Itaú BBA - After the Storm

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After the Storm

March 11, 2016

Risky assets improved globally on the back of improving activity data in the U.S., a stable exchange rate in China and the rebound in oil prices.

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

Global Economy
Risks are down, but so are global growth and interest rates

Global risk has declined and we expect it to continue to ebb down. However, the uncertainty at the beginning of this year probably dented some of the global growth this year

LatAm
Relief in the markets

A looser monetary-policy stance in the core economies and a recovery in commodity prices (especially oil) recently brought relief to the region’s currencies. But activity remains, in general, weak.

Brazil
Recession deepens, reforms needed

Under the most likely scenario, the ongoing fiscal/political problems would keep the economy under pressure. However, the longer the economic difficulties persist and deepen, the greater the likelihood of movements that could bring forward a scenario of adjustments and reforms.

Argentina
No pain, no gain

The adjustments continue, including the agreement with most of the holdouts in New York. But the costs are materializing. The currency’s depreciation coupled with higher utility prices is pressuring consumer prices, and consumer confidence is falling.

Mexico
A help to the peso

Policymakers announced a coordinated response to improve sentiment, leading to appreciation of the peso and lower sovereign risk. The central bank hiked rates, and the Ministry of Finance cut expenditures by 0.7% of GDP.

Chile
Tighter fiscal policy, looser monetary policy stance

The government revised the assumption for long-term copper prices and announced cuts to this year’s budget.  Given the deterioration of activity and our expectation of a decline in inflation, we no longer expect rate hikes.

Peru
Growth momentum improves

Because of higher dynamism of in mining production, we now expect GDP growth of 4.0% this year (3.8% previously). Activity is expected to grow at the same rate in 2017.

Colombia
Fiscal consolidation to the rescue

The government reacted constructively to the negative outlook on its S&P rating, announcing a significant spending cut to meet this year’s fiscal deficit target of 3.6% of GDP.

Commodities
We forecast higher oil and lower iron ore prices

We forecast a recovery in oil prices to USD 55/bbl by the end of the year, as the market finds a new equilibrium during the second semester. Iron-ore prices reacted recently, but fundamentals for the sector point to a reversal.


After the Storm 

Risky assets improved globally on the back of improving activity data in the U.S., a stable exchange rate in China and the rebound in oil prices. Uncertainties linger, but we still believe in a gradual – albeit not continuous - improvement towards a moderate scenario. 

In China, capital flight must be monitored in the short term, as they could cause additional turmoil.

In the mature economies, interest rates will remain low for longer. Even in the U.S., we now expect only two rate hikes per year (instead of three) in 2016 and 2017.

This environment of lower risk and greater liquidity benefits Latin America. After a bumpy start to the year, local currencies appreciated again. Economic activity, however, remains weak. Only Peru shows clear signs of improvement. This month, we revised our growth downward forecasts for Mexico and Chile.

We foresee a slow decline in inflation in the region, reflecting past exchange-rate depreciation and inertia.

In countries without visible improvement in the inflation outlook (as Colombia and Peru), central banks will continue to increase interest rates. In Chile and Mexico, where inflation expectations are anchored and activity indicators have disappointed, we do not expect further rate hikes this year. In Brazil, monetary conditions are already restrictive and inflation is receding. We thus anticipate rate cuts in the second half of the year. 

The Brazilian economy faces a binary scenario. Most likely, fiscal and political problems will keep the economy under pressure and prevent the approval of needed measures and reforms. Major changes will likely come only in the medium term. However, the longer the economic difficulties persist and deepen, the greater the likelihood of a move that would lead toward adjustments and reforms.

ln Argentina, adjustments are occurring. The government reached a deal with most holdouts, pending only congressional approval. The currency continued to weaken in the first two months of the year, leading the central bank to raise rates paid on its sterilization bonds by almost 700 bps. The cost of the adjustment, including on activity, is already visible.


Global Economy
Risks are down, but so are global growth and interest rates

Improving activity data in the U.S., a stable exchange rate in China and signs that oil prices have reached a bottom contributed to better performance from risk assets, despite high volatility and lingering uncertainty. 

We expect these risks to continue to ebb down. In particular, we see a reduction in capital outflows from China that will likely ease fears about tail risks.   

