Itaú BBA - Calmer markets, lingering risks

Global Scenario Review

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Calmer markets, lingering risks

August 10, 2018

The USD has lost a bit of steam against both DM and EM currencies in recent weeks, but risks remain high

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

Global Economy
Tentative signs of stabilization, but risks remain high
The USD lost a bit of steam against both DM and EM currencies, but growth outside the U.S. still needs to become more robust. Trade war risks remain high: a new round of U.S.-China tariffs could potentially trim global growth by 70bps.

A lasting relief?
Currencies in the region have strengthened since early July, with the Mexican peso outperforming (following a sharp depreciation in the second quarter of this year).

Output normalizes in June, but underlying growth keeps losing steam
Activity indicators suggest that underlying growth continues to weaken, despite the normalization of industrial output in June. We still forecast 1.3% GDP growth in 2018 and 2.0% in 2019.

Adjustments under difficult circumstances
The economy is entering a recession. Imports and travel expenditures abroad are plummeting and, consequently, the current account deficit is likely narrowing.

Hopes of a NAFTA deal amid fiscal policy risks
NAFTA negotiations are regaining momentum after the elections. Meanwhile, AMLO’s promise of extra public expenditure – to be compensated by reducing inefficiencies and attacking corruption – creates risks for delivering next year’s fiscal target.

The recovery continues
Activity recovery consolidated in 2Q18. Both investment and private consumption seem to be gaining traction, despite trade war risks. We see growth in Chile increasing to 3.8% this year (versus 1.5% last year) and 3.5% in 2019.

Economy decoupling from politics
Emerging indications of corruption in the justice system could add further discontent with the country’s establishment, at a moment when President Vizcarra’s popularity is already falling. Meanwhile, economic growth is gaining traction supported by higher terms of trade.

Growth revised to the upside
With continued improvement of activity indicators and rising private sentiment amid better terms-of-trade, we revised our growth forecasts to 2.7% this year (from 2.5%) and 3.3% in 2019 (from 3.2%).


Calmer markets, lingering risks

The dollar lost a bit of steam in recent weeks and showed tentative signs of stabilization across the board. However, activity outside the U.S. remains tepid at the margin, casting doubt on the synchronized global expansion story and likely preventing emerging market currencies to gain much ground before we see firmer growth figures. Global risks remain high. On the commercial front, the probability and stakes of a trade war between the U.S. and China are on the rise, offsetting the relief that resulted from more amicable talks with Europe. Another source of concern comes from the fact that, with low slack and close-to-target inflation, the Fed would have little room to cushion negative shocks, in a moment in which growth is already at a later stage of the cycle. Thus, as rates moves towards neutral levels, the U.S. economy should become increasingly vulnerable.

Following the general trend, LatAm currencies have strengthened since early July. However, growth is still not widespread across the region: Brazil and Argentina, whose economies show greater imbalances, are being outpaced by less vulnerable countries. The monetary policy stance in the countries we cover is clearly tighter than before the recent volatility surge in emerging market asset prices and, in a still-uncertain environment, new rate cuts in the region are unlikely.

In Brazil, our scenario has remained broadly unchanged since last month. Output is normalizing after the truckers’ stoppage, but activity indicators suggest that underlying growth continues to weaken. Curbed by the uncertainty about the necessary reforms, weaker employment figures and softer confidence indicators are consistent with our forecast of 1.3% GDP growth for this year. With weak activity as its main backdrop, inflation remained tamed after the recent shocks and the central bank’s monetary policy is set to stay on hold, without clear commitments or signaling about short-term moves. 


Global Economy
Tentative signs of stabilization, but risks remain high

• Global growth outside the U.S. still needs to show clearer signs of stabilization.

• USD has lost a bit of steam against both DM and EM currencies, but risks remain high. 

• Trade war risks remain high. U.S.-Europe tensions have declined, but a new round of U.S.-China tariff threats could potentially trim global growth by 70bps. 

• The Fed has little room to cushion negative shocks to growth in this (late) stage of the business cycle.

• In commodity markets we have seen higher oil prices on supply constraints, but lower metals prices on softer Yuan.

EMFX stabilizes, but global growth ex-U.S. has yet to follow suit

The USD is showing some tentative signs of stabilization, after its strong appreciation in 2Q18. The USD has appreciated against a basket of DM countries (DXY) by nearly 5% in 2Q and 7% against EM countries (USD-EM or EMFX). Both indexes have stabilized at the current level since mid-June (see chart).

But growth outside the U.S. has yet to stabilize. In Europe, GDP failed to recover in 2Q18, increasing 0.3% QoQ, softer than the already weak 0.4% in 1Q18. We revise our forecast down to 2.0% this year (from 2.3%) and 1.7% next year (from 2.0%) for the Euro Area. In China, the Manufacturing PMI declined to 51.2 in July, from 51.5 in June. In response to weaker growth, the PBoC is easing its monetary stance and taking administrative measures to increase bank loans. Meanwhile, the State Council has shifted to a more proactive fiscal policy and is seeking to stimulate infrastructure investment. These measures should help to stabilize Chinese growth, so we maintain, for now, our GDP forecast at 6.5% in 2018 and 6.1% in 2019. Finally, we reduced our GDP forecast for Japan to 1.1% in 2018 (from 1.2%) and 1.2% (from 1.3%) in 2019, as consumption and exports surprised a bit from the downside in 1H18.

