Itaú BBA - Global relief redux

Global Scenario Review

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Global relief redux

June 10, 2016

The global scenario is once again favorable, improving the outlook for exchange rate and inflation in Latin America.

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

Global Economy
Global Environment Still Stable

The global environment has been favorable for emerging markets, with commodities prices up, stability in China and no pressure from a stronger USD. In the U.S., the weak May labor report postponed, in our view, the next Fed interest rate increase to at least September.

Laying the groundwork for recovery

Economic activity in LatAm is weak, but growth is stabilizing, paving the way for some improvement next year. The more favorable evolution of currencies, relative to 2015, amid low growth is helping reduce inflationary pressures.

Reforms start to take shape, but uncertainties remain

Reforms are starting to take shape. However, it is still unclear whether there is political consensus to approve the fiscal measures. The recession continues, but the economy could stabilize in the second half of the year.

Bitter adjustment

The adjustment in relative prices is taking its toll on activity, and the recession is now broad-based. An investment-led recovery is likely ahead, encouraged by new pro-market policies and access to international markets.

Renewed peso volatility

We maintain our forecast that the Mexican peso will finish both this year and the next at 17.5 to the dollar. As the peso recouples with its fundamentals, additional rate hikes this year are unlikely.

No recovery yet

Economic growth remained slow in 1Q16, and high-frequency indicators show that 2Q16 started off on the wrong foot. Low copper prices, less fiscal support and pessimistic private-sector sentiment are weightening on activity. For 2017, we expect a mild recovery, as uncertainty over domestic reforms diminishes.

A new government

Pedro Pablo Kuczynski (PPK) is the next president of Peru. The PPK administration would be welcomed by the business community, but governability will not come easily. 

Tightening cycle coming to an end

We expect the central bank to implement one final 25-bp hike, taking the policy rate to 7.5%. As inflation retreats, we expect rate some monetary easing next year

Gains in agricultural and oil prices are consistent with fundamentals

Oil and agricultural prices sustained their upward trend in May due to better fundamentals, notwithstanding a stronger USD. We expect iron ore prices to continue to slide.


Global relief redux

The global scenario is once again favorable to emerging markets. The U.S. economy continues to recover, but weaker labor market data suggest that the Fed will be in no rush to raise interest rates. In China, growth has been stabilizing, and economic volatility is likely to ease. In this environment, commodity prices have risen and funds are flowing back to emerging markets.

However, risks persist. In the short term, the most obvious is the UK referendum on June 23. The most likely scenario is that the UK will remain in the European Union, but the chances of its leaving are not insignificant. The U.S. presidential election poses another risk to the global economy, but it is likely to be some months before it becomes a determining factor for asset prices.

Global relief has brought exchange-rate stability to Latin America, improving the outlook for inflation and reducing pressure on monetary policy. The central banks that were raising interest rates are likely to stay put over the coming months, except for Colombia, where we expect one final rate hike as a response to the still-high inflation. Even in Argentina, which is facing an inflation rate of around 40%, the peso’s recent appreciation is contributing for lower interest rates.  

Growth remains weak but stable in the region. The external improvement and the possibility of continuing expansionist monetary policy will likely set the stage for some revival in 2017. Idiosyncratic factors, like lower uncertainty over the reforms in Chile and the stabilization of private investment in Peru support the outlook for economic acceleration next year.  

In Brazil, reforms are starting to take shape. The government’s new economic team has proposed a ceiling for public spending growth and has started discussions on social security reform. However, it is still unclear whether there is political consensus to approve the fiscal measures. The recession continues, but high-frequency data continue to improve, suggesting the economy could stabilize in the second half of the year. The weak economy suggests there is room for lower rates, but with current inflation under pressure we have postponed our forecast for a first rate cut, from July to August.


Global Economy
Global environment still stable

After the turbulence at the start of the year, the global environment has been favorable for emerging markets, with commodities prices up, stability in China and no pressure from a stronger USD. We expect this trend to continue through the middle of 2016. But spikes in volatility can still occur as global growth remains subdued and, with very low global interest rates, there are few policy buffers to absorb new shocks. 

The weak May labor report in the U.S. postponed, in our view, the next Fed interest rate increase to at least September. We continue to see moderate growth in the U.S. (we raised our GDP forecast to 2.0% from 1.9% in 2016), which is compatible with rate hikes by the Fed in 2H16.

China’s data remains consistent with growth stability and a muddling-through scenario for the country.