However, uncertainty at the start of this year probably curbed some of the global growth this year, which we are revising down to 3.2% from 3.3% for 2016.  

We also reckon that global interest rates will likely remain lower for longer, and we now see two rate hikes per year (instead of three) by the U.S. Fed in 2016 and 2017.  

Finally, we expect the U.S. dollar to resume a moderate appreciation path (5% on a trade-weighted basis until the end of 2016).

Despite high volatility and lingering uncertainty, most risk assets since January. Stock indexes were up, credit spreads stabilized and emerging market currencies appreciated slightly (see graph).

U.S., signs that oil prices have reached a bottom and a stable exchange rate in China. We expect the first two of these trends to continue. We also believe that the Chinese renminbi will remain stable against a basket of currencies as capital outflows slow down. But we expect it to depreciate against the USD (we see CNY/USD at 6.75 by the end of the year), following a resumption of a mild strong U.S. dollar trend for the rest of 2016.

However, the uncertainty at the beginning of this year probably limited global growth, which we are revising down to 3.2% from 3.3% for 2016.  We revised growth down in the U.S. (to 2.0% from 2.2%), in the Euro area (to 1.5% from 1.7%) and in Japan (to 0.4% from 1.0%).

We also reckon that global interest rates will likely remain lower for longer, and we now see two rate hikes per year (instead of three) by the U.S. Fed in 2016 and 2017.  Meanwhile the ECB and BoJ will continue with their highly accommodative monetary policies for the foreseeable future.

Finally, we expect the U.S. dollar to resume a moderate appreciation path. To put it simply, we continue to see the U.S. recovery in a more advanced phase than its developed-economy peers and the fragile emerging markets. We expect the U.S. dollar to appreciate 5% on a trade-weighted basis. We forecast the euro, the yen and the renminbi at, respectively, 1.05, 120 and 6.75 by the end of the year.

U.S. – A more moderate path of interest rate hikes

Investor fears of a recession in the U.S. receded in February with signs of a pickup in domestic demand. January retail sales and durables goods reports suggest stronger consumption and investment in 1Q16. February ISM reports also showed signs of stabilization (see graph). As a result, U.S. real GDP tracking stabilized around 2.0% qoq/saar in 1Q16, a healthier pace than just 1.0% qoq/saar in 4Q15..

Recession fears are likely to dissipate further in the next months as we expect domestic demand to remain robust in the face of external headwinds. We believe that consumption growth, which will likely be above 3% qoq/saar in 1Q16, could maintain a healthy 2.55-3.0% pace for the rest of 2016, given the solid job market (non-farm payroll growing above 200 thousand per month, the availability of credit and the high level consumer confidence

However, uncertainty will likely remain for the next couple of years. Slow foreign growth and a strong U.S. dollar are expected to trim U.S. GDP growth by 0.6 pp in 2016. The global headwinds seem harder to cope than in the past, given slower productivity growth in the U.S., especially with interest rates near the zero lower bound.

We also reckon that greater uncertainty probably already had an impact on the economy, and hence we reduced our estimate for U.S. GDP growth by 0.2 pp for 2016, to 2.0%, and by 0.1 pp for 2017, to 2.0%.

We also scaled back the pace of interest rate increases. We now see two rate hikes per year (instead of three) by the Fed in 2016 and 2017. A less divergent monetary policy should reduce the volatility in the foreign exchange markets, helping to mitigate the risk of negative spillovers from uncertainty into investments. And it should also help the deleveraging of emerging economies, limiting the negative impact on net exports.

Europe - With looming risks, ecb is working hard to be convincing

Activity data is showing some weakness in the euro area. The composite euro-area PMI was down to 53.0 in February from 54.3 in January.  Consumer and business confidence also fell. Additionally, GDP expanded 0.3% qoq in 4Q15, 0.1% below our expectation.

Downside risks also appear to be slightly higher. The UK-EU referendum, immigration flows and their political consequences, policy uncertainty in the periphery and concerns over the solidity of banks all create dark clouds on the horizon. We don’t expect any of these risks to materialize and create a major crisis. Still, they do affect confidence and hence impede a stronger recovery in the region, which otherwise continues to be sustained by easy monetary policy, a slightly expansive fiscal policy and household income gains.

