At a Glance Brazil – Outlook and key themes for 2014 Italo Lombardi, Mike Moran Brazil – Outlook and key themes for 2014 What happened to growth in Brazil? 3 Brazil’s growth outlook 11 Balance of payments to improve gradually 24 Inflation – Any relief? 27 Fiscal policy – A course adjustment? 29 Monetary policy – BCB on hold for now 32 FX – Positioning signals 35 2 What happened to growth in Brazil? 8 7 6 5 Average 4.2% 4 Average 2.7% 3 2 1 0 -1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Standard Chartered Research 3 What happened to growth? Short-term explanations Exports of basic goods from Brazil to China are more than 35% currently from 5% in the early 2000s: Brazil’s exposure to China’s growth has increased. China’s growth is down to 7.5-8.0% more recently, from 9.5-10% prior to 2011. Commodity prices are down by nearly 20% since their peak in 2011. Latin America, Brazil’s second-largest export destination, is also highly exposed to China: Chile and Peru are important exporters of metals. There are second-round effects. Argentina is the recipient of 20% of Brazil’s exports – 50% of Brazil’s manufactured exports. Monetary policy hikes in early 2011 led to a slowdown in investment. There is a ‘Hangover effect’ from the fast pace of growth of 7.5% in 2010. Source: Standard Chartered Research 4 What happened to growth? Long-term explanations The 1994 stabilisation program may have succeeded. In the 2000s, the economy seemed unable to grow for an extended period of time without having an ‘inflation issue’. Potential growth, productivity and competitiveness: Regardless of growth performance, unemployment continued to trend lower. Measures of labour productivity show a mismatch with real wage growth. Total Factor Productivity (TFP) and the production function. Potential growth and output gap. Explanations: Lack of capital investment Low education level Need for a better tax code and labour laws, among many other things Source: Standard Chartered Research 5 What happened to growth? Long-term explanations Supply and demand mismatch RS, IBC-Br and IP levels SA 210 Retail sales Clearly, the services sector, measured by the performance of retail sales, did much better than the industrial sector Uneven demand for labour The role of the exchange rate Most productive labour lost leverage as the currency 190 appreciated 170 150 IBC-Br Labour productivity by sector % 15 130 Agriculture 10 IP 5 0 110 -5 Industry -10 90 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 -15 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Services Mar-12 Source: BCB, Standard Chartered Research 6 The labour market – A puzzling picture Unemployment rate on a secular downward trend IBGE UR seasonally adjusted Employed population is decreasing Total employed population (’000s) 14 23,500 13 23,000 12 22,500 11 10 22,000 9 21,500 8 7 21,000 6 20,500 5 4 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 20,000 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Source: Standard Chartered Research 7 What happened to growth? Long-term explanations TFP also collapsed over recent years TFP versus labour productivity (y/y %) Output gap already positive by our calculations H-P versus production function output gap (%) 8% 8 6% 6 Labour productivity 4% 2% 2 0% 0 -2% -2 TFP production function -4% -6% Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Production function gap 4 H-P filter gap -4 -6 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Source: Standard Chartered Research 8 What happened to growth? Long-term explanations Potential growth is much lower than 5 years ago Potential growth using production function Potential growth of around 2.5% is a concern for the monetary authority 3.6 3.4 Any pick-up in growth could have implications for inflation 3.2 Economy overheats very easily Interest rates remain elevated 3.0 High interest rates inhibit fixed investment A vicious cycle is established 2.8 2.6 2.4 2.2 2.0 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Source: Standard Chartered Research 9 What happened to growth? Long-term explanations Relative price of capital is stable in Brazil Brazil vs. US relative price of fixed capital 110 100 Brazil 90 80 70 US 60 50 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Source: Standard Chartered Research 10 Growth outlook – Short term versus long term Macroeconomic adjustment: The adjustment is already in progress Monetary policy adjustment initiated in April 2013 Fiscal adjustment has already started, but will be more gradual We expect the current fiscal tightening to last through 2015 The dismal situation in Argentina will not help in the short term Monetary and fiscal adjustments will be essential for a recovery in confidence The next step (2015-18) will be a pick-up in investment, mainly driven by infrastructure projects – PPP and concessions Stronger global growth will help in the transition Source: Standard Chartered Research 11 Growth – Another year of poor performance BCB’s Focus GDP growth median, max and min on April of each year versus actual Historically, there have been plenty of GDP growth surprises; too early to call for a bad year? (%) 8 7.53 Actual 7 6.10 5.71 6 Mean (march) 5.17 5 4 Max. 3.96 3 2.66 2.73 3.16 2 1 1.31 2.28 Min. 1.15 1.80 1.03 0 -0.33 -1 -2 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: BCB, Standard