Itaú BBA - Favorable International Conditions, but Disappointing Growth

Global Scenario Review

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Favorable International Conditions, but Disappointing Growth

May 9, 2014

The current conditions are ideal, though temporary. The U.S. recovery continues, but interest rates remain exceptionally low

Global Economy

Activity is Picking-up, Interest Rates Remain Low, for now                

The pick-up in activity is not pressuring yields of U.S. Treasuries yet, as the Fed signals low interest rates for an extended period. This environment remains supportive for emerging markets.


Tepid Activity, End of Tightening Cycle                                                 

We maintained our estimate for the 2014 IPCA inflation at 6.5%, taking into account adjustments in electricity and lottery games. We expect the end of the tightening cycle. Our GDP growth forecast remains unchanged given the cool-down in economic activity in March and April. 


Energy Reform Advances; the Economy, not So Much                               

The government has sent to congress the secondary legislation for the energy reform. The GDP gained momentum in the beginning of 2014, but it continued to grow below trend. 


Low Growth, Higher Inflation                                                                                    

Chile’s economy grew at a below-potential rate in 1Q14. The central bank left the interest rate unchanged in April, but maintained an easing bias. 


A Mining-Led Slowdown                                                                              

Despite robust activity numbers recently, there has been a worsening in economic growth expectations, mostly due to downward revisions for the mining sector output. President Humala’s popularity remains fragile.


The Beginning of the Tightening Cycle                                                           

The central bank surprisingly increased the interest rate in April, starting the tightening cycle earlier than expected. Higher interest rates will likely lead to a stronger Colombian peso than we previously forecasted.


A Less Harsh Adjustment                                                                     

Although we continue to expect higher interest rates and an additional devaluation of the peso in the second half (once reserves resume their downward trend), we now expect a milder adjustment than in our previous scenario.


Forecasts Revised Upward Due to Geopolitical Risk                                  

We revised our forecasts for the Metals and Energy sub-indexes upward, assuming that the situation in Ukraine will continue to affect prices. Delays in corn planting in the U.S. worsen the balance of risks for grains, while slowing growth and stricter rules in China are leading to lower iron ore prices.

Favorable International Conditions, but Disappointing Growth

The current conditions are ideal, though temporary. The U.S. recovery continues, but interest rates remain exceptionally low. Europe and China are also signaling more stable growth ahead. The combination of better growth along with low interest rates favor emerging economies: capital flows return and financial conditions improve.

But nothing is ideal forever. In our view, the Federal Reserve will increase rates faster than what is priced in, which will most likely be reflected in market yields before year-end. When this situation materializes, global liquidity will dry, the dollar will likely strengthen and volatility will probably return to the emerging markets. We acknowledge, however, that this scenario is taking longer to develop than we initially expected.

Even under these favorable conditions, growth in Latin America remains relatively weak. We have lowered our 2014 growth estimates for Mexico and Peru, while maintaining our below-trend growth forecasts in Brazil and Chile. Colombia remains an exception, as its brisk growth led the central bank to surprise markets by raising interest rates in April.

Domestic themes are increasingly relevant. In Mexico, the reform of the energy sector continues to move forward. In Colombia, all eyes are on the presidential elections in May. In Peru, approval ratings for the Humala administration have hit all-time lows.

In Brazil, despite weak economic activity, inflation is still worrisome and is now being refueled by adjustments in electricity tariffs. However, we expect the central bank to interrupt the monetary tightening cycle. The election debate is becoming increasingly relevant, as polls show a narrowing gap between candidates.

A favorable global environment and soybean exports are helping Argentina. We still forecast exchange-rate depreciation and higher interest rates, but we now expect a milder adjustment. A GDP contraction in 2014 is likely, but a less intense one than in our previous scenario.

Global economy

Activity is Picking-up, Interest Rates Remain Low, for now

• The U.S. GDP growth was just 0.1% (saar) in 1Q14, but indicators point to a strong expansion in the second quarter. 

• The pick-up in activity is not pressuring yields of U.S. Treasuries yet, as the Fed signals low interest rates for an extended period. Low inflation sustains that view for now.

• We still expect the Fed to start increasing rates in 2Q15 and to hike rates at a faster pace than is currently priced in the markets. Our expectation of robust economic expansion is the main reason for our call. However we recognize that the markets might take longer to price this outlook. 

• Growth in China is also likely improve in 2Q14 compared with the weak 1Q14.

• This external environment remains supportive for emerging markets.

Activity in the U.S. is rebounding after a weak start to the year. After expanding a meager 0.1% (seasonally adjusted annual rate – saar) in 1Q14, output is likely to be strong in 2Q14 and converge to a 3.0% trend growth pace in 2H14 and into 2015. We reduced our GDP forecast to 2.5% from 2.8% in 2014, but maintain a forecast of 3.0% for 2015.

