Itaú BBA - Encouraging recovery signs in Brazil and Argentina
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Encouraging recovery signs in Brazil and Argentina

February 10, 2017

Recent indicators are consistent with our expectation of an economic recovery in South America led by Brazil and Argentina.

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

Global Economy
Global data supports emerging markets amid political uncertainty
The background of stronger global activity and moderately rising inflation is positive for emerging markets. Policy uncertainties in the U.S., elections in Europe and a China slowdown remain important risks.

Encouraging growth signs
Recent indicators are consistent with our expectation of an economic recovery in South America led by Brazil and Argentina.

Moving towards the new equilibrium
The reduction of 2019 inflation target to 4% reinforces disinflation and enables lower interest rates. We now expect the Selic rate at 9.25% in 2017 and 8.25% in 2018.

Activity shows improvement
Official indicators confirm a sequential recovery in 4Q16. We adjusted our GDP forecast to -2.1% in 2016 and now see upside risks to our 2.7% growth forecast for 2017.

The dust is far from settled
Growth likely reached 2.3% in 2016, but we see a slowdown to 1.6% this year. Erosion of real wages, tighter macro policies and, most importantly, the uncertainty over U.S. trade policies are powerful headwinds to growth.

No option but to cut
Weak growth and low inflation will likely lead to monetary easing beyond the cycle currently signaled by the central bank.

Higher terms of trade help the economy
After five consecutive years of decline, Peru’s terms of trade have started to recover, which together with higher business confidence should help to lift domestic demand.

Central bank shifts gears
Re-initiation of the easing cycle will likely depend on the incoming data on inflation and inflation expectations. For now, we continue to expect 200-bp rate cuts this year.

Rally still on (for now)
We expect our commodity index to decline 7% from current levels in 2017 due to a slowdown in China (by mid-year) and supply responses to current prices, particularly in oil (U.S. shale producers) and iron ore.


Encouraging recovery signs in Brazil and Argentina

Global activity and inflation started 2017 at a high note. In this environment, interest rates are set to rise in the U.S., but with modest wage pressure the Fed can afford to be gradual. We foresee 3 hikes in 2017, with the next move in May. China is also tightening policy, but activity should hold up for now. The background of better global activity and moderately rising inflation is positive for emerging markets.

However, global uncertainties remain high. In the U.S., it remains unclear how far President Trump will push for protectionism, block immigration and in what shape his tax reform will emerge from Congress.  Europe has important upcoming elections, with the risk of radical change in France. And the risk of China slowdown is a constant threat.

In Latin America, recent indicators are consistent with our expectation of an economic recovery in South America, led by Brazil and Argentina. As the Fed raises interest rates, we expect some weakening of LatAm currencies relatively to the current levels. The trend of interest rates in South America is down, but high inflation expectations for this year in Colombia and Argentina are turning their central banks more cautious.

In Brazil, anchored expectations and falling inflation make room for a reduction in the inflation target to 4% for 2019. Economic activity shows signs of improvement in the margin, in line with our scenario. On the fiscal side, reforms will continue in focus this year. We expect the pension reform to be approved in the second quarter of 2017. We lowered our exchange rate forecasts due to a decrease in country risk. Falling inflation and the progress of fiscal measures allow for a sustained reduction in the interest rate. We now forecast the Selic rate at 9.25% at the end of 2017 and at 8.25% in 2018.


Global Economy
Global data supports Emerging Markets amid political uncertainty

• Positive momentum of global manufacturing continues with a strong Purchasing Manager’s Index (PMI) in January.

• Inflation rates in developed economies are increasing, driven by energy prices, while core measures remain at moderate levels. 

• Interest rates are set to rise in the U.S., but with modest wage pressure, the Fed can afford to be be gradual (we foresee three hikes in 2017, with the next move in May).

• China is also tightening policy, but activity should hold up for now.

• The background of better global activity and moderately rising inflation is positive for Emerging Markets.

• Policy uncertainties in the U.S., elections in Europe and a China slowdown remain important risks.

Global activity and inflation started 2017 on a high note.

The manufacturing cycle continued to improve in January. The global manufacturing PMI increased to 53.3 in the month, from 52.8 in December (see graph). The index is at the highest level since 2011.

Global inflation is also rising. The breakdown shows that it is increasing in Developed Markets (DM), while in Emerging Markets (EM) inflation is dropping. Importantly, in DM, headline inflation is up due to energy prices, but core inflation remains stable (see graph).

This data mix is positive for emerging markets, and EM asset prices. First, stronger manufacturing activity sustains commodity prices. Second, inflation rising in DM with stable core inflation reduces deflationary fears without exerting excessive upward pressure on global interest rates. These developments favor resilient capital flows to EM. Finally, inflation declines in EM maintain space for monetary easing in some countries (in particular, in Latin America).

