Itaú BBA - Emerging Markets in Slow Motion

Global Scenario Review

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Emerging Markets in Slow Motion

June 11, 2014

We have been warning that the favorable liquidity conditions for emerging economies would not be permanent.

Global Economy

Positive External Environment for Emerging Markets Continues
Interest rates in the U.S might remain low for longer and the ECB has eased policies again. Emerging markets benefit from this environment, but their weak growth might limit some of the gains.


Consumers and Businesses Step on the Brakes: Activity Decelerates           
The slowdown in demand is remarkable and we expect negative GDP growth in 2Q14, followed by a slight recovery in the second half. We expect economic growth of 1.0% in 2014 and 1.7% in 2015.


An Unexpected Policy Rate Cut 
The economy disappointed during 1Q14, but for the second quarter, available indicators suggest some improvement. The central bank took markets by surprise and reduced the policy rate in its June meeting.


Private Consumption, Following in the Footsteps of Investment 
Activity has been weak on many fronts. We have reduced our GDP growth forecast for 2014 to 2.8% (from 3.3%), while maintaining our 4.0% growth estimate for 2015.


Private Demand Slows Further
Peru’s GDP growth slowed in 1Q14 as private domestic demand decelerated. Available indicators for 2Q14 also point to weaker activity. We reduced our GDP forecast for this year.  


An Uncertain Presidential Election 
Presidential run-off looms,momentum lies with Zuluaga. On the economy, growth remained robust in 1Q14, driven by the good performance of private consumption.


Paris Is Well Worth a Mass 
The agreement with the Paris Club marks an important step in normalizing the country’s financial relations with the international community and could open up access to international financing.    


Falling Prices for Agricultural Commodities and Metals
Favorable weather conditions  dragged down prices for agricultural commodities. Iron ore prices continue to drop, given the outlook for larger supply from Australia and concerns involving the real estate sector in China.

Emerging Markets in Slow Motion

We have been warning that the favorable liquidity conditions for emerging economies would not be permanent. At some point, the global recovery will lead to a normalization of monetary policy, a process that could mean further volatility in financial markets. Over time, markets tend to stabilize as the beneficial impact of global growth on emerging economies compensates for less favorable financing conditions. The process, however, is inherently volatile.  

We are now six months into 2014, and the process seems to have stabilized. The U.S. economy posted a weak first quarter and the Fed shows no hurry in normalizing monetary conditions beyond the tapering: U.S. treasury yields remain exceptionally low, and they are even dropping. For its part, the ECB assumed a more expansionary stance, reducing interest rates and adopting new measures to inject liquidity.

Is it possible that unusual policies in advanced economies (and low financing cost to emerging countries) are becoming more permanent? We do not believe so. Sooner or later, global liquidity will tighten again. We still forecast rising U.S. interest rates and more depreciated exchange rates for emerging economies in the future.

However, it is worth noting that the favorable effects of the current scenario seem to be wearing out. Commodity prices have reversed the upward trend seen in the first months of the year, and emerging market currencies are no longer appreciating, as growth disappoints.  

In Latin America, we have reduced our GDP forecasts for Brazil, Chile, Mexico and Peru. In Mexico, the weak first quarter led to a drop in growth forecasts, and the central bank responded with an unexpected interest rate cut. Colombia alone continues to post good performance and has rising interest rates. The tight presidential race does not seem to be affecting the economy, as both candidates are market-friendly.

In Brazil, the dynamics of economic activity cause even more concern. The drop in business and consumer confidence in recent months is notable, raising doubts about the performance of consumption and investment in the second half. The central bank stopped raising interest rates, despite the fact that inflation remains close to the upper bound of the target range.

Good news in Argentina: the agreement with the Paris Club marks an important step towards the normalization of the country's financial relations with the international community. But the challenge of macroeconomic adjustment continues. Despite central bank's resistance, we continue to expect exchange-rate depreciation and rising interest rates this year.

