Itaú BBA - Fed and BCB take the other way. Oil prices are stabilizing

Global Scenario Review

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Fed and BCB take the other way. Oil prices are stabilizing

February 13, 2015

While the wave of global monetary expansion continues, growth is recovering in parts of the world, and oil prices stabilize.

Global Economy
Is the wave of global monetary easing close to an end?
The wave of monetary easing seems close to an end, as oil prices are stabilizing and growth in developed countries is improving. We believe the Fed will soon run out of “patience”.

A slowing economy, risks of power and water rationings

Deterioration in economic activity and inflationary pressure are set to continue in the next months. With an unfavorable starting point and lower activity this year, reaching the fiscal target becomes a bigger challenge.

A more conservative fiscal policy

Recovery continues, driven by exports. While private consumption has been weak, real labor income will likely lift it ahead. Still, fiscal-expenditure cuts for this year and other factors led us to reduce our growth forecasts.

Reforms advance

Activity ended 2014 on a positive note. The government has continued to pursue its political agenda. Bills aimed at reforming education, the political system and other social improvements have been approved by Congress. Other reforms will soon be debated.

Slow comeback

Peru’s economy was again sluggish in November and December. Considering our revised copper price forecast and a worse carry-over, we have reduced our 2015 GDP growth forecast to 4.2% (from 4.7% previously).   

Monetary easing ahead

The central bank maintained its policy rate at 4.5% in its January meeting. The central bank’s downward revisions to GDP growth pave the way for rate cuts. The Colombian peso has stabilized as oil prices recover.

A shot in the dark

The image of President Kirchner might be damaged by the mysterious death of a prosecutor that had denounced her. Recent political events will likely push the debt-holdout affair further down on the government’s list of priorities.     

Some relief in the crude-oil market

Oil prices have rebounded somewhat, in a move that we see as consistent with fundamentals. We reduced our forecasts for iron ore and copper prices, since the short-term impulse brought by the recovery in oil markets is not enough to offset the outlook of lower demand growth in China.

Fed and BCB take the other way. Oil prices are stabilizing. 

While the wave of global monetary expansion continues, growth is recovering in parts of the world, and oil prices stabilize. In the U.S., the rebound has been robust enough to probably prompt the Federal Reserve to move in the opposite direction than its peers. We expect a gradual and slow process of interest rate hikes starting in June of this year. This tightening will likely provide additional strength to the U.S. dollar and, in the process, create some volatility in the markets. There are other risks as well, such as the potential for a sharper slowdown in China and the possibility that Greece will leave the euro zone.

In this global context, the inflow of capital to emerging markets seen at the beginning of the year has been losing momentum, affecting emerging market assets. At the same time, the (still incipient) recovery in oil prices has provided some relief to economies that rely on crude oil sales, such as Russia’s and Venezuela’s.

Latin American currencies continue to depreciate, and we expect this trend to persist. We have lowered our exchange-rate forecasts for Colombia, Peru and Chile, anticipating more weakness. Mexico is the exception, as its proximity with the U.S., which stimulates its manufacturing export growth and elicits higher interest rates, along with the recovery in oil prices and the impact of Mexico’s ongoing structural reforms, will likely prompt currency appreciation before year end.

Overall, countries in the region continue to pursue expansionary monetary policies, although this situation might soon change. Peru has reduced its benchmark interest rate, and we expect another cut of 25 bps. We now anticipate rate cuts in Colombia in response to an expected economic deceleration. Moving in the opposite direction, the Brazilian Central Bank has continued its monetary tightening cycle, but this phase will likely end soon, given the country’s economic weakness. In Mexico, we expect the central bank to move in tandem with the Fed and begin to hike rates.

In Brazil, domestic factors are dominant. Political uncertainty, the impact of the corruption investigations involving Petrobras, monetary and fiscal tightening measures, higher tariffs for public services and the risk of water and power rationing will likely push GDP into negative territory in 2015 and make the ongoing fiscal adjustment even more challenging.

The Brazilian real is depreciating both as a result of this domestic scenario and in response to the global economic environment, which favors a strong dollar.

In Argentina, politics is setting the tone. All eyes are on the investigation into the mysterious death of prosecutor Alberto Nisman. The ensuing controversy has gripped Argentine society, pushing economic adjustment and an agreement with the holdouts further down the list of government priorities.


Global Economy

Is the wave of global monetary easing close to an end?

