The date to end the easing cycle was left wide open.
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• We reduced our forecast for the primary deficit in 2017 to -2.3% of GDP from -2.4%. For 2018, we estimate -2.1%. Reforms are required for fiscal rebalancing in the long term.
• Our year-end forecasts for the exchange rate are unchanged, at BRL 3.25 per USD in 2017 and 3.50 in 2018.
• We increased our 2017 inflation forecast to 3.3% due to greater pressure from regulated prices. Our estimate for 2018 remains at 3.8%.
• We anticipate GDP growth of 0.8% in 2017 and 3.0% in 2018, but we do see risks. We revised downward our forecast for unemployment at year-end 2018 to 11.8% from 12.0%, incorporating better than expected job creation in the informal sector in 3Q17.
• The Monetary Policy Committee signaled a 50-bp cut in December but left the February decision wide open. We maintain our year-end forecasts for the Selic benchmark rate at 7.0% for 2017 and 6.5% for 2018.
Fiscal rebalancing requires more than meeting primary budget targets and BNDES transfers
We marginally revised our primary deficit estimate for 2017 to -2.3% of GDP (or BRL -153 billion) from -2.4%, while the target is BRL -163 billion (-2.4% of GDP). Given positive surprises in terms of extraordinary and recurring revenues, lower-than-expected mandatory expenses and better results from states and municipalities, the government – which may announce an additional reduction in discretionary spending cuts in November (currently at BRL 33 billion) – should deliver a slightly better reading than the target set for the consolidated public sector.
For 2018, we maintain our expectation of a deficit of -2.1% of GDP (BRL -149 billion), compared with the target of BRL -161 billion (or -2.2% of GDP). Because spending is fixed exactly at the constitutional spending cap, positive surprises in terms of revenue – such as better economic growth than projected in the budget (our 3.0% call vs. 2.0% by the government) – or faster progress in asset sales would imply beating the target.
Furthermore, the national development bank, BNDES, is returning BRL 180 billion (2.5% of GDP) to the Treasury, temporarily cushioning the impact of large primary deficits on gross public debt. Of this amount, BRL 50 billion (0.8% of GDP) were returned in 2017 and BRL 130 billion may be returned in 2018 (1.7% of GDP), implying a reduction of the same magnitude in gross public debt for each of these years. If this happens, the transfers combined with the rebound in economic growth and lower interest rates may leave gross public debt relatively stable in 2018 (see chart).
Reform approvals are key in the effort to permanently reverse the currently unsustainable path of public debt. Without reforms, the government will be unable to meet the constitutional spending cap amendment after 2019; thus the gradual return to surpluses that are compatible with public debt stabilization becomes unlikely. In particular, the pension reform continues to wait for political consensus to be voted in two rounds of voting on the main floor of the Lower House and later in the Senate.
Global scenario strengthened the USD and pressured the BRL in the past month
The outlook for higher interest rates in the U.S. pressured emerging market currencies (including the Brazilian real) in October. Progress on the bill proposing an expansion of the budget deficit in Congress and stronger data on the U.S. economy consolidated the view that the Federal Reserve will increase interest rates before year-end. The exchange rate reached BRL 3.30 per USD, its weakest level since July, but reversed some of the movement later in the month.
Our year-end forecasts for the exchange rate are unchanged, at BRL 3.25 per USD in 2017 and 3.50 in 2018. The increase in interest rates in the U.S. (albeit gradual) throughout the coming year supports a weaker exchange rate. Domestically, uncertainties surrounding adjustments and reforms tend to persist, pressuring risk premiums.
Balance of payment figures show stability in the current account. The strong trade surplus has helped to maintain low current account deficits, but a rebound in domestic demand tends to produce weaker readings next year. Recent numbers already point in that direction. The seasonally-adjusted annualized three-month moving average for the deficit has been running at wider levels than earlier in the year (deficits around USD 15 billion compared to surpluses in 1H17). In terms of financing, direct investment in the country remains robust, hovering at USD 80-85 billion (over 12 months) since the beginning of the year and covering the current account deficit multiple times. Meanwhile, volatile capital flows (i.e., portfolio flows) are still negative over 12 months, although outflows are substantially thinner now.
