Itaú BBA - Strong dollar and low oil prices globally

Global Scenario Review

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Strong dollar and low oil prices globally

November 11, 2014

November started on a similar note to October, with volatility in financial markets.

Global Economy
USD resumes its appreciation trend as the global growth scare wanes

The global growth scare that hit the markets in early October was exaggerated, in our view. The USD resumed its appreciation trend, including against emerging markets currencies.

Minimal adjustments going forward

Our scenario assumes a set of minimal adjustments needed to avoid economic deterioration, but they will not be enough to enable a vigorous growth recovery.

The future in the spotlight: Oil and security

Lower oil prices reduce the upside that the economy can gain from the energy reform. The disappearance of students in the State of Guerrero has reignited the feeling of insecurity.

The easing cycle ends

The central bank announced another interest-rate cut in October and removed the easing bias, indicating it is satisfied with the amount of stimulus already in place. Activity remained weak, while inflation rose further.

What happened to the latin tiger?

Activity continues to disappoint. While we reduced our GDP growth forecast this year to 2.5%, we still expect a mining-led recovery next year.    

Lower oil prices add a new challenge

Disappointing oil output is reducing the trade balance and lower oil prices will erode external accounts further. We now expect a wider current-account deficit and a weaker currency than in our previous scenario.

Less than minimal

The government is resisting to make the necessary adjustments in the exchange rate and interest rates. Instead, it strengthened controls, what will put more pressure on the informal markets and lower activity further.   

A new reality for crude oil

We lowered our price forecasts for some base metals and crude oil (to reflect OPEC’s declining market power). On grains, we believe supply risks will not materialize and prices are likely to fall again.

Strong dollar and low oil prices globally

November started on a similar note to October, with volatility in financial markets. Early last month, the market was considering the possibility of a new global recession and that the U.S. recovery would be threatened by difficulties in Europe and the rest of the world. Interest rates around the world dropped again in light of this prospect. Equity and commodity prices – especially oil – declined around the world.

The pessimism was exaggerated – as it often happens in periods marked by low confidence and high uncertainty. Over recent weeks, economic indicators again show a consistent recovery in the U.S. and a less-fragile rest of the world. The world economy is far from being poised to grow solidly, but is not on the verge of another recession either. Markets returned to the previous trend. The dollar strengthened, typical of an asymmetric recovery, but oil prices have remained low, with important implications for emerging economies.

In Latin America, exchange rates depreciated again, in line with the global movement of the dollar. Growth remains weak in Chile and Peru. The Mexican and Colombian economies decelerated, but the outlook still points to robust growth ahead. Brazil continues to grow poorly and recession deepens in Argentina.

The decline in oil prices has important effects on the region. Colombia, which exports about 10% of GDP in energy, is the hardest hit. The short-term effect is small in Mexico, Brazil and Argentina, but the loss in the medium term may be higher, due to the energy potential of these countries. Chile, on the other hand, benefits, as it is a net importer of energy, and also because its inflation is more sensitive to oil prices.

In Brazil, the post-election challenge is to balance the economy, restore confidence and resume growth. Our scenario comprises a set of minimum adjustments, including fiscal contraction, realignment of regulated prices and higher interest rates – just enough to avoid a deterioration of the economy. In 2015, growth will likely remain modest, inflation will likely remain close to the upper limit of the target range, and the exchange rate will probably continue to depreciate. Resumption of growth in subsequent years depends on the extent of the adjustments. The scenario of minimal adjustments is consistent with only limited growth ahead.

A scenario of lack of adjustment is what we currently observe in Argentina. Interest rates and exchange rates remain under control, and international reserves are falling. Necessary adjustments are being postponed for the next administration, maintaining uncertainty and raising the cost of a potential adjustment ahead.


Global Economy

USD resumes its appreciation trend as the global growth scare wanes

• The global growth scare that hit the markets in late September and early October was exaggerated, in our view.

• The U.S. economy continues to expand at a good pace, despite weakness elsewhere.

• Inflation remains low in the developed countries, pushing the BoJ and the ECB to do more monetary easing. But in the U.S., the Fed sees the recent decline in inflation as a transitory effect from the decline in oil prices.

• As the fear that global growth would halt the recovery in the U.S. fades, the USD is resuming its appreciation trend, including against emerging markets currencies.

The global growth scare that hit the markets in late September and early October was exaggerated, in our view. The releases of sharp declines in August industrial production (IP) in Japan (-1.9%) and Germany (-3.1%) and a significant slowdown in the IP expansion in China (0.2%) contributed to the impression that the global economy was slowing fast.

It is not that the global economy is booming. In fact, we have again lowered our GDP forecast for the euro zone, to 0.7% (from 0.8%) for 2014 and to 1.0% (from 1.1%) in 2015, due to weaker-than-expected 3Q14 GDP in Germany.