Chartered Research 12 Brazil – FIFA World Cup 2014 Studies show that, on average, economic growth in countries hosting big sports events increases two years after the events. Out of 14 events, 9 resulted in higher growth following the events. Irons (2006) shows that among EM countries, economic growth averages 3.1% in the two years prior to the event, slows down to 1.3% on average in the year of the event, to accelerate on average to 4.1% in the two years after the event. Hosting countries whose national teams win the event experience even greater acceleration in economic growth. In Brazil, a total of BRL 22.7bn is expected to be invested in infrastructure for the World Cup. This compares with c. BRL 30bn in Germany in 2006, and BRL 15bn in South Africa in 2010. Some of the intangible benefits: Increased interest in the country, increased tourism after the event, improved quality of services, and improved domestic sentiment. Some of the intangible costs: Increased traffic, possible increased violence, and reduced business/productive tourism. Source: Standard Chartered Research 13 Brazil – The electricity sector under pressure Risk of electricity rationing is 24% (PSR estimate), gradually rising since early 2014. Risk is mainly concentrated in the southeast and midwest systems, which are responsible for 70% of the hydroelectric energy reserves Thermoelectric plants running close to full capacity. First two months of 2014 were the hottest since 2002. Energy consumption jumped 11% y/y. Q2 temperatures are expected to be much milder – consumption growth is expected to decelerate to 4% y/y. The risk of actual rationing is small. Scattered official energy-saving measures are more likely. Budget implications: The government needs to fund the Energy Distribution Companies (EDC) to make up for the gap between prices paid and prices charged – essentially a subsidy. In 2013 BRL 7.9bn was transferred. In 2014 the government announced BRL 13bn in transfers – not enough. The EDC will issue BRL 8.0bn in debt – costs to be passed to consumers starting in 2015. Currently consumers pay BRL 110/MWh, while wholesale prices are at BRL 800/MWh. Uncertainty on energy tariffs is likely to continue into 2015. Rio Madeira hydroelectric plants to significantly increase capacity in 2014-15. Source: Standard Chartered Research 14 Presidential elections 2014 – More uncertainty Dilma Rousseff is currently well ahead in the polls. However, it is too early to draw conclusions, five months before the start of the campaign: Fragile lead World Cup will attract a lot of attention. Social media makes it easy for large groups of protesters to quickly organise and go to the streets – as in June 2013. Inflation remains high | Frustration with public services | Urban violence Participation of violent groups has frustrated those who favour peaceful protests Election risks for Rousseff are that she doubles up on interventionism, protectionism and less orthodox measures. Other candidates are very well accepted by the business community. If anything, a victory by Aécio Neves (PSDB) or Eduardo Campos (PSB) could result in a market rally. At this point 24% of voters have not yet decided. Lula does not want to come back now -> economy is doing badly and even he could lose. Source: Standard Chartered Research 15 Growth – Private consumption to grow at a pace more consistent with GDP and income growth Real wage bill highly correlated with consumption Private consumption to growth to stabilize in 2014 6% Growth of private consumption and fixed investment has been the base for Brazil’s growth model over the past decade: 4% Private consumption is the most important 10% Wage bill 8% component of demand (63% of GDP) 2% Private consumption Over the past three years, the growth of private consumption has decelerated gradually 0% -2% We expect consumption to continue to be an important source of growth -4% However, household leverage has reached -6% a point where it is unlikely that consumption will grow faster than GDP and income growth -8% -10% Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Source: Standard Chartered Research 16 Consumer confidence close to multi-year low Consumer confidence index is the lowest since June 2009 From the peak in Apr-2012 the index has already fallen 20% 130 125 120 115 110 105 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Source: FGV, Standard Chartered Research 17 Growth – Investment likely to be flat in 2014 Fixed investment to be flat in 2014 Fixed investment vs. our model (level) Elections and market volatility, among other concerns, keep business confidence weak: 200 Fixed investment 190 Higher real interest rates and a weaker real exchange rate may sideline investment in 2014. Despite the negative outlook for 2014, large infrastructure projects are likely to boost investment in 2015-18 – PPP and concessions 180 Model estimates 170 2013 2014 Real interest rate (%) 2.2 4.5 Real exchange rate (level) 89.5 88.7 Business confidence (level) 54 54 Investment growth (%) 5.7 0.0 160 150 140 130 120 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Source: Standard Chartered Research 18 Growth – Government spending cuts to weigh on growth Central government spending to grow much less Government consumption vs. spending 6% Central govt spending 4% 20% Fiscal tightening on course for 2014 In