Brazil: no changes to our forecasts, but a more neutral balance of risks

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1 February 9, 2018 Brazil: no changes to our forecasts, but a more neutral balance of risks o The latest data has been in line with our scenario for the Brazilian economy, but new developments affect the balance of risks. The latest data point to stronger global growth combined with relatively subdued inflation, which remains at comfortable levels. This backdrop remains favorable for emerging economies, as global growth has translated into faster trade growth and higher commodity prices. In our view, this favorable backdrop for EMs outweighs the effect of rising risk aversion related to concerns about faster monetary policy normalization. o On the whole, recent economic data reinforce perceptions that the recovery of the Brazilian economy is gaining momentum. While this economic recovery seems consistent, we have some doubts regarding its intensity. o The scenario of economic recovery without wage pressures, low inflation inertia, anchored expectations and a relatively stable exchange-rate is consistent with our forecast for IPCA consumer inflation of 3.9% in 2018 and that the Central Bank will keep monetary policy on hold with the Selic rate at 6.75% through the end of the year. Even with this benign inflation scenario, we must recognize that the risk balance is more level, with a recent rise in the prices of industrial goods. Global economic outlook remains solid and favorable for emerging economies despite the market s recent correction o Global asset prices underwent a significant correction last week, especially in equity markets. This comes on the heels of a series of developments that raised concerns regarding the pace and intensity of the normalization of U.S. monetary policy. The change in the forecast for US monetary policy normalization backed questions as to whether some asset prices are excessively high. o Despite last week s market movement, we maintain the perception that the fundamentals of the global economy remain solid, with returning investments and increasing commodities prices. Growth remains strong and dissipated among the countries, with a favorable composition driven by investment spending. o This scenario should generate momentum for commodities exports, especially in emerging countries. This supports our perception that this positive growth cycle may last, becoming even more widespread and consistent. In addition, this favorable dynamic for emerging economies reduces the risk of strong exchange rate depreciation during the tightening of monetary conditions in the central economies, even more so since these countries underwent balance of payments adjustments in recent years. o All in all, we believe that last week s market action does not point to a change in the scenario, but rather a correction of prices for some markets. Thus, we assess that the global scenario will likely remain favorable, with strong growth across economies, which is especially favorable for countries exporting commodities, mitigating some of the risk aversion that may originate from higher interest rates. Macroeconomic Research Department 1

2 Brazil: no changes to our forecasts, but a more neutral balance of risks The latest data has been in line with our scenario for the Brazilian economy, but new developments affect the balance of risks. There are indications that global growth accelerated, increasing inflationary tensions (even if headline inflation remains at a comfortable level). This backdrop has continued to favor emerging economies, particularly through higher commodity prices especially metals which have favored EM terms of trade. However, the risk of a more volatile scenario increased due to surprises with inflation or global interest rates (more details in the next section). Higher global risk aversion is relevant for the domestic outlook, but for now, we believe that the external backdrop remains supportive for the Brazilian economy, particularly for CDS and the BRL. The dominant external drivers for the Brazilian economy remain the improvement of terms of trade and stronger external demand rather than greater risk aversion and higher international interest rates. Strong global growth boosted Brazilian exports, which combined with a still timid recovery in imports, resulted in a ballooning trade balance. Despite some BRL depreciation, capital account inflows have continued to outpace the current account deficit. In addition to an adjusted balance of payments scenario, the fiscal scenario, even if driven by extraordinary revenues, showed better short-term figures and should not raise concerns in the coming months. Along the same lines, country risk spreads remain low and have favored primary issuance by several companies. As such, we believe that global and Brazilian fundamentals justify our forecast for the BRL at 3.20/USD at the end of 2018 and 3.30/USD at the end of The risks for these projections continue to come from a more intense reversal of the external environment and uncertainties on the continuity of the country s reform agenda. Recent data continued to point to a gradual but consistent recovery of the economy. In particular, industrial production expanded by 1.9% in the fourth quarter, with growth in almost all categories. Durable goods were the main highlight, but evidence that fixed asset investment is rebounding also called our attention. The services, construction and trade sectors also reported higher than expected growth. Chart producao 1 Industrial industrialproduction Seasonally adjusted, Jan/13 = ,0 100,0 90,0 80,0 70,0 Building materials Non-durable Intermediate Durable 60,0 50,0 Capital Goods Source: IBGE Macroeconomic Research Department 2