For the next years, we maintain our expectation of a gradual increase in the current account deficit, but not to the point of compromising Brazil’s external sustainability. We estimate trade surpluses of USD 65 billion in 2017 (USD 62 billion, previously – due to stronger exports in the last months) and USD 50 billion in 2018. Our estimates for the current account deficit stand at USD 12 billion in 2017 (USD 15 billion) and USD 34 billion in 2018.
We increased our 2017 inflation forecast to 3.3% and maintained our 2018 forecast at 3.8%
We increased our forecast for the consumer price index IPCA in 2017 to 3.3% from 3.0%, given the outlook for greater pressure on regulated prices. In this group, the biggest forecast revisions involve electricity tariffs, gasoline and bottled cooking gas.
Breaking down the index, we expect market-set prices to rise 1.6% (1.8% in the previous report) and regulated prices to advance 8.4% (6.7% in the previous report). Among market-set prices, we anticipate 3.6% deflation for food consumed at home, after a 9.4% increase last year, providing a relief of 2.2 pp to annual inflation. Plentiful crops – amid favorable weather in Brazil and other major global producers –have caused declines in producer prices since September 2016, which has had a favorable impact on retail food prices. We expect industrial prices to rise 1.2% (4.8% in 2016). Service prices are estimated to advance 4.5% this year (6.5% in 2016). As for regulated prices, we have the following forecasts for the main components: -4% for landline phone service, 4% for medication, 5% for urban bus fares, 8% for gasoline, 10% for water and sewage tariffs, 13.5% for health insurance premiums, 14% for electricity tariffs and 18% for bottled cooking gas. Regarding electricity, we incorporated an increase in the amount corresponding to the red flag situation (level 2) announced by regulator ANEEL to BRL 5.00 per 100 kWh of monthly usage from BRL 3.50. Regarding gasoline and bottled cooking gas, we incorporated higher-than-anticipated price adjustments at the margin.
Our 2018 inflation estimate remains at 3.8%. Breaking down the index, we expect market-set prices to rise 3.6% and regulated prices to climb 4.7%. Our below-target inflation estimate for next year will be driven by less inertia from past inflation, anchored inflation expectations and a negative output gap. As for market-set prices, the decline in food prices is set to be reversed by less favorable weather conditions, a sharper increase in industrial prices after a low reading expected for 2017, and another drop in service inflation due to less inertia.
The main risk factors for the inflation scenario are still tied to domestic politics and developments in the international scenario. Rising political uncertainty has hindered progress on reforms and needed economic adjustments, and it may have an additional impact on risk premiums and the exchange rate. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as new tax hikes and/or a reversal of tax breaks next year. As for the external situation, despite more favorable levels at the margin (with sustained risk appetite for emerging market assets), there are policy risks in developed economies that could eventually reverse the improvement in risk premiums, impacting the local currency and domestic inflation.
Substantial slack in the economy may contribute to a sharper decline in inflation in 2018. The negative output gap and the corresponding high level of unemployment for a longer period may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items.
The benign behavior of food prices may mean downside risk to inflation. Prices for food consumed at home are more favorable than anticipated. The downside to 2018 inflation is due to possible second-round effects of the supply shock seen this year, not only on some services, but especially through the inertial effect of past inflation. Importantly, food deflation throughout this year has contributed to lower readings in the INPC, a consumer price index focused on a tighter income bracket (up to 5 minimum wages), where food expenses weigh more on the household budget. The INPC guides not only the adjustment in the monthly minimum wage, but also a substantial share of private sector wages. Hence, results for the INPC that are lower than for the IPCA – we expect the INPC to rise 2.6% this year – may produce an even more favorable inertial effect on 2018 inflation.
Inflation expectations remain anchored, below the 2017 and 2018 targets. The median of market expectations for inflation, as per the Central Bank’s Focus survey, rose to 3.08% from 2.95% in 2017 but declined to 4.02% from 4.06% in 2018. The median estimates for 2019 and 2020 remained at 4.25% and 4.0%, respectively, anchored on the targets set for these years.
Activity: Confidence on the rise in early 4Q17
Recent data remain consistent with GDP growing 0.1% qoq/sa in 3Q17. Industrial production advanced 0.2% in September, partially offsetting the August decline and resuming the upward trend seen since 2Q17. We anticipate similar behavior for retail sales and some improvement in real income from services in September, after a weak performance in August.
