Itaú BBA - A tricky scenario unfolds

Global Scenario Review

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A tricky scenario unfolds

December 9, 2016

Emerging markets face the challenge of higher U.S. rates, but global financial conditions are well behaved and provide a buffer.

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

Global Economy
A tricky scenario unfolds
Emerging markets face the challenge of higher U.S. rates, but broader global financial conditions indicators are well behaved and provide a buffer.

Monetary policy easing amid external volatility
Activity has surprised to the downside, while inflation has evolved below expectations. In this environment, monetary-policy stances are becoming looser in spite of the more challenging external scenario.

Lower growth, higher risks
We have reduced our GDP growth forecast for 2016 and 2017. Fiscal reforms continue to move ahead, however political uncertainty has increased.

Monetary policy to the rescue?
The central bank is easing monetary policy at a faster pace than we expected. Concerns about weak activity and a strong currency are likely behind the interest rate cuts‎.

Calibrating the monetary policy response
As the central bank switched its focus to the pass-through from the Mexican peso depreciation, it is unlikely that the central bank will hike significantly more than the Fed does.

About to cut
As long as financial conditions for emerging markets do not deteriorate significantly more, the central bank would start cutting rates in January, taking the policy rate to 2.5% by the end of next year from 3.5% this year.

No rebalancing of growth sources yet
Economy remains strong, even though internal demand growth is poor. We expect activity to improve a bit more in 2017, but the fact that private investment is failing to recover is a risk.

A second chance for peace
The updated peace deal was ratified by congress and the tax-reform debate has kicked off, with potential short-term inflationary impact.

OPEC reaches a deal
Coordinated action by the cartel will likely balance the oil market as early as January 2017. With falling inventories and rising prices, the response by U.S. shale producers will be the main driver acting against further oil price increases.


A tricky scenario unfolds

The scenario of higher interest rates in the US continues to gain strength. The Trump administration is signaling a big ‘self-financed’ fiscal stimulus while avoiding major disruptive policies related to trade or immigration. In that case, GDP growth will speed up, unemployment rate will decline and inflation will rise. This supports our case for a faster tightening cycle by the Fed in the next two years.

In Europe, political risks dominate, but economic indicators have been resilient, so that we upgraded slightly our GDP forecast for the euro zone this year. However, it is also clear that the economic recovery relies heavily on continued monetary easing.

China has been able to sustain a stable growth trend, and we expect this stability to extend into 2017. Private sector investment will benefit from higher profits, and the public sector still has the means and the will to help maintain the economy’s growth pace. Risks there come from higher interest rates in developed countries that create pressure for capital outflows.

In Latin America, as U.S. interest rates rise we expect the currencies to weaken some more, and the Mexican peso will take time to get back to its fundamental levels.  Activity in the region has disappointed recently, and while we still expect a recovery in 2017, risks are tilted to the downside. As inflation falls, monetary-policy stances are becoming looser.

In Brazil, fiscal reforms continue to move ahead, but political uncertainty has increased. Economic activity disappointed to the downside so we have reduced our 2017 GDP forecast. Inflation continues to fall, the exchange rate remains close to its equilibrium value, and we expect the Central Bank to accelerate the pace of interest rate cuts in January.


Global Economy
A tricky scenario unfolds

• Global manufacturing surveys reached record-high levels in the recent cycle.

• U.S. interest rates will continue to rise and the USD to strengthen as the Trump administration pursues expansionary policies in an economy close to full employment.

• In Europe, political risks will remain high, but we note that recent developments have been balanced.

• In Japan, strong third-quarter GDP and post-Trump yen depreciation counterbalance the TPP’s demise.

• China’s activity remains stable but the pressure from capital outflows and protectionism from the U.S. are important risks.

• Commodities: OPEC reaches a deal; better metal-price outlook, but current levels are stretched.

• Emerging markets face the challenge of higher U.S. rates, but broader global financial conditions indicators are well behaved and provide a buffer.

Global manufacturing reached record levels in the current cycle 

The Global manufacturing Purchaser Manager’s Index (PMI) increased to the highest level in two years (see graph). The index rose to 52.2 from 51.8, maintaining an upward trend after bottoming in the beginning of the year.

Both developed-market (DM) and emerging-market (EM) PMIs are rising. In November,the developed countries’ average rose to 53.2 from 52.6, with increases in the U.S. ISM (to 53.2 from 51.9) and Euro Area PMI (to 53.7 from 53.5). Emerging economies’ PMI increased to 51.0 from 50.8, continuing a slow recovery after the slowdown seen from 2013 to 2015.

