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Volatility surge in markets unlikely to derail synchronized growth

February 9, 2018

Inflation unlikely to force DM central banks off of their gradual tightening path.

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

Global Economy
Asset prices correction unlikely to derail the global recovery
The market selloff reflects U.S equities adjustment to higher interest rates, but it does not seem to result from higher economic risks. The global recovery is deepening: we revised up our 2018 GDP forecasts for the U.S., Euro area, Japan and China.

Synchronized global growth boosts activity in LatAm
Activity is recovering more visibly and growth in the region is set to be markedly higher this year. While most central banks in the region reduced policy rates recently, cycles are getting close to an end (or have already ended) almost everywhere.

Benign scenario for emerging markets supports the BRL and reduces inflation
Despite recent asset price volatility, we have trimmed our year end BRL forecast to 3.25, from 3.50, as a result of the sovereign risk retreat seen in recent months.

Inflation trouble
The Central Bank cut the policy rate twice in January and affirmed that the conditions for disinflation are better in 2018, but reiterated it will be cautious ahead. We do not expect further rate cuts in the near term, as the next inflation-related data releases will likely be unfavorable.

AMLO leads, but the race is not yet over
In spite of anti-establishment candidate López Obrador’s dominant position in the polls, Mexico’s presidential race is still quite uncertain. Meanwhile, the most recent NAFTA renegotiation round increased the confidence that a deal can be reached.

Tailwinds begin to help
With higher copper prices, improving confidence and stronger global growth, we now expect 3.3% GDP growth this year (previously, 3.0%). Higher copper prices also led us to move towards a slightly more appreciated exchange rate forecast, at 620 pesos per USD by the end of the year (previously, 635).

Political crisis goes on
Even though President Pedro Pablo Kuczynski overcame the impeachment attempt in December, his situation remains far from comfortable. Due to disappointing data in 4Q17, we revised our GDP forecast for 2017 down to 2.3% (from 2.7%).

Unwilling to cut more?
The central bank cut its policy rate in January to 4.5% and signaled the end of the easing cycle. Nevertheless, we believe there is room for more easing, given that growth is still below potential, the current account deficit is narrowing and the CLP appreciation should ease inflationary pressures.

Stronger growth, higher commodities prices
Commodity prices continued to rally in January, due to strong global growth and dollar weakness. In this environment, we increased our energy and metal prices forecast.



Volatility surge in markets unlikely to derail synchronized growth

The synchronized global recovery is deepening and we believe the recent volatility surge in developed markets will not derail this accelerating growth trend.  While inflation normalization (led by the U.S.) implies higher interest rates, it is unlikely to happen fast enough to force central banks to choke the global recovery. In this sense, the market selloff seems to reflect an adjustment of U.S equities to higher interest rates, exacerbated by technical aspects, rather than a rebalancing caused by a changing risk balance for the global economy.

The outlook for synchronized global growth favors a weaker USD, mostly against developed country currencies, but also against most of emerging markets. For LatAm, we now forecast stronger currencies versus our previous scenario for most countries we cover. Following global trends, we see in recent data that activity is recovering more visibly in the region. We expect economic growth to be markedly higher this year relative to 2017. LatAm as whole seems to be close to the end of a monetary easing cycle: most central banks in the region reduced their policy rates recently, others seem about to do the same. In this context, Mexico stands out as an exception. After a rate hike in the first meeting of the year, additional hikes are possible (but not our base case scenario).

The influence of the supportive scenario for emerging markets can also be seen in Brazil, where country-risk receded over the last months, leading us to expect a more appreciated BRL (we revised our 2018 forecast to 3.25 BRL per USD, from 3,50). A relatively stronger currency, added to the perspective of lower electricity bill surcharges by the end of the year, will likely lead to lower inflation in 2018, at 3.5% (previously, 3.8%). The central bank reduced its benchmark rate by 25bps in the first meeting of the year and indicated, quite clearly, that unless we have positive data surprises or changes in the balance of risks, they intend to stay put in the March policy meeting. Thus, we revised our call for the end-cycle Selic rate from 6.5% to 6.75%, a level we expect to prevail throughout the year. Released shortly after the Copom´s decision, January’s IPCA inflation reading came in much lower than expected, but given the Copom’s statement, one weak reading will probably not be enough to change the committee’s flight plan. That said, it will be important to follow any hints that may appear in coming official communications of the monetary authority. In the economic activity front, our assessment is that the recovery is following its path without significant surprises, with slightly better-than-expected data at the margin. Finally, we expect public accounts to post somewhat better results in the short-term, but we still emphasize that a sustainable recovery of the fiscal balance depends of reforms.



