Itaú BBA - Turbulent Markets in Search of Differentiation

Global Scenario Review

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Turbulent Markets in Search of Differentiation

February 14, 2014

Emerging markets had a rough ride in the past month. Some of the stress might ebb.

Global Economy
The Global Scenario Remains one of Growth Recovery. Emerging Markets will Continue Under Pressure
Emerging markets had a rough ride in the past month. Some of the stress might ebb. Unfortunately, this will not bring relief to economies with weak fundamentals. Differentiation will play a role again.

Growth Without Energy
Growth has lost momentum in recent months, we have reduced our forecast for GDP growth in 2014. However, we expect now a longer monetary tightening cycle, in response to the more volatile global scenario. 

A Bumpy Recovery
The economy weakened in 4Q13, we reduced our growth forecast for this year. Considering the better prospects for FDI and the exposure of the U.S. economy, the peso will likely continue to outperform other emerging market currencies.

An Easing Bias Amid Higher Volatility
The central bank left the policy rate unchanged in January, but reinforced the easing bias. We expect a 25-bp rate cut this month, but further weakening of the peso could lead the central bank to wait a bit more.

Recovery and No Further Rate Cut
Growth improved, mostly due to solid consumption.To protect the sol, the central bank reduced reserve requirements and is intervening in the market, but we do not expect further interest rate cuts.

Comfortable Exchange Rate Level
Consumption is growing at a robust pace, while the Manufacturing sector remains in negative territory. Authorities seem comfortable with the weaker currency, especially considering the low inflation.

Sharp Depreciation of the Peso, Higher Interest Rates
The government allowed sharp depreciation in the peso and a moderate hike in interest rates. New adjustments in these variables are on the way.

Weather-Related Uncertainty
Hot and dry weather in Brazil has led to reduced crop forecasts for coffee, sugar, corn and soybeans, in descending order of likelihood and magnitude. Non-precious metals prices remain on a downward trend.

Turbulent Markets in Search of Differentiation

It was a turbulent start of the year for emerging economies. Unlike last year, when the turbulence was a reaction to changes in U.S. monetary policy, this time around the main concern is the sustainability of the global recovery and the quality of fundamentals in some emerging markets.

This stress seems exaggerated. The global scenario continues to suggest that growth will rebound. Weakness in U.S. and Chinese data seems temporary. Emerging economies are less vulnerable than the market assumes – we are not back in the 1990s.

Still, volatility and risk aversion will likely continue throughout the year, affecting emerging economies, particularly those with fragile fundamentals. Markets are searching to distinguish between the more robust and the more fragile economies.

In this environment, Latin America experienced turmoil at the beginning of the year. The exchange rate weakened in most countries in the region. We expect this move to be partly reversed, but uncertainty will likely affect monetary policy decisions. We no longer forecast interest rate cuts in Peru and Colombia. We only expect interest rate cuts in Chile. Nevertheless, we expect a recovery in growth in these nations in 2014 after a slow year in 2013.

Mexico was hit to a lesser extent by the negative market sentiment. Proximity to the U.S. and recently-approved reforms improved the outlook for the country in the eyes of investors.

In Brazil, the focus is on the sluggish economic activity growth. Weak manufacturing results, higher energy costs and the possible effects of the Argentine crisis led us to revise our forecast for GDP growth downward this year. With slower growth and lower-than-expected inflation in January, the central bank may reduce the pace of interest rate increases in its next Copom meeting, as long as the international scenario allows it.

Amid international turmoil, the crisis is Argentina has gotten deeper. The government allowed sharp depreciation in the peso and a moderate hike in interest rates. New adjustments in these variables are on the way, likely before year-end. All in all, the much anticipated macro adjustment in Argentina seems to have started at the beginning of the year.

Global Economy
The Global Scenario Remains one of Growth Recovery. Emerging Markets will Continue Under Pressure

•    The global scenario is still a story of recovering growth. The data weakness in the U.S. is likely to be temporary, and concerns about China might be exaggerated.

•    Emerging markets have had a rough ride in the past month. What started last year as a reaction to changes in monetary policy in the U.S. took on new dimensions after idiosyncratic shocks and amid rising concerns about the global recovery.

