Itaú BBA - Markets improve, Latin America adjusts

Global Scenario Review

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Markets improve, Latin America adjusts

November 12, 2015

Concerns over global growth have eased in recent weeks.

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

Global Economy
The global economy shows signs of resilience
The world economy shows signs of resilience as growth in mature economies maintains a good pace, despite the slowdown in manufacturing and the emerging markets. As we expected, the Fed is set to move interest rates up in December.

Stabilization at last
The perception of lower risks for the global economy brought some relief for the region’s asset prices. Growth seems to have bottomed in some countries, but inflation remains elevated, mostly as a result of past depreciation.

No signs of economic stabilization
There are no signs of stabilization in production or demand. A growth rebound is conditional on the adjustment in public accounts, which is not happening. We reduced our GDP forecasts for 2015 and 2016.

Less linked to the Fed?
Weak growth, low inflation and the financial-market stabilization will likely lead the central bank to raise interest rates after the Fed does. We expect the central bank to raise the policy rate only in 1Q16.

Details of constitutional reform unveiled
President Bachelet announced the long-awaited details of the constitutional reform, one of her key campaign promises. The entire process will extend into the next administration, easing political tensions.

Slow recovery
Lower commodity prices are leading to a contraction of private investment. Meanwhile, the public sector is failing to fully implement the approved fiscal stimulus for this year, limiting growth.

A tougher policy response
In response to higher inflation and higher inflation expectations, the central bank increased its policy rate by 50 bps in October meeting, surprising most of the market. It also announced an exchange-rate intervention program. We expect a 25-bp rate hike in November.

Waiting for the runoff
Mauricio Macri’s performance in the presidential elections was much better than expected, bringing the dispute to a second round. Considering that net reserves are falling much faster than expected, a more “front-loaded” depreciation is likely.  

Still-Challenging scenario but sugar rebounds
The scenario for commodity prices remains challenging. Excess supply and concerns over China tilt the risks downward.The sugar market, however, is undergoing an idiosyncratic recovery.

Markets improve, Latin America adjusts

Concerns over global growth have eased in recent weeks. Mature economies have been growing, albeit moderately. In emerging markets, China has shown signs of stabilization, improving the balance of risks to the world economy. In this context, the Fed is on track to start hiking interest rates in December, as we anticipated. Going forward, the debate will likely shift to the pace of US rate hikes.

Latin American markets have also stabilized, benefiting from a more stable outlook in the global economy. Currencies appreciated, but they will likely start  depreciating moderately over time again, as U.S. interest rates increase. Inflation remains pressured by FX, but the economic weakness leads to smaller rate hiking cycles. There are signs of recovery in most countries (Brazil is the exception), improving the outlook for 2016.

In Brazil, economic activity continues to decline, with no signs of stabilization. The renewal of growth depends on the rebalancing of public accounts, which has not occurred. Despite weaker activity, inflation remains under pressure, typical of a supply shock. Inflation tends to decline ahead, but the inflationary inertia and the FX depreciation will keep inflation at high levels over the next year. In this context, Brazil’s central bank extended the convergence horizon to 2017, which reduces the chance of new interest rate hikes in the short term. However, high inflation for longer will not allow interest rate cuts for an extended period. Meanwhile, the external accounts have been improving in response to a more depreciated exchange rate and weaker demand.

In Argentina, the opposition candidate Mauricio Macri is the current favorite in the presidential race. Argentina’s assets have been reacting positively, in the expectation of more integration with global capital (and goods) markets. But the challenges in correcting the existing distortions are significant. As reserves drop at a rapid pace, we expect further exchange-rate depreciation and an interest rate increase soon after the elections.

Global Economy
The global economy shows signs of resilience

• The world economy shows signs of resilience as growth in mature economies maintain a good pace, despite the slowdown in manufacturing and the emerging markets.

• As we expected, the Fed is set to move interest rates up in December. The impact on the market has been moderate so far, but the USD resumed an upward trend. The main debate now should shift to the pace of increases in the next two years.

• The ECB is set to act in December, given downside risks to the inflation. We see its action as preemptive as the economy is showing resilience.

• In China, we expect growth to stabilize in 4Q15. However, this is an investment-credit led recovery, which is likely to be short lived. The scenario remains one of a gradual slowdown with downside risks. 

• In commodities, sugar prices rebound and risks in oil markets become more balanced. However the overall scenario remains unfavorable for most commodity exporters.  

The global economy shows signs of resilience

We reduced our estimate for world GDP growth to 3.1% in 2015, from 3.3%, as we have updated our forecasts for developing economies (ex-China and LatAm). With this revision, global GDP is slowing 30 bps this year from the 3.4% seen in 2014. The weakness is concentrated in emerging markets. In fact, we calculate that China (-4 bps), Brazil (-10 bps) and Russia (-14 bps) explain 90% of the deceleration in global GDP this year. 

