Itaú BBA - Elections in Brazil amid global appreciation of the dollar

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Elections in Brazil amid global appreciation of the dollar

October 3, 2014

October has arrived, and with it the run-up to elections in Brazil.

Global Economy
Stronger U.S. dollar, now relative to emerging markets

Perspective of higher interest rates in the US, falling commodity prices, concerns with growth in China and weak domestic growth fundamentals add to the downward pressures on emerging market asset prices.

Voting time    

Elections are on next Sunday. In the economy, the Copom signaled stable rates ahead, but we see an upward bias if the weakening trend in the real is sustained, even amid a low growth environment.   

Exports and private internal demand take off; public sector lags behind

Exports are leading growth and private internal demand is gradually recovering. However, public consumption and public investment are yet to help the economy.

One final cut to come

Activity indicators for August remained weak. We expect the central bank to reduce the policy rate by 25 bps in October, ending the easing cycle.

Spot intervention makes a comeback

We expect the exchange rate to reach 2.9 and 3.0 soles per dollar for year-end 2014 and 2015, respectively, with intervention continuing to curb the depreciation of the sol.   

Less solid

Activity decelerated in 2Q14 and indicators disappointed in July. We reduced our growth forecast for 2014 and 2015. The central bank left the policy rate at 4.5% in its September meeting,  we expect no further rate hikes this year.

A new change at the central bank

We expect a substantial depreciation of the official exchange-rate this year, to 11 pesos to the dollar, and higher interest rates.      

Not fully reversing the decline

We revised downward our forecasts for prices of major commodities, seeing this year's drop as consistent with fundamentals (supply - side, strong dollar and slightly lower global growth).

Elections in Brazil amid global appreciation of the dollar

October has arrived, and with it the run-up to elections in Brazil. Next Sunday, October 5, Brazilians will vote for president, governor, senators and federal and state legislators. This will be the seventh direct presidential election since the country’s democratization in 1984.

In the global economy, the dollar gains strength. The outlook for the U.S. economy is positive, and the Fed is on track to raise interest rates in 2015. Meanwhile, monetary policy is more expansionary in Europe and Japan. A stronger dollar, declining commodity prices and EM slowdown have exerted pressure on currencies of emerging economies.

In Latin America, a region with a high concentration of commodity exports, this adverse environment is being felt more clearly. Growth has been disappointing, and exchange rates have depreciated relatively quickly since August. In September we reduced our growth forecasts for Brazil, Peru and Chile; this month we reduced our growth forecast for Colombia,

The FX depreciation may also affect monetary policy decisions in some of the region’s countries. In Brazil, for example, we continue to forecast flat interest rates until 2015; however, if the recent depreciation trend is sustained, the central bank may raise interest rates again, despite the low-growth environment.

In Argentina, the exchange rate depreciation – in the parallel market, as the official rate is fixed – has been pushed by domestic issues. The recession has deepened, and inflation is accelerating. Monetary policy has become more expansionary, and FX controls remain tight. We forecast the official exchange rate reaching 11 pesos to the dollar by the end of this year, which would represent a depreciation of about 30% from current levels.

Global Economy

Stronger U.S. dollar, now relative to emerging markets 

• The U.S. Fed is on track to raise interest rates in June 2015, as the economic outlook remains consistent with a decline in unemployment and a gradual rise in inflation. 

With a better economic outlook in the U.S. than Europe and Japan, the U.S. dollar gained ground against major currencies.

Emerging markets are also feeling the pressure from the strong U.S. dollar.

Weak growth fundamentals, falling commodity prices and renewed concerns about growth in China are adding to the downward pressures on emerging market asset prices.

The U.S. Fed is on track to raise interest rates in June 2015. The U.S. economy is sustaining a cyclical 3.0% growth rate and the unemployment rate is declining. As inflation gradually rises, we believe that the FOMC will reach a consensus to start hiking rates in mid-2015.

Meanwhile, given the weaker outlook for their economies, the European Central Bank (ECB) and the Bank of Japan (BoJ) are easing their monetary stance. The former is seeking to move from a passive to an active approach to the management of its balance sheet. The latter is already purchasing large amounts of assets through a program that is likely to be extended at least into 2015.

Given these divergent economic and monetary policy outlooks, the U.S. dollar is appreciating against major currencies. The U.S. currency has gained 3% since July, as measured by Trade Weighted Index (TWI). We expect it to strengthen further, by a similar amount, between now and the end of 2015.

Emerging markets currencies are also losing value against the dollar. Together with the prospects of rate hikes in the U.S., weak fundamentals, falling commodity prices and renewed concerns with growth in China are also putting pressure on asset prices in emerging markets.

