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1 LatAm Macro Monthly Scenario Review October 2014 Global Economy Stronger U.S. dollar, now relative to emerging markets 3 Perspective of higher interest rates in the US, falling commodity prices, concerns with growth in China and weak domestic growth fundamentals add to the downward pressures on emerging market asset prices. Brazil Voting time 7 Elections are on next Sunday. In the economy, the Copom signaled stable rates ahead, but we see an upward bias if the weakening trend in the real is sustained, even amid a low growth environment. Mexico Exports and private internal demand take off; public sector lags behind 13 Exports are leading growth and private internal demand is gradually recovering. However, public consumption and public investment are yet to help the economy. Chile One final cut to come 16 Activity indicators for August remained weak. We expect the central bank to reduce the policy rate by 25 bps in October, ending the easing cycle. Peru Spot intervention makes a comeback 19 We expect the exchange rate to reach 2.9 and 3.0 soles per dollar for year-end 2014 and 2015, respectively, with intervention continuing to curb the depreciation of the sol. Colombia Less solid 22 Activity decelerated in 2Q14 and indicators disappointed in July. We reduced our growth forecast for 2014 and The central bank left the policy rate at 4.5% in its September meeting, we expect no further rate hikes this year. Argentina A new change at the central bank 25 We expect a substantial depreciation of the official exchange-rate this year, to 11 pesos to the dollar, and higher interest rates. Commodities Not fully reversing the decline 28 We revised downward our forecasts for prices of major commodities, seeing this year's drop as consistent with fundamentals (supply - side, strong dollar and slightly lower global growth). Page Macro Research Itaú Ilan Goldfajn Chief Economist Tel: macroeconomia@itaubba-economia.com Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

2 Elections in Brazil amid global appreciation of the dollar October has arrived, and with it the run-up to elections in Brazil. Next Sunday, October 5, Brazilians will vote for president, governor, senators and federal and state legislators. This will be the seventh direct presidential election since the country s democratization in In the global economy, the dollar gains strength. The outlook for the U.S. economy is positive, and the Fed is on track to raise interest rates in Meanwhile, monetary policy is more expansionary in Europe and Japan. A stronger dollar, declining commodity prices and EM slowdown have exerted pressure on currencies of emerging economies. In Latin America, a region with a high concentration of commodity exports, this adverse environment is being felt more clearly. Growth has been disappointing, and exchange rates have depreciated relatively quickly since August. In September we reduced our growth forecasts for Brazil, Peru and Chile; this month we reduced our growth forecast for Colombia, The FX depreciation may also affect monetary policy decisions in some of the region s countries. In Brazil, for example, we continue to forecast flat interest rates until 2015; however, if the recent depreciation trend is sustained, the central bank may raise interest rates again, despite the low-growth environment. In Argentina, the exchange rate depreciation in the parallel market, as the official rate is fixed has been pushed by domestic issues. The recession has deepened, and inflation is accelerating. Monetary policy has become more expansionary, and FX controls remain tight. We forecast the official exchange rate reaching 11 pesos to the dollar by the end of this year, which would represent a depreciation of about 30% from current levels. Hope you enjoy, Ilan Goldfajn and Macro Team Scenario Review World Latin America and Caribbean Current Previous Current Previous Current Previous Current Previous GDP - % GDP - % Brazil Mexico Current Previous Current Previous Current Previous Current Previous GDP - % GDP - % BRL / USD eop MXN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % IPCA - % CPI - % Argentina Chile Current Previous Current Previous Current Previous Current Previous GDP - % GDP - % ARS / USD eop CLP / USD eop BADLAR - eop - % Monetary Policy Rate - eop - % CPI - % (Private Estimates) CPI - % Colombia Peru Current Previous Current Previous Current Previous Current Previous GDP - % GDP - % COP / USD eop PEN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % CPI - % CPI - % Page 2

3 Global Economy Stronger U.S. dollar, now relative to emerging markets The U.S. Fed is on track to raise interest rates in June 2015, as the economic outlook remains consistent with a decline in unemployment and a gradual rise in inflation. With a better economic outlook in the U.S. than Europe and Japan, the U.S. dollar gained ground against major currencies. Emerging markets are also feeling the pressure from the strong U.S. dollar. Weak growth fundamentals, falling commodity prices and renewed concerns about growth in China are adding to the downward pressures on emerging market asset prices. The U.S. Fed is on track to raise interest rates in June The U.S. economy is sustaining a cyclical 3.0% growth rate and the unemployment rate is declining. As inflation gradually rises, we believe that the FOMC will reach a consensus to start hiking rates in mid Meanwhile, given the weaker outlook for their economies, the European Central Bank (ECB) and the Bank of Japan (BoJ) are easing their monetary stance. The former is seeking to move from a passive to an active approach to the management of its balance sheet. The latter is already purchasing large amounts of assets through a program that is likely to be extended at least into Given these divergent economic and monetary policy outlooks, the U.S. dollar