While emerging economies advance at a sluggish pace, the coming month promises emotion and great drama as the globe turns its eyes to Brazil for football. We wish everyone good luck at the World Cup!

Global Economy

Positive External Environment for Emerging Markets Continues

• After a weak start to the year, economic activity in major economies, particularly in the U.S., has improved in 2Q14.

• Meanwhile U.S. interest rates could remain low for longer. We have recently revised our 10-year Treasury forecast for year-end 2014, to 2.90% from 3.45%.

• The ECB eased its policies again, increasing the perception of lower global interest rates for longer.

• Emerging-market assets benefit from this global environment, but  weak growth performance could limit some of the gains.

Economic activity in most major economies is improving. Admittedly, the U.S. economy was very weak in 1Q14, but is now on track to post 3.8% growth (seasonally-adjusted annual rate – saar) in 2Q14. The recovery in the euro zone has been modest, but is expected continue. Even the leading indicators in China have shown a recent improvement. Only in Japan do we see a temporary contraction due to a VAT increase. The simple average growth rate for these countries is likely to increase to 3.7% in 2Q14, from 2.2% in 1Q14 (see graph).

Meanwhile interest rates in the U.S could remain low for longer. Inflation rose, but remains moderate, and the Central Bank’s rhetoric signals no rush to increase rates. We recently changed our call on the timeframe of the FOMC’s next hiking cycle, to 3Q15 from 2Q15. Moreover, we now expect the yield on the 10-year Treasury bond to reach 2.9% (vs. 3.45% previously) by the end of 2014.

The European Central Bank (ECB) carried out another round of easing. We believe that the ECB’s actions (see details below) were necessary to counterbalance the increasing risk of deflation.

Could the global environment get any better for emerging markets? So far, so good. Of course some future risks remain, such as the chance of an earlier rise in U.S. interest rates and the downside risks to activity in China, but they appear to be under control for the time being.

The only (and major) caveat for emerging markets is that their growth continues to disappoint. Some countries experience domestic restrictions such as high inflation and/or a necessary slowdown in fiscal, credit or investment expansion after years of increase. Structural reforms are, for the most part, absent. Weak growth could limit the gains from the current global environment.

Importantly, with little external pressure and a slowdown in growth, policymakers in emerging markets are beginning to increasingly focus on the latter. In the past month, the central banks of Turkey and Mexico surprised the markets with interest-rate cuts triggered by signs of weak activity.

A Strong U.S. Economy and Low Interest Rates

The U.S. economy was weaker than initially expected at the beginning of 2014. The 1Q14 GDP growth was revised 1.0% down (saar), from an initial estimate of 0.1%. The revision was largely due to less inventory accumulation. A sharp inventory correction and harsh winter were clearly the main culprits behind the slowdown in the first quarter.

Activity improved in 2Q14 and, according to our models, GDP is on track to expand 3.8% (saar). The May indicators have been slightly above consensus, confirming the economy’s more solid footing. Non-farm payrolls added another 217 thousand jobs and vehicle sales reached 16.7 million (saar) – the highest level since 2006. Finally, the number of aggregate hours worked has grown at a robust 4.2% annualized pace in the last three months.

We continue to expect the economy to growth at a 3% pace in 2H14. The good performance of the economic indicators in May underpin this positive outlook.

Although comfortable with the outlook, we reduced our 2014 GDP forecast, to 2.3% from 2.5%, due to the negative 1Q14 surprise, but maintained our 3.1% estimate for 2015.

Inflation has been firmer in the last two months, but remains at fairly comfortable levels. The core PCE deflator accelerated from 1.1% year over year in February to 1.4% in April, but remains comfortably below the Central Bank’s 2.0% inflation mandate.  

Meanwhile, FOMC members hint that the hiking cycle ought to begin in 2H15 or later. Although they acknowledge that the decision depends on the inflation evolution and labor-market conditions, the communication suggests a later and slower hike pace for Fed fund rates.

