Itaú BBA - Stronger global growth, not in LatAm (yet)

Global Scenario Review

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Stronger global growth, not in LatAm (yet)

January 20, 2017

Global GDP growth is set to accelerate this year, amid risks from policy shifts in the U.S and elections and Brexit in Europe.

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

Global Economy
Stronger global growth amid political risks
Global GDP growth is set to accelerate to 3.6% this year from 3.1% in 2016 and manufacturing surveys point to upside risks. The main risks at the moment are policy shifts in the U.S., elections and Brexit in Europe.

Economic recovery postponed
Economic activity in the region is not recovering yet. We have reduced our growth forecasts for this year in Brazil, Colombia, Mexico and Peru, but still envisage recovery in some of these economies this year.

Falling inflation brings forward the cycle of interest rate cuts
Falling inflation and disappointing economic activity bring forward the cycle of interest rate cuts. We forecast Selic rate at 9.75% in 2017 and at 8.5% in 2018.

Ready to go?
Recent economic data suggests the economy came out of the recession in 4Q16. We expect 2.7% GDP growth in 2017 to be followed by 3% expansion in 2018.

Aftermath of the “gasolinazo”
The liberalization of gasoline prices will benefit fiscal accounts, but has worsened the near-term inflation outlook and triggered social unrest six months before a crucial regional election that might have a bearing on the result of the presidential and legislative elections in 2018.

Monetary easing begins
The central bank started a loosening cycle in January amid low growth and falling inflation. Recent activity data supports our call of a 100-bp easing cycle this year.

Domestic demand still struggling
We have revised our GDP growth forecast down for 2017 as domestic demand has weakened further. Higher terms of trade, nevertheless, would support growth in 2017.

Fiscal and external accounts improve, while activity weakens
The Santos administration approved the tax reform and gained fast-track authority to pass legislation related to the peace deal. At the same time, external accounts are improving and inflation is falling.

Enjoy the Party, for Now
The short-term outlook may be bullish for commodity prices. Nonetheless, we expect metal and energy prices to decline throughout 2017.

Stronger global growth, not in LatAm (yet)

Global GDP growth is set to accelerate to 3.6% this year from 3.1% in 2016 and there are upside risks. Global inflation is also on the rise, driven by better commodity prices. With better economic outlook, interest rates are set to rise in developed countries. We now expect the U.S. Fed to deliver 3 hikes in 2017 (from 2) and 4 in 2018. The main risks at the moment are political shifts in the U.S., elections and Brexit in Europe. China also poses risks, but we see a stable growth environment in 1Q17.

In spite of more solid economic growth in developed economies, economic activity in the Latin America is not yet recovering. We have reduced our growth forecasts for this year for Brazil, Colombia, Mexico and Peru. While activity is still disappointing, the balance of payments and fiscal picture are improving in the region. Many governments are implementing fiscal consolidations, in spite of their low popularity. Weak growth and low inflation are allowing central banks in South America to embark on easing cycles. We have reduced our policy-rate forecasts for Brazil and Colombia. On the other hand, we now expect a more-aggressive monetary tightening in Mexico relative to our previous scenario.

In Brazil, economic activity disappointed at the end of 2016. We now expect a moderate recovery in 2017 due to a lower statistical carry over. Inflation ended 2016 lower than expected and will continue to decline in the coming months. In this environment, there is room for frontloading the cycle of interest rate cuts. We expect the Selic rate at 9.75% at the end of 2017 and at 8.5% in 2018. In light of a slightly more favorable external scenario for emerging countries, we now forecast a less intense depreciation of the real. On the fiscal side, reforms will continue in focus this year. We expect the pension reform to be approved in the second quarter of 2017.


Global Economy
Stronger global growth amid political risks

• Global GDP growth is set to accelerate to 3.6% this year, from 3.1% in 2016. Manufacturing surveys indicate upside risks.

• Global inflation is also on the rise, driven by rising commodity prices. In the U.S., core inflation is stabilizing as the economy nears full employment.

• With a stronger economic outlook, interest rates in developed countries are set to rise. We now expect the U.S. Fed to deliver three rate hikes in 2017 (from two previously) and four in 2018.

• The main current risks are policy shifts in the U.S., elections and Brexit in Europe 

• China also poses risks, but we foresee a stable growth environment in 1Q17.

Stronger economic outlook

The world economy ended 2016 in good shape. Industrial production was up 2.7% YoY in November and the global Purchaser Manager’s Index reached 54.0 in December – both indexes are at the highest levels since 2014.

We expect global GDP growth to accelerate to 3.6% this year, from 3.1% in 2016. The pick-up is set to occur in both developed and emerging economies (see graph).