•    Some of the stress might soon ebb. Concerns about the global economy could fade, and as a group, emerging markets have less financial vulnerability than they did in the 1990s.

•    Unfortunately, this is not likely to bring relief to the emerging market economies that have weak fundamentals. At the very least, differentiation will matter again.

Exagerated stress

A sequence of weaker data releases in the U.S. and in China, combined with increasing turbulence in the emerging markets, challenged the scenario of global recovery and spooked investors at the start of 2014.

We think that the data weakness in the U.S. is temporary and that the concerns about China’s economy might be exaggerated.

We expect the U.S. economy to continue its recovery this year, as the fundamentals remain good. Financial conditions are supportive, and the fiscal drag is lightening. The recent slowdown is mainly related to the inventory accumulation cycle and weather effects. We continue to forecast GDP growth rates of 3.0% in 2014 and 3.1% in 2015, up from 1.9% in 2013.

China seems more risky, but we expect the country to avoid major mistakes this year and to successfully manage a gradual slowdown of its economy. A decline in the Purchasing Managers’ Indexes in January and the near-default of a Chinese trust fund brought back fears of a hard landing in China. We are cautious about putting too much emphasis on the few and noisy data releases available at this time of the year, just after the Chinese New Year. Moreover, the country’s credit problems seem manageable, as there is fiscal space for state-sponsored solutions without creating much stress. We still expect China’s GDP growth to slow only gradually, falling to 7.5% in 2014 and 7.3% in 2015 from the 7.7% rate posted in 2013.

In the euro zone, economic activity remains good but inflation surprised on the downside again. Leading indicators showed some improvement in January, but inflation came in at 0.7% yoy, down from 0.8% in December. We still see the European Central Bank staying on hold, but the odds of another rate cut in March are increasing.

In Japan, activity picked up at the turn of the year. Consumers are accelerating their spending ahead of the VAT increase scheduled for April, and economic activity has picked up as a result. We expect some deceleration after the VAT increase. If the economy decelerates, the Bank of Japan might need to begin a new round of stimulus by mid-year.

The emerging markets have had a rough ride over the past month. Continuing outflows, idiosyncratic events and weaker numbers from China and the U.S. all contributed to the stress. What started last year as a reaction to changes in monetary policy in the U.S. soon took on new dimensions.

We think some of this stress reflects exaggerated fears. The global scenario remains a story of recovering growth. And as a group, emerging markets have less financial vulnerability than they did in the 1990s, when they faced a series of systemic crises.

Unfortunately, an easing of the stress will likely not bring relief to those emerging market economies that have weak fundamentals. Manufacturing exports, at least, will benefit as the global recovery regains its footing. But interest rates in the U.S. will likely resume their upward trend, and capital will continue to leave the emerging markets.

U.S. – Weakness in activity data is likely to be temporary

Activity data in U.S. decelerated around the turn of the year. A weak non-farm payroll figure in December was followed by a sequence of poor economic data releases. The ISM survey of supply management professionals declined to 51.3 in January from 56.5 in December. And the labor market disappointed again in January, with nonfarm payrolls increasing by only 113,000 jobs, below the market consensus forecast of 180,000 jobs. Indeed, our surprise index for the U.S. activity data dropped significantly in the past two months (see graph).

What happened to the recovery in U.S.? Not much. The softness in the recent data is likely to be temporary, and the outlook is still good for a recovery in growth. A mid-cycle inventory adjustment and bad weather are the main culprits for the recent weakness.

Inventory accumulation contributed 1 percentage point to U.S. GDP growth in 2H13 and reached 0.8% of GDP in 4Q13. This pace is too fast. With GDP growing at 3%, as we forecast in our scenario, inventory accumulation should average only 0.4% of GDP. As a consequence, we expect inventory accumulation to drop to normal levels, which apparently are already happening, and to contribute to reducing GDP growth this quarter.

In addition, an extremely harsh winter in many U.S. states probably affected economic indicators in December and January.

When we look past these short-term effects, however, we see that the economic fundamentals in the U.S. remain good. Financial conditions remain favorable, private-sector balance sheets are improving and the fiscal drag is fading. Moreover, the volatility in emerging markets seems unlikely to reduce U.S. exports enough to change this outlook.

We continue to foresee a pickup in U.S. GDP growth, to 3.0% in 2014 and 3.1% in 2015 from 1.9% in 2013.

