Itaú BBA - Latin America faces volatility

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Latin America faces volatility

October 6, 2015

Weak growth limits further monetary policy tightening

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

Global Economy
U.S. Rates Liftoff in December is still the baseline
Despite some weakness in recent data, we expect the U.S. Fed to raise interest rates in December. The pace of rate hikes will likely be gradual. We expect moderate pressure on Emerging Markets (EM) currencies. But EM growth fundamentals remain weak, and volatility could increase ahead of the Fed liftoff.

Weak growth limits further monetary policy tightening
Volatility in LatAm markets remains elevated. The deterioration of the inflation outlook triggered monetary policy actions in some countries. It is uncomfortable to hike rates amid weak growth, so these central banks are communicating that much higher policy rates are unlikely.

Fiscal challenge, volatile markets
The government announced new fiscal-restraint measures. However, most of them depend on approval by Congress. There are no signs of recovery in economic activity, and weaker exchange-rate is already putting pressure on inflation expectations.

A tighter budget
With oil revenues falling short of expectations (due to both weaker production and lower oil prices), the government announced expenditure cuts of around 0.5% of GDP for next year. The Exchange Rate Commission  rolled over the two foreign exchange intervention programs that were set to expire in September 30.

Rate hikes around the corner
In spite of weak growth, the currency depreciation will keep inflation pressured for some time. The central bank indicated that it would withdraw part of the “sizable” monetary stimulus in the short term. We expect a small tightening cycle, starting in October.

Further hikes ahead?
Headline inflation remains far above the target. However, lower currency depreciation and a negative output gap could help to bring inflation down next year. Following a surprise interest rate hike in September, we do not expect the central bank to act again this year.

The peace deal advances, while the economy slows
Colombia’s economy is gradually slowing. The government and leaders of the FARC indicated a peace deal soon. While a deal would yield long-term growth dividends, it would also generate short-term fiscal costs at a time when the government is cutting expenditures to offset lower oil revenues.

Keep calm and vote for me
According to recent polls, Daniel Scioli from the incumbent party is now closer to win the presidential elections in the first round. The central bank continues to sell dollars and net reserves are approaching a critical low. As a result, the new administration will need to work out a deal with holdouts rapidly to access the capital markets.

No relief
We have lowered our price forecasts for cotton and wheat, and raised our forecast for sugar, due to the supply outlook. We see no relief ahead for commodity producers. Our metals and energy price forecasts remain below the levels that futures contracts are pricing in.


Latin America faces volatility

The Fed December interest rate lift-off is approaching notwithstanding temporary weaker data. The Fed needs to confirm that the recovery is robust enough, including in the labor market, despite continuing global uncertainty. 

The U.S. interest-rate increase will probably be gradual and exert only moderate pressure on emerging market currencies. But market volatility could increase. Growth fundamentals in emerging markets remain weak, especially given the signs of the continuing slowdown in China.

In Latin America, activity continues to decelerate. Volatility in exchange rates is still high, but only the Brazilian real weakened significantly in September. Central banks continue to intervene in currency markets. Cumulative depreciation is pressuring inflation and leading LatAm central banks to raise interest rates. But they will likely embark only in moderate increases in interest rates due to weak growth.

In Brazil, the turbulence has been greater, influenced by domestic factors. The government announced new fiscal measures, but most of them require congressional approval. And the recession continues to weigh on tax revenues. Thus, despite renewed efforts, the fiscal adjustment remains uncertain. In this environment, country risk has once again risen, and the real has weakened. Inflation expectations are on the rise, albeit moderately so far. We believe that the central bank will opt to keep the Selic rate stable but will intensify its intervention in foreign exchange markets using various instruments.

In Argentina, electoral polls point to a lead by Daniel Scioli, the presidential candidate of the governing coalition. Economists tied to Scioli defend a gradual adjustment in the economy, financed by foreign investment. But the crisis in Brazil and uncertainty in China (which is reflected in lower commodity prices) make this strategy more difficult to implement.


Global Economy

U.S. Rates Liftoff in December is still the baseline

• Despite some weakness in recent data, we expect the U.S. Fed to raise interest rates in December as the central bank gets more comfortable with the idea that global uncertainty won’t change the outlook of moderate growth, labor market improvement and rising inflation. The pace of rate hikes will likely be gradual.

