Itaú BBA - Recovery in sight, but sustained growth demands reforms

Brazil Scenario Review

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Recovery in sight, but sustained growth demands reforms

septiembre 8, 2016

We have revised our GDP growth forecast to 2.0% in 2017. However, this scenario depends fundamentally of the fiscal reforms.

Please open the attached pdf to read the full report and forecasts.

Economic activity is stabilizing and we will probably see positive growth in 4Q16. Recent indicators suggest a slightly shallower recession than we had previously predicted. We have revised our GDP growth forecast to -3.2% this year (previously -3.5%) and 2.0% in 2017 (from 1.0%). Despite this recovery in activity, the labor market is likely to continue weakening until the first half of next year. 

• Fiscal accounts continue to deteriorate, a trend that is only likely to be reversed with structural reforms. We have adjusted our primary-result forecast to -2.6% from -2.5% of GDP in 2016 based on lower-than-expected extraordinary revenues, but we are maintaining our 2017 forecast at -2.2% of GDP.

• We kept our 2016 IPCA inflation forecast at 7.2%. We expect inflation to fall over the second half of the year as the food-price shock wanes, in a trend that should consolidate next year. We continue to see IPCA inflation slowing to 4.8% in 2017, with market prices rising 4.7% and regulated prices inflation at 5.2%. 

• We forecast the exchange rate at 3.25 reais per dollar at the end of 2016 and 3.50 reais per dollar at the end of 2017. The still-high interest-rate differential and government efforts to approve reforms, especially on the fiscal side, should sustain the currency at its current levels, even with a U.S. interest-rate hike. This scenario is consistent with a low, albeit slowly increasing, current-account deficit over the coming years. 

• The central bank has changed its communication, indicating that future monetary policy decisions will be more data-dependent. We believe that this change, combined with our expectations for the economy in the coming weeks, is consistent with our call of an easing cycle starting in October. We see the benchmark Selic rate at 13.50% by the end of 2016 and 10.00% at the end of 2017.

A stronger recovery. But is it sustainable?

Recent indicators suggest that the recession will be shallower and the recovery stronger than expected. Industrial output has seen resumed growth and business surveys indicate a stronger-than-expected recovery. For the time being, the recovery is being driven by a cycle of inventory replacement. However, demand remains weak, contained by contractionary monetary policy and a labor market that continues to deteriorate.

Demand must rebound to sustain the recovery. The economic recession and recent exchange-rate appreciation have improved the inflation outlook, which should create room for a long and gradual monetary easing cycle. Monetary stimulus, along with less uncertainty domestically and abroad, will probably boost aggregate demand, making the recovery more sustainable. 

However, this scenario depends fundamentally of the fiscal reforms. As the political transition reaches its conclusion, attention turns to approval of the reforms. Without fiscal rebalancing, economic predictability and stability will be compromised, leading to instability in financial markets and limiting the room for monetary easing. In this scenario, the economic recovery would be compromised.

The government has shown consistent signs of its commitment to reforms. Our base scenario assumes that the bulk of the proposed fiscal reforms will be approved by Congress over the next several months and in 2017.

Economic activity: recent data suggest stronger growth 

The economy is not yet out of recession, but it is starting to stabilize. GDP shrank 0.6% in 2Q16 compared with the previous quarter, in line with our estimates. However, the improving trend is clearer looking forward. Growth is likely to be driven by industry (on the supply side) and investment (on the demand side). Both have risen after a long sequence of quarterly drops. This view is reinforced by industrial production, which posted the fifth consecutive monthly increase in July. Private consumption, on the other hand, is likely to take longer to recover, as the labor market remains weak.

Leading indicators suggest positive growth in the fourth quarter. Our diffusion index – which is based on a wide set of indicators – is set to end July at around 55% (3-month moving average), above what we consider to be the neutral level (44%). Diffusion has shown a clear upward trend in recent months (Graph). The indicator suggests a fourth-quarter rise for GDP, which should also increase next year’s statistical carry over.

Widespread rise in confidence indicators. Business and consumer confidence indicators continued to improve in August. On average, indicators are up approximately 15% year to date, in almost all sectors surveyed. Additionally, inventories are falling in the industrial sector. Generally, confidence surveys indicate that activity is improving faster than we expected.

We now forecast a smaller drop in GDP this year, and a stronger recovery in 2017. We still expect GDP to shrink further in the third quarter. However, leading indicators suggest that GDP will resume growing in the fourth quarter, bringing the recession to an end. If these forecasts are confirmed, the carry-over for 2017 will be zero, compared with -0.5% in our previous scenario. Thus, the short-term revision alone would add 0.5 pp to 2017 growth on top of our previous forecast (1.0%). The outlook for 2017 is also looking more positive. In addition to rising confidence, our calculations suggest that the unit cost of labor continues to fall, which should contribute to a cyclical return to profitability for companies. Moreover, the cycle of monetary-policy easing that we expect to start this year should boost demand, even if the impact on activity only starts to become apparent from the middle of next year.