the short term, fiscal tightening has a negative impact on aggregate demand and growth 10% The federal government announced a total spending cut of BRL 44bn for 2014 2% 0% Government consumption, LHS 0% -10% -2% -20% Despite the uncertainties about fiscal figures and market skepticism, the economy will likely go through a fiscal adjustment Medium-term, fiscal adjustments have a positive impact on growth, reducing inflation risk and risk premium, and adjusting relative prices distortions We think that the current fiscal adjustment is gradual and will last through 2015 -4% -30% Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 Source: Standard Chartered Research 19 Growth – Net exports to help significantly in 2014 Net exports to improve significantly Exports vs. imports, y/y Weaker imports and stronger exports in 2014 Net exports are expected to improve significantly in 40 2014: When production is weak and domestic demand remains strong, imports fill in the gap 30 In 2014 we expect both private and government Imports spending to moderate, as well as investment to weaken; the result is less need for ‘external savings’ or imports. 20 Stronger global growth (3% from 2009-13; 4.0% 10 expected for 2014) and a weaker BRL to help boost exports Exports From 2004-08 exports of goods and services 0 grew by 7.3% y/y; from 2009-13 they grew by only 2.0% y/y on average If exports had maintained the same pace of -10 growth, GDP growth would be closer to 4.0% in 2009-13 as opposed to 2.7% on average -20 4Q' 04 4Q' 06 4Q' 08 4Q' 10 4Q' 12 4Q' 14 Source: Standard Chartered Research 20 Growth outlook – Short term vs. Long term 2014-15: Macroeconomic adjustment + beginning of a new administration 2015 onwards: Recovery of economic stability will lead to better business sentiment and investment Infrastructure investment boosted by PPPs and concessions to play an important role Source: Standard Chartered Research 21 Growth outlook – Different mix, same headline 2013 2014 2.3 1.8 Private consumption 2.3 1.8 Government consumption 1.9 1.8 Fixed investment 6.3 0.0 Exports 2.5 3.2 Imports 8.4 3.0 GDP Source: Standard Chartered Research 22 Balance of payments to improve gradually Trade balance to recover importantly through 2015 Constructive view for the trade balance medium12-month accumulated trade balance (USD mn) term: 50,000 40,000 30,000 Capacity expansion in the oil sector Increased refining capacity behind a shift from deficit to surplus on the oil trade balance. Current oil production of 2mb/d to 4mb/d by 2020 Oil deficit of USD 5bn in 2013 to a surplus of more than USD 40bn by 2020 20,000 10,000 0 -10,000 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14 2013 2014 2015 2.6 6.0 25.0 Current account (USD bn) -81.4 -63 -58 Current account (% GDP) -3.6 -2.8 2.4 FDI (USD bn) 64 54 54 Reserves (USD bn) 376 373 385 Trade balance (USD bn) Source: Standard Chartered Research 23 Balance of payments to improve gradually Current account deficit to improve over 2014-15 Current account % of GDP 3 We expect the current account deficit to improve gradually Real exchange rate depreciation of more than 30% 2 since 2011 is expected to have an impact on services and income deficits. 1 Weak economic growth to keep imports from growing much faster 0 But, international commodity prices remain soft; -1 Argentina is expected to perform very poorly, profit and interest remittances abroad are expected to increase. -2 We expect FDI inflows to slowly moderate -3 High interest rate increases attractiveness of carry-trade, improving the outlook for portfolio inflows – hard to forecast -4 -5 -6 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-14 Source: Standard Chartered Research 24 Balance of payments to improve gradually FDI breakdown by sector (2013) % of total FDI Real estate 1% Services 50% Retail ex-auto 11% Transportation 6% Insurance 6% Financial 4% Agriculture 16% Oil and gas 11% Industry 33% Metals 5% Food 5% Auto 5% Source: Standard Chartered Research 25 Balance of payments to improve gradually Argentina remains relevant Brazil’s exports: Manufactured goods to Latin America, % total 50 45 Developments in Argentina are clearly negative for Brazil: Around 90% of Brazil’s total exports to 40 Argentina in 2013 were of manufactured products 35 The bulk were autos (passengers’ cars 30 account for 25% of exports to Argentina Latam ex-Argentina 25 Argentina is also the third-largest supplier to Brazil, accounting for 7% of Brazil’s total imports (cars are also the highlight) 20 15 10 Exports to Argentina 5 0 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Argentina accounted for 8% of Brazil’s total exports in 2013 (USD 20bn); therefore, the depreciation of the USD-ARS exchange rate will likely affect Brazil’s currency as well Jan-12 Source: MDIC, Standard Chartered Research 26 Inflation – Any relief? Underlying measures of inflation to remain elevated Headline, services, monitored and market price inflation (% y/y) 10 9 Services 8 Market 7 IPCA 6 5 4 3 Monitored 2 1 0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Source: Standard Chartered Research 27 Inflation – Any relief? Risks to the upside for inflation in 2014 Exchange rate – FX volatility and asymmetry of pass-through Inflation expectations consolidating above the target Large lag between administered prices and market prices – distortions Foods prices – Unusually low level of rainfall Risks to the downside: Good grain harvest expected for the year Weak activity and a moderation in labour market to ease pressures on services Source: Standard Chartered Research 28 Fiscal policy – A course adjustment? % of GDP 2011 2012 2013 2014 3.1 2.4 1.9 1.6 2.3 1.7 1.6 1.4 Revenues 19.7 20.0 20.4 20.6 Spending 17.5 18.3 18.8 19.2 0.8 0.5 0.3 0.2 2.7 1.8 1.0 0.8 Public-sector primary surplus Central government primary surplus Regional government primary surplus * Recurring primary surplus Source: Standard Chartered Research 29 Fiscal policy – A course adjustment? 