Itaú BBA - Markets improve, but activity continues to decline

Brazil Scenario Review

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Markets improve, but activity continues to decline

mayo 11, 2015

We raised our forecast for the IPCA this year to 8.5% from 8.2% due to tax hikes and greater increases in some regulated prices.

• The market improvement in Brazil reflects the gradual implementation of macroeconomic adjustments designed to avert a crisis scenario.

• Economic activity continues to deteriorate. Business and consumer confidence remain near historic lows. The unemployment rate increased again, and the upward trend will likely persist. Our forecast for year-end 2015 stands at 7.3% (our seasonal adjustment). We maintain our GDP forecast for a 1.5% decline in 2015. In 2016, we expect a moderate recovery, with 0.7% growth.

• We revised our forecast for the current account deficit due to the methodological change in the balance of payments statistics. However, we have not changed our expectation of a gradual adjustment in the external accounts. We maintained our forecasts for the exchange rate at 3.10 reais per dollar by the end of 2015 and 3.40 reais per dollar by the end of 2016. The announcement of the reduction in the rollover pace of FX swap contracts expiring in June by the BCB supports our scenario of a more depreciated exchange rate.

• We raised our forecast for the IPCA this year to 8.5% from 8.2% due to tax hikes and greater increases in some regulated prices. These two factors affected the forecast for market prices, from 6.8% to 6.9%, and regulated prices, from 13.1% to 14.0%. We continue to forecast a slowdown in services this year compared with last. For 2016, our forecast for the IPCA remains at 5.5%, with a 6.0% variation for regulated prices and 5.4% for market prices, with lower services inflation as a highlight.

• 1Q15 data show restraint in federal spending, but tax revenues continue to fall as a result of declining economic activity. We maintain our primary surplus forecast at 0.8% of GDP for this year and 1.5% of GDP for 2016.

• We expect an additional 0.25 pp hike in the Selic rate in June, to 13.50%. We believe that the weakening of economic activity will lead the Copom to end the cycle after the June hike. For 2016, the persistence of fiscal and quasi-fiscal adjustments, weak activity and falling inflation will probably create room for a drop in the Selic rate, to 12.00%.


Adjustments advance, markets improve, but activity cools down in the short term

The macroeconomic adjustments necessary to maintain the country’s investment grade status are gradually being implemented. The prices of various assets, such as country CDS, the exchange rate and the stock exchange, among others, are now reflecting a higher probability of improvement.

Asset prices reflect the fundamentals and affect the economy. The drop in country risk reduces the cost of borrowing abroad. A less volatile exchange rate reduces uncertainty. Increases in stock prices improve corporate financing conditions. The outlook for the economy has improved marginally.

However, the scenario remains challenging. The most recent data have been corroborating our projection of a declining GDP in the short term. The drop in activity is widespread. The labor market has been feeling the effects of weaker activity: unemployment is on an upward trend and wages have moderated. Business confidence continues to fall, with no sign of recovery.

Deterioration of economic activity

Economic activity has been experiencing a widespread downturn. Our diffusion index (based on a broad set of data, including business and consumer confidence, retail sales and demand for credit) ended February at a level similar to that seen in the 2008 financial crisis. Preliminary indexes for March and April indicate a continuation of this trend.

Industrial production fell by 0.8% in March mom/sa, confirming our expectations for a drop in the month. The result was widespread with a retreat in all four large economic categories. The coincident indicators, such as the level of capacity utilization in the Industrial sector, point to a further decline in April.  Broad retail sales will likely post another drop in March. The Service sector data has been weakening in recent months.

Confidence at low levels. In April, business and consumer confidence remained at historically low levels. The highlight is the decline in confidence in the Industrial sector, which reached its lowest level since 1998. This indicator, combined with further increases in already high industrial inventories, suggests continued weakness in the sector ahead.

We maintained our GDP forecast for a 1.5% contraction in 2015. Recent data corroborate our scenario of deteriorating economic activity. We continue to forecast a decline of 1.5% of GDP for 2015. For 2016, we still expect a moderate recovery, with an increase of 0.7% year over year.

Unemployment is rising. The unemployment rate increased further, from 5.6% in February to 5.7% in March (our seasonal adjustment). The participation rate (ratio between the labor force and the working-age population) has been flat in recent months. The percentage of people reporting difficulty in finding employment, an important leading indicator of the labor market, continues to increase. We maintain our year-end forecast for the unemployment rate at 7.3% (our seasonal adjustment). The downturn in the labor market is reflected in the deceleration of wages. In March, nominal growth stood at 5.3% yoy, down from 7.3% in February. CAGED starting wages, which usually anticipate the evolution of labor force wages, suggest the persistence of this trend.

