Itaú BBA - GDP declines further

Brazil Scenario Review

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GDP declines further

abril 10, 2015

The various macroeconomic adjustments continue to advance amid economic and political uncertainties.

• The various macroeconomic adjustments – fiscal and quasi-fiscal, regulated prices, inflation targeting and the balance of payments – continue to advance amid economic and political uncertainties. The markets started to price in a lower probability of short-term rupture, reflecting the aforementioned adjustments and a calmer international scenario following the Fed’s signal of a more gradual rise in U.S. interest rates.

• The release of last year's GDP showed a virtually stagnant economy, and the outlook for this year has deteriorated. Business confidence continues to decline at a rapid pace, suggesting further GDP fall in the short term. Labor market data also reflects weakness. Thus, we revised our GDP forecast for 2015, from -1.1% to -1.5%. For 2016, we expect a less intense recovery and forecast GDP growth of 0.7% (from 1.1% previously). Likewise, we revised our unemployment forecast to 7.3% for the end of 2015 and 2016 (from 6.6% and 6.7% previously).

• We reduced our primary surplus forecasts to 0.8% of GDP this year (from 0.9%) and 1.5% of GDP next year (from 1.8%). These revisions result from the impact of weaker economic activity on cyclical revenues, and not from a change in the assessment of the fiscal stance, which remains contractionary.

• We revised our trade-surplus forecast as a result of lower commodity prices. However, other items of the current account, such as services and income, have shown an improvement in recent months, in line with our scenario of a more depreciated exchange rate. We maintained our year-end exchange rate forecasts at 3.10 reais per dollar in 2015 and 3.40 reais per dollar in 2016.

• We raised our inflation forecast for this year, from 8.0% to 8.2%, with an increase in the outlook for market-price inflation, from 6.5% to 6.8%. This increase takes into account a reassessment of the impact of the exchange rate passthrough and the higher cost of electricity on certain market prices. We continue to project service inflation deceleration. For regulated prices, we maintained our forecast at 13.1% this year. For 2016, our IPCA forecast remains at 5.5%, with a 6.0% increase for regulated prices and 5.4% for market prices, with the slowdown in service inflation as the main highlight.

• We believe that the COPOM will not extend the interest rate hiking cycle beyond its April meeting. We expect a final increase of 25 bps in the SELIC rate, to 13.00%, but the COPOM may opt for a 50 bps hike. The behavior of the exchange rate remains a risk for this scenario. For 2016, the lower inflation and the persistence of the fiscal adjustment will create room for a drop in the SELIC rate, to 12.00%.

Adjustments advance, but the scenario remains challenging

The various macroeconomic adjustments – fiscal and quasi-fiscal, regulated prices, inflation targeting and the balance of payments – continue to advance amid economic and political uncertainties. Despite significant efforts, the fiscal results are being affected by the declining tax collection (reflecting weaker activity) and the need to execute expenditures related to prior years. However, we believe that a sufficient portion of the fiscal adjustment will be implemented to prevent the loss of the investment grade status. The increase in regulated prices and the exchange-rate adjustment pressure inflation this year, but weaker activity makes room for a significant decline in IPCA inflation next year. The external accounts are beginning to show signs of improvement, partly reflecting the more depreciated exchange rate, and the central bank announced the end of the daily FX-intervention program in March.

The markets started to price in a lower probability of short-term rupture, reflecting the aforementioned adjustments and a calmer international scenario following the Fed’s signal of a more gradual rise in U.S. interest rates.

We believe that the adjustment-implementation scenario will materialize, but only to the extent required to maintain the country’s investment grade status and avoid a crisis, despite the worse outlook for economic growth this year.

Declining economic activity

The new GDP methodology has shown greater growth in recent years, but the stagnation in 2014 remained unchanged

The IBGE released the quarterly GDP data according to the new National Accounts methodology, which led to a revision of the time series' GDP growth. The most significant changes occurred in the 2011-2013 period, with an upward revision, but the result did not change the economic activity stagnation in 2014. Last year, GDP grew 0.1% yoy. The statistical carryover for this year translates into stability, but only slightly better than we anticipated (-0.1%).