U.S. – Interest rates will continue to rise

The Trump administration is signaling a big ‘self-financed’ fiscal stimulus while avoiding, for the time being, major disruptive policies related to trade or immigration. His cabinet appointments have mixed loyal campaign advisers with establishment Republicans. Importantly, Trump made sure to secure good jobs for the political affiliates of the House and Senate leaders.

Trump has been gathering support for his fiscal agenda. The appointed Treasury Secretary, Steven Mnuchin, said that the number-one priority is the tax reform. He argues that the corporate tax cuts to 15% is crucial to raising GDP growth to 3%-4% and will be self-financed.

Meanwhile, the post-election rhetoric on trade and immigration has reduced concerns about disruptive measures. Trump’s day-one priorities will be to withdraw from the TPP, negotiate bilateral trade deals and ask to investigate visa abuses, all much softer than the campaign promises. The next Commerce Secretary, Wilbur Ross, dismissed the idea of an immediate imposition of import tariffs – instead, tariffs could be the outcome if negotiations to expand U.S. exports fail. 

Nevertheless, recent events indicate that the next presidency is likely to be louder on foreign policy. Trump’s phone call to the Taiwan president indicates less respect for traditional diplomatic protocols. These kinds of event may occur more often and raise the risk of escalation, given the president’s unapologetic profile. He later criticized China on trade and military policies in his Twitter account to justify his phone call.

Altogether, we continue to see fiscal expansion (1.1% of GDP within 18 months) speeding up GDP growth, to 2.2% and 2.4% in 2017 and 2018, respectively, up from 1.6% in 2016. This GDP growth outlook is consistent with steady payroll growth at 180 thousand jobs per month, pushing the unemployment rate to 4.1% by 4Q18 (see graph) and the core PCE deflator to 2.1% yoy in 4Q18.

This supports our case for a faster tightening cycle by the Fed in the next two years. We believe that the FOMC will need to raise the Fed Funds rate seven times in the next two years, once in 2016, twice in 2017 and four times in 2018. This forecast means the Fed Funds rate’s mid-range will be 2.125% in 4Q18, essentially a zero ex-ante real interest rate in a slightly overheated economy.

Finally we see risks tilted toward three hikes 2017, if the fiscal measures are approved more expeditiously than expected. Markets currently price in between four and five hikes by end-2018. The market catch-up with our call may occur in 1Q17, as President Trump unveils his fiscal proposal and the FOMC raises its interest-rate forecasts.

Europe – Politics dominate the debate

Economic indicators have been resilient in Europe. GDP growth has stayed constant at 0.3% qoq in 3Q16. The leading indicators for 4Q16 are strengthening, with credit data continuing to show the positive effect of the ECB’s easing policies.

Nonetheless, the need for continued monetary easing is still strong. The economic recovery relies heavily on favorable financial conditions, especially for the periphery, where a spike in yields could compromise fiscal sustainability.Accordingly, the ECB announced in December a nine-month extension of its current QE program. Despite reducing the monthly pace to EUR 60 billion the Central Bank vowed to adjust the rhythm as needed in order to maintain a loose monetary policy stance.

Political risks still dominate the European scenario, but recent news is not all bad. In the UK, the Brexit Minister David Davis has hinted that a negotiation approach on the lines of “Soft ” exit is being discussed within the government. In France, the Republican primaries have surprisingly resulted in former PM François Fillon becoming their candidate ahead of the 2017 presidential elections. Fillon has a reformist policy program that is also conservative on immigration issues, which makes him the favorite to win the election next year. Additionally, President François Hollande has decided not to run in the Socialist primaries, which reduces the odds that the eurosceptic National Front’s Marine Le Pen becomes president next year. In Germany, Angela Merkel has confirmed her intention to seek a fourth term as chancellor. In Austria, the presidential election yielded a positive surprise with the defeat of far-right candidate. Finally, in Italy the referendum on constitutional reform turned out to be a huge defeat for PM Matteo Renzi’s reformist government. With a strong 69% turnout, the “No” camp had 59% of votes whereas “Yes” ended up with 41%. Though Mr. Renzi has decided to resign, we do not expect early elections given the political establishment´s aversion to facing a possible win by populist forces.

We raised our GDP forecast for the euro zone to 1.6%, from 1.5%, in 2016 (stronger fourth-quarter data) and kept it at 1.3% for 2017.