3 Labor market conditions continued to improve at the end of last year. Recovery occurred in the generation of formal vacancies and the unemployment rate continued to fall. We expect the generation of formal employment to gain traction in the coming months, compared to informal, which stood out in It is worth noting that wage pressures have not been accompanying this improvement, benefiting the maintenance of inflation at contained levels. This wage containment is a symptom of a high degree of idleness in some sectors of the economy. With respect to the credit market, we continued to observe a heterogeneous movement among the portfolios, but lending to firms starting to accelerate. For most of 2017, lending growth to firms was weaker than we had anticipated in light of the recovery of the economy and lower interest rates. The latest data suggests that corporate lending is beginning to gain traction and reinforces our view that the recovery process, although gradual, will continue this year. In our view, the credit market will contribute positively towards the recovery of the economy, as it is an important transmission channel between the interest rate cuts in recent months and consumption and investments. In addition, measures of non-performing loans in the market continued to improve, which is an additional factor supporting future credit growth. Our forecast for GDP growth in 2018 remains unchanged at 2.8%. We acknowledge that the economic recovery is consistent, but doubts remain as to its intensity. While we expect a more effective transmission of credit to final demand, there will be no stimulus in 2018 resulting from the release of FGTS funds, and real income growth will be more modest with inflation stabilizing. The first indications for 2018 suggest some accommodation of the economy in January. New data will be disclosed in the next several weeks that may help dispel whether Crescimento growth anual is indeed do PIB, em losing % momentum. For now, we maintain our growth forecast unchanged. Chart 2 Annual GDP growth In % Source: IBGE, Bradesco Economic recovery scenario without wage pressure, low inflation inertia, anchored expectations and a contained exchange rate are reflected in our forecast of IPCA consumer inflation of 3.9% in Data for the beginning of 2018 will likely confirm this benign inflation outlook. Measures of core inflation will likely decelerate during the first quarter. Part of this movement is associated with the modest increase in the minimum wage, which has a direct impact on items in the IPCA sample with a weight of 5.8%. However, core inflation is slowing even if we exclude the direct effects of the minimum wage. As such, inflation will most likely remain below the center of the Central Bank s target, given the gradual growth return, the persistence of low levels of installed capacity utilization and comfortable external accounts. Macroeconomic Research Department 3

4 Even with this benign inflation scenario, the balance of risks is moving back to neutral. On the positive side, a successful grains harvest and lower risk of a La Niña weather phenomenon lowers the risks of pressure on food inflation. Along the same lines, improved rainfall forecasts points to less risk for electricity prices, although the medium-term outlook still requires attention. Meanwhile, petroleum is still a focus of attention, since even with some short-term accommodation in prices, geopolitical concerns can affect commodity prices and, consequently, gasoline prices. Core industrial wholesale inflation has accelerated faster than expected considering the current phase of the economic cycle. If we consider the historical transmission of these wholesale prices to industrial good consumer prices in the IPCA, there appears to be a risk of a surprise of about 20bps in headline inflation relative to our baseline forecast. Although low levels of installed capacity utilization may limit pressure on final consumer prices, this factor draws attention in case overall growth surprises to the upside. In this case, we could observe some restoration movement for retail margins, which have been compressed by the pressure in the industrial prices without the respective transfer to the consumer. Chart 3 IPCA of industrial goods Effective and suggested by the core of the lagging industrial IPA 9% 8% 7% 6% 5% Goods Goods (suggested by the IPA nuclei) 4% 3% 2% 1% 0% Effect of output gap % 2.37% Source: IBGE Still, it is worth noting that the risks we are discussing are mostly supply shocks, that is, they are not related to the degree of monetary stimulus in the economy, with the obvious exception of a positive surprise in growth. In light of the persistence of low levels of capacity utilization, negative shocks (with price increases) tend to have limited side effects, ultimately reassuring us of a benign inflation scenario for 2018 and a low risk of abrupt or intense interest rate reversal. The January IPCA data (+ 0.29%) confirms this benign vision, with a full index accumulating only 2.85% in 12 months and core and service prices at very comfortable levels. In light of the above, we maintain our forecast that the Central Bank will keep rates on hold at 6.75% through the end of With a gradual recovery of economic activity and a benign inflation scenario, we believe rates will remain below their neutral level throughout this year despite the balance of risks having reverted back to a more neutral stance on the back of more volatility in asset prices caused by fluctuations in the external environment and domestic uncertainty. The Central Bank signaled that keeping the rates on hold through the end of the year is the most likely scenario, with a small chance of an additional rate cut if the balance of risks evolves favorably over the next 45 days. Macroeconomic Research Department 4

5 Finally, a point of improvement in the short-term risk balance is associated with public finances, despite the medium-term challenges. Non-recurring (and even recurring) revenues supported an improvement in the fiscal numbers in recent months. As a result, the primary fiscal deficit of the consolidated public sector ended 2017 significantly below the target and consequently, gross public debt at the end of 2017 was lower than expected. This improvement in Brazil s fiscal performance could repeat itself in If on one hand, spending growth is already at the celling of the new spending growth rule, revenues could outperform expectations if the government reaches a deal with Petrobras regarding the onerous assignment of oil (in practice, the government sells oil reserves to the oil company), which is starting to look increasingly likely. This could add about BRL 60bn to public coffers, ensuring that the 2018 target is met. Despite the improvement in the short-term fiscal outlook, the medium-term challenges remain unchanged. Meeting the spending growth cap will remain difficult in the absence of reforms that address medium and long-term fiscal trends. Macroeconomic Research Department 5