Economic activity declining in various sectors 

Recent data shows a contraction in several sectors of the economy. Industrial production fell 0.9% in February mom/sa, with a sharp decline in the production of capital goods and the fifth decline in the production of consumer goods. Coincident indicators, such as the level of capacity utilization in the industry suggest a further contraction in March. Our diffusion index (which is based on a broad set of data that includes business and consumer confidence, retail sales and demand for credit) will likely end February at a level similar to that of the 2008 financial crisis, and March shows a similar evolution. In retail, we expect a slowdown in broad retail sales (which includes vehicles and construction materials) in February. Vehicle sales suggest persistently weak activity in March. We note that sales of trucks and buses are related to investment and reached their lowest level since 2009. Finally, nominal revenue in the services sector posted the lowest growth since the beginning of the series in 2012.

Business and consumer confidence receding rapidly. For the second consecutive month, business confidence declined in all major economic activity sectors (industry, services, construction and trade). In March, there was a decline of over 5.0% in all business sectors. Consumer confidence posted a smaller decrease (-2.9%), but reached a new record low. Industry inventories increased in the month. Thus, the fundamentals will likely limit economic activity in the coming months.

We revised our GDP contraction forecast from 1.1% to 1.5% for 2015. The latest economic activity data and the sharper decline in business and consumer confidence in recent months have resulted in a more unfavorable scenario at the margin. We therefore revised our GDP growth forecast for 2015, from -1.1% to -1.5%. Economic activity will probably remain weak throughout the year, with declines in the first two quarters and stagnation from the second half onward. For 2016, there will be some recovery, though more moderate than we had anticipated. As a result, we forecast an increase of 0.7% relative to 2015.

Upward trend in the unemployment rate. Unemployment increased again in February, to 5.6% (our seasonal adjustment) from 5.4% in January. There was a decrease in the employed population, but a sharper increase in the unemployment rate was avoided by the reduction in the economically active population (EAP). Formal employment data (CAGED) continue to show accelerated job destruction in February, consistent with weaker activity at the margin. In addition, consumers continue to report growing difficulty in finding employment, suggesting a worse situation in the labor market than indicated by the current unemployment rate. Thus, we revised our unemployment rate forecast for the end of this year to 7.3% in seasonally-adjusted data, the same rate expected for year-end 2016 (previously 6.6% and 6.7%, respectively).

New loans recede in February. The daily average of non-earmarked new loans fell by 0.5% in real terms mom/sa. There was also a 1.0% drop in earmarked new loans. However, the decrease in new loans in the month failed to offset the increase observed in January. Total outstanding credit continued to decelerate, with real annual growth falling from 3.6% to 3.1%. In the same comparison, non-earmarked outstanding credit continued to fall (-2.4%), while earmarked credit moderated from 10.4% to 9.7%. The system’s delinquency rate remained stable at 2.8%, while both the interest rate and average spread increased.

Lower rationing risks

Favorable evolution in March. Rainfall remained favorable for the potential generation of hydropower plants in March, with a volume of 108% of the historical average. The two consecutive months of above-average rainfall have enabled a recovery of Affluent Natural Energy (to approximately 80% of LTA) and a 6.9 pp increase in the reservoir levels, which reached 30.1% of capacity. The evolution was even better in the Southeast, with rainfall at 123% of the historical average and an increase of 7.9 pp in reservoir levels. In terms of water supply, the water sources that supply the city of São Paulo benefited from above-average rainfall , which led reservoir levels to increase during the period (and eliminated the risk of collapse in the short run).

Current situation and outlook for April reduce the risk of announcement of electricity rationing at the end of month. The recent recovery of ANE and the forecast of above-average rainfall at the beginning of April indicate that reservoirs will reach 35% of capacity by the end of the month. This removes the risk of the announcement of a rationing by the end of the rainy season, which would be appropriated if the aggregate reservoir level fell below 30% by the end of the month.