is appreciating against major currencies. The U.S. currency has gained 3% since July, as measured by Trade Weighted Index (TWI). We expect it to strengthen further, by a similar amount, between now and the end of Emerging markets currencies are also losing value against the dollar. Together with the prospects of rate hikes in the U.S., weak fundamentals, falling commodity prices and renewed concerns with growth in China are also putting pressure on asset prices in emerging markets. U.S. Fed on track to raise interest rates in June 2015 Economic indicators in the U.S. remain in line with a healthy 3.0% growth pace. U.S. GDP growth for 2Q14 was revised upward to 4.6% qoq/saar (seasonally adjusted annual rate) from 4.2%. Our real GDP tracking indicates that 3Q14 growth remained close to 3.0%. The stronger economic outlook for the U.S., relative to its trading partners, has boosted the U.S. dollar TWI by 3% since July. We expect the dollar to strengthen by another 2% by the end of The impact of the stronger dollar on the U.S. economy looks small so far. We shaved off only 0.1 pp from our GDP forecast in 2015 due to the stronger currency. The impact on core inflation (excluding commodities) looks negligible at this point. We are leaving our 2014 GDP growth forecast at 2.2%, but we are reducing our 2015 GDP forecast to 3.0% from 3.1%. The labor market continues to improve. We forecast that non-farm payroll will continue to expand by an average of 200,000 jobs per month and that the unemployment rate will decline to 5.95% and 5.25% in December 2014 and December 2015, respectively, from the present 6.1%. We foresee a pick-up in the core inflation measures after two months of subdued numbers. The core PCE deflator, the Fed s preferred measure, of inflation, increased by 0.08% MoM in August and by 0.10% in July. Both figures represent a deceleration from the average 0.14% monthly change seen in 1H14. We believe that this is a temporary slowdown reflecting volatility in monthly figures and indirect effects of the commodity price declines June. Nonetheless, we have lowered our year-end 2014 forecast for the core PCE deflator to 1.5% YoY from 1.7% YoY. Looking ahead, we continue to expect a gradual increase in the core PCE deflator to 1.8% YoY by December The gradually tighter labor market and well-anchored inflation expectations should continue to push inflation towards 2%. With the improvement in the labor market and a gradual increase in inflation, we see the Fed as on track to raise rates in June At its September Page 3

4 meeting, the FOMC reaffirmed its conviction that the Fed funds rates should be kept at their current levels for a considerable time. However, FOMC participants increased their estimates for the Fed fund rates at the end of 2015 and The new forecasts are consistent with a start of the hiking cycle in June 2015, reinforcing our confidence in this rate hike scenario. We see the risks tilted toward an earlier, rather than later, start of the hiking cycle. The main risk for the U.S. economy in the current scenario still is, in our view, the possibility that the labor market improves faster than expected over the next six months. At the same time, it is true that, with the core PCE deflator below the 2% inflation target and only moderate wage increases, the FOMC is likely to raise rates slowly. Hence, after a first hike in June 2015, we believe that the Fed will raise rates at every other meeting for the rest of In 2016, over the course of which we expect inflation to gain momentum, the pace of rate hikes will likely accelerate to every meeting. Finally, the FOMC will likely withdraw its guidance that interest rates will remain at the current level for a considerable time only when we are closer to the first hike, in order to avoid a premature tightening of financial conditions. If the economic outlook is broadly confirmed, we expect the FOMC to revise its forward guidance at its December meeting. We left our year-end forecasts for the 10-year U.S. Treasury yield unchanged, at 2.70% for 2014 and 3.25% for Europe ECB is fully committed to lifting inflation expectations The ECB didn t announce new policies in its October meeting, after having significantly eased its monetary policy in September. The central bank cut all its policy rates by 0.1% in September, leaving the deposit rate at -0.2% and the policy rate at 0.05%. Additionally, the central bank will start purchasing covered bonds in October and asset-backed securities at some point in 4Q14. No specific size of purchase was released, but ECB president Mario Draghi has indicated that the measures could expand the ECB balance by EUR 1 trillion in two years. These measures come in addition to the program of offering banks four-year low-cost loans (known as TLTROs), which started with a first auction in September; future auctions are scheduled for December and for The central bank s aim is to boost current inflation, which reached 0.3% YoY in September, even as long-term inflation expectations dropped below 2%. The euro zone s economic recovery lost momentum in 1H14, and the current data point to feeble activity in 2H14. In an environment of already low inflation, weak activity prompted market-implied long-term inflation expectations to drop dangerously below 2%, the ECB s nominal target. Will these measures succeed in raising inflation expectations? In our baseline scenario and the ECB s, the answer is yes, but risks remain tilted to the downside. The current policies have eased credit conditions and depreciated the euro. Both measures are helpful for the inflation problem. But overall weak aggregate demand, ongoing relative price adjustments in the peripheral European economies and falling commodity prices are all still putting downward pressure on prices. Importantly, the ECB has a clear commitment do more, if needed, to lift inflation expectations, which