Itaú BBA - Lower growth worldwide and in Latin America

Global Scenario Review

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Lower growth worldwide and in Latin America

July 8, 2016

Despite less global growth, the main drivers of more stable external environment for emerging markets remain in place.

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

Global Economy
Brexit doesn’t derail the emerging markets outlook

Despite the less global growth due the impact from Brexit, the main drivers of more stable external environment for emerging markets remain in place.

Digesting the impact of Brexit

Exchange rates in Latin America have been volatile since the Brexit vote, but without a clear trend. The more-benign evolution of the exchange rates relative to 2015 will continue to ease inflationary pressures.

Fundamentals improve, but fiscal progress is still lacking

The economy continues to adjust, but public accounts continue to deteriorate. A stronger and sustainable economic recovery depends on the approval of fiscal reforms, especially on the expenditure side.

The recession deepens              

Coincident indicators show that the recession deepened in 2Q16. We now expect a GDP contraction of 1.6% in 2016. We left unchanged our 3% growth forecast for 2017.

Tighter fiscal and monetary policies amid slower activity

We have reduced Mexico‘s GDP forecasts for 2016 and 2017. Besides weaker data at the margin, our downward revisions are also related to our new forecasts for the U.S and tighter fiscal and monetary policies.

Activity continues to disappoint

Activity has weakened beyond expectations. We now expect GDP growth of 1.5% this year, below the 2.1% rate from last year, and 2.0% for 2017. Activity is being hindered by less fiscal support, low commodity prices and weak confidence.

Waiting for private investment

Peru is the only country in Latin America with a visible pick-up in activity, boosted by mining production and a rebound of public investment. We expect private investment to pick up, lifted by greater business confidence and infrastructure spending.

Peace deal is close

The Colombian government and the FARC guerillas are nearing a peace agreement after signing a historic ceasefire. President Santos is pushing for a final deal for this month, freeing the political agenda for the tax-reform debate.

Fundamentals support prices  

Positive fundamentals with lower supply and robust demand growth continue to contribute to the rise in commodity prices. We increased our soybean and sugar forecasts for YE 2016 and slightly reduced our oil forecasts, incorporating the impact of the Brexit.


Lower growth worldwide and in Latin America

Few believed it would happen, but the British voted to leave the European Union. Brexit is likely to take some time to conclude, but it has had an immediate negative impact on the European economy and, to a lesser extent, on the global economy. The world’s central banks, however, have responded with looser monetary policies, which will likely limit any financial contagion from Brexit. We expect the European Central Bank to expand its quantitative easing program and the Fed not to hike interest rates this year. Apart from Brexit, China’s ability to rebalance its economy while avoiding a sharp deceleration remains a significant risk for emerging economies.  ‎

Latin American exchange rates have been more volatile since Brexit, but with no clear trend.  Regardless of global events, regional growth has been disappointing, leading us to reduce our GDP growth forecasts this year for Mexico, Chile and Argentina. Next year, we expect a rebound, especially in Brazil and Argentina.

The positive evolution of the exchange rate compared with last year, coupled with weaker growth, has reduced inflationary pressure throughout the LatAm region, allowing for a less conservative approach to monetary policy. The central banks in Chile and Peru are gradually moving away from monetary policy tightening. The central bank in Argentina has been cutting interest rates after the large hike at the start of the year. In Colombia, where the inflation outlook is more challenging, we expect another interest rate hike before the end of the cycle. In Mexico, the central bank again tightened monetary policy in response to the sharp currency depreciation. We do not expect further interest rate hikes in Mexico this year, unless the currency continues to depreciate.

The Brazilian economy is adjusting, with external accounts improving and industrial inventories falling. Inflationary pressures and the inflation expectations  continue to fall in a trend supported by the central bank’s more cautious approach. Business and consumer confidence have started to improve. Public accounts, however, continue to deteriorate. A stronger and more sustainable economic recovery depends on congressional approval of fiscal reforms, especially on the expenditure side.