• The wave of monetary easing might not be so strong ahead, as oil prices are stabilizing and growth in developed countries is improving.

• After the last payroll printed 257 thousand new jobs, we believe the Fed will soon run out of patience.

• The activity trend is turning positive in Europe. We increased our GDP forecasts to 1.2% from 1.0% in 2015 and to 1.6% from 1.4% in 2016.

• China and Greece remain significant risks in the scenario.

• Emerging markets saw an uptick in capital inflows in January. But the outlook remains challenging.

The start of 2015 was marked by a wave of monetary easing from central banks across the globe. The European Central Bank (ECB) launched an aggressive asset-purchase program, the central banks of Canada, Australia, Turkey and Peru cut rates unexpectedly, the Monetary Authority of Singapore depreciated its currency, China’s PBoC cut its reserve ratio requirement (RRR) and even Russia, after aggressively increasing the interest rate to 17%, lowered it slightly, back to 15%.

Looking ahead, it is unlikely that monetary stimulus at the global level will increase much further. The recent wave of easing was led, in our view, by the decline in inflation due to the fall in oil prices, weak activity and some desire from central banks to not see their currencies appreciate. Some of these trends are losing strength.

We see the recent recovery in oil prices as consistent with fundamentals. As oil stabilizes, headline inflation will also stabilize through the year.

Moreover, the composition of global growth might be improving, at least within the developed world. Our measure of the global manufacturing Purchasing Manager’s Index (PMI) declined again in January, but its composition was positive in developing markets. The decline came from the U.S. print, where we remain confident about the growth prospects. Meanwhile, the PMI for developed markets excluding the U.S. increased in the month (see graph), pulled by Europe.      

And the next big story in the coming months will likely be that the U.S. Fed remains on track to raise rates by June. With strong labor markets and signs that Europe and oil prices are stabilizing, we think that the Fed will remove the word “patient” from its statement at the March meeting, signaling that it might raise the Fed fund rates in June, in line with our baseline scenario. 

But significant risks remain in the scenario, as China continues to slow down and a Greek exit from the euro area cannot be ruled out yet. In China, we believe the PBoC will need to further ease monetary policy in March or April as the current slowdown becomes clear to the authorities. In Greece, we expect an agreement to be reached eventually, but the current program with international lenders ends on February 28 and no agreement is in sight.   

Emerging markets saw an uptick in capital inflows in January (see graph) but the outlook remains challenging. Led by oil, commodities prices could stabilize and provide some relief. But if the Fed indeed moves toward an interest-rate increase in June, as we expect, we could see some further volatility and pressure in exchange-rate markets.

We believe the overall scenario remains supportive for the USD to continue to gain ground in 2015

U.S. – The Fed will soon run out of patience

U.S. GDP expanded 2.6% qoq/saar in 4Q14, down from 4.6% in 2Q14 and 5.0% in 3Q14. GDP grew 2.4% in 2014, up slightly from 2.2% in 2013. The gain might seem small, but it was achieved despite the unusually severe winter last year.

Despite the GDP slowdown in the last quarter of 2014, consumption momentum is solid, boosted by oil-price declines. Real personal-consumption expenditures actually accelerated to a solid 4.3% qoq/saar, and consumption growth should remain at a robust 3.0% pace in the first half of 2015.

We forecast GDP growth to accelerate to 3.1% in 2015 compared with 2.4% in 2014. For 2016, we continue to expect 2.5%. 

Meanwhile, conditions in the labor market are improving at a solid pace. The Non-Farm Payroll rose 257 thousand in January and job creation totaled 3.1 million in 2014, up from 2.4 million in 2013. The unemployment rate rose to 5.7% in January (vs 5.6% in December), due to a rise in the participation rate. Importantly, the unemployment rate is close to the NAIRU range (5.2%-5.5%) estimated by FOMC members and we continue to foresee a decline to 5.0% by the year-end.

CPI has been down to -0.31% per month in November and December, compared with the 0.14% average in the 12 months to October, but this should prove transitory. About 80% of this deceleration is explained by the sharp decline in energy prices (from -0.7% yoy up to October to -7.7% in the last two months of the year). January should still experience a sharp decline in gasoline prices. However, as oil prices stabilize, we expect the headline CPI to return to positive territory in the following months.

