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Global Scenario Review

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Strong Dollar Worldwide

September 12, 2014

The U.S. economy continues to recover slowly, but steadily.

Global Economy
Strong U.S., Weak Europe

The U.S. economy outlook remains positive, while Europe has lost momentum .Very low interest rates in Europe and geopolitical risks can hold down interest rates risk premium for longer in the U.S. But we still expect the Fed to start lifting interests rates in mid-2015.

Delayed Recovery

The still-slow recovery in economic activity and unfavorable fundamentals continue to indicate weak activity in the near future. The Copom reinforced the signal of stable interest rates ahead.

Hello Recovery, Goodbye Disappointment

The first activity indicators available for 3Q14 suggest that the positive momentum of the 2Q should continue. Capital flows associated with reforms will likely cause the peso to perform better than most EM currencies.

The Government’s Grace Period Is Over

The economy weakened further in 2Q14 and the available indicators for 3Q14 do not suggest a rebound just yet. President Bachelet’s approval rating fell to the lowest level recorded so far in her second presidential term.

Economic Growth Vanishes

Peru’s economy decelerated rapidly in 2Q14, increasing by a weak 1.7% year over year.  Weak mining output has led to a sharper-than-expected widening of the current account deficit. We forecast a weaker sol ahead.   

Speed Bump or Halt?

Activity disappointed in June, but confidence indicators suggest that the economy remains robust. The central bank increased the interest rate to 4.50% in August, but hinted that the tightening cycle may be over.

Living in Default

The default will probably last longer than the market originally expected, increasing the risk of debt acceleration. We think the currency will depreciate more (and maybe in a disorderly fashion), and  we see now a deeper recession in 2015.     

Lower Soybean and Iron ore Prices

We lowered our forecasts for soybeans, sugar and iron ore prices for 2015. Conflicts in Iraq and Ukraine are not preventing a decline in crude oil prices. The market sees little risk of global supply being affected.

Strong Dollar Worldwide

The U.S. economy continues to recover slowly, but steadily. Over the coming months, we expect a gradual change in the Fed’s rhetoric, which will likely start suggesting tighter monetary policy ahead. In contrast, on the other side of the Atlantic the scenario is still challenging. Europe needs to grow more rapidly, geopolitical risks remain high in Ukraine and the likelihood of Scotland gaining independence from the UK has increased. The ECB announced new monetary stimuli and has held the door open for additional measures.

In this environment, the dollar has been appreciating against other G7 currencies, and it is also starting to strengthen against emerging market currencies. This movement will become clearer with the likely rise in U.S. Treasury yields in the coming months.

Growth in emerging markets has also been disappointing. In Latin America, we (again) reduced our growth forecasts for Brazil, Chile and Peru. In Brazil, we expect growth in 2014 to reach only 0.1%, due to weaker 2Q14 results and the sluggish pace of recovery. Confidence at historically low levels and high industrial inventories will probably limit growth ahead. With low growth, fiscal accounts continue to decline. We reduced our forecast for conventional primary surplus in 2014 from 1.3% to 1.1% of GDP, and the recurring result from 0.6% to 0.4%.

The combination of higher interest rates in the U.S. and weak growth in emerging economies tends to depreciate Latin American currencies.

On the more positive side, Colombia is still poised to grow, despite weaker data in June. And in Mexico, the latest indicators confirm the recovery started in 2Q14. In these cases, the FX depreciation is buffered by domestic factors, particulary in Mexico, where the implementation of reforms tends to attract foregn investments.

Finally, Argentina continues to follow its own path. The congress pass a bill to enable the change of payment for restructured debt from New York to Buenos Aires or Paris. Thus, we understand that the default will last longer. We now expect sharper FX depreciation and a deeper recession in 2015.

Global Economy

Strong U.S., Weak Europe 

• The U.S. economy outlook remains the same: growth above 3% in 2S14 and 2015, improving job market, gradual increase in inflation and first interest rate hike in June/15.

• The European economy has lost momentum, increasing downside risk to inflation. The ECB cut interest rates and will buy private assets in response.

• Activity data became more mixed in China after a strong 2Q14.

• Low rates in Europe (and geopolitical risks) will likely hold down interest rates risk premium for longer

The U.S economy remains on track for a strong 2H14. We raised our GDP growth forecast to 2.2% (from 2.0%) for 2014 and to 3.1% for 2015 (from 3%). With this pace, the economy should continue to create on average more than 200 thousand (non-farm) jobs per month.

On the other side of the Atlantic, the outlook is bleak. The Eurozone economy loosened momentum in an environment of very low inflation. Geopolitical risks remain high in Ukraine. We recently lowered our GDP forecast to 0.8% from 1.0% in 2014 and now lower our forecast to 1.1% from 1.5% in 2015.

The European Central Bank (ECB) eased policy further to avoid the de-anchoring of inflation expectations. The measures reduced the already record-low interest rates in the region and depreciated the Euro.  We think these actions will help lift inflation but will not provide a substantial boost to activity.

