Itaú BBA - After the World Cup, Back to the Economy

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After the World Cup, Back to the Economy

July 11, 2014

The economic performance in the Americas has been uneven.

Global Economy
Sticking With the Strong Job Creation        
The U.S. faced an odd combination of weak GDP growth and strong job creation during the first half of the year. The growth in China is stabilizing, and it is positive for EMs.

Brazil
Economy Held Back, Unchanged Interest Rates in 2015     
We lowered our GDP forecast for 2014 and 2015, given the weakness in current activity and deteriorating confidence. Weaker growth should lead the Copom to keep the Selic rate at 11% in 2015 as well.

Mexico
Recovery at Last
The secondary laws of the telecommunication reform were approved on July 4 in the Senate and on July 9 in the lower house of Congress. The congressional voting on the secondary laws of the energy reform is now expected take place during the first week of August.

Chile
Monetary Policy Board Is Split on Rate-Cut Timing
We raised our inflation forecast for this year and expect the policy rate to end this year at 3.5%, but with rate cuts resuming only in 4Q14. For 2015, we do not expect rate moves.

Peru
Introducing Policy Rate Cuts
The secondary laws of the telecommunication reform were approved on July 4 in the Senate and on July 9 in the lower house of Congress. The congressional voting on the secondary laws of the energy reform is now expected take place during the first week of August.   

Colombia
A Strong Growth Surprise
GDP grew above expectations in 1Q14, and indicators hint that the economy remained robust in 2Q14. As a result, we have raised our growth and interest rate forecasts for this year.

Argentina
From Hell to Heaven?
We expect the government to reach a deal with the holdouts, paving the way for increased capital inflows. Our scenario on Argentina is now more optimistic, but we acknowledge that the risks of a new default must not be downplayed.    

Commodities
Stronger Agricultural Supply Reduces Price Forecast
We lowered our price forecasts for agricultural commodities, in the face of stronger supply. We expect metal prices to advance some more by year-end. We project lower geopolitical risk and, thus, lower oil prices ahead.


After the World Cup, Back to the Economy 

As in the World Cup, where some teams  were out in the group stage and others reached the final, the economic performance in the Americas has been uneven. The U.S., for instance, is facing an atypical combination of weak GDP growth and strong job creation. The labor market figures seem to be more representative and are likely to better reflect the economic outlook. We therefore continue to expect the Federal Reserve to raise interest rates at a faster pace than the market is pricing in. But while the growth outlook remain uncertain, the Treasury yields are likely to remain subdued for the time being, thereby stretching the window of abundant international liquidity.

The growth indicators in Latin America are mixed. The region benefits from global liquidity, but the scenario is still vulnerable to the path of U.S. interest rates, as well as to China’s economic performance (recently improved) and geopolitical risks. Although there are signs of recovery in Mexico and Chile, they are not strong enough to offset a weaker start of the year. In Peru, the slowdown has intensified. Only Colombia has sustained a robust pace, particularly in investments.

The Brazilian economy remains sluggish. GDP growth was probably negative in 2Q14, and the sharp decline in confidence levels suggests that activity will remain weak. Part of the deterioration is temporary – a consequence of the lower number of working days due to the World Cup; but another part has been induced by the recent dynamics of the fundamentals (higher interest rates, inflationary pressures, and low, volatile growth). Given the current environment, we now believe that the Central Bank will refrain from raising interest rates in 2015.

A new turn in the legal battle between Argentina and the holdouts also got investor attention, after the U.S. Supreme Court ruled against the country. A deadlock could lead to a default, putting Argentina’s goal of returning to international capital markets at risk. In this context, the likelihood of a sudden currency devaluation and even tougher capital and trade controls increases. On the other hand, if (as we expect) an agreement is reached, the solution to this dilemma of several years may lead to a better-than-anticipated scenario.

Global Economy

Sticking With the Strong Job Creation

• The U.S. faced an odd combination of weak GDP growth and strong job creation during the first half of the year. We believe, however, that the latter is more representative of the U.S. economy’s strength and maintain our forecast of better growth ahead.

• We continue to expect the FOMC to raise interest rates in 3Q15, but Treasury yields are likely to increase only modestly until investors gain confidence in the growth outlook.

• The ongoing stabilization of the growth in China is positive for EMs. 

• There are tentative signs of growth stabilization in other emerging economies, but they are small and uneven, leaving EM economies still vulnerable to changes in the global scenario.

The U.S. faced weak GDP growth but strong job creation in the first half of the year. Output contracted 2.9% QoQ/SAAR (seasonally adjusted annual rate), and we estimate an average growth of barely 0% in 1H14. Job creation, on the other hand, was strong, at an average of 231 thousand per month in the same period.

Although this odd combination generates some uncertainty, we believe that the message from the job market will prevail and stand by our better growth forecast. We revised our U.S. 2014 GDP forecast down to 1.6% (from 2.0%) due to the weak first half, but maintain a 3.0% annualized pace for 2H14 and 2015.

