Itaú BBA - Global Stimulus for Emerging Markets

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Global Stimulus for Emerging Markets

April 4, 2016

Looser policies are once again supporting the global economy and acted as a tailwind for emerging markets.

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

Global Economy
Some tailwinds for emerging markets

Global monetary policy and tentative stabilization in commodity prices became more supportive for emerging markets asset prices. But this doesn’t mean that EM are out of the woods, as a number of challenges remain.

Relief from abroad

The external environment for LatAm’s currencies improved and we now expect stronger exchange rates across the region than in our previous scenario. Low growth and less pressure on the exchange rate make more room for a looser monetary policy stance.

On hold domestically, amid a favorable external scenario

The outlook for Brazil is a binary one. Without reforms, the economy will likely continue to struggle. With reforms, the fiscal outlook will look better, boosting confidence and opening room for an economic recovery.

Return to the markets

The congress approved the agreement with the holdouts. As a result, Argentina will issue USD 12.5 billion in bonds. In the meantime, the costs of the adjustments are starting to appear. We now expect a deeper recession in 2016.

No further rate hikes this year

The slack in the economy continues to contain pressures on domestic prices. At the same time, the focus of the central bank on the exchange rate means that the board would not react automatically to higher interest rates in the U.S.

Losing momentum

Weak confidence and low copper prices are weighting on economic activity. We see 2016 growth at 1.8%, and a mild rebound next year, to 2.3%. Amid weaker growth, we expect no additional rate hikes this year or next.

Heading to the election

Keiko Fujimori, who has consistently led the presidential polls, was cleared by the electoral court to take part in the presidential election. She will likely face Pedro Pablo Kuczynski in a runoff election. The polls indicate no clear winner.

Still resilient

The recent indicators show that the economy remains resilient, in spite of the negative terms-of-trade shock. As Inflation continued to accelerate, we expect further interest rate hikes ahead.

Weaker U.S. dollar, stronger commodity prices

Commodity prices rose in March, driven by a favorable macro environment. We have raised our YE16 price forecasts for base metals and agricultural commodities, and we expect oil prices to continue to climb, reaching USD 55/bbl by year-end.


Global Stimulus for Emerging Markets

Looser policies are once again supporting the global economy. The Fed has signaled a more cautious approach to interest rate hikes this year, and the ECB has announced further measures to expand credit. In China, the government has also moved towards looser (monetary and fiscal) economic policies, as a response to the risk of a slowdown.

At the same time, growth seems to be stabilizing in the world’s main economies, reducing the likelihood of a recession.

This expansionary environment has improved global financial conditions and raised commodity prices, benefitting Latin America. Compared to our previous scenario, we now expect stronger exchange rates across the continent’s major countries.

Low growth and less pressure on the exchange-rate market have made room for lower interest rate paths in the region.  We are not forecasting interest rate hikes in Chile and Mexico for this year, and we expect Brazil to start cutting rates from July. In Peru, we only expect to see one further rate increase. The sole exception is Colombia, where the outlook for inflation remains challenging, so we expect additional rate hikes. 

The outlook for Brazil is a binary one.  On the one hand, without adjustments and reforms, the economy will likely continue to struggle as the fiscal situation deteriorates, confidence wanes and the recession continues. On the other hand, if the country takes the path of adjustment and reform, the fiscal outlook will soon brighten, boosting confidence and opening the way for an economic recovery. While we wait for one of these two scenarios to play out, public accounts continue to deteriorate. Inflation finally seems to be slowing, and this, combined with the prolonged recession and greater exchange rate stability, should allow the central bank to embark on a downward interest rate cycle sooner than we anticipated (in July instead of August).

In Argentina, the government has negotiated an agreement with holdouts and will soon regain access to capital markets. In the meantime, the economic costs of adjustments are starting to appear. We now expect GDP to contract 1.0% this year.



Global Economy
Some tailwinds for emerging markets

The U.S. Fed signaled that it would make only two rate hikes in 2016, in line with our forecast for the year. Together with the ECB’s credit easing, this gradual approach supports global financial conditions. 

Growth in mature economies is stabilizing, reducing the risk of a recession. We are maintaining our 2016 GDP forecasts for the U.S., the euro zone and Japan at 2.0%, 1.5% and 0.4%, respectively.

For China, we expect fears of a renminbi devaluation to recede and economic growth to remain stable in 2Q16, as a result of the government’s looser policy stance.

We believe that commodity prices have bottomed out, and although we anticipate some differentiation among commodities, we expect our Itaú Commodity Index (ICI) to gain 12% by year-end.

Some of the fundamental conditions that have led to a strong dollar are now losing steam, and we expect the USD to remain broadly stable at current levels.