Global Economy
Asset prices correction unlikely to derail the global recovery

• The synchronized global recovery is deepening. We have raised our 2018 GDP forecasts to 2.9% (from 2.4%), 2.6% (2.1%), 1.6% (1.4%) and 6.5% (6.3%) for the U.S., euro zone, Japan and China, respectively.

• Inflation normalization, led by the U.S., implies higher interest rates. But it is unlikely to force central banks to choke the global recovery. 

• The market selloff primarily reflects an adjustment to higher interest rates in the U.S. equities market, which has been exacerbated by technical issues affecting equity volatility indexes; there are few signs that the correction reflects increased macro risks, and as yet there has been limited contagion to other assets.

• The synchronized global growth favors a weak USD. We have lowered our year-end 2018 DXY forecast to 87.5 (from 92.0), we also expect a stronger CNY and believe we that emerging markets have stronger external balances.

The synchronized global recovery is accelerating 

The global recovery is gaining speed. Easy financing conditions, looser fiscal policies, a revival of capital spending by corporations and improvements in labor markets are fueling global consumption and investment. Both the global manufacturing Purchasing’s Managers Index and international trade (see chart) indicate that the world economy is on firmer footing.

We have revised our global GDP growth forecast for 2018 to 4.1% from 3.8%, based on our expectation of widespread improvement. We have raised our 2018 GDP forecasts to 2.9% (from 2.4%), 2.6% (2.1%), 1.6% (1.4%) and 6.5% (6.3%) for the U.S., euro zone, Japan and China, respectively. For LatAm, we forecast 2.4% growth in 2018, a pick-up from 1.1% in 2017. A global GDP increase of 4.1% this year would represent a reasonable acceleration from the 3.8% and 3.2% rates seen in 2017 and 2016, respectively.

Inflation unlikely to force DM central banks off of their gradual tightening path

With the world economy growing faster than its potential, we expect a rise in inflation. Both wages and commodity prices are being boosted by the current global expansion. The aggregate output of Developed Markets (DM) will likely turn positive this year and contribute to a normalization of inflation (see chart). 

However, there has been no rush to ditch easy monetary policies, as core inflation rates remain below targets. In the U.S., the core PCE deflator (excluding food and energy) is at 1.5% yoy, 50 bps below the 2% target. In the euro zone, consumer price inflation (excluding food and energy) is at 1.0%, about 90 bps below ECB’s 2% target. And in Japan, core CPI (excluding fresh food and energy) is at 0.4% yoy, well below the BoJ’s 2% target. Hence, the Fed, ECB and BoJ are signaling that they can gradually and cautiously normalize monetary policy, if economic and financial conditions continue to evolve in a positive direction.

In the U.S., the economy is at full employment and hence the Fed has less freedom to act to cushion the economy. Indeed with unemployment rates reaching historically low levels, wages are on an upward trend. Hence, the Fed is unlikely to stop raising rates even after a correction in the S&P 500.

However, the inflation-overshooting risk seems limited and the Fed can continue tightening at a gradual pace. 

First, if there are four to six additional hikes before the end of 2019 (the markets are pricing in 4.5 hikes, while we expect 6), the Fed Funds Rate will get closer to a neutral level and become less expansionary.

Second, long-term inflation expectations are 25 bps below the Fed’s 2% inflation target, which helps to anchor price-setting across the economy. 

Third, the “Wage Phillips Curve” is working, and steeper close to full employment, (see chart) but its impact on core inflation remains limited. Even if average hourly earnings, which rose by 20 bps per year over the last four years, accelerate from 2.9% yoy in December 2017 to 3.5%-4.0% in 2018-19, the core PCE would move to 2.1%-2.2% (the wage pass-through to the core PCE deflator is 20%). After years of low inflation, this small overshoot in the PCE would be unlikely to trigger a strong reaction from the Fed.

Finally, the FX rate pass-through is just 3%, so a 10% depreciation in the USD would raise core inflation by 30 bps over the next year. It seems unlikely that the USD (or import prices) could be a major source of inflation overshooting. If a healthier “rest of the world” economy pushes the USD down, that should enable the Fed to normalize monetary policy a bit faster.

