.

Business confidence remains subdued. Most private investment projects remain on hold. The scenario for investment-related sectors, however, is more favorable, as public investment picks up. There are signs of recovery in infrastructure projects. A more depreciated exchange rate increases protection of the Capital Goods sector against competition from imported goods.

The Real Estate industry is more optimistic this year. Sales are gradually recovering. On the production side, the expectation is for relatively low growth. Inventory levels remain relatively high, and the cost of purchasing land inhibits entrepreneurs.

In Agricultural Commodities, the 2013-14 crop should hit a new production record. The highlight is the soybean crop, which has been gaining ground over corn due to favorable prices. In the Sugar-Alcohol sector, this year's crop should be large again. The quality, however, tends to be slightly lower than last year.

In Steel and Mining, currency depreciation and more stable growth in the U.S. and China have fostered a more optimistic outlook.

Production costs have remained high throughout the second half, driven by the still high wages and the lagged effects of currency depreciation. The pass-through to prices remains challenging. The margin squeeze leads to efforts towards more efficiency and cost reduction, which in some cases means reduction in the workforce.

Our view: The latest data suggest that GDP might have shrunk less than we had forecasted. The improvement in financial conditions points to a recovery starting this quarter.

Consumption and Production of Goods and Services

The slowdown in consumption-related segments continued in recent months. Reports suggest either lower growth or stability compared with last year. In most cases, performance is below what companies had planned at the beginning of the year. Still, there is no sudden stop. The recovery in consumer confidence since July, the still-heated labor market and the expectation for gradual credit recovery help to relieve somewhat the fear of a steeper drop felt in the beggining of the 3Q13.

Sales of non-durable consumer goods or necessities such as hygiene and beauty items, pharmaceuticals and food were reported as "reasonable" or "good". But companies perceive demand as more conservative, so there is little room for pass-through of costs. Some more superfluous consumer goods segments, such as personal accessories and non-essential food items, have experienced a steeper slowdown in sales.

Expensive consumer goods sectors, which are more dependent on credit, have felt more difficulty maintaining their sales pace. As most of those goods are imported or have a high content of imported raw components, the pass-through of the exchange rate depreciation is more intense, affecting demand (producers and retailers claim they prefer to pass on the cost, even if losing volume). The Minha Casa Melhor program boosts segments such as home appliances and household items. But there is indication that this effect is gradually fading.

Reports suggest that the Automobile sector lost momentum in October. Inventories have continued to rise in recent months and sector-supplier segments such as auto parts reported declining orders. The expectation in the sector is that the IPI tax reduction will extend into 2014. An acceleration of sales is not expected if the IPI is maintained, but there is a downside risk if the tax increases back.

In general, retailers have experienced a slower-than-expected pace in store openings. Vacancy in shopping malls has been rising, increasing the leverage of retailers in negotiations between them and store lessors.

The slowdown also affects the Service sector. Restaurants and hotels report increased idleness. As noted in our last Orange Book, sectors that provide services to industry and trade are failing to renew their contracts due to cost-cutting efforts in different sectors of the economy. Even the demand for essential services, such as security and transportation, has scaled back.  

In short, the slowdown in consumption seems more evident and widespread in the economy. More conservative demand and still-high costs are creating concern in several segments. On the other hand, the sudden stop suggested by the negative shock at the beginning of 2H13 hasn't materialized.

Investment

Business confidence remains subdued. Our indicator, built from a wide client base, fell again in October, erasing much of the recovery seen in August and September. The current level is only slightly higher than the level seen in July and the average of 2H11, which were the lowest levels of the series (started in 2010). Production costs and tax uncertainty remain among the main concerns. Another worry is the increase in transportation costs due to, among other factors, changes made to the labor legislation in the sector.

Since June, the risk to economic activity decreased with the improvement in financial conditions and global growth indicators. In contrast, there is declining confidence over the sustainability of domestic demand and concern over the volatility that may be generated by the 2014 presidential race.

Thus, most sectors remain cautious, preferring to postpone decisions on capacity expansion. The effort, in most sectors, is towards gaining operational efficiency and reducing outlays.