Global inflation is also rising. Our GDP weighted index of world inflation is likely to rise to 2.8% in 2017, from 2.4% in 2016 (see graph), helped by better commodity prices. We note that some developed economies, particularly the U.S., are also close to full employment and seeing stabilization in core inflation.

U.S. – Stronger growth, higher rates, but policy-related uncertainty

Growth of the U.S. economy accelerated to 3.0% in annualized terms in 2H16. Consumer and business confidence indicate positive domestic demand momentum, including a significant pick-up in business investment. Global manufacturing surveys are supportive of U.S. export growth.

We raised our 2017 GDP growth forecast to 2.3% from 2.2%, and expect a further a further pick-up to 2.4% in 2018.

Inflation was softer in November, but largely consistent with a gradual stabilization of core measures. The core PCE will likely close 2016 at 1.8%, compared with 1.4% in 2015, and we expect it to remain at 1.8% by the end of 2017.

Stronger growth and increased business investment leads to a shift in the outlook risks. We anticipate a decline in the unemployment rate to 4.3% by 4Q17, 20 bps below the FOMC’s December forecast. We see risks of an even lower unemployment rate, given that business investment may spur stronger payroll growth.

We now forecast three Fed rate hikes in 2017, instead of two, and continue to expect another four hikes in 2018. A more preemptive Fed seems likely to mitigate the risk of a sharper unemployment rate undershooting of the NAIRU over the next few years.

We foresee a moderate policy mix by Presindent Trump, albeit with significant fiscal impulse. We expect a reduction in corporate and individual tax rates coupled with increases in import tariffs on a country-by-country basis.

However, US policy risks seem to have increased. 

There is uncertainty surrounding the actual measures to be adopted by the new administration. President-elect Trump’s speeches and interviews have so far lacked concrete information about his plans, while his cabinet indications have sent mixed signals about polices. 

President-elect Trump has also upped his protectionist rhetoric. He has talked down the “border tax adjustment” advocated by House Speaker Paul Ryan, but mentioned 35% taxes on Mexican auto imports. And he has called on companies to invest and create jobs in the U.S., rather than overseas.

Although president-elect Trump has so far refrained from supporting the border tax adjustment, he could change his mind, which we see as the main protectionist risk. With a border tax adjustment, companies would pay zero taxes on export income but a full tax rate on import costs. This has a similar effect to imposing higher import tariffs and lower export tariffs. It can also be seen as a fiscally-induced devaluation of the USD.

We note that the border tax adjustment could raise government revenues. It can be used to partially offset the decline in revenues from the corporate and individual tax rate cuts.

The long-term benefits are likely to be null or negative. Traded weighted USD should fully adjust to this new fiscal regime, and US trading partners could raise import tariffs in retaliation, causing negative long-run spillovers from the de-globalization.

Summing up, policy changes are likely coming to the U.S. and risks remain high about what shape they will take.

Europe – Resilient activity amid political risks

Resilient economic indicators in Europe. The 4Q16 leading indicators improved, as the credit data reflects the positive effect of the ECB’s easing policies. The solid November Industrial Production ex-Construction figure, which rose 1.5% MoM (see graph), also suggests a stronger 4Q16 (0.4%-0.5%).

Improving financial conditions, slightly expansionary fiscal policy and a milder external drag contribute to stronger growth. We note that despite the recovery in headline inflation, which reached 1.1% YoY in December, the ECB is likely to retain its accommodative stance for some time. This means that real interest rates are likely to fall, supporting economic activity.

Some risks have not materialized. Despite the demise of Italy’s Renzi reformist government, a quick formation of a pro-establishment administration and the EUR 20 billion rescue plan for the Italian banking system should sustain the country’s brittle stability for now.

Political risks will nonetheless remain at center stage in Europe. In the UK, Brexit negotiations are expected to begin after the triggering of Article 50 in March. In our view, political incentives favor a hard Brexit, as the UK wants control of its borders and regulations, which implies leaving the Single Market. The Netherlands will hold general elections in March, and the Eurosceptic party, PVV, continues to rise in the polls.

In France, former PM François Fillon’s reformist policy program, which is also conservative on immigration issues, makes him the favorite to win the election next year. But the Eurosceptic National Front candidate, Marine Le Pen, still has a good chance of winning the elections in 2Q17. Finally, although not our baseline scenario, there is a chance of early elections in Italy.

We raised our GDP forecast for the euro zone to 1.6% from 1.3% in 2017 and left it at 1.6% for 2016; political risks are likely to hurt confidence in 2018, and we anticipate a deceleration of 1.3% for the year.

Japan – Continued growth in 2017

Japan’s National Accounts underwent a general review. As such, 3Q16 GDP growth totaled 1.3% QoQ/saar, driven by Net Exports, which contributed 1.3 pp. Consumption and Government Expenditure rose by 1.3% QoQ/saar and 1.2% QoQ/saar, respectively.