implies the possibility of a government bondbased QE program. Overall, the central bank is moving toward more proactive management of its balance sheet. If current policies are not enough, it could start purchasing other assets, including government bonds, to achieve its goal of balancesheet expansion. This is not our baseline scenario. But there remain substantial odds that the central bank might need to go into this direction. This situation is keeping euro zone interest rates down and supporting the depreciation of the euro. We expect the dollar/euro exchange rate to close 2014 at 1.27 and to drop to 1.22 in We are leaving our growth forecasts unchanged, at 0.8% for 2014 and 1.1% for Our forecast of stillfeeble economic activity in 2H14, following a weak 1H14, appears to be materializing. China Stronger-than-expected slowdown prompts more targeted stimuli China s activity decelerated in August. Industrial production was up 6.9% YoY, well below the market consensus estimate of 8.8% and the 9.0% figure posted in July. Fixed asset investment growth slowed to 13.3% from 15.6%. The weak figures are not a signal of hard landing. Some indicators, like the PMIs and retail trade, suggest a smoother slowdown. And some of the deceleration in industrial production was due to a Page 4

5 smaller number of working days this August compared with August of last year. Moreover, external demand remains favorable: new export orders stand above their 2013 average, and export volume is up almost 10% this year through August, compared with the same period of last year. Finally, the government seems comfortable with a moderate slowdown. We note that investment in government-controlled sectors and general government expenditures have decelerated over the last three months. Moreover, credit growth continues to slow. Nonetheless, the slowdown was sharper than expected and highlights the downside risks to growth in China. The several stimulus measures launched in 2Q14 had an even shorter life than we anticipated. And the correction in the property sector continues. In response to the weaker data, the government has already launched some new stimulus measures. The PBoC opened relending quotas totaling RMB 500 billion (USD 81 billion) to the five largest commercial banks for three months. This is equivalent to a 0.50% cut in the required reserve ratio, if the provision is rolled over. The central bank also lowered the 14-day repo rate by 20 bps in its open market operations. More targeted stimulus is needed to maintain a gradual slowdown. Some of the additional liquidity created as a result of the government s stimulus measures will be offset by deposit withdrawals ahead of China s National Day holiday (October 1-7). Besides, the drag of the slowing property sector and declining infrastructure investment is proving to be powerful. We have lowered our GDP forecast for 2014 to 7.3% from 7.4%, and we maintain our 7.0% forecast for Emerging market currencies under pressure The U.S. dollar has appreciated by 5.6% against an equal-weighted basket of emerging market (EM) currencies since the beginning of July (see graph). The gain was widespread. It happened in all the three main regions (Asia: 2.0%, CEMEA: 8.5%, and Latin America: 7.4%), although to a lesser degree in Asia because China s yuan is also appreciating. The strong dollar is the main driver of the weak performance of EM currencies. The U.S. dollar appreciated by 7.6% against developed country currencies over the same period (see graph). This strong dollar movement then expanded to EM countries, starting mostly in August. Falling commodity prices are adding to the pressure on EM exchange rates. The Itaú Commodity Index has now registered a cumulative drop of 15.5% this year. This decline in prices is only partly explained by the strong dollar (see below), and hence is putting further pressure on EM currencies. Indeed, the U.S. dollar has climbed by 8.9% since July against currencies of countries that are dependent on commodities. Dollar appreciating Jan2000=1 Dollar against emerging currencies Dollar against developed currencies (rhs) Jan-14 Apr-14 Jul-14 Oct-14 Source: BEA, BLS, Itaú Finally, the poor growth outlook in EM is not helping. A weighted average of manufacturing Purchasing Managers Indices (PMIs) stabilized after declining in 1H14. But the current level of 50.8 is lackluster and points only to modest growth ahead. Commodities Not fully rebounding from the declines The Itaú Commodity Index (ICI) has declined by 7.8% since the end of August, with all sub-indices once again falling in the period. The ICI has now registered a cumulative 15.5% drop this year to date, after falling by 6.1% in The breakdown by component shows declines in all three sub-indices: agriculture (-18.7%), metals (-22.4%) and energy (- 10.0%). The decline this year is consistent with a combination of surprises in global supply, a stronger dollar and slightly weaker global growth. We estimate that supply surprises account for Page 5

6 approximately 50% of the drop. A superharvest in the U.S. affected agriculture prices. Iron ore prices are reaching new lows as high-cost iron ore mining operators refuse to shut down amid additions of lowcost supply. A strong rise in non-opec oil production is putting pressure on oil prices. The strong dollar is second in our list of causative factors, explaining 40% of the decline, according to our computations. Finally, the slightly weaker global growth explains the remaining 10% of the drop this year. Renewed concerns about growth in China also contributed to the fall of commodity prices in August. The drop seen over the latest two years will not be fully reversed in the near future; hence, we have lowered our price forecasts for almost all commodities. We have lowered our year-end 2015 ICI forecasts by 5.9 pp. Our forecast now implies only a modest increase of 6.0% between the end of September 2014 and the end of Forecasts: World Economy F 2015F GDP Growth World GDP growth - % USA - % Euro Area - % Japan - % China - % Interest rates and currencies Fed Funds - % USD/EUR - eop YEN/USD - eop DXY Index* - eop Source: Central Banks, IMF, Haver and Itaú. * The DXY is a leading benchmark for the international value of the U.S. dollar, measuring its performance against a basket of currencies that includes the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona. Page 6

