Itaú BBA - S&P Downgrades Brazil`s Rating and Local Assets Improve in March

Brazil Review

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S&P Downgrades Brazil`s Rating and Local Assets Improve in March

abril 1, 2014

Brazil’s credit rating was downgraded by Standard & Poor's, but remains one notch above investment grade.

The Brazilian economy in March 2014

Brazil’s credit rating was downgraded by Standard & Poor's, but remains one notch above investment grade. The Central Bank is likely continue to raise the interest rate, but has already indicated the end of the cycle despite the higher weather-related food inflation. Despite the recovery in growth indicators earlier this year, economic fundamentals continue to indicate sluggish expansion ahead. Meanwhile, unemployment remains at historical lows. President Dilma continues to lead in the voting polls, but her approval rating has fallen. Brazilian assets posted a strong appreciation during the month.

Standard & Poor's Downgrades Brazilian Risk Rating

Standard & Poor's rating agency downgraded Brazil's sovereign credit rating from "BBB" to "BBB-". The BBB rating, achieved in November 2011, had been under a "negative outlook" for the last eight months. The agency cited fiscal issues as well as slowing economic growth as the reasons behind the downgrade. The "BBB-" rating maintains the country a level above investment grade status. According to S&P, the outlook for the country’s rating is now stable, indicating that the agency is unlikely to make new moves in the short term. The other ratings agencies, Moody's and Fitch, continue to rate Brazil two levels above investment grade level and maintain a stable outlook for the country.

Inflation Suffers Additional Food-Related Pressure

The IPCA-15 rose 0.73% in March, led by transportation and food/beverages – already reflecting the weather effects. The 12-month rolling rate accelerated from 5.65% in February to 5.90% in March. While core and service inflation decelerated on a sequential basis, the 12-month rolling rates rose to 6.2% and 9.0%, respectively, given that the readings were higher than in March of last year. Higher food inflation has become the main upward risk for inflation in the short term.

BCB Indicates that It Will Continue to Hike Interest Rates, But Not for Long

The Brazilian Central Bank’s Monetary Policy Committee (COPOM) 1Q14 inflation report included an upward revision of the 2014 inflation forecasts, but expectations of a resumption of the downward trend beginning in mid-2014. The COPOM also stressed that the monetary policy transmission mechanisms have been operating normally and that their effect on inflation are cumulative and lagged. We see the report as consistent with the continuity of a short-lived rate-hike cycle ahead and forecast at least one additional 0.25-pp SELIC rate increase at the next COPOM meeting.

Monthly GDP Rises Sharply, But Fundamentals Continue to Indicate Slower Growth

Itaú Unibanco’s monthly GDP (PIBIU) rose sharply in January, recovering from the drop in December. The highlights were the gains in manufacturing production and retail, while the main negative contributions to economic activity were agriculture and mineral extraction output, which declined in January. The available data for February came as a positive surprise, suggesting further monthly GDP growth, albeit at a much more moderate pace. However, there are signs that the higher activity in February caused an unwanted accumulation of inventories. Given that the fundamentals have not changed, some reduction in activity is likely. The combined data still suggests a GDP variation of close to zero in the first quarter, but the downside risks have decreased.

Unemployment Rate Remains Low, with Slower Working Population Growth

The unemployment rate stood at 5.1% in February, close to market expectations. However, there was a negative surprise in both the working population and the workforce. In our view, lower labor supply, particularly in the 18-24 age range, is likely to keep the unemployment rate at historically-low levels in the coming quarters, despite the modest employment growth. The increase in real average income also reflects the low unemployment rate. The real wage bill strengthened, but the growth pace decreased relative to previous years because there is no longer a positive contribution from the working population. As a result, consumption is likely to continue to grow, but at more moderate rate.

Primary Surplus Rises in February Due to Improvement in Regional Governments

The 12-month primary surplus increased from 1.7% in January to 1.8% in February. Excluding atypical revenue and expenses, the surplus also rose from 0.8% to 0.9% of GDP. Although the improved result of regional governments was a key driver behind the better consolidated result, we see the improvement as temporary. We continue to expect a primary surplus of 1.3% of GDP this year.

Government Approval Worsens, but President Dilma Rousseff Continues to Lead the Voting Polls

The latest Ibope survey revealed that government approval (percentage of those who consider the government "great" or "good") fell from 39% in February to 36% in March. Ibope also revealed that President Rousseff continues to lead the voting polls with 43% of the voting intentions, followed by Aécio Neves with 15% and Eduardo Campos with 7%. If these results are maintained in the October election, Dilma would win in the first round.

Brazilian Assets Appreciate

Brazilian assets posted strong gains during the month. The exchange rate appreciated 3%, with most of the movement occurring in the second half of the month. The Ibovespa rose 7.1% in BRL and 10.4% in USD. Brazilian risk ended the month at 171 bps, down 0.4% from the previous month.

What’s Next?

The next COPOM meeting to set the monetary rate will be held on April 2. We expect a 0.25-pp rate hike, bringing the interest rate to 11.00%. The PSDB party’s TV program will air on April 17. All parties are entitled to air time during the first half of the year; the PSB's program aired in March and the PT's is scheduled for May.


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