The disappointing 1Q14 growth, modest inflation and Fed rhetoric have led us to postpone our forecast of interest-rate increases in the U.S. We have recently revised the start of the monetary policy tightening cycle to 3Q14, from the second quarter of 2015. We still expect the FOMC to raise rates by 25 bps per meeting, outpacing the current market pricing and itself, but the current Fed rhetoric is likely to anchor rates for longer. We therefore reduced our 10-year U.S Treasury yield forecast, to 2.9% in December 2014 (from 3.45%) and 3.5% in December 2015 (from 3.7%).

The ECB Carries out a New, Aggressive Round of Easing to Counterbalance the Increasing Risks of an Overly-prolonged Period of Low Inflation. 

The ECB lowered the interest rate on overnight bank deposits to an unprecedented negative value of 0.10% (from 0%) and reduced its main bank-lending rate by 0.10%, to 0.15%.

Furthermore, the Central Bank will lend funds (known as TLTRO – target long-term refinancing operation) to banks for up to four years at a fixed cost of 0.25%. Banks will be able to initially borrow up to 7% of their outstanding loans to nonfinancial corporations and households (excluding mortgages).  The combined initial entitlement totals approximately EUR 400 billion (USD 550 billion). The actual placement will depend on banks’ demand for ECB funding. Banks will be able to place their orders in September and December 2014. The TLTROs will continue from March 2015 to June 2016 but will be limited to the banks’ net lending performance. Note that if banks do not increase their net lending to the non-financial private sector (relative to specific benchmarks), they will be required to pay back the borrowed amount in September 2016. These measures are intended to improve bank lending to the private sector.

The ECB also ended the weekly sterilization of its periphery sovereign-bond portfolio, which was acquired during the euro crisis and is likely to imply the immediate addition of around EUR 120 billion in liquidity.

Finally, the Central Bank reinforced its forward guidance of low interest rates It has done so by extending its full allotment procedure, by which it allows banks to borrow unlimited funds per one week, to the end of 2016 from mid-2015. The ECB President Mario Draghi has pointed out this extension and the fixed rate until 2018 on the TLTRO suggests that interest rates will remain low for long.

Will these actions work or should we expect further easing?

To some extent, the measures are off to a good start in terms of the impact on inflation expectations. Implied long-term inflation expectations rose from 1.45% at the beginning of May to 1.57% (see chart). It remains to be seen, however, whether this will translate into a broader rise in inflation expectations.

Despite a disappointing 1Q14, we expect the modest economic recovery to continue. The 1Q14 GDP figure was weaker than expected, at 0.2% qoq, showing a slightly decline from the 0.3% reported in 4Q13. Although we see a slight growth improvement going forward, the negative 1Q14 surprise led to a downward revision of our forecasts for 2014 to 1.1% (from 1.3%). Our forecast for 2015 remains unchanged at 1.5%.

We expect this recovery to contribute to a reduction in disinflationary pressures ahead and avoid the need for further monetary policy easing by the ECB.

But the risks are tilted toward further action. Inflation has been persistently weaker than expected and there is a lot of uncertainty about the actual demand for the TLTRO. The ECB has already signaled that it could carry out asset-backed securities purchases, which might reach sovereign bonds if inflation continues to fall. We believe that, if necessary, a new easing cycle could occur in December or early 2015.

China – Signs of Improvement in 2Q14; Downside Risks from the Property Sector

Manufacturing PMI rose to 50.8 in May (from 50.4 in April), mainly driven by new domestic orders. The improvement in domestic demand suggests that the small, targeted measures are beginning to add up and helping to stabilize the economy, thereby offsetting the drag caused by the weakness in the Property sector.

The risks, however, remain tilted toward the downside, with the spotlight now on the Property sector. Several indicators show weakness in the sector during the first four months of the year and extending into May. An additional slowdown in housing might take China’s GDP growth to below 7.0% this year.