We now forecast GDP to decline 3.2% this year (-3.5% previously), and to grow 2.0% in 2017 (1.0% before). 

Despite signs of improvement in the economy, the labor market continues to weaken. In July, payroll declined by 94 thousand. Job contraction was widespread, affecting 6 out of 7 sectors of economic activity. This is a natural outcome, given that employment normally lags behind in the economic cycle.

Unemployment rate remains high. According to the PNAD Contínua survey, the nationwide unemployment rate rose to 11.6% in July. Over the last 12 months, unemployment has risen an average of 0.25 pp every month. We believe that job losses will continue into the first half of next year. We forecast the unemployment rate to reach 12.5% at the end of this year. The faster economic recovery should cause unemployment to stabilize next year. We have revised our unemployment forecast to 12.2% at the end of 2017 (previously 13.0%).

The fiscal reform debate heats up. Will reforms be approved?

Fiscal results continue to fall. In July, the 12-month cumulative primary deficit reached 2.5% of GDP. Over the same period, the nominal deficit was 9.6% of GDP. As a result, gross debt remained high: it reached 69.5% of GDP in July, compared to 66% of GDP at the end of 2015 and 57% of GDP in 2014 (see graph).

We have reduced our primary-result forecast for 2016 ) to -2.6% of GDP (BRL 162 billion) from -2.5% (BRL 155 billion, matching the fiscal target. Our revision includes a BRL 9 billion (0.1% of GDP) reduction in extraordinary revenues from sovereign wealth fund withdrawals and IPOs for Caixa Seguridade and IRB (the reinsurance company), which are only likely to occur in 2017. This reduction more than offsets the BRL 2 billion increase in tax revenues related to the improvement of our GDP forecast for 2016.

As expected, the 2017 budget submitted to congress by the government’s economic team does not contemplate tax increases. To fulfill the 0.9% of GDP (BRL 55 billion) effort required to achieve the primary result target of 2.2% of GDP (BRL -143 billion), the budget assumes that 0.2% of GDP (BRL 14 billion) will come from the upward revision in its 2017 GDP forecast (from 1.2% to 1.6%), 0.6% of GDP (BRL 36 billion) from extraordinary revenues linked to asset sales and concessions, and 0.1% of GDP (BRL 5 billion) from cuts in discretionary spending.

We have maintained our forecast for a primary result of -2.2% of GDP in 2017 (BRL 143 billion), in line with the government target. 

The constitutional amendment proposing a cap on public-spending increases is in Congress. The proposed 2017 budget is already consistent with the bill, as the increase in total primary spending is lower than past inflation. If approved, the reform will represent a structural change for the Brazilian economy, as public spending has risen in real terms almost continuously over the past 20 years. Under the cap, if any expenditure (for example, on Social Security) rises in real terms, it will have to be offset by a reduction of other expenditures.

The social security reform is critical to ensure that the spending cap remains feasible in the years ahead and to improve the medium-term fiscal outlook. Social security expenditure represents 45% of the federal government’s total spending (8.5% of GDP) and will increase in real terms over the next several years. A social security reform that increases the minimum retirement age to 65 and delinks benefits from the minimum wage would mitigate the need to make significant cuts in other areas.

We believe that, if approved, these measures will improve debt dynamics over the medium term. However, even with these reforms, primary results will remain in negative territory for several years and public-debt stabilization will result from higher economic growth and lower interest rates.

Short-term pressure do not change disinflation outlook 

We have maintained our IPCA inflation projection for 2016 at 7.2%, with 7.6% increase in market prices (compared with 8.5% in 2015). Looking at the components in the market prices group, we estimate an increase of 11.9% for food at home (12.9% in 2015), 5.6% for industrial prices (6.2% in 2015) and 7.0% for services (8.1% in 2015). We forecast a 6.0% increase in regulated prices (compared with 18.1% in 2015). Two factors are upside risks for our IPCA forecast: i) more persistent food-price increases; ii) change in the electricity “flag” to yellow from green (a “yellow flag” would have an impact of around 0.10 pp on inflation).

We expect short-term pressure from food inflation to fade during the second half. We estimate a 2.8% increase in household food prices in the second half of the year, after rising 5.4% over the same period last year and 8.8% in the first half of this year. During this period, we expect to see a drop in prices of fresh fruit and vegetables, as well as beans and milk, which would give back a significant proportion of the increases seen in recent months (0.60 pp impact on the IPCA between June and July). In any event, we believe that a large part of these products’ price accommodation will only be seen next year, after supply conditions have fully normalized.

