Itaú BBA - LatAm still struggles despite favorable global environment

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LatAm still struggles despite favorable global environment

June 9, 2017

Growth in the region is still far from robust.

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

Global Economy
Less inflation, low risks
Global growth is holding up in the second quarter, while inflation is going through a soft patch in developed markets and will likely become mixed in China. With less inflation, the pressure on global interest rates is modest.

External tailwinds fail to lift growth
Even as the external environment remains favorable, growth in the region is not robust.

A setback for reforms and a more challenging scenario
A more turbulent political scene tends to delay reforms in Congress, making fiscal rebalancing more difficult and, consequently, affecting confidence levels and asset prices.

Moderate growth, bumpy disinflation
A gradual (and still unbalanced) recovery continued in the first quarter. Inflation fell in May, but remains under pressure, reducing space for monetary policy.

Politics in the spotlight
Local election results represent a victory for the current administration, but political risks linger for the 2018 presidential election.

Ending the easing cycle, despite economic weakness
The central bank has signaled that the current cycle of monetary easing has ended, but we see risks of further interest rate cuts this year.

Falling inflation provides room for interest rate cuts
Inflation surprised to the downside in May, thus making room for more aggressive monetary policy.

Parked on the runway
Activity in the first quarter of the year was the worst since the global financial crisis. However, signs of persistent inflation suggest that the pace of interest rate cuts tends to be slower throughout the rest of the year.

Cheaper oil in 2018
We maintain our yearend Brent forecast of USD 54/bbl (WTI: USD 52.5/bbl). However, for 2018, we decreased our yearend Brent forecast for USD 51/bbl (WTI: USD 50/bbl), due to lower marginal cost of US shale oil producers.


LatAm still struggles despite favorable global environment

Global growth is holding up in the second quarter, while inflation is going through a soft patch in developed markets and will likely become mixed in China. With slower reflation, the pressure on global interest rates is modest. Steady growth, modest private-sector leverage and a still-easy monetary-policy stance sustain risk appetite.

This favorable global environment makes life easier for LatAm countries, but growth in the region is still far from robust. 1Q17 growth was strong in Brazil and Argentina, but not widespread. Given the political uncertainties in Brazil, we reduced our growth forecasts for the country and, consequently, for Argentina as well. The Mexican economy is losing dynamism, as inflation reduces real wages and uncertainty over trade relations with the U.S. affects investment decisions. Growth in Chile, Colombia and Peru has been weak, even when excluding specific factors such as El Niño in Peru and strikes in the Chilean mining sector. We have reduced our growth forecast for Colombia as well.

Back to Brazil, the main problem that arises with the complex political situation is that it will probably delay much needed reforms that require congressional approval. This increases the challenge to regain fiscal equilibrium, with negative impacts on asset prices and business and consumer confidence. We reduced our GDP growth forecast to 0.3% this year and 2.7% in 2018, and now anticipate a weaker exchange rate, at 3.50 reais per U.S. dollar by the end of 2017 and 3.60 in 2018. In light of recent favorable releases, we have trimmed our forecast for the IPCA consumer price index in 2017 to 3.7%, but lifted our call for 2018 to 4.1% from 3.8% due to the expectation of exchange-rate depreciation. The Selic rate is now expected to reach 8.0% by the end of this year.


Global Economy

Less inflation, low risks

• Inflation is going through a soft patch in developed markets, and will likely become mixed in China. With slower reflation, the pressure on global interest rates is still modest.

• Global growth is holding up in 2Q17, with activity recovering in the U.S., solid in Europe, improving in Japan, and moderating only gradually in China.

• Political risks remain a worry both in DM and EM, but in Europe, risks have become more symmetric.

• Despite the high level of global political uncertainty, steady growth, modest private-sector leverage and a still-easy monetary policy stance sustain a low VIX (an index of volatility of the U.S. S&P stock market index) in the U.S. And this environment supports the appetite for EM assets.

Less global inflation, but growth holding up well

Inflation (headline and core) indices in the U.S. and in the euro area are going through a soft patch (see chart). The end of energy-price base effects, calendar distortions in Europe, and idiosyncratic shocks in the U.S. explain most of the weakness. We expect this to fade and inflation to resume its gradual rise, responding to closing output gaps, by the end of 3Q17. 