EMFX is unlikely to appreciate until global growth outside the U.S. stabilizes. Indeed, the global manufacturing PMI ex-U.S. declined again in July, continuing to cast doubt on a synchronized global story that helped EMFX appreciation in 2017 (see chart).

Larger U.S.-China trade war could reduce world GDP growth by 0.7 pp in 2019

The U.S. has reached an agreement with Europe and seems to be advancing on NAFTA negotiations. The U.S. has reached an agreement to work with Europe to bring to zero tariffs on non-auto industrial goods, lower service tariffs and non-tariff barriers to trade, while vowing not to raise auto tariffs, at least during negotiations. These measures reduced the odds of auto tariff hikes in the short term.

But the probability and stakes of a trade war between the U.S. and China are rising. President Trump has upped his threat to impose tariffs on all USD 505 billion of China imports, perhaps to as high as 25%. The U.S. has imposed 25% tariffs on USD 34 billion in Chinese imports and has scheduled to expand these tariffs to an additional USD 16 billion starting on August 23rd.  The USTR issued a second list of USD 200 billion in China imports and President Trump asked the USTR to perhaps raise tariffs to 25%, as opposed to his original target of 10%. If China retaliates as pledged, Trump threatens to impose tariffs on the remaining USD 255 billion in Chinese imports.

China responded in kind against the first USD 34 billion in U.S. exports and promised further retaliation. China has already released a list of U.S. products slated for retaliation immediately after the next USD 16 billion and USD 200 billion in tariffs are implemented.

Assuming the U.S. imposes 25% tariffs on all USD 505bn of Chinese imports and China retaliates against approximately 50% of U.S. tariff hikes, global growth could drop by 0.7 pp over four quarters. We use our Vector Auto Regression analysis for the U.S, China and Euro Area GDP and two financial condition indexes (one related to DM interest rates and another that capture broader global financial conditions). The methodology allows us to calculate the total direct effect of tariff hikes on GDP, while also considering indirect global impacts through iterations from trade and financial channels. In our simulation, we consider that the Fed has less policy space to absorb a shock in this late cycle, with low U.S. unemployment rates and inflation close to 2% (see table at the end of the section).

The impact on growth would be higher in China (-0.9) and Europe (-0.8) than in the U.S. (-0.4). The reasons are the U.S. is less open and has higher reliance on commodities, for which it is easier to find replacement buyers, and therefore should be less affected by the trade channel. China’s GDP would be directly hurt by the tariffs. The Euro zone would be hurt by the trade channel, mainly due to China’s slowdown and also by its relevant financial channels.

Risk of a full scale trade war will remain high until at least the mid-term U.S. elections on November 6. Despite President Trump’s escalation of tariff threats, U.S. equity prices remain firm and fighting China is popular among American citizens, even if some U.S. industries fear the side effects of the President Trumps currently hawkish negotiation strategy. 

After the mid-term elections, as U.S. growth starts to slow down, President Trump should have more incentive to cut a reasonable deal with China. China knows this and has pledged to respond to every U.S. move, adjusting its domestic policies to withstand a more prolonged trade dispute.

Fed has little room to act, as late-cycle risks rise

Given the unemployment rate at 3.9%, below the Fed’s median NAIRU estimate (4.5%), and the core PCE deflator close to 2.0%, the Federal Reserve must continue to raise Fed Fund Rates to the nominal neutral level, estimated to be around 3.0%. An acceleration of inflation above 2% would push the Fed Fund Rates above their neutral level, but the slowdown in core PCE in Q2 has alleviated this risk for now.

As the U.S. monetary policy reaches and stays at neutral levels, the U.S. economy should become increasingly vulnerable to a negative economic shock, including from a U.S.-China tariff war. Using econometric methods, we estimate a 10% probability of a U.S. recession over the next 12 months and a higher, 35% probability over the next 24 months. This equation considers the level of Fed Fund Rates, the slope of the U.S. Treasury yield curve, private sector leverage and other risk asset prices. In the short term, the positive fiscal impulse and inventory cycle still mitigates U.S. recession risks, but these risks should increase when the Fed Fund Rates reach neutral levels by mid-2019.

If a full scale U.S.-China trade war is not avoided, the probability of a recession in 2019 would rise to 50%, probably leading the Fed to stop raising Fed Fund Rates at 2.75%, two 25bps rate hikes below our current forecast of 3.25% for YE19. U.S. GDP growth would decelerate 40bps to 2.0% YoY in 2019 and close to potential (1.75%) on a 4Q/4Q. The rise in the recession probability closer to 50% would probably justify a more cautious Fed, but its reaction should be limited by the low unemployment and inflation close to 2%. 

