Itaú BBA - Latin America suffers

Global Scenario Review

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Latin America suffers

August 10, 2015

The scenario has become more difficult for LatAm. Commodity prices declined again, affecting the region’s growth outlook.

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

Global Economy
Moderate growth and weak commodity prices
Commodity prices plummeted in July, and we see most of the fall as permanent. Emerging markets, including Latin American economies, will remain under pressure because of the less favorable external environment and weak domestic conditions.

Latin America
Further drop in commodities brings additional challenges to the region
Activity in the region remains weak. The additional fall in commodity prices make the outlook even harder, as it will weigh negatively on growth and led to further currency depreciation.

More challenges, lower targets
The scenario has proved more complex. The recession will likely last longer. The government significantly reduced its fiscal targets. More difficult financing conditions demand further depreciation of the exchange rate.

Risks for the energy reform
The results of the first oil tender missed expectations. As a response, the government is improving the terms for the following tender to attract more interest from private firms. However, the further decline in oil prices increases the risks for the coming auctions.

Lower copper prices weigh on the economy
We have reduced our 2016 growth forecast due to the deteriorating copper price outlook. A worsening external environment for emerging market currencies weakened the Chilean peso further.   

Renewed commodity shock
With lower metal commodity prices, we now expect lower GDP growth, wider current account deficit and weaker currency. As inflation continues to surprise to the upside and the currency weakens further, we increased our inflation forecast for 2015.

Oil’s casualty
We have lowered our 2015 and 2016 GDP growth forecast. The Colombian peso has been one of the hardest-hit currencies in July .Weaker currency puts more pressure on an already elevated inflation.

Who wants to be President?
The preliminary results of the primary elections in Argentina hint that a runoff presidential election is more likely. Scioli´s advisors advocate for a gradual approach to tackle macroeconomic distortions. We expect a weaker real exchange-rate next year with higher interest rates.

Still falling
We revised our forecast for Brent crude downward because we incorporated efficiency gains in non-conventional output in the U.S., which will lead to lower equilibrium prices. We also lowered our price forecasts for metals (the oil pass-through and weaker demand from China), sugar and coffee (on a weaker BRL).


Latin America suffers

The global scenario has become more difficult for Latin American countries. Commodity prices have declined again. In China, the worst of the stock market correction seems to be behind us, but the slowdown continues and there are more downside risks than the market expects for the second half. The U.S. continues to recover and the probability of a lift off  in the coming months have increased, leading to a stronger dollar.

 We believe that this scenario is here to stay, increasing the challenge in Latin America. The new commodity prices are curbing economic activity and weakening exchange rates, which puts more pressure on inflation.

This reality complicates the implementation of monetary policy across the region. We expect stable interest rates in most LatAm countries for the rest of 2015 and throughout 2016. In Mexico, we forecast rate hikes, but not before the first quarter of 2016. In Brazil we expect cuts, but starting only in the third quarter of next year.

Under current scenario, it became more evident that most economies in Latin America need structural reforms.

In Brazil, political uncertainties have deepened, as have the investigations into the Lava Jato operation. The recession has worsened and will likely last longer. The government significantly reduced its fiscal targets and has conceded the difficulties of execution going forward. In this more difficult scenario, external financing conditions become less favorable, requiring further depreciation of the exchange rate. The weaker real pressures inflation, reducing room for interest rate cuts next year. The recession, in turn, creates further difficulties in the fiscal scenario.

In Argentina, Daniel Scioli has consolidated the lead in the election. Scioli’s advisors advocate "gradualism" to address macroeconomic distortions. We continue to expect a real depreciation of the exchange next year along with interest rate hikes.


Global Economy

Moderate growth and weak commodity prices

• The U.S. economy recovered in 2Q15 and is creating jobs at a good pace, but wage inflation remains low. We see the Fed raising interest rates later this year.

• The crisis in Greece didn’t change the outlook for a modest recovery in the euro area. However, the current pace is slightly lower than we anticipated. We revised GDP growth estimates to 1.4% from 1.6% in 2015, but we maintain the 1.9% for 2016.

• In China, the worst of the needed correction in the stock market seems to be over, but we believe there is room for disappointment with the Chinese economy in 2H15 and maintain our below-consensus GDP forecast for 2015 (6.7%).

• Commodity prices plummeted in July. We see most of the fall as permanent.

• Emerging markets, including Latin American economies, will remain under pressure because of the less favorable external environment and weak domestic conditions.