In China, producer price inflation has probably seen its peak and will soften from here (see chart). We expect producer inflation to continue to decelerate as commodities prices flatten, but without returning to negative territory.

With slower inflation, at least in the short term, major central banks can remain accommodative. We believe that the U.S. Fed will continue to normalize policy and the ECB will start to adjust its forward guidance. But, with modest inflation, both can afford to proceed cautiously. Finally, monetary conditions have tightened in China, but the PBoC is likely to maintain a prudent stance, adjusting its policy as necessary to prevent a soft lending from becoming something more bumpy. 

Meanwhile, activity is holding up well. In 2Q17, a pick-up in the U.S. and a steady pace in Europe will compensate for a modest slowdown in China (see chart).

U.S. – Moderate growth, soft inflation

We estimate GDP growth of 3.0% qoq/saar in 2Q17, an improvement from 1.2% in the first quarter. There have been some mixed prints in construction spending and vehicle sales, but economic and financial conditions should support moderate growth (2.0%-2.5%) of domestic demand in the second half of the year.

Hence, we continue to forecast U.S. GDP growth of 2.3% in 2017 and 2.4% in 2018.

Payroll growth appears to have moderated a bit this year, but remains fast enough to push the unemployment rate down. Payroll grew 162k on average year to date, down from 190k last year. The combination of slower payroll and faster GDP growth indicates a pick-up in productivity growth this year. 

Given the decline in labor-market slack, the recent inflation soft patch should be transitory. In fact, the Core PCE deflator deceleration, to 1.5% YoY (from 1.7%), can be partially explained by transitory factors like a company-specific phone-plan discount. Meanwhile, the slack in the labor market continues to shrink, with unemployment dropping from 4.7% in December to 4.3% in May.

We expect the FOMC to continue to normalize monetary policy gradually. Although labor markets appear to have little slack, wages are sluggish (2.5% yoy) and long-term inflation expectations are below historical norms. We see a rate hike in June and September, and the announcement of a balance-sheet reduction in December. Given the soft patch in inflation, the risk is that the Fed doesn’t hike in September.

Finally, we continue to assume that President Trump can pass a modest fiscal stimulus (1% of GDP) by year-end. Investors have low expectations about any significant policy move. Modest tax cuts are likely because Republicans in Congress must show results for their electorate in the mid-term elections (4Q18). However, given Congress’s tight schedule, the contours of the tax reform should only become clear in 4Q17.

Europe – Stronger growth to continue as political risks have become more symmetric

Emmanuel Macron´s supporters are expected to have a strong performance in the June National Assembly elections (June 11 and June 18). With most polls suggesting that Macron´s camp is likely to have an absolute majority, alongside collaboration from Les Republicans (which is set to be the second-largest party in Parliament), Macron should be able to undertake the necessary labor-market reforms in order to structurally reduce unemployment in France. In addition, his reformist agenda is set to help foster Franco-Germanic partnerships that can advance his pro-European agenda. Germany’s Angela Merkel has recently said that she would be willing to show more flexibility, which has sparked a debate on Germany being more prone to pursuing fiscal integration within the EU.

Europe still faces political risks, particularly in Italy. The country is contending with a worrisome combination of high migration flows, high unemployment and low growth, all of which could fuel Europopulism (see Macro Vision: Has Europopulism been stopped?) Though risks of an early election have increased, we understand that anticipation cannot take place before late 3Q17. This is because Italy’s congress needs to approve changes to the electoral law before President Sergio Mattarella dissolves parliament and calls for general elections. In such an event, we expect Renzi’s DP to form an unstable alliance with Berlusconi’s FI in order to achieve a governing majority and halt ascension from the Eurosceptic 5 Star Movement (see chart).

Meanwhile, activity remains strong. Euro zone GDP was revised to 0.6% from 0.5% qoq in 1Q17, a solid pace for the region. The purchasing managers’ index (PMI) reached 56.8 in May, its largest figure since April 2011. Improving financial conditions, slightly expansionary fiscal policies and a milder external drag have broadened the recovery in the euro zone.