Despite the still-cautious climate, the scenario for investment-related sectors is more favorable. The approach of the World Cup and the election year is spurring acceleration in public works. The recovery in demand and the more depreciated real (compared with last year's average), which protects against imported competition, have been stimulating the Capital Goods sector and infrastructure projects.

Suppliers of capital goods to the Consumer Goods industry, in turn, do not report accelerating demand. The second half of 2013 is better than the previous one due to currency protection, but a recovery in the sector is not yet underway. 

The Heavy Vehicles sector – buses, trucks and agricultural machinery – was an important driver of investment in the first half. The performance was due to a combination of a favorable agriculture crop and subsidized interest rates offered through BNDES’ Investment Support Program (PSI). Sales cooled down between August and September but regained strength in October. The prospect of a new record harvest, especially for grains, explains the still-robust sales. The industry is concerned, however, about the new financing conditions of PSI, which will likely be more restricted in 2014.

Real Estate

The Real Estate sector is more optimistic this year. Sales are gradually rebounding, a trend that continued in September and October. The recovery is still being driven by midsize residential properties targeted to the upper middle class. Another segment that remains fairly heated is high luxury, mainly due to supply restrictions.

In contrast, real estate traditionally demanded by investors, such as commercial offices, small-sized residential properties, has seen a significant slowing in the pace of sales. In the past, low interest and inflation risk boosted this market, stimulating supply. The economic environment has changed and has led to a slackening in demand and an increase in inventories.

On the production side, the expectation is of relatively low growth. First, inventories of commercial and residential properties are still considered high. Second, the cost of land is high, which discourages new acquisitions (something that may take a while to adjust, due to the relative downward rigidity of land prices).

Commodities

The 2013-14 harvest, which is being planted now, will likely hit a new production record. The highlight is soybeans, which are been gaining ground over corn due to favorable prices. Rain conditions are favorable at the beginning of this harvest.

Increased production has generated negative pressure on prices. With high costs, the industry will depend on a more depreciated exchange rate to improve profitability. The exchange rate near (or below) 2.20 reais per dollar makes agribusiness tight. Few took advantage of the recent currency peak to lock in their exports. In this environment, there is an effort across the Agribusiness sector to improve efficiency. 

In the Sugar-Alcohol sector, this year's crop will likely be bulky again. The quality, however, tends to be slightly lower than last year. Depending on the price relationship between ethanol and sugar, there is an expectation that production is proportionally more focused on ethanol than previous crops. The sector continues to see little investment due to the price rigidity. In two years, the production capacity has been reduced by about 5%.

In the Steel and Mining sectors, the weaker currency and more stable growth in the U.S. and China have fostered a more optimistic outlook. There are no tangible investment plans in the sector, but companies with spare capacity are gradually resuming production. Domestically, the outlook is more mixed. On one hand, infrastructure projects are gaining traction. On the other hand, the production of durable consumer goods, especially cars and large home appliances, will likely be limited by high inventories and the more modest growth expected for consumption in coming quarters.

Labor Market, Production Costs and Prices

Production costs remain high in the second half of the year, driven by still-high wages and the lagged effects of currency depreciation. Part of the increased costs is being passed on to the consumer. However, most sectors report difficulty in the pass-through, due to a more conservative demand and fierce competition.

The margin squeeze has led to efforts to improve efficiency and reduce costs, which in some cases means workforce dismissals. Some sectors have already gone down that path in 2013, while others plan to do so in 2014. Even among those who have already made the adjustment, few report plans to increase their workforce in 2014.

Our View

The economic activity probably retreated in the third quarter. Agriculture and industrial GDP growth were likely negative, erasing part of the increase seen in the first half. Weakness in manufacturing affects transportation, services provided to companies and communication activities. In other words, it hurts the service sector.

However, the latest data on retail sales and formal job creation surprised positively, suggesting that GDP contraction may have been slightly lower in the 3Q13. The improvement in financial conditions (country risk premium, volatility of exchange rate, equity prices) indicates a resumption of growth starting in the fourth quarter. One factor that holds back the pace of economic recovery is the high level of inventories, particularly in the Industrial sector.

From a structural point of view, bottlenecks in infrastructure and productivity limit the potential of the Brazilian economy.



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