U.S. – Positive outlook, but political uncertainties remain high

GDP slowed down to 1.9% qoq/saar in 4Q16, from 3.5% in 3Q16, but underlying private domestic demand rose a solid 2.8%. Consumption expanded 2.5% and business fixed investment accelerated to 2.4% (from 1.4%). In addition, the big net-exports drag (-1.9 pp) was a one-off drop in soy exports after a strong 3Q16.

We estimate that growth will accelerate to 2.2% qoq/saar in the start of 1Q17. 

Moreover, we see chances of higher GDP growth throughout the year. Easing financial conditions and positive consumer and business sentiment indicate a 30-50-bp upside risk to our 2.3% GDP forecast for 2017.

Labor markets reflected this improved environment and had a strong start to the year. Job creation reached 227k in January, taking the three-month moving average to 183k, from 165k. We expect the pace of job creation to remain at 175k per month this year. This pace will likely lower the unemployment rate to 4.3% in 4Q17 (from 4.8% in January).

Recent softness in wages and core inflation indicates that some slack remains in the economy. The 12-month change in the average hourly earnings declined to 2.5% yoy, from 2.8% (revised down from 2.9%). The core PCE deflator increased just 1.3% qoq/saar, reaching 1.7% yoy in 4Q16.

Nonetheless, with a strong job market, wages and inflation will continue to trend up (see graph). The softer core inflation in 4Q16 was due to the strong USD and seasonal distortions. The tightening labor market remains broadly consistent with the core PCE rising to 1.9% by 4Q17.

We continue to see three rate hikes by the Fed in 2017. We expect the next move to occur in May, and see two other interest increases in 2H17.

What risks does the new Trump administration bring to this scenario?

In his first weeks, President Trump rapidly started to put forward his campaign promises. Executive orders i) terminated the Trans-Pacific Partnership; ii) started the NAFTA renegotiation; iii) started to revamp the “Obamacare” health law; iv) restricted immigration; v) asked for review of the bank regulation (Dodd-Frank act); and vi) deregulated the energy sector.

From these first few weeks, we can make some inferences about the policy risks ahead.

First, President Trump could focus solely on trade protectionism and immigration restrictions. We think that this is unlikely, as President Trump has so far followed through on his campaign promises, which include a pro-growth fiscal agenda.

Second, President Trump may not convince the Republican base to pass his pro-growth fiscal reform through Congress. The main obstacle is finding sources of revenue and/or spending cuts to finance his corporate and individual tax cuts, making his tax-reform budget neutral.

One contentious idea from House Republicans Paul Ryan and Kevin Brady is the Border Adjustment Tax (BAT). The BAT excludes export and import input costs from corporate net income, effectively not taxing exports and taxing imported goods (at the full corporate tax rate). Given the current U.S. trade deficit, this measure would raise revenues by 0.6% of GDP.

However, a handful of Senate Republicans have reservations about the BAT. Who is paying for it (consumers, shareholders, foreigners)? Is it consistent with other international obligations? How to prevent overburdening some specific industries? The tax legislation needs the votes of at least 51 out of the 52 Senate Republicans to be approved by simple majority.

Given the difficult balancing act, the BAT may have to be excluded from the package, be significantly changed and/or be implemented in a long phase-in period. Thus, the Trump administration may have to significantly reduce his tax-cut plans.

We expect a balance to be found, but the negotiation of the tax bill will likely take at least a few months.

Third, even if the BAT is actually implemented as proposed by Congress members Ryan and Brady, the measure might be seen as a trade war. This could lead other countries to retaliate, hammering global growth and triggering a stagflation scenario.

Fourth, the new administration’s unorthodox governing style could lead to institutional gridlock. One example is the restriction on immigration, which is being challenged by U.S. courts. Another example is President Trump and Peter Navarro (National Trade Council) talking about the value of the USD, breaking a long tradition of leaving the foreign-exchange policy in the domain of the Treasury secretary. Such an unorthodox approach could lead to retaliation by other countries and/or to increasing cross-institution stress.  

Despite the risks and the noisy start, we expect a pro-growth policy mix to prevail. For that to happen, the new administration must pass the pro-growth fiscal reforms and avoid a trade war.

We maintain our GDP forecast at 2.3% in 2017 and 2.4% in 2018

Europe – Strong activity ahead of upcoming political risks

GDP expanded a strong 0.5% qoq in 4Q16. Improving financial conditions, slightly expansionary fiscal policy and a milder external drag contribute to stronger growth. Credit flows are improving, reflecting the positive effect of the European Central Bank’s (ECB) easing policies.