Inflation is finally set to pick up in 2017. Headline inflation rose to 0.5% YoY in November from 0.1%. Though the effect continued to be driven by the recovery in energy prices and the strong increase in food prices, we expect it to pass through to Core CPI, as the BoJ maintains its accommodative policy stance and inflation expectations start to pick up.

We raised our GDP estimates to 1.1% from 0.8% for 2016 and to 1.4% from 1.2% for 2017 due to the methodological review of Japan’s national accounts.

China – Stable growth environment in 1Q17

Economic growth is set to remain stable in 1Q17. Credit growth has exhibited a solid pace in recent months, suggesting no monetary tightness despite the hawkish rhetoric. Investment will continue to be supported by higher corporate profits (on a weaker currency and higher producer prices) and the still hot propertysector (prudential measures to cool-off the sector are expected to affect investment after 2Q17).

Strong economic activity and intervention in the FX market will probably prevent another China shock like the one in early 2016. Last year, China’s challenging policy predicament, which combined loose monetary policy in the face of weak activity, liberalizing financial flows and an exchange rate peg, created expectations of a strong RMB depreciation and generated global financial market stress. But these three factors are now more nuanced. First, the improvement in activity/inflation dynamics has led to a reduced need for loose monetary policy. Second, one of the sources of capital outflows (unwinding of carry trade liabilities) has declined, and the government is tightening capital controls – contrary to last year when it was liberalizing financial flows. Finally, after depreciating 6.2% year to date vs. the CFETS basket (the new focus of FX policy), the currency seems less overvalued than in 2015.

We forecast GDP growth of 6.7% for 2016, 6.3% for 2017 and 5.8% for 2018.

Commodities – Stability in China to sustain higher metal prices, for now

The Itaú Commodity Index (ICI) has risen by 7% since the end of November – agriculture (5%), metals (5%) and energy 9% – as global economic activity keeps up the strong pace. Furthermore, signs that OPEC members are complying with the production cut deal support the view that the global oil market is already with a small deficit, causing Brent prices to increase by 8% since November 30 (the day the deal was announced).

The rise in agricultural commodities was driven by the reversal of earlier declines. We lowered our price forecasts for coffee (stronger Brazilian crop in 2017) and wheat (assuming that the current environment of a lower premium to corn will continue). Besides coffee and wheat, there were no material changes in the supply outlook, as the La Niña anomaly fades and the crop in South America advances under normal conditions.

We expect China’s economy to remain stable in 1Q17, supporting higher metal prices for a few months. We do not expect a supply increase in response to current prices anytime soon.

Oil prices are also set to remain high for some time, as the market assimilates the coordinated supply cut and global indicators show upside risks for an already-improved growth environment.

Beyond the 1Q17, we expect the ICI to decline to 8% below its current level by the end of 2017. The two main culprits are the expected slowdown in China in 2H17 (which will impact metal prices in particular) and a supply response from U.S. shale producers that could partially offset the cartel’s cuts.


Economic recovery postponed

• Economic activity in the region is not recovering yet, so we have reduced our growth forecasts for this year in Brazil, Colombia, Mexico and Peru.

• While facing low popularity and weak growth, many governments are taking measures to improve fiscal accounts. 

• Weak growth and low inflation are allowing central banks in South America to embark on easing cycles. We have reduced our policy-rate forecasts for Brazil and Colombia. On the other hand, we now expect a more-aggressive monetary tightening in Mexico relative to our previous scenario.

Activity is still sluggish…

In spite of more solid economic growth in developed economies, economic activity in the region is not yet recovering. In Brazil, recent data point to another sequential GDP contraction in 4Q16 (which would be the eighth consecutive quarterly GDP drop). In Chile and Colombia, activity is still losing momentum and growth has been very low relative to the historical standards. Peru – the fastest growing economy in the region – also lost momentum in 4Q16. This was mostly a result of a temporary fiscal drag (as the government slashed expenditures to comply with the fiscal target set for 2016), but it is also true that private demand has yet to react to the improved confidence levels since the new Peruvian government was elected. On the other hand, in Mexico, growth has been resilient so far (at around 2.0% year over year, which seems in line with potential): manufacturing exports are starting to recover in line with the better U.S. ISM manufacturing numbers, while private consumption is still solid. Finally, in Argentina the IGA (a GDP proxy estimated by the private sector) suggests that the economy came out of recession in 4Q16.

We have reduced our growth forecasts for this year for Brazil, Colombia, Mexico and Peru. The activity numbers for 4Q16 GDP in Brazil point to a less favorable carryover for 2017. In Colombia, the approved fiscal reform strengthens the country’s fundamentals, but at the cost of higher short-term inflation and a further decrease in real wages. President-elect Trump’s rhetoric on manufacturers operating in Mexico remains harsh. Although our base-case scenario is one with no meaningful changes in U.S. trade policies, rising uncertainty on this matter will likely affect investment in Mexico by more than we were previously expecting. In Peru, even though we still believe that there will be a recovery of domestic demand (in particular of private investment), the rebound would not be strong enough to more than offset the deceleration of mining production.