Core inflation also decelerated, but a few items explain most of the fall and we also expect this to be transitory. Core CPI (excluding food & energy) averaged 0.04% mom in the last two months of 2014, 11 bps below the prior 12-month average. However, the deceleration was almost entirely related to three volatile sub-items: apparel, used cars, and airline tickets. Excluding these three items, the core CPI remained stable at 2% yoy. Looking forward, core CPI is likely to normalize in the months ahead. Apparel and used cars are mean reversing, and there are already signs that they will improve soon. The airline-ticket decline may still have a leg down, as it is related to energy prices. But they will stabilize together with oil prices during the year.

With good growth momentum and the falling unemployment rate, we believe that the FOMC will remove the term “patience” from its statement in March, giving itself the option to raise the Fed Funds rate in June. Given that Janet Yellen has been communicating that “patience” means not lifting rates in the next two meetings, removing it at the March meeting will signal the possibility of an interest increase in June.

When we get to June, we continue to believe that the FOMC will feel comfortable to start increasing interest rates. The key driver of the decision will be the inflation outlook, which we think will have improved by then, as the transitory downward pressures we discussed above will have diminished.

The risk remains tilted towards a later liftoff though. The FOMC may decide to wait longer, mostly because market-based inflation expectations are at low levels. But these measures may also be distorted by market conditions and should rise once oil prices stabilize. Hence, even in the event of a delay, we suspect the liftoff will happen no later than September this year.

We continue to expect U.S. Treasury yields to increase faster than currently priced in the forward markets, but made some downward adjustment to our forecasts. We revised the 2-year Treasury forecast down to 1.8% (from 2.1%) at the end of 2015, as investors will likely continue to price a moderate pace of rate hikes. The context of monetary easing by several central banks around the globe contributes to this perception. But we maintain our 10-year Treasury forecast at 2.8% in end-2015 and 3.3% in end-2016.

Europe – The activity trend is turning positive, but Greece remains a risk

The economic activity trend is turning positive in the euro zone. The composite PMI rose to 52.6 in January, the second increase since reaching the recent low of 51.1 in November (see graph). The euro-zone economic sentiment survey also increased, to 101.2, the highest level since mid-2014. Other survey data are also showing similar improvements. Hard data have improved. Credit also seems to have turned a corner, with December data showing a rise in the amount of loans to households and corporations for the first time since early 2012, and surveys showing demand improving and looser credit standards.

The sharp fall in oil prices is giving a positive impulse to the economy. Euro-zone consumption, which maintained a good pace even as the overall economy decelerated during 2014, received another boost. Retail sales were up 2.9% year over year in December, the fastest pace since early 2007.

In addition, the European Central Bank (ECB) announced an aggressive quantitative-easing program, further reducing interest rates in the region, depreciating the euro and helping reduce deflation fears. The central bank committed itself to buy EUR 60 billion in assets a month until at least September 2016. It also made clear that it could extend the length of the program if it is not convinced that medium-term inflation is headed to the “close to, but below” 2% target. This will help euro-zone growth by bringing interest rates even lower and depreciating the euro.

We increased our GDP forecasts to 1.2% from 1.0% in 2015 and to 1.6% from 1.4% in 2016.

Greece nonetheless remains an important risk, as the time for an agreement is running out. The current agreement with its international creditors ends on February 28. The initial talks between the elected Greek government and leaders across Europe went nowhere. If a deal (or an extension of the current program) is not agreed by the end of the month, the Greek government could run out of cash in late March or April. Additionally, the ECB could further limit its liquidity provision to Greek banks. At the moment, we cannot rule out the chance of a Greek exit from the monetary union.

Japan – As economic data remains mixed, focus turns to wage negotiations and (again) to the BoJ

The economic recovery remains tortuous in Japan. On the positive side, after the strong depreciation of the yen since 2013, real exports are finally increasing in a more consistent way and were up 4.8% qoq in 4Q14. Consumer confidence appears to have bottomed out, and increased in December after four months of decline. However, on the negative side, retail sales declined for the third month in a row (-0.3% mom in December). Industrial production remains volatile, growing 1.0% mom in December, less than expected after a surprising fall in November. Meanwhile, core inflation (excluding food, energy and April’s VAT increase) remained at only 0.4% yoy in December.

With inflation still far from the Bank of Japan (BoJ) 2% objective, investors are again speculating about more monetary easing ahead.

We think this is misplaced, and that investors should focus on wage growth. Although the goal of reaching the 2% inflation target in early 2016 seems unrealistic, part of this is due to the decline in oil prices and BoJ seems to be shifting its focus to the broader price and economic goals instead of sustaining targets in the near term.