But it’s not slowing down sharply. IP in Japan (2.7%), Germany (1.4%) and China (0.9%) recovered in September. Global manufacturing Purchasing Manager’s Index increased to 52.9 in October from the year low 52.1 in September, led by the developed countries. And the 3Q14 GDP in China was better than expected (although with an unexciting composition – see below), leading us to increase our GDP forecast for 2014 to 7.4% from 7.3%.

Importantly, the U.S. economy continues to expand at a good pace, despite weakness elsewhere. Growth will likely moderate in 4Q14 (see below), but the average pace should remain at a healthy 3.0% in 2H14.

Nonetheless, the lack of a solid pick-up in global growth and the decline in oil prices (see below) are pushing worldwide inflation down, particularly in developed countries. Our measures of global inflation (a weighted average of countries that account for most of the world GDP) declined to 2.5% yoy in September from 2.7% yoy in August. In developed countries, the average reached just 1.3%. The decline in oil prices is a major force pushing world inflation down.

With low inflation, monetary policy in major countries remains supportive, but we continue to the see the U.S. Fed on a path to raise rates in mid-2015. Indeed, the Bank of Japan announced an expansion of its purchases program in October. We think the European Central Bank (ECB) will follow in December or in 1Q15 (see below). In the U.S, the labor market is improving and the Fed seems to view the effects of the oil fall on inflation as temporary. We still think that the Fed is likely to start raising rates in June 2015.

As the fear that global growth would halt the U.S. recovery fades, the USD is resuming its appreciation trend, including against emerging markets (EM) currencies. The fact that commodities prices remain weak also adds pressure on emerging-market currencies.

U.S. – Fed likely to start raising rates in June 2015

U.S. economic indicators have softened, but remain consistent with a healthy 3.0% growth pace in the second half and in 2015. GDP grew 3.5% qoq/saar (seasonally adjusted annual rate) in 3Q14. Our models indicate that growth will likely slow down to 2.5% in 4Q14, leaving the average pace at a healthy 3.0%.

We are leaving our GDP growth forecast at 2.2% in 2014 and 3.0% in 2015.

Furthermore, the labor market continues to improve as expected. Non-farm payroll grew by 214 thousand jobs in October and has averaged 235 thousand per month in the last six months. And the unemployment rate declined to 5.76% in October. We continue to forecast that the non-farm payroll will continue to expand by an average of 200,000 jobs per month, and the unemployment rate will average 5.7% in 4Q14 and drop to 5.0% in the fourth quarter of 2015.

The current pace of labor-market tightening should lead the Fed to start to raise rates in June 2015. At its October meeting, the FOMC ended QE and reaffirmed that the Fed funds rates should be kept at their current levels for a “considerable time.” Importantly, it acknowledged that the underutilization of labor resources has diminished. This seems consistent with our view that the Fed will start increasing rates in June 2015.

However, we now see the risks tilted toward a later start of the hiking cycle, for example in September, rather than earlier. Inflation pressures are likely to be tamed by lower oil prices in the short term, thus reducing the chances of an earlier rate hike. In addition, if the global growth disappoints further in the future causing a persistent tightening in financial conditions, it could reduce U.S. GDP growth in 2015, thus leading the Fed to wait one or two quarters, before starting the hiking cycle.

As a consequence, we revised down our year-end forecasts for the 10-year U.S. Treasury yield to 2.50% from 2.70% for 2014 and to 3.00% from 3.25% for 2015. We note, however, that these levels are still above current market prices.

Europe – Signs of stabilization, but still a bit shaky

Activity data in Germany has been mixed and the economy is likely to recover less than we previously thought in 3Q14. The German industrial production (IP) declined 3.1% mom and exports were down 5.8% in August. IP recovered 1.4% in September, but retail sales dropped 3.2%. Leading indicators are also mixed. The composite Purchasing Managers’ Index improved to 54.3 in October from 54.1 in September. But the IFO, an important business survey in Germany, continued to decline (see graph). Overall, we expect growth in Germany to improve from the contraction in 2Q14, but less than we previously believed. We lowered our 3Q14 GDP forecast to 0.10% from 0.3% previously.

With mixed signals in Germany and persistent weakness in France and Italy, investors fear that the euro-area economy might fall into a recession again. For example, in its latest forecasts released in October, the IMF said the probability of recession had increased to about 40% (from 20% in April).

Despite weak growth, we think that recession fears are overblown. Credit conditions and the fiscal situation are improving. Confidence surveys show signs of stabilization after dropping during the European summer. Domestic consumption is holding well across the region. It is also a relief that the German IP rebounded in September, while the sharp drop in retail sales in the month seems to be a due to one-off distortions related to the timing of school vacations and weather. All of these point to modest growth ahead in the euro area.

