Itaú BBA - A permanent change

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A permanent change

April 10, 2015

The scope for adopting counter-cyclical policies to boost in Latin America has narrowed

Global Economy
Rate increases after liftoff to be gradual
The FOMC indicated a gradual approach to raising rates after liftoff. But the trend remains one of strong dollar and weak commodity prices. Combined with their weak growth fundamentals, the outlook remains challenging for emerging markets.

GDP declines further
Business confidence continues to decline at a rapid pace, suggesting further GDP  fall in the short term. Labor market data also reflects weakness. We revised our GDP forecast for 2015, from -1.1% to -1.5%.

Lower growth, controlled inflation...and higher interest rates?
The central bank emphasized that activity is weak and inflation expectations are well anchored. Still, it has made clear that its actions will be mostly determined by Mexico’s monetary policy stance relative to that of the U.S. We expect the hiking cycle in Mexico to start in September, in conjunction with the Fed’s liftoff, but there are risks that Mexico's central bank moves months after the Fed.

A more cautious Central Bank
As a response to the worsened inflation outlook, the Central Bank introduced a tightening bias in its Monetary Policy Report. In our view, the bias seeks to maintain expectations anchored at the target. We continue to expect no rate moves in our forecast horizon, but if inflation surprises to the upside or if inflation expectations for the medium term rise, rate hikes become likely.

A less impressive recovery
While we still expect that a rebound in mining production and fiscal stimulus will lift growth from the weak rate recorded in 2014, we reduced our GDP growth forecast for this year (to 3.5%). For 2016, we now expect 4.5%.   

Mind the current-account gap
Lower oil prices, disappointing oil production and solid internal-demand growth widened the current-account deficit to an uncomfortable 5.2% of GDP in 2014. We expect a further deterioration this year, as lower oil prices more than offset the benefits of a weaker peso and the expected economic slowdown

Not so easy
Despite the market-friendly profile of the main presidential candidates, President Kirchner may maintain influence in the Congress and in the Peronist party, balking at adjustment policies and an agreement with holdouts.     

No recovery in sight
Commodities resumed a downward trend in March. We cut our year-end forecasts for oil and iron ore prices, as we acknowledged slower adjustments in supply. Downside risks remain. Among agricultural commodities, we lowered our forecasts for soybeans and sugar.

A permanent change

Weaker activity data and a risk-averse stance by the Federal Reserve have driven markets to reduce their expectations for the pace of interest-rate hikes in the U.S. Long-term Treasury yields fell again, opening a new liquidity window for emerging markets.

However, this effect tends to be short lived. We expect the Fed to begin a gradual interest-rate hiking cycle in September. Commodity prices are likely to remain low, in response to the weak growth in China and elsewhere. Iron ore prices have dropped 14% since mid-March, and are 74% below the recent highs.

This environment reduces the room for maneuvering in Latin America. The scope for adopting counter-cyclical policies to boost these economies has narrowed. Tighter global liquidity and lower commodity prices represent a permanent change that will lead to slower growth and weaker currencies in the region. We reduced our 2015 GDP growth forecasts for Mexico, Peru, Colombia and Brazil. The exchange-rate depreciation has kept current inflation high despite the sluggish activity. Some central banks, including those in Chile and Colombia, have adopted a more hawkish stance. We no longer expect interest rate cuts in Colombia and Peru. 

In Brazil, several macro adjustments – which include fiscal and quasi-fiscal, regulated prices, inflation targeting and balance of payments – are advancing amid economic and political uncertainties. Notwithstanding the significant efforts, falling revenues and the need to execute delayed disbursements have been weighing on fiscal results. We reduced our primary-budget-surplus forecast, but believe that the figure will still be enough to maintain the country’s investment grade status. A substantial increase in regulated prices will put pressure on inflation this year. We continue to expect a significant deceleration in inflation next year, but to a level that would remain above the center of the target. External accounts have started to show some improvement, driven by the currency depreciation - a trend that is reinforced by the end of the central bank’s daily intervention program in March. Meanwhile, business and consumer confidence levels continue to decline, suggesting a further contraction in activity over the next few quarters.

In Argentina, the presidential election in October is dominating the news flow. Although the chances of a victory by opposition candidate Mauricio Macri are still good, recent polls indicate a tighter race. We maintain our view that deeper economic adjustments will only be carried out in 2016.

Global Economy

Rate increases after liftoff to be gradual

• Activity in the U.S. was weak in 1Q15 but we expect a rebound ahead. The euro area had a strong first quarter, and the good pace will likely continue in the second. Growth in Japan is failing to impress, but it might improve during the year.  

• China had a weak 1Q15. We expect a stimuli-led improvement in 2Q15 but the underlying trend remains growth moderation.  

• The FOMC indicated a gradual approach to raising rates after liftoff. We lowered our forecasts for the 2-year Treasury to 1.2% (from 1.6%) and the 10-year to 2.5% (from 2.8%) at year-end 2015.

