Itaú BBA - Stability, but for how long?

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Stability, but for how long?

October 11, 2016

Global economy remains stable. But risks for the global economy have increased and should be monitored closely.

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

Global Economy
China stability likely to extend into 2017, but global risks have increased
In China, recent stability tends to extend into 2017, as political transition favors growth-friendly policies and housing is no longer a drag. But risks for the global economy have increased.

Mexico decouples from the South
As inflation is falling, monetary policy stances are becoming more expansionary in Latin America. The only exception is  Mexico, where the central bank is raising interest rates to support the peso.

The reforms begin
The fiscal reforms definitely take central stage. Approval of those reforms is critical to pave the way for a long monetary easing cycle and for a sustainable economic recovery.

Resetting targets
Argentina’s central bank has set an inflation target for 2017: a range of 12%-17%. This target still looks ambitious, given the likely inertia in wage negotiations and potential new increases of regulated prices.

A Rally Coming?
We expect the Mexican peso to strengthen to 17.5 to the dollar before the end of this year, if Trump loses the U.S. presidential elections.

Less fiscal support, more monetary stimulus
A tighter budget for 2017 means less support for a faltering economy. However, faster disinflation will allow the central bank to cut the policy rate by 50 basis points next year.

A fast track to structural reforms
Congress has granted President Kuczynski a 90-day period of fast-track authority to implement structural reforms on economic activity and formalization, domestic security, corruption, water and sanitation, and the national oil company.

Elusive peace
The Colombian population rejected the peace deal with FARC in a referendum. This result raises uncertainty about the next steps in the peace process, the future of a necessary structural tax reform, and the economy.

OPEC surprises
The promise of production cuts by the cartel reinforces our outlook for oil trading for USD 50-55/bbl in 2017, but increases the chances of price overshooting if the cut materializes and the reaction by U.S. producers takes longer to stabilize global markets.


Stability, but for how long?

Global economy remains stable. Steady albeit somewhat lackluster growth has marked the global economy this year, which has become the norm since the global financial crisis. The U.S. continues to grow moderately, reducing the likelihood of both recession and overheating scenarios. The monetary-policy stance also remains expansionary in other G7 economies. In China, recent stability tends to extend into 2017, as political transition favors growth-friendly policies and housing is no longer a drag, among other factors. Thus, the external environment continues to be supportive for EM assets.

But risks for the global economy have increased and should be monitored closely, as they might signal a sudden deterioration in the environment for EM assets. At the moment, the mains ones are: i) the U.S. elections; ii) the market reaction to the probable Fed hike in December, as well as to signs that monetary policy in advanced economies may turn, for a variety of reasons, less accommodative; and iii) political and financial issues in Europe.

As yet, LatAm currencies continue with a solid performance year-to-date. Some depreciation is expected going forward, as the Fed raises interest rates. We continue to expect an economic recovery next year in the region, largely led by Argentina and Brazil.

Because of the more favorable evolution of currencies and a negative output gap, inflation is falling in many LatAm countries. In this context, monetary-policy stances are becoming more expansionary, except in Mexico, where the central bank is raising interest rates to support the peso.

In Brazil, the fiscal reforms definitely take central stage. In October, the Lower House will vote on the constitutional amendment of the spending cap. The government will then send a Social Security reform bill to Congress. In our view, approval of those reforms – which remains our baseline scenario – is critical to pave the way for a long monetary-easing cycle and for a sustainable economic recovery. We continue to see the Central Bank cutting the Selic rate by 25 bps in October, and GDP growing 2.0% in 2017.

We count on the global environment remaining broadly EM friendly in the forecast horizon, but cannot fail to note that a combination of risk factors might create new challenges for EM countries in general, and LatAm in particular.


Global Economy
China stability likely to extend into 2017, but global risks have increased

• We expect the recent stability in China to extend into 2017 as i) political transition favors growth-friendly policies; ii) housing is no longer a drag and macro prudential policies seem enough to prevent localized signs of overheating; iii) deflation is subsiding; iv) the exchange rate is closer to fundamentals; and v) credit ratios are high, but still manageable. We raised our GDP forecasts to 6.6% from 6.5% in 2016 and to 6.3% from 6.0% in 2017.