7 Brazil Voting time Elections on October 5. Voters will choose the president, state governors, one-third of the Senate, plus federal and state representatives. Brazil has around 142 million voters; voting is mandatory for those aged 18 to 70, and optional for those aged 16 and 17, older than 70, and the illiterate. All ballots are cast using electronic devices. In order to be elected in the first round, the presidential or gubernatorial candidate must have more than 50% of valid votes (excluding blank and null votes). If this is not achieved, the two candidates with the most votes face each other in a second round, on October 26. We maintained our GDP growth forecast at 0.1% for For 3Q14, we estimate a stagnant GDP reading, due to the weak recovery in economic activity and the unfavorable statistical carryover. For 4Q14, we expect economic activity to normalize, prompting moderate growth in 2015 as well. We increased our forecast for the IPCA consumer price index this year to 6.4% from 6.3%, due to a 0.10 p.p. adjustment in our call for September (to 0.47% from 0.37%). Our estimate contemplates increases of 6.6% for market-set prices and 5.7% for regulated prices in For 2015, our forecast remains at 6.4%, with regulated prices expected to rise 7.0% and market-set prices set to advance 6.2%. The primary budget surplus remains on a downward trend. We reduced our forecasts for the conventional primary surplus to 0.9% of GDP from 1.1%, and for the recurring primary surplus to 0.3% of GDP from 0.4% in The central bank s Monetary Policy Committee (Copom) kept the Selic rate at 11% in its September meeting, and continued to signal stable rates ahead. We believe that the benchmark Selic rate will remain unchanged, but see an upward bias if the weakening trend in the exchange rate is sustained. A stronger U.S. dollar and lower commodity prices put pressure on most currencies in September, as already incorporated in our scenario. For now, we maintain our year-end forecasts for the exchange rate at 2.40 reais per dollar in 2014 (possibly weakening beyond that level) and 2.50 in Still-slow rebound in economic activity Recent data suggest a slow recovery in economic activity throughout 3Q14. Our diffusion index (based on a broad dataset including business and consumer confidence, retail sales and credit demand) showed increases for 60% of its components in July, and should remain close to this level in August. Despite a widespread recovery in activity since June, overall growth in indicators has been insufficient to reverse the declines seen that month. For instance, broad retail sales (including vehicles and construction material) rose only 0.8% in July, after sliding 3.45 in June. Industrial production still has not caught up to its level in May, despite two consecutive readings of 0.7% growth in July and August. After many years expanding faster than GDP, retail sales now weigh on the recovery. In July, core retail sales dropped 1.1%, disappointing our estimate and market consensus. Broad retail sales climbed 0.8% in July, not enough to rebound from a 3.4% slide in June. Both results imply a negative statistical carryover for 3Q14. Retail sales: a model reaching its limit? index sa 85 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Source: IBGE, Itaú Core Broad Economic fundamentals continue to point to weak activity ahead. Business and consumer confidence levels remain low. Confidence among executives in the manufacturing, service, retail and construction sectors declined in September. Meanwhile, consumer Page 7

8 2012.I 2012.II 2012.III 2012.IV 2013.I 2013.II 2013.III 2013.IV 2014.I 2014.II 2014.III 2014.IV 2015.I 2015.II 2015.III 2015.IV LatAm Macro Monthly October 2014 confidence increased slightly. Still, the trend seen in the past months is one of stability at a low level. Still-low business confidence levels Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Source: FGV, Itaú We maintain our forecast for GDP growth in 2014 at 0.1%. Recent data point to a gradual recovery in activity, but given the still-negative statistical carryover for several indicators, we continue to forecast stagnant growth in GDP in 3Q14. For 4Q14, we expect a more favorable statistical carryover. Combined with less uncertainty in the domestic scenario, this will contribute to a moderate reading of 0.5%. We thus forecast annual GDP growth of 0.1% in For 2015, we anticipate moderate growth of 1.3%, as some factors, such as investment, return to normal levels. GDP to recover moderately in % 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Actual Forecast Source: IBGE, Itaú Construction Industry Services Retail -0.2% 0.0% -0.6% index, sa Jul/10=100 QoQ S.A. 0.5% 0.4% 0.5% 0.4% 0.4% Unemployment rate rises 0.4% between April and August. For the first time since the April report, census bureau IBGE published information for all six metropolitan regions in the Monthly Employment Survey (PME). The unemployment rate increased moderately, to 5.0% in August from 4.6% in April, according to our seasonal adjustment. Despite the advance, the unemployment rate remains close to its lowest reading since The recent increase was produced by an expansion in the labor force and a slight decline in the working population. If the labor force resumes a faster growth pace, reversing the trend seen in recent months, weak economic activity should