Itaú BBA - What to expect in 2016?

Global Scenario Review

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What to expect in 2016?

December 8, 2015

The coming year shouldn’t be bad for the global economy. But risks remain.

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

Global Economy
Better global growth and inflation in 2016
We expect global growth to improve in 2016 as developed countries maintain a moderate pace and emerging markets see signs of stabilization. Inflation should also increase with risks becoming more balanced.

2016 - Less turbulence
We expect economic growth in Latin America to recover in 2016. Exchange rates will likely depreciate somewhat against the U.S. dollar, but much less than in 2015.

Political uncertainty and continued recession in 2016
The political and economic uncertainties in the domestic scenario are intertwined and will likely continue. We expect unemployment to rise and another decline in GDP next year.

2016 starts on December 10
Mauricio Macri takes office on December 10. The new administration has indicated welcome policy changes. There are low-hanging fruits in the economy. But the government will inherit a number of economic imbalances.

Higher growth and low inflation in 2016
The weaker peso and the U.S. recovery will likely boost manufacturing exports. A recovery of external demand would spill over to the domestic economy, helping the solid momentum of consumption.

Growth to remain low for another year
For 2016, we now expect even milder economic activity recovery of 2.3% (2.5% previously), from the 2.0% estimated for this year. This would be the third consecutive year of low growth as the economy adjusts to low copper prices.  

Mild recovery in an electoral year
We expect growth to accelerate in 2016, led by stronger mining production, private investment and better execution of subnational government investment.

The year of peace?
We expect the economy to continue to adjust to lower oil prices in 2016, with GDP growth of 2.8%, from the 3.0% this year. Meanwhile, the signing of a peace deal with the FARC is very likely.

Have prices reached the bottom?
We forecast a slight recovery in commodity prices in 2016, driven by adjustment in the oil market in 2H16, capacity cuts in China and still-robust growth in demand for agricultural commodities.

What to expect in 2016?

On the whole, the coming year shouldn’t be bad for the global economy. The mature economies will probably sustain their current recovery while emerging economies stabilize. Commodity prices will finally bottom: Some recovery is likely, reducing risks of global deflation and improving the terms of trade for many emerging countries.

But risks remain. The Federal Reserve may need to raise interest rates faster than the market is pricing in,  causing some volatility. In China, despite signs of improvement, risks continue to be of a greater-than-expected deceleration.

In Latin America, we foresee a gradual growth recovery in 2016. We expect local currencies to depreciate further, but at a much slower pace. Current account deficits should continue to improve. We forecast inflation readings to fall, but to remain above the target center, leading some central banks to increase rates modestly.

Brazil is an exception in many ways. Fiscal and political uncertainties will remain significant, reducing predictability in the economy. We expect unemployment to rise and another decline in GDP in 2016. Inflation will remain high, but on a downward trend. We expect the central bank to keep the benchmark interest rate stable, but there are risks of further hikes next year, given the  central bank’s recent communications and the last monetary policy decision’s split vote.

Argentina carries the biggest hopes for change. Elected President Mauricio Macri has been signaling new, welcome, policies, but addressing the current imbalances is still a big challenge.

Global Economy

Better global growth and inflation in 2016

• We expect global growth to rise to 3.3% in 2016, up from 3.1% in 2015, as developed countries maintain a moderate pace of growth and emerging markets see signs of stabilization. Inflation will also likely increase, with risks becoming more balanced.

• In the U.S., risks to inflation will swing to the upside in 2016. In our view, investors currently underestimate the pace of interest rate hikes next year.

• In the euro area, we believe the recovery will advance with the help of the ECB.

• In Japan, we see a steady but still difficult trajectory to end deflation.

• China will continue to be the main risk to the global economy in 2016.

In 2015 emerging markets decelerated and threatened global growth. China’s GDP likely slowed just 0.4 pp, to 6.9% in 2015 from 7.3% in 2014. But the slowdown was stronger in China’s Industrial sector and investment spending, affecting global demand and commodity prices. Meanwhile, Russia and Brazil lapsed into recession.