Still, the situation requires attention and does not eliminate the need for additional measures. The aggregate level of 35% by the end of the rainy season (and between 31% and 33% in the Southeast) is low. The absence of rationing postpones the risks to 2016 and requires: i) hydrology close to the historical average during the dry season; ii) an effective reduction in consumption based on the combination of rising tariffs and modest economic growth; and iii) continued strong use of thermal power plants. If one of these items fails to materialize, the country may face even greater risks in 2016, or operational problems still in 2015.

The recovery of the Cantareira system will take a long time. Even with the lower withdrawal of water and above-average rainfall, reservoirs are still at negative levels, discounting the so-called dead volume. The recovery process will require the current withdrawal level (approximately 50% below 2013 levels) to be maintained for at least one year.

Fiscal scenario – Intensifying headwinds

The data released in January and February show some contention in federal spending, but still insufficient to offset the decline in revenue. Tax collection (excluding one-off revenues) posted a real decrease of 5.1% year to date, compared with the same period of last year. This decline is greater than the drop observed in GDP and is widespread between different types of taxes and contributions. Federal spending fell by 1.0% in the same comparison. The main reduction is in investment (-31.3% in real terms year to date), as expected, given the greater flexibility of this line in the short term.

The central government's primary surplus accumulated in the year reached only 5.5% of the target set for 2015 (BRL 55 billion). In recent years, the primary surplus during the first two months of the year represented on average 19% of the result for each year. Thus, the data indicate that the central government will face a challenging scenario in meeting the target set for this year. 

The good news come from the regional governments, which posted a primary surplus of BRL 5.2 billion in February, following the surprisingly positive result of BRL 10.5 billion in January. The results are higher than initially expected before the beginning of the year and suggest a reversal of the deterioration trend observed during the second half of last year. The target set for regional governments this year is a primary surplus of BRL 11.0 billion (or 0.2% of GDP), below the cumulative result for January and February (BRL 15.7 billion). This does not mean that the target has already been met, especially in a year when the drop in economic activity will affect the cyclical collection of states and municipalities. However, data released in the first two months of the year reduce the downside risks attributed to the performance of regional governments this year.

The nominal deficit accumulated over the last twelve months increased from 6.4% to 7.3% of GDP, mainly due to the unfavorable result of the BRL 27.3 billion in FX swap operations in February. The net public sector debt fell from 36.6% to 36.3% of GDP, reflecting the favorable impact of exchange rate depreciation on the public sector's assets. The gross general government debt increased from 64.4% to 65.5% of GDP. We note that when the central bank incorporates the new GDP series (revised by IBGE) into the fiscal statistics, net debt will be revised to 33.8% and gross debt to 60.9% in February.

We reduced our primary surplus forecasts to 0.8% of GDP this year (from 0.9% previously) and 1.5% of GDP next year (from 1.8%). The revisions result from the impact of the decline in economic activity on cyclical revenue, and not from a change in the assessment of the fiscal stance, which remains contractionary. Our disaggregated economic-activity forecasts indicate a remarkable adjustment in the domestic-demand indicators (i.e., retail sales, wage bill, quantum of imports), which tend to have a significant impact on tax collection.

External accounts show signs of gradual improvement

The Brazilian Central Bank (BCB) announced the interruption of the daily FX swap sales program. At the end of March, the BCB announced that it would discontinue the FX swap program started on August 22, 2013. The monetary authority also informed that it would seek to roll over the entire batch of contracts maturing from May 1 onward, thus maintaining the stock of swaps flat at USD 113 billion.

The trade balance posted a USD 5.6 billion deficit in the first quarter of the year, a slightly better result than the USD 6.1 billion deficit posted in the same period of 2014. This result was mainly due to the reduction in the value of commodity exports and to imports, which, despite being on a downtrend, still haven't decreased fast enough to ensure a higher trade balance in the period.

We believe that the effects of the more depreciated exchange rate and the weaker economic activity will likely hold back imports this year. Still, revisions to the average prices of iron ore, soybeans and sugar led us to revise the trade-surplus forecast from USD 10 billion to USD 6 billion this year. For 2016, we also expect a smaller trade surplus of USD 10 billion, from USD 17 billion.

