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A benign external environment meets a still-clouded political scenario in Latin America

August 8, 2017

Solid global growth and slow pace of monetary tightening have maintained favorable financial conditions.

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

Global Economy
Positive environment for emerging markets continues
Solid global growth and slow pace of monetary tightening have maintained favorable financial conditions.

LatAm
A benign external environment meets a still-clouded political scenario
Some positive news on the reform agenda led to an outperformance of the BRL in July, while uncertainties over mid-term elections in Argentina made the Argentine peso the worst performing currency last month.

Brazil
Tougher fiscal challenges
Tax increases are insufficient to meet the primary fiscal target, which remains highly dependent on extraordinary revenues and other measures.

Argentina
Facing imbalances and political uncertainty
While the ruling coalition will likely lead the mid-term election at the national level, the political debate revolves around the outcome of the senatorial election for the Province of Buenos Aires, where former president Cristina Kirchner holds a slight lead in the polls.

Mexico
Curbing rate cut expectations
The Central Bank has indicated it is currently in no mood for rate cuts. Our base-case scenario is that Banxico will take a cautious approach in light of the Fed rate hikes and the uncertainty surrounding the presidential election next year.

Chile
More easing ahead
With inflationary pressures likely to remain muted and activity still weak, we foresee further monetary easing, with the policy rate reaching 2.0% by the end of this year.

Peru
Growth will benefit from firmer metal prices
The improvement of copper prices will likely have positive consequences on growth. We have revised the growth forecast for 2018 (to 4.2%, from 4%).

Colombia
Easing cycle close to a pause
The central bank is signaling that the space for rate cuts is limited. This is consistent with our view of only one additional 25-bp rate cut this year (in August).

Commodities
Higher metal prices
Commodities prices rebounded in July due to good global demand and weaker dollar. We now expect iron ore prices at USD 60/mt (USD 55/mt, previously) and copper prices at USD 5700/t (USD 5600/t, previously) by the end of the year.


 


A benign external environment meets a still-clouded political scenario in Latin America

The positive environment for emerging markets is still on, as global growth remains solid. We revised our GDP forecasts for China to 6.7% in 2017 and 6.3% in 2018, from 6.5% and 5.8%, respectively. Interest rates in developed countries are likely to continue rising, but the pace will be slow, as the Fed and ECB are careful not to derail the global recovery. Capital flows to emerging markets benefit from this environment. Risks continue to exist, of course – geopolitical uncertainty emanating from the Trump administration; a repricing of the inflation pessimism in the U.S.; too much tightening that could cause a sharp slowdown in China – but remain modest at the moment..

In Latam, political uncertainty remains high, leading to a mixed performance for currencies. Some positive news on the reform agenda led to an outperformance of the BRL in July, while uncertainties over mid-term elections in Argentina made the Argentine peso the worst performing currency last month. Activity remains weak almost everywhere, but some encouraging indicators in core economies make a recovery seem more likely. Many central banks are still finding room to cut interest rates, but in Argentina the challenging outlook for inflation will likely lead to more gradual rate cuts than we were previously expecting.

In Brazil, a challenging fiscal scenario unfolds, as tax increases are insufficient to offset rising mandatory expenditure and meet the fiscal target. We reduced our exchange rate forecast to 3.35 BRL/USD by year-end (from 3.50), taking into account the positive global scenario, but increased the inflation forecast this year to 3.4% (from 3.3%) due to the fuel-tax increase. The benign inflation scenario opens room for the BCB to continue cutting the Selic rate, which we expect to end this year at 7.25%. Finally, we cut our unemployment rate forecasts for 2018, thanks to the increase in informal sector job creation. 


 


Global Economy

Positive environment for emerging markets continues

• Global growth remains solid. We revised our GDP forecasts for China to 6.7% in 2017 and 6.3% in 2018, from 6.5% and 5.8%, respectively.

• Interest rates in developed countries are likely to continue rising, but the pace will be slow, as the Fed and ECB are careful not to derail the global recovery.

• Flows to emerging markets benefit from this environment and from the improving EM-DM growth differential.

• Risks remain modest at the moment: geopolitical uncertainty emanating from the Trump administration; a repricing in the inflation pessimism in the U.S.; too much tightening causing a sharp slowdown in China.

