Itaú BBA - Liquidity window has widened. For how long?

Global Scenario Review

< Back

Liquidity window has widened. For how long?

May 11, 2015

Emerging markets got some relief as the strong USD trend took a pause and commodities prices improved. But growth remains weak.

Global Economy
Some relief for emerging markets
Global growth weakened in 1Q15, with disappointing performance from the U.S., Japan and China. Emerging markets got some relief as the strong USD trend took a pause and commodities prices improved. But growth remains weak.

Markets improve, but activity continues to decline    
Markets’ improvement reflects the gradual implementation of macroeconomic adjustments that drive away the crisis scenario. Economic activity continues to deteriorate, as confidence remains near historic lows.

Weaker U.S., weaker Mexico    
The economy weakened in 1Q15, as exports fell. Weaker activity in the U.S. is likely behind the momentum loss. The central bank kept the policy rate at 3.0%. Board members are divided on when the central bank should hike.  

Political noise
President Michelle Bachelet announced that the government will start a constitutional reform process in September. She also made a surprise announcement of a significant cabinet reshuffle. The minutes of the most recent monetary policy meeting show that board members are in no rush to hike.  

Better political environment
Prime minister Pedro Cateriano received a vote of confidence from Congress, calming the political environment for now. We expect a rebound in mining production and fiscal stimulus measures to boost growth this year, but the recovery will likely be gradual.   

Appreciation not likely to last
Activity is slowing, while inflation is temporarily high. The central bank’s tone remains neutral. With higher oil prices and a weaker U.S. dollar in April, the peso appreciated strongly, but the Fed’s liftoff combined with a high current-account deficit will likely reverse the exchange-rate path.

Increasing international reserves
Recent results in provincial primaries for governor have been encouraging for the opposition parties. The government raised USD 1.4 billion through bonds under Argentine law, despite some legal risks, and YPF issued another USD 1.5 billion. The current government is benefitting from the expectation of a political change.     

Price increase sustainable for oil, temporary for iron ore
Oil prices rose above USD 65/bbl in April, amid stronger signs of a supply adjustment and lower short-term risks for storage. We moved our scenario of convergence of Brent crude prices to USD 70/bbl up by six months, to December 2015. Iron ore prices advanced after many months of declines, driven by temporary demand. The outlook, however, is still for losses.

Liquidity window has widened. For how long?

Global growth weakened in the first quarter. The U.S. and Japan, which had both been experiencing good recoveries in 2014, have lost momentum. Emerging economies, led by China, continue to slow down. In this environment, most countries have been maintaining (or adopting) an expansionary monetary policy, which is helping to maintain global liquidity at high levels.

This movement, along with some improvement in commodity prices, has boosted emerging assets over the past few weeks. But the scenario remains challenging. We understand that the U.S. slowdown is temporary, with signs that inflation is already trending towards the target. We maintain our view that the Fed will start to gradually increase interest rates in September. In China, the risk is that the government stimuli are not sufficient, threatening the recent recovery in commodity prices.

In Latin America, exchange rates have appreciated with the global scenario. But we continue to expect depreciation ahead, along with the monetary tightening in the U.S. Growth in the region continues to disappoint, in line with the global slowdown of emerging markets. Despite the sluggish growth, most central banks have made it clear that there is no room for further loosening of monetary policy, and some have been discussing the timing of future hikes.

In Brazil, the scenario is of consolidation of macroeconomic adjustments (required to maintain the country’s investment-grade status). The prices of many assets such as CDS spreads, the exchange rate and the stock market, among others, now reflect a scenario without crisis. However, challenges remain. The latest figures have been corroborating our scenario of GDP contraction and weakening of the labor market already in the short term.

In Argentina, the presidential elections in October have been dominating the economic scenario. Polls show a polarization between Daniel Scioli, incumbent, and Mauricio Macri, the opposition candidate, who is seen as more market-friendly. Meanwhile, the current government has been taking advantage of the expectation of political change to raise funds in the capital markets, restoring part of its international reserves. Thus, a faster adjustment of the exchange rate and interest rates before the election has become less likely.


Global Economy

Some relief for emerging markets

• Global growth weakened in 1Q15, with disappointing performance from the U.S., Japan and China. 

• On the positive side, Europe saw an improvement in activity, which reduces downside risks coming from the region, a constant source of worry in the past few years. 