New loans expanded in March, but the trend remained weak. The daily average of new non-earmarked loans grew by 1.9% mom/sa in real terms. New earmarked loans also expanded, by 7.7%. However, year-over-year growth in total outstanding loans continued to slow down, to 2.8% from 3.0%, in real terms. By the same metric, non-earmarked outstanding loans continued to decline (-2.7%), and earmarked credit growth moderated from 9.7% to 9.5%. Overall delinquency in the system remained largely stable. The interest rate in the system increased, while the average spread narrowed.

Reservoirs advanced to 35% of capacity by the end of April. Rainfall was less favorable in the month, totaling 83% of the historical average. Still, favorable rainfall in February and March helped Affluent Natural Energy (ANE) to reach 79% of the long-term average (LTA), which led to an increase of 4.8 pp in hydroelectric reservoirs. Given the recent signaling of regulatory bodies and the outlook of weak electricity consumption, a rationing announcement at this point is no longer a significant risk.

The rainy season was fairly positive. The month of April marks the end of the rainy season. The current cycle (Nov 2014 to Apr 2015) experienced rainfall at 94% of the historical average, above the cycles between Nov 2011 and Apr 2012 (83%) and between Nov 2013 and Apr 2014 (88%).

Risks postponed to 2016. The aggregate level of 35% at the end of the rainy season is low, creating risks for the dry season (May to October). However, the fact that the Pacific Ocean is under the influence of El Niño increases the chance of rainfall in the southern region in the coming months and reduces the risk in the short term. Thus, risks are postponed to the next rainy period.

Higher current account deficit, but already declining

The review in the balance of payments methodology showed a higher current account deficit in 2014 (4.4% of GDP). The main change was in the income account, due to the incorporation of two new items: coupon payments on bonds to non-residents and reinvested direct investment earnings. Despite the impact of these changes on the current account, its funding is "automatic", i.e. it generates a counterparty with the opposite sign in the financial account. Therefore, the impact on the result of the balance of payments is zero.

Despite this change in level, we continue to expect a gradual improvement in the external accounts. The current account deficit ended 1Q15 at USD 25.4 billion, down from USD 27.7 billion in the same period of 2014. Items that are more sensitive to the exchange rate movement, such as international travelling, transport and profits and dividend remittances, continue to improve, in line with the more depreciated currency.

We revised our current account forecasts for 2015 and 2016, incorporating the methodological changes in the balance of payments. We forecast a current account deficit of USD 80 billion in 2015 (up from USD 68 billion) and USD 69 billion in 2016 (compared with USD 61 billion).

The main methodological change in the financial account came from direct investments in the country (former foreign direct investment). There was a substitution of the directional principle by the assets and liabilities principle. Thus, loans from branches overseas to headquarters in Brazil and from headquarters overseas to branches in Brazil became part of direct investment in the country (DIC), which added up to USD 97 billion in 2014 (compared with USD 63 billion in the former foreign direct investment account). For the coming years, due to the slower pace of economic activity and loss of momentum in the service and industrial sectors (main receivers of DIC in recent years), we forecast lower inflows: USD 66 billion in 2015 and USD 76 billion in 2016.

The exchange rate appreciated over the past month, returning to levels close to 3.00 reais per dollar. This movement reflected domestic and external factors. In the domestic scenario, the progress of fiscal measures and the release of Petrobras' financial statements helped. In the international scenario, emerging markets (including Brazil) have benefited from the global liquidity window, which increased capital flows to those markets.

We maintain our forecast for the exchange rate at 3.10 reais per dollar by the end of 2015 and 3.40 reais per dollar by the end of 2016. We continue to believe that the international environment, with the hike in US interest rates in the second half of the year and lower commodity prices, will likely pressure the currency. Additionally, the need to reverse the current account deficit requires a more depreciated exchange rate.

The Brazilian Central Bank announced that the rollover of contracts maturing in June will probably be partial. The BCB started to roll over June contracts at the pace of 8,100 contracts/day. If the same pace is maintained until the end of the month, the monetary authority will roll over 80% of the total batch, a lower volume than last month.

We increased our forecast for the IPCA this year from 8.2% to 8.5% but maintained the forecast of 5.5% for 2016

The IPCA rose 0.71% in April, in line with our forecast and a bit below the median of market expectations. The largest upward contributions came from food and beverages, health and personal care, and housing. The electricity bill grew by 1.3%, following an expansion of 22% in the previous month. In the first four months of the year, the IPCA increased by 4.56% so far this year, compared with 2.86% over the same period in 2014. During this period, electricity posted a variation of 38%. Over the past 12 months, the IPCA reached 8.17%, compared with 6.28% in the same period last year.