For 2018, we expect growth to strengthen, fueled mainly by the performance of the Brazilian economy

…but the balance of payments and fiscal picture are improving

While activity is still disappointing, the balance of payments is improving. The current-account deficits of Peru and Colombia (which have been wide) continue to narrow. In Mexico, the more recent trade-balance figures also suggest lower external imbalances. In Chile and Brazil, current-account deficits remain low. However, the current-account deficit in Argentina (at almost 3% of GDP) is wide, especially considering the weak internal demand and the reliance on portfolio flows for funding.

In addition, many governments are implementing fiscal consolidation, in spite of their low popularity.Gasoline price hikes in Mexico and the tax reform in Colombia are the latest examples. Even in Peru, where there is fiscal space that the government was planning to use, a VAT cut was far more modest than promised during the presidential election campaign, and it was conditioned on VAT revenues reaching an improbable threshold. While Argentina’s government is not in a rush to reduce the fiscal deficit, the outcome of the amnesty for undeclared assets has been much better than expected (around USD 100 billion has already been declared), allowing the government to comply with its fiscal targets.

Exchange rates are helping inflation in South America

South American currencies started the year with a good performance, following a solid performance during 2016. On the other hand, the Mexican peso continued to weaken as risks related to U.S. trade policies increased. We have updated our estimates of equilibrium exchange rates for Latin America. Considering the level of terms of trade today, we found that the BRL, CLP and PEN are close to fair value, whereas the COP seems to be overvalued and the MXN undervalued. If we consider the average terms of trade over the last 20 years, the MXN may be even more undervalued, and the CLP is overvalued compared with medium-term fundamentals. The Argentine peso is also overvalued, but this is largely because we assume in this exercise that the sustainable current account deficit is the average value of the past 20 years – in the case of Argentina, this is very low. If Argentina’s current access to international financing is indeed a new equilibrium, the fair value of the currency would be stronger than we estimate in this exercise.

In an environment of weak growth and well-behaved exchange rates, inflation is edging lower in most Latin American countries, although it ended 2016 below the target center only in Chile. In fact, our Itaú Inflationary Surprise Index marked -0.38 in December, which is fairly stable from the -0.37 registered in November. The index’s downward momentum was mostly because of Brazil, though recent downside inflation surprises in Colombia and Chile were also recorded. On the opposite side, Mexico and Peru have been undergoing stronger inflationary pressures recently, largely fueled by currency depreciation in the former and by one-off factors in the latter.

However, we note that inflation expectations for 2017 recently worsened in Argentina, Colombia, Mexico and Peru. Within this group, only in Peru expectations sit below the upper bound around the central bank’s target. Mexico is the country where the outlook for inflation is deteriorating the most. The further weakening of the Mexican peso following the US election and higher gasoline prices are the most to blame, but other factors (such as the minimum wage increase) will also contribute to worsen inflation dynamics this year. Finally, in Colombia the VAT hikes associated with the tax reform will likely keep inflation high during 2017 (although lower than last year’s figure). On the other hand, inflation expectations continue to improve in Brazil and Chile. 

Interest rates will likely fall further in South America and rise in Mexico

Central banks facing weak growth and falling inflation are embarking on easing cycles. In Brazil, the central bank increased the pace of rate cuts (to 75 bps). Colombia’s central bank started to slash interest rates sooner than we and the market were expecting. In Chile, the central bank started an easing cycle this month. On the other hand, the recent deterioration of inflation expectations in Argentina led the central bank to pause the easing cycle starting in the first week of December. In Peru, where growth is stronger and inflation has surprised on the upside, the central bank remains on hold. Finally, in Mexico the central bank increased the interest rate by 50 bps in December, which was more than the market was expecting. While in previous decisions the central bank of Mexico was, in our view, acting mostly to shield the Mexican peso, its actions now seem to have been focused on the evolution of inflation and inflation expectations (which deteriorated markedly), although the Fed’s interest-rate decisions will likely continue to play an important role.

We now expect lower interest rates (relatively to our previous scenario) for this year in Brazil (9.75%) and Colombia (5.5%). In Mexico, we expect more tightening (an additional 125 bps) than before. In Chile, we still see a 100-bp easing cycle (more than the 50-bp cycle that the market is expecting and that the central bank signaled in its last monetary policy report): recent activity and inflation data are consistent with larger interest-rate cuts. We see further rate cuts in Argentina, even though we do not expect the central bank to meet the inflation target for this year (12%-17%). Finally, Peru’s central bank is expected to remain on hold.


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

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