Global Economy
Brexit doesn’t derail the emerging market outlook

Brexit increases uncertainty in Europe. We reduced our GDP forecast for the euro area to 1.3% from 1.7% in 2017. The spillover to other regions is moderate: we lowered GDP in the U.S. to 1.9% for both 2016 and 2017, down from 2.0% and 2.1%, respectively. In Japan we now expect GDP at 0.3% in 2016 and 0.7% in 2017 compared with 0.4% and 0.9% before. 

For China, the challenges remain domestic ones. We see a muddle-through scenario, which requires further policy easing. We maintain our GDP forecast at 6.5% in 2016 and 6.0% in 2017.

We lowered our GDP forecasts for the world economy to 3.1% from 3.2% in 2016 and to 3.3% from 3.6% in 2017. 

Despite lower global growth, we expect financial contagion from Brexit to remain contained, helped by accommodative monetary policy. We expect the European Central Bank (ECB) to extend its QE program and the U.S. Fed to remain on hold in 2016.

Less global growth is not positive for Emerging Markets (EM), but the impact from Brexit seems manageable. The main drivers of more stable external environment for EM remain in place: low interest rates for longer in developed countries, a muddle-through scenario in China and stable commodity prices.

Europe – Greater political and economic uncertainty will be a drag on growth

Given the result of the UK referendum, Brexit is moving forward. Despite calls for a second referendum, chances of it actually happening are slim. The successor to Mr. Cameron is likely to be a Leave supporter, given that the Tory party is largely in favor of Leave. The announcement of the next UK prime minister will come on September 9, and he or she will likely activate Article 50 of the Lisbon Treaty by early next year. From then on, it is a two-year process to take the UK out of the European Union (EU). Finally, the EU is unlikely to make concessions to keep the UK within it, as that would open a window of opportunity for unsatisfied members to threaten leaving in order to achieve similar benefits.

Brexit increases political and economic uncertainty in Europe for the next two to three years. The UK leaving the EU is important not just for the former but also for the latter. We see two possible scenarios over the next few years. The EU can emerge stronger, with a deeper fiscal and banking union, following the original European project. Or the political imbalances may increase due to Brexit, paving the way for more Eurosceptic/anti-austerity parties to gain support, which in turn will increase the already high political barriers that have been blocking reforms and sparking the anti-integration sentiment across Europe. We believe the weaker EU scenario is more likely. Italy’s constitutional referendum and the new presidential elections in Austria, both in October, will be the next tests.

Higher uncertainty will be a drag on euro-area growth. We incorporated two shocks into our econometric model for the region. First, a slowdown in UK to an average growth pace of about 0.8%-1.0% q/q saar from 2.0%-2.5% in 1H16. Euro-zone exports to the UK account for about 3.5% of its GDP. Hence the slowdown in UK subtracts close to 0.10 pp of the quarterly growth pace in the euro area. Second, greater political and economic risks will reduce confidence and increase volatility in Europe. We assume this shock to be around 25% of the euro crisis confidence impact of 2011-13. This subtracts, according to our estimates, another 0.05 pp from the euro zone’s quarterly GDP growth pace.

However, we expect financial stress to be contained by the ECB. The main financial risks are higher sovereign spreads in the periphery and a contraction in bank credit across the region. Both of these seem stable. The ECB’s QE and OMT programs mitigate risks to the periphery (see graph) and to corporate bonds. Ample liquidity provision from the central bank, including long-term lending at negative rates, limits the risks to banking sector. Better bank capitalization than during the 2011-2013 crises also helps. It is true that the banks’ stocks in Europe are at historic lows (see graph). But we see this as a natural reflection of deterioration of the macro outlook in the region and not a sign of a banking crisis. For the long term however, we are concerned that the lack of reforms may overburden the ECB, leading it to reach the limits of what its monetary policy can do.

We have revised our GDP forecast for 2017 down to 1.3% (from 1.7%), but we maintain our expectation of 1.5% for 2016.

U.S. – Fed on hold in 2016

The Brexit shock seems manageable, but the Fed will likely wait longer before resuming its gradual normalization of monetary policy. 

Even before the UK referendum, the FOMC was signaling that it wanted to verify that the recent slowdown in job creation is temporary. We think this is the case, and that payroll growth will recover to average 150-175k per month in 2H16. Nonetheless, the Fed will need a few of months to be sure that the labor market isn’t deteriorating.

