Itaú BBA - Lower Commodities prices, weaker growth in Latin America

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Lower Commodities prices, weaker growth in Latin America

December 12, 2014

The drop in oil prices, mainly driven by supply issues, is positive for global growth.

Global Economy
Oil decline supports global growth but pressures central banks

The scenario supports continuing USD gains against developed and emerging-market currencies. EM currencies face the additional challenge of lower commodities prices.

End of the cycle, and some adjustments

To avoid a downturn in the economy, economic adjustments are needed, with limited room for maneuvering. We reduced our GDP growth forecast for 2015, and expect a more depreciated currency.

Exchange-rate intervention returns

The continued strengthening of the U.S. dollar and the recent drop in oil prices have weakened the Mexican peso, leading policy-makers to announce an intervention program.

Oil prices speed up the external adjustment

Weak internal demand growth and exchange-rate depreciation are improving Chile’s external accounts. Lower energy imports will likely more than offset the drop in copper external sales, leading to an even narrower current-account deficit in 2015.  

A helping hand from fiscal policy

Even with more fiscal and monetary stimulus, the recent weak activity numbers and lower copper prices led us to reduce our growth forecast for 2015.   

Oil prices erode the economic outlook

Due to the importance of the Oil sector in the economy, the peso has underperformed recently. We expect slower growth and a weaker currency in 2015 than we were previously forecasting.

Do not open until Christmas 2015

The government tries to buy time to postpone an adjustment in the exchange rate and interest rates. The strategy is aided by the proximity of the 2015 political change and potential capital inflows.    

No action, no rebound

In the absence of a reaction by OPEC to lower oil prices, we now forecast a Brent crude oil price of USD 70/bbl in 2015, so as to balance supply and demand.  We have also lowered our price forecasts for iron ore and copper, after incorporating lower cost assumptions and evidence of inventory accumulation.

Lower Commodities prices, weaker growth in Latin America

The drop in oil prices, mainly driven by supply issues, is positive for global growth. One of the main beneficiaries, in the short term, is likely to be the U.S., whose economy  is already showing a  good recovery compared with the rest of the world. The drop in oil prices further reduces inflation around the world, adding pressure on central banks that are struggling with inflation below their targets, such as the BoJ and ECB. Thus, the decline in oil prices reinforces the strong dollar trend scenario.

In Latin America, the recent drop in oil prices affects oil exporters like Colombia and helps importers like Chile. Over the medium term, the drop in oil reduces the value of oil reserves in Argentina, Brazil and Mexico.

Because the production of commodities is intensive in the region, declining prices of oil and other products such as iron ore, copper and grains bring significant challenges. The less-favorable external environment and the recent slowdown of activity in the region led us to reduce our growth forecasts in Brazil, Chile, Colombia, Mexico and Peru.

Most central banks in the region are on hold with respect to their policy rates (Brazil is the exception) and many are intervening in the market to smooth the FX-depreciation trend.

For 2015 onwards, we expect a gradual recovery of Latin American economies as they benefit from the recovery in global growth, led by the US.

In Brazil, high inflation, deterioration of public finances, the current-account deficit, and especially weak growth call for adjustments in the economy. The recent announcement of the new economic team is in line with our scenario of minimal (but not easy!) adjustments: We expect an increase in the primary surplus, further depreciation of the exchange rate, additional hikes in the Selic rate, the beginning of a hiking cycle in the BNDES’ long-term interest rate (TJLP). These adjustments are enough to prevent the deterioration of the economy and partially restore confidence; however, they are not sufficient to boost the growth rate significantly over the coming years


Global Economy

Oil decline supports global growth but pressures central banks

• The decline in oil prices is positive for growth and should help world GDP expansion to increase from 3.2% in 2014 to 3.4% in 2015.

• It also lowers energy prices and puts pressure on the BoJ and ECB, which are fighting low inflation.

• In the U.S., solid gains in the labor markets keep the Fed on track to raise rates in mid-2015.

