Itaú BBA - Weak activity in LatAm, despite an improving Brazil

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Weak activity in LatAm, despite an improving Brazil

September 9, 2016

Economic activity remains weak in the region. GDP in Brazil is expected to resume growing next year, but from low levels.

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

Global Economy
External environment still favorable for emerging markets

With global interest rates set to remain at a very low levels and China activity risks under control, the external environment remains supportive for emerging markets.

Monetary policy (partially) decouples from the Fed

We expect most LatAm currencies to weaken slightly from their current levels. The Mexican peso is an exception.

Recovery in sight, but sustained growth demands reforms

We have revised our GDP growth forecast to -3.2% (from -3.5%) this year and to 2.0% in 2017 (1.0%, previously). However, this scenario depends fundamentally of the fiscal reforms.

Driving on a bumpy road            

The Supreme Court suspended the gas tariff hikes decreed in April, an important setback for the government.

Fiscal adjustment in the spotlight         

Amid a challenging outlook for public sector finances, Luis Videgaray stepped down as Finance Minister.

Officially neutral           

The central bank finally dropped the tightening bias for monetary policy and will probably keep rates on hold until at least the end of 2017.

A slower fiscal deficit reduction            

We maintain our forecasts of the fiscal deficit for 2016 and 2017 at 3.1% of GDP and 2.6% of GDP, respectively, but the risks are for a higher deficit.

Tightening cycle comes to an end, peace seems at hand           

The central bank left the policy rate unchanged, likely ending the tightening cycle. The government announced a peace agreement with the Farc, shifting the focus to the tax reform debate.

Sustaining the recovery             

We expect oil price at USD 50/bbl by yearend. We have revised downward our grain and soybean forecasts, but increased our sugar prices forecasts.


Weak activity in LatAm, despite an improving Brazil

The U.S. Fed is moving toward another rate hike. We think December is the most likely timing, but the risk of a September move seems underpriced. In any event, the Fed will likely maintain its gradual and cautious approach. At the same time, the other G7 central banks are likely to maintain their very loose monetary stances.

With global interest rates set to remain at very low levels and China activity risks under control, the external environment remains supportive for emerging markets.

Despite the favorable global liquidity conditions, however, economic activity remains weak in most countries in Latin America. In Brazil and Argentina – both of which are enduring recessions and going through reforms – GDP is expected to resume growing next year, but from low levels. In a context of weaker inflationary pressure, monetary policy is becoming more expansionary, which will help the region to recover in 2017. With the Fed policy becoming tighter, we expect LatAm currencies to weaken slightly from their current levels between now and the end of 2017.

In Brazil, recent indicators suggest a stronger rebound than we had previously predicted. We have revised our GDP growth forecasts to -3.2% for this year (up from -3.5% previously) and to 2.0% for 2017 (up from 1.0%). We expect inflation to continue to decline over the coming quarters. The central bank has changed its communication, indicating that future monetary policy decisions will be more data-dependent, which is consistent with our scenario of an easing cycle starting in October.

However, this scenario depends fundamentally on progress in fiscal reform. Without fiscal rebalancing, economic predictability and stability will be compromised, leading to financial market volatility and limiting the room for monetary easing. In such a scenario, Brazil’s economic recovery would be compromised.


Global Economy
External environment still favorable for emerging markets

• The U.S. Fed is moving towards another rate hike. We think December is more likely, but the risk of a September move seems underpriced. 

• Importantly, the Fed will likely hold to a gradual and cautious approach as it balances job gains and financial stability on the one hand with below-target inflation, global risk and the asymmetric possibilities of monetary policy, in a world of low interest rates, on the other hand.   

• The European Central Bank (ECB) is in a wait-and-see mode, as activity shows some resilience after the UK Brexit vote, but with an easing bias, given that inflation remains substantially below the target.

• The Bank of Japan (BoJ) is struggling to find the right policy mix, but it will probably still add stimulus within its current negative-rate quantitative easing framework. 

• China’s data remains consistent with a muddling-through scenario. 

• With global interest rates set to continue at very low levels and China activity risk under control, the external environment remains supportive for emerging markets.