We raised our GDP forecasts for the Euro area to 1.7% from 1.6% in 2017, as domestic demand can further improve. We increased our GDP forecast for Japan to 0.9% from 0.7% in 2017, as Abe’s administration adds fiscal support to the economy.   

The main short-term risk for the global economy is the UK vote on whether to stay in or leave the European Union. The vote is scheduled for June 23. But the most likely scenario remains for a “stay in” victory. The U.S. election poses another political risk for the global economy, but we are still a few months away before it becomes an import driver of asset prices.

U.S. – No need to panic, but the Fed will need to wait

The non-farm payroll grew by just 38k in May. Even excluding distortion due to the Verizon strike (-38k), job growth would have increased by only 73k, barely enough to match the labor-force growth (85k per month). In addition, it was revised downward by 59k in the prior two months. Hence, the average monthly job creation slowed to 116k over the last three months.

We don’t see the weak labor report in May as a sign of slowdown in the U.S. economy. 

There is indeed a slowdown in job creation, but we expect payroll growth to stabilize at 150-175k per month in 2016. The slowdown in job growth is explained by the decline in GDP growth, to 2.0% in 2016 (from 2.4% in 2015), if we assume productivity growth remains sluggish, at 0.7% in 2016 (from 0.5% in 2015).

Activity data released so far point to a GDP expansion of 3.0% qoq/saar in 2Q16. The second-quarter rebound doesn’t seem to require much job growth, as it is sustained by a jump in productivity. This looks like a repeat of the seasonal pattern seen since 2010 (see chart).

In fact, we have raised our GDP forecast to 2.0% from 1.9% in 2016 and maintain it at 2.1% for 2017.

Even though the weak labor report has shown no improvement, we believe that the outlook for moderate growth in the U.S. is a reminder of some downside risks. From abroad, there is the risk of a bigger slowdown in China and the potential decision in the UK to leave the EU. Domestically, the presidential election could create some policy uncertainty and market volatility going forward. Corporate profits in the U.S. are already weak due to the decline in energy prices and the USD appreciation. A new spike in uncertainty could undermine business confidence and curtail capital spending or job creation.

Against this backdrop, the Fed will probably wait for new information before moving the fed funds rate again. 

Wage and inflation pressures still look moderate, and the Fed can wait to better assess the state of the U.S. economy. The fall in unemployment rate, to 4.7% in May from 5.0% in April, isn’t a signal of a much tighter labor market. First, the decline occurred because of a decline in the labor force to 62.6% which may be partially reversible. Second, the underemployment rate, a broader measure of slack in the labor market, remained stable, at 9.7%. Third, average hourly earnings came in at 2.5% yoy, so wage inflation is accelerating gradually and remains below its normal range (3.0%-3.5%).

We now expect one rate hike this year instead of two and that the next move will happen in September. Given limited scope to stimulate the economy, global risk tilted to the downside and low inflation risk, it makes the sense for the Fed to wait. There is still a chance for the Fed to move in July if there is a convincing rebound in the payroll next month.

Europe – Resilient growth amid political risks

Euro-zone GDP remains on track to expand 1.5% in 2016. The output expansion was a strong 0.6% q/q in 1Q16, but this was mostly due to transitory factors such as the effect of oil-price declines and the mild weather during the winter. We anticipate growth of 0.2% q/q for 2Q16. Nevertheless, fundamentals are consistent with growth returning to 0.4% q/q in 2H16.

We project better growth in 2017 as consumption improves further and construction reaches a turning point. Expansionary monetary policy is making its way through the Banking sector and facilitating credit for households and the private sector. In particular, construction could be at a turning point. Housing prices are increasing across the region (including in Ireland and Spain, which experienced a pre-crisis bubble). Moreover, leading indicators are improving and suggest that construction spending could rebound ahead (see chart).

As a consequence, we raised our GDP forecast to 1.7% from 1.6% in 2017, but maintain at 1.5% in 2016.

Still, political risks persist, with the UK holding its EU referendum on June 23 and parliamentary elections in Spain on June 26. Brexit risks became even greater after this week’s polls, but we think the chance of an exit remains low. The probability of a “Remain” win is still above 75% (see chart), according to the statistical institute NC Politics. In Spain, the center right Popular Party is leading the polls, but the radical left Podemos is gaining ground over the center-left Socialist Party. The elections might result again in a divided parliament, which would prolong the political uncertainty in Spain.

Japan – Fiscal support to help consumption

Japan grew 1.9% q/q saar in 1Q16 after contracting 1.1% in 4Q15. Consumption was up 2.6% q/q, but investment contracted 2.6% after three quarters of expansion.Net exports remained healthy, up 0.7 pp for the quarter.