 We revised our growth forecast to 1.5% from 1.7% for 2016, while we have left our estimate for 2017 unchanged, at 1.6%

The ECB has eased its policy further in light of the mounting risks. The central bank increased the size of monthly QE purchases by EUR20bn to 80bn, added corporate bonds to the pool of assets being bought, cut the deposit rate by 10bps, bringing it to -0.40% and offered more long-term refinancing operations (LTROs) for banks, potentially with negative rates.

Japan – Lower growth but still on track to end deflation

Japan’s GDP grew just 0.5% in 2015 and contracted by 1.1% qoq in 4Q15. Last year was bumpy, with the economy improving only slightly compared with the 0% growth in 2014. In the fourth quarter, consumption declined 3.4% qoq, while investment (6.3% qoq) and net exports (0.6% pp) remained positive.

Signs of growth remained weak in 1Q16 amid uncertainties about Abenomics. Consumption continued to be weak, with both retail sales (-1.1%) and household expenditure (-0.2%) contracting in January. The disappointment in activity and worries over the impact of BoJ’s negative interest rate policy on banks led to a further loss of momentum in Abenomics and to an appreciation of the yen. As a result, wage growth and hence consumption recovery will likely be more moderate in 2016.

We revised our GDP forecasts to 0.4% from 1.0% for 2016 and to 0.7% from 0.9% for 2017.

However, we continue to believe that the BoJ will succeed in leading Japan out of deflation. Despite the absence of structural improvements in the Japanese economy, growth will remain above trend and help to sustain a further tightening in the labor market, which could gradually drive wages up and hence push inflation toward the 2% target in 2017. If confirmed, this will be a partial but still big success for Abenomics.

China – Capital flows will stabilize

Investor fears of further renminbi devaluation receded in February following pledges from several policymakers that China will not seek a competitive devaluation and that fundamentals are consistent with stability against a basket of currencies. In addition, the pace of FX reserve declines slowed to USD 29 billion in February from USD 99 billion in January (see graph).

We believe that China will be able to stabilize capital outflows and reduce the pressure on foreign reserves. The sizable current account surplus (2.7% of GDP) allows net capital outflows without the need to sell reserves. In addition, expectations of a massive devaluation have receded. We don’t believe in the likelihood of capital flight. External liabilities have already fallen considerably in the last few months. Finally, the government has opened the inter-bank bond market to qualified foreign institutional investors, a move that could generate some inflows. We see capital outflows of around USD 650 billion in 2016, compared with USD 742 billion in 2015.

We maintain our scenario of a gradual slowdown, to 6.3% GDP growth for 2016 from 6.9% in 2015.

We see a gradual slowdown, but no triggers for banking problems. There is for sure overcapacity, along with associated unsustainable debt problems in some sectors, and the exact dimension is hard to estimate (in particular, in a banking system where assets are equal to 300% of GDP). However these problems are in state-owned enterprises that have borrowed too much from state owned banks. And banks in China are funded by domestic deposits. Hence the solution for the credit problem will most likely be sponsored by state, which still has fiscal capacity, without imposing any burden on the banks’ creditors (who are, again, mostly local depositors). This structure drastically reduces the risk of banking problems in China. Indeed there is no sign of a bank-deposit flight so far. Unfortunately, the government has also been slow to address overcapacity issues, which will keep investors worried.

Commodities – Higher oil and lower iron ore prices ahead

The Itaú Commodity Index has risen 6.9% since the end of January, driven by higher metal prices (18%) and oil-related prices (9.2%). The ICI-agricultural index fell 1.2% over the same period.

Metal prices advanced 17.6% year to date, with improvement in investor sentiment and with the replenishment of iron-ore inventories in China. The latter is a temporary boost. Investor sentiment improved as fears of a global recession subsided.

Oil prices moved above USD 40/bbl despite the ongoing oversupply. We believe this resilience was caused by news related to (some) coordination between Russia and Saudi Arabia (which is unlikely to lead to an actual supply cut) and to lower production guidance from several companies.