In 2016, global growth will likely reach 3.3% (versus 3.1% this year), as developed countries maintain a steady pace and emerging markets start to see some stabilization. This forecast for 2016 is in line with the 3.4% average seen between 2012 and 2014. We don’t see factors that could push growth higher than that, as developed countries are already having difficulties growing at current rates, China will continue to slow down and other emerging markets still need to find a growth model that relies less on commodities. Still, some of the deeper recessions in large emerging markets (like Russia) might ease.

We expect the balance of risks for inflation to change in 2016, as headline inflation increases and core measures in developed countries continue to move up. We expect most commodity prices to stabilize and oil prices to post a small recovery in 2H16. This will be enough to increase headline inflation as the base effect of past declines in oil prices fade away (see graph). In addition, slack in the labor market continues to decline in developed economies, helping to slowly push wages and core inflation up (see graph).  

Heterogeneuos growth

In developed countries, the inflation outlook – and hence the monetary outlook – remains differentiated. Progress will be clearer in the U.S., and we see interest rates going up by more than the markets expect. In Europe, inflation will move up gradually with the help of the ECB. In Japan, there are still downside risks, and the fight to end deflation remains tough.

In emerging markets, some countries still need to stabilize, and monetary policies will also diverge. Brazil will face another year of deep recession. In terms of monetary policy, we see interest rates steady or up in Latin America, where growth is stabilizing and inflation is above the target. But in Asia, inflation is subdued, and there is still some scope for monetary policy easing.

The USD will probably see a final, modest increase in 2016. We see the USD rising another 5% against an equal-weighted basket of emerging market currencies. This is a small move compared with the gain of 38% since 2012. We expect the euro to approach parity as monetary policy continues to diverge but not to break lower, as the recovery in the euro area advances.

China will continue to be the main risk to the global economy in 2016, as it still has to rebalance its economy amid high debt levels in local governments and the corporate sector.

U.S. – Risks to inflation will swing to the upside in 2016

As the Fed approaches its first interest rate hike in almost 10 years, we believe investors are not fully pricing in the tightening cycle that is about to start. The FOMC will likely increase the Fed Fund Rate at its December 16 meeting. We expect the FOMC to increase rates by 100 bps in 2016, but the Fed Funds futures price is just 65 bps. Hence, we see two-year Treasury yields increasing to 2.0% by year-end 2016, up from 1.0% at year-end 2015, which is about 35 bps above the current forward curve. The market prices imply that the Fed will increase rates only twice in 2016. We note that in the past three tightening cycles, the Fed Funds Rate was raised by 175-250 bps in the first year.

Why do investors price in such modest increase in the interest rate? Investors continue to believe in the “Secular Stagnation” hypothesis that equilibrium real interest rates are structurally low, and hence, they see inflation risk tilted to the downside. Indeed, the break-even for five-year CPI inflation is at 1.3%, 70 bps below the Fed’s 2% inflation target.

However, the balance of risks to the inflation outlook is likely to swing up in 2016. The external headwinds to inflation from energy price deflation and the USD appreciation are likely to ease, while domestic wage price dynamics could put some upward pressure on inflation, as the U.S. economy is expected to reach full employment around mid-2016.

Two important movements will help reshape investor perceptions of inflation.

First, the headline inflation is set to rise and converge close to the core measures in 1Q16, as most of the gasoline price deflation will drop off the 12-month change. The CPI will increase to 1.6% year over year in the first quarter, from 0.1% year over year in October. This should be an important event, as it has been holding back the breakeven inflation compensation implied by government bond yields (see graph).

Second, the core PCE deflator should rise to 1.7% year over year by end-2016, up from 1.3% year over year at year-end 2015. The appreciation of the nominal effective exchange rate (NEER) of 15% YoY in 3Q15 has been holding down core goods inflation (see graph). This headwind will dissipate because we believe that the NEER will strengthen, but “only” by an additional 5% in 2016. In addition, wage inflation should rise from 2.0%-2.5% in 2015 and to 2.5%-3.0% in 2016, adding some pressure to core services price inflation.

Finally, we forecast that GDP will expand 2.2% in 2016, enough to continue to help the slack labor market and contribute to inflation normalization. Economic indicators suggest growth at 2.0% SAAR in 2H15. The Manufacturing sector continues to adjust production and inventories to accommodate slower external demand. Domestic private demand remains solid, boosted by easy domestic financial conditions. This strength is set to continue into 2016, as interest rates will remain low, despite the expected rate hikes. Moreover, federal government spending will become a slight additional tailwind in 2016, given the FY16 budget. It is true that net exports should continue to limit the output expansion, but growth will remain at an above-trend pace, enough to continue to reduce the labor slack.