Prime Minister Abe announced that he will postpone the next VAT on sales and indicated a new fiscal stimulus ahead. The VAT increase was postponed from March 2017 to October 2019. He also said that he will propose further fiscal stimuli by September. Both measures aim to provide fiscal support to the economy, avoiding downside risk that could lead it back do deflation. Despite expanding 2.6% in 1Q16, consumption has been lacking a clear recovery since the first VAT hike in 2014. We believe that the measures, combined with the continued gradual increase in wages, could lead to a better consumption trend the next year.

We have revised our GDP forecast for 2017 up to 0.9% (from 0.7%), but we maintain our expectation of 0.4% for 2016.

China – Growth stability in a muddle-through scenario

Economic activity weakened in April, reducing hopes that the strong recovery seen in March would be sustained. Indeed, growth in March looked abnormally strong (consistent with annualized GDP at 7.9%, according to our estimates), much higher than our forecasts and the official target growth of 6.5%.  A meaningful recovery is unlikely, given the need to rebalance the economy and the fact that growth around 6.0% is enough to maintain job creation and wage growth.

However, we don’t see this as sign of a steeper slowdown. A muddle-through scenario seems the most likely one. First, as mentioned above, April’s slowdown came from abnormally strong growth levels in March. Second, credit growth, once adjusted for local government bond issuance (see chart), remains supportive of short-term growth, although it remains a source of concern for the medium term. Third, the Real Estate sector shows a widespread improvement and is likely to continue as a tailwind for economic growth. Fourth, there is no trigger for a crisis in the short term, as capital outflow fears have receded and excess capacity and debt remain contained to specific sectors related to “old” China.

We maintain our GDP forecasts for 2016 and 2017 at 6.5% and 6.0%, respectively. 

Commodities – Agricultural and oil prices up, despite stronger USD

The Itaú Commodity Index declined 1.3% in May but was 14.5% higher year over year. In May, lower iron ore and base metal prices declined 26% and 7%, respectively, as inventories adjusted and investors priced out the chance of growth acceleration in China. Meanwhile oil-related prices (ICI-energy: 5%) and agricultural prices (ICI- agricultural: 3%) continued to edge higher. We note that these increases happened despite a stronger USD (see chart), which usually forces commodity prices down. In both cases, the global supply-demand balance is shifting to a deficit after two to three years of excess supply.

Higher sugar, lower base-metals price forecasts. We increased our sugar price forecasts by 15%, recognizing that declining inventories will break the correlation with the BRL, so sugar prices will remain well above sugar-equivalent ethanol prices in Brazil. Conversely, we revised our base-metal price forecasts downward, by 1% for 2016 year-end.

Our price scenario for year-end 2016 remains the same for Brent (USD 55/bbl) and iron ore (USD 42/ton).

Our scenario implies that the ICI will rise 4% by year-end from current levels (energy up 11%; stable agricultural; metal prices down by 2%).


Laying the groundwork for recovery

• The U.S. treasury yields dropped substantially after the most recent payroll number, bringing relief for the exchange-rates in LatAm after a sharp depreciation in May. We expect stronger currencies relative to our previous scenario in Argentina and Brazil. For the other countries, our forecasts are unchanged.  

• Economic activity in LatAm is weak, but growth is stabilizing almost everywhere, paving the way for some improvement in activity next year.

• The more favorable evolution of currencies, relative to 2015, amid low growth is helping reduce inflationary pressures. In this context, the monetary policy stance is loosening. Additional rate hikes in Chile and in Peru are unlikely. In Colombia we expect a final 25-bp rate increase this month. In Brazil, we now expect the easing cycle to start in August instead of July. On the other hand, we reduced our interest-rate forecast for the end of this year and the next in Argentina.

Fed re-introduces volatility

Exchange rates weakened substantially in May, as the market priced in an interest rate hike in the U.S. for June and activity disappointed in China. During last month, the Colombian peso and the Mexican peso underperformed most emerging-market currencies despite the recovery in oil prices. While the wide current account deficit in Colombia is leaving its exchange rate more vulnerable to changes in external financial conditions, the reason for the Mexican peso’s fragility is less clear. Politics in the U.S. (namely, the rise of Donald Trump) could have played a role, but many market participants believe it is the high liquidity and the low carry of the currency that caused the underperformance during recent risk-off episodes. The exception was in Argentina, where the exchange rate kept strengthening in May due to high domestic interest rates, the recovery in soy prices, seasonally-higher export volumes and debt issuance abroad by corporates and provinces.