We expect crude oil prices to rise to USD 55/bbl (Brent) by year-end 2016. The adjustment in the Energy sector is happening. Investment is already declining fast in the U.S shale oil industry and will start to affect production more strongly in 3Q16. The lower production guidance from several oil producers supports our scenario that lower supply in the U.S. will offset increased exports from Iran, balancing the global market by mid-2016.

Conversely, we expect iron ore prices to decline ahead. Prices rose to USD 60/ton recently from USD 37/ton in mid-January, driven by both macro and micro factors (as mentioned above). But we project that the global surplus will widen in 2016, with stable global supply (higher production in Australia offsetting companies facing environmental issues in Brazil and capacity cuts in China) and negative growth in global demand. Therefore we maintain our forecast for iron ore prices at USD 42/ton by year-end 2016.

Base metal prices should recovery slightly, while higher oil prices may also help prices through higher refining/transport costs.

Lower forecasts for the price of corn and wheat. Agricultural prices declined slightly in February, driven down by favorable weather in key producing regions and signals that the U.S. farmers will not reduce planted area in the next grain crop. We lowered our forecasts for corn and wheat by approximately 5%, recognizing that the next crop year will face a combination of high beginning stock-to-usage ratio and high supply.

The combination of higher oil, lower iron ore and small increases in agricultural and base metal prices implies that our ICI will rise 17.2% by year-end from current levels.


LatAm
Relief in the markets

• A looser monetary policy stance in the core economies and a recovery in commodity prices coupled with domestic reaction by the region’s central banks brought relief to LatAm’s exchange-rates. 

• Activity in the region remains weak, with only Peru displaying a visible recovery. We reduced our growth forecasts for Mexico and Chile, but raised them for Peru. 

• Facing lower fiscal revenues, governments reduced expenditures further in a bid to preserve their credit ratings.

• In spite of weak growth, the outlook for inflation remains challenging in all of the region’s economies but Mexico. While we no longer expect rate hikes in Chile, we expect the central banks to tighten monetary policy slightly more than we were previously expecting in Colombia and Peru. In Brazil, we continue to expect rate cuts once the recession meets a convincing inflation decline. 

• In Argentina, the government reached an agreement with most of the holdouts. The congress must now repeal some laws that prevent the government from offering better financial terms to holdouts than offered in the 2005-2010 debt swaps. The Argentine peso kept weakening in the first two months of the year, leading the central bank to raise the interest rate paid on its sterilization bills by almost 700 bps. While adjustments advance, the costs for activity are appearing.

Relief in the markets

A looser monetary-policy stance in the core economies and a recovery in commodity prices (especially oil) recently brought relief to the region’s currencies. From the beginning of February until the first week of March, the Brazilian real was the outperformer.

Idiosyncratic factors also helped the currencies. In Brazil, markets started to price in higher chances of a shift in the current scenario. In other countries, currencies were affected by central banks’ reactions, especially in Mexico. Policy makers in Mexico announced a coordinated response to improve sentiment, leading to a peso appreciation and improvements in the sovereign risk. In an extraordinary meeting, the policy rate was raised by 50 bps and the government announced expenditure cuts of 0.7% of GDP. In addition, the central bank announced a new intervention policy – the dollar auctions with minimum price were suspended, but authorities added that they can carry out discretionary sales, resulting in less-predictable actions. In Colombia, the central bank continues to raise rates and is not signaling a near-term end to the tightening cycle. Furthermore, the board decided to lower the exchange-rate depreciation threshold necessary to trigger auctions of dollar-call options (to 3% depreciation from the 20-day moving average, from 5% previously). In Peru, the central bank raised the policy rate for the third consecutive month in February and continues to sell dollars. 

However, we continue to expect currencies to weaken somewhat from the current levels. An expected recovery of oil prices later this year will likely partially offset the impact of higher interest rates in the U.S. for Colombia and Mexico, while in Chile the higher price of crude means a terms-of-trade deterioration. In Brazil, uncertainties about the fiscal and political scenario will continue to weigh negatively on the currency. Our forecasts for the exchange rate are unchanged, meaning, in most cases, a weakening from the current levels. In Mexico, we expect the exchange rate to remain broadly stable.