• The pressure on emerging markets might have moved down a notch with the U.S. Fed’s gradual approach. But the trend remains one of a strong dollar and weak commodity prices. Combined with their weak growth fundamentals, the outlook remains challenging for emerging markets.

U.S. – The FOMC indicated a gradual approach to raising rates after liftoff

Economic growth was weak in 1Q15 but will likely rebound in the rest of the year. We revised our estimate of GDP growth to 1.0% qoq/saar in 1Q15, a slowdown from the already moderate 2.2% growth in 4Q14. The slowdown was led by temporary factors like the harsh winter and port strikes in the west coast. In addition, further capital-expenditure cuts in the oil industry contributed to the slowdown. But the overall fundamentals of the U.S. economy remain good. In particular, financial conditions remain loose and supportive for growth of around 2.5%. Hence, we expect a growth rebound in 2Q15 and 3Q15 as the temporary factors fade away and oil-related investments stabilize in the second half.

Labor-market conditions are likely to continue to improve, despite the slowdown in March. Non-farm payroll slowed down to 126,000 in March, but averaged 197,000 per month in 1Q15. The unemployment rate ended the quarter at 5.5%, down from 5.7% in the fourth quarter. We see the March slowdown in job creation as consistent with the weaker GDP growth in 1Q15. As the latter improves, we expect the former to maintain a pace of close to 200,000 per month until the end of 2015. In that case, the unemployment rate is likely to reach the Fed’s full employment range (5.0%-5.2%) in 3Q15.

In terms of inflation, the core PCE deflator was up 0.13% mom (1.4% yoy) in February, stronger than the 0.05% average of the prior three months. We expect the core PCE to remain around the February pace on average, which will stabilize the annual rate at 1.2% yoy between 2Q15 and 3Q15, before rising to 1.3% yoy in 4Q15.

The March FOMC meeting all but eliminated the chance of the Fed increasing the fed funds rate in June. We expect the first move in interest rates to occur in September. 

FOMC members seem confident that economic conditions are likely to warrant the first interest-rate increase since the financial crisis later this year. We think that the labor market and inflation outlook outlined above will allow the FOMC to be “reasonably confident” to start increasing rates in September.

The main risk is the possibility of a further weakening in core inflation measures. The trade-weighted measure of the U.S. dollar appreciated 5% in each of the last two quarters. We see a chance that the pass-through to prices may be higher than we anticipate, which could cause the core PCE deflator to slip back down to 0.09% mom (or less) per month, lowering the annual rate to 1.1% yoy (or less) in 4Q15. And as Yellen has said in her latest speeches, she would feel uncomfortable raising rates if measures of underlying inflation were to weaken.

Importantly, the FOMC signaled a more gradual pace of interest-rate increases in the beginning of the hiking cycle. In the March FOMC meeting, members projected raising the Fed Funds rates by 50, 100 and 150 bps in 2015, 2016 and 2017, respectively, a more gradual pace than in the December meeting (75, 150, 125 bps, respectively).  

The Fed justifies its gradualist approach because it estimates that the equilibrium real federal funds rate is well below the historical average, and will rise only gradually. For us, the elevated uncertainties about the equilibrium real rate at the moment and the risks of removing accommodation too quickly are inclining the FOMC to approach the period of interest-rate normalization cautiously, in particular while inflation remains well below 2% and growth is moderate. We foresee a faster pace of rate hikes in the future, as the Fed approach its targets of full employment and 2% inflation. But this will only occur in late 2016 or early 2017.

Given the FOMC’s cautious approach, we lowered our forecasts for the 2-year Treasury to 1.2% (from 1.6%) and the 10-year to 2.5% (from 2.8%) at year-end 2015. These levels remain above the forward market prices

Europe – Activity continues to improve

Economic activity continues to improve in the euro area. ‎Retail sales are on a upward trend, up 1.4% in 1Q15 compared with the previous quarter. The Purchasing Manager’s Index continued to rise, with the services indicator for March at 54.3, the highest level since mid-2011. Consumer, industrial and service sector confidence improved markedly in the last few months. 

We see four drivers for the improvement. First, fiscal policy is no longer a headwind to the economy. Second, financial conditions are getting looser across the region. This includes falling interest rates on loans to companies and households in core and peripheral countries. Third, credit growth is returning, with banks mentioning fewer liquidity or capital constraints and firms and families feeling less pressure to deleverage. These three factors are pushing domestic demand. Finally, a weaker exchange rate provides a renewed boost to net exports.

We raised our GDP forecasts to 1.6% from 1.4% in 2015 and to 1.9% from 1.8% in 2016.

Japan – Wage increases will likely help to improve consumption

Japan’s economy has recently seen a pick-up in exports, but domestic consumption has been shaky. Exports are finally benefiting from the yen depreciation. But consumption is weak, as real income fell since the VAT hike last year.

The annual wage spring negotiations are resulting in pay hikes larger than last year and might improve consumption growth during the year. Preliminary results show basic wage up 0.7% yoy for workers in large companies, 0.3pp higher than last year’s. These hikes set a positive precedent for wages across the economy and signal that households real income might start improving and sustain a stronger recovery in consumption from mid-year.