U.S. – Fed on track to raise interest rates in June 2015

Economic indicators in the U.S. remain in line with a healthy 3.0% growth pace. U.S. GDP growth for 2Q14 was revised upward to 4.6% qoq/saar (seasonally adjusted annual rate) from 4.2%. Our real GDP tracking indicates that 3Q14 growth remained close to 3.0%.

The stronger economic outlook for the U.S., relative to its trading partners, has boosted the U.S. dollar TWI by 3% since July. We expect the dollar to strengthen by another 2% by the end of 2015.

The impact of the stronger dollar on the U.S. economy looks small so far. We shaved off only 0.1 pp from our GDP forecast in 2015 due to the stronger currency. The impact on core inflation (excluding commodities) looks negligible at this point.

We are leaving our 2014 GDP growth forecast at 2.2%, but we are reducing our 2015 GDP forecast to 3.0% from 3.1%.

The labor market continues to improve. We forecast that non-farm payroll will continue to expand by an average of 200,000 jobs per month and that the unemployment rate will decline to 5.95% and 5.25% in December 2014 and December 2015, respectively, from the present 6.1%.

We foresee a pick-up in the core inflation measures after two months of subdued numbers. The core PCE deflator, the Fed’s preferred measure, of inflation, increased by 0.08% MoM in August and by 0.10% in July. Both figures represent a deceleration from the average 0.14% monthly change seen in 1H14. We believe that this is a temporary slowdown reflecting volatility in monthly figures and indirect effects of the commodity price declines June.

Nonetheless, we have lowered our year-end 2014 forecast for the core PCE deflator to 1.5% YoY from 1.7% YoY.

Looking ahead, we continue to expect a gradual increase in the core PCE deflator to 1.8% YoY by December 2015. The gradually tighter labor market and well-anchored inflation expectations should continue to push inflation towards 2%.

With the improvement in the labor market and a gradual increase in inflation, we see the Fed as on track to raise rates in June 2015. At its September meeting, the FOMC reaffirmed its conviction that the Fed funds rates should be kept at their current levels for a “considerable time”. However, FOMC participants increased their estimates for the Fed fund rates at the end of 2015 and 2015. The new forecasts are consistent with a start of the hiking cycle in June 2015, reinforcing our confidence in this rate hike scenario.

We see the risks tilted toward an earlier, rather than later, start of the hiking cycle. The main risk for the U.S. economy in the current scenario still is, in our view, the possibility that the labor market improves faster than expected over the next six months.

At the same time, it is true that, with the core PCE deflator below the 2% inflation target and only moderate wage increases, the FOMC is likely to raise rates slowly. Hence, after a first hike in June 2015, we believe that the Fed will raise rates at every other meeting for the rest of 2015. In 2016, over the course of which we expect inflation to gain momentum, the pace of rate hikes will likely accelerate to every meeting.

Finally, the FOMC will likely withdraw its guidance that interest rates will remain at the current level for a “considerable time” only when we are closer to the first hike, in order to avoid a premature tightening of financial conditions. If the economic outlook is broadly confirmed, we expect the FOMC to revise its forward guidance at its December meeting.

We left our year-end forecasts for the 10-year U.S. Treasury yield unchanged, at 2.70% for 2014 and 3.25% for 2015.

Europe – ECB is fully committed to lifting inflation expectations

The ECB didn’t announce new policies in its October meeting, after having significantly eased its monetary policy in September. The central bank cut all its policy rates by 0.1% in September, leaving the deposit rate at -0.2% and the policy rate at 0.05%. Additionally, the central bank will start purchasing covered bonds in October and asset-backed securities at some point in 4Q14. No specific size of purchase was released, but ECB president Mario Draghi has indicated that the measures could expand the ECB balance by EUR 1 trillion in two years. These measures come in addition to the program of offering banks four-year low-cost loans (known as TLTROs), which started with a first auction in September; future auctions are scheduled for December and for 2015.

The central bank’s aim is to boost current inflation, which reached 0.3% YoY in September, even as long-term inflation expectations dropped below 2%. The euro zone’s economic recovery lost momentum in 1H14, and the current data point to feeble activity in 2H14. In an environment of already low inflation, weak activity prompted market-implied long-term inflation expectations to drop dangerously below 2%, the ECB’s nominal target.

Will these measures succeed in raising inflation expectations?

In our baseline scenario and the ECB’s, the answer is yes, but risks remain tilted to the downside. The current policies have eased credit conditions and depreciated the euro. Both measures are helpful for the inflation problem. But overall weak aggregate demand, ongoing relative price adjustments in the peripheral European economies and falling commodity prices are all still putting downward pressure on prices.

Importantly, the ECB has a clear commitment do more, if needed, to lift inflation expectations, which implies the possibility of a government bond-based QE program. Overall, the central bank is moving toward more proactive management of its balance sheet. If current policies are not enough, it could start purchasing other assets, including government bonds, to achieve its goal of balance-sheet expansion. This is not our baseline scenario. But there remain substantial odds that the central bank might need to go into this direction.