Europe – Recovery to advance in 2016 with the help of the ECB

The economic recovery in the euro area is set to continue in 2016 on easy ECB policy. Growth has been more stable in 2015 – even if not particularly buoyant – with domestic demand leading the way. This is likely to remain the case next year, with the help of easy financial conditions as the ECB keeps interest negative and continues to expand its balance sheet. Easy monetary policy is helping final borrowers, as interest rates at which they borrow drop and credit expands (see graph).

Marginally expansionary fiscal policy and low oil prices should also aid the cyclical recovery. We see oil prices stabilizing ahead, but the drop this year will still be positive for consumption in 2016.

Inflation is bound to recover, but only slowly, keeping the ECB on alert for downside risk. Headline inflation will likely move up from the 0% seen this year, as the base effect from the drop in oil prices becomes more favorable. But inflation will likely hover around 1% for most of 2016 before picking up again at the end of next year. Meanwhile, we see core inflation inching up only slowly due to the large output gap in the region. This means the ECB will continue to see downside risk for the inflation outlook, and it will be ready to ease policy further if it deems necessary.

The domestic recovery is not without risks though, with geopolitics and weak potential growth the main issues. The threat of more terrorist attacks in Europe will be big concern 2016. While the recent Paris attacks are likely to have only a minor transitory effect on GDP growth, business and consumer confidence could plummet if more terrorist killings occur. Additionally, weak potential GDP growth, which we estimate to be around 1% could be even lower as the outlook for structural reforms is modest.

We leave our 2015 and 2016 GDP growth forecasts unchanged, at 1.5% and 1.7%, respectively. 

Japan – Did the Bank of Japan (BoJ) lose its fight to end deflation? Is Abenomics over?

Japan’s economy traveled a bumpy road in 2015. GDP contracted 0.5% qoq in 2Q15, but increased 1.0% in 3Q15. We expect it to expand 0.6% for the year as a whole. This is not bad in per-capita terms (0.9%) but still a soft recovery after the 0% growth seen in 2014 and the 1.2% we forecasted for 2015 at the beginning of the year.

Progress in the fight against deflation has also become less clear. Inflation excluding food and energy increased to 0.7% in October 2015 from 0.4% in December 2014. However, inflation expectations have started to decline again, posing a risk that the Japanese deflationary mindset will return.

We don’t expect progress on the structural side of Abenomics. Indeed, Abenomics already lost its momentum this year, with little progress in overcoming fiscal and structural challenges. We don’t expect a revival in 2016, and we don’t anticipate change in Japan’s longer-term growth prospects.

However we believe that Japan will keep working to exit deflation and that the BoJ will be ready to react if necessary. We see inflation slowly increasing in 2016 and reaching the 2% target in 2017. With the economy expanding above-trend in 2016 (we expect GDP growth of 1.0%), the labor market will remain tight and drive wages up. This should increase inflation, as the effect of the yen depreciation fades. However, downside risks remain. Next year annual wage negotiations, which start in April, are essential. If global or domestic factors threaten wage increases during negotiations, the BoJ could further ease its already ultra-loose policy.

China – Downside risks into 2016

China’s economy is reaching the end of 2015 with mixed activity data but some stabilization in financial markets. After the stock market crash and messy change in the exchange rate policy in the middle of the year, policymaking has become more stable. The IMF finally announced that the yuan will enter the SDR basket, and China’s policymakers continue to say they seek a stable currency. Activity data, however, remains mixed. Industrial production was up 5.6% yoy, and retails sales 11.0% yoy in October, fairly stable compared with 5.7% yoy and 10.9% yoy, respectively, in September. Fixed investment improved to 9.3% yoy from the weak 6.8% level in the previous month. In November the manufacturing PMI declined to 49.6 from 49.8 in the previous month, but the non-manufacturing PMI increased to 53.6 from 53.1. We continue to forecast that 2015 GDP will expand 6.9%, but the unusual contribution from the financial sector accounts only for 0.3 pp of this growth.