• Growth in Europe remains resilient, but in Japan GDP might contract in 3Q15.

• In China, we continue to see signs of a slowdown.

• We expect moderate pressure on emerging market currencies after U.S. rates are increased. But EM growth fundamentals remain weak, and volatility could increase ahead of the Fed liftoff. 

U.S. - Rates lift-off in December is still the baseline

We expect the Fed to raise interest rates in December. We base our view on four arguments.

First, the Fed wants to raise rates gradually, and hence it’s better to start to increase them sooner rather than later. Given the monetary policy lags, the Fed should start to raise interest rates sometime before the economy reaches full employment and inflation reaches its 2% target.

Second, the progress of the labor market has been substantial and the recent deceleration in jobs creation should prove temporary. The underemployment rate – conventional unemployment rate (5.1%) plus discouraged workers and employed working part-time for economic reasons – has fallen to 10.0%, which is about 1.0 pp above full employment. It is also close to when the Fed lifted interest rates in the past in 1994 and 2004, but it has been falling at a faster pace than in these past tightening cycles. There is just enough slack in the labor market if the Fed wants to be able to raise rates gradually.

Third, the U.S. economy has been growing above potential, and the economic outlook remains positive. GDP was revised up to 3.9% qoq/saar for 2Q15, sustained by solid domestic demand, especially consumption (revised to 3.6% from 3.1%). Domestic demand fundamentals remain healthy, as the private sector remains underleveraged and financial conditions remain accommodative. Hence, we expect the GDP expansion to average 2.3% in 2H15, followed by a gradual slowdown in 2016. The risk to third quarter GDP is tilted to the downside due to inventory adjustment. We maintain our GDP forecast at 2.5% and at 2.2%, respectively for 2015 and 2016.

Finally, inflation is likely to rise soon to more normal levels. The PCE deflator is likely to rise to around 1.5% YoY in 1Q16 from 0.3% today, as the negative base effects from the oil price declines and U.S. dollar appreciation (from late 2014 and early 2015) drop out of the 12-month change. We expect the same for core inflation, which is likely to rise to 1.5% YoY in 1Q16 from 1.3% in August.

We see two main risks to our December liftoff call.

First, further declines in commodity prices and/or appreciation of the U.S. dollar could postpone the expected rise in inflation. In this case we expect the Fed to delay the liftoff for a few months.

Second, a tightening of financial conditions caused by a bigger slowdown in China and emerging markets could derail the U.S. recovery. We think the probability of this risk is small, but the consequences would be substantial (the Fed could even discuss easing policies). So far, the financial contagion has been mainly contained to the appreciation of the dollar, which the U.S. economy has been able to weather. More recently, there have been some spillovers to U.S. equities and credit, but it is likely to be transitory.

We left our year-end forecast for the two-year Treasury stable, at 1.0%, and the 10-year yield forecast at 2.4%. These forecasts are in line with a December liftoff and are higher than what is currently priced in by the markets.

Europe – Economic Activity remains resilient

Economic activity in the euro area remains resilient, maintaining a moderate growth pace despite downside risks from China and emerging markets. The composite PMI for September came at 53.9, continuing around the range it has been since this March and consistent with an unchanged pace of growth of around 0.4% qoq. Additionally, consumer confidence stabilized at a high level, and business confidence remains buoyant. Job creation and retail sales growth are also keeping a good pace.

The European Central Bank is monitoring downside risks to inflation, but we see the central bank on hold for now. The decline in oil prices since July lowered the headline inflation and market-based inflation expectations again. Additionally, the ECB has flagged that it is paying close attention to growth developments abroad and how they affect the domestic scenario. But we believe the spillover from China and EMs on euro-zone growth will be limited – a view data have so far corroborated. And core inflation has been picking up on the margin while the year-over-year rate has been stable, at 0.9%, and is likely to continue inching up ahead. Thus, we don’t think the ECB needs to act and can wait to assess if there is any material change to the outlook.

Japan – Risk of another quarterly GDP contraction increased

Economic activity has shown weakening signs, risking another GDP contraction in 3Q15. Retail sales remained stable and industrial production (IP) declined 0.5% mom in August. IP likely contracted in 3Q15 (its average level in July-August is 1.0%, down for the quarter). Our current activity index, which tracks GDP growth, slowed to 0.2% in August from 0.4% in July. We see increasing risks that GDP will contract in 3Q15 instead of expanding, as in our scenario. If it happens, Japan will be back into technical recession.