The pick-up is not pressuring yields of U.S. Treasuries yet, as the Fed continues to indicate low rates for an extended period. Low price and wage inflation support that guidance for now.

Nonetheless we continue to expect the FOMC to start increasing the Fed funds rate by 2Q15 and to hike rates at a faster pace as growth remains robust and the labor market gets tighter. Hence we continue to expect higher Treasury yields by year-end than currently priced in the markets. We recognize, however, that the relative low yields might persist into early 2015 and move up only when we get closer to the first rate hike.   

Developments in the other major regions also point to better growth ahead. In China, authorities have announced targeted stimulative measures. It is not a major stimulus; nonetheless it will likely improve output growth in 2Q14 after a weak 1Q14. For the medium term, we still expect China’s economy to slow down. The European recovery has become more sustainable and we have increased our 2014 GDP forecast to 1.3% from 1.1%. Finally, Japan’s economy will slow down in 2Q14. But it is a temporary effect, due to the VAT increase in April.

This external environment remains supportive for emerging markets in the near term. With interest rates in the U.S. well-behaved and stabilizing growth in China, financial flows have returned to developing economies. Both factors could change. But for now the external environment is proving supportive for financial assets in emerging economies.

U.S. – activity rebounds after a weak start to the year

The U.S. GDP grew only 0.1% (saar) in 1Q14, well below our expectations and the market consensus. A decline in inventory accumulation trimmed 0.6 percentage points from annualized growth. The inclement winter probably weighed even more on growth in the period.

After this weak start to the year, the economy is rebounding. We raised the U.S. real GDP growth forecast to 4.0% (saar) in 2Q14. And we see output expansion reaching 3.0% trend pace in 2H14 and moving into 2015.

Several economic indicators confirm this strong pick-up in activity. Real personal consumption expenditure jumped 8.7% (saar) in March, and is tracking at 3.5% in 2Q14. Core retail sales have also recovered and are back to trend (see chart). ISM Manufacturing also reached 54.9 in April, a new high after bottoming at 51.3 in January. Payroll increased 288K in April. The average net job creation reached 203k in the last month, erasing all the winter slowdown. Finally, aggregate hours worked in the private sector could surpass a 2.0% annualized pace of growth in 2Q14, after bottoming at 0.9% in the 1Q14.

The only (and important) missing part in the rebound is the housing market. Residential investment declined 5.9% (saar) in 1Q14, after a 7.9% drop in 4Q14. The deceleration in housing is probably partially explained by the increase in mortgage rates last year, and partially by the weather. However, housing data in March has shown little signals of a spring rebound.

All in all, we reduced our GDP forecast to 2.5% from 2.8% in 2014 due to the weaker 1Q14. However, we left our 3.0% forecast for 2015 unchanged.

The FOMC brushed off the 1Q14 slowdown and has left its current monetary policy strategy unchanged. This strategy is twofold. First, continue to taper its asset purchase program. Second, signal low rates for a considerable period.

Accordingly, in the April meeting the central bank reduced its asset-purchase program by another USD 10 billion. This cut maintained the expectation that it will end the program with a last USD 15 billion reduction in October.

More importantly, the FOMC indicates that the Fed fund rate will stay at the current range until 2H15, because the labor market is weaker than implied by the unemployment rate alone. The central bank also says that it expects to lift the Fed funds rate at a slow pace of 25 bps every other meeting during the hiking cycle. In the FOMC view, higher domestic and global savings rates, slower real GDP potential growth and lingering constraints on the availability of credit justify a very gradual adjustment of interest rates.

The current low wage and price inflation supports the Fed guidance of low rates at the moment. Indeed, the core PCE deflator was 1.2% yoy in March, well below the 2% long-run goal of the central bank. And average hourly earnings were 1.9% yoy in April, significantly below their steady state 3.5% annualized pace.

Nonetheless, we expect the FOMC to raise its Fed funds rate at a faster pace than its current forward guidance. To put it simply, we expect that by next year, with the strong economic pace, the job market will be tighter and wage growth more robust. Hence, as the central bank starts to increase interest rates by mid-2015, it will be compelled to raise rates at the normal pace of 25 bps per meeting, as in previous hiking cycles.

We expect the market to anticipate this movement and hence we see the yield on the 10-year Treasury at 3.45% by the end of the year, about 40 bps above the current market pricing.

However, we recognize a risk of lower Treasury yields this year. Given that consumer price and wage inflation are still low and may rise at a slower pace than we anticipate, the market might only challenge the FOMC’s forward guidance closer to the first rate hike. This could anchor expectations of lower rates into the next year.

