Itaú BBA - Aftermath of the Trump shock

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Aftermath of the Trump shock

November 16, 2016

The results of the U.S. election will lead to major policy changes. The risk of protectionism is negative for global growth.

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

Global Economy
A new global landscape creates headwinds and risks for emerging markets   
The results of the U.S. election will likely lead to major policy changes. Fiscal expansion and higher interest rates in the U.S. will likely put pressure on emerging market currencies and local rates. The risk of protectionism is negative for global growth.

LatAm
Hit by Trump
Donald Trump´s victory in the U.S. presidential elections has put pressure on emerging market currencies, turning monetary easing more challenging in the region.

Brazil
Dealing with a more uncertain world
We now expect a more depreciated real and another 25-bp rate cut in November, due to the increase in macroeconomic uncertainty after the U.S. election surprise.

Argentina
Building credibility in a challenging environment
The central bank resumed interest rate cuts. Higher U.S. treasury yields, a consequence of the expected Trump agenda, will probably turn capital inflows to Argentina more expensive, so disinflation will be harder.

Mexico
Facing the Trump fallout
The outcome of the U.S. presidential election has weakened Mexico’s economic prospects. We now see growth at 1.8% next year, and expect the central bank to raise interest rates by 100-bps in November.

Chile
Scope for extra monetary easing
With a faster-than-expected disinflation process and weak activity, we now expect additional rate cuts. We see the central bank taking the policy rate to 2.5% next year from the current 3.5%.

Peru
Strong activity, in spite of anemic domestic demand
We expect GDP growth at 3.8% in 2016 and 4% in 2017. Economic activity is being driven by exports (mainly mining), while domestic demand remains weak.

Colombia
Negotiating an unpopular reform
Congress will begin debating this month a structural tax reform that seeks to offset the loss of oil-related fiscal revenues. While unpopular, the reform will be key for the country to retain its BBB credit rating.

Commodities
Trump helps metals, but not enough to trigger a new boom
We are increasing our price forecasts for iron ore and some base metals, acknowledging the improved outlook for demand and greater discipline among producers. But the promised infrastructure spending in the U.S. is not enough to trigger a new boom in metal prices.


 


Aftermath of the Trump shock

The results of the U.S. elections are creating a new external environment. We believe President-Elect Trump, with support from congressional Republicans, will be willing and able to implement sizeable fiscal stimulus. There is more uncertainty about his agenda on trade, immigration, deregulation and micro reforms, but sources from the transition team have stressed that supply-side measures will also be part of the initial policy package. For now, we treat these as risks to the scenario. The net effect of fiscal stimulus is expansionary in an economy close to full employment. This fiscal policy shift will contribute to the ongoing trend of rising UST yields. We still believe that the Fed will increase interest rates in December and twice in 2017. But we now foresee four rate hikes (from two) in 2018, and the risks in 2017 are tilted to three hikes. For emerging markets (EM), Trump's victory is generally negative. Our baseline scenario is that higher interest rates in the U.S. will pressure emerging market currencies and local rates. And the risks of protectionism and tariff wars are negative for EM.

Within LatAm, the Mexican economy is the most vulnerable to "Trumponomics" (as highlighted by the sharp underperformance of the Mexican peso throughout this year), and we reduced our growth forecasts for 2017. Because uncertainty over protectionism is expected to diminish only gradually, weaker investment in Mexico’s manufacturing sector will likely be a major drag on growth. Countries with weak balance-of-payment positions (like Argentina and Colombia) are also vulnerable. On the other hand, Chile, which exports copper (a commodity that is already benefiting from the expectation of fiscal stimulus in the U.S.) and has a low current account deficit, is better prepared to deal with the Trump shock.

In Brazil, fiscal reforms continue to advance. In October, the constitutional amendment for a spending cap was approved by the Lower House. Regarding economic activity, recent data disappointed. However, leading indicators and fundamentals continue to suggest a rebound ahead, driven by the Industrial sector. Inflation continues its downward trend. Due to the new external environment, we now expect a more depreciated exchange rate. The central bank will probably prefer to proceed gradually, with another 25-bp rate cut, rather than 50-bp, which we had been expecting, thanks to the increase in macroeconomic uncertainty after the U.S. election surprise.


