Itaú BBA - Global recovery, but struggles in Latin America

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Global recovery, but struggles in Latin America

March 13, 2015

The U.S. economy continues to grow while Europe recovers. In Latin America, economies face struggles.

Global Economy
Global growth is on the rise; U.S. interest rates will soon follow

The fundamentals of the U.S. economy remain solid. The Fed is on track to raise interest rates sometime between June and September. We think that the USD will continue to appreciate, also against EM currencies.

Worsening prospects 
Economic activity remains on a worsening trend and political and economic uncertainties require a faster adjustment in the balance of payments. We reduced our growth forecast and expect a weaker exchange rate in 2015.

Before, with or after the Fed?

The most recent indicators suggest that growth lost momentum. However, the minutes from the most recent monetary policy meeting confirmed that the debate is over when to hike, depending on the Fed.

A turning point?

Following recent strong activity data, we have increased our GDP growth forecast for 2015. With the recent recovery of copper prices since February, the Chilean peso has outperformed most EM currencies.

Still crawling

A moderate recovery in investment (driven by fiscal stimulus) and stronger mining output will likely lead to a better economic activity this year The pressure on exchange-rate continues, prompting the central bank to intensify its intervention while also allowing some weakening of the currency.   

Cautious on Inflation

Headline inflation rose sharply and is now above the central bank’s target range. The weaker exchange rate and supply-side shocks are behind the increase. The central bank has turned more cautious.

Changes in the pole position

We believe the government will postpone the necessary adjustments in the exchange rate and interest rates. According to recent polls, the support for right-wing presidential candidate Mauricio Macri has grown.     

Recovery sustained by crude oil
Brent crude prices continued to trend upwards, reinforcing our scenario of  Brent prices at USD 70.0/bbl by year-end. We lowered our price forecasts for sugar and coffee after incorporating the prospect of better supply in Brazil, and increased our price forecast for corn, given signs of a reduction in the planted area.

Global recovery, but struggles in Latin America

The U.S. economy continues to grow while Europe recovers. The trend is favorable for emerging economies, but the transition is worrisome. The Federal Reserve will probably start to raise interest rates, as so much “patience” is no longer needed. In this context, capital flows to emerging markets tend to decelerate, and the strengthening trend of the U.S. dollar is likely to continue. Rising interest rates in the U.S. and the inflationary impact of exchange-rate depreciation make less room for countercyclical policies in emerging economies – even amid a relatively weak growth environment.

In Latin America, falling commodity prices and weaker currencies — the latter putting pressure on inflation — reduce the room for further economic stimulus and hold back the recovery. Lower oil prices have weighed on public accounts in Colombia and Mexico, producing some fiscal tightening. Higher inflation and the outlook for further depreciation in the peso have led the Chilean central bank to close the door on new cuts in the interest rate. In Colombia, we still expect some monetary easing, but authorities are concerned over the potential effects of exchange-rate depreciation on inflation, and they have signaled that interest-rate cuts are unlikely in the short term. In Peru, easing via lower reserve requirements continues, but the signal is that monetary loosening may be near an end. Even in Mexico, where inflation is better behaved and the recovery is still slow, the Banxico has signaled hikes in interest rates, given its concern over the impact in Mexico of rate increases in the U.S.

In Brazil, greater economic and political uncertainties have led to sharp currency depreciation. Some fiscal tightening measures are at risk to not be approved by the congress, as a consequence also of continuing investigations in the Lava Jato corruption probe. A weaker exchange rate intensifies the pressure on expected inflation, which is already high due to higher tariff for public services. We forecast 8% inflation in 2015. The central bank maintained the same pace of rate increases, which could continue if the exchange rate does not stabilize.

In Argentina, political change looks more likely. Market-friendly opposition candidate Mauricio Macri is leading in the electoral polls (albeit by a small margin), increasing the chances of orthodox adjustments in the economy. We now expect tougher adjustments in 2016 than we had assumed in our previous scenario, implying slower economic growth next year, though faster in the future.


