Gray Newman and Claudia Castro (New York)
The twin jobs and inflation reports from the US have raised the specter once again that the Fed will act sooner rather than later, and could produce a bond debacle reminiscent of 1994 (see Richard Berner’s “2004: Déjà vu All Over Again?” Global Economic Forum, April 12, 2004). While many argue that 2004 is different — and we believe that it is in many ways — there are enough similarities between 1994 and 2004 to cause emerging market investors to pause (see also Steve Roach’s “Shades of 1994,” Global Economic Forum, April 12, 2004). And nowhere in Latin America do these concerns appear to be greater than in Brazil.
Brazil’s vulnerability is easy to understand. After last year’s downturn in the economy — private consumption posted its most severe contraction in more than a decade — policy makers are under fire to ensure that growth is back, long before the closely watched municipal elections slated for October. While the new administration might try to stay the course with prudent fiscal and monetary policy even if good growth does not re-emerge, there is significant risk that investors will not stay around to find out. And given Brazil’s large — and largely floating — debt stock, the absence of good growth could trigger a sudden reversal of risk appetite and reignite fears of 2002’s vicious cycle, regardless of the pace of the Fed’s tightening.
The stakes have rarely been higher in Brazil. Without good growth in Brazil in 2004, the risk that political pressure forces a change in policy — or simply prompts investors to expect a policy shift — is considerable. Add to that the market jitters seen around the globe as investors try to prepare for the Fed’s exit strategy from the past two and a half years of unusual monetary accommodation, and it is easy to see why concerns over Brazil have risen. With that in mind, we have decided to review the latest indicators of activity in Brazil.
We conclude that Brazil’s economy is still on track for strong growth in 2004 and we expect growth this year to exceed the market consensus near 3.5%. However, the data points from the first months of the year are hardly uniform. Indeed, we are still puzzled by the newly revised industrial production series, which appears to be out of synch with other indicators suggesting a much stronger 2004.
With an uneven recovery, it is not hard to pick and chose from the plethora of data releases in Brazil to support a more negative view. But in forecasting, as in driving a car, focusing on the rearview mirror can be hazardous. The best news coming from Brazil is that the drivers of activity — which give us a glimpse of what is to come — remain positive.
Our biggest disappointment comes from the newly revised industrial production series that suggests output is slumping. While February industrial production rose 1.8% compared with the previous year, it appears to have fallen from January’s level of output. Even after attempting to correct for the shorter month and the fact that the carnival holidays fell within February this year, the series suggests that the downturn actually began late in the fourth quarter of 2003. The previous series had suggested a pause in December 2003 and January 2004, but the new series — rebased with new industries — is indicative of a downturn. Interestingly enough, the one piece of good news in the new, rebased series is that semi- and non-durable consumer goods production is up — consistent with the improvement that we are seeing in retail sales and an encouraging sign that the recovery is broadening.
We are hesitant to read too much into the February data. First, we are still examining the new industrial output series. It appears to be applying seasonal weights from the old series to the new series, which has been rebased with new industries only back to the beginning of 2002. The correct seasonality for the moving carnival holiday is hard to determine. Second, the results appear to be inconsistent with a host of other data series — from hours worked in the manufacturing sector to employment and installed capacity — suggesting something at worst more akin to a pause than a downturn. Finally, given the traditional responsiveness of Brazil’s economy to monetary easing, the present trajectory of rates, and the positive developments in a host of leading indicators, too great a focus on the February industrial output series could lead to “rearview mirror” economics.
Leading good news
We are maintaining our upbeat view on growth in 2004 thanks to our belief that, with inflation largely under control, the authorities can continue to cut interest rates further. The central bank’s modest 25 basis-point cut on April 14 to 16% for the Selic target rate can hardly be characterized as significant monetary stimulus, but it does serve notice that the central bank is interested in prolonged growth rather than a one-off boost that will be quickly aborted as inflation expectations rear their head. We expect the monetary authorities to continue to ease rates to 14% during the course of the year.
In turn, we expect the Brazilian economy to respond to lower interest rates during the current cycle much as it has in the past. During those brief periods in the past decade when real interest rates have fallen below 10%, activity has responded strongly. And with lower interest rates and lower inflation, credit should improve along with gains in real wages. With an improvement in activity, investment and employment should also show signs of a turnaround.
The good news is that real wages are gaining ground for the first time in nearly two years in Brazil. The turnaround — reconfirmed with the release of February data — should not be much of a surprise: It comes as a result of the successful fight on the part of the central bank to rein in inflation and inflation expectations.
On the jobs front, we continue to see an improvement in formal employment. Our focus is on formal employment because much of the job creation during 2003 — job creation was up 5.5%, the strongest in the past ten years — was of questionable origin. There is evidence that the workforce increased last year as workers sought to supplement their real wages, which had been damaged by inflation. An improvement in employment and wage mass brought on by declining average wages is hardly the kind of recovery in jobs to be lauded. The good news, however, is that the most recent data in early 2004 suggest a turnaround in average wages and a continued improvement in formal employment. The most recent data from Brazil’s industrial chamber (CNI) suggest employment rose slightly in February compared with January, as did hours worked. The biggest gains, however, were seen in real wages, up 1.2% from the previous month and up 7.2% compared with the same month from the previous year.
While consumer confidence has been a bit more volatile, business confidence remains upbeat. The most recent survey, conducted by Sao Paulo’s FIESP in March, showed 63% of those surveyed were optimistic about their operations in 2004, virtually unchanged from 65% in February. (There was a slight decline in the proportion of “very confident” responses, to 8% from 12% the previous month).
Meanwhile, credit conditions continue to improve, with consumer credit leading the way. Our Latam banks analyst, Jorge Kuri, sees upside to bank forecasts of 20-25% credit growth in 2004. In meeting after meeting with the principal banking groups in Brazil in mid-April, the message from Jorge remains upbeat on good loan growth. Indeed, there is some anecdotal evidence that corporate lending and activity has begun to gain ground in late March and early April.
For example, signs of strong paper packaging demand in March and in early April bodes well for an upturn in industrial activity and retail sales in the months to come. In March, Brazil paper packaging sales posted a strong recovery, reaching 180,196 tons, a 13% increase year over year. Even adjusting for the carnival holiday (which fell in March last year in contrast with February this year), year-to-date sales were still up 6% year over year. According to our Latam paper and pulp analyst, Andres Perez, the packaging pickup suggests that consumption is gaining ground as the bulk of paper packaging is used in non-durable and semi-durable consumer goods industries.
It’s inevitable with any turnaround — the pace of the recovery is rarely constant. After a strong upturn in industrial activity in the second half of 2003, and an improvement most dramatically seen in interest-rate sensitive durable consumption, Brazil’s upturn is showing signs of consolidation. It is easy to pick one or two months of industrial output data and argue that the recovery is over — or, even more misguided, to ask when the recovery is set to begin. But the good news is that the underlying drivers of a turnaround — real wages, employment and lower interest rates — are all kicking in for the first time in years. While the markets are likely to experience considerable jitters in the months to come as the Fed hike becomes “imminent,” then fades as a risk and then becomes “imminent” again, we believe Brazil’s real economy is likely to surprise in 2004 with better growth than most expect.