U.S. – Fed holds to a very gradual and cautious approach

The case for a rate hike in 2H16 has strengthened in recent months with further improvement in the labor market and looser financial conditions.

The labor market is improving at a good pace, supporting the central bank’s outlook for growth. Payroll has grown at a solid 175k per month over the last six months. While payroll growth slowed down to 151k last month, from 275k in July, job gains in August usually surprise to downside in the first data report, only to be revised up afterwards. A strong job market supports consumption and hence keeps the U.S. economy expanding at pace close to 2%.

The tightening labor market should exert some upward pressure on inflation. The current trend of job gains is well above the estimated labor force breakeven point (75k per month). As consequence, the unemployment rate should drop from 4.9%, which is already close to the FOMC’s estimate of full employment (4.7%-5.0%).

Financial conditions have continued to settle and support above-potential GDP growth. In fact, we expect GDP to expand 3% qoq/saar in 3Q16, after a slow 1H16, when it grew only 1%. Consumption remains at a healthy 3% annual pace. Business investment may be stabilizing, with tentative signs that the negative effects from the USD and oil price shocks are fading.

Nonetheless, the tightening path for interest rates in the U.S. should remain gradual and conservative, given the balance of risks to the economic outlook and still quiescent inflation.

Despite a gradually improving economic outlook, the balance of risks remains asymmetric, with limited scope to respond to a negative shock. In her speech at Jackson Hole, Fed Chair Yellen showed simulations that suggest the Fed’s current toolkit (interest rates, forward guidance and QE) may be enough to fight the next recession. But the worst-case simulation assumed the 10-year Treasury would be at 3% when the economy is next hit by a recession, whereas the current 10-year Treasury yield is only 1.6%. So, if the next recession starts soon, the Fed’s toolkit may not be enough.

In addition, the short-term neutral real rate in the U.S. seems to be quite low, in the current context of slow productivity growth and low global interest rates. In short, there seems to be no need for a large increase in Fed Funds rates in the next couple of years, unless inflation rises much faster than expected.

Finally, we think inflation risks remain relatively low, providing further scope for the Fed to remain on a very cautious and gradual path. Our estimates suggest that with well-anchored inflation expectations, even if the unemployment rate undershoots significantly and plummets to around 3.5%, measures of core inflation would reach 2.25% by 2018, only 25 bps above the 2% inflation target (see graph).

Summing up, we continue to expect one rate hike in 2016, more likely in December than September, and two hikes in 2017. We maintained our GDP growth forecast at 1.5% for 2016 but adjusted it slightly, to 2.2% from 2.1%, for 2017.

Europe – ECB on hold but with an easing bias

Activity has shown some resilience in Europe. In the Eurozone, the August Manufacturing Purchasing Managers Index (PMI) was down to 51.7, but it remains at levels consistent with moderate growth. In the UK, the PMI recovered from July’s sharp fall and rose to 53.3, above pre-Brexit levels (see graph). The depreciation of the British pound and the realization that the EU exit process will be a protracted affair have provided support to the rebound.

The ECB is in wait-and-see mode but with an easing bias, as weak inflation points to the need for future action. Euro area CPI stayed at 0.2% yoy in August, with core inflation falling to 0.8% from 0.9% in July. Both measures are still far from the ECB’s target of “close to but below 2%.”

We maintain our GDP forecast for the euro area at 1.5% and 1.3%, respectively, for 2016 and 2017. 

Japan – September assessment will likely signal future BoJ action.

Despite its efforts, the BoJ is struggling to achieve its 2% inflation target. CPI inflation is negative, currently at -0.4% yoy, while core inflation has fallen from 0.7% to 0.5%. Meanwhile, consumer inflation expectations fell from 1.8% to 1.6%. The challenge for the BoJ to anchor inflation at its 2% target is huge, and credibility may be an issue.

The central bank will release a comprehensive assessment of its policy in September. BoJ officials have clarified that their comprehensive review aims to study the transmission of the current monetary policy instruments to find the best way to reach the 2% inflation goal as soon as possible. Based on statements from board members, particularly Governor Kuroda at the Jackson Hole Forum, we believe the BoJ is leaning towards the conclusion that negative interest rates have been the most efficient tool to bring down long-term rates. This indicates that the BoJ will not abandon negative rates and could still lower rates further, while maintaining its QE.

