Economics Group Special Commentary Eugenio J. Alemán, Senior Economist eugenio.j.aleman@wellsfargo.com (704) 410-3273 Erik Nelson, Currency Strategist erik.f.nelson@wellsfargo.com (212) 214-5652 Shannon Seery, Economic Analyst shannon.seery@wellsfargo.com (704) 410-1681 Brazilian Economy Back from the Brink Executive Summary It took a very long time, by Brazilian historic economic standards, but the Brazilian economy is back from the brink and firing on key cylinders. It is still a five cylinder economy, with two cylinders having issues, one being real government consumption and the other being real investment. Another one is working in reverse, as is normally the case for an economy that depends on imports so heavily, being real imports of goods and services. However, the other two cylinders, real personal consumption expenditures (PCE) and real exports of goods and services, are providing all the force they can, as we consider the still difficult political environment that has continued to affect Brazil. That is, although the political crisis seems to have improved from what was happening last year, the uncertainties regarding the future political environment are still important, especially as the country prepares to enter a presidential election cycle in 2018 where things could get ugly once again. Furthermore, it is true that today s economic performance is being measured against a very depressed economic performance that had lasted for more than two years, the country s first, so we need to take this ensuing recovery with caution. This is especially true for the political reason we previously mentioned, as political uncertainty next year could wreak havoc on the current improvement in economic activity. Third Quarter Growth Points to a Positive Year in Brazil As the Brazilian economy expands for the third consecutive quarter, third quarter GDP results have come in as a pleasant surprise for many, with growth of 0.6 percent over the quarter (Figure 1). Although the Brazilian economy was up only 0.1 percent sequentially, less than the expectation of the market at 0.3 percent, growth in the second quarter saw a significant revision. Second quarter growth was revised up from an original estimate of 0.2 percent to a 0.7 percent sequential growth rate, not annualized, which will positively impact the full year 2017 growth estimates. Our current forecast for Brazilian growth this year is 0.6 percent, which has been among the highest of the consensus forecast expectations. However, after receiving the third quarter results, the economy has already accumulated a rate of growth of 0.6 percent year to date, which will push us to upwardly revise our estimate. Although the Brazilian growth rates are partially affected by base effects coming off of the recent recessionary period, the recent trends point to continued, yet gradual, growth. Third quarter growth was in part driven by domestic demand, with a surge in real gross fixed investment and continued growth in the consumer sector. Steady household spending continued to contribute to the gradual recovery in Brazil, with real personal consumption expenditures up 2.2 percent year over year, and 1.2 percent sequentially. Although remaining negative on a yearover-year basis, gross fixed investment surged in Q3, up 1.6 percent. With this third quarter rate for gross fixed investment being the first positive print in four years, such strong growth is encouraging as the Brazilian economic recovery moves forward, as investment has been one of the most affected sectors this past recession. It appears that the successive reductions in the Brazilian policy rate, by 675 bps since October 2016, are finally affecting one of the most interest rate sensitive sectors of the economy, gross fixed investment. It is expected that investment growth The Brazilian economy is back from the brink and firing on key cylinders. Growth in the second quarter saw a significant revision. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.
Brazilian Economy Back from the Brink should continue in the near future, likely adding to fourth quarter growth. However, growth in government consumption remains lackluster, down 0.6 percent year over year. Figure 1 Figure 2 1 Brazi Real GDP Bars = Compound Annual Rate, SA Line = Yr/Yr % Change, NSA 1 3 2 2 Brazilian Exports of Goods and Services, Not Seasonally Adjusted Exports of Goods and Services: Q3 @ 7. 4-Q Moving Average: Q3 @ 1.1% 3 2 2 1 1 - - -1-1 - - - Real GDP: Q3 @ 0. : Q3 @ 1.4% -2 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 - -2-1 -1 - - -2-2 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Overall third quarter growth rates were kept at bay due to this increase in import growth. Real PCE and real exports of goods and services are driving the economy forward. Source: IHS Global Insight and Wells Fargo Securities The third quarter growth print appears even more encouraging when we analyze the trade dynamics that have unfolded over the past quarter. Economic growth was perhaps kept relatively low due to the strong increase in real imports of goods and services. With imports up 5.7 percent year over year, and 6.6 percent sequentially, not annualized, it is evident that overall third quarter growth rates were kept at bay due to this increase in import growth. However, real exports of goods and services were also strong in the third quarter, up 7.6 percent year over year, and 4.1 percent sequentially, not annualized (Figure 2). Export growth is being increasingly fueled by a quickening in global demand, which is helping boost exports of traditional Brazilian products such as agricultural products. Supply GDP Improvements a Reflection of PCE and Exports When looking at the supply side of the Brazilian economy, it is clear that real PCE and real exports of goods and services are