Itaú BBA - Global and Brazilian interest rates on the rise

Global Scenario Review

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Global and Brazilian interest rates on the rise

June 18, 2015

Interest rates increased in developed economies as the risks of deflation diminished. Greece remains a risk.

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

Global Economy
Global interest rates on the rise
Interest rates increased in developed economies as the risks of deflation diminished. Greece remains a risk.

A difficult reversal
Inflation has increased and growth has worsened in Brazil, making it harder to conduct monetary and fiscal policy.

No rate hikes this year
Mexico’s central bank will only start to remove the monetary stimulus in 1Q16, when the economy will regain traction.     

Expectations weigh on activity
The year began on a positive note as activity growth accelerated in 1Q15. However, the economy is losing momentum in the second quarter.

Investment weakens further
In spite of the recent improvement in natural resource activity, the economy elsewhere remains sluggish.    

More-challenging fiscal stance
The medium-term fiscal framework published by the Ministry of Finance indicates that the central government deficit would be higher than previously anticipated.

Electoral calendar dominates
Daniel Scioli (incumbent) appointed Carlos Zannini as his running mate, indicating that the Kirchnerism would remain influent if he is elected.     

Lower agricultural prices despite El Niño
Lower agricultural prices result from more robust crops in the U.S. and Brazil, as well as clogged supply reaction.


Global and Brazilian interest rates on the rise

Global growth has resumed and deflation risks diminished, as oil prices stabilized. This environment increases global yields and supports expectations for a U.S. benchmark rate liftoff in September. In Europe, negotiations with Greece have stalled, but apparently markets believe that an exit from the Eurozone would not be so traumatic. We aren’t so sure about that. The combination of rising interest rates in developed economies and Greece exit may generate volatility.

In emerging economies, in contrast, growth has been weak. The stimulus measures adopted by the Chinese government have not apparently been enough to avert a slowdown. We expect additional measures in the second half of the year. In this context, commodity prices are unlikely to rebound.

In Latin America, growth forecasts continue to be revised downward. We lowered our estimates for Mexico, Chile, Peru and Brazil. Slower activity will prevent interest rate hikes in Chile and Mexico. We still expect the Chilean central bank to keep rates on hold, and we don’t expect the Mexican monetary authority to increase rates until 1Q16, no longer in tandem with the Fed.

In Brazil, inflation is up, and growth down, worsening the trade-off for monetary and fiscal policies. A sharper decline in economic activity and other difficulties of the fiscal adjustment led us to revise down our estimate for the primary budget surplus. The central bank of Brazil has reiterated the message that it will fight inflation with “determination and perseverance,” pointing to another likely hike in the benchmark rate in July.

In Argentina, all eyes are on the presidential race, with expectations for change in the future anchoring the present. But not all future prospects are better. Recently, U.S. District Judge Thomas Griesa extended the same rights to the other holdouts and now threatens also to intervene in bonds governed by Argentinian law. This will intensify the pressure on the next administration to reach a deal with the holdouts.


Global Economy

Global interest rates on the rise

• Interest rates increased in developed economies as the risks of deflation diminished. Europe led the movement.

• Growth in the U.S. is recovering and raising the odds of the interest-rate increase in September. 

• Europe is also seeing better growth, but Greece remains a risk. 

• In China, growth will remain modest despite the monetary policy easing. We maintain our below-consensus 2015 GDP-growth forecast (6.7% versus 7.0%).

• The U.S. dollar will probably be more stable against developed economies’ currencies, but it is likely to continue to appreciate against emerging economies. 

Interest rates in advanced economies increased with a better inflation outlook

Oil prices are up almost 20% since their lows in early in 2015 and will push energy inflation up. We believe that this movement is consistent with fundamentals and expect oil prices to remain around the current levels. As a consequence, we see global energy inflation turning positive (from -5.8% yoy in January) by the end of the year and global inflation moving back to 3% (see graph).

In addition, wage increases are showing tentative signs of improvement in developed countries. Unemployment rates are declining and reaching historical low levels in the U.S., UK, Germany and Japan. Importantly, these declines may be starting to create some upward pressure on wages (see graph). In the euro area as a whole, the unemployment is also going down, but remains high. Nevertheless, wages in the region also appear to have stabilized (see graph).

Both factors (oil and wages) improved the inflation outlook and contributed, in our view, to an upward repricing in long-term interest rates in the advanced economies. This movement was led by Europe, where the interest rates on 10-year German bonds increased from about 0% to close to 1%. Long-term interest rates also increased in the U.S., UK and Japan (see graph). We think that these new levels are consistent with the decline in deflation risks.