Global Economy

Global growth is on the rise; U.S. interest rates will soon follow

• The fundamentals of the U.S. economy remain solid. The recent slowdown in activity is likely to be transitory. The Fed is on track to raise interest rates sometime between June and September.

• The news from Europe is also improving, with consumption and investment leading a recovery.

• Even in Japan, where domestic demand has been weak, exports are finally rebounding and helping to maintain hope of better GDP growth ahead.

• China remains on a decelerating trend, although there is room for additional monetary and fiscal stimulus to smooth growth.

• We think that the USD will continue to appreciate, also against emerging-market currencies. We have lowered our forecasts for the euro and think that, after years of appreciation, China’s renminbi will no longer appreciate against the U.S. dollar. 

The U.S. economy slowed down slightly at the start of 2015, but its fundamentals are healthy and the labor market is strong. We expect growth to pick up as early as 2Q15 and then sustain an above-trend pace for the rest of the year.

Growth in the euro zone is also accelerating, with domestic demand in the driver seat. Consumption boomed at the end of 2014 and in early 2015. Retail sales in Germany were up 5.3% y/y in January, the highest rate since the early 1990s.

In Japan, domestic demand remains weak, but exports are finally recovering. With weak domestic demand, Japan’s GDP growth is still lackluster. But we expect wage negotiations in March and April to generate reasonable gains for workers and hence support a future recovery in consumption.

China’s economy is decelerating, but the downside risks to activity seem manageable at the moment.

Meanwhile, global inflation has also bottomed and will likely rise ahead. As long as oil prices remain stable and in the $50-60 range, the impact of the oil price drop on inflation is almost over (see graph).

In this scenario, we expect the Fed to start increasing interest rates between June and September. We think that the odds are tilted slightly toward June but are still close to 50/50 between these two months.

For emerging markets, where growth remains lackluster, the challenges will persist as the U.S. dollar continues to appreciate. Importantly, exchange-rate depreciation is starting to affect their yield curves.

U.S. – Countdown to the federal-funds rate liftoff

U.S. economic growth hit in a soft patch in 1Q15, but this recent slowdown is likely to be transitory. We expect GDP growth to slow down to 1.6% qoq/saar in 1Q15 from 2.2% (revised downward from 2.6%) in 4Q14. Most of this slowdown looks transitory, stemming from the harsh winter and port strikes on the West Coast. The economy’s fundamentals remain solid, with financial conditions becoming slightly more accommodative due to lower high yield corporate bond spreads and higher equity prices.

We have slightly lowered our 2015 GDP growth forecast to 2.9% (from 3.1%), but we continue to expect stronger growth than the 2.4% posted in 2014. For 2016, we continue to expect 2.5% growth. 

The U.S. labor market continues to improve at a solid pace. Non-farm payrolls rose by 295,000 in February, and it averaged 288,000 per month in the second half of 2014. The unemployment rate reached 5.5% in February, within the 5.2%-5.5% range considered as full employment by most FOMC members. We expect unemployment to decline to 5.0% by the end of 2015.

The consumer price index inflation will likely turn positive from February onward as gasoline prices stabilize. CPI decelerated to -0.2% in January 2015 from 2.0% y/y in June 2014 (excluding food and energy, CPI inflation decelerated to 1.6% from 1.9%). Over the same period, gasoline prices declined by 40% and accounted for 190 bps of the total decline in the CPI. The impact of gas prices on the CPI is over, and gasoline retail prices were already up 1.2% m/m in February. Hence, we forecast that the CPI will increase by 0.2% m/m in February and that growth will remain positive throughout the rest of the year.

The FOMC is likely to replace its pledge to remain “patient” with more data-dependent forward guidance at its March meeting. In her semiannual testimony before Congress, Fed Chair Janet Yellen said that the Fed should change its forward guidance before raising the fed funds rate. In addition, she stated that the “committee anticipates that it will be appropriate to raise the target range for the federal funds rate” when it is “reasonably confident that inflation will move back over the medium term toward our two percent objective.” She added that a new forward guidance will not warrant a liftoff at one of the following couple of meetings, as happened in the last hiking cycle.