driving the economy forward, while some of the sectors that would need a relatively stronger improvement in investment, i.e., construction, information and communication, etc., are still in the early stages of their recovery process. That is, the agricultural sector posted the strongest year-over-year growth rate during Q3, up a strong 9.1 percent. However, this sector posted the largest decline of all the supply sectors on a sequential basis, not annualized, down 3.0 percent. This was the second quarter of decline after a 2.3 percent quarterover-quarter decline in Q2, not annualized. However, this is not something that should be of great concern, because the sector surged 12.9 percent in the first quarter on a sequential basis and not annualized, which means that the country produced a bumper crop in Q1 that has been difficult to match during the subsequent quarters. This is the reason why the year-over-year number of 9.1 percent is a better gauge for this highly seasonal component of Brazilian GDP. The Brazilian industrial sector was also up on a year-over-year basis for the first time since Q1-2014, up only 0.4 percent (Figure 3). However, the sector was up a strong 0.8 percent, sequentially and not annualized. By components, the manufacturing sector was up 2.4 percent on a year-earlier basis and by a strong 1.4 percent sequentially and not annualized. This was also the first positive year-over-year reading for the manufacturing sector since Q1-2014. The manufacturing sector has been expanding sequentially during the whole of 2017. 2
Brazilian Economy Back From the Brink Figure 3 Figure 4 2 Brazilian Total Industrial Output Total Industry: Q3 @ 0.4% 4-Q Moving Average: Q3 @ -1.4% 2 21% Brazilian Central Bank Policy Rate Percent 21% 1 1 - - -1-1 - 97 99 01 03 05 07 09 11 13 15 17 - Selic Rate: Nov @ 7.5 05 06 07 08 09 10 11 12 13 14 15 16 17 Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities Public utilities output was also up on a year-earlier basis, but by just 0.2 percent, while inching up only 0.1 percent sequentially and not annualized. This sector of economic activity has weakened considerably over the past two quarters, after remaining relatively strong in 2016. The weakest component of the industrial sector was construction activity, a sector greatly affected by the political/corruption crisis, i.e., Odebrecht, plus very high interest rates, and the fact that this was one of the strongest sectors before the severe recession that affected the country for over more than two years (i.e., partially due to the growth in construction activity ahead of the Brazilian Summer Olympics). However, there is good news from all fronts on this sector, which is good for future potential economic growth. As seen in Figure 4, interest rates have come down considerably over the past year or so, while the worst issues regarding the Odebrecht political corruption scandal are somewhat behind. Furthermore, an improvement in this sector, even if it is very small, will help turn around gross fixed capital investment as the sector requires large amounts of investment spending. This will add to the already strong improvement in machinery and equipment that has been boosting gross fixed investment for the production of automobiles, and is good news for the economy going forward (Figure 5). For now, it is clear that the demise in construction remains the culprit for the weakness in the industrial sector. Construction activity dropped 4.7 percent on a year-earlier basis in Q3, an improvement from a collapse of 7.1 percent during the second quarter of the year (Figure 6). However, the sector was flat on a quarter-over-quarter basis, which means that it may be close to breaking the negative spell that has affected the sector for the past several years. Figure 5 Figure 6 20 16 Total Brazilian Vehicle Production Total Vehicles: Oct @ 42.2% 3-Month Moving Average: Oct @ 42. 20 16 2 2 Brazilian Construction Output Construction: Q3 @ -4.7% 4-Q Moving Average: Q3 @ -6. 2 2 It is clear that the demise in construction remains the culprit for the weakness in the industrial sector. 12 12 8 8 1 1 4 4 - - -4-4 -1-1 -8-8 - 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Source: IHS Global Insight and Wells Fargo Securities - 3
Brazilian Economy Back from the Brink Commerce activity was the strongest sector of the economy on a sequential basis, increasing 1.6 percent. We expect the Brazilian currency to gain on trend against the U.S. dollar. The last of the industrial sectors, mining or extractive industries, improved 2.4 percent on a yearearlier basis, a noted slowdown from the 6.0 percent increase in the second quarter. However, the sector improved 0.2 percent sequentially and not annualized, which was a rebound from a 0.2 percent decline during Q2. From the service side, another positive sector in Q3 was commerce, which is basically a reflection of the strength of domestic demand, but principally of PCE. Commerce increased a strong 3.8 percent on a year-earlier basis, the second consecutive positive year-over-year print and an indication that the strong slowdown in inflation as well as the appreciation of the currency has continued to help consumers. 