Itaú BBA - Recession spreads, exchange rate pressures costs

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Recession spreads, exchange rate pressures costs

octubre 16, 2015

The Brazilian economy continues to weaken, and the recession has been spreading to more sectors and regions of the country.

With information through October 15, 2015

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 Brazilian economy continues to weaken, and the recession has been spreading to more sectors and regions of the country. Inventories remain high at factories and retailers.

Investment  
The political uncertainties, the prospect of a prolonged recession and the volatility of financial assets – especially the BRL – are inhibiting investment.

Labor Market, Production Costs and Prices    
Production costs – electricity prices, taxes, a more depreciated currency, fuel costs, nominal wages – remain under pressure, fueling the recession.

Real Estate  
The real estate adjustment continues. In the residential segment, the pace of sales remains slow, limited by low consumer confidence and more conservative credit conditions.

Commodities
The agricultural sector has been making a positive contribution to Brazilian economic growth this year. In the steel sector, the prolonged recession in the manufacturing industry has kept domestic sales low.

Our View         
Brazil’s economic slowdown reflects its fiscal and political difficulties. The domestic uncertainty remains high and is inhibiting investment. The decline in activity will probably be longer – and deeper – than we originally anticipated.


Summary

The Brazilian economy continues to weaken, and the recession has been spreading to more sectors and regions of the country. In most consumption segments, the second half of the year is looking worse than the first, with weaker demand, higher delinquency and higher costs pressured by the US dollar. The weaker exchange rate is encouraging retailers to look for more local suppliers, which is shifting demand to domestic production and partly offsetting the decline in total demand.

The political uncertainties, the prospect of a prolonged recession and the volatility of financial assets – especially the real– are inhibiting investment. High spare capacity in many sectors is reducing incentives to add capacity and to purchase machinery, equipment and trucks. The capital goods sector is still being affected by the drop in government purchases.

Production costs – electricity prices, taxes, a more depreciated currency, fuel costs, nominal wages – remain under pressure, fueling the recession. Weak demand limits the pass-through of costs to consumer prices. But some of these cost increases, especially those related to the depreciation of the real, will have to be transferred to consumers, even if that leads to a further drop in sales. On the employment side, companies in most sectors continue to downsize or are pursuing new collective bargaining agreements with unions.

The real estate adjustment continues. In the residential segment, the pace of sales remains slow, limited by low consumer confidence and more conservative credit conditions. In the commercial segment, the economic recession has led to a high level of vacancy, especially in office buildings. In general, there have been declines in prices and rents in both segments.

Among the commodity sectors, agriculture has been making a positive contribution to Brazilian economic growth this year. Volumes have been rising, and the exchange rate is boosting the sector’s profitability. For industrial commodities, however, the outlook is gloomy. In the steel sector, the prolonged recession in the manufacturing industry has kept domestic sales low. In mining, there is concern about the external scenario and the slowdown in China. In the oil sector, uncertainties remain high.

Our View: Brazil’s economic slowdown reflects its fiscal and political difficulties. Domestic uncertainty remains high and is inhibiting investment. The decline in activity will probably be longer – and deeper – than we originally anticipated. Leading and coincident indicators suggest that the recession is likely to extend at least until the end of this year. The worsening in financial markets in recent months – higher market interest rates, the drop in stock prices, higher FX volatility – contributes to the prolonged recession.

Consumption and Production of Goods and Services

The Brazilian economy continues to weaken, and the recession has been spreading to more sectors and regions of the country. In most consumption segments, the second half of the year is looking worse than the first, with weaker demand, higher delinquency and increased prices for inputs in US dollars. Inventories remain high at factories and retailers. With unemployment running high and the prospect of higher interest rates for an extended period, there are scant expectations for a recovery in demand in 2016.

Sales and production levels in durable goods sectors such as automobiles, motorcycles, home appliances and electronics continue to fall, despite the strong adjustments implemented until the first quarter. The cost of inputs, mostly imported, is squeezing margins. Companies have been trying to cope through mandatory vacations and new product releases, which provide some relief. But the scenario is clearly recessionary.

In semi- and non-durable goods segments such as clothing, office supplies, food and cleaning materials, the slowdown has been intensifying. Many segments that were still exhibiting relatively positive activity into the second half of the year began to falter in September and October. Rising political and economic uncertainty and the rapid currency depreciation seem to be making consumers even more cautious. Most of these sectors are also feeling the impact of rising prices for imported factors of production, especially chemicals (for packaging) and wheat (for pasta and biscuits).

Concerns about delinquency, mentioned in the last Orange Book, continue to grow. Requests by retailers for payment renegotiations with the industry have significantly increased. Segments that supply the public sector, such as medicine and books, have been especially affected. This trend has intensified concerns about liquidity in the economy, particularly given the current level of interest rates.

Delinquency is also a concern in the service sector. Schools, gyms, outsourced services (security, cleaning) have been reporting late payments and some evasion. Demand continues to slow, even in sectors that had been showing resilience, such as online services. Regarding costs, the exchange rate depreciation is affecting some sectors, but the largest cost increases are coming from wage negotiations (wage increases have been below inflation, but still high in nominal terms), transportation costs (due to the increase in diesel prices) and electricity prices (which could increase again in 2016).

The more depreciated real is encouraging retailers to look for more local suppliers, which is shifting demand to domestic production and partly offsetting the decline in total demand. Companies in segments such as food, construction (finishing) materials and textiles report that domestic production is cheaper than imported products, despite local cost increases. In retail, segments selling goods that compete with products typically acquired on trips abroad (clothing, accessories, electronics) are showing some improvement. Services that cater to tourists, such as hotels and car rental, have also benefited.

