Itaú BBA - A favorable global environment, with important events on the horizon

Global Scenario Review

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A favorable global environment, with important events on the horizon

May 12, 2017

The global outlook remains favorable for emerging markets

Please open the attached pdf to read the full report and forecasts.

Global Economy
The global outlook remains favorable for emerging markets
The growth outlook for the U.S. and Europe remain positive, while China undergoes a manageable slowdown.

A focus on politics, while still waiting for growth
Economic activity in the region remains decoupled from financial conditions. Meanwhile, key political events will take place in Brazil, Chile, Argentina and Mexico.

Hanging on the Social Security reform
The Social Security reform advances in the Lower House. We expect approval of the Social Security reform in Congress by the end of 3Q17.

Central bank activism
The central bank left the monetary policy rate unchanged, and reiterated that it is ready to act (again) if disinflation does not resume in May

Resilient to shocks, but inflation prone
Activity surprised to the upside in 1Q17, but inflation is on the rise, driven by the lagged effects of last year’s peso depreciation.

Clarifying the appetite for easing
The central bank implemented the additional 25-bp rate cut that it had signaled in its recent Inflation Report, and added that some further easing is possible.

Monetary easing cycle begins, amid weaker activity
The Central Bank cut the reference rate by 25-bp in May, against the backdrop of anemic growth. The monetary authority found itself at crossroads in May, as it had to choose between cutting rates or protecting the credibility of its inflation mandate.

Weak growth, sticky inflation 
Activity has disappointed at the start of the year, and the indications are that a recovery ahead is limited. The disinflation process came to a halt as regulated price inflation surprised to the upside.

A correction, not a new downward trend
We believe that the recent decline in commodities are a correction and not the start of a new downward trend for commodity prices overall.

A favorable global environment, with important events on the horizon

The global scenario remains favorable for emerging markets, as the growth outlook improves and risk diminishes. We expect growth in the U.S. to pick up in the second quarter. The Fed is expected to raise interest rates in June, continuing the gradual process of adjusting monetary conditions. For the euro zone, we have raised our growth forecasts to 1.8% from 1.6% for 2017 and to 1.5% from 1.3% for 2018 due to lower political risk. After a strong first quarter, China’s economy will likely decelerate in line with the government’s implementation of contractionary policies. However, the government will likely refrain from exaggerated tightening in an environment where the economy’s cyclical momentum has improved and capital outflows remain subdued (thus reducing exchange-rate-related risks). Our view is that the recent drop in commodity prices represents a correction from previous excess, not a trend.

The global economic environment remains favorable for Latin America, despite some deterioration in asset prices recently. The positive effect of this environment on the region’s economic growth is not yet visible. With growth still weak and exchange rates stable, conditions remain favorable for interest rate cuts in many South American countries. However, in Mexico, we now foresee  the reference rate reaching a higher level than we previously expected, given still-unfavorable inflationary dynamics. In addition to the potential approval of the social security reform in Brazil, the main upcoming political events in the region include the presidential elections in Chile, midterm elections in Argentina and gubernatorial elections in the State of Mexico.

In Brazil, after a sequence of data between December and February that were consistent with increasing activity, weak results in March raised doubts as to the robustness of the recovery. We have maintained our GDP growth forecasts of 1.0% in 2017 and 4.0% in 2018, with the weakness of recent data offsetting the stronger growth seen in the first quarter. We have also maintained our inflation forecasts at 3.9% this year and 3.8% in 2018. We have revised our exchange rate forecast for year-end 2017 to 3.25 BRL/USD (from 3.35), given the benign external scenario and signs of robust risk appetite on the part of global investors, despite falling commodity prices. We expect the central bank to cut interest rates by another 100 bps at the end of May, but there is a risk of a sharper cut in the event of a favorable vote on the social security reform this month. We believe that the social security reform will be approved in Congress by the end of the third quarter.

Global Economy

Still favorable scenario for EM, despite lower commodity prices

• The global scenario remains favorable for emerging markets, with better global growth and lower risks.

• In the U.S., we expect growth to pick up in 2Q17. The Fed will likely increase the fed funds rate in June and stay on a gradual hiking path.

• For the euro zone, we have raised our GDP forecasts to 1.8% from 1.6% for 2017 and to 1.5% from 1.3% for 2018, as political risks have not materialized.