We raised our GDP forecast slightly, to 0.5% from 0.4% in 2016, but we kept it at 0.7% in 2017.

China – Risks remain contained

The latest economic data is in line with a muddling-through scenario. This can be described as a gradual slowdown in activity, benign inflation and capital flows under control. This scenario limits spillovers from China to the global economy, as it doesn’t apply too much downward pressure on commodities and keeps the RMB depreciation risk under control.

We have been highlighting, though, that currently the main risk to this scenario has been the constant slowdown in fixed investment. Nominal fixed-asset investment slowed to 3.9% y/y in July from 7.3% in the previous month. This rather sharp slowdown, particularly in the private sector, might drag down industrial production and metal prices.

Encouragingly, this risk might moderate, as we see factors that could stabilize investment growth in the short term. First, other data for the real estate sector reveal a much brighter picture than nominal investment in the sector. Second, the narrowing of PPI deflation is helping to improve industrial profits, which in turn will probably sustain a better pace of investment ahead (see graph). In fact, our models suggest that industrial profits help to explain fixed investment both in the same month and with a three-quarters lag. Finally, policymakers seem to be leaning toward providing additional fiscal stimuli (via tax cuts).

We continue to expect GDP to expand 6.5% in 2016 and 6.0% in 2017.

Commodities – Sustaining the recovery

The Itaú Commodity Index (ICI) was 2.4% above the level seen at end of July, with a mixed performance among its components over the period. Energy prices were up 10.2% due to a partial recovery in oil prices from recent lows. Agricultural prices fell as field surveys reinforced the scenario of above-average yield for corn and soybean. Finally, the ICI-metals index fell 2.8% with falling aluminum, copper and iron ore outweighing gains in lead, zinc and tin prices.

Fine-tuning our metal price forecasts. The 6.3% decline in copper prices in August – despite rising oil, still-strong Chinese imports and disappointing output in Chile – is a strong signal that the market is structurally oversupplied. Hence we lowered our year-end copper forecasts. Meanwhile, other base metals are well above our year-end forecasts, so we adjusted our scenario for lead, tin, zinc and nickel slightly upward. The net effect on ICI-metals is negligible.

We expect oil prices to recover by year-end 2016. Advancing beyond the recent ups and downs caused by talk of a deal among major producers, we believe additional supply from the U.S. shale industry will be needed to balance the market in 4Q16. We are confident that equilibrium prices are close to USD 50/bbl and the risk of oil prices dipping below USD 40 is low.

Lower grain and soybean prices; higher sugar forecasts ahead. We lowered our forecasts for corn, soybeans and wheat, recognizing recent surveys pointing to abnormally high crop yields in the U.S. Conversely, we revised our sugar scenario upward in accordance with prices in the futures curve, as there are no clear factors to drive prices lower in the short term. Despite the revision, our sugar scenario remains tilted to the upside.

Our estimates imply that the ICI will be stable by the end of 2016 from its current levels, and then rise by 4% in 2017.


Monetary policy (partially) decouples from the Fed

• Consistent with some strengthening of the U.S. dollar globally, we expect most LatAm currencies to weaken slightly from their current levels between now and the end of 2017.

• Activity remains weak across the region, with varying levels of momentum at the margin. We have raised our growth forecasts for Brazil but left unchanged our forecasts for most of the other countries. Brazil and Argentina will likely drive the region’s recovery next year, helped in both cases by a low comparison base.

• In a context of lower inflationary pressure, monetary policy stances in the region are becoming more expansionary, with most LatAm central banks – the exception being Banxico – decoupling from Fed policy.

LatAm currencies are unlikely to weaken much in response to the Fed’s upcoming rate hikes

The probability of a new interest rate hike by the Fed before the end of this year has increased, but so far this has had only a limited impact on emerging market assets. In a world of low interest rates, the Fed will likely maintain its gradual and cautious approach. We continue to expect one Fed hike in 2016 (more likely in December than in September) and two hikes in 2017. In this context, the performance of LatAm currencies in August was mixed. The Colombian peso recorded strong gains, influenced by rising oil prices and the historic peace deal reached between the government and the FARC. But the Chilean peso and the Peruvian sol both weakened as copper prices fell.