We have lowered our 2015 GDP forecast to 0.9% from 1.0%, but we continue to expect 1.6% growth in 2016

China – Stimuli to provide a mild recovery in growth following the weak 1Q15

Economic growth weakened further in 1Q15. Industrial production growth slowed to 6.8% yoy in January and February from 7.9% in December. The official manufacturing PMI declined to around 50.0 in February and stayed there in March, well below the average (50.9) seen in 2H14. We forecast GDP growth to decelerate to 7.0% yoy in 1Q15 from 7.3% in the previous quarter. The sequential pace will remain around 6.0% qoq/saar.

We expect a mild recovery in 2Q15, led by official stimuli. ‎The PBoC is cutting interest rates and injecting liquidity. The Ministry of Finance also helped, by easing rules on the property market. Recent speeches by key policymakers suggest additional monetary and fiscal stimuli ahead. The environment of low inflation indeed makes room for a looser policy. We expect a moderate fiscal package, additional interest rate adjustments and required reserve-rate cuts still in this quarter.

As a result, we can see this year’s growth pattern similar to 2014’s, with a weak first quarter being followed by a better second quarter (see graph). Our GDP-growth forecasts stand at 6.9% for 2015 and 6.6% for 2016.

Emerging Markets – Weak growth; external environment remains challenging

The weighted average of the emerging markets’ PMI declined to below 50 in March, indicating that growth remains weak in most countries. The drop occurred even if we exclude China from the sample (see graph). Brazil has the weakest PMI (46.2) in our sample. Meanwhile, countries in Europe, like Czech Republic (56.1), Hungary (55.6) and Poland (54.8), which benefit from the recovery in the euro area, have the highest prints.

The U.S. dollar’s appreciation moderated after the U.S. Fed signaled a gradual approach. Indeed, since the March FOMC meeting, the dollar has depreciated 1,5% and 3,0% against a basket of developed- and emerging-market currencies (see graph), respectively.

We believe the dollar’s upward trend is not over yet, although it could be less steep for the rest of the year. We maintain our forecasts that the euro will depreciate to 1.05 and the yen to 124 by year-end. In LatAm, we also expect the Chilean peso and the Peruvian sol to resume a depreciation trend. Furthermore, we now expect the Mexican peso and the Colombian peso to end this year weaker than we were previously expecting, in line with a more gradual recovery of oil prices

With a strong dollar and the Fed starting to raise interest later this year, the scope for countercyclical monetary policy in emerging markets will continue to diminish. In LatAm, we no longer expect rate cuts in Colombia or in Peru. In Chile, we continue to expect rates on-hold, but the risks for higher rates are increasing. Finally, we expect Mexico’s central bank to start a tightening cycle in September, together with the Fed.

Finally, commodity prices dropped again in March (see below), hurting the prospects of commodity exports across the developing economies. 

Commodities – No recovery in sight

Commodity prices resumed the downward trend from early March onward, with the Itaú Commodity Index (ICI) declining 4.6% in the period. This movement was mainly driven by lower iron ore and crude oil prices, but all components fell in March: agricultural (-1.3%), metals (-9.8%), energy (-4.3%).

Oil (Brent) prices fell to USD 58/bbl from USD 63 in the beginning of March, amid signals that the market will remain oversupplied for a longer period. Despite early signals of a slowdown in investment, the U.S. production maintained an upward trend. And global demand is failing to pick up in response to low prices. We now expect the market oversupply to end by 1H16, approximately six months after our previous scenario. Hence, Brent prices will take longer to recover partially to USD 70/bbl and we lowered our 2015 year-end forecast to USD 65/bbl.

Iron ore prices plummeted to USD 50/t from USD63/t in early March, driven by the combination of low demand growth, increasing supply and lack of production cuts from the high-cost suppliers. Looking ahead, we do not expect that the stimuli in China will lead to a stronger domestic demand for steel production, and the rising supply trend from Brazil and Australia is set to continue for a while. Hence, we see no reasons to expect a recovery in iron ore prices. We lowered our year-end forecasts to USD 52.5/t from USD 63.

In addition, risks are tilted to the downside in both oil and iron ore prices. If high-cost producers continue resisting production cuts, both prices could decline further in the short term. Crude oil prices may also be affected by bottlenecks in storage or a final nuclear deal that allows Iran to increase oil exports this year.

Agricultural prices also declined in March due to lower sugar and soybean prices. We lowered our forecasts for both commodities, acknowledging that the outlook of surpluses in soybeans is set to remain in the 2015/16 crop season, and incorporating our BRL scenario and parity between international sugar and domestic ethanol prices in Brazil.

We lowered our ICI 2015 year-end forecast by 5.5 pp and the 2016 year-end forecast by 2.2 pp. This revision implies that, from current levels, the ICI will rise by 8.1% in 2015 and by 6.9% in 2016.



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

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