6 Indonesia Denmark Malaysia Egypt Brazil Norway Finland Portugal Canada Poland Ireland Nasdaq South Africa United Kingdom Bradesco World Index India Russia Australia Mexico Switzerland Sweden S&P 500 Turkey Italy Germany Dow Jones Ind Average Belgium France Austria Netherlands South Korea Europe 50 Hong Kong Taiwan Spain Greece China Japan Argentina Economic Outlook Global economic outlook remains solid and favorable for emerging economies despite the market s recent correction Global asset prices underwent a significant correction last week, especially in equity markets. This comes on the heels of a series of developments that raised concerns regarding the pace and intensity of the normalization of U.S. monetary policy. The change in the forecast for US monetary policy normalization backed questions as to whether asset prices, especially in stock markets, are too high. The shift in the FOMC s communication at the January 31 meeting was decisive for this environment. In the statement issued shortly after the meeting, in addition to the committee signaling that it should raise interest once again during the March meeting, as was widely expected by analysts, it also pointed out that economic conditions require gradual additional interest rate increases, suggesting that Fed officials estimate a more intense increase cycle than previously estimated. A second factor was the surprising increase in US wages, reflecting a very tight labor market. Finally, the interview with Janet Yellen shortly after her last meeting as Fed chairperson, in which she mentioned that asset prices may be at a high level, contributed to the shift. Chart 1 Major stock market changes Feb 1 until the latest data available, in local currency 2% 0% -0.1% -2% -4% -6% -8% -10% -12% -2.3% Last update 02/14/2018 semana -3.2% -3.5% -3.7% -4.4% -4.7% -5.6% -6.5% -7.2% -9.4% Source: Bloomberg, Bradesco Despite last week s market movement, we maintain the perception that the fundamentals of the global economy remain solid, with returning investments and increasing commodities prices. Growth remains strong and dissipated among countries, with a very favorable composition driven by investment spending. The recovery of investment follows a long period of very low levels of installed capacity utilization and low productivity growth worldwide. Initial January data indicates growth nearing 5.0% in global GDP in the first quarter, a rate that has not been seen for many years. Another factor that reinforces the perception that the world grows on solid bases is the appreciation of commodities, especially metals and oil. This more widespread increase in the last two months is associated, for the most part, with additional warming of global demand. Although some geopolitical tensions persist with respect to oil, influencing its price behavior, the upward trend driven by demand seems consistent. Therefore, a more intense normalization of interest rates in the world will be the product of greater global growth and risk aversion tends to be limited in this environment. Macroeconomic Research Department 6

7 Singapore Taiwan South Korea Thailand Czech Republic Israel China India Turkey Hungary Philippines Switzerland Poland Romania Mexico Indonesia Brazil South Africa Malaysia Canada Peru Colombia Australia New Zealand Chile Russia Economic Outlook The favorable scenario for global growth and commodities prices, especially metals, works as a major driver for some exporting countries, notably emerging countries. This contagion reinforces our perception that the positive growth cycle may last, since it should become even more widespread and consistent. In addition, this favorable dynamic for emerging economies reduces the risk of strong exchange rate depreciation during the tightening of monetary conditions in the central economies, even more so since these countries underwent significant balance of payments adjustments in recent years. Chart 2 shows some of the economies most benefited by the scenario of higher commodities prices. Chart 2 Net commodities exports In % of the GDP 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% Agriculture Ores Total Energy Iron and Steel Source: Bloomberg, Bradesco The strong growth scenario was accompanied by very low inflation, however recent data shows a gradual acceleration of the nuclei. In light of this situation, the world s main central banks have been raising the tone of their communication, signaling that monetary conditions should tighten. In the US, as we mentioned before, the FED signaled that in addition to the March increase, current conditions require additional gradual increases, consistent with our scenario of four interest rate increases throughout In line with this scenario, the European Central Bank (ECB) raised the tone of its communication, reinforcing our perception that it will likely terminate the asset purchase program in September. In this regard, interest rates in Europe may be the most affected by a perception of global inflation acceleration given their still very low levels. Finally, in the United Kingdom, the Título Bank do Gráfico of England also signaled that it will continue with a gradual upward trend for the interest rate. Chart 3 Accumulated inflation over 12 months 6% 5% 4% USA United Kingdom Euro Zone Japan 3% 2% 1% 0% -1% -2% -3% Source: Bloomberg, Bradesco Macroeconomic Research Department 7