• Activity in China and low interest rates in developed economies maintain a favorable external environment for EM assets. 

• But risks for the global economy have increased. At the moment, the mains ones are: i) the U.S. elections; ii) the market reaction to the probable Fed hike in December; and iii) political and financial issues in Europe.

China – Stability to extend into 2017

The recent batch of economic data shows stability. Industrial production rose to 6.3% yoy in August from 6.0% in the previous month, retail sales improved to 10.6% yoy from 10.2%, and fixed investment accelerated to 8.2% yoy from 3.9% in the same period. The PMIs suggest that this favorable performance is likely to continue in September. In addition, inflation dynamics have been benign, and both capital outflows and the pace of RMB depreciation have slowed considerably. All these factors helped to reduce investors’ concerns with the economy, despite all the medium-term challenges due to mounting debt and banks’ bad assets.

Looking forward, we expect this growth stability to continue until 2017, for five reasons. 

First, the leadership transition in 2017 will cause the government to focus on short-term growth by maintaining strong infrastructure investment. The government is also signaling tax cuts, while risky reforms are being postponed.

Second, the real estate sector will be neutral to positive after being a drag 2015. The sector underwent an important inventory adjustment between 2015 and 1H16, and strong year-to-date sales should lead to a strong pace of new constructions for a while.

Overheating in the housing market could be a worry, but the issue seems to be localized and macro prudential policies might be enough. House prices in major cities have been rising too fast (see chart), raising some concerns about the whole sector. However, the process is being addressed by a combination of a cautious policy stance by the PBoC and local governments issuing prudential measures. These measures tend to influence the pace of sales and activity in the cities affected. Nonetheless, this localized cooling-off will not be enough to depress activity in the whole sector to a lower pace than overall economic growth.

Third, the narrowing of PPI deflation is likely to continue ahead. This move is helping to increase industrial profits, not only improving the ability of companies to repay debt but also allowing stronger investment without increasing financial leverage.

Fourth, the CNY is better adjusted to fundamentals and has weakened 8% on REER terms since its peak in early 2015. This could help exports and improve fixed investment in the manufacturing sector.

Finally, the risks related to rising credit/GDP and hidden NPLs will need to be addressed one day, but we believe that this adjustment can and will be delayed until 2H17 or later. There are indeed several signs of bad assets within the banking sector. However, the funding structure of banks – strongly reliant on domestic deposits and core capital – suggests that there is no trigger for a short-term adjustment, and the strong debt growth partially reflects strong domestic savings.

We are revising our GDP growth forecasts upward for 2016 (to 6.6% from 6.5%) and 2017 (to 6.3% from 6.0%).

U.S. – Focus on elections now, and on the Fed latter.

The FOMC left the Fed funds rate unchanged in September but signaled that a hike is likely before year-end. The meeting’s statement said “the case for an increase in the federal funds rate has strengthened but [the Committee has] decided, for the time being, to wait for further evidence of continued progress toward its objectives.” Three FOMC members already dissented in favor of a rate hike, and all but three participants see at least one rate hike in 2016.

We agree that economic and financial conditions should allow a rate hike, but probably only in December. Economic data improved in September from weak August data, remaining consistent with a moderate GDP growth forecast (3Q16: 2.9%; 4Q16: 2.2%) in the second half. Both ISM surveys rebounded to modestly above 50. The non-farm payroll grew 156k, close to its six-month average (169k per month). In addition, the core PCE deflator rose to 1.7% yoy in August, consistent with 1.75% yoy in 4Q16 and an improvement from the 1.6% average seen in 1H16. However, we don’t believe that the FOMC will raise rates at its next meeting, just six days before the U.S. presidential election.

Before the Fed, the U.S. election is a bigger risk.

A victory by Hillary Clinton is the base case, but the presidential race has remained relatively tight and subject to the surprising turn of events. Hillary Clinton’s average lead over Donald Trump in national polls rose to 8 pp in early August, after the Democratic National Convention. It then fell to about 2 pp in late September, after Hillary Clinton called Trump supporters “deplorables” and got sick during the 9/11 memorial event in New York City. After the first presidential debate, Clinton’s lead surged to 4 pp in mid-October.