For May, our preliminary forecast indicates an increase of 0.55%. The drop in inflation compared with the April figure will be driven by the slowdown in the rise in food, transportation, and health and personal care groups.

For 2015, we increased our forecast for the IPCA from 8.2% to 8.5%, given tax hikes and higher increases in some regulated prices. The main upward factors were the increase in the ICMS tax rate in the state of Paraná for various products, the authorized correction of lottery games and the adjustment in electricity tariff – in the context of fourth tariff review cycle of distributors – proposed by the Brazilian Electricity Regulatory Agency (ANEEL) for Eletropaulo, both at a higher-than-expected percentage. These factors, among others of lesser magnitude, affected the forecast for both market and regulated prices.

For market prices, we slightly increased our forecast for this year from 6.8% to 6.9%. We raised the forecast for food at home from 7.0% to 7.4% (against 7.1% in 2014), due to the higher pressure on results at the margin and the estimated effect of the ICMS increase on foodstuffs in Paraná. For services, we slightly adjusted our full-year forecast from 7.8% to 7.9% (compared with 8.3% in 2014), due to the higher pressure of food away from home and some services that are more dependent on electricity consumption. However, we maintain our assessment that the worsening in labor market conditions and the Real Estate sector, with a consequent moderation in wages and rents, will likely result in lower services inflation this year and next. In this respect, the market values ​​of residential rents already show below-inflation increases year to date.

For regulated prices, we increased our forecast from 13.1% to 14.0%. The main upward factors were the higher-than-expected increase in lottery games and in electricity tariffs in São Paulo. In addition, there were tax hikes on fuel prices in some states (gasoline in Minas Gerais and bottled cooking gas in São Paulo) and higher-than-expected increases in the water and sewage tariff in Belo Horizonte. For regulated prices with the highest weight on inflation, we forecast increases of 50% for electricity, 9.5% for gasoline, 12.5% for urban bus fares, 12% for water and sewage, 9.3% for health insurance and a 4% drop in fixed telephone service tariffs.

For 2016, we maintained our IPCA forecast at 5.5%. Forecasts for market and regulated prices were maintained at 5.4% and 6%, respectively. For services, we forecast a 6.3% increase.

The IGP-M rose 1.17% in April, accumulating increases of 3.2% so far this year and 3.5% over the past 12 months. The IPA-M – the component with the largest weight in the IGP-M (60%) – climbed 1.41% in the month, largely reflecting the impact of FX depreciation of previous periods. Nevertheless, the IPA-M accumulated in 12 months remains low, at 1.4%. The IPC-M – with a share of 30% in the IGP-M – rose 0.75% in April, with the 12-month rate reaching 8.3%. The INCC-M –  with a 10% weight in the IGP-M – changed 0.65% in the month and 6.9% over the past 12 months.

For this year, we adjusted our forecast for the IGP-M to 6.5% (6.0% in the previous report), mainly due to the higher-than-expected result in April. On the other hand, the recent exchange-rate appreciation could help results in the coming months, especially wholesale prices. In disaggregated terms, we forecast a 5.8% increase for the IPA-M this year, 8.4% for the IPC-M and 7.0% for the INCC-M. For 2016, we maintained our forecast for the IGP-M at 5.8%.

Fiscal: spending cuts in the first quarter

Federal spending was restrained in 1Q15, and tax collection continued to decline due to the drop in economic activity. We maintain our forecast for the primary surplus at 0.8% of GDP for this year and 1.5% of GDP for 2016.

Federal spending fell by 2.0% in real terms in 1Q15. In March, spending fell by 3.1% in real terms, which means that the adjustment has intensified at the margin. As expected, the main drops occurred in investment (-31.7% year to date) and discretionary administrative costs (-0.5%), lines characterized by their greater flexibility in the short term. We project that spending cuts will consolidate during the year. We forecast a 6.0% decline in federal spending in real terms in 2015. For comparison purposes, federal spending grew by 5.2% in real terms in 2014, 6.4% in 2013, 4.8% in 2012 and 3.5% in 2011.

However, tax collection continues to decline due to the downturn in economic activity, particularly in consumption and the labor market. Core revenues (excluding royalty revenues) decreased by 2.2% in real terms year to date. The largest downward contributions came from social security revenues and PIS/Cofins sales tax collection. Tax collection in Brazil depends largely on indicators related to consumption and the labor market (retail sales, wage bill). In the past, these indicators outperformed GDP, which was positive for tax collection. This growth composition is inverting now, which tends to have negative effects on tax collection.