1 Commerce activity was the strongest sector of the economy on a sequential basis, increasing 1.6 percent. Furthermore, this strength was even stronger because it came after another strong performance in Q2 when it was up 2.2 percent compared to Q1, not annualized. Again, all these rates of growth have to be taken with caution because of the very low base of comparison, but they nevertheless continue to point to an improved economy. Real estate activity improved 2.1 percent on a year-earlier basis while posting the third strongest sequential rate of growth, up 0.9 percent. This is also good news for the construction sector as it starts to recover from its deep recession. Modest Gains Ahead for the Brazilian Currency The Brazilian real has struggled somewhat in 2017 after its outperformance in 2016, likely a reflection of ongoing political challenges and a still-nascent economic recovery. Indeed, the real is essentially unchanged against the greenback in a year when most emerging currencies have displayed solid gains. Going forward, however, we expect the Brazilian currency to gain on trend against the U.S. dollar. The economic recovery that is currently underway in Brazil should be a key factor of support for the real, particularly as the recovery gathers pace and becomes more broad-based. Moreover, Brazil s high real interest rates among the highest in emerging markets should remain a key factor of support for the Brazilian real, particularly as Brazil s central bank has likely neared the end of its monetary policy easing cycle. However, the upcoming presidential elections in Brazil could pose a risk to our positive outlook for the real, particularly given the prevailing uncertainty around the country s fiscal situation. Political and fiscal concerns could perhaps limit the extent of medium-term gains in the real, and it is unlikely that the real will perform as strongly as it did during 2016 going forward. However, we still see Brazilian fundamentals as consistent with modest strength in the real over time, particularly given our outlook for trend U.S. dollar weakness over the medium term. Inflation Is Looking Promising Inflation and interest rates are still looking promising for several of the most inflation and interest rate sensitive economic sectors of the economy even though CPI inflation turned the corner in October on a year-earlier basis. That is, although the rate of inflation moved higher on a year-over-year basis in October, it remained at 2.7 percent, one of the lowest inflation rates since February 1999, just after Brazil abandoned the crawling-peg exchange rate system, which at the time, triggered a surge in inflation and a serious debt/fiscal crisis due to the large depreciation of the currency that ensued. As Figures 7 and 8 show, the recent strengthening in wholesale prices is, once again, pushing higher consumer prices in the country, something that the central bank of Brazil will follow closely so as not to unsettle inflationary expectations once again. For now, markets remain relatively benign on the need by the central bank to reverse the current phase of monetary policy expansion even though they seem to believe that interest rates may not go down further for now, something that has changed over the past several months. 1 See the exchange rate section below. 4
Brazilian Economy Back From the Brink Figure 7 Figure 8 Brazilian Consumer Price Index CPI: Oct @ 2.7% 5 Brazilian Wholesale Price Index WPI: Oct @ -3. 5 4 4 3 3 2 2 1 1 3% 3% 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018-1 -1 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Source: IHS Global Insight and Wells Fargo Securities Conclusion Although the Brazilian economy has turned the corner, there are plenty of risks on the horizon that can sour our projections regarding Brazil. These risks are probably similar to those that have burdened the economy over the past several years. However, the magnitude of these risks on the economy going forward, if they come through, would pale compared to what we have seen in the past several years. Thus, we remain optimistic for the prospects in the immediate future, but cautious, pointing to the presidential cycle next year as well as the delicate fiscal situation today. Thus, any improvement on this front will be positive news for the prospects of the overall economy. However, we point out that the economy is close to firing on all cylinders, and this means that growth could probably surprise on the upside over the next several years if the political risks remain contained. We remain optimistic for the prospects in the immediate future, but cautious. 5
Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) 410-1801 (212) 214-5070 diane.schumaker@wellsfargo.com John E. Silvia, Ph.D. Chief Economist (704) 410-3275 john.silvia@wellsfargo.com Mark Vitner Senior Economist (704) 410-3277 mark.vitner@wellsfargo.com Jay H. Bryson, Ph.D. Global Economist (704) 410-3274 jay.bryson@wellsfargo.com Sam Bullard Senior Economist (704) 410-3280 sam.bullard@wellsfargo.com Nick Bennenbroek Currency Strategist (212) 214-5636 nicholas.bennenbroek@wellsfargo.com Eugenio J. Alemán, Ph.D. Senior Economist (704) 410-3273 eugenio.j.aleman@wellsfargo.com Azhar Iqbal Econometrician (704) 410-3270 azhar.iqbal@wellsfargo.com Tim Quinlan Senior Economist (704) 410-3283 tim.quinlan@wellsfargo.com Eric Viloria, CFA Currency Strategist (212) 214-5637 eric.viloria@wellsfargo.com Sarah House Economist (704) 410-3282 sarah.house@wellsfargo.com Michael A. Brown Economist (704) 410-3278 michael.a.brown@wellsfargo.com Jamie Feik Economist (704) 410-3291 jamie.feik@wellsfargo.com Erik Nelson Currency Strategist (212) 214-5652 erik.f.nelson@wellsfargo.com Michael Pugliese Economic Analyst (704) 410-3156 michael.d.pugliese@wellsfargo.com Harry Pershing Economic Analyst (704) 410-3034 harry.pershing@wellsfargo.com Hank Carmichael Economic Analyst (704) 410-3059 john.h.carmichael@wellsfargo.com Ariana Vaisey Economic Analyst (704) 410-1309 ariana.b.vaisey@wellsfargo.com Abigail Kinnaman Economic Analyst (704) 410-1570 abigail.kinnaman@wellsfargo.com Shannon Seery Economic Analyst (704) 410-1681 shannon.seery@wellsfargo.com Donna LaFleur Executive Assistant (704) 410-3279 donna.lafleur@wellsfargo.com Dawne Howes Administrative Assistant (704) 410-3272 dawne.howes@wellsfargo.com Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. 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