The direct impact of Brexit on the U.S. economy is small. We estimate a drag of 0.3 pp on the GDP level by end-2017. This reflects lower growth in the euro area and a 5% appreciation of the trade-weighed U.S. dollar. We estimate the impact in the labor market outlook to be modest, given that the slower external-demand growth will mainly hit the manufacturing sector, with low impact on labor demand. We continue to expect the unemployment rate to decline to 4.6% by end-2016. In addition, we reduced the core PCE-deflator forecast by 0.1 pp to 1.7% in 2016, but maintained it at 1.9% in 2017. Finally, the 5% appreciation of the dollar that we forecast will likely come mostly in 2017, as we still assume that the Fed will increase interest rates twice next year while other major central banks, like the ECB, will continue in full expansionary mode.

Nonetheless, Brexit is another case where global risk spikes during a sluggish U.S. economic recovery, causing undesired tightening of financial conditions. The Fed is operating near the zero lower bound. Given that there is little room to accommodate negative shocks, the only alternative has been to delay the rate hikes. We think that the Fed will respond in the same way again.

We lowered our GDP forecast to 1.9% in both 2016 and 2017, from 2.0% and 2.1%, respectively. We also reduced our forecast for the Fed fund rates to 0.38% from 0.63% for 2016 and to 0.88% from 1.13% for 2017.

Japan – Yen appreciation is a risk to Abenomics

Brexit affects Japan’s economy mostly by causing an appreciation of the yen. As economic and political uncertain increases in Europe, the global economy itself becomes more fragile. As a consequence the demand for safe assets like the yen increases. The exchange rate was already under pressure to appreciate because of the strong current-account surplus, hedge demand from domestic investors and corporations– Japan’s net international investment position has increased to 70% from 50% of GDP in the past five years. The yen is also at historically weak levels in real terms. Finally, it seems that the Bank of Japan doesn’t have much room to add further stimulus to its extremely loose monetary stance. 

We revised our forecast for the yen against the U.S. dollar to 100 and 105 for 2016 and 2017, respectively, from 115 for both years.    

A strong yen poses two main downside risks to Japan’s economy. 

First, it could bring back the deflationary mindset, which the BoJ’s Kuroda and Prime Minister Abe are fighting against. A stronger yen could indeed reverse the rise in inflation seen in the last few years, and this might contribute to reduce the already-declining inflation expectations from consumers and companies.

Second, a strong yen could reduce corporate profits and investment. Recent surveys show that manufacturers’ confidence in the economic outlook is declining as the yen gains strength (see graph).   

We revised our GDP forecast down to 0.3%, from 0.4%, for 2016 and to 0.7%, from 0.9%, for 2017.

China – Muddle-through requires more stimulus

We see a muddle-through scenario in China, which is consistent with stability in commodities prices, no major capital outflow in the country and the RMB not being a destabilizing force to global markets. Industrial production and retail sales have been consistent with this scenario, remaining roughly stable in April and May, at 6.0% and 10% respectively. Moreover, the PMIs suggest that this stability will continue in June.

However this scenario requires well-structured policy support. Fixed investment disappointed and slowed considerably (see chart) due to weaker private investment. Unless the government provides additional stimuli, this weakness could derail industrial production in the 2H16.

We believe that an interest rate adjustment would be more effective to provide support to private companies. Other stimuli like fiscal spending, which expands infrastructure investments, or RRR cuts, which would increase the already-appropriate bank liquidity, seem less appropriate for reaching private manufacturers. CPI inflation fell to 2.0% y/y in May and the spike in food prices is fading – there is no inflationary pressure in the short term to worry the PBoC.

Hence, we foresee a 50-bp interest-rate cut coming as soon as July. We had penciled in a 50-bp cut in the benchmark interest rate (25 bps by the end of 3Q16 and 25 bps by mid-4Q16). However, we now think that support could come as soon as July. The Central Bank has already ordered banks to lend to private enterprises under the State Council guidelines. We don’t think that is enough, as the guidance might affect banks’ willingness to lend, but not the demand from private enterprises. Loan demand would increase with lower funding costs. Therefore, we expect a 50-bp cut to 3.85% (benchmark lending rate, 1 year) by the end of July.