However, fears of a deeper slowdown are exaggerated, as growth in the services sector and in developed countries remain resilient. Despite the investor’s fear (unjustified, in our view) that the global economy would drag the U.S. into a recession, the American economy will likely expand 2.4% this year, the same rate as in 2014. And both Europe and Japan are growing more in 2015 than they did in 2014. Developed countries are showing resilience to the weakness in emerging markets. Another related comparison shows that the services sector is maintaining its strength globally, despite the weakness in manufacturing. Indeed, the global Services PMI went up to 56.0 in October and is now 4.6 pts above the manufacturing PMI (see graph).

Next year, global growth will likely move back to 3.3%. This forecast for 2016 is in line with the 3.4% average seen between 2012 and 2014. We don’t see factors that could push growth higher than that, because developed countries are already having difficulty growing at current rates – China will continue to slow down, and other emerging markets still need find a growth model that relies less on commodities. But some of the deeper recessions in large emerging markets (like Russia) might ease, and global growth will likely maintain a modest expansion next year.

China will continue to post the main risk to the global economy in 2016, as it still has to rebalance its economy amid high debt levels in the corporate and local government sectors. India is one bright spot among the emerging markets and could grow above 7.0% for a few years. But China will remain the most important economy to the world (India’s contribution to world growth will equal about 50% of China’s until the end of the decade).

U.S. – The Fed debate shifts to the pace of rate increases in the next two years

Financial conditions in the U.S. have returned to levels that are more supportive to economic growth. As some of the extreme worries about a meltdown in the global economy abate, both the S&P 500 and the VIX have recovered from the weak levels seen in September (see graph). The USD has resumed an appreciation trend, but at a moderate pace, and overall financial conditions are better now than they were in September.

The labor market report for October provided further indication that economic conditions remain positive. The non-farm payroll has expanded 187 thousand on average in the last three months (see graph), well above the break-even level, which we estimate at 85 thousand per month, that would maintain the unemployment rate constant in the long run. The unemployment rate declined to 5.0% from 5.1% (see graph) and is now close to estimates of full employment. Although other measures of unemployment suggest that there is still some slack in the labor market, the average hourly earnings have accelerated to 2.5% YoY (from 2.3%).

In line with our view, the likelihood of a December liftoff is very high. Both the labor market and financial conditions confirm that domestic demand in the U.S. remains strong. 

To us, the main debate now should shift to the pace of interest-rate increases in the next two years. 

We estimate that the U.S. economy can withstand 100 bps in rate hikes per year, more than the 65 bps per year average that is currently priced in.

First, the economy will continue to grow at moderately above-trend pace next year. The 3Q15 GDP (1.5% qoq/saar) was weaker than we had expected, but mainly due to a stronger adjustment in inventory. Domestic demand continues to grow at solid 3% qoq/saar. Additionally, the U.S. congress approved higher federal government spending in the budget for 2016 and suspended the debt limit until March 2017, erasing an important source of economic uncertainty. We now foresee a slightly higher contribution from government spending in 2016. We reduced the U.S. GDP-growth forecast to 2.4% (from 2.5%) in 2015, but have revised it up to 2.3% (from 2.2%) in 2016

Second, we believe that inflation will get closer to the Fed’s mandate by the end of 2016. We foresee some appreciation in the trade-weighted U.S. dollar, but less than the 15% appreciation seen in last 12 months. That appreciation is responsible for holding the core PCE down despite the continuing decline in the labor market. As the strong dollar effect dissipates, the core PCE deflator should gradually increase from 1.3% in 4Q15 to 1.7% in 4Q16. In addition, if oil prices remain stable, the headline PCE deflator should converge to the core PCE deflator by the end of 2016.

The global economy remains the main risk, particularly for the inflation outlook. If the USD appreciates significantly more than the 4% we expect on a trade-weighted basis and/or oil prices fall again, core and headline inflation will likely remain weak and give the Fed less confidence to keep raising interest rates.

We forecast the yield of the two-year Treasury at 1.0% at the end of 2015 and 2.0% at the end of 2016. For 10-year yields, we forecast 2.4% this year and 3.0% next. These values, particularly for 2016, are above current market prices.

As the market adjusts the expected Fed fund-rate path, the USD resumed an upward trend (see graph) against emerging- and developed-market currencies. We think that this movement still has some way to go. But a large chunk of the USD increase might have already occurred, in our view. We expect the USD to appreciate a further 5% on a trade-weighted basis by the end of 2016.