For 2016 we expect to see gradual progress in the rebalancing of the economy, and we believe that the GDP will decelerate to 6.3%, still in a two-speed economy. From the demand viewpoint, investment is likely to decelerate further while domestic consumption continues to grow rapidly. From the supply side, we believe that Industrial sector will lag behind Services, but the slowdown is likely to be less steep than in 2015. We assume that the unusual contribution from the Financial sector will fade through the year. The “adjusted” GDP growth will be approximately 0.3 pp lower than in 2015 (and not 0.6 pp, as the headline number suggests).

However, there will still be downside risk, as the goals of rebalancing and of a soft landing could run counter to economic policy. Excessive leverage in the economy and liberalization measures may limit the effectiveness of monetary policy, while the ongoing anti-corruption campaign and changes in local government funding could affect fiscal policy. Besides, bad governance of state-owned enterprises is still costing money, and fixing the problem is a slow process.

Commodities – Have prices reached the bottom?

Commodity prices continued to drop in November. The Itaú Commodity Index (ICI) declined 6.4% over the period, still reflecting the oversupply in most markets and spillover from lower oil prices to base metals production and transport costs. Base metals and energy prices were hit harder (-8.9% and -7.6%, respectively), while agricultural prices outperformed again (-3.5%). The recent performance repeats the pattern of the whole year: Metal prices declined the most (-32%), followed by oil-related commodities (-20%), while agricultural prices outperformed (-11%). We believe that differences in demand growth explain the divergence across components.

We lowered our 2016 price forecast for metals and soybeans. We see no reason for a sizable rebound in metals to reverse the recent price decline. An additional supply of soybeans from Argentina amid exchange rate policy and tax reforms will pressure soybean prices.

However, we see ICI rising 10% in 2016, driven by a partial rebound in crude oil prices, a reduction in overcapacity in China and a favorable balance for agriculture commodities. Current low oil prices, which we think will stay low given the ongoing inventory buildup, will prompt additional declines in capex, reducing future supply and balancing the market by 2H16. A recovery in oil prices affects costs (and prices) of metals and agricultural products. China is likely to take some steps to reduce overcapacity in metals, withdrawing supply from the market. Finally, the increase in demand for agricultural commodities remains strong, and climate-related issues may affect crops in the next year, after two favorable years.

Although this expected rise is small compared with the accumulated 50% decline since 2012, it is enough to improve commodity exporter terms of trade and to reduce global deflationary pressures.

Latin America

2016 – Less turbulence

We expect economic growth in Latin America to recover in 2016. Exchange rates will likely depreciate against the U.S. dollar, but much less than in 2015. Aided by weaker currencies, current-account deficits should narrow. The stabilization of exchange rates will help bring inflation down, but due to inertia, the central banks’ target centers are unlikely to be met. With inflation still pressured, some central banks will probably continue to increase interest rates, but we expect policy rates to peak soon. Also next year, there will be key political events (the evolution of the fiscal/political crisis in Brazil, presidential elections in Peru, the peace deal between the Farc and the Colombian government, the ongoing reform debate in Chile). Finally, in Argentina, 2016 starts on December 10th, when the recently elected President Mauricio Macri takes office.    

The economies in Latin America will likely perform slightly better next year than in 2015. For Brazil, that still means a contraction in 2016 (through less intense than in 2015). In Peru, the recovery will be stronger as new mining projects enter into operation, private investment stabilizes and public capital spending (a major drag on growth this year) picks up. In Chile, the stabilization of investment will also help growth. In Colombia, the economy this year has been sustained by credit and public investment. As these two factors are unlikely to help next year (due to the tightening of macro policies), we expect the economy to slow down somewhat. However, some specific factors (the Cartagena refinery and the 4G infrastructure program) will likely sustain growth. Mexico is the only country where we expect growth to surpass its average of the past few years. The recovery of the U.S. economy, combined with the weaker Mexican peso and, to a lesser extent, the implementation of the energy reform, will likely lift activity.

Exchange rates in Latin America will likely depreciate slightly against the U.S. dollar in 2016. On one hand, we expect the Fed to raise interest rates next year a bit more than the market is pricing in, so an additional – albeit small – appreciation of the U.S. dollar is likely. On the other hand, we expect some recovery of commodity prices. The Brazilian real will likely continue to underperform, as uncertainty over politics and public finances remains. As uncertainty about the external scenario recedes, we expect many central banks to gradually reduce intervention. In fact, the recent stabilization of the Mexican peso encouraged the country’s policy makers to eliminate the USD 200 million daily auctions with no minimum price, meaning that dollar sales will only occur if the exchange rate depreciates at least 1%.