U.S. – Positive growth, despite a dysfunctional government

GDP growth accelerated to 2.6% qoq/saar in 2Q17, from 1.2% in 1Q17. Consumption has sped up to 2.8% in 2Q17 from 1.9% in 1Q17, while non-residential fixed investment continued to grow at a healthy 5.2%. In 1H17, domestic demand expanded 2.4% over 2H16/saar.

We believe that the economy will continue to grow at an above-trend pace of 2.5% in 2H17. Financial conditions are easy, the global economy supports exports, and the inventory accumulation, which remained close to zero in 1H17, is likely to pick up in the second half.  

We forecast U.S. GDP to grow 2.1% in 2017 and 2.3% in 2018.

The softer inflation in the first half is likely to be transitory, as wages will likely accelerate with the tightening of labor markets. Above-trend GDP growth is consistent with payroll growth at 175k per month and the unemployment rate dropping to 3.9% by 4Q18 (from 4.3% in June). Hence, the average hourly earnings should rise to 3.2% yoy in 4Q18 (from 2.5% in 2Q17), helping to push the Core PCE deflator to 2.0% yoy in 4Q18 (from 1.5% in 2Q17).

The Fed has signaled the start of balance-sheet normalization relatively soon and the continuation of gradual interest-rate hikes. We expect the central bank to announce the start of the reduction of its balance sheet in September, a rate increase in December, and three more hikes in 2018. 

The market still does not price enough increase in the fed fund rate, in our opinion. Investors believe that the fall in inflation is permanent, and fear that the economy cannot sustain its current above-potential pace for much longer. We disagree with both opinions. 

Nonetheless, the dysfunctional U.S. government creates downside risks. The FBI’s Russia investigation has been broadened and will not end soon, leaving President Trump politically vulnerable. Moreover, President Trump is still struggling to put forward a coherent team and policy agenda. 

On the domestic front, a government shutdown and the debt limit (early October) are the main risks, while there is little hope for a tax reform. The administration could not find a simple majority in the Senate to repeal and replace the Affordable Care Act, and now needs a 60-vote majority in the Senate to pass the FY18 budget. A temporary budget maintaining the FY17 spending levels seems more likely, which could avert a shutdown. In the same budget legislation, congress is likely to increase the debt limit, but this can no longer be taken as sure. The budget resolution for 2018, the legislation that sets the limits of budget changes that can be made by a simple majority in the Senate, should limit the scope of a tax reform.

On the external front, the main risk is North Korea, in particular, its implications for U.S.-China relations. North Korea is thought to be a year away from being able to deliver a nuclear device into U.S. territory. The U.S. administration is likely to keep increasing the pressure on China to negotiate an end to the North Korean nuclear program. As making progress remains difficult, President Trump could impose unilateral trade sanctions against China soon. Moreover, there seems to be an increasing possibility of a preemptive U.S. military strike in North Korea, for the next 1-2 years.

Europe – Solid growth, ECB cautiously preparing to reduce its asset purchases

Euro-area GDP expanded 0.57% qoq in 2Q17. Diminishing political risks, accommodative financial conditions, increasing lending through banks and improving labor markets support growth in the euro area. 

Leading indicators suggest that the economy is maintaining its positive momentum. Indeed, July’s Purchase Manager’s Index (PMI), indicates GDP growth of around 0.5%-0.6% qoq in 3Q17 (see graph). 

With a better economic outlook, the ECB will likely start a reduction in its asset purchases later this year. Draghi stressed the need to persist with a prudently loose stance, but if the economy continues to make progress and global risks stay contained, the ECB will need to adjust its policy “parameters.” In our view, the ECB will reduce its monthly asset purchases to EUR 40 billion (from EUR 60 billion) in 1H18 (an announcement is likely to come in October).

We maintain our GDP forecasts at 2.0% and 1.7% for 2017 and 2018, respectively.

Japan – Healthy Growth in 2Q17

Japan’s economy is showing signs of improvement. Exports are being boosted by strong industrial production and a lagged weak-yen effect, which supports our view that the Japanese economy is set to grow faster than its potential rate this year. Additionally, a tightening labor market – unemployment stayed at 2.8% in April – should help consumption ahead. In fact, 1Q17’s preliminary GDP print came in at a strong 2.2% saar. 

Our GDP growth forecasts for Japan remain unchanged at 1.4% in 2017 and 1.0% in 2018.