If Clinton wins, we expect no major change in the economic outlook. She has been supporting a temporary increase in public investment of USD 50 billion per year over the next five years, but it is to be partially financed by higher taxes on wealthy individuals, so the net fiscal stimulus should be relatively small. Economic-policy uncertainty should decline, allowing the Fed to hike in December.

In the event that Trump gets elected, anti-trade foreign policies, big fiscal stimulus, and a more-hawkish Fed create risks to emerging markets. The short-term market reaction may be a typical risk aversion amid higher economic policy uncertainty. We expect the yield curve to bear-steepen and the U.S. dollar to appreciate. EM currencies should suffer.

On foreign policy, Trump promises to renegotiate free trade agreements (FTAs), including the NAFTA, and to raise import tariffs from Mexico and China. It should be noted that U.S. presidents can change FTAs without approval of the Congress, after a six-month notice to the involved trading partners.

Trump has also proposed a big fiscal stimulus, which would increase the federal government debt by USD 5 trillion over ten years. His plan is to cut taxes for individuals and corporations and raise government infrastructure spending by USD 100 billion per year over the next five years. It seems reasonable to suppose that his fiscal proposal, especially the tax cuts, would end up being significantly trimmed by Congress. However, his fiscal policy should be more expansionary than Clinton’s. It is worth mentioning that if he wins, the Republicans are likely to retain the majority in both houses.

Last, Trump has repeatedly promised to replace the Fed’s chair Janet Yellen, whose mandate ends on February 2018. At this stage, Trump’s choice to replace Yellen is not yet known. However, it seems quite plausible that Trump will find a more hawkish economist who can be approved by the Congress.

Despite the Trump risks, we still expect Clinton to win and hence we estimate U.S. GDP growth of 1.5% in 2016 and 2.2% in 2017.

Europe – Political and financial risks 

Political risks are accumulating in Europe. In the UK, Prime Minister Theresa May has announced her intention to trigger Article 50 by March 2017. The discussion now centers on whether there will be a “hard Brexit,” whereby the UK gives up access to the EU’s single market in exchange for more control over immigration. In Spain, the leader of the center-left party PSOE has been forced to resign following poor results in regional elections. His resignation clears the way for a minority center-right government to be formed. However it will likely be a weak government. Moreover, Catalonia has announced that will hold an independence referendum in September 2017. Finally, Italian Prime Minister Matteo Renzi has announced the Referendum on Constitutional reform to be held on December 4. Though he has backed down from resigning in the event of a loss, a defeat in the referendum would hinder his government support and make the passage of necessary structural reforms difficult.

Meanwhile, the European financial system remains under pressure. Bank stocks are close to their minimum levels (see graph). The financial sector faces challenges from slow economic growth, negative or very low interest rates and, in some cases, outdated business models and litigation risks. Although we believe that the European financial system is better capitalized and has ample liquidity when compared with the financial crisis, low bank profitability can hinder effective monetary-policy transmission and is a downside risk to the economy.

We maintain our GDP forecast for the euro area at 1.5% and 1.3%, respectively, for 2016 and 2017

Japan – BoJ shifts focus to the yield curve to gain flexibility.

The Bank of Japan (BoJ) has adopted a “new” framework called “QQE with Yield Curve Control” following its latest monetary policy meeting. The framework moves away from bond purchases to focus on yield levels. It allows the BoJ to maintain an accommodative stance for longer while avoiding unintended consequences of very low yields in long term bonds. The BoJ will now target the 10-year bond (around 0.0%), while maintaining the short term rates at -0.10%. The BoJ also kept the JPY 80 trillion pace of JGB purchases, but with a higher degree of flexibility. Future policy easing will focus on further interest-rate cuts while JGB purchases will likely slowdown.

We raised modestly our GDP forecast to 0.6% from 0.5% in 2016 due to an upwards revision on 2Q GDP growth (from annualized 0.2% to 0.7%) due to stronger investment figures. We kept it at 0.7% in 2017.