 


Global Economy
A new global landscape creates headwinds and risks for emerging markets

• The results of the U.S. election will likely lead to major changes in U.S. policy. We believe that President Trump will be able to implement significant fiscal stimulus in the U.S., and have incorporated this assumption into our forecasts. There is too much uncertainty about his agenda on trade, immigration, regulation and microeconomic reforms. For now, we are treating these as risks to the scenario, and will incorporate them into the forecasts if/when they materialize.

• We expect fiscal stimulus worth 0.8% of GDP over the next two years as well as higher policy uncertainty. The net effect is likely to be expansionary in an economy that is already close to full employment.

• We have kept our 2016 GDP forecast at 1.5%, raised our 2017 estimate to 2.2% from 2.1% and raised our 2018 forecast to 2.4% from 1.9%. We still believe that the Fed will increase interest rates in December and twice more in 2017. But we now foresee four rate hikes (from two) in 2018 and the risk in 2017 seem to be tilted to three hikes. We see the yields on the 10-year Treasuries rising, reaching 2.20%, 2.60% and 2.80%, at the end of 2016, 2017 and 2018, respectively.

• With higher U.S. rates we now expect exchange rates of the Euro, the JPY and the CNY, at 1.07 (from 1.10), 108 (105) and 6.90 (6.70) at the end of 2016, and at 1.03 (1.07), 120 (110) and 6.95 (6.75) at the end of 2017, respectively.

• Europe deserves attention, as the resilience of economic activity will be tested by a busy political agenda. 

• In China, aggressive Trump protectionism is a new risk, but not our baseline scenario.  We continue to foresee China’s GDP expanding by 6.6% and 6.3% in 2016 and 2017, respectively.

• For commodities, we foresee U.S. fiscal expansion helping metals, limiting downside risks, but not enough to create an upward trend.

• For emerging markets (EM), Trump’s victory is negative. Our baseline for higher interest rates in the U.S. will put pressure on EM currencies and local rates. And the risk of protectionism and tariff wars is negative for EM.

U.S. – Tighter monetary policy needed to offset fiscal expansion

Donald Trump’s surprising victory will bring about major change in U.S. policy. We believe that he will be able to implement a moderate fiscal stimulus, and have incorporated this assumption into our forecasts. (see graph).

The U.S. Congress is likely to support a moderate fiscal stimulus. The Trump campaign has pushed a major fiscal expansion (1.5% of GDP) through a combination of tax cuts ($4 trillion over 10 years) and increased public spending ($500 billion over 5 years). The Republican Party has retained simple majorities, which are required to approve budget legislation, in both the Senate and the House of Representatives. However, even the Republican-controlled Congress could limit too much fiscal stimulus, as signs of recklessness could be politically harmful in the future. We expect a fiscal stimulus worth 0.8% of GDP over the next two years.

Economic policy uncertainty about President Trump’s agenda on trade and immigration remains a risk to our scenario. He has promised to shield the domestic economy from foreign competition by lifting import tariffs and imposing tighter restrictions on immigration.

We expect these plans to be watered down, as higher tariffs risk igniting an inflation shock, but the risk remains, and the policy uncertainty will likely linger into the first quarter of 2017. The president has executive power to change import tariffs and impose stricter immigration rules. He will likely need to deliver something on these fronts, given his campaign promises. But we expect a cautious approach, as such polices could cause significant economic harm in both the short and long-term. In any event, policy uncertainty will likely remain high for the next couple of quarters.

The net effect of Trump’s plans is expansionary in an economy close to full employment. At the end of 2018, we now forecast that the U.S. unemployment rate will reach 4.1% (instead of 4.5%) and that the core PCE deflator will rise to 2.1% (instead of 2.0%). A mild overshooting of the Fed’s targets - with the risk tilted towards higher inflation.

This policy shift requires tighter monetary policy. We still believe that the Fed will increase interest rates in December and twice more in 2017, given that the fiscal impulse may kick off only in 2H17. But we now foresee four rate hikes in 2018 and we see risk in 2017 as tilted to three hikes.