China – Stronger growth in 2017 and 2018

China’s GDP grew by 6.9% yoy in 2Q17, maintaining the robust growth rate of the previous quarter. Moreover, the economy ended 2Q17 at a solid pace. In June, year-to-date industrial production and fixed-asset investment grew by 7.6% yoy and 8.6% yoy, respectively. Retail sales rose by 11% yoy in the same period.

We now expect only a modest slowdown ahead, and revised China’s GDP to 6.7% in 2017 (6.5%, previously) and 6.3% in 2018 (5.8%, previously). Looking at the breakdown, we expect consumption to maintain its contribution (4.3 pp in 2017 and 2018), a 0.1 pp contribution for 2017 and neutral for 2018, from the external sector (after two years of negative contributions) and at last, a moderate slowdown from investment contribution (see table at the end).

Why do we expect stronger Chinese growth?. First, the external sector is no longer a drag. Net exports’ contribution to GDP became positive in 2017 (0.3% yoy in 2Q17, from -0.5% in 2016), in line with the concurrent improvement in the global economy and a more competitive exchange rate.

Second, a recovery in private investment has offset the decrease in public investment (see chart). The private sector was helped by the significant deleveraging that has occurred in the sector since 2012. Also, the improved global environment boosted the manufacturing sector.

Third, the housing sector is more balanced. Inventories are lower and sales are increasing at a faster pace than construction. At the end of 2013, 12-month-average floor-space started was at 121 million square meters, while sales growth was at 96 million square meters, so inventories were on a positive trend. At the beginning of 2015, sales began to outpace construction, and inventories started to decrease (see chart).

All this should allow some policy tightening without causing a major slowdown. The government initiated a policy shift in late September 2016 by implementing macro-prudential measures to cool of the property sector. The central bank hiked several policy rates in early 2017 and adopted more rigid financial regulations. Also, there was less fiscal stimulus, as public investment has been decreasing since the beginning of the year. Macroeconomic policy is likely to continue to be tightened to adjust some imbalances, such as the high leverage of the state-owned enterprises.  

The risk is a policy mistake, with too much tightening causing a sharp slowdown. However, this risk tends to be low in the short term, as the policymakers will probably refrain from much tightening in advance of the Party Congress.

Emerging Markets – Inflows set to continue

Interest rates are slowly rising in developed markets with the Fed moving forward with its policy normalization, the Bank of Canada being the second major central bank to raise rates, and the ECB about to start reducing it policy accommodation. We think that this process reflects better global growth (see graph), and that central banks will remain careful not to derail this recovery. Low inflation gives central banks space to maneuver.

A slow increase in global rates will likely not interrupt inflows to emerging markets. Current-account deficits have declined and inflation is converging to target in several emerging economies. This reduces exchange-rate risks and allows a fall in interest rates. Moreover, growth in emerging markets is improving in relation to developed markets. Financial inflows to EM usually rise in line with better EM-DM growth differential (see chart). As long as the process of interest increases in developed countries remains gradual, inflows to EM should continue.

Commodities – Higher metal prices

The Itaú Commodity Index recovered 4.3% in July with good global demand and a weaker dollar. Metals and Energy increased 7.5% and 6.0%, respectively. The agriculture index remained broadly stable over the same period.

Oil recovered from recent lows, but we maintain our year-end forecasts of USD 45 (WTI) for both 2017 and 2018. The recent rally was explained by stronger stock draws and some stabilization in investment in the shale industry in the U.S. 

We increased our price forecasts for base metals due to better growth in China. We now expect iron ore prices at USD 60/mt (USD 55/mt, previously) and copper prices at USD 5700/t (USD 5600/t, previously) by the end of the year.

We also raised our price forecasts for soybeans, wheat and corn. Adverse weather conditions reduced the grains’ productivity in the U.S. 

Our new ICI forecast is 6.3% above our previous scenario. Despite the revision, our year-end ICI forecast is 5.8% below its current level, due to lower metal and energy prices.


 


LatAm

A benign external environment meets a still-clouded political scenario

• The external scenario remains benign for emerging market asset prices. Some positive news on the reform agenda led to an outperformance of the BRL in July, while uncertainties over mid-term elections in Argentina made the Argentine peso the worst performing currency last month. 