The current account balance posted more favorable results in the first two months of 2015. The current account deficit totaled USD 6.9 billion in February. Thus, the seasonally-adjusted annualized 3-month moving average deficit fell once again, from a USD 96 billion deficit in January to a USD 88 billion deficit in February 2015. Both the service and income deficit declined (-5.3% and -15.5% in the first two months of 2015 yoy), in line with a scenario of weaker economic activity and a more depreciated exchange rate. The main highlights were the declines in the international travelling deficit and profits and in dividends remittances.

For 2015 and 2016, we continue to forecast a recovery of the trade balance and a reduction in the current account deficit. On the one hand, we expect a slightly smaller trade surplus as a result of lower commodity prices. On the other hand, the service and income accounts will likely post a smaller deficit than we initially estimated. These drivers will result in a current account deficit of USD 68 billion in 2015, compared with USD 66 billion previously (3.6% of GDP vs. our previous estimate of 3.7% of GDP)[1]; and USD 61 billion in 2016, compared with USD 59 billion previously (3.2% of GDP vs. our previous estimate of 3.3% of GDP).

Our year-end exchange rate forecasts stand at 3.10 reais per dollar in 2015 and 3.40 reais per dollar in 2016. Throughout March, the exchange rate fluctuated between 3.00 and 3.30 reais per dollar, in line with our view of an overshooting in 2015. Domestically, the political and economic uncertainties and the need for a faster and more consistent reversal of the current account deficit continue to weigh. Internationally, there are uncertainties regarding the possible U.S. interest rates hike this year.

We increased our forecast for the IPCA this year, from 8.0% to 8.2%, but maintained our forecast of 5.5% for 2016

The Consumer Price Index (IPCA) rose 1.32% in March, in line with our forecast (1.33%) and below the median of market expectations (1.39%). The largest upward contributions came from housing (0.79 pp) and food (0.29 pp). In the case of housing, the highlight is electricity, which rose 22.1% and caused an impact of 0.71 pp on the IPCA. The increase in electricity bills reflected the extraordinary adjustment in tariffs and the increase in the value of the tariff under the red-flag system, both applied earlier this month. In the first quarter, the IPCA accumulated a 3.83% increase, compared with 2.18% in 1Q14. Over the last 12 months, the IPCA variation reached 8.13%, compared with 7.70% until February and 6.15% in the same period of last year.

For the month of April, our preliminary forecast suggests an increase of 0.65%. The drop in inflation over the previous month will be determined by the lower upward contribution from electricity. After rising 22.1% in March, we forecast an average increase of 2.5% in electricity bills in April, equivalent to a relief of 0.6 pp in the IPCA.

For 2015, we raised our estimate for the IPCA from 8.0% to 8.2%, with an increase in the market-price inflation forecast, from 6.5% to 6.8%. This increase took into account a reassessment of the impact of the more depreciated exchange rate and the higher cost of electricity on certain market prices. We raised the forecast for prices of food consumed at home from 6.5% to 7.0% (from 7.1% in 2014), with slightly larger increases in meats and wheat products. In any case, some factors will probably help reduce the pass-through of exchange rate depreciation to market prices. In addition to the outlook of decelerating domestic demand, we take into account a more beneficial commodity-price scenario for inflation. In the case of food, we highlight the increased supply of agricultural products, particularly grains, amid confirmation of good harvests and recovery in global inventory levels. Meats, which rose 22% last year due to low supply and rising prices in the international market, will likely show a more benign inflation behavior this year. This movement will probably avoid a more pronounced hike in market prices in the tradable sector: we anticipate an increase of 5.8%, compared with 6.0% last year. For services, we revised the forecast for this year from 7.5% to 7.8% (from 8.3% in 2014), with an adjustment in the forecast for food consumed away from home and certain services that are more dependent on electricity consumption. Nevertheless, we maintain the assessment that the worsening in labor market conditions and in the real estate sector, with the resulting moderation in wages and rents, will likely result in lower service inflation this year and the next. In short, despite the upward revision in our market-price forecast, a context of weaker economic activity and increase in the unemployment rate may result in a lower currency pass-through than originally suggested by our models. The same reasoning seems valid for the expected pass-through of the higher cost of electricity.