Moreover, we expect the ongoing decline in the unemployment rate and the normalization of inflation to ultimately drive the FOMC to raise interest rates. We continue to expect the committee to begin a hiking cycle in 3Q15.

Nonetheless, the disappointing 1H14 is likely to prevent a meaningful pick-up in U.S. yields, at least until investors see confirmation of a better growth trend in 2H14. We see only a modest pick-up in the 10-year U.S. Treasury, to 2.9% by the end of 2014.

Emerging markets (EM) continue to enjoy the absence of external financial pressure. The improved growth in China and the ongoing monetary easing in Europe and Japan have also helped.

Although EM growth has been lackluster so far this year, some early signs of stabilization have emerged. The improvement is only marginal though, and several developing economies remain vulnerable to changes in the global scenario.

U.S. – Disappointing GDP, But We’ll Stick With the Strong Job Creation

U.S. GDP contracted 2.9% QoQ/SAAR in 1Q14. After two downward revisions, the data now shows negative contributions from inventory accumulation (-1.7%), net exports (-1.5%), investment (-0.3%) and government spending (-0.1%). Only consumption contributed a modest 0.7% growth in the period.

More importantly, the latest GDP revision and the personal income and spending report cast doubts on the strength of the consumption pace. Private consumption growth in 1Q14 was revised to just 1.0% QoQ/SAAR, from 3.1%. The personal income and spending report revealed that real personal consumption declined 0.1% MoM in May, missing expectations of a 0.2% rise. These negative surprises dragged our 2Q14 consumption tracking to 2.0% QoQ/SAAR, which is very frustrating given that we expected consumption to finally accelerate to a near 3.0% pace.

Based on the weaker consumption data, growth in 2Q14 is likely to improve less than we previously expected.  We lowered our 2Q14 GDP forecast to 2.8% QoQ/SAAR, from 4.0%. Overall growth in 1H14 seems weak, barely reaching 0%.

As a consequence of the weaker 1H14, we revised our 2014 GDP growth forecast down to 1.6% (from 2.0%).

Although the negative surprises raise some doubts, we continue to expect growth to improve to a 3.0% annualized pace in 2H14 and 2015. Because the GDP data seems a little odd, we prefer to look to the labor market and a broader set of indicators to grasp the state of the U.S. economy.

First, as highlighted in previous reports, 1Q14 growth was distorted by the unusually harsh winter and an inventory adjustment – both of which are transitory effects.

Second, the GDP data for 1H14 does not seem to accurately describe the real pace of the U.S economy. On all of the previous occasions in which GDP declined about 3.0% on an annualized basis, the country was in a recession, which we do not believe is the case now. Business and consumer confidence provides a broader indication that the economy expanded at a 3% pace in 1H14, which is significantly better than the GDP readings.

Third, the consumption slowdown was mainly related to revisions in healthcare spending, which are likely to be transitory. It is unusual for healthcare, a first-need spending item, to experience a sharp slowdown. We suspect that the decline in health spending in 1Q14 and the sluggish start to 2Q14 are probably due to the household learning curve and measurement errors related to the newly-enacted health insurance scheme within the ObamaCare legislation.

Fourth, the slowdown in consumption came in conjunction with an increase in household savings, from 4.1% in December to 4.8% in May. Household net worth, however, has been increasing since the beginning of the year, mainly driven by equity and housing prices. Moreover, the unemployment rate continues to decline and consumer confidence has been trending upward. These fundamentals suggest that the rate of savings could remain on a downtrend.

Finally, job creation has been strong. The non-farm payroll expansion averaged 231 thousand per month in 1H14 as a whole, picking up to 272 thousand in 2Q14. It is unusual to see a solid increase in payroll together with a GDP contraction (see graph).

We also believe it is important to focus on the labor market to forecast the path of interest rates in the U.S. 

At its last meeting, the FOMC downplayed the recent firming in core inflation and signaled no change in its easing monetary policy stance. The FOMC’s participant core PCE forecast remained virtually unchanged, and Fed Chair Janet Yellen labeled the recent firming as talk surrounding the trend of inflation’s gradual return to its 2% objective.

The unemployment rate, however, continues to decline at a robust pace (see graph), exceeding the FOMC’s expectation. The June reading came in at 6.1% – the level expected by the FOMC for the end of the year. Moreover, the ongoing improvement in the labor market is likely to contribute to the inflation normalization.

We therefore continue to expect the FOMC to begin the hiking cycle in 3Q15.

Nonetheless, the disappointing 1H14 is likely to prevent a meaningful pickup in U.S. yields, at least until investors are able to confirm the better growth prospects for 2H14. We see only a modest pickup in the 10-year U.S. Treasury yield, to 2.9% by the end of 2014 and 3.45% by the end of 2015.