Fiscal policy is more constrained

As a response to lower commodity revenues and lower growth, many governments are reducing expenditures to prevent excessive widening of the fiscal deficit. In Mexico, Colombia and Chile, fiscal tightening announcements were recently made. In Brazil, political fragmentation prevents fiscal adjustments and rating agencies continue to downgrade the economy. Standard and Poor’s also put a negative outlook on the BBB sovereign rating of Colombia, highlighting that structural fiscal measures would be needed to correct the wide current-account deficit – the Achilles’s heel of the economy. If Colombia’s government fails to pass a tax reform later this year, a downgrade becomes more likely, although the country’s investment-grade status should nevertheless be maintained. 

Recovery is rare

Activity in the region remains weak. In Mexico, one of the few countries in the region presenting a recovery, the recent data has been disappointing: the IGAE (monthly proxy for GDP) lost momentum within the 4Q15; manufacturing exports are failing to respond to the weaker peso; construction activity, which was already suffering from the capital-expenditure cuts of the public sector, is now facing slowing housing activity. In Chile, the recent data shows that economic growth failed to stabilize at 2%. Colombia’s economy continued resilient in 4Q15, but the sharp deterioration of consumer confidence points at weakening consumption in the beginning of this year, while oil companies and the government reduce budgeted expenditures in a low-oil-price environment. In Brazil, the recent coincident and leading indicators do not indicate a near-term stabilization of output. On the other hand, Peru’s economy has been a positive surprise: mining production is rising faster than expected, as investment in the sector matures, while gross fixed investment – a major drag on growth in 2015 – seems to be stabilizing. 

We reduced our growth forecasts for Mexico and Chile, but raised them for Peru. In Brazil, we continue to expect a deep recession. We also continue to expect a moderate slowdown of Colombia’s economy this year, though tighter macro policies pose downside risks to our forecasts.

High inflation still challenging

The outlook for inflation remains challenging in all the economies of the region but Mexico. Past exchange-rate depreciation and other relative-price adjustments are the drivers of high inflation. Inertia is also playing a role, as highlighted by the elevated non-tradable inflation. In this environment inflation expectations are well-behaved only in Chile and Mexico. 

We no longer expect rate hikes in Chile, while in Colombia and Peru, we expect the central banks to tighten monetary policy slightly more than we were previously expecting. For Mexico and Brazil, our policy-rate forecasts are unchanged. The weakening economy in Chile, the well-anchored inflation expectations, the likelihood that inflation will enter a declining path soon and the more concerning tone of the central bank regarding activity (domestic and abroad) are behind our new forecast for the policy rate. In Peru and Colombia, inflation expectations are uncomfortable and the central banks of the two countries give no evidence that an end to the tightening cycle will come in the very near term. In Brazil, we continue to expect that once the deep recession meets a convincing inflation decline interest-rate cuts will come. Finally, in Mexico, the central bank explicitly said that the rate hike in the extraordinary meeting was not the beginning of a cycle and that the evolution of the exchange rate will be an important determinant of future policy moves. Given our expectation of exchange-rate stability in Mexico, the deterioration of activity and the low inflation expectations, we do not expect additional hikes this year, although we acknowledge that episodes of volatility could lead to more tightening.  

Argentina: adjustments advance, as their costs appear

In Argentina, the government reached an agreement with most of the holdouts in New York, including Elliott and Aurelius. This agreement represents 85% of all lawsuits in New York. Argentina will pay the claims in cash, with a 25% discount. However, before Argentina makes any payment, the congress must repeal some laws that prevent the government from offering better financial terms to holdouts than those offered in the 2005-2010 debt swaps. Although the administration does not have a majority in parliament, we expect it to gather the necessary alliances to make the legislation changes.

The Argentine peso weakened by around 20% in the first two months of the year (adding to the 32% devaluation in December). With the weaker currency and higher energy prices, the outlook for inflation is more challenging. In response, the central bank increased the interest rate paid on its 35-day sterilization bills (Lebacs) to 38% from 31.2% so far this month.  

The short-term costs of the adjustments are appearing (high interest rates, negative growth, higher inflation and lower real wages). Consumer confidence is deteriorating. We see downward risks to our forecast for activity this year (-0.5% from 2015).



 


 



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