The ECB is likely to retain its accommodative stance for some time. Headline inflation reached 1.8% yoy in February. But Mr. Draghi outlined four conditions for successfully achieving price stability: Inflation must be i) durable; ii) achieved over the medium term; iii) self-sustaining, so it could endure even without monetary-policy stimulus; iv) applied across all euro-zone countries. These conditions are far from being met. Real interest rates will remain low, supporting economic activity.

Upcoming political events will nonetheless challenge the recovery in Europe.

In the UK, Brexit negotiations are expected to begin after the triggering of Article 50 in March. UK PM Theresa May has outlined a plan for Hard Brexit, as the UK wants control of its borders and regulations, which implies leaving the single market.

Netherlands will hold general elections in March, and the Euroskeptic party, PVV, continues to rise in the polls. However, it is still unlikely that the PVV will form a governing majority.

France’s presidential election is the main event of 1H17. The Eurosceptic National Front candidate Marine Le Pen will most likely make it to the run-off ballot. Who her opponent will be is less clear. Former PM François Fillon has been losing ground amid reports of nepotism throughout his political career. Independent runner Emmanuel Macron now appears to be the most likely candidate to make it to the final round. But the Socialist Benoît Hamon also has a shot. In fact, the three candidates are within error margins in the latest polls (see graph). Although all candidates are ahead of Ms. Le Pen in second-round polls, she still has a good chance of winning.

Finally, although it is not our baseline, there is a chance of early elections in Italy. The probability has increased following the Constitutional Court’s decision to maintain the majority premium, scrap run-off elections and state that elections can occur under the revised electoral law.

We maintain our GDP growth forecasts at 1.6% and 1.3% for 2017 and 2018, respectively.

Japan – An ally for President Trump?

Japan’s economy is showing signs of improvement. Slowly improving soft data aligned with strong industrial production and a weak yen boosting exports support our view that the Japanese economy is set to grow above its potential rate this year.

Japan’s PM Shinzo Abe’s summit with Donald Trump on February 10 will likely conclude on a positive note. President Trump has insisted that the BoJ’s monetary policy is targeted at depreciating the yen, which hinders the competitiveness of U.S. goods. Japan’s PM Shinzo Abe is set to reinforce that the BoJ is independent and has conducted its accommodative policy stance in order to re-inflate the economy, adding that the BoJ has not intervened in the foreign-exchange market since 2011. Additionally, Abe should be able to win President Trump over by offering to finance his infrastructure expansion plans (Japan’s Government Pension Investment Fund can buy U.S. infrastructure bonds), to help with cyber-defense technology and to further share the burdens of defense spending. The latter would reinforce the win-win relationship, as Japan’s annual defense budget is currently around 1% of GDP and the government would like to increase it, and President Trump has said that he wants America’s strategic allies to shoulder a greater share of the defense costs.

As for the BoJ, expect Governor Kuroda to leave its policy framework unchanged. Recently, the BoJ conducted fixed-rate operation for 5-10-year JGBs for the first time, to calm down the 10-year JGB yield that had surged to 0.15%. This showed the Bank’s seriousness about defending the 0% 10-year yield target.

We left our GDP estimates at 1.1% for 2016 and 1.4% for 2017. We project growth at 1.0% in 2018.

China – A lot to lose in a trade war

China’s economic growth is set to remain stable in 1Q17. Economic activity and credit growth have exhibited a solid pace in recent months. Investment is finding support in higher corporate profits (on a weaker currency and higher producer prices). Manufacturing PMI remained high in January, and our Current Activity Index, which summarizes several economic indicators, suggests that the economy is still running close to an 8% pace (see graph).

Given that strong growth comes with too much credit (and an inflation pick-up), the government is tightening policy. First, it implemented macro prudential measures to cool off the property sector in 2H16. Since the end of 2016, the PBoC has hiked several policy rates; it is likely to continue to tighten ahead.

Nonetheless we do not expect a sharp slowdown in 1H17. The macro prudential measures have slowed housing prices, but housing investment will remain hot for a few months as the pipeline under construction is completed. In addition, monetary policy hits the economy with lags. Hence, growth should continue at steady pace in the next few months before a policy-induced slowdown occurs around mid to late -2017.

The main short-term risk in China comes from changes in U.S. taxes/tariff policies. Despite some advances in rebalancing its economy toward domestic consumption, exports still account for 22% of China’s GDP, well above other large economies. Meanwhile domestic consumption accounts for approximately 50% of GDP. A shock in exports to the U.S. (18% of the total) would also directly affect the share of fixed investment related to the export supply chain. The government has tools to partially offset the shock, for example, fiscal stimuli and allowing a weaker RMB, but the remedy would aggravate China’s imbalances and be negative for China-related assets that would fall along with the RMB.