• In the U.S., fundamentals continue to support consumption ahead, and investment should stabilize after the sharp drop related to cuts in the shale oil industry. 

• China remains a risk and needs a strong policy response, which has already started, to stabilize growth. We lowered our 2015 GDP growth forecast to 6.7% from 6.9%.

• Emerging markets got some relief as the strong USD trend took a pause and commodities prices improved. But growth remains weak. 

U.S. – 2Q15 will likely prove that the GDP slowdown in 1Q15 was transitory

GDP growth decelerated to 0.2% qoq/saar in 1Q15. The bad winter weather seems to have restrained consumption, which slowed to 1.9% in 1Q15. This pace is soft, given the fact that real personal disposable income grew 6.2% in the quarter. Fixed investment declined 2.5%, mainly on a sharp contraction in capital expenditures by the shale oil industry.

We expect a better 2Q15 as fundamentals for households remain solid and the adjustment in the oil industry moderates. The household savings rate rose to 5.5% in 1Q15 from 4.6% in 4Q14, leaving room for acceleration of consumption. Fundamentals also remain supportive of a moderate rebound in residential investment in the next few quarters.  Finally, after the sharp contraction in 1Q15, we expect a more modest decline in oil industry investment in 2Q15 and stabilization in 2H15.

Because of the negative surprise in the first quarter, we revised GDP growth down to 2.5% (from 2.8%) in 2015, but we maintained our 2.5% projection for 2016. 

Job creation is likely to continue at about 200,000 per month, if real GDP growth accelerates as expected. Non-farm payroll grew 223,000 in April, averaging 194,000 per month in the first four months. The unemployment rate declined to 5.4% in April from 5.5% in March. The unemployment rate is likely to reach the Fed’s full employment range (5.0%-5.2%) until the year-end.

We continue to expect the FOMC to lift the Fed Funds rate in its September meeting, although this could still be delayed until later (December). In the April meeting, the FOMC recognized that the economic slowdown in the first quarter was partially transitory. Besides, the committee left the economic and monetary policy outlooks unchanged, indicating the base case for a September increase remains unchanged. After the soft economic activity in 1Q15, the risk remains tilted to a later hike (December). But such risk is likely to dissipate in the next few months as the economy recovers in line with our expectation.

We maintained our forecasts for the two-year Treasury note at 1.2% and the 10-year bonds at 2.5% for year-end 2015. These levels remain above the forward market prices.

Europe – Activity is holding up

Even though activity data started to become more mixed, it generally supports our view of a pickup in euro-zone growth. Consumption seems to have grown a solid 0.7% qoq in 1Q15. Lower oil prices provided a boost to retail sales at the end of 2014 and into early 2015. This positive effect is fading, but overall conditions for households are improving because of easing credit conditions, stabilization in wages and declining unemployment. Indeed, consumer confidence is at relatively high values (see graph).  It is true that some soft data were weak in April. For example, the composite euro-zone PMI declined slightly, to 53.9 from 54.0 in March. Still, the level of most soft data suggests a pace of GDP expansion between 0.4%-0.5% qoq, which is in line with our scenario.

Greece remains a risk, although we continue to expect a deal with creditors. Greece’s precarious cash position implies negotiations cannot extend further than mid-year. It is important to note that if negotiations fail, it doesn’t necessarily imply that Greece will leave the euro zone (a “Grexit”). None of the involved parties seems interested in a Grexit.  If the impasse continues, we could end up with capital controls, a cap on Emergency Lending from the ECB and some missed payments on the government debt but no reintroduction of the drachma or a redenomination of contracts from euros to drachmas (this is the definition of a Grexit, in our view). In this “limbo” scenario, we believe contagion to other countries will be small.

We hold our GDP growth forecast for 2015 at 1.6% and at 1.9% for 2016.

Japan – Activity still weak, but wage hikes will help it get better

Japan’s economy has shown disappointing signs in March. Consumption surprised on the negative side, with retail sales down 1.9% mom/sa and showing little momentum (see graph). Real exports rose 0.2% in March, soft after the 6.5% drop in February and still modest compared with strong gains in previous months. With weaker consumption and exports, industrial production declined for the second month in a row and continued to give no signs of stronger growth.