A stable USD and a small increase in commodity prices would provide some external tailwinds for emerging markets. But this doesn’t mean that emerging markets are out of the woods, as a number of challenges remain.

U.S. – Fed signals only two rate hikes in 2016

Fed officials indicated that they will take a more cautious approach to interest rate hikes in 2016. The median projection for the Fed Funds rate at the Fed’s March meeting suggests just two rate hikes this year, a projection which is in line with our forecast and is down from the median projection of four rate hikes registered at the December meeting.

In our view, this approach from the Fed supports financial conditions and will contribute to growth, amid an already-positive consumption outlook. We see the Fed as willing to take the risk of the U.S. economy running a bit hot, given the uncertain outlook for the global economy. This supports financial conditions and household consumption. With job creation averaging more than 200,000 positions per month, consumer confidence higher and bank managers indicating that credit supply to households is increasing, we expect consumption growth to remain around 3% in 2016.

Positive financing conditions could fuel gross fixed investment in the next quarters. Financing conditions for corporations have improved significantly with higher equities and a perceived improvement in credit conditions. In addition, a more gradual path of interest rate hikes by the Fed may lead to a weaker USD. The ISM Manufacturing Index increased to 51.8 in March. We take this as an early sign of improvement.

A weaker dollar and higher oil prices will likely reduce the risk of low inflation persisting over the first half of the year. The core PCE deflator averaged 0.22% mom for the first two months of 2016, reaching 1.7% yoy for the first time since 2012. Setting aside some short-term noise, services inflation has been firming up gradually, as we expected. In addition, the weaker dollar is likely to limit the risk of lower core inflation stemming from FX pass-through. Lastly, the recent increase in oil prices should boost the headline PCE deflator.

We maintain our forecast of 2.0% GDP growth for the U.S. in both 2016 and 2017.

Europe – The focus shifts from financial risk to political risk

The ECB’s credit easing in March has mitigated financial risks to economic activity. Indeed, credit spreads for corporate and sovereign borrowers have improved substantially since peaking in late February (see graph). The EUR 20 billion increase in the central bank’s monthly asset purchases and its new, targeted long-term refinancing operations for banks, which have very attractive conditions, both contributed to this improvement.

The ECB’s measures are helping to maintain economic activity and a stable, albeit modest, pace of growth. In the euro zone, industrial production surged by 2.1% mom in January, while retail sales were up 0.4% mom. The gain in retail sales was particularly important, as sales had slowed in the second half of last year. Survey data are off their mid-2015 highs, but the PMIs have recovered somewhat in March and continue to point to GDP growth of 0.4% qoq, in line with our scenario.

We maintain our GDP forecasts for the euro zone at 1.50% for 2016 and 1.60% for 2017.

The main downside risks in Europe at present are the impact of immigration flows and the upcoming Brexit vote in the UK. While a recent EU deal to send immigrants back to Turkey will provide some respite in the short term, most observers remain skeptical that it will be effective. As temperatures become milder over the coming months, the flow of refugees is likely to increase, which in turn could further strengthen European extremist parties. The UK’s referendum on the EU also looms large, with polls suggesting that the outcome is essentially a coin toss. The vote, which will be held on June 23, is a major risk for Europe.

Japan – Tentative signs of a stabilization in growth

Activity data are showing signs of stabilizing in Japan. Consumption, which contracted by 3.4% qoq saar in 4Q15, is starting to show a recovery, with the CAO real consumption index increasing by 0.6% mom in January. Meanwhile, investment has remained on a steady upward trend. As a consequence, we expect GDP to rise by 0.5% qoq saar in 1Q16, allowing the country to avoid two consecutive quarters of economic contraction.

We maintain our GDP forecasts for Japan at 0.4% in 2016 and 0.7% in 2017.

China – Growth likely to remain stable in 1H16 as a result of looser policy stance

Foreign-exchange-related fears have receded in March. We believe that fundamentals will continue to support improving sentiment on China. The determining factors include repeated pledges from several policymakers that China will not pursue a competitive devaluation, as well as sizable current account surpluses and a benign composition of capital outflows (mostly debt repayment). In addition, a stable USD trend would put less pressure on the China’s exchange rate (see graph).

With investor concerns about exchange rates receding, attention will likely turn to economic activity.

The government is seeking to ensure a very mild GDP slowdown in 2016 by taking a more pro-growth stance. China’s GDP growth target range for 2016 has been set at 6.5%-7.0%, compared with around 7% growth in 2015. Meanwhile, the fiscal deficit and M2 growth targets have been set above the previous year’s, signaling a looser policy stance, particularly on the fiscal front.

This policy stance will likely help bring stability to economic activity in 1H16, after a softer-than-expected start to 2016: industrial production slowed to 5.4% yoy in January-February from 5.9% yoy in December, while retail sales growth eased to 10.2% yoy from 11.1% yoy in the same comparison.