Activity data became more mixed in China after a strong 2Q14. We think the economy needs more  stimuli to grow close to 7.5% target this year.

The economy in Japan is also disappointing. Since our last monthly, we revised our GDP forecast for the country to 0.9% from 1.5% in 2014 and to 1.0 from 1.2% in 2015.

We reduced our year-end forecast for the 10 year U.S. Treasury yield to 2.7% (from 2.9%) in 2014 and to 3.25% (from 3.45%) in 2015. We didn’t change our view on the U.S. economic and monetary policy. But record-low rates in Europe (and geopolitical risks) will likely hold down U.S. interest rates risk premium for longer.

Growth outlook in emerging markets (EMs) remain mixed. In LatAm, Mexico is on a recovery path, while Colombia’s data remains solid. On the other hand, Brazil, Chile and Peru continue to surprise on the downside, even though we expect growth in the 2H14 to be better than 1H14.

Although we don’t expect sudden movements this year, EMs remain exposed to changes in U.S. Fed monetary policy communication. We see a gradual change ahead. But a signal of earlier tightening from the Fed will rock the boat in EMs.

The growth outlook in emerging markets (EMs) remains mixed. In LatAm, Mexico is on a recovery path, while Colombia’s data remains solid. Brazil, Chile and Peru continue to surprise on the downside, even though we expect growth in the 2H14 to be better than 1H14.

EMs should be able to navigate the international environment safely until the end of the year. Risks remain tilted to the downside though. In particular, a signal of earlier tightening from the U.S. Fed would make several emerging markets suffer.

U.S. – Economy remains on track for a strong 2H14

U.S. economic indicators are broadly in line with a cyclical 3.0% growth pace for 2H14 and into 2015. The GDP growth was revised up to 4.2% qoq/saar (seasonally adjusted annual rate) from 4.0%. Several confidence indicators reached new cyclical highs in August. The ISM Manufacturing index increased to 59.0, while the ISM Non-Manufacturing index rose to 59.6 (see graph). Our 3Q14 GDP tracking rose to 3.5% from 3.0% last month.

Consumption has been soft but will likely accelerate soon. Real spending declined 0.2% MoM in July. We expect a rebound in August and September and forecast consumption growth at 2.0% qoq/saar in 3Q14. This is still down from the 2.5% in 2Q14, but we see an increase to 3.0% in 4Q14. The pickup will be supported, in our view, by a reversal in the recent increase in households’ saving accounts, as confidence reaches new highs, interest rates remain low and banks keep easing credit standards.

We note that the recent slowdown in Europe will not likely have any material impact on U.S. growth. We revised euro-area GDP down to 1.1% from 1.5% in 2015. We estimate that this revision reduces the U.S. GDP by only about 0.1% in 2015,  given the elasticity of euro-area imports to GDP and the size of U.S exports versus Europe (2.7% of GDP)

Summing up, we have raised our GDP growth forecast to 2.2% (from 2.0%) for 2014 and maintain our 2015 projection at 3.0%.

Based on this estimated growth pace, the U.S. economy would need to continue creating more than 200 thousand (non-farm) jobs per month. The non-farm payroll was very weak in August, with only 142k jobs versus our expectation for 225k. But we believe this represents temporary volatility in the data. The other parts of the labor report (e.g., the unemployment rate, average hourly earnings) were in line with our expectations.

If the labor force continues to shrink even slightly, as we expect, then the unemployment rate should continue to fall faster than currently envisioned by the Federal Reserve (Fed).

The core PCE deflator, which is the Fed’s preferred inflation measure, increased only 0.09% month over month in July, but we expect a gradual convergence toward the Fed’s 2% target in 2H15. This came after recordings of 0.15%, 0.18% and 0.19% in the prior three months. High-frequency price indicators suggest another relatively soft reading n August. However, the core inflation measures have been on average firmer this year. We expect the core PCE to gradually rise from 1.5% YoY in July to 1.7% in December, as a tighter labor market should push wage costs higher.

As a consequence of the improving labor market and gradual inflation convergence, we continue to expect the Fed to start increasing interest rates in June 2015. Given our economic outlook, especially for the labor market, the risks seem tilted toward an earlier start of the rate-hiking cycle by the Fed. In Janet Yellen’s own words, if we see a “faster convergence toward our dual mandate, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.”

Moreover, we see a gradual change in the Fed’s rhetoric ahead as it tries to prepare investors for this first hike.

Nonetheless, we reduced our year-end forecast for the 10-year U.S. Treasury yield to 2.7% (from 2.9%) in 2014 and to 3.25% (from 3.45%) in 2015. Increased geopolitical tensions and extremely low interest rates due to weaker activity in Europe will likely hold down the U.S. interest-rate risk premium. These factors, however, don’t change our view on the U.S. economic outlook. We hold the same view about the Fed’s monetary policy, as we’ve explained above. 