Europe – The ECB is set to act in preemptively

We expect the ECB to extend the duration of its asset purchases and cut interest rates, given the downside risks to inflation. The central bank said that it will reevaluate the adequacy of its monetary stance in December. Downside risks to the inflation outlook remain significant, stemming from the large output gap in the region, possible further oil-price declines and currency appreciation in an environment of fragile inflation expectations. Given these downsides risks, we believe that the ECB will choose further action. We expect the central bank to extend the minimum duration of the QE program by six months to March 2017 and to cut the deposit rate by 10 bps to -0.30%.

We see the ECB action as preemptive, as the euro-area economy has shown resilience to the global and domestic risks. We note that this is different from 2014, when the ECB added stimulus progressively, culminating in the QE announcement last January. Back then, inflation and activity were slowing. Now activity remains resilient, with the latest PMIs and hard data pointing to a stable 0.4% qoq pace of growth. Easier fiscal and financial conditions are working their way through to the economy, despite global risks. Inflation is also showing a better picture, with core inflation increasing from 0.7% yoy in December 2014 to 1.0% in this last October. It is seems to us that the ECB is acting preemptively to avoid downside risks, rather than responding after some of these risks materialize. We see this combination of ECB action and a resilient economy as positive for risk assets in Europe.

Given the expected ECB preemptive action, we now see the euro at 1.05 (previously 1.10) at the end of 2015 and 1.02 (previously: 1.07) at the end of 2016. We leave our GDP growth forecasts unchanged at 1.5% in 2015 and 1.7% in 2016.

Japan – BoJ stays on course, but chance of further easing in 2016 remains

The Bank of Japan (BoJ) stayed on hold in its October meeting. The central bank lowered its inflation forecast but delayed the timeframe to reach its inflation target by six months, due to lower oil prices. The central bank now expects inflation at 2% around March 2017 and hence didn’t see a need for further stimulus.

We continue to see the BoJ on hold ahead, but risks for further easing next year remain. The BoJ sees a stronger slowdown in China and emerging markets as the main risk to its outlook of a moderate recovery. Growth and inflation expectations could be affected by these risks. The central bank sees the annual wage negotiations, which start in April next year, as important to achieve its inflation goal. If the global or domestic risks threaten wage negotiations, the BoJ could further easy its policy next January or April to strengthen the case for wage growth and avoid the return of the Japanese deflationary mindset.

We maintain our GDP forecasts at 0.6% for 2015 and 1.0% for 2016

China – Stability, for now

We expect economic growth to stabilize in 4Q15. First, the recent pickup in new construction is likely to cause some improvement in real estate investment. Second, infrastructure investment could also strengthen further following the recent increase in government expenditure. Third, overall credit growth has stopped slowing down, and some reaction from enterprises to lower interest rates is likely to affect other sectors as well. Overall, the batch of October data was in line with this scenario as an improvement in fixed investment and retail sales offset a small decline in industrial production yoy growth.

However, this is an investment/credit-led recovery and is likely to be short lived, and the scenario for 2016 remains one of a gradual slowdown with downside risks. The main constraint is the high leverage of the economy, which is likely to force credit (and investment) growth to decelerate further ahead, while the external sector has been (and is likely to continue to be) a drag on growth. In addition, the ongoing management of capital outflows and the CNY level reduce room for aggressive rate cuts. Meanwhile, the labor market remains solid, increasing the government’s willingness to accept lower growth.

We revised our 2015 GDP forecast upward to 6.9% from 6.7%, and for 2016 to 6.3% from 6.2%. Our revision recognizes a better result this 2H15, without improving the outlook for future growth.

Commodities – Rebound in the sugar market

The Itaú Commodity Index (ICI) dropped a further 3.0% from the end of September, driven down by metals, natural gas and grains, but with higher agriculture prices and stable oil. The sugar price was the highlight of the month and rose 18%. Finally, oil prices remained near the levels seen in September, trading around USD 48-50/bbl.

We increased our sugar price forecasts, as the market shifts to a deficit and requires higher prices to increase supply in the next few years. We also adjusted our forecasts for natural gas and some metals, partly offsetting the positive impact from the review in the sugar-price scenario. The net effect was a 0.3 pp increase in our ICI forecast for 2016 year-end.

However the overall scenario remains unfavorable for most commodity exporters. We forecast that the ICI will increase 9.3% from current levels by the end of 2016. But this is a minor move compared to the accumulated decline of 29.8% 12 months. And risks for most commodity prices remain to the downside, with oversupply and ongoing concerns with China.

The oil market may be an exception, as risks to prices are becoming more balanced. The unstable geopolitical scenario in the Middle East, fueled by macroeconomic issues in Saudi Arabia and the other oil-producing regions, may affect oil supply in the region and cause a steep increase in prices.