This stance keeps the Fed on track to start increasing the fed fund rates in June or September. The odds are tilted slightly toward an initial hike in June. But the odds are close to equal between the two months.

We continue to expect U.S. Treasury yields to increase faster than the forward markets are currently pricing in. We forecast the 2-year Treasury at 1.6% and the 10-year Treasury at 2.7% at year-end 2015.

Europe – Activity continues to improve

The recovery in the euro area is progressing and becoming broader-based. Following two quarters of paltry growth, GDP expanded by 0.34% qoq in 4Q14, propelled by growth in consumption (0.4%) and investment (0.4%). This momentum has carried over into 2015, with most activity indicators continuing to improve. The composite Eurozone PMI came in at 53.3 for February, compared with 52.6 in January and 51.4 in December. Retail sales also picked up, growing by 1.1% m/m in January from 0.4% m/m in December. Credit data for January also show that lending to households and companies has been slightly positive for the last two months after almost three years of being a drag on activity. Importantly, the gains are also reaching France and Italy, the current laggards in the region.

Activity will maintain a good pace of growth as the euro depreciation helps exports and lower oil prices push consumption. In addition, interest rates on loans to corporations have been falling steeply in recent months, particularly in Italy and Spain, suggesting better transmission of the European Central Bank’s loose monetary policy stance. Greece remains a risk, but for the moment it hasn’t dented business and consumer sentiment across Europe.

We have raised our GDP forecasts for the euro zone to 1.4% from 1.2% for 2015 and to 1.8% from 1.6% for 2016.

Despite the better activity momentum, monetary policy in the euro area will remain much looser than in the United States. Indeed, the European Central Bank has just started its quantitative easing program, while the Fed is about to raise interest rates.

We lowered our year-end exchange-rate forecasts for the euro to 1.05 (from 1.10) and 1.00 (from 1.10) for 2015 and 2016, respectively. 

Japan – The depreciation of the yen is finally providing a boost to exports

Japan’s GDP expanded less than expected in 4Q14 (by 1.5% qoq/saar), with soft domestic demand and strong exports. The main negative surprise was the softness in consumption growth (2.0% qoq/saar) and investment growth (-0.4%). Both have made only a moderate recovery after the mid-2014 dip caused by the VAT tax rise. Worryingly, retail sales dropped by 1.3% m/m in January, suggesting that domestic demand remains weak in 2015. On a more positive note, exports are rising, having jumped by 10.8% qoq/saar in 4Q14 and climbed by another 5.0% m/m in January. Finally, the yen’s depreciation since mid-2013 is stimulating exports (see graph).

Japan’s spring wage negotiations, where annual wage increases are set for workers in most of the country’s large companies, is the next key event that could dictate the pace of domestic demand growth. We expect wage hikes of at least 2.5% y/y, up from last year’s 2.2% increase. This would be a positive precedent for wage growth in the economy as a whole and would sustain a recovery in domestic demand.

Given the weak 4Q14 numbers, we have lowered our 2015 GDP forecast for Japan to 1.0% from 1.2%, but we continue to expect 1.6% growth in 2016.

China – The end of the steady appreciation of the renminbi

Recent data suggest that China’s economic growth is weakening further in 1Q15 and that inflation’s downward trend continues. The Chinese government set its growth target for 2015 at around 7.0%, down from 7.5% in 2014, in line with our scenario of a gradual slowdown. But the manufacturing PMI has been below 50 since January, suggesting that there are still downside risks to activity. Meanwhile, CPI inflation declined to 1.4% y/y in February from 2.0% six months ago.

In this environment, the PBoC lowered its benchmark lending and deposit rates for the second time in three months. The cuts provide little stimulus, though, only countering the rise in real interest rates as inflation expectations fall.

We believe that more stimulus is needed to prevent a sharper slowdown. We expect further cuts in interest rates and required reserve ratios but suspect that fiscal stimulus will also be needed. The government has pledged to step up fiscal policy support and has increased the fiscal deficit target to 2.3% of GDP in 2015 from 1.8% of GDP in 2014, opening room for a more proactive stance.