U.S. – Liftoff later this year

In the first official release, the U.S. GDP growth accelerated to 2.3% qoq/saar in 2Q15, but we forecast it will be revised to 2.8% qoq/saar, close to our initial expectation of 2.9%. The rebound was led by Consumption, which grew 2.9% in 2Q15, up from 1.7% in 1Q15, as we expected. Non-residential investment remains sluggish, having declined 0.6% in the first estimate, which is likely to be revised up to 0.9%. In addition, the 1Q15 GDP was revised upward, to 0.6% (from -0.2%), due to the new seasonal adjustments, as we expected.

We expect the economy to sustain a 2.7% pace in 2H15, better than the modest 1.5% in 1H15. Non-residential investment is likely to resume growth supported by rising consumption and easy financial conditions, while investment by oil corporations should stabilize at lower levels after declining sharply in the first half of the year.

Although better than 1H15, the output expansion in 2H15 is still modest, as current productivity growth in the U.S. might be lower than previously thought. The Bureau of Economic Analysis revised its GDP growth estimates to 2.0% from 2.3% per year in the period of 2012 to 2014 due to downward revision in the output per worker. Job creation averaged 215 thousand per month in the period. Hence, if productivity growth does not pick up, U.S. GDP growth is likely to drop below the 2% we currently estimate.

We maintained the GDP forecast at 2.4% in 2015, but revised down to 2.4% from 2.5% in 2016.

The labor market continues to create more than 200k jobs per month, with a declining unemployment rate. The unemployment rate remained at 5.3% in July, down from 5.7% at the start of the year and close to the FOMC central tendency forecast (5.2%-5.3%) for the fourth quarter.

With diminishing slack in the labor market, we believe the Fed is getting closer to raising the Fed fund rate this year. Indeed, in its July meeting, the FOMC said it needs “some” further improvement in the labor market before increasing interest rates, suggesting that a few months of continuing job gains are enough for liftoff.

However, with little sign of wage inflation, December remains more likely than September. The average hourly earnings rose 2.1% yoy in the past twelve months, remaining in the range of 2.0%-2.2% since the great recession. In addition, the employment cost index, the Fed’s preferable gauge of wage growth, declined to 2.0% yoy in 2Q15 from 2.6% in the 1Q15 (see graph). The inflation outlook is slowly improving, with the core PCE deflator increasing 1.8% qoq/saar in 2Q15 (compared with 1.0% in 1Q15) and the pass-through of the USD gradually fading, and it could justify a September liftoff. Nevertheless, annual inflation remains at 1.3% yoy, below the 2% target. Hence, we continue to believe the FOMC liftoff is more likely in December, with some chance of it coming as early as September.

Finally, we believe downward revision in productivity favors a gradual pace of interest rate increases, as has been signaled by the FOMC. We revised the 2-year Treasury rate forecast downward, to 1.1% (from 1.2%) by year-end. We maintain our 10-year yield forecast at 2.70%.

Europe – Greek crisis didn’t change the prospects for a modest recovery

With the Grexit risk receding, the scenario for the euro area remains one of modest recovery. Indeed, the fundamentals that underline the recovery are still in place. The pace of fiscal adjustment has slowed this year and is likely to remain modest in the coming years. The ECB’s easy monetary policy also continues to trickle through the economy, with for example the average interest rate for a corporate loan in Spain (weighted by volume) at 2.7% from 3.6% a year ago and at 2.1% from 3.1% in Italy. Banks have also reported stronger loan demand, while conditions for lending have eased moderately. The fall in oil prices will continue to help household real income. Finally, the 10% drop in the trade-weighted euro since December looks like it will last and has been helping exports.

We made a small downward revision, to 1.4% from 1.6%, in our 2015 GDP growth forecast but maintain our 1.9% estimate for 2016. The euro-zone purchasing managers’ indexes are currently consistent with a GDP growth pace of around 0.4% qoq, slightly below the 0.5% we projected for 2Q15 and 3Q15. We adjusted our GDP forecasts for 2015 accordingly but continue to expect the economic indicators to improve by the end of the year.

Finally it is worth noting that politics will remain a focus this year, with elections in Spain and Portugal, but we don’t expect a disruptive scenario to emerge. In Portugal (elections on October 4), there are no successful anti-euro parties, with polls showing a close race between the ruling center-right PSD-CDS coalition and the center-left Partido Socialista, neither of which indicate they want to reverse the reforms of recent years. The situation looks riskier in Spain (elections in November or December), where leftist party Podemos is likely to gain a significant share of the vote, though it is unlikely to be part of a future government. Polls show the incumbent center-right party PP leading modestly against the center-left PSOE, and for now a hung parliament looks likely. A hung parliament would likely lead to a PP minority government, which could halt future reforms, although a large share of the adjustment process has already been carried out

Japan – A GDP contraction in 2Q15 should prove to be temporary

Japan’s GDP likely contracted 0.5%‎ qoq saar in 2Q15, but this should be temporary. Consumption and investment slowed down in the second quarter and net exports were lackluster. But the contraction will likely be due to a payback from a strong 1Q15, when GDP expanded 3.9%, with inventories contributing 2.2% percentage points. 