The challenge continues to be balancing short- and medium-term growth. The government is, in our view, seeking to stabilize growth and advance reforms. This is a fine balance, given that some of the reforms, such as pushing for some deleveraging, will harm short-term growth. Despite the risks, we believe that the combination of targeted stimuli (not a repeat of the broad measures of the past) and an emphasis on reforms improves the medium-term outlook.

With the recent gain in the country’s PMIs, we are confident that activity is stabilizing. We maintain our GDP forecast at 7.2% for 2014 and 7.0% for 2015.

Japan – With better activity, the BoJ is unlikely to increase its (already-aggressive) easing policies.

Japan’s GDP grew 5.9% (qoq, saar) in 1Q14, significantly above consensus. Private investment rose an impressive 20.1%, notably above expectation. Moreover, current economic indicators suggest a modest decline in activity due to a VAT increase in April, from 5% to 8%, but in line with expectations.

We revised our 2014 GDP growth forecast up to 1.7%, from 1.1%. 

Given the improvements in activity and inflation, which are so far in line with the BoJ’s forecasts, we no longer expect further monetary easing (we previously expected an announcement in October).

Emerging Markets – Favorable External Liquidity Conditions Amid Weak Growth

External liquidity conditions remain supportive for emerging markets assets. Interest rates in major developed countries remain low, with little pressure to rise, but we believe that the situation will change at some point. For now, however, the environment supports financial inflows to emerging economies.

Notwithstanding the supportive environment, growth in developing economies continues to disappoint. In Latin America, we have reduced our GDP forecasts for Brazil, Chile, Mexico and Peru.

Importantly, the weak growth performance could limit some of the gains from the favorable global environment. For example, following the strong appreciation trend until April, several emerging-market currencies have remained mostly flat or even depreciated (see graph).

Commodities - Falling Prices for Agricultural Commodities and Metals

The Itaú Commodity Index (ICI) has fallen 3.7% since the end of April, driven by lower agricultural, iron ore and natural gas prices. Favorable weather conditions, particularly in the U.S., have improved the supply prospects for corn, wheat, soybean and cotton, leading the ICI-Agricultural index to fall 10.0% in the period. Easing concerns surrounding Ukraine are somewhat responsible for the drop in grain and natural gas prices.

The ICI-energy sub-index rose 0.6%. apart from lower natural gas prices, there was no clear driver for other energy-related commodities. Brent and WTI crude prices rose 1.5% and 4.5%, respectively, with no relevant changes in fundamentals. We continue to expect the Brent price to drop to USD 105/bbl by year-end (from 108.5 in early June) as a result of the better expected supply in Iran, Iraq and Libya going forward. We forecast a WTI price of USD 101/bbl, close to the current levels.

Iron ore extended the losses in May, leading the ICI-metals sub-index to fall 3.7%. The slowdown at the beginning of the year, tighter regulation, and now concerns about the Real Estate sector in China continue to weigh on the sector. Moreover, the stronger supply from Australia also encouraged prices to drop below USD 95/t. We believe there is some undershooting at play, as the current prices are below some producers’ operational costs. However, the supply-demand balance suggests that these procedures are still necessary in order to reach equilibrium. We therefore maintain our year-end forecast at USD 101/t (6% above the current levels).  

Improved supply conditions dampen agricultural prices. Our index has fallen 10.0% since the end of April, partially reversing the year-to-date gains. All of the main commodities we track registered declines: corn (-12.3%), wheat (-14.1%), soybeans (-4.8%), cotton (-10.2%), coffee (-18.6%) and sugar (-1.5%). The first four were affected by better supply prospects, particularly in the U.S., while the last two oscillated amid uncertainties regarding the fundamentals, given that estimates range from a small surplus to a sizable deficit.

Our year-end ICI forecasts remain unchanged at -1.4% for 2014 and 1.6% for 2015, but not without a couple of downside risks: i) iron ore prices could reach equilibrium below USD 95/t and ii) above-average weather conditions ahead could lead to further declines in agricultural prices.

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

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