prompt a moderate advance in the unemployment rate in the next months. We thus maintain our year-end forecast for the seasonally adjusted unemployment rate at 5.4% (4.6% in the unadjusted series), slightly higher than in December 2013 (5.1% seasonally adjusted and 4.3% unadjusted). Inflexion point in unemployment Unemployment rate (%), sa 4 Aug-04 Aug-06 Aug-08 Aug-10 Aug-12 Aug-14 Source: IBGE, Itaú Hydropower generation set to improve as the rainy season begins in October, but risks for 2015 remain. Hydropower generation remained below its historical average in September. Even the intense usage of thermal power plants was not enough to prevent another decline in reservoir water levels. The transition to the rainy season in October should provide relief to the operational difficulties caused by low reservoir levels in the Southeast/Center-West basin, but does not change the expectation of low reservoir levels in the end of this year and beginning of next year. Thus, the outlook of intense usage of Page 8

9 thermal power plants for a prolonged period and power-rationing risks in 2015 still stands. Slight growth in new loans in August. The daily average of new non-earmarked loans rose 3.2% mom/sa in real terms, which was not enough to offset the drop seen in July. The moderate pace of new loans reflects the cool-down in growth of total outstanding loans. Year over year, real growth in total outstanding loans slowed to 4.3% in August from 4.7% in July. Overall delinquency remained at 3.1%, but increased for non-earmarked loans granted to non-financial corporations (to 3.6% from 3.5%). The increase in earmarked loans (which typically experience lower delinquency rates) as a share of total loans contributed to the stability in the overall delinquency rate. We forecast 6.4% increases for the IPCA in 2014 and 2015 We revised our forecast for the IPCA consumer price index in 2014 upward to 6.4%, from 6.3% in the previous report. The adjustment was driven by a revision in our estimate for the September reading, to 0.47% from 0.37%, mainly due to the higher-thanexpected result in the mid-month index IPCA-15. Market-set prices (representing 77% of the IPCA) are set to advance 6.6%, after climbing 7.3% in Breaking down by component, food consumed at home is expected to rise 5.5% (7.6% in 2013) and services to advance 8.3% (8.7% in 2013). Regulated prices (23% of the IPCA) are estimated to increase 5.7%, vs. 1.5% in 2013, with most of the upward pressure coming from electricity tariffs, health insurance premiums and gasoline. We continue to forecast an increase around 5% for gasoline at the pump before year-end. For 2015, our IPCA forecast remains at 6.4%. Compared with our expectations for 2014, we expect lower inflation for market-set prices and higher inflation for regulated prices, which are set to climb 7.0%, due to sharp adjustments in tariffs for electricity, water and sewage, and urban bus fares. These price adjustments may put pressure on inflation early next year for the following reasons: hikes in urban bus fares, which are usually concentrated in this period, and the adoption of a system known as bandeiras tarifárias which implies changes in electricity tariffs according to the conditions for power generation, and should prompt an earlierthan-expected increase in tariffs starting in January. Regarding the discounts on water tariffs through a program in São Paulo that was set to last just until the end of the year, the effect of their termination may not be felt immediately. We believe the program may be extended for a few more months, as reservoir levels need to recover. For market-set prices, we still anticipate a 6.2% advance in 2015, due to smaller increases for food consumed at home and service costs. Food prices should benefit from a still-favorable scenario for agricultural supply, especially grains, amid an outlook for plentiful crops and recovery of global inventory levels. Tame grain prices this year and next year should provide relief to prices charged for animal protein and wheat byproducts. Prices for private services are set to slow down due to the easing of the labor market and the real estate sector, with a likely moderation in wage and rental costs. IPCA still near the upper limit of the target range 9% 8% 7% 6% 5% 4% 3% 2% 1% yoy IPCA Market-set prices Regulated prices Source: IBGE, Itaú forecast 6.6% 6.4% 5.7% 0% Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 The IGP-M general price index rose 0.20% in September, after four months of deflation. This reading was lower than the lowest of the market estimates. The IPA producer price index the component with the greatest weight in the IGP-M advanced 0.13%, with increases of 0.14% for industrial prices and 0.10% for agricultural prices. Hence, the IGP-M is up by 1.76% year-to-date, while the yearover-year change slid to 3.5% from 4.9% in August. Current data suggest another moderate increase in October, with the year-over-year change receding to a little over 3%. We maintain our forecast for the IGP-M in 2014 at 3.5%, given the relief in producer prices. The IPA-M producer price index should climb a little less than 2%, with advances of 2.4% for industrial prices and 0.5% for agricultural prices. The largest downward contributions to the IPA should come from soybeans (grains and meal) and iron ore, while the greatest Page 9