Growth will likely improve to an above-moderate pace in 2H15. Exports showed slight signs of recovery in June after two months of declines, while, despite the deceleration in its growth rhythm, investment has continued to build a positive outlook following better sentiment among firms. It is true that consumption still looked weak, as retail sales declined 0.8% mom and remained stable in the quarter. Wage increases and a historically depreciated yen will help consumption to firm and investment to keep recent gains.

We lowered our 2015 GDP forecast to 0.8% from 0.9%, reflecting the weaker 2Q15, and we continue to expect 1.6% in 2016.

China – Slowdown in 2H15

The worst of the correction in the stock market seems to be over, with limited impact on the rest of the economy. The government intervened heavily, causing prices to trade sideways (with a lot of volatility) since early July. Prices are now 28% below the recent high levels, but we do not expect this decline to affect the rest of the economy: the wealth effect is lower than in advanced economies, equity financing is not a major source of funding for the corporate sector and bank stocks were not much affected by the recent volatility.

Nevertheless, we now expect economic growth to decelerate to 6.0%-6.5% qoq/saar in 3Q15 and 4Q15 (previously: 7.0-7.5%) from 7.0% in 2Q15, driven by a lower contribution from the financial sector. The above-consensus GDP yoy growth in 1H15 came from an abnormal contribution from the financial sector (1.4 pp vs 0.8 pp in 2014). Looking forward, the end of the stock rally is likely to cause a steep decline in IPO and brokerage fees, thereby normalizing the value-added contribution. This adjustment will lead to a slowdown even with stability in the Manufacturing sector and a modest improvement in real estate investment by the end of the year.

We maintain our GDP forecasts for 2015 and 2016 at 6.7% and 6.6%, respectively. The consensus for 2015 (6.9%-7.0%) implies stable growth in 2H15, so we believe there is room for more disappointment ahead with the Chinese economy.

Emerging markets – Still under pressure

The currencies of emerging markets remain under pressure, with several of them hitting a 15-year nominal low. Indeed the dollar hit a new record high value against an equal-weighted basket of emerging market currencies (see graph). The index was up 7.9% in 1H15, rising 3.2% only in July.

With a less favorable external environment and weak domestic factors, the pressure will likely continue. Our Itaú Commodity Index (ICI) plummeted 11.4% in July, resuming the downward trend seen for most of 2014. We incorporated this fall in our scenario and expect lower commodity prices ahead. Additionally, the US economy continues expanding at modest pace and will raise interest rates this year. On the domestic front, most emerging economies also face structural challenges, exposed by this new external reality. 

Commodities – Still falling

The Itaú Commodity Index (ICI) plummeted 13.9% in July, resuming the downward trend after remaining roughly stable in 2H15. The breakdown shows declines in all components: agricultural (-12.4%), metals (-6.6%), and oil-related (-19.1%). Our new scenario assumes a moderate 5.2% increase in the ICI from current levels by year-end, so we see most of the recent decline as persistent and consistent with fundamentals.

Idiosyncratic factors that explain moves of specific commodities share a common story: ongoing shifts in the supply curve and weaker demand outlook. The specific factors include lower risks to the U.S. crops, a stronger-than-expected oil supply and lower (and less commodity-intensive) growth in China. A stronger dollar (the part that is exogenous to commodity prices) also helps to explain the movement.

The shocks to some commodities spread to the others, reinforcing the decline. One example is lower oil prices, which reduce milling and transport costs, thereby reducing break-even costs for other commodities. Another is the decline in BRL, caused by lower iron ore and soybean, which spreads to sugar and coffee, given the weight of Brazil in global exports for these two products.

We lowered our price forecasts for oil (Brent to USD 60/bbl from USD 70/bbl in 2016ye), metals and sugar/coffee. Our new oil scenario assumes that efficiency gains in U.S. unconventional production will lead to lower equilibrium prices and that the rising supply from OPEC countries will postpone the equilibrium in the global market to the end of 2016 (previously: end of 2015). The downward revision to metals comes from more cost deflation and weaker growth in China in 2H15. Finally, we lowered both sugar and coffee price forecasts due to a weaker BRL. The combined effect is a 10.1 pp downward revision to our ICI forecasts for the end of the year.

We now forecast the ICI to drop 14.1% yoy in 2015, following declines in 2011 (-6.5%), 2013 (-6.1%) and 2014 (-27.5%). The small increase seen in 2012 (+3.5%) and our expectations for 2016 (+5.0%) are not enough to prevent the overall downward trend.

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

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