Hence, we view the annual spring wage negotiations as the next key event. Real wages are still declining in Japan, as headline inflation increased but wages rise lagged behind. In March, most large companies negotiate their annual wage rise and this usually provides guidance to the overall behavior of wages in the economy. The BoJ and government seem confident that the increase will be close to 1% yoy, compared with 0.5% last year.

We maintain our GDP forecast for Japan at 1.2% in 2015 and 1.6% in 2016.

China – The RRR cut addressed liquidity issues, but did not improve the growth outlook

China’s economy grew 7.4% in 2014, slightly down from 7.6% in 2013 and 0.1% below the 7.5% official target for the year. The result reiterates the more-flexible approach from the Chinese government towards their GDP growth target. We think that this flexibility will continue this year, for which we expect the target to be set at 7.0%, showing that the government is indeed accepting a new normal for economic growth.

Looking ahead, GDP is set to decelerate further. Sequential growth decelerated to 6.1% qoq/saar in 4Q14 from 7.8% in 3Q14. Industrial production and some other activity indicators improved in December, but they were helped by more working days and a payback from the temporary shutdown of factories before the APEC Summit in November. Essentially, the weakness in the property sector remains a headwind for growth and credit growth still needs to slow down. Finally, the PMIs have declined in January, showing that underlying growth is indeed weak and economic activity is likely to slow down in the absence of stimuli.

Amid these signals of slowing growth, the PBoC announced a 50-bp cut to the RRR in February. The cut came a bit earlier than expected, injected around RMB 650 billion liquidity into the banking system, and raised hopes that the government has turned to a more pro-growth stance.

However, we believe that the central bank has simply offset the liquidity drained by currency interventions and will need to cut rates to smooth the slowdown. We expect further easing only in March or in April, after the data following the Chinese new year are released and provide a better picture of economic activity.

We are lowering our GDP forecast for 2015 to 6.9% from 7.0% and continue to expect 6.6% in 2016.

Commodities: some relief in the oil market

Commodity prices showed strong volatility at the end of December: The Itaú Commodity Index (ICI) fell 10% between the end of December and January 29 and has risen 6.1% since then. Crude oil was the main driver in both movements, causing the ICI-energy sub-index to drop 13.3% and rise 14.9% in the same periods of time. Agricultural prices and metals also recovered from recent lows, but are negative year-to-date (agricultural: -4.9%, metals: -8.9%).

The recovery in oil prices from USD 50/bbl to USD 57/bbl is consistent with signs of a decline in investment related to unconventional oil production in North America. The weekly count of Baker Hughes oil rigs has declined by 28% since October, and several companies already report a delay for new investment plans. Finally, the rise in oil prices came despite a strike that is affecting oil refineries in the U.S. (lowering demand for crude oil in the short term). We are increasing our forecasts for average Brent prices in 1H15 to USD 55.6/bbl from USD 52.5/bbl, recognizing that the increase is based on fundamentals. Our year-end scenario remains at USD 70/bbl.

A partial and sustainable recovery in oil prices can help commodities in the short term. The movement is likely to lead investors to a risk-on behavior, as it reduces risks to key producing countries, to O&G companies and to banks exposed to these agents.

However, we believe that the pass-through of lower oil prices to transport and production costs has not been fully priced in commodity prices. We see a downward pressure ahead due to cost deflation even if oil prices rise back to USD 70/bbl, since these prices will be well below the previous equilibrium (at USD 110/bbl).

The prospect of lower demand growth in China also helps to explain year-to-date declines in iron ore and copper prices (-11.8% and -8.5%, respectively). We lowered our year-end forecasts for iron ore to USD 67/t from USD 70/t, and for copper to USD 5,600/t from USD 6,100/t.

Finally, the prospect of sizable surpluses in the fundamentals of agricultural prices is still driving prices lower. The impact of the drought in Brazil on corn and soybean prices has been offset by favorable weather conditions in Argentina. Sugar prices fell further, unaffected by two bullish adjustments in Brazil: the drought in key sugarcane producing regions, and the incoming increase to the ethanol mandate in gasoline.

We lowered our year-end 2015 and 2016 ICI forecasts by 1.4 pp and 1.7 pp, respectively. In addition to the downward adjustment to iron ore and copper, we lowered forecasts for cotton, natural gas and cocoa. Our scenario assumes that the ICI will rise 11.8% in 2015 from current levels and 3.1% in 2016.


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

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