10 (grains and meal) and iron ore, while the greatest upward contributions should come from beef and coffee. For the other components, we estimate increases of 6.4% for the IPC-M consumer price index and 6.9% for the INCC-M construction cost index. We expect the IGP-M to climb 5.3% in IGP-M: moderate increase after four months of deflation 1.7% 1.5% 1.3% 1.1% 0.9% 0.7% 0.5% 0.3% 0.1% -0.1% -0.3% -0.5% -0.7% -0.9% Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Source: FGV, Itaú % MoM Actual Forecast Copom signals stable Selic, but the exchange rate is a risk The central bank s Monetary Policy Committee (Copom) kept the Selic rate at 11% in its September meeting, and continued to signal stable rates ahead. In the minutes of the meeting and in its Quarterly Inflation Report (IR), the Copom repeated that if monetary conditions are maintained that means, the strategy that does not include the reduction of the monetary policy instrument inflation tends to enter in a trajectory of convergence to its target in the final quarters of the projection horizon. The Copom made it clear that the options are to keep or to raise the Selic rate. In an interview following the IR publication, Deputy Governor for Economic Policy Carlos Hamilton stated that Copom is currently considering whether to keep or to raise the Selic rate. According to Hamilton, the monetary policy will be adjusted in a timely fashion, if the inflationary outlook so demands. We expect a stable Selic rate ahead, but the exchange-rate dynamics are a risk. We maintain our forecast that the Selic will remain stable at 11.0% until the end of this year. For 2015, the scenario is more uncertain. The realignment of administered prices and, most of all, the ongoing depreciation of the exchange rate, may demand additional tightening of monetary policy, even in a low growth environment. Thus, the weaker BRL trend, if intensified and maintained in the medium term, induces an upward bias to our forecast of the Selic rate remaining steady at 11.0% in Fiscal Policy: recurrent primary surplus turns negative The primary fiscal surplus continues on a declining trend. In August, the public sector posted a primary deficit of BRL 14.5 billion in August, despite having relied on revenues of BRL 7.1 billion from Refis and BRL 5.4 billion from dividends paid by stateowned banks. Accumulated over twelve months, the conventional primary surplus decreased from 1.2% in July to 0.9% of GDP in August, while our estimate for the recurring primary surplus fell from 0.3% to -0.1%, moving into negative territory for the first time since the beginning of the series (2002). Primary surplus continues shrinking 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.9% 0.5% Conventional Primary Surplus Recurrent Primary Surplus 0.0% -0.1% -0.5% Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Source: Central Bank, Itaú % GDP 12M The payment of part of the delayed mandatory expenditures weighed on the August result, but government costs (outras despesas de custeio) also picked up. Expenses with unemployment insurance totaled BRL 9.6 billion, which was BRL 5.2 billion higher than the average of August 2013 and Other capital expenditures totaled BRL 6.6 billion, which was BRL 3.3 billion higher than in August 2013, with the expenses of the Minha Casa Minha Page 10

11 Vida program accounting for BRL 2.6 billion of this increase. Finally, the real growth in expenditures on social security benefits accelerated to 2.0% year to date, a pace that is more consistent with fundamentals (i.e. increase in the minimum wage and in the number of beneficiaries). We also observed a pickup in government costs, which accelerated from 5.7% in real terms year to date in July to 9.5% in August. We revised our forecast for this year's conventional primary surplus from 1.1% to 0.9% of GDP and the recurrent primary surplus from 0.4% to 0.3% of GDP. The revisions are based on data released for August and the expectation of a lower volume of atypical revenues over the coming months. We still expect a slowdown in discretionary spending in the last months of the year and some recovery in tax revenues. The recurrent primary surplus accumulated over 12 months will have a positive base effect in the last months of the year, due to negative results posted in the same period last year (the recurring result from September to December 2013 was negative by BRL 7.0 billion). The same cannot be said about the conventional primary surplus, which at the end of 2013 was lifted by non-recurring revenues. Public debt is on the rise. Net public sector debt rose from 35.4% of GDP in July to 35.9% in August. Year to date, the net debt increased by 2.3 pp of GDP. Gross general government debt rose from 59.5% to 60.1% of GDP from July to August and is up to 3.4 pp of GDP this year. Due to the drop in the primary surplus, the nominal deficit reached 4.0% of GDP in the twelve months ended in August (3.9% in July). We expect the increase in the cost of public debt financing to generate an upward trend in interest expenses over the coming quarters. This implies that, for the same primary surplus, the nominal deficit and the upward pressure on debt will be higher. In our assessment, the primary surplus required to stabilize public debt in the long term stands between 2.0% and 2.5% of GDP. Public Sector Primary Surplus 12M Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Conventional (%GDP) 3.1% 2.4% 1.9% 1.7% 1.8% 1.7% 1.9% 1.5% 1.4% 1.2% 0.9% Recurrent (%GDP) 2.7% 1.8% 0.9% 0.7% 0.7% 0.7% 0.9% 0.6% 0.5% 0.3% -0.1% Conventional (BRL bn) Recurrent (BRL bn) Adjustments* * Non recurrent Revenues and Expenses Source: Central Bank, Itaú Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Total Revenues 10.1% 1.2% 4.4% 0.2% 2.8% 4.7% 3.7% 1.2% 0.4% -0.1% 0.4% Tax Collection 10.0% 1.0% 2.0% -1.3% 0.1% 0.9% 1.0% -1.0% -0.7% -1.2% -2.1% Social Security Revenues 8.9% 5.3% 2.7% 4.2% 4.6% 3.0% 2.0% 1.6% 1.7% 1.3% 1.6% Other revenues (non-tax) 10.8% 2.1% 21.5% 3.3% 19.1% 31.9% 22.2% 11.7% -0.2% -1.0% 8.8% Total Spending 3.5% 4.7% 6.4% 11.9% 8.0% 7.4% 2.9% 3.8% 3.3% 3.2% 5.1% Payroll 1.1% -1.9% 2.9% 10.1% 7.4% 6.2% 0.8% 0.6% 0.3% 0.5% 0.7% Social Security Benefits 3.7% 6.3% 6.5% 0.0% 1.9% 1.5% -1.9% -0.6% 0.8% 1.7% 2.0% Investment 4.9% 6.7% 0.4% 9.4% 16.2% 14.8% 12.5% 22.6% 14.7% 14.3% 20.0% Government Costs 2.2% 8.5% 9.3% 25.8% 17.8% 14.8% 8.9% 8.0% 5.3% 5.7% 9.5% Source: National Treasury, Itaú Central Government - Revenues and Expenses (real ytd growth) Real weakens on changes in the international scenario The international scenario strengthened the U.S. dollar against the Brazilian real and many other currencies in September. The exchange rate depreciated beyond 2.40 reais per dollar for the first time since the beginning of the year. Although the U.S. Federal Reserve is committed to keeping the benchmark rate at low levels for a considerable period of time, the hike in interest rate forecasts for 2015 and 2016 was read as a leading indicator of normalization in U.S. monetary policy, pressuring several currencies. Sluggish data from China and a deteriorated outlook for commodity prices also contributed to weaken the real and other currencies. We maintained our year-end forecasts for the exchange rate at 2.40 reais per dollar in 2014 and 2.50 in Recent moves confirmed our outlook for depreciation in the real this year and next year. In the next months, the exchange rate may weaken beyond 2.40 reais per dollar. We revised our forecast for the trade balance in 2015 due to lower commodity prices. For 2014, we Page 11

12 continue to forecast the trade balance at USD 2.5 billion, as the decline in exports is offset by an even sharper slide in imports. For 2015, lower prices for commodities sold by Brazil, such as soybeans and iron ore, led us to revise our estimate for the trade surplus downward to $7.2 billion from $10.3 billion. Strong dollar worldwide Jan/2014=100 The current account deficit narrowed to USD 5.5 billion in August. The decline in the current account deficit was driven by a reduction in the service deficit. Over 12 months, the deficit was stable at 3.5% of GDP. Foreign direct investment (FDI), however, was the biggest surprise, at USD 6.8 billion during the month. Over 12 months, FDI advanced to 3% of GDP from 2.8%. Our estimate for the current account deficit in 2014 was maintained, but we revised our call for 2015 to USD 77.4 billion (3.5% of GDP) from USD 74.4 billion (3.3% of GDP) R$/US$ DXY 90 Emerging market currencies Jan-14 Mar-14 May-14 Jul-14 Sep-14 Source: Bloomberg, Itaú Forecast: Brazil F 2015F Economic Activity Real GDP growth - % Nominal GDP - BRL bn 3,239 3,770 4,143 4,392 4,845 5,136 5,464 Nominal GDP - USD bn 1,620 2,142 2,473 2,247 2,243 2,229 2,227 Population (millions) Per Capita GDP - USD 8,371 10,956 12,529 11,277 11,157 10,992 10,927 Unemployment Rate - year avg Inflation IPCA - % IGP M - % Interest Rate Selic - eop - % Balance of Payments BRL / USD - Dec Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Primary Balance - % GDP Nominal Balance - % GDP Net Public Debt - % GDP Source: IMF, IBGE, BCB, Haver and Itaú. Page 12

13 Mexico Exports and private internal demand take off; public sector lags behind The economy continues to recover in the third quarter of Exports remain performing well, supported by strong U.S. industrial activity. Private domestic spending is also recovering, but public sector demand is not contributing yet to the economic recovery. We maintain our growth projection of 2.4% in 2014 and 3.8% for Annual headline inflation stayed above the upper bound of the central bank s target range, led by higher non-core food prices. We now expect headline inflation to end this year at 3.9% (previously: 3.7%). For 2015, we expect inflation to fall to 3.2%, helped by a negative output gap, more favorable telecom tariffs, lower gasoline price hikes and the fading impact of the tax increases introduced this year. The exchange rate depreciated recently, as the dollar strengthened globally. However, Mexico is closely linked with the U.S. economy, and reforms will likely attract meaningful capital inflows, so the Mexican peso will probably perform better than most emerging market floating currencies. We see the exchange rate at 13.2 pesos per dollar by the end of this year and the next. The minutes of the latest monetary policy decision revealed that the board was more upbeat on growth, but rate hikes are unlikely in the near term because the economy still has substantial slack. We see the policy rate at 3.0% by the end of this year and at 3.50% by the end of 2015, with rates hikes starting only by the end of 2Q15. Eleven of twenty two service contracts that Pemex currently has with private oil companies are in the process of migrating to risk-sharing agreements, from now until the end of the year. This means that the first capital flows associated with the energy reform may come as soon as 1Q15. The economic recovery continues in 3Q14 The demand-side breakdown of the GDP indicated that the external sector was the main engine of growth in 2Q14. Exports increased by an impressive 16.5% qoq/saar, leading to 4.2% GDP growth. There were also solid growth rates in private consumption (5.5%) and private investment (6.8%). On the other hand, although government expenditures have grown rapidly this year (public expenditures in fixed capital assets, for example, grew 34% year over year in nominal terms during the first seven months of 2014), they haven t yet impacted internal demand. Public sector fixed investments actually contracted in the second quarter (-4.8% qoq/saar), according to national account statistics, after a 22.4% drop in 1Q14. Anecdotal evidence suggests that the decoupling between fiscal capital expenditures and public sector investment as recorded in the national accounts is mostly due to delays in the execution of projects already approved. This means that public demand, in particular infrastructure investment, will likely add to growth ahead. Public sector still lags behind 7% 5% 3% 1% -1% yoy, sa -3% Private Demand Public Demand Real Exports -5% Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Source: INEGI, Itau The first indicators available for 3Q14 hint that the recovery continues. Mexico s IGAE (monthly proxy for GDP) came in at 2.5% year over year in July. Sequentially, the IGAE increased 0.4% from June as the Industrial and Service sectors both expanded by 0.3%, and the volatile Agricultural sector grew by a strong 3.98%. On a quarter-over-quarter (annualized) basis, the IGAE grew by a robust 4.0%. Retail sales Page 13