We maintain our GDP forecasts at 6.5% and 6.0% for 2016 and 2017, respectively.

Emerging Markets – A favorable external environment despite lower global growth

We see a more-stable external environment for emerging markets this year compared to the intense pressure of the previous few years. First, the global rates remain at low levels and the U.S. Fed is consistent in recognizing that its normalization cycle will be gradual and shallow. Second, risks remain to the downside in China, and the pace of slowdown, capital outflows and exchange-rate misalignment seems more moderate this year. Finally, commodity prices are stable or up in the year, after a broad-based decline from 2013-2015. As a consequence, the terms of trade are stabilizing in the commodity exporters’ regions (see graph).

As a result, exchange rates in emerging markets are more stable and even appreciating in 2016. This year, according to our estimates, the U.S. dollar was down 3.5% against an equal-weighted basket of emerging-market currencies in 1H16, after rising 35% between 2013 and 2015.

With less external pressure, financial conditions are starting to improve in emerging markets. In 2014 and 2015, average long-term interest rates (5 years) in emerging markets were moving up despite the decline seen in developed countries. This year, helped by the stability in exchange rates, these rates started to decline in EM, following the new leg down in developed economies (see graphs)

Most emerging economies still face considerable domestic challenges, but at least the external environment, although still volatile, seems more favorable at the moment. 

Commodities – Resilience due to constructive fundamentals

Commodity prices rose further in June (3%, according to the Itaú Commodity Index – ICI), extending the rally to 18% year-to-date. Metals surprisingly outperformed the other groups and rose 8% without a clear reason (given our models). Meanwhile, oil-related prices rose 3% and the agricultural complex ended at the same level over the same period.

We revised some agricultural price forecasts upward and our oil-price scenario for the end of 2016 downward; metal-price forecasts remain unchanged. The adjustment to agricultural prices takes into account crop losses in Brazil, the outlook of drier conditions in U.S. reducing yields from now through the end of the year, and lower-than-expected soybean planted area in the U.S. These factors reinforce the outlook of falling global stocks over the 2016/17 crop year. We fine-tuned our Brent prices to USD 52/bbl from USD 55/bbl due to weaker growth in advanced economies and a stronger U.S. dollar following the Brexit.

Our scenario implies that our ICI will remain stable compared with current levels, with agricultural prices up 4%, energy up 3% and metal prices down by 9%.


Digesting the impact of Brexit

Exchange rates in Latin America have been volatile since the Brexit vote, but without a clear trend. We now expect the Brazilian real to end this year at 3.25 to the dollar. For the Mexican peso, we continue to expect an appreciation from the current levels, as we see the currency as undervalued.

• Recent activity data in Latin America disappointed. We have reduced our growth forecasts for Chile, Mexico and Argentina. However, we continue to expect growth in the region to improve in 2017 relative to this year, led by Brazil and Argentina.  

• The more-benign evolution of the exchange rates relative to 2015 will continue to ease inflationary pressures. In this context, the monetary-policy stance is loosening in many countries: the central banks of Chile and Peru are gradually abandoning the tightening bias, while the debate in Argentina and Brazil is on the size and/or timing of the easing cycle.  

Digesting the impact of Brexit


Exchange rates in Latin America have been volatile since the Brexit vote, but without a clear trend. The UK exit from the European Union means lower global growth, but we expect financial contagion to remain contained due to accommodative monetary policy abroad. In fact, comparing with early-June levels, most LatAm’s currencies are appreciating, with a strong overperformance of the Brazilian real. The real is helped by the expectation of an extended tight monetary policy, as well as greater optimism regarding the fiscal reforms. The outcome of the presidential elections in Peru helped the sol. On the other hand, the Mexican peso continues underperforming. The weakness of Mexico’s currency is likely related to a combination of low carry, high liquidity, risks associated with the elections in the U.S. and concerns over Mexico’s own fiscal accounts.