8 All in all, we believe that last week s market action does not point to a change in the scenario, but rather a correction of prices for some markets. Thus, we assess that the global scenario will likely remain favorable, with strong growth across economies, which is especially favorable for countries exporting commodities, mitigating some of the risk aversion that may originate from higher interest rates. Furthermore, we believe that the normalization of monetary conditions should maintain a gradual trend throughout 2018, but in an environment of increasing inflationary pressure, with greater volatility in asset prices. Macroeconomic Research Department 8

9 Economic forecast ( ) * 2018* 2019* DOMESTIC ACTIVITY, INFLATION AND INTEREST RATES GDP (%) Agriculture (%) Industry (%) Services (%) Private consumption (%) Government consumption (%) Investment (%) Exports of goods and services (%) Imports of goods and services (%) GDP (R$ billion - current prices) 6,000 6,267 6,599 7,132 7,746 GDP (US$ billion) 1,801 1,796 2,067 2,218 2,380 Population (million) Per Capita GDP (US$ - current prices) 8,808 8,713 9,955 10,604 11,300 Industrial Production - IBGE (%) Unemployment Rate - IBGE (%) Retail Sales - (%) CPI - IPCA - IBGE (%) WPI - IGP-M - FGV (%) Nominal Interest Rates - Selic target (end of period - %) Nominal Interest Rates - Selic target (12-month - %) Real Interest Rates - Selic (12-month - %) EXTERNAL ACCOUNTS AND FX Trade Balance (US$ billion) Exports (US$ billion) Imports (US$ billion) Trade flow (exports + imports) (% of GDP) Current Account Deficit (US$ billions) Current Account Deficit (% of GDP) Foreign Direct Investment (US$ billions) FX - end of period (R$ / US$) FX - yearly average (R$ / US$) International Reserves (US$ billion) Total Medium and Long term External Debt (US$ billion) Moody's sovereign credit rating Baa3 Ba2 Ba2 - - S&P sovereign credit rating BB+ BB BB - - FISCAL ACCOUNTS Primary Surplus (R$ billions) Primary Surplus (% of GDP) Gross Public Debt (domestic and external) (% of GDP) Net Public Debt (domestic and external) (% of GDP) (*) Forecast Source: IMF, Bradesco Macroeconomic Research Department 9

10 International indicators ( ) * 2018* 2019* GDP World Developed markets United States Euro Area United Kingdom Japan Emerging markets China Latin America US INTEREST RATE AND CPI Fed Funds (%) CPI (%) International indicators Latin America( ) * 2018* 2019* Argentina GDP (%) CPI (%) Interest rate (%) ARS/US$ (end of period) Brazil GDP (%) CPI (%) Interest rate (%) BRL/US$ (end of period) Chile GDP (%) CPI (%) Interest rate (%) CLP/US$ (end of period) Colombia GDP (%) CPI (%) Interest rate (%) COP/US$ (end of period) 3,174 3,001 2,984 3,080 3,100 Mexico GDP (%) CPI (%) Interest rate (%) MXN/US$ (end of period) Peru GDP (%) CPI (%) Interest rate (%) PEN/US$ (end of period) (*) Forecast Source: IMF, Bradesco Macroeconomic Research Department 10

11 Technical Staff Director of Economic Research and Studies Fernando Honorato Barbosa Economists Ana Maria Bonomi Barufi / Andréa Bastos Damico / Constantin Jancso / Daniela Cunha de Lima / Ellen Regina Steter / Estevão Augusto Oller Scripilliti / Fabiana D Atri / Igor Velecico / Leandro Câmara Negrão /Myriã Tatiany Neves Bast / Priscila Pacheco Trigo / Regina Helena Couto Silva / Robson Rodrigues Pereira / Thomas Henrique Schreurs Pires Interns Alexandre Stiubiener Himmestein / Camila Medeiros Tanomaru / Felipe Yamamoto Ricardo da Silva / Rafael Martins Murrer / Thaís Rodrigues da Silva economiaemdia.com.br DEPEC BRADESCO is not responsible for any acts/decisions taken on the basis of the information available through its publications and projections. All data or opinions contained in the information herein is carefully checked and prepared by fully qualified professionals, but should not be taken, under any circumstances, as a basis, support, guidance or standard for any document, assessment, judgment or decision-making, of a formal or informal nature. Thus, we emphasize that all consequences and responsibility for the use of any data or analysis of this publication are assumed solely by the user, exempting BRADESCO from all actions resulting from the use of this material. We also point out that access to this information implies acceptance of this term of responsibility and usage. The total or partial reproduction of this publication is strictly prohibited, except with authorization from Banco BRADESCO or full citation of the source (naming of the authors, the publication and Banco BRADESCO). Macroeconomic Research Department 11