Our GDP-growth forecasts stand at 6.9% for 2015 and 6.6% for 2016.

We are changing our scenario, though, to incorporate our expectation of a stable renminbi against the U.S. dollar. We don’t expect the renminbi to join most of the world’s currencies in depreciating against the dollar because such depreciation is a poor instrument for stimulating the economy and would conflict with the government’s medium-term goal of internationalizing the renminbi. However, after the renminbi appreciated by 32% against the U.S. dollar between July 2005 and July 2013, and given the strong correction in China’s current account over this period (see graph), we expect to see a stable renminbi showing two-way volatility.

We believe that the exchange rate will end 2015 at 6.22 renminbi per U.S. dollar, close to current levels. Nonetheless, the capital outflows over the last three quarters suggest that the risks are tilted toward a weaker exchange rate over the next few months.

Emerging Markets – Exchange-rate depreciation is starting to affect interest rates

The U.S. dollar’s appreciation reaccelerated in March. In the first two weeks of the month, the dollar strengthened by 4.0% (now 8.4% for the year to date) and 3% (now 5.5% for the year to date) against baskets of currencies from developed and emerging economies, respectively.

Importantly, the exchange-rate depreciation is starting to put pressure on interest rates in emerging economies. In previous months, the decline in oil prices pushed global inflation down, which helped to create a global wave of monetary easing outside the United States. This counterbalanced the effects of the U.S. dollar’s appreciation, and interest rates declined in most emerging markets, particularly for longer tenors. Now global inflation has reached a trough (as oil prices have stabilized) and the Fed is getting closer to increasing interest rates. As a consequence, the wave of global monetary easing is fading and interest rates in emerging-market countries are starting to rise, particularly in countries where yields are already high (see graph).

Commodities – A partial recovery driven by oil prices

Commodity prices have been roughly stable since early February, with the Itaú Commodity Index (ICI) rising by 0.8% in the period. The flat aggregate index reflects the combination of higher oil-related prices (+4.3%) with stable agricultural prices and falling metal prices (-4.1%).

We note, though, that the ICI has recovered by 3.6% since last January 29 – only a modest rise, but still good news after the sharp decline seen in 2014.

Oil prices rose further with Brent prices reaching USD 61/bbl. This recovery is consistent with renewed signs of decline in investment in unconventional oil production in North America. The weekly count of Baker Hughes oil rigs has declined by 26% since the end of January, and more companies are reporting that they are delaying new investment plans.

However, the rising odds of a deal between the U.S. and Iran generate risks of additional oil supply, which could add to the downward pressures on oil prices. Since economic sanctions on Iran were imposed, Iranian oil production has declined to 2.8 mmbd in 2014 from 3.6 mmbd by 2011. The end of these sanctions could allow Iranian production to rebound by at least 500 mbd in less than two years.

Metal prices have remained on a downward trend, given the lack of improvement in the demand outlook. We have lowered our year-end 2015 iron ore price forecasts to USD 63/ton from USD 67/ton, recognizing the absence of catalysts to drive prices up, and we see the risks as tilted to the downside. Copper was the exception to this overall decline, with prices for the metal rising by 4.2% since the end of January on news of lower investment ahead. We expect this rebound to be short-lived, and project copper prices declining to USD 5,600/ton by year-end.

Agricultural prices have declined recently, driven by lower sugar, coffee and wheat prices. Both sugar and coffee prices have declined as favorable weather in Brazil has improved the outlook for the next crop, easing fears fueled by the drought in January. Meanwhile, wheat prices have fallen in response to weak external demand from the United States. Looking ahead, we are lowering our price forecasts for coffee and sugar due to a better supply outlook in Brazil. We are also raising our corn price forecasts in response to indications that the planted area for the grain will be smaller in the next crop season.

The changes to our agricultural and metal price forecasts offset each other, leaving our ICI forecasts virtually unchanged. Our scenario assumes that from current levels, the ICI will rise by 14.3% in 2015 and by 3.4% in 2016.



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

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