Japan – Strong third quarter and post-Trump yen depreciation offset TPP’s demise.

Japan’s 3Q16 GDP growth amounted to 2.2% qoq/saar. Net exports, contributing 1.8 pp,were the major driver of this strong result. Despite U.S. President-elect Donald Trump’s decision to pull out of the Trans-Pacific Partnership (TPP), we expect the damage to the Japanese economy to be more than offset by an improvement of its trade balance given the yen’s 9.2% depreciation following the U.S. election and the China-led Regional Comprehensive Economic Partnership (see graph).

We raised our GDP estimates to 0.8% from 0.6% due to base effects in 2016 and for 1.2% from 0.7% in 2017 (0.3 pp from base effects and 0.2 pp from yen depreciation).

China – Stable economic activity; renewed capital outflows

Economic activity continues to show steady growth. Industrial production and fixed investment are roughly stable at, respectively, 6.1% yoy and 8.8% yoy in October (see graph). Real estate private-led investment offset a small slowdown in public investment. In November, the official manufacturing PMI rose further to 51.7, suggesting positive economic-activity figures for the remainder of 4Q16.

We expect this growth stability to extend into 2017. First, there is room for fiscal stimuli and a leadership transition in the Fall that increases the willingness to maintain the growth pace. Second, real estate investment will remain strong in 1H17, before regulatory tightening takes effect. Third, higher corporate profits (weaker currency and higher producer prices) support investment. Finally, the government is still able to control the timing of painful adjustments.

Nonetheless, higher interest rates in developed countries and a stronger USD increase the pressure of capital outflows and pose risks to China. Local interest rates in China are rising (see chart), a movement that can be explained by capital outflows affecting domestic liquidity and upward pressure from global rates. Although China’s government still has instruments to deal with capital outflows (direct and indirect capital controls, large foreign reserves), an undesired tightening of financial conditions can be negative. 

We maintain our GDP forecasts for China at 6.6% for 2016 and at 6.3% for 2017.

Emerging Markets – What are the global financial conditions that matter?

Higher interest rates in the U.S. will likely put pressure on EM currencies and local rates.

But broader financial conditions also matter, and they remain well behaved, helped by better global growth and commodity prices. Indeed, we have statistically computed (principal component analysis) summaries of financial conditions in both EM and DM economies. For DM we obtain two factors, one that summarizes sovereign yields (which are mostly related to monetary policy) and another related to credit, equity and volatility conditions. We find that the financial conditions that matter most for growth in EM are mainly related to this second factor, which tracks DM equity, credit and volatility conditions and has remained well behaved – due to better global growth data – since the US election (see graph). 

The continuation of this behavior (U.S. yields up, well behaved broader financial conditions) is important to allow monetary policy easing across LatAm. In this environment, Argentina will continue to cut interest rates, but at a slower pace. If there is no additional volatility in global markets, we expect an acceleration of the pace of interest rate cuts in Brazil at the beginning of next year. Chile and Colombia are likely to start monetary easing cycles in 2017. On the opposite track, we expect Mexico’s central bank to follow the Fed and raise interest rates by 25 bps this month.

Commodities – OPEC reaches a deal. Better metal-price outlook, but current levels are stretched

The Itaú Commodity Index (ICI) has risen by 7% since the end of October, driven by higher oil (ICI-energy: 11%) and metal (15%) prices, while the agricultural sub-index fell 2%. 

Oil prices rose as OPEC successfully reached a deal to cut output by 1.2 mbd. The cartel expects non-OPEC countries to join with additional 0.6 mbd cuts, but in our view Russia is the only likely source of cuts (-0.3 mbd). Regardless of the reaction of other countries, the deal is enough to balance the market as soon as it becomes effective (January 1), and global inventories will likely begin to fall afterward. We maintain our Brent price forecast at USD 54/bbl for YE2017, a level that allows some additional response from US production to partially offset the cartel’s cut. In the short term, we see balanced downside (non-compliance risks) and upside (non-OPEC countries joining the cut, lagged reaction in the U.S.) risks.

The recent metal-price rally will partially fade in 2017. Stronger demand (particularly in China), upward adjustments of inventory and tighter supply discipline have led metals to outperform other commodities in 2016. We forecast prices to drop in 2017, as China’s housing market will cool down and as higher metal prices will lead to some reaction from marginal producers. Nonetheless, we expect prices to remain well above the 2016 lows in 2017, providing better economic conditions for major global suppliers.