3.5 3.0 Primary surplus 2.5 2.0 1.5 Recurring 1.0 0.5 0.0 2009 2010 2011 2012 2013 2014 Source: Standard Chartered Research 30 Fiscal policy – A course adjustment? Spending cuts or ‘contingenciamento’: Total of BRL 44bn planned for 2014 in spending cuts Government is targeting 1.9% or GDP or BRL 99bn Election year = slower increase in public payroll spending (limited hiring) Deceleration in public pension spending due to a smaller increase in the minimum wage Electricity subsidies expected to increase from BRL 9bn in 2013 to BRL 15bn Source: Standard Chartered Research 31 Brazil – Monetary policy: BCB on hold for now SELIC rate rollercoaster SELIC target rate (%) Inflation expectations drifting higher 12-months ahead IPCA expectations (Focus survey) 13 6.5 12 6.0 11 5.5 10 9 5.0 8 4.5 7 6 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 4.0 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Source: Standard Chartered Research 32 Brazil – Monetary policy Hiking cycle seems close to an end BCB has been preparing to end the hiking cycle since November 2013 Loose fiscal policy makes life for the monetary authority more difficult Anchoring inflation expectations is more complicated Long end of the curve widens Recent moderation (January) in inflation is likely temporary – IPCA to end 2014 at 6.3%, but the peak may be 6.8% in Jul/Aug-2014 BCB projects better numbers for 2015, but models still call for inflation above the center of the target of 4.5% The exchange rate remains a significant risk The pass-through is larger and quicker the higher the level of the USD-BRL FX volatility is typically higher in the second half of an election year Weak growth will prevent the output gap from widening (more positive) Source: Standard Chartered Research 33 Brazilian real (BRL) – 2014 Outlook Brazil has, in the last six months, been included in the so-called ‘Fragile Five’ group of countries. However, we view this grouping as an over-simplification of the macroeconomic issues in these economies. Granted, Brazil shares some fundamental weaknesses with Turkey and South Africa, such as sluggish growth, high inflation and a weak current account position. However, there are also critical differences. We think Brazil’s overall balance-of-payments position is better than the ‘Fragile Five’ and less vulnerable to turns in market sentiment. Brazil runs a healthy capital account surplus, offsetting the current account deficit. The financial account surplus was USD 75.3bn in 2013, up from USD 70bn the previous year. 34 Brazilian real (BRL) – 2014 Outlook (part 2) The removal of the IOF tax in June 2013 should be positive for capital inflows medium-term. Brazil’s FX reserves, at USD 377bn, are substantially larger than those of Turkey and South Africa, both on an absolute basis and as a percentage of GDP. Our BM&F positioning signals show that net BRL short positions have been reduced since early 2014 (see page 36); much of the bad news for Brazil is already priced in – even a credit downgrade from Standard & Poor’s was largely expected by the market. We maintain our Overweight the BRL both short and medium-term versus current forwards; long-term capital flows into Brazil have been less disrupted by recent volatility. With portfolio and FDI inflows remaining strong in 2014, the expected narrowing of the current account deficit to 2.4% of GDP should further improve Brazil’s balance-ofpayments dynamic throughout the year. 35 Positioning signals have produced useful reversal points for BRL Excessive differentials in domestic and foreign positioning have produced useful FX signals BM&F USD futures positioning by domestic and foreign investors, no. of contracts 400,000 300,000 200,000 100,000 0 -100,000 -200,000 -300,000 -400,000 Dec-07 Foreign investors Domestic investors Bullish USD-BRL signals Bearish USD-BRL signals Onshore/offshore differential Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Source: BM&F, Standard Chartered Research USD-BRL reversal points Domestic/foreign positioning extremes have produced directional signals for USD-BRL historically 2.6 2.4 2.2 2.0 1.8 1.6 1.4 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Source: Bloomberg, Standard Chartered Research 36 Global Disclaimer (page 1 of 2) Analyst Certification Disclosure: The research analyst or analysts responsible for the content of this research report certify that: (1) the views expressed and attributed to the research analyst or analysts in the research report accurately reflect their personal opinion(s) about the subject securities and issuers and/or other subject matter as appropriate; and, (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research report. 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