The fiscal policy also represents a risk for the inflation scenario. Future attempts to increase government revenues could lead to fresh tax increases and/or larger increases in regulated prices. However, favorable fiscal developments could improve the outlook for inflation, either through exchange rates and inflation expectations, or through a switch from the current expansionary to a neutral or even contractionary stance on fiscal policy.

The high level of idle capacity in the economy is also likely to help drive inflation down even further as we move ahead. The negative output-gap measurement could lead to faster market price disinflation in the second half of the year, particularly for industrial products and services.

In this scenario, we have maintained our forecast that IPCA inflation will fall to 4.8% next year. Next year’s drop in inflation will reflect the end of relative price adjustment (regulated prices and exchange rates), less inflationary inertia, lower inflation expectations, more favorable weather conditions and the impact from the high level of idle capacity. A more intense reversal of this year’s food-price shock is a downside risk for inflation next year.

Declining inflation expectations reinforce the scenario of falling inflation. According to the Focus survey, inflation expectations fell further last month. Median expectations for 2018 and further ahead are at the central bank’s target (4.5%), reflecting economic agents’ increasing conviction that the BCB will act to ensure that the IPCA will indeed converge to the target over time. Expectations for 2017 remain slightly above 5%, due to inflation inertia and fiscal uncertainty, but this figure could still fall as we move ahead.

On a disaggregated basis, we forecast a 4.7% rise in market prices and a 5.2% increase in regulated prices for 2017. Among market prices, we are forecasting a 4.0% increase for food at home as the exchange rate is expected to stabilize and weather conditions are likely to be more favorable. In this scenario, a considerable proportion of the price increases from certain products (such as milk and beans) are likely to be reversed over the coming year. We forecast a 5.5% increase in service prices and 4.0% increase in industrial prices.

The BRL remained stable as external and domestic factors offset each other

The exchange rate held steady at around 3.20 reais per dollar in August, with foreign and domestic factors offsetting one another. 

Currencies were driven by the Fed. Members of the Federal Open Market Committee (FOMC) indicated that U.S. interest rates could rise this year, following a recovery in activity and more favorable financial conditions. This signaling led the dollar to appreciate against emerging currencies, including the Brazilian real.

In Brazil, government efforts to push through reforms and adjustments continue to sustain the currency. 

We have maintained our exchange-rate forecast of reais 3.25 per dollar at the end of 2016 and reais 3.50 per dollar at the end of 2017. Even if U.S. interest rates rise this year, the differential between Brazilian and foreign interest rates will remain substantial. Domestically, greater consensus on fiscal reforms should also help keep the real at current levels.

Despite their significant improvement throughout 2015, external accounts are stabilizing. The current-account deficit is stabilizing at around USD 20 billion. Improved activity and, to a lesser extent, the recent currency appreciation have contributed to more modest current-account results in recent months. On the financing side, net foreign direct investment inflows were somewhat lower in July (compared with other months), resulting from one specific banking-sector transaction that is unlikely to be repeated in the coming months. Portfolio (fixed income and equities) flows reveal an inflow over the past two months, but remain negative for the year.

We have marginally reduced our trade balance forecast. We forecast a US$ 47 billion trade surplus in 2016 (previously US$ 50 billion) and US$ 42 billion surplus in 2017 (previously US$ 46 billion). We are forecasting a US$ 21 billion current account deficit in 2016 (previously US$ 18 billion) and US$ 33 billion deficit in 2017 (previously US$ 28 billion).

We believe that the current-account deficit will remain low over the coming years. 

Monetary Policy: Copom in data-dependent mode, we expect easing cycle to begin in October

The balance of inflation risks continues to improve. The weak labor market, stronger exchange rate, deflation in wholesale food inflation and conservative approach to monetary policy have reinforced the outlook for disinflation ahead. In this scenario, inflation expectations are converging to the target for 2017, and are already at the target for 2018 and beyond.

Focus on bringing inflation to the target in 2017 has prevented the central bank from cutting interest rates so far. At its August meeting, the Central Bank Monetary Policy Committee (Copom) once again held interest rates at 14.25%, the same level they have been since September 2015.

However, the Copom changed its communication in order to make future steps more data-dependent. Both in the post-meeting statement and in the minutes, the committee dropped the expression stating that “there is no room for monetary policy easing.” Instead, it listed several conditions that monetary easing would depend on: limited persistence of food-price shocks, an appropriate speed of disinflation in the IPCA components most sensitive to monetary policy and activity (i.e. services) and less uncertainty surrounding fiscal adjustment implementation and composition.

We believe the central bank’s change in its communication and our expectations for the economy in the short term are consistent with our scenario of an easing cycle starting in October. We forecast an initial 0.25 pp cut followed by a 0.50 pp cut in November, with the Selic benchmark rate ending the year at 13.50% p.a.

We expect the easing cycle to continue in 2017, bringing the Selic rate to 10.00%.


 

Please open the attached pdf to read the full report and forecasts.

 



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