Europe – The economy has lost momentum

The euro-zone GDP expanded by a meagre 0.03% qoq in 2Q14, slowing down from 0.22% in 1Q14. A decline in investment and an inventory adjustment were the main drags.  The country breakdown shows that Germany (-0.2% qoq) and Italy (-0.2%) were the biggest problems. Meanwhile, the French economy stagnated. On the bright side, both Spain’s and Portugal’s GDPs were up 0.6% in the quarter.

Leading indicators point to a moderate improvement in 3Q14, but less than we previously thought. The euro-zone service PMI is up slightly, averaging 53.6 in July and August, compared with 53.1 in 2Q14. The manufacturing PMI, however, is down to 51.2 from 52.4, and it seems to be on a downward trend. Other surveys of consumer and business confidence are also generally down or flat in the period.

Geopolitical and policy uncertainty are weighing on business and consumer confidence and limiting the cyclical recovery. The conflict in eastern Ukraine has been dragging on, with sanctions (and counter-sanctions) being imposed on Russia. Although the direct impact on growth seems small, it is undermining confidence and hampering investment decisions. Within the euro zone, infighting in Hollande’s cabinet has created policy uncertainty. A recent reshuffle has given a clearer, more reformist direction to the cabinet, but scepticism about reforms remains. Meanwhile, in Italy, a surge in optimism over Renzi’s rise to power is waning as he has yet to pass meaningful economic reforms. All these factors seem to be affecting consumer and business confidence. Investment in the euro zone declined 0.3% qoq in 2Q14 and might contract again in 3Q14. Consumption posted a 0.16% qoq gain in 2Q14. But this pace is at best moderate, and the decline in consumer confidence suggests no upside ahead.

The ECB provided further stimulus in September by cutting interest rates by 10 bps and announcing it would buy privately issued securities. The ECB president Draghi has also kept the door open for further action if inflation fails to pick up, especially moving into next year.  We see the central bank in full easing mode to fight low inflation. Interest rates across all maturities and countries in the euro are reaching records lows. We think they will remain at these low levels for an extended period.

We believe that the ECB actions reduce the risk of deflation in the euro zone, but are not enough to provide a substantial boost to activity. The policies help the stabilization of credit to the private sector, which is still falling in the region. But the main impact of these policies, in our view, is to depreciate the euro. We just revised our year-end forecast for the euro against the U.S. dollar to 1.27 (from 1.33) in 2014 and to 1.22 (from 1.30) in 2015. This should help to increase inflation, but with an only moderate impact on activity (through higher exports).

We maintain our 2014 GDP growth estimate at 0.8% (which we lowered recently from 1.0%) and reduce our 2015 forecast to 1.1% from 1.5%. We continue to expect a cyclical recovery in the region. But the improvement seems to be more gradual than we had anticipated (see graph).

China – Growth momentum remains fragile and requires more targeted stimuli

Mixed data in July and August indicate that economic momentum remains fragile. Industrial production and fixed investment slowed down in July. Credit growth has also weakened, even after adjusting for distortion in the latest two releases. Finally, the manufacturing PMI declined to 51.1 in August from 51.7, suggesting further deceleration ahead.

After the stimuli-driven improvement in 2Q14, does the economy need another shot?

Several factors are consistent with a slowdown in 2H14. The weakness in the property sector continues to be a drag. Most stimuli announced in the previous quarter will fade through the second half because they provide only one-off benefits.

We already take these factors into account but suspect that the economy needs more stimuli to limit the slowdown to a gradual pace (grow between 7.4% and 7.5% in 2014). In the absence of additional stimuli, the steeper decline suggested by the fundamentals could lead annual growth to be between 7.2% and 7.3%. This would likely be negative for assets related to Chinese growth.

Recent statements from key policymakers indeed suggest new measures ahead. Inflation is well behaved and provides opportunities for action. We also believe authorities are more comfortable staying close to the 7.5% growth target for 2014.

We maintain our GDP forecast at 7.4% for 2014 and 7.0% for 2015.

Commodities – lower soybean and iron ore prices

The Itaú Commodity Index (ICI) has declined 4.7% since the end of July, with all sub-indexes falling in the period. Soybean, iron ore and oil prices led the fall. Corn and wheat prices posted small gains, while base metals are stable and coffee prices were strong.

We lowered our year-end price forecasts for soybean, sugar and iron ore. A sizable surplus in the soybean market for the 2014-15 crop year is in the making. High inventories prevent a recovery in sugar prices. Finally, the equilibrium price for iron ore seems closer to USD 90/ton, lower than our previous forecasts (USD 101/ton).

We revised our estimate for coffee prices upward, reflecting a worse outlook for the Brazilian crop.

Our year-end ICI forecast is down to -7.0% yoy for 2014 (vs. -5.6% previously) and 2.1% yoy for 2015 (vs. 3.0% previously). From current levels, these revisions imply a 5.3% increase in the ICI by year-end.


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

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