As internal demand stabilized and commodity exports fell further, the current-account deficits of many countries in Latin America deteriorated between 2Q15 and 3Q15. In Brazil, where the economy has yet to bottom, the current-account deficit continues to narrow. In any case, we expect the current-account deficits of most countries in the region to narrow in 2016, driven by the lagged impact of exchange-rate depreciation. 

With exchange rates depreciating far less than in 2015 and growth still weak, inflation will likely fall next year. However, except in Mexico, we do not expect inflation to reach the central banks’ respective target centers in 2016. With inflation running above the target range for many months in Brazil, Chile, Colombia and Peru, we expect slow convergence of inflation to the target.

Because inflation is still pressured, some central banks will probably continue to increase interest rates, but we expect the tightening cycle to end soon. While growth remains weak, exchange-rates stabilize and inflation gradually falls, central banks are unlikely to raise interest rates by much. In Brazil, where monetary policy is already tight, we do not expect rate moves; the high level of inflation and inflation expectations stand in the way of rate cuts, while the deep recession prevents additional rate hikes. In Colombia, in spite of the rising inflation expectations, the central bank reduced the pace of rate hikes to 25 bps in November and indicated that two years is the appropriate horizon to bring inflation to the 3% target, given the size of the shocks affecting inflation. We expect the Colombian central bank to end the cycle with a 25-bp rate increase in each of the next two meetings. In Chile and in Peru, where inflation has stabilized, the tightening cycle has been more gradual (Peru’s central bank left the policy rate unchanged in October and November, after delivering a rate hike in September, while the Chile’s maintained the policy rate in November, after starting a tightening cycle the month before.) We expect only one additional 25-bp rate increase in Chile and two additional 25-bp rate hikes in Peru. Finally, in Mexico, we think that the more benign performance of the Mexican peso together with the further downside surprises in inflation will likely encourage the board to delay interest-rate hikes to 1Q16, after the Fed’s liftoff in December. We expect rate hikes totaling 100 bps in Mexico next year, starting in March.

There are key political developments in the region in 2016. An agreement between the Farc and the Colombian government is expected by March, and a referendum on the deal will be held soon after. In Peru, there are the presidential elections in April. While the candidates leading the polls are perceived as market friendly, some uncertainty remains, given that in the past, polls at this time of the year have failed to capture the outcome of the elections. In Chile, the debate and approval of the controversial reforms will continue. In Brazil, the focus will continue to be on how the political/fiscal crisis unfolds.

In Argentina, 2016 starts on December 10, when Mauricio Macri, the center-right candidate who won the presidential elections, takes office. The names announced for the economic team were welcomed by the markets, but there are significant challenges for the incoming administration.

We see little room for postponing a devaluation of the Argentinean peso, given the low level of international reserves and its downward trend. We expect the exchange rate to end this year at 13 pesos to the dollar (a 34% depreciation from the current nominal level). To contain dollar purchases and prevent inflation from rising much, monetary policy will likely tighten. We expect the Badlar rate to end this year at 35%. Also, to reduce the pressure on the exchange rate, controls on dollar transactions will not be fully eliminated in the near term, though they will probably be loosened. Meanwhile, the government will likely seek to attract dollar inflows (from foreigners or from Argentineans’ savings abroad). In 2016, we expect the exchange rate to end the year at 17.1 pesos to the dollar, implying a real exchange rate that is broadly stable from our year-end 2015 forecast. The real exchange rate should continue strong based on. its own history. However, history might not repeat itself. With more market-friendly policies, Argentina can live with a larger current-account deficit than in the past. Still, we acknowledge that managing the transition will not be easy, so there are risks that the exchange rate depreciates by more than we expect.  

We expect Argentina’s economy to contract by 0.5% in 2016. The negative impact of the devaluation on real wages and the tightening of macro policies will likely more than offset the benefits of increased confidence in the short term. In the medium term, however, adjustments will pay off. We expect a rebound of activity in 2017, with a decrease in inflation.



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


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