The U.S. Fed also appears to believe that the slowdown is temporary. It reduced its asset purchase program by another USD 10 billion in January, and is now buying USD 65 billion per month. We expect the FOMC to continue tapering at the current pace in the next meetings, ending the program in 4Q14. Janet Yellen, who has finally assumed her new role as chair of the Board of Governors of the Federal Reserve System, has indicated the continuity of this strategy.

The weakness in data could persist a little longer, but we expect economic data to soon pick up. As it does, the yield on U.S. Treasuries, which has declined in response to the negative surprises (see graph), will move up again. We continue to expect the 10-year U.S. Treasury yield to be at 3.45% by year-end 2014.

China – Risks come to the forefront, but we still see a gradual moderation

The NBS manufacturing PMI declined to 50.5 in January from 51.0 in December, renewing concerns over a pronounced slowdown in China. The fall followed disappointing activity data in December, when industrial production growth slowed to 9.7% yoy from 10.0% in November.

A near-default of a “shadow banking” product added to concerns over China’s economic health. Total credit in China has increased from 120% of GDP in 2008 to 185% of GDP last year (see graph). Most of the rise has occurred outside the banking system, in products ranging from traditional capital market securities like corporate bonds to special financing vehicles, usually seen as opaque and labeled “shadow banking”. Combined, these products now account for 32% of the outstanding credit in the economy, compared with 17% in 2008 (see graph). Their rapid growth, together with the investment boom in China, has sparked fears of a credit meltdown. In January, a USD 500 million trust fund, which had made loans to a mining company, nearly defaulted on its investors. A last-minute rescue by the combined forces of a local government, the bank responsible for marketing the fund and the trust company that created the product averted a default. But the episode touched a nerve among investors who worry about credit quality in China.

Despite the risks, we continue to expect a gradual moderation and no hard landing.

A moderate slowdown in growth, after the strong 7.8% pace seen in 2H13, seems unavoidable as the economy shifts to a more sustainable mix of growth sources, with less investment and more consumption. The People’s Bank of China also appears willing to allow higher interest rates and push for some deleveraging in the financial system, putting additional downward pressure on activity.

But January data from China is noisy and could be distorted to the downside. The Chinese Lunar New Year holidays came early this year and likely slowed down activity in the month of January. The latest PMI drop could be reflecting this effect. We don’t think that one should read too much into the data for this period. We will only have a reliable picture of activity trends around mid-March, when the main activity data for January and February will be released.

Moreover, Chinese policy-makers are sending a message of stable policies and growth. We believe that they will be able to manage a smooth transition in China’s economy. If a deeper slowdown is in fact occurring, there is room for some small and localized stimulus measures, as inflation remains well behaved.

In addition, we don’t expect a major crisis in China’s financial sector. The risk of a Chinese financial crisis is probably overestimated. Trust companies, where a large part of this risk lies, manage about RMB 10 trillion (USD 1.65 trillion). But half of that is made up of equity investments, whose investors likely understand the risks. The other half is trust loans, and this is where most of the potential issues are. Yet it seems to us that any eventual problems would not be likely to create a liquidity crisis that could have a domino effect, mainly because there is little cross-participation in the trust industry. Given the low presence of foreign investors and the fiscal capacity of China’s government, a state-sponsored solution might become available without much stress. In the end, the main issue is credit quality.

We continue to see China’s GDP growth slowing gradually, to 7.5% in 2014 and 7.3% in 2015 from the 7.7% posted in 2013.

Emerging Markets – A full-blown crisis is unlikely, but there will be continued pressure on countries with weak fundamentals

Emerging markets have had a rough ride over the past month. The sharp exchange rate depreciation in Argentina, emergency interest rates hikes in Turkey, political turmoil in Ukraine and contagion everywhere recalled the emerging-market crises of past decades.

Weaker-than-expected activity numbers from China and the U.S. contributed to the stress.

What started last year as a reaction to changes in monetary policy in the U.S. later took on new dimensions. The correlation between the yield on U.S. Treasuries and emerging markets currencies broke down. Last year, a rise in the former made the latter depreciate. This time around, emerging-market exchange rates depreciated while yields on Treasuries declined, in a typical flight-to-quality movement. Even developing countries with solid fundamentals suffered.