Some leading signs of stabilization are already showing up, with fixed investment rising to 10.2% yoy in January-February from 6.8% in December. The improvement was broad-based, visible across infrastructure, real estate and manufacturing. We expect fixed investment growth to remain relatively strong over the remainder of 1H16, driven by a startup of projects after the National People’s Congress and a modest pickup in real estate investment in medium-size cities. We expect this growth in investment, together with resilient domestic consumption, to sustain industrial production growth of around 5.5% yoy throughout the first half of the year. The official manufacturing PMI has already improved in March, rising to 50.2 from 49.0.

Notwithstanding the stronger first half of the year, our view is that China continues to face structural challenges. 

We maintain our scenario of GDP growth rates of 6.3% in 2016 and 6.0% in 2017.

Emerging Markets – Tailwinds for emerging markets

Emerging markets have faced strong external headwinds in the past few years, with a decline in commodity prices and a strong USD. Since 2012, commodity prices have declined by 50% (according to our ICI index) and the traded weighted USD basket has appreciated by 25%. Together, these factors contributed to an increase of 35% in the value of the USD against an equal-weighted basket of emerging-market currencies in the period.

We believe that these external headwinds will subside, and eventually even reverse course. 

Some of the fundamental conditions that led to strong dollar are now shifting, and we expect the dollar to remain broadly stable at current levels. The divergences in monetary policy among mature economies are becoming less sharp, now that the Fed is signaling an even more gradual pace of rate hikes. For its part, the ECB at its last meeting focused on easing domestic credit conditions instead of on the value of the euro. And fears about a renminbi depreciation are easing.

Together, these factors are likely to translate to less upward pressure on the USD. We have revised our year-end exchange rate forecasts for the euro, the yen and the renminbi to 1.08 EUR/USD, 115 JPY/USD and 6.60 RMB/USD from 1.05, 120 and 6.75, respectively.

In addition, although low commodity prices are likely here to stay, we think that overall prices have bottomed out and that prices for some commodities will rebound. We expect higher oil prices, lower iron ore prices and stable agricultural-commodity and base metal prices through year-end. Putting all this together, we project that our ICI will gain 12% from current levels (see graph) by the end of 2016.

None of this means that emerging markets are out of the woods, as formidable challenges remain. But the external headwinds that have battered these economies over the last few years are starting to die down.

Commodities – Weaker dollar, higher prices

The Itaú Commodity Index (ICI) rose by 7% in March, with all three of its components posting price gains: agricultural commodities (4%), metals (4%) and oil-related commodities (12%). The overall increase was a consequence of the favorable macroeconomic environment, with less risk aversion and a weaker dollar.

Oil and iron ore prices outperformed the ICI due to idiosyncratic factors. Oil prices remained above USD 40/bbl despite ongoing stock-building. We believe that this resilience was caused by investors anticipating the end of the oversupply, as oil and gas investment remains very weak and weekly crude oil production in the U.S. continues to fall. Iron ore prices rose at the beginning of March, reaching USD 55-60/ton amid a short-term squeeze in China that is likely to fade soon.

We have raised our year-end price forecasts for sugar (+7%), coffee (+7%) and base metals (+2%), consistent with a weaker USD. The net effect is a 0.7-pp upward revision in our year-end ICI forecast.

We expect crude oil prices to rise to USD 55/bbl (Brent) by year-end 2016. The adjustment in the energy sector is underway. Investment is already declining rapidly in the U.S. shale oil industry, and this will start to affect production more strongly in 3Q16. Lower supply in the U.S. will offset increased exports from Iran, likely balancing the global market by mid-2016.

Conversely, iron ore prices are likely to decline as the restocking cycle fades. We project that the global surplus will widen in 2016, with stable global supply (higher production in Australia offsetting environment-related slowdowns in Brazil and capacity cuts in China) and declining global demand. Therefore, we are maintaining our forecast for iron ore prices of USD 42/ton at year-end 2016.

The combination of higher oil prices, lower iron ore prices and stable agricultural-commodity and base metal prices implies that the ICI will rise 12% by year-end from its current levels in our base-case scenario.



Relief from abroad 

• The external environment for LatAm’s currencies improved and we now expect stronger exchange rates across the region than in our previous scenario.

• Low growth and less pressure on the exchange rate make more room for a looser monetary policy. We do not expect hikes in Chile and Mexico this year, and expect an easing cycle starting in July in Brazil. In Peru, we only expect one additional hike. The exception is in Colombia, where additional hikes are likely due to inflation. 

• Low economic growth is the norm (recessions in Argentina and Brazil). We do not expect a recovery this year.  