Exports have also started to react to the currency depreciation. There has been an uptick in food exports (beef, chicken, pork), and exports of manufactured goods, such as shoes and capital goods, have recovered somewhat. But export growth is still slow, especially for manufactured goods.

Investment

Business confidence remains stifled. Our indicator, which is drawn from a wide customer base, has remained relatively stable into the second half of the year, at levels close to historical lows. The indicator is about 30% below the level posted at the same time last year. Most surveyed sectors report that inventories remain high.

The political uncertainties, the prospect of a prolonged recession and the volatility of financial assets – especially the real – are inhibiting investment. High spare capacity in many sectors is reducing incentives to add capacity and to purchase machinery, equipment and trucks. The capital goods sector is still being affected by the drop in government purchases. Thus, domestic sales remain low, with no signs of stabilization. By contrast, the sector is already showing some recovery in exports.

On the infrastructure side, the challenge is amplified by the uncertainty swirling around the Lava Jato investigations and the drying-up of credit from BNDES. The federal government’s concession program and the entry of new firms are expected to stimulate activity in the sector, but only in the medium-to-long term. In the short term, the outlook continues to indicate contraction.

The exchange rate depreciation makes Brazil more competitive, which is likely to quicken the interest of companies (especially multinationals) in acquiring new assets in order to expand or diversify their businesses. But the prevailing mood is nonetheless cautious, given the short-term risks and the possibility of further currency depreciation.

Labor Market, Production Costs and Prices

Production costs – electricity prices, taxes, a more depreciated currency, fuel costs, nominal wages – remain under upward pressure, exacerbating the poor prospects for economic growth. Weak demand limits the pass-through of costs to consumer prices. But some of these cost increases, especially those related to the depreciation of the real, will have to be transferred to consumers, even if that leads to a further drop in sales.

In addition to FX pass-through, another pressure on costs and consumer inflation is coming from electricity prices. Our base-case scenario is for an increase of 10% in electricity prices in 2016. But some industry experts are forecasting larger hikes of up to 30%.

The difficulty of absorbing costs continues to intensify along the production chains. Over time, this kind of strain typically leads to higher efficiency, paving the way for future growth. But for now, the margin squeeze is increasing the overall stress in the economy, contributing to the drop in business confidence.

On the employment side, companies in most sectors continue to downsize or are pursuing new collective bargaining agreements with unions. The process is gradual, though not necessarily slow. Salary increases are reported to have been close to zero or negative in real terms. But because inflation has been high, the nominal increases are significant.

Real Estate

The real estate adjustment continues. In the residential segment, the pace of sales remains slow, limited by low consumer confidence and more conservative credit conditions. The number of launches continues to decline, but inventories remain high. Prices have been falling for newly launched as well as existing properties, which is boosting demand, but still not enough to revitalize sales.

In the commercial segment, vacancy levels are high, especially for office buildings. With high interest rates and declining economic activity, investors have lost their appetite for the sector. Prices and rents continue to retreat, which is creating pressure – and opportunities – for companies to reduce costs.

In the shopping-mall segment, traffic continues to weaken in line with the general decline in retail sales. Tenants’ cost management has become more complex, and spare capacity continues to increase. Only the more mature shopping malls are still busy. Malls that target high-income consumers have been the most robust performers, as they are benefiting from the redirecting of demand triggered by the depreciated currency.

Commodities 

The agricultural sector has been making a positive contribution to Brazilian economic growth this year. Volumes have increased compared with last year, and profitability has improved because (dollarized) inputs were purchased at former exchange rates while sales are being made at the current exchange rate. The highlight in this sector is cellulose, for which international demand is still heated and international prices are on the rise.

Looking ahead, however, we see risks. The availability of credit has declined, limiting investment capacity and hampering cash management in more highly leveraged segments, such as sugar and ethanol. In grains, global carryover inventories are high, which could depress prices ahead. In the next harvest, costs will be under more pressure from the exchange rate. In any case, stable or declining international prices and a depreciated BRL are favorable to the sector.

In the steel sector, the prolonged recession in the manufacturing industry has kept domestic sales low. The depreciation of the BRL has increased the sector’s external competitiveness but is also affecting cash management, as steel companies have US dollar-denominated debts. In mining, there is concern about the external scenario. Emerging-market economies, especially China’s, have continued to weaken, worsening the outlook for prices and volumes.

In the oil sector, uncertainties remain high. Low prices and the sector’s high indebtedness continue to affect the supply chain and limit the flow of investment. The possibility of public asset sales continues to draw companies’ attention. Expectations of a better regulatory environment for private investments may also revive the sector.

Our View

Brazil’s economic slowdown reflects its fiscal and political difficulties. The uncertainty around the domestic scenario remains high and is inhibiting investment. The decline in activity will probably be longer – and deeper – than we originally anticipated. Past and present indicators suggest that the recession is likely to extend at least until the end of this year. The worsening of financial markets in recent months – higher market interest rates, the drop in stock prices, increased exchange-rate volatility – contributes to the prolonged recession.

In September, our diffusion index – which tracks the number of indicators with positive variations, based on a broad set of data, including business and consumer confidence, retail sales and credit demand – will likely end the month at a level compatible with a 4% (annualized) activity decline. The diffusion index is a leading indicator and suggests that the current scenario will persist over the coming months.

With a prolonged recession, the unemployment rate will likely continue to rise, holding down consumption ahead.


 



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