The ECB changed its guidance, recognizing a neutral assessment of the balance of risks and, as a consequence, removing its bias to further lowering interest rates. Nonetheless, the ECB will continue stressing the need to maintain its accommodative stance for now. We believe the central bank to be preparing the ground for a gradual removal of stimulus, likely by year-end. We expect that in 2018 the ECB will raise the deposit rate to 0.0% from -0.40%, while also reducing the monthly pace of assets purchases to EUR 30-40 billion from EUR 60 billion. 

We raised our 2017 GDP growth forecasts for the euro zone to 1.8% from 1.7% due to the upwards revised 1Q17 print, while maintaining 2018 forecast at 1.5%.

Japan – The economy underperforms in 1Q17

Japan’s economy is showing healthier signs, but 1Q17 growth disappointed at 1.0% saar. Slowly improving soft data, in line with strong industrial production and a lagged weak-yen effect boosting exports, supports our view that the Japanese economy is set to grow faster than its potential rate this year. Additionally, a tightening labor market – unemployment stayed at 2.8% in April – should give a boost to consumption ahead. 

Our GDP growth forecasts for Japan remain unchanged at 1.4% in 2017 and 1.0% in 2018.

China – A modest policy-driven slowdown

Economic activity in China started to slow down in April. Industrial production growth decreased 1.1 pp to 6.5% yoy, fixed investment came at 8.9 % yoy YTD, and retail sales decelerated to 10.7% yoy. The official manufacturing PMI suggests that economic activity remained broadly stable from its April level.

We expect economic growth will continue to weaken in 2H17, due to tighter economic policy. However, we don’t expect the current economic slowdown in China to have an impact on global markets. First, the economy is in a good position in the cycle, hence less prone to hard-landing scares. Second, economic policy can be adjusted, if necessary, to avoid a bumpier landing. Finally, capital outflows have diminished.

We maintain our forecast of 6.5% GDP growth for 2017 and 5.8% growth for 2018.

Political uncertainty has not changed the fundamentals for low risk, so far.

Measures of risks, like the VIX, have decoupled from measures of Economic Policy Uncertainty (see graph). This decoupling has puzzled market observers. Our analysis (see next paragraph) suggests that economic-policy uncertainty has to first cause a deterioration of economic fundamentals in order for it to lead to higher volatility over time. But political events, at least in developed countries with strong institutions, are low-frequency dynamics and hence, spikes in volatility caused by political surprise have so far faded fast. 

Despite high policy uncertainty, low private-sector leverage, steady GDP growth and the U.S. Fed’s monetary-policy stance explain the currently low VIX level (see graph). According to our econometric analysis, these are the main drivers of the VIX, not political uncertainty. Of course, the latter can at some point affect these fundamental drivers (growth, leverage, monetary policy) and hence the VIX. But so far it hasn’t. 

Commodities – Lower oil prices in 2018

The Itaú Commodity Index (ICI) fell by 3.7% in May, driven by metal and energy price indexes. The former plummeted 8%, led by a 20% drop in iron ore price. Meanwhile, energy prices declined 3.2% with a correction in oil prices.

OPEC’s deal and the decline in U.S. inventories should provide support to oil prices only in the short term. Even with the extension of OPEC’s deal, we believe that the deficit will continue during the year. We maintain our year-end Brent forecast of USD 54/bbl (WTI: USD 52.5/bbl). However, for 2018, we decreased our year-end Brent forecast to USD 51/bbl (WTI: USD 50/bbl), due to lower marginal costs of U.S. shale-oil producers.

Firmer global growth limits declines in metal prices. The downside risks to improvement in the global manufacturing cycle seem limited at the moment, even with a slowdown in China. If the global Manufacturing PMI remains close to its current levels, metal prices are unlikely to enter a downward trend. This is consistent with our forecast of a 3% decline in the ICI Metals from its current level, with iron ore prices falling to USD 55/mt by the end of the year. 