Risks of further easing by the Bank of Japan (BoJ) have also increased. Despite positive signs in inflation, excluding energy, BoJ’s optimistic inflation forecast relies on the economy growth to lead improvements in the labor market and to close the output gap. With activity weakening and inflation expectations still distant from the 2% target, the likelihood of more monetary stimuli in October or later, in January next year, has increased.

We keep our GDP forecast at 0.6% for 2015, but we have revised it downward, to 1.0% from 1.4%, for 2016.

China – More signs of slowdown

Activity data continued to point to a slowdown in activity in September. The official manufacturing PMI rose 0.1 to 49.8 in September, indicating a still weak pace of growth in industrial production.

Meanwhile policymakers resumed their rhetoric focused on medium-term reforms and signaled that the current pace of growth is acceptable. In September, China advanced the reform agenda by opening the domestic FX market to foreign central banks (another move to boost renminbi’s internationalization) and issuing guidelines to improve governance of State-Owned Enterprises. At the same time, both president Xi and premier Li signaled that growth was within an acceptable range, reducing further expectations of a material shift in terms of policy stance

We maintain our below-consensus GDP forecasts at 6.7% for 2015 and 6.2% for 2016. These forecasts assume growth of around 6.0% qoq/saar for the next few quarters. It is consistent with a modest boost from monetary, fiscal stimuli and some recovery in the housing market. These tailwinds are offset by a lower contribution from the financial sector (compared with the strong 1H15) and the ongoing structural slowdown.

Emerging Markets – Volatility ahead of a U.S. rate liftoff

Emerging markets have depreciated significantly since mid-2013. Indeed, the USD has appreciated 37% since May 2013 (see graph), when the first talks of QE tapering started in the U.S.

We expect the depreciation of emerging market currencies to be moderate after the U.S. rate liftoff. The Fed will likely increase rate hikes gradually, and the terminal interest rate will be lower than in the past. In addition, the current account deficit in emerging markets are declining (see graph), benefiting from depreciated currencies and (not in all countries) lower oil prices.

But volatility should be high as we approach the liftoff, and emerging markets will still likely suffer from poor domestic fundamentals. Low commodity prices, lack of structural reforms, weak productivity growth and less scope to continue increasing credit after the boom of the last decade (see graph) will continue to weigh on emerging markets for the years to come.

Commodities – No relief

The Itaú Commodity Index (ICI) dropped a further 1.4% in September. The decline was driven by the oversupply in the oil market, with the ICI-energy declining 6.9%. The ICI-agricultural rose 4.1%, and metals fell 0.6% over the same period. The year-to-date figures show double-digit declines for all components: agricultural -10.1%, metals -22.0% and energy: -14.5%.

We lowered slightly our forecasts for the ICI-agricultural. Adjustments to supply conditions are consistent with lower wheat and cotton price forecasts and higher sugar prices. The net effect is a 0.4 pp downward adjustment to our scenario for the end of 2016.

Our forecasts for most commodities remain below the levels priced in by the futures curve, implying an unfavorable environment for most net commodity exporters.


Latin America

Weak growth limits further monetary policy tightening

Most LatAm economies continue to grow at a slow pace, but the recession in Brazil is getting deeper. While currency volatility remained high in September, only the Brazilian real weakened significantly in the month. Central banks that were intervening continued to do so. While we expect the Fed to start to raise its policy rate in December, we foresee only limited further weakening of LatAm currencies. The past depreciation is putting pressure on both inflation and some measures of inflation expectations. In response, some central banks are already raising rates. However, because growth is weak, policymakers are also signaling that interest rates won’t rise meaningfully.

Economies in the region continue to grow slowly, with no signs of a rebound in most countries. The exception is Peru, where mining output is benefiting from the investments made in the sector over the past few years and is leading a moderate recovery. In Brazil, the domestic scenario remains uncertain, and we have further reduced our growth forecast for both this year (to a 3.0% contraction) and next (to -1.5%). In Mexico, the manufacturing sector remains sluggish in spite of higher growth in the U.S. and a weaker currency; although we expect a recovery, our growth forecast for this year has been lowered to 2.2%. In Chile, the economy weakened further and we reduced our growth expectation to 2.0% and 2.5% in 2015 and 2016, respectively. In Colombia, activity data have been mixed, leading us to maintain our growth forecasts.