Nonetheless, with growth picking up only slowly and very low inflation, we now expect the ECB to announce the extension of its asset purchases to corporate bonds in December. Inflation came at 0.4% yoy in October and will likely remain close to this level until the end of the year. Weak growth and low inflation are depressing long-term inflation expectations in the euro area, with market-based measures remaining dangerously below 2%. Moreover, in its November meeting, the ECB made clear its commitment to expand its balance sheet and said it was studying new measures to implement if necessary. As a consequence, we now expect the ECB to announce in December that it will buy high-grade corporate bonds (along with the already announced covered bonds and asset-backed securities) to help expand its balance sheet and further ease credit conditions in the euro area.

Finally, we have lowered our euro-zone GDP forecasts to 0.7% (from 0.8%) for 2014 and to 1.0% (from 1.1%) in 2015 due to our revision of Germany’ 3Q14 GDP.

China – Stronger-than-expected 3Q GDP, but with an unexciting composition

China’s 3Q14 GDP came at 7.8% qoq/saar, better than the 7.0% we expected and only slightly below the 8.2% in the previous quarter. Activity data in September also surprised on the upside, with industrial production (IP) recovering to 8.0% yoy from 6.9% yoy in August. Calendar effects explain part of the bounce in IP. But overall, these results suggest that the moderate stimuli launched since mid-August were quick to offset the weakness in the property sector, helped by a favorable contribution of net exports.

With the better print in 3Q14, the growth deceleration in China has been very modest so far this year. GDP was up 7.4% in the 9 months up to September compared with the same period last year, when it was 7.6%, just 0.2 pp above the current print.

However, domestic demand, in particular investment, is decelerating faster than headline GDP. Growth remains relatively stable because the year-to-date contribution of net exports improved to 0.8% compared with -0.1% in the same period in 2013 (see table). Most of this gain in net exports occurred in the 3Q14. Meanwhile, domestic demand contribution declined 1.2 pp to 6.6% from 7.8% (see table). The entire decline in domestic demand came from gross capital formation.

Untimately, it is domestic demand’s (lack of) strength in China that matters for global growth and commodities prices. Its weakness helps to explain why hard commodities prices fell in 3Q14 and barely reacted when the better-than-expected activity data was released in October.

Looking ahead, we believe that GDP will decelerate to 6.8% qoq/saar in 4Q14. The external environment is unlikely to contribute as much as it did in the 3Q14. The weakness in the property sector and the slowdown in credit growth continue to be two important domestic headwinds. Finally, the official target of “around 7.5%” for 2014 is well within reach, and hence the government may switch focus to reforms for the remainder of the year.

Nonetheless, the 3Q14 results have led us to increase our GDP forecast for 2014 to 7.4% from 7.3%. We maintain our 7.0% forecast for 2015.

USD resumes its appreciation trend against emerging-market currencies

So far this year the U.S. dollar has appreciated by 7.5% against an equal-weighted basket of emerging market (EM) currencies. This trend started in earlier July (see graph). After a brief pause in October, the USD resumed its upward move in November.

We expect this trend to continue, as the U.S. economy remains at a solid pace despite the global weakness. Indeed, the recent depreciation of EM currencies followed the rise in two-year rates in the U.S., which is closely linked to when the Fed will start to increase interest rates. As the global growth scare pushed the U.S. two-year rate down, the USD stopped gaining ground against EM. As these fears subsided, the U.S two-year rate is moving up again and will likely pressure EM currencies ahead (see graph).

The weakness in commodity prices (see below) and the slowdown in domestic demand in China (see above) also add pressure to EM currencies. This is particular true for the currency of commodity exporter.

Commodities – A new reality for oil

The Itaú Commodity Index (ICI) has declined by 4.5% since the end of September, driven by lower oil-related prices. Meanwhile, the agricultural sub-index rose 7.3% on risks and rumors related to supply in the U.S. and Brazil, and the metal sub-index stood roughly flat over the same period. The ICI now registers a cumulative 19.3% drop year-to-date.

Brent crude prices dropped to USD 85/bbl from USD 111.4/bbl in June due to a new reality in oil markets. The demand growth has been weak and lower than ex-OPEC supply growth since 2013. Moreover, supply in the politically unstable OPEC countries is rising in 2014, putting the burden of trying to balance the market on the rich countries (Saudi Arabia, UAE and Kuwait). We assume that these countries will cut supply ahead, which will lead prices to recover part of the recent losses. Nevertheless, we are lowering our 2014 year-end prices to USD 93/bbl from USD 100/bbl, considering that oil prices will not remain sustainably above USD 100/bbl anymore.

The rise in agricultural prices (corn, soybean and wheat) is more related to weather risks than to actual losses in supply or stronger demand. Our base case is that normal weather conditions ahead will reduce these risks and lead prices to fall again, given the context of sizable surpluses. Hence, we maintain our agricultural forecasts.

We have revised our ICI forecasts downward, mainly due to lower oil prices, but also due to a small revision to base metals. We have lowered our year-end 2015 ICI forecasts by 2.8 pp, implying only a modest increase of 8.0% between the end of October 2014 and the end of 2015.


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

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