Commodities – OPEC surprises

The Itaú Commodity Index (ICI) extended gains in September, rising 7% from the end of August and leading the year-to-date growth to 19%. Most commodities rose over the period, with bullish surprises from both supply (e.g., OPEC promising a deal, mines closure in the Philippines) and demand (the rising confidence that China’s economy will remain stable for a while, better manufacturing PMIs in the world). The two notable exceptions were soybeans (flat) and iron ore (-7%), two of the most important products to Brazil’s exports.

Despite the recent decline, we are revising our iron ore prices upward for 2017 to USD 48/ton from USD 45. We see a more steel-intensive growth in China due to strong growth in infrastructure investment and less supply increase from now on. We are also raising our nickel forecasts due to the ongoing closure of mines in the Philippines. The net adjustment is a 3.5% increase in the ICI-metals forecast for the end of 2017.

OPEC members act to reduce downside risk to oil prices. The cartel surprised the market and announced a preliminary deal to cut oil output. There are some missing details and the actual supply adjustment will only take place after the formal meeting on November 30, but the new strategy is indeed bullish for crude oil prices, which should trade around USD 50/bbl until the final announcement. We maintain our forecasts for Brent prices at USD 54/bbl for year-end 2017, as the breakeven cost of shale-oil suppliers will still be the driver of equilibrium regardless of a lower OPEC supply. Nonetheless, the incoming deal will increase the risk of price overshooting and lower the downside risk in the next quarters considerably.

The ICI-agricultural rose 8% from the end of August, driven by sugar extending year-to-date gains, and corn and wheat prices partially recovering from strong declines in August. We are revising our coffee price upward to include weather-related shocks for the supply in 2017, and see upside risks for sugar. Meanwhile, the overall outlook for grains/soybean remains the same: favorable 2016/17 crop in the U.S., strong incentives for increasing planted area in Brazil and Argentina in the next crop, and high global stocks.

Our estimates imply that the ICI will be stable by the end of 2016 from its current levels, and then rise by 3% in 2017.


Mexico decouples from the South

• Most latAm currencies continue their solid year-to-date performance, although we expect this rally to abate going forward as the Fed raises interest rates. The Colombian peso in particular is set to underperform, while Mexico’s peso could strengthen substantially should Donald Trump be defeated in the U.S. presidential elections.

• We continue to expect an economic recovery in the region next year, largely led by Argentina and Brazil.

• Because of the more favorable evolution of currencies and a negative output gap, inflation in the region is falling faster than expected in many countries. In this context, monetary-policy stances are becoming more expansionary, except in Mexico where the central bank is raising interest rates to support the peso. We now expect rate cuts in Chile and see more rate reductions in Colombia and Argentina than we were previously expecting.

Exchange rates well behaved almost everywhere

Most LatAm currencies continue to show a solid performance year-to-date. Lower uncertainty over the Chinese economy, the stabilization/recovery of key commodity prices and loose monetary policy abroad create a supportive scenario for emerging-market assets. The Brazilian real has continued to outperform, benefiting from a higher probability of meaningful fiscal reforms as well as high interest rates and a low current-account deficit. High interest rates in Argentina are also helping its currency, adding to the benefits of the political change. The regional exception is the Mexican peso, which continues to perform poorly, more recently influenced by the uncertainty over the U.S. presidential elections. 

We expect some depreciation of most LatAm currencies ahead, as the Fed raises interest rates. The Colombian peso is set to underperform given the country’s wide current-account deficit, uncertainty over the peace deal (Colombians rejected the agreement with the FARC in a plebiscite on October 2) and likely interest-rate cuts next year. On the other hand, we expect a strong appreciation of the Mexican peso from the current levels, contingent on a Trump defeat in the U.S. presidential elections. Higher interest rates in Mexico, progress on the fiscal-consolidation targets, recovering oil prices and improving external accounts (the trade deficit is narrowing at the margin) will also help to improve sentiment toward the currency. 