Stronger USD and favorable weather conditions have caused agricultural prices to drop. Weather conditions have been roughly favorable for the ongoing crop in the Southern Hemisphere. In addition, sugar and coffee underperformed, as both are more affected by the weaker BRL and had overbought technical position by hedge funds around mid-November. We believe that the prices of both commodities may recover, as the supply deficit comes back as the major driver.

We expect ICI to remain stable from its current level until the end of 2016 and then drop 2% in 2017due to metal prices.


Monetary policy easing amid external volatility

• As interest rates in the U.S. rise, the currencies of South America are expected to weaken some more while the Mexican peso will take time to get back to its fundamental levels.  

• Activity in the region disappointed in November and remains weak. We expect a recovery in 2017, but risks are tilted to the downside. 

• As inflation falls, monetary-policy stances are becoming looser.

Adjusting to Trump

The foreign exchange market continues to digest the consequences and uncertainties associated with the election of Donald Trump. In this environment, the Chilean peso and the Peruvian sol have performed well, almost flat from their respective pre-election levels, because the expectation of fiscal stimulus in the U.S. contributes to push copper prices up. But as oil prices rebounded strongly on the back of the OPEC deal, the region’s outperformer was the Colombian peso, despite the fact that the country’s large current-account deficit leaves its currency vulnerable to higher U.S. Treasury yields. The Mexican peso remains the underperformer, but the Brazilian real has also weakened substantially, with uncertainties over fiscal reforms contributing to deteriorating sentiment. Finally, faster-than-expected monetary easing in Argentina and an even wider fiscal deficit in the country added to the worsening of the external environment and put pressure on the Argentine peso.

As interest rates in the U.S. rise, the South American currencies are expected to weaken some more. In Brazil, Chile, Colombia and Argentina, interest-rate cuts will contribute to the depreciation. Meanwhile, we expect Mexico to appreciate slightly in 2017, as uncertainty over protectionism in the U.S. diminishes only gradually.

According to our estimations for equilibrium exchange rates, the Mexican peso would remain weaker than its fundamentals suggest, while the Colombian peso needs to depreciate further so the currency can recouple with its fundamentals. Meanwhile, the Brazilian real, the Peruvian sol and Chilean peso are already around their fair values. In our Macro Vision “Estimating sustainable exchange rates in Latin America”, we calculated the exchange rate that is consistent with bringing the current-account deficit to sustainable levels for each country within our coverage. As an assumption for current-account sustainability, we used the average of the past 20 years. Under this methodology, the Argentine peso is also overvalued, but as we discussed in the report, there are good reasons to believe that Argentina can live with wider current-account deficits than they have in the past.

Further activity disappointment

Activity in the region disappointed in November and remained weak. Our Itaú Activity Surprise Index returned to negative territory in November. Colombia was the country that disappointed the most, while Peru surprised positively. Overall, economies in the region remain weak, with Brazil and Argentina still failing to emerge from their recessions, while growth in Colombia and Chile is not clearly bottoming-out. Growth has been around trend in Mexico, which is low. While growth has been stronger than expected in Peru, internal demand continues to be very weak, as private investment has yet to recover.

While we expect a recovery in the region in 2017 (mostly because we expect Argentina and Brazil to come out of their recessions), we see the balance of risks tilted to the downside. Besides the risk of protectionism and lower capital inflows (due to higher interest rates in the U.S.), idiosyncratic factors can also limit growth next year.

Disinflation allows for looser monetary-policy stance

The positive news is that disinflation is under way in many countries and has been faster than expected by the market. Our Itaú Inflationary Surprise Index registered -0.37 in November, down from -0.28 in October. Inflationary pressures continue to recede in most of the region’s economies, with Brazil still being the major player pulling down on the index, while Mexico recorded a positive surprise (due to the Mexican peso weakening). The more favorable evolution of currencies (compared with the previous years), together with weak activity and the waning of some supply shocks, is supporting disinflation in the region.

In this environment, monetary-policy stances are becoming looser. We expect Brazil to increase the pace of rate cuts. In Chile and in Colombia, we see an easing cycle in 2017. In Argentina, we also expect the easing cycle to continue, but at a more moderate pace as further disinflation becomes more challenging. On the other hand, we continue to see rate increases in Mexico, in lockstep with the Fed, but even there the appetite of the central bank for hikes beyond those determined by interest parity considerations is clearly diminishing as highlighted in recent communication.


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


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