• China’s economy will likely slow down after a strong 1Q17 as policy becomes tighter. However, Chinese policymakers will likely be careful to not overdo it, as the economy is in a better cyclical position and capital outflows remain subdued (reducing exchange rate risks).

• We view the recent drop in commodity prices as a correction, not a trend.

U.S. – GDP likely to rebound in 2Q17; we expect Fed hike in June

We expect U.S. GDP to grow by 3.7% QoQ/SAAR in 2Q17, up from 0.7% growth in 1Q17. We see a rebound in consumption and inventory accumulation after a weak start to the year. Fixed investment will likely continue to grow at a moderate pace.

Labor market and sentiment indicators corroborate our view that the growth momentum is better than the soft 1Q17 GDP suggests. The U.S. economy has created (on average) 175,000 net non-farm jobs per month in the last three months. The unemployment rate declined to 4.4% in April, its lowest level in 10 years. Business and consumer sentiment indices have been holding up at levels consistent with consumption/investment growth above 3%.

In the absence of renewed external risks, financial conditions will likely remain supportive of growth. An acceleration in domestic activity is likely to sustain optimism about corporate income. It is true that the prospects of President Trump’s ambitious fiscal reform agenda are fading. But we don’t believe that this will have much effect on the 2Q17 GDP rebound in a context of lower external risks. In our 2018 forecasts, we still assume that the Trump administration will enact a fiscal stimulus amounting to 1% of GDP.

We maintain our forecast for U.S. GDP growth rates of 2.3% in 2017 and 2.4% in 2018.

We continue to expect the Fed to raise interest rates in June and September, in addition to starting balance-sheet normalization in December. We foresee four more rate hikes in 2018, assuming that a moderate tax cut (1% of GDP) is enacted by year-end 2017. If President Trump fails to get a fiscal stimulus package passed, we expect three rate hikes in 2018.

The risk of faster Fed rate hikes this year seems low, given muted inflation pressures. Average hourly earnings (2.5% YoY) and the core PCE deflator (1.6% YoY) remain well behaved. We believe that in June the median FOMC participants estimate for the 4Q17 unemployment rate will drop to 4.3% from 4.5%. But the core PCE deflator forecast for 4Q17 is likely to decline by 10 bps, to 1.8% YoY, given some recent weakness in core inflation.

We still foresee 2-year and 10-year Treasury yields rising by 2.2% and 2.8%, respectively, by year-end.

Europe – Better growth set to continue as French election risk is avoided

Emmanuel Macron has become the new president of France, in a positive development for the euro zone. Macron’s win averted the risk of a Europopulist government being elected in France. In addition, Macron has a reformist and pro-European agenda. Of course, many doubt that he will be able to implement that agenda. The elections for the National Assembly in June will be a key indicator of how much support Macron will have in the French Parliament.

Europe still faces political risks, particularly in Italy. Italy is contending with a worrisome combination of high migration flows, high unemployment and low growth, all of which could fuel Europopulism (see Macrovision: Has Europopulism been stopped?). Nonetheless, we continue to expect that a general election in Italy will not be held until next year.

Meanwhile, activity remains strong. Euro zone GDP grew by 0.5% qoq in 1Q17, a solid pace for the region. The purchasing managers’ index (PMI) reached 56.8 in April and is indicating that growth could improve further in the second quarter (see chart). Improving financial conditions, slightly expansionary fiscal policies and a milder external drag have broadened the recovery in the euro zone.

Despite this improving outlook, the ECB is likely to stick to its accommodative stance for now. But we do expect its forward guidance to gradually shift toward a neutral assessment of the balance of risks. This could amount to preparing the ground for the removal of stimulus, likely by year-end. We expect that in 2018 the ECB will raise the deposit rate to 0.0% from -0.40% while also reducing the monthly pace of assets purchases to EUR 30-40 billion from EUR 60 billion.

We have raised our 2017 and 2018 GDP growth forecasts for the euro zone to 1.8% and 1.5%, respectively, from 1.6% and 1.3%.

China – A manageable slowdown

In 1Q17 China’s GDP grew by 6.9% YoY, a stronger increase than in the two previous quarters. The GDP breakdown shows strong demand and supply. Industrial production and fixed asset investment grew by 8.4% yoy and 9.1% yoy, respectively. Retail sales rose by 10% yoy over the same period.