Commodities – higher oil, lower metal price forecasts

The Itaú Commodity Index (ICI) has remained flat since the end of June, as increases in agricultural prices (up 5.9%) were offset by decreases in metals (-2.1%) and energy (-5.3%). The agricultural price index rose, driven by wheat, corn and cotton affected by unfavorable weather in Eastern Europe and the U.S. Meanwhile, the decline in oil-related prices reflects signals that Opec will indeed deliver its output increase, despite setbacks in Venezuela, Angola and Libya. Finally, the drop in base metal prices reflects increased risks of a full trade war, an event that would reduce global growth.

We revised our forecasts for oil, wheat and cotton prices upward. We lifted our Brent price forecast to USD 72/bbl from USD 68/bbl, as prices have declined by less than we expected with the news of additional supply by Opec+ and U.S. shale. The upward adjustment to wheat and cotton price forecasts adjusts for lower output in the current crop year. 

We lowered base metal forecasts, recognizing that macro risks and weaker CNY will lead to lower prices over the next few quarters. The adjustments (YE18 prices in USD/t) were: copper (-3% to 6600), aluminum (-2% to 2,150), lead (-4% to 2,300), zinc (-10% to 2,800) and nickel (-3% to 14,300). We also reduced price forecasts for sugar (-9%) and coffee (-3%) for the end of 2018, amid oversupply expectations for the 18/19 crop year.

Following the revisions, our YE18 forecasts see agricultural and metal prices rising slightly from current levels and oil prices falling a bit more before stabilizing.


A lasting relief?

• Currencies of Latin America have strengthened since early July, with the Mexican peso outperforming (following a sharp depreciation in the second quarter of this year). 

• Less vulnerable countries are outgrowing Brazil and Argentina, whose economies show greater imbalances.

• In a still-uncertain environment, rate cuts in the region are unlikely. Central banks in Chile, Peru, Colombia and Brazil removed the easing bias over the past few months. Further monetary policy tightening is unlikely in Mexico if a NAFTA deal is reached, but above-target inflation means that rate cuts will not come so soon. Finally, inflation and inflation expectations in Argentina have yet to show a clear stabilization, leaving no room for monetary easing for now.  

Despite the lingering uncertainties surrounding global trade and activity growth in the U.S. decoupling from the rest of the world, currencies of Latin America have strengthened since early July. The MXN has outperformed (not only other LatAm currencies, but all other major currencies) despite the strong victory of anti-establishment candidate Andrés Manuel López Obrador (AMLO) and his coalition in the presidential and congressional elections. More recently, the Mexican currency has benefited from renewed momentum in the NAFTA negotiations, with high-ranking officials (from Mexico and the U.S.) signaling a deal “in principle” before the end of August. In Argentina, the currency could be stabilizing. In fact, the substantial real exchange rate depreciation (which we believe will be enough to generate a more sustainable current account deficit in 2019, given the expected normalization of agricultural exports and the ongoing fiscal consolidation), high interest rates and sizable IMF package should be enough to prevent another stress on the market, although risks remain high. The Brazilian real (BRL) also had a good performance, but the news flow on elections over the coming weeks will likely keep the exchange rate volatile. In Chile, Colombia and Peru, the currencies have remained broadly flat since the beginning of July. 

Economic growth is still not wide spread across countries. Specifically, more vulnerable economies (Brazil and Argentina) have underperformed. Argentina is entering a recession, not only due to the harsh drought but also due to the impact of tighter financial conditions on real wages and on fiscal and monetary policies. In Brazil, activity normalized following the transitory drag from the truckers’ stoppages, but confidence indicators have not rebounded and there has been a further loosening of the labor market. In Mexico, although the economy disappointed recently, growth is still expected to be around trend this year, with solid manufacturing exports and private consumption growth (boosted by a strong U.S. economy and a robust labor market, respectively) and weakening investment (affected by the uncertainty over trade relations with the U.S., domestic policy direction and fiscal consolidation). Meanwhile, growth in Chile, Colombia and Peru – economies with fewer imbalances and lower political risks, which are also benefiting from higher export prices – is picking up, although the acceleration is still incipient in Colombia. 

Monetary policy stance in the region is clearly tighter than before the recent volatility episode in emerging market asset prices. In Chile and Peru – where inflation has run below the target, growth is strong and policy rates are considerably below neutral - central banks have removed the easing bias (Chile’s central bank has indicated the beginning of policy normalization by year-end). In Colombia and Brazil, central banks also stopped cutting interest rates recently, but rate hikes seem far off given that the output gap has not yet begun to narrow. In Mexico, the central bank kept the policy rate unchanged in its most recent decision, likely due to the performance of the currency. Although the board has maintained a vigilant tone, if a NAFTA deal is reached in the short term (anchoring the MXN at stronger levels), further monetary policy tightening is unlikely. Finally, in Argentina, the central bank has adopted a new policy rate (and left it at 40% in the most recent decision, the same level where the previous policy rate was standing). The central bank of Argentina has also communicated that monetary policy is now taking into account the evolution of monetary aggregates, but set no target for them, and it recently raised the reserve requirements. Given inflation in the country is not clearly stabilizing, the risk continues tilted towards rate hikes in the short-term. 

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

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