We continue to expect a recovery in the next months, with wage hikes leading to improvements in consumption. Higher import prices and the consumption tax hike depressed household real income in the last two years. But pay increases are coming in higher than last year and will likely create conditions to start a more solid recovery in domestic demand in 2Q15.

We have lowered our 2015 GDP forecast to 0.7% from 0.9%, but we continue to expect 1.6% growth in 2016.

China – More stimuli needed to reach 6.5%-7.0% growth in 2015

GDP growth slowed to 5.3% qoq/saar in 1Q15 from 6.1% qoq/saar, confirming that economic growth weakened further.  The result was 0.8 pp lower than our expectation. The deceleration since  3Q14 has been sharp (see graph). The GDP deflator fell to -1.1% yoy from 0.4% yoy in 4Q14, showing the first negative number since 3Q09 and reinforcing deflation fears. If sequential growth remains at the first-quarter level, the GDP expansion in 2015 will be lower than 6.0%, well below the official target of 7.0%.

The slowdown requires more aggressive stimuli, and the government has indeed shifted to a more pro-growth stance recently. The PBoC announced a larger-than-expected 100-bp cut in the Required Reserve Ratio (RRR) in April. Unlike the previous RRR cut, this one was not used to offset banking liquidity issues, and interbank rates were already at low levels.

We estimate that more measures are needed. The effectiveness of the monetary instruments may be less than in the past due to lower bank profitability because of rising non-performing loans and lower growth prospects in sectors such as steel, coal and O&G. Hence the PBoC has to further use its traditional tools to stabilize growth in the short term, even though the already high credit/GDP ratio remains a constraint to the size of any additional push. An additional comprehensive package is likely to include new cuts to benchmark interest rates and RRR plus an increase in government expenditure.

Even with more stimuli ahead, we have lowered our 2015 GDP growth forecast to 6.7% from 6.9%. Our scenario stands at 6.6% for 2016.

Emerging Markets – Some relief on the external side, but growth remains weak

The two trends pressuring emerging markets since last year reversed last month: the strong U.S. dollar and the fall in commodities prices. The dollar depreciated 2.7% and 5.1% against a basket of emerging-market and commodities exporters’ currencies in April, respectively.

We believe, however, that the dollar’s upward trend will resume as the U.S. GDP recovers in 2Q15, allowing the Fed to hike interest rates in September. The risk remains for a later (December) increase in the Fed Funds rate (see above), and so in the short term the USD could remain sideways.

The recovery in commodities is likely to be permanent, with oil prices sustaining their recent gains but not metals (see below).

Despite some relief on the external side, the growth picture remains weak for emerging markets.  Emerging markets manufacturing Purchaser manager’s index declined to 49.7 from 49.8 in April, remaining below the 50pts threshold. This is the lowest level since Nov/11.  China was stable at 50.1, but its recent weakness continued to pressure the emerging ex-China that fell to 49.4 from 49.6.

Commodities – Sustainable oil recovery, unsustainable iron ore pickup

The Itaú Commodity Index (ICI) rose 9.3% since the end of March, driven by higher crude oil and iron ore prices. Indeed, the ICI-energy sub-index rose 19.4%, and the ICI-metals rose 9.6% while the ICI-agricultural agricultural index declined a bit (-1.9%).

Brent crude prices rose to USD 69/bbl from USD 58 by early April, showing a recovery consistent with fundamentals. U.S. crude production has finally signaled a declining trend, consolidating the projection for a slowdown in O&G investment in the region. In addition, the pace of crude inventory buildup has slowed, easing fears that storage bottlenecks could prevent additional storage trade and lower the short future contracts. As a result, we now see Brent prices converging to USD 70/bbl by the end of 2015, six months earlier than our previous scenario.

Iron ore prices were up 10% in April, reaching USD 58/ton, but we think this is unsustainable. The trigger was a restocking cycle by Chinese mills. However, this is a temporary increase in demand and does not change the outlook of sizable surpluses in the iron ore market. Global demand is set to remain lackluster, while supply from low-cost producers continues to rise. Hence, we expect prices to resume the downward trend, and we maintain our year-end price forecast at USD 52.5/ton.

We lifted our ICI 2015 year-end forecasts by 2.7 pp due to an earlier convergence of Brent prices to USD 70/bbl. Our forecast implies that, from current levels, the ICI will rise by 3.6% in 2015 and by 3.5% in 2016.



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

< Back