While the pace of growth in 1Q17 was quite strong, activity started to slow down in April. The official manufacturing PMI slowed to 51.2 in April from 51.8 in March. Lower new orders relative to inventories signals that the index will continue to drop in May.

Why is China’s economy starting to slow down? Tighter economic policy. First, the government initiated a policy shift in late September 2016 by implementing macro-prudential measures to cool off the property sector. Second, the central bank hiked several policy rates in early 2017 and recently adopted more rigid financial regulations. Since last October, the 1-year swap rate has increased sharply, to 3.8% from 2.5%. Although these measures were aimed at reducing financial risks, they have still created some headwinds for activity. Third, the government has been removing fiscal stimulus. Public investment has been decreasing since the beginning of last year.

However, we don’t expect the current economic slowdown in China to impact global markets as the last slowdown did in 2013-16.

The economy is in a good position in the cycle. The housing sector is more balanced: inventories are lower, and sales are increasing at a faster pace than construction. At the end of 2013, 12-month average floor-space-started was at 121 million square meter, while sales growth was at 96 million square meters (see chart). The outlook for the external sector is also positive. China’s exports have been on a positive trend since the second half of 2016 (see chart), in line with the concurrent improvement in the global economy. And at last, the decrease in public investment has been offset by a recovery in private-sector investment (see chart).

Economic policy can be adjusted, if necessary. In our view, China’s central bank will maintain its current prudent/tight stance and wait to see how much activity will slow, adjusting its policy as necessary. We believe that the overall bias of policymakers in China is cautious and that their preference is to err on the side of tightening too little rather than too much.

Finally, capital outflows have diminished. Capital controls and higher domestic deposit rates have reduced capital outflows. Indeed, foreign reserves have increased over the past three months (see chart).

We have increased our 2017 GDP growth forecast for China slightly, to 6.5% from 6.4%, due to the stronger-than-expected activity at the beginning of the year. We maintain our forecast of 5.8% GDP growth in 2018, which implies meaningfully slower activity in the coming quarters.

Commodities – A correction, not a new downward trend

The Itaú Commodity Index (ICI) fell by 5.3% in April, pulled down by declines in the metal and energy price indexes. The former plummeted by 12%, led by a 22% drop in iron ore prices,  while the latter declined by 6% on a correction in oil prices.

We believe that the price declines in both commodity groups are a correction of previous excess, and not the start of a new downward trend for commodity prices overall.

Firmer global growth limits declines in metal prices. The downside risks to an improvement in the global manufacturing cycle seem limited at the moment, even with a slowdown in China. If the global manufacturing PMI remains close to its current levels, metal prices are unlikely to start a downward trend (see chart). This is consistent with our forecast of a 6% decline in the ICI Metals from its current level, with iron ore prices falling to USD 55/mt by the end of the year.

An extension of OPEC’s deal and the decline in U.S. inventories (albeit from high levels) will likely provide support to oil prices. We estimate that the market balance reached a small deficit in 1Q17. Even with an extension of the OPEC deal, we believe that the deficit will persist this year. We maintain our year-end Brent price forecast of USD 54/bbl (WTI: USD 52/bbl).

In addition, the current decline in oil prices is creating fewer balance-sheet concerns than the 2015-16 decline did, so it is likely to have a more limited impact on the global economy. In the U.S., the negative correlation between high yield corporate spreads and oil prices has been broken (see chart) due to the improvement in the balance sheets of oil and gas companies and the better economic outlook for 2017.

Finally, the ICI Agricultural sub-index remained broadly stable in 1Q17. Sugar and coffee prices dropped by 8.6% and 2.5%, respectively, due to a weaker BRL and a better outlook for sugar in the 2018-19 crop year. On the other hand, soy and wheat prices have increased by 2.8% and 3.7%, respectively.

We expect the ICI to gain 2% from its current level by the end of 2017, with the increase mainly stemming from higher oil and agricultural prices.


A focus on politics, while still waiting for growth

• Market conditions remain favorable for Latin America, in spite of some deterioration in asset prices recently. The benefits for economic growth have yet to be felt.

• With economic growth still weak and exchange rates under control, conditions remain conducive of rate cuts in many South American countries. However, in Mexico we now foresee the reference rate peaking somewhat higher than we did previously, as inflation dynamics continue to be unfavorable.