Still waiting for a recovery

Activity in the region remains weak, although signs of a recovery in Brazil continue to emerge. Lower inventories are already contributing to a recovery of Brazilian industrial production (although industry in August was weak, possibly affected by the Rio de Janeiro Olympics). Meanwhile, gross fixed investment posted a positive quarter-over-quarter rate in 2Q16 and we expect further strengthening, given ongoing corporate deleveraging and, more importantly, expected progress on fiscal reforms. In Argentina, which is also facing a recession, recent indicators suggest that output could be stabilizing. In Peru, the economy continues to expand at a solid pace, although this is driven by supply-side factors (particularly the maturing of important mining projects). On the other hand, in Chile and Colombia the economies continue to slow. In Mexico, manufacturing exports are improving, which are likely to benefit other sectors given the openness of the economy. However, the tightening of macro policies (especially fiscal) and weak oil output (as many of the budget cuts are executed at Pemex) is a risk. 

We continue to expect an economic recovery next year in the region, largely because Argentina and Brazil would come out of their recessions. We expect a growth rate of 3.0% in Argentina next year, supported by higher real wages and strengthened business confidence. In Brazil, we expect 2.0% growth in 2017, following a 3.2% contraction this year. We also see somewhat higher growth in 2017, relative to 2016, for Mexico, Chile, Colombia and Peru.

Greater central bank confidence on the inflation outlook, but not in Mexico

With the more favorable evolution of the currency and negative output gaps, inflation in the region is falling. The dissipation of supply-side shocks, such as El Niño, is also contributing to bring inflation down in countries like Brazil, Colombia and Peru. In Chile and Peru, inflation is now within the range around the target (in Chile it is very close to the 3% target), while in Mexico inflation is slightly below 3%. In Brazil and Colombia, inflation is still far above the upper bound of the target, although disinflation was faster-than-expected in December. 

In this context, monetary policy stances are becoming more expansionary almost everywhere. The exception is Mexico, where the central bank continues to raise interest rates (by 50 bps in September) in a bid to support the Mexican peso. The minutes of the most recent policy meeting in Chile reveal a debate on the possibility of rate cuts. In Colombia, the tightening cycle has come to an end, but board members are containing the expectation of cuts. In Peru, the communication of the central bank indicates comfort with the inflation outlook, even though officially the monetary authority retains a tightening bias. Meanwhile, the central bank of Brazil is carefully setting the stage for an easing cycle. In the latest quarterly inflation report, the central bank outlined four scenarios for inflation (contrasting with the usual two). In two of the scenarios, the monetary policy committee presented inflation forecasts for 2017 at the 4.5% target, and in three of the four scenarios for 2018 inflation is at or below target (and is above target by just 10 bps in the other one). Faced with this set of forecasts, an inflation-forecast-targeting central bank is bound to reduce the policy rate. Finally, in Argentina the central bank recently confirmed that it will pursue an inflation target range of between 12% and 17% next year. Given that inflation expectations for next year in Argentina remain somewhat above 20%, the central bank decided to leave the Lebac rate unchanged in the last week of September.

Rate cuts (or further rate cuts) are likely in Argentina, Chile, Colombia and Brazil, while the central bank of Mexico will likely hike by more. We continue to expect an easing cycle in Colombia next year (we see the policy rate next year at 6.0%, compared to 6.5% in our previous scenario), though the outcome of the plebiscite on peace is now an additional source of uncertainty (the government may not be able to raise the VAT, or at least not raise it by as much as it was intending, and the currency could be weaker). Rate cuts are also likely in Brazil: we expect a 25-bp rate cut in October, followed by 50-bp cuts, bringing the Selic rate to 10% before the end of 2017. Additional rate cuts in Argentina this year and the next are also likely (by more than we were previously expecting, given the progress on disinflation), although it will be very challenging to meet next year’s inflation target. In Chile, we now see rate cuts totaling 50-bps in 1Q17, although there is risk for further cuts. In Peru, we forecast rates on hold for the rest of this year and in 2017. Mexico is the one country going in the opposite direction: although its central bank continues to forecast subdued growth and at-target inflation, its focus remains on the evolution of the currency and on the Fed decisions, so more rate hikes are likely as the Fed raises interest rates. We expect the next interest rate increase in Mexico in December (25 bps). A Trump win in the presidential race could mean earlier and higher interest rates.


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


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