Consistent with some strengthening of the U.S. dollar globally, we expect most LatAm currencies to weaken slightly from the current levels between now and the end of 2017. The exception is the Mexican peso, which we continue to see as undervalued. Although Mexico’s fundamentals have weakened (as highlighted by the recent decision of Standard and Poor’s to change the outlook on its sovereign rating from Stable to Negative), we see the peso’s depreciation as excessive, and we expect a correction ahead. A Clinton win in the U.S. presidential elections, a narrowing of the current account deficit, more progress in the fiscal consolidation effort and additional rate hikes (we expect Mexico’s central bank to hike rates in tandem with the Fed at least until the end of 2017) are all potential triggers for markets to reassess the valuation of the Mexican peso.

Brazil and Argentina likely to drive the region’s recovery

Economic activity remains weak across the region, with varying levels of momentum at the margin. Brazil’s economy is not yet out of recession, but recent indicators suggest that activity is at last rebounding. For the time being, the recovery is being driven by a cycle of inventory replacement. In Argentina, the other country under our coverage that is enduring a recession, activity is not yet clearly stabilizing. In Chile, Colombia and Mexico activity has recently weakened further. The Peruvian economy continues to stand out, showing solid growth relative to the rest of the region (but not relative to its own past), largely due to higher mining production.

We have raised our growth forecasts for Brazil, reduced our 2016 growth forecast for Colombia and left unchanged our growth forecasts for the other countries. Argentina and Brazil will, in our view, come out of their recessions. We expect a growth rate of 3.0% in Argentina next year, supported by higher real wages and strengthened business confidence. In Brazil, we now expect 2.0% growth in 2017 (up from 1.0% in our previous scenario), following a 3.2% contraction this year (up from -3.5% previously). We also see somewhat higher growth in 2017, relative to 2016, for Mexico, Chile, Colombia and Peru.

Looser monetary policy stances

As exchange rates in LatAm are evolving in a more favorable direction and activity remains weak, inflation continues to fall in most countries in the region. In Argentina, although annual inflation – in the city of Buenos Aires – has yet to peak, it has been moderating substantially on a month-over-month basis, with preliminary indicators pointing at a further slowdown in August. In Brazil and Colombia, the most recent data show annual inflation falling but still far above the upper bounds of the respective target ranges. In Chile and Peru, inflation is back within the ranges targeted by the central banks. In Mexico inflation remains below the midpoint of the target range, although it is gradually rising with the sharp weakening of the peso.

In this context, the region’s monetary policy stances are becoming more expansionary. The central bank of Chile officially removed the tightening bias from its communication, and one board member even wanted to discuss the possibility of rate cuts. We expect Chile’s policy rate to be left unchanged at least until the end of 2017; still, the likelihood of rate cuts is clearly increasing (and in our view is higher than the risk of further rate hikes). The faster-than-expected drop in inflation in Argentina led that country’s central bank to continue reducing its policy rate (by 200 bps in August), and we now foresee more rate cuts than we did in our previous scenario. Meanwhile, the central bank of Colombia has left its policy rate unchanged, likely putting an end to a 325-bp hiking cycle. An easing cycle next year in Colombia is likely as inflation falls towards the target range. Rate cuts are also likely in Brazil: the central bank changed its post-meeting statement to indicate that future steps would be more data-dependent, dropping the expression “there is no room for monetary policy easing” while listing potential drivers of rate cuts. In our view, the change in communication is consistent with our call that an easing cycle will start in October, with a 25-bp rate cut. Mexico is the one country going in the opposite direction: although its central bank continues to forecast subdued growth and at-target inflation, its focus remains on the evolution of the currency and on the Fed’s decisions, so more rate hikes are likely as the Fed raises interest rates. We expect the next interest rate increase in Mexico in December (25 bps), but if the Fed moves in September, the central bank of Mexico would probably also move to raise rates in its September meeting.



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


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