We have kept our 2016 GDP forecast at 1.5%, raised our 2017 estimate to 2.2% from 2.1% and raised our 2018 forecast to 2.4% from 1.9%.

In addition, we have raised our 10-year Treasury yield forecasts to 2.20%, 2.60% and 2.80% at the end of 2016, 2017 and 2018, respectively.

Europe – Resilient activity amid political risks 

Economic indicators have been resilient in Europe. Our GDP estimate for 3Q16 has stayed constant at 0.3% qoq. The leading indicators for 4Q16 are also strong. Germany’s sentiment indicators have improved and credit data continue to show the positive effect of the ECB’s easing policies.

With resilient economic activity, the need for additional monetary easing has declined, but Trump’s victory, and the consequent increase in policy uncertainty across the Atlantic, deals a blow to tapering talks. We still expect the ECB to announce in December a six- to nine-month extension of its current QE program. In addition, we expect the central bank to change the parameters of the QE in such a way as to maintain low yields on the periphery while allowing long-term yields in core countries to increase (which would take the pressure off banks, particularly in Germany).

Political risks continue to pile up in Europe. In UK, the Brexit drama will take several years to unfold. In France, the Republican and Socialist parties will hold primaries ahead of the 2017 presidential elections. The most likely outcome is a market-friendly one, with former Prime Minister Alain Juppé becoming the Republican nominee and the favorite to win the election next year. But there are alternative scenarios, in which the odds of the Eurosceptic National Front’s Marine Le Pen becoming president increase. In Germany, Angela Merkel is expected to confirm her intention to seek a fourth term as chancellor, but there remains some chance that she won’t and that more “hawkish” candidates will emerge (for example, the current finance minister Wolfgang Schäuble). In Italy, the referendum on constitutional reform is moving toward a defeat for PM Matteo Renzi’s government. Though we do not expect Renzi to resign, he will be in a weaker position to advance the pro-reform agenda needed to boost Italy’s GDP. In Austria, the coming presidential election re-vote is shaping up to give far-right candidate Norbert Hofer the victory, and though parliamentary elections are not due until 2018, the legitimation of an anti-establishment head of state in Austria would give Euro-skepticism even more momentum.

We maintain our GDP forecast for the euro zone at 1.5% and 1.3% for 2016 and 2017, respectively.

China – An aggressive Trump-led protectionism agenda is a new risk, but not our baseline

The recent batch of economic data from China reinforces the “growth stability” story. In 3Q16 China’s real GDP grew by 6.7% yoy, the same pace as in the two previous quarters, while its nominal GDP accelerated slightly, to 7.8% yoy from 7.3%. October data showed industrial production stable at 6.1% yoy and fixed investment roughly stable at 8.8% yoy, as real estate private-led investment offset a small slowdown in public investment.

We expect this growth stability to extend into 2017. Why? The leadership transition in 2017; stronger real estate investment; higher corporate profits due to a weaker currency and the end of PPI deflation; and the ability to control the timing of painful adjustments. The first round of the leadership transition was favorable to president Xi Jinping’s quest to consolidate power, but he may need a strong economy to continue to suppress rival factions within the Party throughout the process.

The main short term risk is an overheating of the housing sector, but the issue seems to be localized and macro prudential policies might be sufficient to deal with it. If localized and macro prudential policies fail to cool down the sector in major cities, the government may be forced into a broad-based tightening of monetary conditions, affecting the whole economy. Recent experience suggests that this risk is modest. Both in 2010 and 2013, the government unleashed similar macro-prudential tools, successfully cooling off the housing market without causing an overall growth slowdown.

A “tariff war” between the U.S. and China is a risk, but not our baseline scenario. A potential 45% punitive tariff on Chinese goods was mentioned during the presidential campaign. If such a tariff were imposed, China could respond not only with reciprocal tariffs, but also by punishing U.S. companies domestically and devaluing its currency. The effects would spill over to the world, including the U.S. The consequences of such moves are so unpredictable that we believe any mention by the U.S. of action on tariffs is only a bargaining tool aimed at negotiating better terms.

We maintain our GDP forecasts for China at 6.6% for 2016 and at 6.3% for 2017

Emerging Markets – Improving fundamentals but new headwinds.