• The scenario supports continuing USD gains against developed (we see the euro/U.S.-dollar rate at 1.10 for end-2015) and emerging-market currencies

• Emerging-market currencies face the additional challenge of lower commodities prices.

The decline in oil prices to about USD 70/bbl was the major development in the world economy in the final months of the year. OPEC’s decision to maintain supply shifted the burden to adjust about 1.2 mb/d in the global supply-demand balance to the demand and to non-OPEC producers. This is a substantial change in our view, and will keep oil prices around the current low levels in 2015.

We see the drop in oil prices as net positive for growth. We are not making major changes to our growth forecasts. We made only minor adjustments to our 2014 GDP forecasts in the U.S. (to 2.3% from 2.2%), Europe (to 0.8% from 0.7%) and Japan (to 0.2% from 0.9%) due to realized data. For 2015, we changed only Japan (to 1.2% from 1.0%). We left China unchanged (2014: 7.4%; 2015: 7.0%). But the decline in oil prices make us more confident that world growth will increase from 3.2% in 2014 to 3.4% in 2015.

However the fall in energy prices adds pressure on the European Central Bank (ECB) and the Bank of Japan (BoJ), which are fighting against low inflation. The latter has already increased its asset-purchase program and we now expect the former to follow in March.

Even in China, the decline in inflation together with persistent headwinds to activity has led the PBOC to adopt broader-based monetary easing.  

The case of the U.S. Fed is different; the growth impulse is more important than the transitory impact on inflation at the moment. Hence the Fed remains on track, in our view, to raise interest rates in June 2015. Good growth pace, solid gains in the job market and tentative signs of firmer wage inflation sustain our call for a mid-2015 rate increase.

This scenario is supportive for the USD to continue to gain ground against developed and emerging market (EM) currencies in 2015. For EM, although we don’t expect further declines, commodities prices should remain close to the current low levels and remain a risk next year. 

U.S. – the Fed likely to start raising rates in June 2015 and the risk of a later increase is fading

We expect a temporary moderation in GDP growth to 2.5% qoq/saar in 4Q14, compared with our previous expectation of a strong 3.9% in 3Q14. This modest deceleration is mostly due to inventory adjustments.

The increase in households’ real disposable income from the oil-price decline reduces the downside risks to our 3.0% GDP forecast in 2015. We incorporated a USD 20 decline in the price of oil relative to last month. This is equivalent to a push of 0.2pp to 0.3pp to US GDP in 2015, concentrated in the first half of the year. It is true that a stronger U.S. dollar affects net exports and offsets this positive impulse from oil. The trade-weighted U.S. dollar continues to appreciate. In addition to the gains against the euro and the yen due to divergent monetary policies, lower oil prices harm Canada and Mexico, two of the major U.S. trading partners. Nonetheless, the stronger domestic demand makes us more comfortable about the U.S. economic outlook.

We revised our 2014 GDP forecast up to 2.3% (from 2.2%) due to better data in the third quarter and maintain 3% for 2015.

With growth maintaining its good pace, the labor market continues to improve. The non-farm payroll growth averaged 258 thousand in the last six months to November, a pace that pushed the unemployment down to 5.8% from 6.1% in the period.  

Meanwhile, the impact of the oil-price drop on inflation is likely to be temporary. We expect the headline PCE deflator to fall below 1.0% yoy by mid next year. However, we estimate only a modest impact on the core PCE deflator, which should remain stable at 1.5% yoy for a while longer. Besides, we expect more evidence of firmer wage inflation to emerge in the first half of 2015, as the unemployment rate should average 5.6% in the period.

We continue to believe that the Fed will start to raise rates by June 2015. Given the expected low headline inflation in the first half 2015 and still-low wage inflation, the Fed is likely to remain patient in the short term. But the improving outlook for the U.S. economy is consist with the first rate hike in June 2015.

Moreover, the risks around the June 2015 start date are becoming more symmetric instead of tilted to a later start of the hiking cycle. The solid gains in the U.S. job market and tentative signs of firmer wage inflation are a welcome and wanted progress for the Fed.