We now expect the Brazilian real to end this year at 3.25 to the dollar. For the Mexican peso, we continue to expect an appreciation from the current levels, as we see the currency as undervalued. The commitment of Mexico’s authorities to the currency (through fiscal, monetary and exchange-rate policies) combined with loose monetary policy abroad will likely recouple the Mexican peso with its fundamentals. For the rest of the currencies, we expect them to end this year somewhat weaker than current levels. For 2017, a small depreciation is likely throughout the region, as the Fed resumes rate hikes.

Activity remains bumpy

Recent activity data in Latin America disappointed and growth remains weak. Argentina’s economy continues to suffer the negative impact of the relative price adjustments, and the recession is deepening. In Colombia, the economy is also losing momentum, in spite of a recovery in manufacturing output driven by the oil-refining sector. There was also a sequential deceleration in Mexico, as manufacturing exports remain poor, contrasting with a still-strong trend of consumption. Uncertainty over domestic reforms and low copper prices continue to weigh negatively on Chile’s economy. On the other hand, leading indicators in Brazil have improved further and activity in Peru continues to benefit from the expansion of mining production and a rebound of public investment. We have reduced our growth forecasts for Chile, Mexico and Argentina. 

We continue to expect growth in the region to improve in 2017 relative to this year, led by Brazil and Argentina. Higher oil prices will benefit activity in Mexico and in Colombia. The recovery of U.S. industry (as the negative impact of the strong dollar and low oil prices fades) will also help Mexico. With uncertainty over reforms in Chile diminishing, some recovery in confidence is likely amid low real interest rates, lifting investment. Peru’s economy may also grow faster next year, as private investment becomes less of a drag, offsetting an expected slowdown in mining production. In the two countries currently facing recessions, Brazil and Argentina, the improvement in activity will be more meaningful. We expect the Brazilian economy to grow by 1.0% (compared to a 3.5% contraction this year) due to the ongoing inventory adjustment in industry, deleveraging and less uncertainty over public debt. Argentina’s economy is expected to grow by 3% in 2017 (vs. a 1.6% GDP decline in 2016), as the economic adjustments implemented this year bear fruit.

Monetary policy stance loosening almost everywhere

The more benign evolution of the exchange rates relative to 2015 will continue to ease inflationary pressures. Inflation in Chile, Peru and Brazil remains above the upper bound of the target, but is on a downward trend. Activity weakness also helps to bring inflation down in the region, although we note that in many countries the bulk of the slowdown is structural and unemployment rates haven’t increased much. This is certainly not the case in Brazil, where the unemployment rate is far above the lowest levels reached in 2014, with employment falling. However, in Colombia, inflation hasn’t peaked yet and it is now 4.6% above the ceiling of the target range, due to the impact of El Niño on food prices in addition to the past weakening of the peso. In Argentina, inflation has also surprised to the upside: besides the pressure from regulated prices, core inflation (which excludes regulated goods and services) is also higher than expected.

In this context, rate hikes in the region are becoming rarer. Although the central banks of Chile and Peru officially retain a tightening bias, the wording of the official communications suggests that the probability of additional rate hikes in both countries is low, given declining inflation and weak internal demand. We see both central banks leaving the policy rate unchanged at least until the end of 2017. In Brazil, the new governor of the central bank, Ilan Goldfajn, indicated that he wants to bring inflation to the target center in 2017. So, although we continue to expect rate cuts in Brazil starting in the second half of the year, the easing cycle will likely start somewhat later and more cautiously than in our previous scenario (we now expect rate cuts starting in October with an initial 25-bp rate decrease). In Argentina, which like Brazil is in recession with a tight monetary policy, the central bank continued to slash rates, supported by the expectation (shared by economic analysts) that inflation will fall sharply in the short term. In our view, the weak economic activity and the strength of the Argentine peso (especially in real terms) are also weighing in the central bank’s policy decisions and we expect more rate-cuts ahead. On the other hand, the outlook for inflation in Colombia remains challenging, and we now expect one additional rate hike before the cycle (which already totals 300 bps) ends. Should inflation in Colombia continue to surprise to the upside, more rate increases are possible. Finally, Mexico’s central bank continues to focus on curbing the weakening of the Mexican peso, increasing the policy rate by 50 bps in June and leaving the doors open for additional increases. We do not expect further interest rate hikes this year in Mexico, unless the poor performance of the exchange rate continues.


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


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