• Besides the congressional vote of the social security reform in Brazil, key upcoming political events in the region include the presidential elections in Chile, the midterm elections in Argentina and the gubernatorial elections in the State of Mexico.

In spite of the recent declines in commodity prices, which followed disappointing economic data from China, financial market conditions remain favorable for Latin America. In fact, most Latin American currencies have continued to record gains against the dollar since the beginning of the year. We highlight the behavior of the Argentine peso, which has outperformed the region’s other currencies over the past month – in spite of the recent announcement of a reserve accumulation target that was followed by purchases of dollars by the central bank in the exchange rate market. In real and multilateral terms, the Argentine peso strengthened by 6.5% over the first four months of the year, favored by higher domestic interest rates and strong agricultural output.

Economic activity in the region remains decoupled from financial conditions. Supply-side factors (such as the mining strike in Chile and the El Niño weather phenomenon in Peru) have played a role in the weak activity seen in some countries. Activity has also weakened further in Colombia, likely in response to VAT increases. In Brazil, strong agricultural production and carryover effects probably propelled the economy out of recession in 1Q17, but the recovery is still far from widespread – similar to the story in Argentina, where the economy is already showing positive growth rates, but activity has been volatile and growth has been largely confined to the agricultural sector. In Mexico, however, activity has been a positive surprise, with consumption remaining strong (despite weak confidence and a slowing real wage bill growth) and manufacturing exports picking up.

Given that the more benign global economic environment is taking longer to benefit activity in LatAm than we were previously expecting, we have reduced our growth forecasts for Colombia and Peru and see downside risk to our growth forecast for Chile. However, we have increased our 2017 growth estimate for Mexico (to 2.0%). Although our new 2017 growth forecast for Mexico is not far from last year’s growth rate, we note that the carryover is very favorable for 2017, so a 2.0% expansion this year would represent a significant sequential deceleration – which we think is likely, given the tightening of macro policies, a still-uncertain outlook for trade relations between Mexico and the U.S. (investment has been weak) and lower real wages. In any case, we expect economic growth in the region to improve relative to 2016 as Argentina and Brazil emerge from recession.

With economic growth still weak and exchange rates under control, conditions remain conducive of rate cuts in many South American countries. In Argentina, the central bank is sticking with its tightening bias, warning that it could resume interest rate hikes if disinflation doesn’t resume in May. But the easing cycles continue in Chile, Colombia and Brazil, and one has just begun in Peru. Colombia’s central bank even increased the pace of rate cuts, though recent inflation dynamics make it likely that a more cautious approach will be adopted in its next meetings. Inflation is also more unfavorable in Mexico, and we now see Mexico’s policy rate peaking slightly above our previous expectation (at 7.25%, instead of 7.0%).

Political developments remain important drivers for LatAm economies. The June 4 gubernatorial elections in the State of Mexico (the country’s most populous state and a stronghold of the ruling PRI party) will be closely monitored, as a victory by Delfina Gómez (the candidate of López-Obrador’s Morena party) would fuel perceptions that Mexico is likely to move left in next year’s presidential elections. According to the most recent polls, the PRI candidate is leading the race by a narrow margin (Delfina Gómez is in second place). In Chile, another outsider – the leftist Beatriz Sánchez – has emerged as a player in the presidential campaign. Although her voting intentions are far below Sebastián Piñera’s and Alejandro Guillier’s, the fact that there is large proportion of undecided voters in the country will likely sustain political uncertainty until the election (an obstacle to economic recovery). In Argentina, former president Cristina Kirchner recently suggested that she will not participate in the midterm elections in October. While this decision eliminates a significant downside risk for Argentina (the possibility of a strong Kirchner showing in the election, which would indicate that she could be competitive in the next presidential elections), it also eliminates an upside risk: if her voter support had been disappointing, the perceived risk of policy disruption after the 2019 presidential elections would likely decline meaningfully. In any case, President Macri has now recovered the bulk of the popularity he lost early this year, regaining approval ratings which, if sustained, would position his party well for the midterm elections. Finally, in Brazil the debate over social security reform remains the key driver of asset prices. The government has already passed a version of the bill in a special committee of the Lower House (after some dilution). The market is now waiting for the vote in the Lower House floor to be scheduled, which would be a significant event in itself because – according to political observers – the government will only put the bill up for a vote when it is confident that it has enough support for approval.


Please open the attached pdf to read the full report and forecasts.

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