Latin America
Stabilization at last

The perception of lower risks for the global economy brought some relief for the region’s asset prices, despite the growing probability that the Fed will start to raise interest rates in December. Intervention is helping to support currencies. At the same time, growth in many countries seems to have bottomed. Mostly as a result of past depreciation, inflation remains high almost everywhere in the region, and inflation expectations continue to deteriorate in some countries. Many central banks are raising interest rates or are about to start tightening monetary policy, but at the same time, they are signaling a modest cycle, as low economic growth is still a concern. In Argentina, the results of the presidential elections increased the likelihood of meaningful policy changes, bringing a positive reaction in domestic asset prices.  

As concerns over global economic growth eased, there was relief for exchange rates in the region in spite of the high probability that the Fed will raise interest rates in December. The better mood particularly benefited the Brazilian real and the Colombian peso – the two currencies that had been depreciating the most in the region. Both currencies have gained significantly against the dollar since the beginning of October. The remaining core currencies of the region have been more stable.

Intervention is helping to support the currencies. The central bank of Colombia announced an intervention program based on auctions of call options, likely a preemptive move to the Fed’s liftoff. The announcement contributed to the recent strong performance of the Colombian peso. Among the main central banks of the region, only the Chilean is not intervening now.

However, we expect exchange rates in the region to weaken from the current levels. In Brazil, where domestic uncertainties are unlikely to go away soon, and in Colombia, where the current-account deficit is too wide, a reversal of the recent gains is likely; we expect both currencies to underperform, even though we now expect less depreciation of the Colombian peso than in our previous scenario. Our forecasts for the other currencies of the region are unchanged.

Economic growth seems to have bottomed in most LatAm countries, but not Brazil. In Colombia, the deceleration has been less harsh than suggested by the deterioration of terms of trade, so we are revising our growth forecasts upward. In Peru, the recovery, boosted by the maturing of large mining projects, is ongoing but slower than we were expecting, leading us to reduce our growth forecasts. In Mexico, growth improved somewhat in 3Q15. However, it is not exports to the U.S., but rather private consumption and the stabilization of oil output that are contributing the most to the recovery. In Chile, the economy also picked up between 2Q15 and 3Q15. Meanwhile, the recent set of activity indicators in Brazil disappointed again, weakening the carry-over for 2016 further and hinting that activity stabilization (that is, zero quarter-over-quarter growth) will come later than we were previously expecting. As a result, we now see a deeper contraction of the Brazilian economy this year and next.

Inflation remains temporarily high in several countries. In Colombia, inflation keeps surprising on the upside, due not only to the first-order impact of the exchange-rate depreciation, but also to the impact of the El Niño weather phenomenon on food prices. In Brazil, inflation in October also rose further. In Peru and in Chile, inflation has moderated recently, but is still far from the target center. The exception is Mexico, where inflation reached a new low, in spite of the exchange rate pressure on tradable prices. With lower exchange-rate depreciation next year and low economic growth, we expect inflation in the region to fall by the end of 2016, but still remain above the target center.

Some central banks are raising interest rates, but weak growth will likely limit additional tightening. In Chile, the central bank started a tightening cycle in October, but continues to signal that the total cycle is unlikely to surpass 75-bps. In Peru, the central bank kept rates unchanged after a surprise 25-bp increase in September. Mexico’s central bank left the policy rate unchanged in October, as expected, but did not change the tone of its statement in spite of the harsher tone adopted by the Fed, suggesting that the board is open to raising interest rates after the Fed does. The central bank of Brazil is now aiming to bring inflation to the target center only by 2017, instead of 2016, indicating that additional rate hikes are unlikely. On the other hand, in Colombia, the upside surprises on inflation coupled with the further increase in inflation expectations led the central bank to hike by 50 bps, above the 25-bp increase expected by the market (and also above the 25-bp rate increase in September). We expect only one additional 25-bp rate hike in Chile and in Colombia (implying a policy rate 0.25% above our previous forecasts for Colombia). In Peru, we see another two 25-bp rate increases. In Mexico, we expect a tightening cycle to start only in 1Q16, after the Fed’s liftoff in December, contrasting with market expectations (which are for starting rate hikes at the same time as the Fed). The central bank of Brazil will likely stay put for the rest of this year and in 2016.   

In Argentina, the performance of the opposition in the presidential election was much better than expected, bringing the contest to a second round. Markets (for equities and credit) reacted very positively to the results of the election. The election results raised the probability of a more market-friendly administration, which would handle the economic distortions, let the private sector play a more significant role and reinsert Argentina in the international markets for goods and capital. Still, we note that the challenges are significant. The new administration will receive an economy in stagflation with an overvalued exchange rate, low reserves, a number of exchange-rate controls and a fiscal deficit approaching 6% of GDP (adjusted for central bank profits) mostly financed by the central bank, not to mention the legal dispute with the holdouts. In fact, we now see less room for postponing devaluation and we have adjusted our scenario accordingly. The new administration’s adjustments will have short-term costs on activity. In the medium-term they will pay off, and we expect a rebound of activity after 2016 with decreasing inflation.


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


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