However, the U.S. treasury yields already fell substantially after the most recent payroll number, and we now expect only one interest rate hike in the U.S. during the second half of 2016 (instead of two in the previous scenario). We also expect a further improvement in oil prices, which would also benefit the non-oil exporters of the region through looser external financial conditions. Less uncertainty over China’s growth could also provide some support to exchange rates in LatAm.

We expect stronger currencies relative to our previous scenario in Argentina and Brazil. For the other countries, our forecasts are unchanged. We expect the currencies in Chile, Colombia and Peru to end this year near their respective end-of-May levels. Our expectation for the Mexican peso implies an appreciation from the end of May. In our view, a further improvement in oil prices before the end of the year, the implementation of the announced fiscal consolidation measures and a recovery of manufacturing exports will probably help to improve sentiment regarding the Mexican currency. For the Brazilian real, our revision (to 3.65 reals to the dollar by the end of this year) is still consistent with a challenging fiscal picture. For Argentina, our exchange-rate forecast is now 16.2 pesos to the dollar, also helped by the better evolution of the Brazilian real.

A pre-recovery stabilization

Economic activity in LatAm is weak, but growth is stabilizing almost everywhere. In Mexico, growth is hovering around the historical trend (which is disappointing considering all the approved reforms), but it is unbalanced, with consumption strong and exports weak. Chile’s economic growth is stuck at around 2%, with the uncertainty over domestic reforms adding to lower copper prices. In Peru – the only economy within our coverage presenting a recovery – it seems that growth peaked in the first quarter of the year. In Brazil, the recession continues, but the GDP contraction in 1Q16 was much lower than expected and leading indicators are stabilizing. On the other hand, the recession has deepened in Argentina due to the short-term negative impact of the relative-price adjustments and climate effects. For 2016, we expect less economic contraction in Brazil than in our previous scenario, but we reduced our growth forecast slightly for Peru and Colombia.  

We are expecting growth to improve somewhat in 2017 relative to this year. A further oil-price recovery will benefit activity, especially in Mexico and Colombia. As uncertainty over reforms in Chile diminishes, some recovery in confidence is likely amid low real interest rates, benefiting investment. Peru’s economy may also grow faster next year, as private investment becomes less of a drag and mining production continues to be strong. In the two countries currently facing a recession, Brazil and Argentina, the improvement in activity will be more meaningful. We expect the Brazilian economy to grow by 1.0% (compared to a 3.5% contraction this year) due to the ongoing inventory adjustment in the industry, deleveraging and an easing in uncertainty over public debt. Argentina’s economy is expected to grow by 3% in 2017 (versus a 1% GDP fall this year), as the economic adjustments implemented this year bear fruit.

The case for rate hikes is weakening

Inflation remains above the upper bound of the target in most cases, but it is on a downward trend. The more favorable evolution of the currencies relative to 2015 amid low growth is helping to reduce inflationary pressures. The reversal of some shocks (like the utility price adjustments in Brazil) is also helping to bring inflation down. In Argentina, the tariff adjustments are lifting inflation by more than we were expecting, but the dynamics of core inflation (which excludes regulated items) at the margin is already consistent with disinflation. On the other hand, inflation in Colombia is yet to start falling. In Brazil, the latest IPCA results have shown a temporary reversal in the downward trend for inflation, leading us to revise our forecast for inflation for this year upward, though this is still consistent with a substantial decline from 2015. 

In this context, the monetary policy stance is loosening. In Chile, the central bank is gradually abandoning its tightening bias. The central bank of Peru last increased the policy rate in February. Even in Colombia, where the inflation outlook is more challenging, the central bank is indicating that the tightening cycle is about to end, as interest rates already rose substantially. In Argentina, the strengthening of the currency and the signs that inflation is retreating are leading the central bank to bring its reference interest rate down much faster than we were anticipating. In Brazil, the debate continues on when and by how much the central bank will cut interest rates. On the other hand, the weakening of the Mexican peso in May and the importance of the exchange rate in the reaction function of the central bank led again to a debate on rate hikes in the near term, in spite of the low level of inflation.

Our view for monetary policy in the region is broadly unchanged. We do not expect further rate hikes in Chile, Peru or Mexico (in line with our forecast for the Mexican peso), while in Colombia we expect a final 25-bp rate increase this month. In Brazil, we now expect the easing cycle to start in August, instead of July, due to the worse-than-expected inflation numbers and still-high uncertainty over political support for reforms. For Argentina, we reduced our interest rate forecast for the end of this year and the next.


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


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