We revised the GDP forecast to 6.4% (from 6.3%) in 2017, due to a better statistical carry-over from 2016 while still envisaging a moderate slowdown in 2H17. We forecast 5.8% for 2018.

Commodities – Macro outlook and supply maintain the rally, for now

The Itaú Commodity Index (ICI) has risen by 1% in 2017, extending 4Q16 gains as global economic activity keeps up the strong pace, the USD weakens and producers show renewed discipline. 

Metal prices advanced further. The macro background and supply-related concerns in nickel (closure of mines in the Philippines) and copper (risks of strikes in Chile) supported prices.

Oil prices have fallen 3% in 2017, as signs that OPEC members are complying with the deal were offset by increasing drilling activity in the U.S. Uncertainty over the new U.S. presidency is also neutral for prices: worse relations between the U.S. and OPEC countries increase risks of non-compliance, but may also increase the ‘geopolitical risk’ component implied in oil prices.

The ICI-agriculture component rose 5% year to date, benefitting from a weaker USD, a recovery of sugar and coffee prices from a technical undershooting, and floods affecting crops in Argentina (and delaying harvest in Brazil). Despite the floods in South America, crop conditions are consistent with a stronger summer crop than last year, particularly in Brazil. Looking forward, the Pacific Ocean is set to remain neutral (no El Niño nor La Niña patterns) until 3Q17. Given earlier expectations of La Niña, neutrality implies lower risks for Brazil’s winter corn crop and the next crop in the U.S.

Looking ahead, we expect the ICI to decline 7% from its current level by the end of 2017.We expect a slowdown in China in 2H17 to lower metal prices. Moreover, we expect U.S. shale-oil producers to expand their output and an increase in iron ore supply (supply from traditional and exotic players) to pressure prices during the year.


Encouraging growth signs

• Recent indicators are consistent with our expectation of an economic recovery in South America, led by Brazil and Argentina. 

• The external environment has been supportive for LatAm currencies, but higher interest rates in the U.S. ahead will likely lead to some depreciation from current levels. 

• Interest rates in South America are on a downtrend, but high inflation expectations for this year in Colombia and Argentina have made their central banks more cautious.

Improving growth amid a supportive external environment

Activity in Brazil and Argentina has shown some improvement. Recent indicators seem to confirm that Argentina’s economy is making its way out of the recession. In Brazil, while a negative quarter-over-quarter GDP growth in 4Q16 is likely, there are signs of improvement in activity at the margin: industrial production posted a second consecutive gain in December, our diffusion index likely reached its highest level since 2012, and business and consumer confidence are rising.

But there is less excitement elsewhere in the region. Growth has been around trend in Mexico, but is set to slow given the uncertainty over U.S. protectionism.Meanwhile, activity in Chile and Colombia continues to slow.  

The external environment has been favorable for emerging markets (Mexico being the clear exception), despite the high political risks in developed economies. Solid growth in the U.S., higher commodity prices and very gradual policy normalization by the Fed have led to further exchange rate appreciation since the year began. We recently expanded our Itaú Market Conditions Index to other countries in the region (Mexico, Chile, Colombia and Peru). This shows an improvement in financial conditions since the beginning of the year for all countries but Mexico.

As the Fed raises interest rates (we expect three 25-bp rate hikes before the end of this year), some weakening of LatAm currencies from current levels is likely. 

We expect an economic recovery this year, driven by Brazil and Argentina. In Chile and Colombia, we see more modest recoveries and with downside risks given the recent disappointing numbers. In Peru, we see stable growth between 2016 and 2017, based on our forecast of a recovery in internal demand that would offset the slowdown in mining production. We continue to expect a slowdown in Mexico, caused by uncertainty over U.S. protectionism.

Interest rates falling, but more gradually in Colombia and Argentina

Inflation in South America is trending downward faster than expected. Our Itaú Inflationary Surprise Index remained in negative territory in January (in line with the lower-than-expected inflation), despite the deteriorating inflation outlook for Mexico (affected by a weaker currency and higher gasoline prices). Better-behaved exchange rates and negative output gaps have led to a reduction in the pace of consumer price increases in South America.

In this context, we continue to expect lower interest rates in Brazil, Chile, Colombia and Argentina. However, in Colombia and Argentina, above-target inflation expectations for this year have made their central banks more cautious about delivering monetary stimulus. The timing of the next rate cuts will therefore depend on the data. In Mexico, further interest rate hikes will be necessary to avoid second-round effects of the shocks currently affecting consumer prices.


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

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