Finally, agriculture prices have remained broadly stable since the end of April, despite of the sharp fall of 11.3% in sugar. The drop was mainly caused by a stronger-than-expected supply x demand balance. Therefore, we lowered our price forecast for sugar. Soy and wheat decreased 3.6% and 0.4%, respectively, over the same period.

We expect the ICI to gain 2.8% from its current level by the end of 2017. The increase will stem mainly from higher oil and agricultural prices.



External tailwinds fail to lift growth

• While financial conditions continue favorable to emerging markets, the Brazilian real weakened because of rising political uncertainties, with negative spillovers to the Argentine peso. Meanwhile, the Mexican peso continues to overperform, recently boosted by a positive outcome in the local elections.  

• Even with a favorable external environment, growth in the region is far from robust. In particular, the recovery in Brazil and in Argentina still seems fragile.

• While we see more interest-rate cuts ahead in most countries, the room for monetary easing seems narrower in some of them. In Mexico, the tightening cycle is likely near its end.

While financial conditions continue favorable to emerging markets, the Argentine peso and Brazilian real weakened over the past month. Renewed political turbulence in Brazil increased uncertainty about reforms, widening the sovereign CDS and depreciating the currency. Because Brazil is an important trade partner of Argentina, the Argentine peso was negatively affected, leading the BCRA (Argentina’s central bank) to interrupt its aggressive dollar purchases, which had been initiated just days before the new political crisis in Brazil began. We now expect a weaker currency in Brazil relatively to our previous scenario and see more-balanced risks for our forecast for the Argentine peso (18 pesos to the dollar by the end of this year). 

Meanwhile, the Mexican peso continues to over-perform the other currencies of the region, trading stronger than it was right before the election of Donald Trump to the U.S. presidency. The results of the regional elections in Mexico (in which the PRI candidate defeated the candidate supported by the left-wing leader Andrés Manuel López Obrador in the State of Mexico, the most populated state) contributed to the good mood. But in our view, many other factors are supporting the currency: the perception of lower protectionism risks in the U.S., monetary-policy tightening, a still-solid growth rate, the stabilization of public debt and a narrower current-account deficit.

Even with a favorable external environment, growth in the region is not robust. Sequential growth in Brazil and Argentina was solid in 1Q17, but far from widespread. Due to the uncertainties about the political scenario in Brazil, we reduced our growth forecasts for Brazil and, consequently, in Argentina. In Mexico, growth was solid in 1Q17, but there are signs that consumption is losing momentum as inflation erodes real wages and investment decisions are put on hold due to remaining uncertainties over trade relations with the U.S. In Chile, Colombia and Peru, supply-side factors (such as El Niño in Peru and mining strike in Chile) have contributed to economic weakness in 1Q17, but even excluding these effects, activity has been poor (in fact, we further reduced our growth forecast for Colombia).    

In most countries of the region, interest rates will continue to fall, although the room for monetary easing seems narrower in some countries. In Brazil, the central bank indicated that it will reduce the pace of rate cuts, amid higher uncertainties about reforms. We now expect a higher terminal Selic rate than in our previous scenario. In Colombia, inflation has been stickier (although annual headline inflation is falling, due to dissipation of shocks including El Niño and exchange-rate depreciation), leading the central bank to revert to a 25-bp rate cut in May (following a 50-bp move in April). We see pauses in Colombia’s easing cycle during the second half of the year, with the policy rate reaching 5.5% before the end of 2017 (75 bps below the current level). Chile’s central bank delivered the fourth 25-bp rate cut of the cycle somewhat earlier than we were expecting, and removed the easing bias. In Argentina, the current level of ex-ante real policy rate (using different measures of inflation expectations) is above the 4%-5% range that the central bank deems consistent with a disinflation path. However, given the uncertainty over the inflation outlook there (and the recent CPI upside surprises), we see the BCRA lowering rates only when data gives a more clear indication that inflation is on a downward trend. On the other hand, in Peru we now expect more rate cuts than previously, as the effect of El Niño on food prices is reverting rapidly. In Mexico, part of the board (likely the majority) sees the cycle ending soon (we expect only two additional 25-bp rate hikes). 



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

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