For regulated prices, we maintained our forecast unchanged at 13.1%. The downward revision in the forecast for electricity (from 50% to 47%) offset the upward revision in the forecast for medicines (from 4.8% to 6.5%). The reduction in the forecast for the readjustment of electricity took into account the new bank loan parameters to cover the electricity sector's expenditure last year: addition of new installment, interest-rate hike and extension of financing terms. As for medicines, the new forecast incorporated the average values ​​authorized by the regulatory agency. For the other regulated prices with higher weight on inflation, we forecast increases of 10% in gasoline prices (increase of PIS / COFINS and CIDE), 12.5% ​​in urban bus fares, 9.5% in water and sewage tariffs, 9.4% in health plans, and a 4% drop in fixed telephone tariffs (reduction in the value of calls made from fixed-line to mobile phones).

For 2016, we maintained our IPCA forecast at 5.5%. The forecast for market prices decreased from 5.5% to 5.4%, while the forecast for regulated prices increased from 5.5% to 6%. The revision in the forecast for regulated prices took into account a greater impact from inflationary inertia than previously anticipated. In the case of market prices, the revision was based on the outlook of a further slowdown in economic activity throughout the forecast horizon, especially in the labor market. For services, we forecast a 6.4% hike in 2016.

The General Price Index (IGP-M) rose 0.98% in March, with the 12-month rate falling to 3.16%. The Producer Price Index (IPA-M) – the component with the largest weight in the IGP-M (60%) – rose 0.92% in the month, under pressure from agricultural prices (up 2.5%). Over the last 12 months, the IPA-M variation was only 0.75% (2.8% in agricultural prices and no change in industrial prices). During this period, we highlight the drop of 43% in iron ore prices. The Consumer Price Index (IPC-M) – with a 30% participation in the IGP-M – rose 1.42% in March; the 12-month rate advanced to 8.4%. The greatest pressure on the IPC-M came from electricity and gasoline. The National Construction Cost Index (INCC-M), on the other hand – with a 10% weight in the IGP-M – changed 0.4% in the month and 6.9% over the last 12 months.

For this year, we maintained our forecast for the IGP-M at 6.0%. In disaggregated terms, we forecast hikes of 5.0% in the IPA-M, 8.2% in the IPC-M and 7.0% in the INCC-M. For 2016, we continue to forecast and increase of 5.8% in the IGP-M.

COPOM: Hiking cycle near the end, room to cut in 2016

Relative price adjustments (regulated prices, exchange rate) and persistent service inflation have led the central bank to maintain the interest-rate hiking cycle. In March, the COPOM once again raised the SELIC rate by 0.50 pp, to 12.75%, and signaled that the advances "are still insufficient."

The weak activity and ongoing monetary and fiscal adjustments will likely limit the transmission of high inflation to 2016, although still insufficient to bring inflation to the mid-point target. In its 1Q15 Inflation Report, the COPOM expressed confidence in disinflation, stating that the inflationary effects of relative price adjustment "tend to be limited to the short-term and be strongly mitigated in 2016."

In this scenario, we believe that the COPOM will not extend the interest-rate hiking cycle beyond its April meeting. We expect a final increase of 25 bps in the SELIC rate in April, to 13.00%. The COPOM may, however, opt for a hike of 50 bps to strengthen the disinflation trend in 2016.

The exchange-rate behavior remains a risk in this scenario. If the real resumes the trend of rapid depreciation observed until mid-March, the tightening cycle might be extended.

For 2016, we believe that lower inflation and ongoing fiscal adjustments will create room for a drop in the SELIC rate, to 12.00%.


 


[1] The new forecasts for current account as a percentage of GDP already incorporate the GDP revision carried out by IBGE. The former figures, however, take into account the previous GDP.

 



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