Hence, we believe that the Fed will recognize all these developments and adjust its forward guidance in its December 17 meeting.  More specifically, the FOMC is likely to drop the “considerable time” from its guidance of how long the short-term rates will remain at the current range. This is consistent with the recent communication from the FOMC members. For example, the Fed Vice Chairman Stanley Fischer said that “we are closer to getting rid” of the statement that the FOMC is likely to keep short-term rates at the current range for a “considerable time.” Fischer also added that they “don’t want to surprise the markets.” With the adjustment in language, we think the Fed will aim to give markets time to prepare for the coming start of rate-hiking cycle.

We continue to expect U.S. yields to increase from current market prices. We see the 10Y treasury yield at 2.40% and 2.90% at the end of 2014 and 2015, respectively.

Europe – The ECB is slowly moving towards a government-bond purchase program

The ECB moved closer to government-bond QE in its December meeting. The central bank again lowered its inflation forecasts and said that the new figures do not fully incorporate the recent decline in oil prices. The statement showed a stronger commitment to expanding the balance sheet by saying it was an “intention,” compared with an “expectation” previously. While there are still signs of resistance in the governing council, Mario Draghi made clear that they would be willing to push through such a policy even without a unanimous vote.

Meanwhile activity data have been mixed and suggest only modest growth this quarter. The composite Purchasing Managers’ Index (PMI) fell to 51.1 in November, compared with a reading of 52.1 in October. The current level suggests growth at around 0.15% qoq in 4Q14, similar to 3Q14.

We see a modest pick-up in activity in 2015. Lower oil prices and an expected depreciation of the exchange rate (we see the euro/U.S. dollar rate at 1.10 for end-2015) should provide some support -to activity in the coming year

Nonetheless, headline inflation will continue around 0.3% yoy in 1H15, keeping long-term-inflation expectations dangerously below the ECB’s 2% inflation target. The oil shock is depressing headline inflation further. With poor growth and a weak labor market, the prolonged period of low inflation is affecting long-term-inflation expectations in the euro area.

We now think the ECB has to further ease its monetary-policy stance, and that it will start buying government bonds in March 2015. With interest rates effectively at their lower bound, the U.S., Japan and the United Kingdom have mostly relied on balance-sheet expansion to ease their monetary policy. The institutional and political environment in the euro area makes it harder for the ECB to follow the same path. But the prolonged bleak inflation outlook will end up forcing the central bank to act and balance sheet expansion is the only tool left. We have seen progress in this direction in the December meeting (see above) and now expect an announcement in the March meeting. By then, the central bank will have had the time to assess the impact of the several measures it took in the second half of the year – and which we don’t see as having enough an impact to avoid more action.

We slightly raised our 2014 growth forecast to 0.8% from 0.7% due to revisions in past GDP data, and maintain 1.0% for 2015.

Japan – Adjustments to keep Abenomics alive.

With the economy struggling to recover from the VAT hike back in April and oil prices pulling inflation down, Prime Minister Abe and the BoJ took steps to keep Abenomics alive.

First, the BoJ surprisingly announced an expansion of its qualitative and quantitative easing in October in order to maintain expectations that inflation can move towards 2% (the first “arrow” of Abenomics).

Then Prime Minister Abe decided to postpone the second VAT hike (initially planned for next year) to avoid further damage to the economy. This has raised doubts about the promised robust fiscal adjustment (the second arrow of Abenomics) and led Moody’s to downgrade Japan’s sovereign debt. The postponement is for 17 months, and if it succeeds in boosting the economy it could at the end be net positive for the debt dynamics.  

Finally, to confirm the popular support for his economic policies, Abe decided to call a snap election. If his party maintains the majority in congress, the elections could give another push for the implementation of structural reforms (the third and most difficult arrow of Abenomics).

In response to these unexpected measures, the yen depreciated and the Nikkei stock exchange has gained ground in the past couple of months (see graph). We forecast the exchange rate at 120 and 125 by year end 2014 and 2015, respectively.