This situation is keeping euro zone interest rates down and supporting the depreciation of the euro. We expect the dollar/euro exchange rate to close 2014 at 1.27 and to drop to 1.22 in 2015.

We are leaving our growth forecasts unchanged, at 0.8% for 2014 and 1.1% for 2015. Our forecast of still-feeble economic activity in 2H14, following a weak 1H14, appears to be materializing.

China – Stronger-than-expected slowdown prompts more targeted stimuli

China’s activity decelerated in August. Industrial production was up 6.9% YoY, well below the market consensus estimate of 8.8% and the 9.0% figure posted in July. Fixed asset investment growth slowed to 13.3% from 15.6%.

The weak figures are not a signal of hard landing. Some indicators, like the PMIs and retail trade, suggest a smoother slowdown. And some of the deceleration in industrial production was due to a smaller number of working days this August compared with August of last year. Moreover, external demand remains favorable: new export orders stand above their 2013 average, and export volume is up almost 10% this year through August, compared with the same period of last year. Finally, the government seems comfortable with a moderate slowdown. We note that investment in government-controlled sectors and general government expenditures have decelerated over the last three months. Moreover, credit growth continues to slow.

Nonetheless, the slowdown was sharper than expected and highlights the downside risks to growth in China. The several stimulus measures launched in 2Q14 had an even shorter life than we anticipated. And the correction in the property sector continues.

In response to the weaker data, the government has already launched some new stimulus measures. The PBoC opened relending quotas totaling RMB 500 billion (USD 81 billion) to the five largest commercial banks for three months. This is equivalent to a 0.50% cut in the required reserve ratio, if the provision is rolled over. The central bank also lowered the 14-day repo rate by 20 bps in its open market operations.

More targeted stimulus is needed to maintain a gradual slowdown. Some of the additional liquidity created as a result of the government’s stimulus measures will be offset by deposit withdrawals ahead of China’s National Day holiday (October 1-7). Besides, the drag of the slowing property sector and declining infrastructure investment is proving to be powerful.

We have lowered our GDP forecast for 2014 to 7.3% from 7.4%, and we maintain our 7.0% forecast for 2015.

Emerging market currencies under pressure

The U.S. dollar has appreciated by 5.6% against an equal-weighted basket of emerging market (EM) currencies since the beginning of July (see graph). The gain was widespread. It happened in all the three main regions (Asia: 2.0%, CEMEA: 8.5%, and Latin America: 7.4%), although to a lesser degree in Asia because China’s yuan is also appreciating.

The strong dollar is the main driver of the weak performance of EM currencies. The U.S. dollar appreciated by 7.6% against developed country currencies over the same period (see graph). This strong dollar movement then expanded to EM countries, starting mostly in August.

Falling commodity prices are adding to the pressure on EM exchange rates. The Itaú Commodity Index has now registered a cumulative drop of 15.5% this year. This decline in prices is only partly explained by the strong dollar (see below), and hence is putting further pressure on EM currencies. Indeed, the U.S. dollar has climbed by 8.9% since July against currencies of countries that are dependent on commodities.

Finally, the poor growth outlook in EM is not helping. A weighted average of manufacturing Purchasing Managers Indices (PMIs) stabilized after declining in 1H14. But the current level of 50.8 is lackluster and points only to modest growth ahead.

Commodities – Not fully rebounding from the declines

The Itaú Commodity Index (ICI) has declined by 7.8% since the end of August, with all sub-indices once again falling in the period. The ICI has now registered a cumulative 15.5% drop this year to date, after falling by 6.1% in 2013. The breakdown by component shows declines in all three sub-indices: agriculture (‑18.7%), metals (-22.4%) and energy (-10.0%).

The decline this year is consistent with a combination of surprises in global supply, a stronger dollar and slightly weaker global growth. We estimate that supply surprises account for approximately 50% of the drop. A superharvest in the U.S. affected agriculture prices. Iron ore prices are reaching new lows as high-cost iron ore mining operators refuse to shut down amid additions of low-cost supply. A strong rise in non-OPEC oil production is putting pressure on oil prices. The strong dollar is second in our list of causative factors, explaining 40% of the decline, according to our computations. Finally, the slightly weaker global growth explains the remaining 10% of the drop this year. Renewed concerns about growth in China also contributed to the fall of commodity prices in August.

The drop seen over the latest two years will not be fully reversed in the near future; hence, we have lowered our price forecasts for almost all commodities. We have lowered our year-end 2015 ICI forecasts by 5.9 pp. Our forecast now implies only a modest increase of 6.0% between the end of September 2014 and the end of 2015.


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

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