• Activity remains weak almost everywhere, but the solid activity data in core economies make a recovery seem more likely.

• Many central banks are still finding room to cut interest rates, but in Argentina the challenging outlook for inflation will likely lead to more gradual rate cuts than we were previously expecting.  

The external scenario is still supportive of emerging market asset prices, recently helped by stronger data in China (with the expected spillovers to commodity prices), lower-than-expected inflation in the U.S. and the guidance provided by the ECB on future policy decisions. In this environment, the Brazilian real has outperformed the other currencies in the region, helped by the approval of the labor reform by a wide margin in the Senate. On the other hand, the Argentine peso kept depreciating fast, mostly due to concerns over the possibility of a victory for former president Cristina Kirchner in the key battle for the Senate in the Province of Buenos Aires during mid-term elections in October. The political uncertainty in Argentina comes at a time when signs of overvaluation (namely the fast deterioration of external accounts) are becoming visible. The Central Bank of Argentina sold dollars to contain the depreciation pressure, but we note that the relatively low level of foreign exchange reserves is an obstacle for systematic intervention.   

Activity remains weak in the region, but the positive developments in the Chinese economy and activity in developed markets increase the odds of a recovery. In Brazil, the available data show activity resilient to the latest political crisis, suggesting that a gradual recovery continues. In Argentina the economic recovery is gaining traction and becoming more widespread across sectors. Still, in both countries political developments (the mid-term elections in Argentina and the fiscal reforms in Brazil) will continue to dominate the market’s attention, with consequences (positive or negative) for economic growth. In Chile and Peru, the improvement in activity during 2Q17 is nothing but an expected comeback from one-off negative shocks (mining strike in Chile and El Niño in Peru), and in both countries we note that politics have also been a drag on the economy (presidential elections in Chile will dictate the fate of some controversial reforms, maintaining uncertainty, and corruption scandals are paralyzing important infrastructure projects in Peru). In Mexico, the economy has weakened at the margin in 2Q17, according to the bulk of available activity indicators, with contrast between weakening internal demand and strong exports. But as uncertainty over the fate of NAFTA continues to ease and real wages rise with the strengthening of the currency, internal demand will likely recouple with exports. 

Central banks facing weak activity and falling inflation are still finding room to reduce interest rates. In Brazil, the central bank reduced the policy rate by 100 bps for the third consecutive meeting, bringing the Selic rate to 9.25%. The minutes of the meeting suggest that the debate within the board for the next decision (in September) is whether to cut by 100 bps once again or to reduce the pace to 75 bps. Given that we do not expect the scenario (domestic or external) to change materially until September, we expect the central bank to deliver another 100-bp cut, thereafter slowing the pace to 50 bps, as the Selic rate approaches the terminal level expected for this cycle. In Chile, the large downward surprise in inflation in June coupled with weak activity will likely lead to further easing. The minutes of the most recent policy decision already show one board member (out of five) voting for a rate cut, while two members sounded open to the idea of increasing monetary stimulus. As a result, we now see two 25-bp rate cuts in Chile before the end of this year. Meanwhile, some Colombian central bank board members (including two who had previously called and voted for more aggressive monetary policy action) indicated that the space for rate cuts had narrowed. In our view, the communication is consistent with our call of only one additional 25-bp rate cut in August, before the central bank in Colombia takes a pause. In Peru, the central bank delivered the second cut of the cycle in July (25 bps), but Governor Julio Velarde said recently that he saw only one or two additional 25-bp rate cuts (consistent with our call of two additional 25-bp rate cuts this year). On the other hand, while rate hikes are unlikely in Mexico, board members are curbing expectations for rate cuts, also in line with our view that rate cuts in Mexico will only come in the second half of 2018 and will be gradual (we see two 25-bp rate cuts next year). On the other hand, monetary policy in Argentina is facing greater challenges, as core inflation readings remain high and the recent depreciation of the peso makes disinflation harder. So, the central bank has left the monetary policy rate unchanged, at 26.25%, since the beginning of April (when there was a 150-bp rate hike) and tightened monetary policy through the yield paid on its short-term sterilization bills (Lebac). We now expect a more gradual and back-loaded easing cycle in Argentina, with the policy rate ending the year at 25% (22% in our previous scenario). The outcome of the mid-term elections is a key risk for our interest rate call.


 


 


 

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



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