This is an asset prices correction – not an ominous signal of macro deterioration or financial instability

The recent selloff does reflect an adjustment in fundamentals, but it has been significantly exacerbated by technical issues affecting the S&P 500 volatility index (VIX) market. 

First, the fundamentals. As it has become clearer that wage and inflation will indeed rise, U.S. equity market investors have had to adjust their interest rate expectations, which are used to discount future cash flows. If rates rise, prices have to be lower. In addition, with higher growth, higher inflation and less central bank accommodation, volatility will likely rise from the depressed (repressed) levels seen through last year. 

But the surge was concentrated in the VIX. The long duration of the economic recovery coupled with easy Fed policy has fostered short volatility-trading strategies. It so happened that the shake-up of these positions occurred exactly when the Fed was pointing to “further” gradual hikes in interest rates and when average hourly earnings growth rose to 2.9%. 

The responses of other asset classes were disproportionally mild relative to the rise in the VIX. If assets had responded to the spike in the VIX per the historical correlations observed, on average, between 2008 and 2016, the selloff would have been much more severe (see chart). 

We interpret this muted response in other asset prices as indicative that global macro risks remain contained.

In addition, we do not see evidence that the correction is pointing to or will generate deeper financial problems. Even in the U.S., which is the farthest along in this expansion, non-financial private leverage is low. The Chicago Fed National Financial Conditions Index, an indicator of financial imbalances that has often anticipated recessions, remains below historical levels. And the lower leverage in the banking sector after the financial reform should mitigate the risk of another episode of systemic financial instability. 

Synchronized growth favors a weak USD

With the U.S. expansion cycle already far along and the Fed halfway through its policy normalization, we foresee a catch-up by the rest of the world, which favors a weak USD environment. 

In Europe, the ECB can continue reducing stimulus, as political risks are low and the recovery strong. Euro-zone GDP is probably growing at a rate of 2.5%-3.0%, which is very strong for the region. Good growth and fading policy risks could prompt an inflow of capital, which fled from the currency during the euro crisis. Hence, the euro’s appreciation is a reflection of better fundamentals in the region and is likely to have little impact on the inflation outlook. We therefore expect the ECB to end its QE program in September 2018 and to start raising interest rates in 2019. 

In Japan, global growth is spurring exports and fixed investment – tentative signs that the Japanese economy can continue to grow faster than potential without further JPY depreciation. Japan equity prices have continued to rise and even JGB inflation break-evens are holding up, breaking their past negative correlation with the JPY. The BoJ is likely to be extra-cautious, given Japan’s deflationary mindset, but if wages, core inflation and expectations rise further with further tightening in the labor market, the BoJ could adjust its 10-year JGB target by 20 bps in 2H18. 

In China, stronger growth and lower risks open room for a stronger CNY. China’s GDP growth was 6.9% in 2017, up from 6.7% in 2016. Growth was boosted by the external sector, whose contribution turned positive last year, rising to 0.6 pp from -0.4 pp in 2016. The Chinese economy is now more balanced: a tightening of excess capacity in heavy industry helped end PPI deflation, real estate inventories are lower and external risks have eased amid stronger exports and diminished exposure to speculative foreign capital. Better activity and less capital outflows (see chart) relative to 2013-16 are causing the CNY to appreciate, a movement which policymakers seem comfortable with.

Emerging-market countries outside China have generally improved their macro positions. Current accounts have adjusted; inflation has declined, allowing interest rates to be lowered; and growth is resuming. All these signs point to a better macro balance. But in several economies the recovery is still in its early stages, and capital flows are just starting to come back. Better-synchronized global growth and firmer commodities are likely to support EM currencies.

Finally, synchronized currency appreciation against the USD reduces the impact on real effective exchange rates (REER). As all other currencies make gains against the U.S. dollar, which accounts for 12% of world trade, we estimate that REERs have given back little of the depreciation that occurred between 2011 and 2016 (see chart). Only the euro has retraced about one-third of its previous depreciation, reflecting the lower political risk in that region. 

We have lowered our year-end 2018 DXY forecast to 87.5 (from 92.0), and we expect a stronger CNY (6.20 CNY/USD at the end of 2018 and 6.00 CNY/USD in 2019).

Commodities – Stronger growth, higher commodity prices

The Itaú Commodity Index (ICI) has risen by 1.7% since the end of December – agriculture is up 1.1%, metals are down 0.1% and energy is up 3.4%. Strong global economic activity and dollar weakness explain the rally of the last couple of months. 