Although exchange-rate volatility remained high in September, reflecting the uncertain environment for emerging markets, only the Brazilian real ended the month much weaker than it started. The region’s other currencies ended the month almost flat with their respective levels at the end of August. Some central banks continued to intervene in the currency markets. Mexico’s Exchange-Rate Commission (made up of members of the central bank and the finance ministry) announced an extension of the two intervention mechanisms in place, so the central bank will continue to sell USD 200 million daily without a minimum price and another USD 200 million every day when the exchange rate weakens by at least 1%. The mechanisms were extended to November 30 (they had previously been set to expire on September 30). In Brazil, the central bank intensified its intervention, both through exchange-rate swaps and U.S. dollar credit lines. In Peru, likely due to the downward trend in reserves (once liabilities with residents are excluded), the central bank opted not to intervene through the spot market in September, instead using other tools to curb volatility.

While we expect the Fed to start to raise its policy rate in December, we expect only limited further depreciation of LatAm currencies. Our exchange-rate forecasts are unchanged.

Past depreciation continues to put pressure on inflation. Annual inflation in Brazil fell only slightly in August, remaining far above the upper bound of the target range. Inflation rates in Chile, Colombia and Peru rose further in August, taking them farther above the upper bounds of their respective target ranges, lifted by higher tradable prices. Core measures are also above their target ranges in Brazil, Chile, Colombia and Peru. In this environment, inflation expectations are rising. Only in Mexico is inflation staying low, and even there inflation expectations are deteriorating with the weakening of the currency. In Brazil, we now see inflation at 9.7% for this year (up from 9.5% in our previous scenario). In Mexico, by contrast, we now expect an inflation rate of 2.8% this year (down from 3.0% previously).

The deterioration of the inflation outlook triggered monetary policy actions in some countries. The central banks of Peru and Colombia raised interest rates in September (earlier than we and market consensus were expecting), while Chile’s central bank hinted that a rate hike is likely “in the short term”. It is certainly uncomfortable to hike rates amid weak growth, so these central banks are communicating that much higher policy rates are unlikely. Board members are expressing in both formal and informal communications that policy rates remain expansionary and that rate hikes are specifically aimed at sending a signal to economic agents that the banks remain committed to their inflation targets. In Brazil the central bank continues to signal that the policy rate will remain unchanged, even though it recognizes that the balance of risks for inflation has deteriorated: so far, the monetary authority is content to deal with the exchange-rate pressures through intervention instead of rate hikes. In Mexico, the central bank left the policy rate unchanged at 3.0% in September. Up until Fed’s decision to leave rates on hold, most analysts expected a rate hike in Mexico. Board members of Mexico’s central bank remain highly concerned about the impact on Mexico of the monetary policy tightening in the U.S., even though they acknowledge that the economy remains weak and inflation under control.

We expect only a moderate increase of policy rates in Mexico, Chile, Colombia and Peru through the end of the next year and we do not expect additional rate hikes in Brazil. In Peru and Colombia, only two additional and non-consecutive 25-bp rate hikes are likely. In Chile we expect the tightening cycle to start in October, but we see room for only two 25-bp rate increases. In Mexico, we expect the tightening cycle to start only in 1Q16, after a Fed liftoff in December and once there are more clear signs that the U.S. recovery is benefiting Mexico. While potential exchange-rate volatility could lead to Mexico’s first hike coming in December (together with the Fed’s), the recent downside surprises on growth and inflation increase the odds that board members will wait before starting to withdraw the monetary stimulus now in place.

Finally, recent polls in Argentina indicate that Daniel Scioli, the candidate of the incumbent party, is likely to win the presidential elections outright, avoiding a runoff in November. Economists linked to Scioli advocate a gradual adjustment of macro policies, financed by foreign investment. However, the challenges that will have to be overcome for this strategy to succeed are rising, with the deterioration of growth in Brazil, the sharp depreciation of the Brazilian real, the uncertainty over the Chinese economy and lower commodity prices. It will be hard to implement a gradual devaluation of the currency and to attract meaningful capital inflows when the trend for emerging markets is precisely the opposite.


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


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