Importantly, as the global inflation outlook improves in advanced economies, the prospect of monetary-policy divergence seems less pronounced than before. In addition, economic growth in Europe is becoming more widespread (see below). We revised our forecast for the euro against the U.S. dollar to 1.10 and 1.08, from 1.05 and 1.00, in 2015 and 2016 respectively.

U.S. – The 2Q15 GDP rebound is materializing

Activity data is recovering and reinforcing our view that the economic slowdown was mainly transitory. Retail sales expansion was stronger than expected, indicating significantly stronger consumer spending in the last three months. Our estimate of GDP growth in 2Q15 is at a healthy 3.2% qoq/saar. This is an important rebound after the weak first quarter (the latest release shows a GDP contraction -0.7% qoq/saar in 1Q15, but we estimate that it will be revised to -0.1% in the next revision.)

We revised the GDP growth forecast down slightly to 2.4% (from 2.5%) in 2015, while maintaining 2.5% for 2016.

The labor market continues to improve at a moderate pace. In May, the Non-Farm Payroll rose 280 thousand and has averaged 207 thousand per month in the last three months. The unemployment rate ticked up to 5.5% (from 5.4%) due to an increase in the labor force participation rate, but remains on a downward trend.

The risks to the inflation outlook are gradually abating. The core PCE deflator rose 0.11% mom in April and has grown at 1.5% annualized pace in the last 3 months. Market-based long-term inflation expectations have increased in the past months. In addition, there are signs of gradual acceleration in wage inflation, with average hourly earnings up 0.3% mom (2.3% yoy) in May, the highest level since the 2008 recession.

The activity recovery, diminishing downside risks to the inflation outlook and signs of pick-up in wage gains raise the odds that the FOMC will start raising interest rates in September. Since inflation pressures remain subdued, risks continue to be tilted to a postponement of the liftoff to December.

We continue to forecast the 2-year Treasury to rise to 1.2% by year-end. But, we raised our 10-year Treasury forecast to 2.7% (from 2.5%), due to higher term premium. 

Europe – Steady growth and a pick-up in inflation, but Greece remains a risk

Economic growth is spreading across the euro area and showing a steady pace. GDP expanded 0.4% qoq in 1Q15 up from 0.3% in 4Q14. Importantly, growth is driven by domestic demand (actually, net exports took off 0.2% of growth in the period) and is spread among the four large economies (Germany: 0.3% qoq; France: 0.6%, Italy: 0.3% and Spain: 0.9%). The second-quarter data have broadly shown growth close to 0.5% qoq, in line with our scenario.

Inflation turned positive (actual: 0.3% yoy, prior: 0%) in May, with a pick-up also in core measures (actual: 0.9%; prior 0.6%). We expect inflation to stay sideways for the next couple of months and then rise until the end of the year as oil prices have improved from their lows, activity has improved in the region and inflation expectations have stabilized.

However we see inflation ending 2016 close to 1.6% and hence still far from the European Central Bank (ECB) inflation target of below but close to 2%. Hence we don’t believe that the central bank will change its easy monetary policy stance anytime soon.

Greece remains a risk as its government still doesn’t agree with the adjustment program proposed by the troika of international creditors. If no agreement is reached, Greece is unlikely to meet neither the IMF payments by the end of June, nor the large repayments in July and August of bonds held by the ECB. In response, the ECB will likely impose a cap in the liquidity it provides to Greek banks and Greece will need to impose capital controls. This doesn’t necessarily imply that Greece is out of the monetary union (which we define as the reintroduction of the drachma and full redenomination of domestic contracts), but the risk of exit will increase. In this scenario, the economic situation in Greece will continue to deteriorate, which could eventually lead to either an exit or a new government that would reach an agreement with the troika.

We maintain our euro-area growth forecasts unchanged at 1.6% in 2015 and 1.9% in 2016.

Japan – Investment is improving but consumption growth is still shaky

GDP growth accelerated to 3.9% qoq/saar in 1Q15 from 1.2% in 4Q14, led by investment (11% qoq/saar) and large inventory accumulation (which contributed 2.2 pp). The print was almost twice as large as the first estimate.

We expect a more moderate GDP pace ahead with some downside risks as consumption shows weakness. The investment expansion will likely moderate but remain on the positive side as machinery orders were strong in April, up 3.8% mom/sa and back to the prior-2008 crisis level. Inventory accumulation is transitory and will be a drag on growth in 2Q15 but neutral afterwards. The main risk to our scenario of modest growth comes from consumption, which after a modest 1.5% (qoq/saar) expansion in 1Q15, declined 1.1% mom in April, according to the CAO real consumption indicator. We expect better growth ahead as wages growth continues to improve in the country (see above).