We have increased our energy and metal price forecasts due to the better global environment. We have moved our year-end forecasts to USD 55/bbl (from USD 52/bbl) for WTI and to USD 58/bbl (from USD 55/bbl) for Brent. As for metals, we have raised our year-end price estimate for copper to USD 6,700/mt (from USD 6,500/mt) and for iron ore to USD 65/mt (from USD 60/mt).


Synchronized global growth boosts activity in LatAm

• In spite of recent volatility, the external environment is still supportive for LatAm assets. We are now forecasting stronger currencies versus our previous scenario for most countries we cover.

• Activity is recovering more visibly. Recent data leave us more confident that economic growth in the region will be markedly higher this year relative to 2017.

• While most central banks in the region reduced their policy rates recently, cycles are getting close to an end (or have already ended) almost everywhere. In Mexico, the central bank hiked the policy rate further in its first meeting of the year, and additional hikes are possible (but they are not our base-case scenario).

In spite of recent volatility, the external environment – including synchronized growth, higher commodity prices and low interest rates in core economies – is still supportive for LatAm assets. The benign external environment meets narrow (or narrower) current account deficits in most countries. Higher terms of trade combined with a still-incipient internal demand growth are keeping external accounts in good shape. Year to date, most currencies in the region recorded a significant appreciation against the U.S. dollar. An exception is Argentina, where uncertainties over monetary policy and an increasingly large external deficit led to a sharp weakening of the peso. 

For most countries within our coverage, we are now forecasting stronger currencies versus our previous scenario. The new forecasts still imply some weakening from current levels, as commodity prices moderate and the Fed tightens monetary policy more than the market currently prices in. 

The benign external environment has so far contained any potential damage from domestic risks. But such risks are unlikely to be ignored for much longer. In particular, in Brazil, Colombia and Mexico presidential elections are key, while in Peru a political crisis could still lead to the ousting of President Pedro Pablo Kuczynski.  

Activity is recovering more visibly. Recent data leaves us more confident in our view that economic growth in the region will be markedly higher relative to 2017. Given the size of its economy, Brazil plays an important role, but we also expect higher growth in Argentina, Chile, Colombia and Peru. For Mexico, we expect growth to be unchanged this year, as the solid U.S. expansion continues to offset the impact that uncertainty over NAFTA and the elections is having on investment. 

However, output gaps still appear to be wide, as activity recovery is still incipient. Moreover, well behaved currencies aid disinflation. In this context, most central banks in the region recently loosened monetary policy. In their first monetary policy meeting of the year, the central banks in Brazil, Colombia and Peru reduced their policy rates by 25 bps. In Brazil, the monetary authority indicated in its statement announcing the decision that the cycle has likely ended, while in Colombia the central bank surprisingly closed the doors on more monetary easing (a guidance that was later loosened in board members’ press statements). In Peru, the central bank retains an easing bias (as inflation and activity perform below expectations). Following the upward revision in inflation targets, the central bank of Argentina cut its policy rate by 150 bps in January, in spite of inflation data suggesting even the new targets are unlikely to be met. In Chile, where the policy rate remains at expansionary levels, the central bank left the policy rate unchanged in February and retained an easing bias. However, the central bank is clearly more upbeat with the outlook for activity, so the probability of additional cuts is low. On the other hand, Mexico’s central bank hiked the policy rate once again in February, as inflation remains uncomfortable and risks for the currency persist. 

But cycles are getting closer to an end (or have ended) almost everywhere. In Brazil and Chile, we do not expect further rate cuts. In Peru, we expect a final 25-bp rate cut in March. Meanwhile, we expect the Colombian central bank to deliver two additional 25-bp rate cuts. Activity in Colombia is still weak, and the policy rate is only slightly expansionary, so as the negative output gap and the stronger Colombian peso bring inflation down, the central bank would likely revise its “on-hold” guidance. In Argentina, the central bank will likely stay put in the very short term, given the unfavorable data on inflation and inflation expectations. But we do expect BCRA to resume rate cuts, once inflation resumes a downward trend, even if the disinflation path is not fast enough to meet the 2018 or 2019 targets. Finally, in Mexico, we think the central bank is done with its hiking cycle, although uncertainty over monetary policy in the U.S., NAFTA and the elections clearly leaves open the possibility of further tightening. If such risks subside, rate cuts in the second half of this year are likely.


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

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