We revised our 2014 growth forecast from 0.9% to 0.2% but we increased it to 1.2% from 1.0% in 2015.

China – A change in the monetary policy approach

Economic activity entered 4Q14 at a soft pace, affected by a temporary shutdown of factories. Industrial production growth slowed to 7.7% yoy in October from 8.0% in the previous month, and other indicators also suggest a slowdown. The temporary shutdown of factories near Beijing to improve air quality for the APEC Summit between November 7 and November 11 is likely to have affected October and November results.

Despite this one-off factor, the activity momentum in China is indeed weak. The property sector remains a headwind for growth (despite the marginal improvement since October) and credit growth still must slow down. The external environment has been mixed, as a lower demand outlook is offset by favorable terms of trade with lower crude oil and iron ore prices.

Inflation has been declining and reached 1.4% in November (compared to 2.3% back in June). The decline is affecting inflation expectations and increasing real interest rates.

In this environment, the PBOC lowered the one-year lending rate to 5.6% from 6.0% and the one-year deposit rate to 2.8% from 3.0% on November 21. This is the first cut in these medium-term interest rates since 2012. Despite hurting banks’ profitability, the cuts offset the increase in real interest rates, and will benefit mortgage and corporate borrowers.

It is true that the interest-rate cuts were partly offset by giving banks more flexibility on how much they can pay for deposits. Banks can now offer deposit rates at 20% above the benchmark rate, up from 10%. Hence, the upper band for the deposit rates is left unchanged at 3.3% and reports suggest that banks have left interest rates unchanged. The central bank has also removed the benchmark guidance for the five-year savings rate and has said that it will continue the orderly liberalization of deposit rates. 

In addition, policymakers reiterated after the cut that there is no need to adopt strong stimuli for the economy and that they won’t change the prudent monetary policy stance.

Nevertheless, we see the rate cut as a change to more broad-based monetary easing compared with the more-targeted measures implemented during the year. We expect additional interest-rate and reserve-requirement-ratio (RRR) cuts ahead. The next move could be an RRR cut still this year, to replace the RMB 500 billion liquidity injected by the PBOC’s relending program, which is due on December 17.

We maintain our growth-moderation scenario unchanged, with GDP growth at 7.4% for 2014 and 7.0% for 2015. Neither the rate cut nor the temporary shutdown of factories is enough to change our growth forecast for 2014. Looking ahead, the positive shock in terms of trade and adjustments in monetary policy can reduce downside risks, but not increase growth in 2015. Instead, we consider that these factors will improve the government’s room to maneuver, allowing it to advance reforms further.

Commodities – OPEC decision leads to another drop in oil prices

The Itaú Commodity Index (ICI) has declined by 10.0% since the end of October, driven again by lower oil-related prices. Iron ore and copper prices also fell, both affected by a combination of oversupply, worse demand prospects and lower energy costs. Meanwhile, the agricultural sub-index has risen slightly by 2.7%, but is not showing any clear trend given the absence of relevant news. The ICI now registers a cumulative 25.8% drop year-to-date.

Brent crude prices dropped to USD 70/bbl from USD 85/bbl in mid-October following OPEC’s decision to maintain current supply. The decision came after a long-awaited regular meeting of the cartel on November 27 and surprised investors, who expected some adjustment to offset the surplus of around 1.2 mb/d in the global supply-demand balance.

Even though a coordinated supply cut may be negotiated in the coming months, our base case moved towards a scenario of no coordinated reaction.

In this new reality, we estimate that Brent prices need to remain at USD 70/bbl (previously at USD 95) in 2015 to balance supply and demand. The adjustment comes from higher demand and lower supply growth, mostly from non-OPEC producers in response to lower prices.

We have lowered our year-end 2015 ICI forecasts by 13.3 pp. In addition to oil prices, we also lowered our iron ore and copper forecasts. Our new forecasts imply stable prices in 2015, when compared with current levels.


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

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