We increased our 2015 GDP forecast to 0.9% from 0.7% and continue to expect 1.6% in 2016.

China – Growth will remain modest with downside risks, despite the policy-easing effort

The economic activity recovered only modestly in April and May after the weak first quarter. The manufacturing purchasing manager’s index rose only 0.1 point (to 50.2) between March and May, and the sequential improvement in industrial production seems partially related to a payback from March’s weak figures. The April-May recovery is modest compared to the movement seen in 2Q14.

The easing measures are making their way into the economy and would probably generate some activity gains. The RMB 1 trillion (later expanded to RMB 2 trillion) local-government-debt swap program (from loans to municipal and provincial bonds) and restrictions on borrowing by local-government financial vehicles (LGFV) may explain the low impact of stimuli so far. Both affect local government’s investment capacity and the former was also pressuring market interest rates. Now both constraints seem to be eased with the relaxation on LGFV borrowing and the PBoC allowing muni bonds to be used as collateral in short-term liquidity programs. Since these measures have been implemented, several cities successfully issued bonds with low spreads to sovereign bonds.

In addition, we believe that the PBoC will continue easing policy by cutting interest rates and the required reserve ratio by 50 bps each before the end of 3Q15. 

These stimuli will likely drive GDP growth to 7.0%-7.5% qoq/saar in 2Q15 and 3Q15 (compared to 5.1% in 1Q15). This recovery won’t be evident in the headline indicators, measured on a year-over-year basis, due to an unfavorable base effect.

Nonetheless, we believe that monetary stimulus is less effective now than was in the past in China. We see downside risk to activity. Bank profitability is lower, because of rising non-performing loans and declining net interest margins, and will likely reduce banks’ willingness to lend. Sectors such as steel, cement and coal continue to have over-capacity and are likely to have reduced demand for new loans. Overall, the already high credit/GDP ratio is increasingly a constraint to the size and impact of any additional push.

We maintain our below-consensus 2015 GDP growth forecast at 6.7% (consensus: 7.0%). Our scenario stands at 6.6% for 2016.

Emerging Markets – Exchange rates to depreciate as global interest rates increase

With interest rates increasing in the developed countries, exchange rates in emerging markets will likely depreciate until the end of the year. An average index of the value of the USD against emerging-market currencies already resumed an upward trend in the past few weeks (see graph). The move should continue as we approach the first interest increase in the U.S. later this year.

The depreciation might be less steep than before as commodities prices are more stable and the U.S. dollar’s strength against advanced economies is more subdues. Both of these factors pressured emerging markets’ currencies last year and will likely be softer ahead.

But emerging markets will remain more fragile until their growth recovers. We note that despite the slowdown in China, better growth in developed countries would probably bring an impetus to the developing world (although we may need to wait until 2016 to see a clear impact).

Commodities – Lower agricultural price forecasts, despite El Niño

The Itaú Commodity Index (ICI) has declined 2.7% since the end of April. The components (energy, metals and agriculture) showed the same pattern, despite some differences within each group. We lowered our forecasts for the ICI-agricultural sub-index, lowering the ICI by 2.8 pp in the end of 2015. Our new scenario assumes a 5.3% increase from current levels until year-end.

Most agricultural prices declined since early May with an outlook of sizable surpluses for each commodity. The exception was wheat, rising 4.4% due to excessive rainfall in the U.S. and rising risks of lower yields in South America due to El Niño. Looking ahead, we lowered our forecasts for most agricultural products, recognizing lower risks to supply in both North and South America.

We are under the El Niño weather anomaly, which should last until the end of 2015, posing both upside and downside risks to agriculture prices. Lower expected rainfall in Asia increases risks of drought-related losses in the region. Besides, stronger expected rainfall in America’s producing regions reduces risks of drought-related losses, but generates tail risks of losses related to excessive rainfall. In general, El Niño tends to be relatively bearish for commodities in which Asia/Oceania production accounts for a lower global share (particularly soybeans). The upside risks seem to be stronger for wheat and sugar international prices.

Iron ore prices rose further in May and early June, to USD 63/ton, still apparently driven by a restocking cycle by Chinese mills. However, this is a temporary increase in demand and does not change the outlook of sizable surpluses in the iron ore market. Hence, we expect prices to resume the downward trend, and we maintain our year-end price forecast at USD 52.5/ton. Other base metals declined in May, erasing gains from April, amid an outlook of weak demand growth.

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

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