From a demand standpoint, GDP composition is set to be more balanced in 3Q17, with growth in investments and consumer spending. For gross fixed capital formation, we forecast growth above 1% qoq/sa, with gains in purchases of machinery and equipment and stability in construction spending. Household spending will probably increase less than in 2Q17 (when influenced by withdrawals from inactive accounts held under the employment protection program FGTS), but it will be positive again. Advances in GDP components reflect improved fundamentals: falling interest rates, better corporate and household balance sheets and rising real incomes thanks to lower inflation.
Confidence indicators went up again in October, with gains in the industrial (2.8%), retail (3.7%), service (2.6%) and construction (0.6%) segments. The move also drove these indicators to their highest levels since 2014, resuming an upward trend after the negative impact caused by greater political uncertainty in May.
Our 2017 GDP forecast stands at 0.8%. This forecast may change due to the revision in quarterly GDP readings up to 2Q17 that census bureau IBGE will release in the coming weeks. In our view, the 3Q17 report may lead to an upward revision in 2Q17 GDP growth to 0.6% (from 0.2% in the first report) if the revision does not materially change the data already presented.
However, there are headwinds that may prevent growth from topping 3% in 2018. Firstly, early assessments of supply conditions (a lower agricultural GDP and possible increase in the usage of thermal power plants) mean downside to the scenario. Secondly, possible intensification of uncertainties regarding reforms and/or worsening liquidity for emerging markets may lead to deterioration in financial conditions, hurting activity.
The labor market is recovering gradually. In September, 34,400 formal jobs were created in net terms (according to the Ministry of Labor’s CAGED registry). The seasonally adjusted moving average is near zero and has been improving gradually since 2Q16. National household survey PNAD Contínua shows that unemployment has been receding since March, driven mostly by informal jobs.
We expect the seasonally adjusted unemployment rate to decline to 11.8% by the end of 2018 vs. 12.6% in 3Q17 (previous forecast for year-end 2018: 12.0%). Formal jobs tend to play an increasingly important role in the decline in unemployment. The revision incorporates additional increases in informality in 3Q17.
Monetary policy: 7.0% by year-end, but February decision is wide open
The Copom delivered the widely expected outcome, a 75-bp rate cut to 7.5% p.a., in a unanimous vote. The meeting statement and its minutes suggest that the plan is still to slow down the pace of easing moderately. Based on a communication pattern established by this Copom, we read this as a signal that the December move will probably be a reduction of 50 bps, which would take the Selic to 7.0% p.a. The committee stressed that, as always, such assessments depend on maintaining current economic conditions – i.e., economic recovery amid wide slack, particularly in the labor market.
The committee continues to have a benign reading of inflation, but it has removed language that emphasizes such an assessment. According to the Copom, inflation evolution remains favorable (vs. “quite favorable” previously), with several measures of underlying inflation at comfortable levels (“low levels” previously), including components that are more sensitive to monetary policy (i.e., service prices). The committee stressed that the economy faces favorable and unfavorable price shocks. The former refer to falling food prices and the latter to rising energy costs. Authorities stated that they intend to fight the second-round effects of these shocks in a symmetric way. Regarding economic activity, the minutes show that the committee discussed the latest figures, which were quite soft, but also the chances of a stronger recovery going forward. Committee members concluded that, given the current degree of slack (wide) in the economy, such short-term fluctuations are unlikely to cause material changes in prospective inflation.
The date to end the easing cycle was left wide open. The committee removed from the statement the sentence that indicated its preference for a gradual end to the easing cycle, suggesting that the next 50-bp cut in December may be its last or, alternatively, that an additional 50-bp cut may be announced in February 2018. The minutes emphasize a flight plan that takes the Selic to 7.0% by year-end, but the February decision was purposefully left wide open. This suggests that the authorities may consider, given the magnitude of estimated economic slack and the balance of risks for the basic scenario, that a little more stimulus than currently priced in may be appropriate. We thus, for now, stand by our call that the end will only come in February, with a final 50-bp rate cut, taking the Selic to 6.5% p.a.
 As per the Ministry of Trade (MDIC)