Macro Notes:Brazil,A Consumption-Led Recovery

Despite the unstable political environment, a sharp decline in inflationis allowing the BCB to ease monetary policy, which is driving aconsumption-led recovery. Brazil’s GDP grew 0.2% QoQ in 2Q17, whichwas in line with our forecast and therefore we are keeping our 2017GDP forecast unchanged at 0.7%. For 2018, however, we have raisedour forecast to 2.6% from 2.1%, given the latest positive indications forconsumption, better-than-expected employment data and lower interestrates.

    We expect consumption to continue recovering due to monetary easing,incipient credit expansion and labor market stabilization. However, weremain pessimistic about a quick rebound in investment, given thevery low level of capacity utilization in the economy and high politicaluncertainty surrounding the 2018 presidential elections (even though theeconomic recovery could, in theory, benefit a market-friendly candidate).

    Inflation remains subdued due to the steep deflation of agricultural prices,high unemployment and FX stability. We have cut our 2017 inflationforecast to 2.9% from 3.1% and our 2018 forecast to 4.1% from 4.6%.

    Inertia (mainly through administered prices and wages) will contribute tokeep inflation below the 4.5% target next year and the main risks will bea strong rebound in food prices and a sharp FX depreciation triggered bypolitical events, in our opinion.

    The BCB has cut the SELIC overnight rate to 8.25% and has signaledfurther easing ahead, albeit at a slower pace. Given the benign near-termoutlook for inflation, we have cut our year-end SELIC rate forecast to7.00% from 7.25%. We forecast a 75bp cut for the next COPOM meetingin October and expect a final rate cut of 50bps in December. That said, aneven deeper-than-expected process of disinflation could prompt the BCBto cut rates further.

    While low inflation and a comfortable situation in the balance of paymentshelp support Brazilian assets, the steady fiscal deterioration is makingthe country more vulnerable to negative shocks. Due to disappointing taxrevenues, rapid increase in the social security deficit and heavy relianceon uncertain extraordinary revenues, the government raised the primarydeficit ceilings for 2017 and 2018. Consequently, the public debt will groweven faster and the president elected next year will have to implement apainful and politically challenging fiscal adjustment in 2019.