• Argentina reached an agreement with the holdouts and will be able to tap the markets. However, the economic costs of the adjustments are high. We now expect a 1.0% GDP contraction this year.

A more supportive external environment

The external environment for LatAm’s currencies became more favorable. The factors that led the improvement – not fully independent one from the other – were: the looser monetary-policy stance in the U.S., the perception of lower risks for the financial system in Europe, the stabilization/recovery of oil prices, and less concern over capital outflows from China. The more fragile currencies were the ones that performed better. In March, the Brazilian real was the best performing currency in the region, influenced by the political environment. The Colombian peso was also among the best performers, even though local news was not helpful (the postponement of the peace deal and the possibility of energy cuts). In Mexico, the external environment added to the policy support given in mid-February. 

We now expect stronger exchange rates than in our previous scenario in most countries. We expect the Fed to raise interest rates twice this year (by 25 bps in each move). These hikes are expected in the market and would only occur if the committee believes that global markets would react in an orderly fashion. In Brazil, the probability that the currency stays stable is increasing together with the chances of a new scenario of adjustments and reforms. However, the central bank is already taking the opportunity to reduce its large short-dollar position in the swap market, limiting further appreciation. Because of Colombia’s wide current-account deficit, we expect the Colombian peso to depreciate more than the currencies of Chile, Mexico and Peru, even though we see an oil price recovery before the end of this year. 

Hiking cycle ending almost everywhere

Policy interest-rate increases in the region are becoming rare. The central bank of Peru left the policy rate unchanged in March, after three consecutive 25-bp hikes. In Chile, the central bank hasn’t moved since December 2015, and in the most recent monetary-policy report, it signaled a very modest additional tightening ahead. The central bank of Mexico also kept the policy rate unchanged, consistent with its guidance that the surprise hike in February wasn’t the start of a cycle. On the other hand, the central bank of Colombia is not indicating that the tightening cycle is about to end; in fact, some board members continue to vote for a faster tightening pace. Finally, in Brazil, rate cuts are the most likely scenario, but the central bank is holding back expectations of rate cuts in the short term.

Low growth and less pressure on the exchange-rate market make room for a looser monetary-policy stance. We maintain our expectation of no rate hikes in Chile and in Mexico this year, while in Peru we now expect only one additional rate hike. In Brazil, we expect the easing cycle to start sooner than in our previous scenario, so the Selic rate would end 2016 at 12.25% (instead of 12.75% previously), 200 bps lower than its current level. However, the outlook for inflation in Colombia remains challenging, so we continue to expect two additional rate hikes, bringing the policy rate to 7%.

No recovery in sight

Economic growth remains low almost everywhere, but recent indicators show momentum differentiation within the countries. In Brazil, the deep recession continues, while in Chile the economy weakened further. Meanwhile, recent activity indicators in Mexico reduced downside risks for growth this year, while the data in Colombia shows that the economy remains surprisingly resilient to the oil-price shock. In Peru, growth improved, focused on higher mining production and the stabilization of investment.

We do not expect a recovery this year in most countries. The exception is Peru, where growth will likely continue to be lifted by more mining projects maturing (our forecast is 4.0% growth). The Brazilian economy will likely contract sharply again this year (by 4.0%), as imbalances and uncertainty about their correction remain. We expect Chile’s economy to grow somewhat less than the already low rate recorded last year (we expect 1.8%), as confidence is negatively influenced by the lengthy and bumpy reform debate. In Colombia, lower capital expenditures in the oil sector, lower real wages, and tighter fiscal and monetary policies will likely lead to a deceleration from 2015 (to 2.5%), but there are offsetting factors (such as the 4G PPP program and a more competitive currency). Contrasting with other countries in the region, Mexico will continue to grow at a pace similar to the one seen over the past decade (we expect a 2.5% expansion), but this is disappointing considering the high expectations set over the past few years.     

Good policies but a contraction in Argentina

Argentina will likely tap global markets soon. The congress approved the legislation that allows the government to offer a deal to the holdouts with better terms than the previous debt swaps. Now, the government plans to roadshow for a debt issuance of around USD 12 billion. After the holdouts are paid, the government would be free to resume the service of the restructured debt, although the U.S. court of appeals must first confirm Griesa’s ruling (which frees the service of the restructured debt after the holdouts are paid).

We now expect the economy to contract by 1.0%. In our previous scenario, we were expecting a 0.5% fall. The relative price adjustments are reducing real wages and leading to higher interest rates. The recent activity indicators are already reflecting the costs of the necessary changes. Positively, the recent interest-rate hikes together with the more supportive external environment brought relief to the Argentine peso, which will help the central bank to control inflation, especially considering that fiscal policy is not contributing much to ease pressure on prices.


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


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