China – slowdown in 1Q14 and a few signs of improvement in 2Q14

GDP growth confirmed expectations and slowed down to 5.7% qoq saar in 1Q14 from 7.0% in 4Q13. March industrial production, investment and retail sales data showed a small improvement, but remained at weak levels.

There are some weak signs of improvement ahead. The official manufacturing PMI posted a small gain in April, rising by 0.1 to 50.4 (see graph). The breakdown was more encouraging, with the ratio between new orders and inventories rising on better domestic demand. This is usually a leading indicator of better activity ahead.

Further moderate stimuli will also help the economic activity in 2Q14. Following the mini-stimulus package from April 2, the government has announced i) a RRR cut for rural banks; ii) liberalization measures for infrastructure investment; and iii) export and employment subsidies. These measures are consistent with the government seeking moderate and targeted measures to fine-tune economic growth.

It is important to note that these stimuli are modest, intended to stabilize growth (likely in the 7.0%-7.5% range) rather than to provide a major boost. Indeed, government officials have hinted that activity in 1Q14 was in line with their expectations, showing tolerance for lower growth.

We maintain our GDP forecast at 7.2% in 2014 and at 7.0% in 2015.

Euro area – the recovery is becoming more robust

The recovery in the euro zone is becoming more robust. The economy continues to improve. Retail sales have picked up, growing 0.7% QoQ in 1Q14. Industrial production is maintaining a good pace, up 0.4% in the year compared with 4Q13. Survey data suggest that the good growth momentum continues. The composite Purchasing Managers’ Index increased to 54.0 in April from 53.1 in March.

We raised our growth forecast for the region to 1.3% from 1.1% in 2014. We maintain 1.5% in 2015.  

Japan – a temporary slowdown

In Japan, after a strong first quarter, activity is slowing down in response to the VAT tax hike in April. Surveys and anecdotal evidence suggest, however, that the deceleration is not extreme. We expect the slowdown to be temporary and the economy to resume growth in 3Q14.

In that context, the Bank of Japan remains confident about reaching its 2% inflation objective. The central bank continues to see inflation converging to the 2% target. In fact, its most recent forecasts show inflation at 1.3% in 2014, 1.9% in 2015 and 2.1% in 2016.

We still believe that more monetary stimulus will be needed to reach this inflation goal. Inflation expectations remain below 2%, wages are not rising and the effects of last years' currency depreciation will likely fade. But it should take until October for the BoJ to recognize a meaningful divergence of the inflation path from its economic outlook.

Commodities – higher prices due to ongoing geopolitical risks

The Itaú Commodity Index (ICI) has risen 1.7% since mid-April, driven by higher agricultural, base-metal and natural-gas prices, despite flat oil and lower iron ore prices. In addition to strong demand and the weather-related issues, delayed corn planting in the U.S. is pushing agricultural prices up. Meanwhile, renewed concerns with Ukraine are affecting grains, nickel and natural-gas prices.

This recent performance maintains the divergence among the different commodities seen in the year so far. Agricultural prices have risen 17.1% year-to-date, due to supply losses related to unfavorable weather, strong demand (particularly for soybeans and corn) and the low price levels by 2013 year-end. Oil-related prices are practically flat, gaining 1.2% ytd, with higher natural gas and WTI prices and lower Brent prices. Finally, metal prices dropped 12.5% over the same period. The drop in iron ore (discussed below) explains most of the performance in the metal sub-index.

We increased our year-end forecasts for the metals and energy sub-indexes, considering that fears of sanctions against Russia will add further “geopolitical risks” into prices. We now expect the ICI-metals to drop 11.8% yoy and the ICI-energy to drop 2.3% (less than we previously thought: -12.4% and -3.2%, respectively).

We maintain our year-end forecast for the ICI-agricultural (+9.5% yoy). The delayed corn planting in the U.S. increases the probability of a significant crop loss, but does not change the base case of yields in line with the long-term trend.

Growth slowdown and tighter regulation in China continue to lead iron ore prices down. Iron ore prices have fallen 21.6% year-to-date to USD105/ton, -7.6% since mid-April. The slowdown in China is consistent with a deceleration in steel production growth, leading to an equivalent deceleration in iron ore demand. In addition, there are rumors that the authorities in China are tightening rules to curb the use of iron ore as financial collateral. Besides, current prices are still well above break-even costs for the main suppliers. In sum, the drop is consistent with fundamentals and we forecast an additional drop through 2014 to USD 101/ton.

All in all, we revised our ICI index slightly upward. We now expect the ICI index to drop 1.4% yoy in 2014 instead of 1.9%.

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


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