We think that the fears of a full-blown crisis in the emerging markets are unjustified. These economies are less financially vulnerable than they were in the 1990s (for details, see our LatAm Macro Monthly from July 2013). In addition, in our view, to worry about low growth and higher interest rates in the United States at the same time is inconsistent.

As concerns over the global recovery ease, differentiation will return, with countries that have weak fundamentals continuing to be under pressure.

We expect the real to depreciate further. The recent exchange rate depreciations in Chile, Colombia and Mexico might partly revert. We believe that their currencies will end 2014 stronger than they are now. In Peru – a partially dollarized economy – the central bank is intervening aggressively to protect the PEN from volatility, so its exchange rate remains stronger than our year-end forecast.

The recent turmoil might prompt some central banks to be more cautious about further easing. Hence, we no longer expect Colombia and Peru to reduce their policy rates. However, we continue to see room for easing in economies where inflation and current-account deficits are not a concern. Chile can further cut rates, for example, while Mexico can postpone rate hikes.

In Brazil, we continue to believe that the tightening cycle is close to an end, but we now see slightly higher interest rates at the end of 2014 (11%, up from 10.75% previously)

Apart from external shocks, idiosyncratic issues will continue to matter and may contribute to negative sentiment toward the whole emerging-market asset class. In Argentina, the government allowed sharp exchange-rate depreciation after it became clear that currency controls were failing to address the overvaluation of the ARS. However, the depreciation has not been accompanied with a proper monetary response. The country needs much higher interest rates to encourage USD inflows. In the absence of such an adjustment, pressure on reserves has continued even after the depreciation. We expect a further weakening and a significant increase in interest rates over the next few months. During this period, Argentina could once again create noise in the markets.

Commodities – Weather risks

The Itaú Commodity Index (ICI) rose by 1.7% from its recent low (January 9) as weather conditions pushed up agricultural prices (+4.1%) and energy prices (+3.4%), and despite a new drop in metal prices (-4.0%). Agricultural prices were affected by strong export sales for grains and unfavorable weather for production (a frigid winter in the U.S., as mentioned in our last report and a dry spell in Brazil). Energy prices were up due to the cold weather in North America and to regional improvements in the oil transportation infrastructure, which increases the outflow capacity for “WTI oil”. Nevertheless, we are leaving our 2014 year-end forecasts unchanged (see below).

Agricultural prices rose recently due to a drought in Brazil, which also adds uncertainty to the scenario, and to very strong external demand indicators for corn and soybeans. The former poses a significant upside risk for coffee and sugar prices, but should not affect soybean or corn prices. Regarding soybeans, the negative impact on the Brazilian crop is being offset by more rain in Argentina. For corn, the drought is delaying the second-crop planting, increasing the risk of ground frost affecting crops later in the year. However, we expect only domestic prices to be affected, given the strong global surplus in corn. All things considered, we are maintaining our year-end price forecasts for agricultural commodities, but we see an upside bias to our price estimates for sugar (USD 0.184/lb) and coffee (USD 1.50/lb).

Metal prices have fallen amid renewed concerns about the global economy, concerns which, as discussed above, we expect to be temporary. The ICI-metals has fallen by 7.6% year-to-date, driven down by lower prices for iron ore (-11.4%), aluminum (-5.5%) and copper (-3.6%). The renewed worries about China and other emerging markets and the weak data from the U.S. explain this poor performance. However, we expect the China concerns to fade and see the U.S. data weakness as temporary. Hence, we are maintaining our year-end forecasts for metal prices, which imply a less steep drop (-2.4%) from current levels over the remainder of the year.

Finally, the environment for WTI prices is more constructive. WTI oil prices have risen by 8.2% since January 9, driven by the combination of marginally lower oil production in the U.S. and increased outflow capacity from the Cushing region of in the central United States. Meanwhile, Brent prices continue to slide on the prospect of a looser balance in 2014 and lower geopolitical risk. Hence, the shrinking in the discount of WTI to Brent prices is consistent with the fundamentals and is likely to persist throughout the year, as we already expected. We are maintaining our year-end forecasts for both Brent (USD 105/bbl) and WTI (USD 101/bbl) prices.

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

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