Among the taxes whose rates were increased, only the IOF on individuals posted real annual growth (+30.5% year to date). The IPI tax on cars declined by 2.5% year to date despite the higher rate, as vehicle sales fell 16% by the same metric. PIS/Cofins on fuels declined 3.5%. According to the Federal Revenue Service, there was a negative impact from the truck driver strike, which caused a drop in fuel consumption in February. The pace of tax collection will likely increase in the second half of the year, as economic activity tends to improve and some tax hikes only start to be effective in the second half (PIS/Cofins on financial income, partial reversion of payroll tax cuts). We forecast a 0.3% growth in tax collection this year.

The central government's primary surplus in the first quarter is consistent with a primary surplus below the target by the end of the year. In 1Q15, the central government posted a primary surplus of BRL 4.9 billion. Usually, the central government's primary surplus in 1Q15 represents around 25% of the full-year result. Thus, if we extrapolate the 1Q15 results, we obtain a primary surplus of the central government of BRL 19.6 billion in 2015, below the target of BRL 55 billion and our forecast of BRL 33.7 billion. However, the increase in tax collection and intensification of spending cuts will probably improve results throughout the year.

The negative primary result of regional governments in March (BRL -1.1 billion) indicates some normalization in their performance, after surprisingly positive data earlier this year. Regional governments' results in the first two months of the year seemed more favorable than what would be consistent with fundamentals, such as the decline in economic activity and its negative impact on tax collection. Regional governments accumulated a primary surplus of BRL 14.6 billion in the first quarter, above their target for 2015 (BRL 11 billion, 0.2% of GDP). Our scenario is a primary surplus of regional governments at the target this year, which implies an accumulated deficit of BRL 3.5 billion from April to December.

Nominal deficit reached 7.8% of GDP (6.8% in February), largely due to losses on currency swaps (BRL 34.5 billion in March). Net public debt declined. Interest expenses accumulated over twelve months rose from 6.2% of GDP in February to 7.1% in March. The primary result (in the same comparison) fell from -0.6% to -0.7% of GDP. Net public sector debt fell from 33.8% of GDP in February to 33.1% of GDP in March, due to the favorable effect of exchange-rate depreciation on the public sector's assets. For the same reason, gross general government debt excluding international reserves fell from 41.7% to 41.0%. Gross general government debt, on the other hand, increased from 60.9% to 62.4%. We project that the upward trend of public debt to GDP will continue, despite the ongoing fiscal adjustment, as the primary surplus will remain below the result required to balance the debt dynamics (around 2.5% of GDP, according to our calculations).

Central bank pursues its adjustment

Monetary policy continues to be implemented in an environment of high current inflation and weak activity. Relative price adjustments (exchange rate, regulated prices) continue to pressure inflation. Until April, the IPCA accumulated over 12 months expanded by 8.17%, almost two percentage points above the upper limit of the target range. At the same time, recent data shows a contraction of economic activity in various sectors.

The central bank has emphasized the convergence of inflation. In a speech presented at the Macrovision event organized by Itaú (April 14), the central bank president Alexandre Tombini noted that "it's a role of monetary policy to contain the second-round effects stemming from relative price adjustments (...) ensuring the necessary conditions to enable the convergence of inflation to the target center by December 2016."

The Selic interest rate rose again and reached 13.25%. We expect an additional increase of 0.25 pp in June. The intention to bring inflation to the 4.50% target by the end of 2016 emphasized by the central bank may require further adjustment of monetary policy. Thus, we expect an additional increase of 0.25 pp in the Selic rate in June, to 13.50%.

However, we believe that the weakening of economic activity will lead the Copom to end the cycle after the June hike.  We understand that economic activity continues to lose strength, and GDP performance in the second quarter will be the worst of the year. Recent figures from the labor market, showing rising unemployment and declining real incomes, reinforce this scenario. In our view, this background will lead the Copom to interrupt the hiking cycle after the June meeting, maintaining the Selic at 13.50% until the end of this year.

The recent appreciation of the exchange rate will likely also provide some comfort to the Copom.  We expect the exchange rate to end 2015 at 3.10 reais per dollar, weaker than current level but stronger than the peaks observed in March.

For 2016, the persistence of fiscal and quasi-fiscal adjustments, weak activity and declining inflation will probably create room for a drop in the Selic rate to 12.00%.

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