14 increased by 6.3% qoq/saar in July, lifted by a stronger labor market: formal employment increased by 4.4% year over year in July, while temporary employment (a leading indicator of permanent employment) expanded by 6.2%. Meanwhile, manufacturing exports retreated in August, but they still expanded at a solid 10% qoq/saar pace, while imports of consumer goods exfuel were up by 14.7% qoq/saar. On the other hand, imports of capital goods which closely track investment in machinery and equipment fell 0.1% qoq/saar in August. We maintain our growth forecasts at 2.4% for 2014 and 3.8% for This implies a similar sequential growth pace in the second half of this year to the second quarter of For 2015, the first impacts of the structural reforms and the sustained fiscal stimulus (the public deficit planned for next year implies a sound fiscal impulse) and monetary stimulus alongside the U.S. recovery will all contribute to the economic expansion. Inflation temporarily high Inflation is still above the upper bound of the target range. On a year-over-year basis, headline inflation stood at 4.21% in the first two weeks of September, from 4.23% in the second half of August. Non-core inflation came in at 7.09%, led by higher agricultural and livestock prices, which rose by 7.51% (from 6.81% previously). Meanwhile, core inflation reached 3.34% (from 3.41%), somewhat above the center of the target range. We have increased our inflation forecast for 2014 to 3.9% from 3.7%, as non-core food inflation has been more persistent than we previously thought. However, our inflation estimate for 2015 remains at 3.2%. Next year, inflation will likely approach the center of the target, helped by a negative output gap, more favorable telecom tariffs, lower gasoline price hikes (next year, gasoline price will increase one-off in January, according to expected inflation, contrasting with an average yearly increase of around 10% over the recent years) and the fading impact of tax increases introduced this year. On the other hand, it is important to highlight as an upside risk to inflation that the mayor of Mexico City, from the left-leaning PRD party, recently sent to congress a proposal to increase the minimum wage by 26%. As a response, the federal government announced the creation of a committee that will evaluate mechanisms to adjust the minimum wage. The committee will be formalized on October 24 and will have six months to divulge its findings. The discussions on this matter will likely take place during the first half of Outperformance of the peso to continue Although the Mexican peso depreciated in September, it performed better than most of its peers. Because Mexico is closely linked with the U.S. economy and the reforms will likely attract meaningful capital inflows, the outperformance of the peso is set to continue amid higher U.S. treasury yields. We kept our exchange-rate forecasts at 13.2 pesos per dollar for the end of this year and the next. No rate hikes in the near term The minutes of the latest monetary policy decision hinted that interest rates will likely stay on hold for a while, even though the board is much more optimistic on growth. The document revealed a unanimous decision to leave the policy rate unchanged, at 3.0%. Most of the members see an improved balance of risks for activity. Still, in the board s view, the output gap remains negative, which means that demand-side inflationary pressures are unlikely in the near future. So, the central bank remains comfortable with the inflation outlook for the medium term. However, due to transitory factors (higher livestock prices), there is a worse balance of risks for inflation in the short term, according to the minutes. Our year-end forecasts for the policy rate are unchanged, at 3.0% in 2014 and 3.5% in In our scenario, activity will probably grow above potential over the next quarters, but we also think that there is enough spare capacity to keep inflation under control. The central bank will probably preemptively remove the monetary stimulus, but it is unlikely to start doing so before the Fed. Therefore we see rate hikes starting only by the end of 2Q15. Energy reform underway The migration to risk-sharing contracts of 11 (of the 22) service contracts that Pemex has with private oil companies will be finalized by December. The first capital inflows of this process could come as soon as 1Q15. The migration of the remaining contracts will be done in The total investment associated with the renewal of these 22 contracts is estimated at USD 44 billion. Page 14

15 The energy reform regulations are expected to be announced in October, and the final guidelines of the bidding rounds will likely be announced in February next year (Round 1 and farm-out agreements). For example, the Ministry of the Economy is in the process of determining how to measure the national content, which was established at 25% and will increase to 35% over 10 years. This initial 25% will be an average for oil exploration and production activities, so some of the oil activities will require lower domestic-content requirements (such as deep-water drilling) than others. Forecast: Mexico Economic Activity Real GDP growth - % Nominal GDP - USD bn 1, ,051 1,165 1,186 1,255 1,335 1,430 Population (millions) Per Capita GDP - USD 9,906 7,909 9,194 10,067 10,129 10,601 11,164 11,841 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments MXN / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Balance - % GDP Net Public Debt - % GDP Source: IMF, Bloomberg, INEGI, Banxico, Haver and Itaú Page 15