China – Activity Continues to Stabilize

Recent activity data shows further signs of improvement. The Manufacturing Purchasing Managers’ Indexes (PMI) have been rising since April. The HSBC PMI, which is more related to small and medium enterprises, rose to 50.7 points in June from 48.0 in March. Most of the other economic indicators also improved in April, in line or above expectations. The positive surprises generated an improvement in investor sentiment toward economic growth in China, following a period of concern during the first four months of 2014.

The 2Q14 GDP is set to confirm a growth stabilization. In sequential terms, we believe that China’s GDP accelerated to 7.4% QoQ/SAAR, from 5.7% in 1Q14. These results are consistent with a combination of better PMIs, industrial production, retail sales and net exports, despite still-weak fixed investment.

The Property sector continues pose the main downside risk. Prices have dropped in last two months (MoM), sales remain weak and investment is decelerating at a faster pace than in the other sectors. The government seems to be offsetting this drag by stimulating other sectors.

We remain confident that activity is stabilizing, despite the weakness in the Property sector, and maintain our GDP forecast at 7.2% for 2014 and 7.0% for 2015.

Europe – ECB Awaits the Impact of Recent Easing Measures

The European Central Bank (ECB) is waiting for the effects of the easing measures adopted in June to materialize. Inflation is likely to remain low, picking up only marginally from the 0.5% YoY reported in June. Barring any negative surprises, this allows the ECB to remain on hold until the end of the year in order for the effects of the easing measures announced in June to bear fruit. At the July meeting, the ECB outlined fairly lax conditions for banks to access its longer term refinancing operations, which should generate strong take-ups and inject a significant amount of liquidity into the euro zone over the next 12 months. Although ECB President Mario Draghi estimated a total volume of up to EUR 1 trillion (USD 1.35 trillion), there are still substantial concerns regarding the measure.

Meanwhile, contrary to the more generalized improvement of the previous months, the recent activity data has shown a slight weakening. The euro-zone composite PMI dropped from a high of 54.0 points in April, to 52.8 in June. Retail sales were unexpectedly stagnant in April, while the monthly European Commission sentiment survey indicated slightly weaker consumer and industrial sentiment. While these are not enough to warrant a change in our outlook for euro-zone activity, it is a reminder that the recovery in the region still has some downside risks.

Despite the recent weakness, the data is still consistent with our scenario. We see the GDP in the euro zone increasing 1.1% this year and 1.5% in 2015.

Emerging Markets – Early Modest (and Uneven) Signs of Growth Stabilization

External liquidity conditions remain supportive for emerging-market assets and interest rates in major developed countries remain low, with little pressure to rise. While we believe that the situation will change at some point, for now, the environment supports financial inflows to emerging economies.

Emerging-market growth has been lackluster so far this year, although there were some early signs of stabilization at the end of the first half. After declining in 1Q14, the manufacturing PMI in developing economies has begun to stabilize, led by China – although the average excluding China also appears to be stabilizing (see graph).

In the LatAm region, growth in 2Q14 seems mixed. The data indicates an improvement in Mexico, deterioration in Brazil and Peru and a virtually unchanged scenario in Chile. In Colombia, growth remains strong, led by investment.

The overall improvement is only marginal though, and several developing economies remain vulnerable to changes in the global scenario. The main risks continue to be a sharper increase in U.S. interest rates, a reversal of the recent stabilization in China and/or an increase in geopolitical tensions across the globe.

Commodities – Stronger Agricultural Supply Reduces Price Forecast

The Itaú Commodity Index (ICI) has declined 1.6% since the end of May. Metal prices rose due to improved investor sentiment toward China, while oil-related prices rose as a result of the mounting geopolitical tensions in Iraq. The increases were not enough to offset the plummet in agricultural prices caused by a better supply outlook following the USDA’s latest acreage and stocks report, a weaker-than expected El Niño phenomenon (which lowers the odds of grain losses in Asia), and upward revisions of Brazilian coffee production estimates.

We downwardly revised our agricultural price forecasts but maintained our metals and energy-related prices unchanged. The supply adjustments, which are likely to lead to a looser supply-demand balance for several agricultural commodities, are consistent with a downward revision of the price forecasts. As a result, our YE14 ICI-Agricultural Index estimate is 8.4% below our previous scenario. We expect oil-related prices to fall from the current levels, due to decreased geopolitical risks and a stronger supply from some OPEC countries, and iron ore prices to rise slightly as they recover from the recent undershooting. We therefore maintain our year-end forecasts for the ICI-Metals (+0.7%) and ICI-Energy (-3.7%) components.

Given the revision of our agricultural commodity price estimates, our year-end ICI forecasts have been revised down to -4.0% YoY for 2014 (vs. -1.4% previously) and -2.4% YoY for 2015 (vs. -1.6% previously), assuming a 1.0% decline in the ICI from the current levels.

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



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