Fiscal expansion and higher interest rates in the U.S. will likely put pressure on EM currencies and local rates.

Improving fundamentals in EM, as compared with the recent past provide some cushion. First, the external vulnerability in emerging markets has declined since the taper tantrum in 2013, as current-account balances have improved and foreign reserves as a share of GDP have increased. Second, better growth prospects will likely continue to attract capital flows to emerging markets (see graph). Finally, the currencies of countries with higher interest rates are better protected. In this respect, Latin America and Russia stand out, as their central banks have increased interest rates in the past couple of years to fight higher inflation.

Still, some countries rank worse than others in their external position and hence are more vulnerable to rising in interest rates in DM economies. In relative terms, Colombia, Argentina, Turkey and South Africa have relatively weaker external positions. On the positive side, Brazil, Russia and Indonesia have reduced their external vulnerability since 2013 (see graph).

In addition, the risk of protectionism in the U.S. is negative for EM. Countries with higher trade surpluses with the U.S. (see graph) are more vulnerable.

Commodities – Trump helps metals, but not enough to trigger a new boom

The Itaú Commodity Index (ICI) has risen by 1% since the end of September, as a rally in metal prices (+19%) and stability in agricultural commodities have been partly offset by a decline in oil-related prices (ICI-energy: -9%). Metal prices were already rallying before the U.S. election, and its surprising outcome caused another leg up (while crude oil and agricultural prices were largely unaffected). Oil prices fell on diminishing expectations of an OPEC deal.

We have raised our metal price forecasts. The ICI-metals is up 41% year-to-date, a huge surprise in a year that began with fears of a global recession led by China. There are indeed reasons to see better fundamentals. Domestic steel demand in China picked up in 2016 (+3% YTD, vs. -1.5% in 2015) and iron inventories seem to have already adjusted. For base metals, a recovery in global manufacturing and tighter supply discipline is helping to prevent market oversupply. Finally, the prospect of stronger infra-structure spending in the U.S. is positive for metal prices. Hence, we are revising our YE17 iron ore price forecast upward to  USD 55/ton from USD 48/ton. Together with the forecast changes for base metals, the net effect is a 7.1% increase in our ICI-metals forecast for the end of 2017.

Nonetheless, we still forecast a modest decline in metal prices throughout 2017. Our scenario relies on slowing demand growth in China as the housing market weakens by mid-2017 and, in response, a lower supply from marginal producers. Finally, the promised infrastructure spending in the U.S. will not get close to replacing China as the main driver.

The outlook for an OPEC deal has become murkier with the uncertainty about President Trump’s geopolitical strategy. Nonetheless, we maintain our scenario forecast for Brent prices at USD 54/bbl at YE17, assuming the cartel will indeed reach a deal. The reason is that fiscal considerations can prompt the Saudis and Iranians to push prices to the top of the range (USD 40-60/bbl) that, if exceeded, could trigger a meaningful response from U.S. producers. In other words, prices below this range are fiscally inefficient for these strategic suppliers.

The ICI-agricultural sub-index has traded sideways since the end of September. We are further revising our coffee forecasts, recognizing that a likely global deficit in 2017 could sustain current price levels. Meanwhile, the overall likelihood of a grain/soybean oversupply was increased by the largely favorable planting conditions in South America, although La Niña risks continue to shadow the southernmost planting regions.

Our estimates imply that the ICI will rise 3% from its current level by the end of 2016 (due to a rebound in oil prices), and then remain unchanged.


 


LatAm

Hit by Trump

• Donald Trump´s victory in the U.S. presidential elections has put pressure on emerging market currencies. Relatively to our previous scenario, we now see weaker LatAm currencies versus the U.S. dollar.

• Even with the recent weakening, the performance of most LatAm currencies is far more favorable this year compared with the previous two years, which is still supporting disinflation. At the same time, growth remains weak throughout the region and weaker-than-expected in countries like Brazil and Argentina. We revised our growth forecasts downward for Argentina, Colombia and Mexico, and we acknowledge that there is a downward bias for our forecasts for Brazil.

• In a context of weak growth and falling inflation, many central banks are in (or are entering) an easing mode. However, the new external environment will likely turn policy makers more cautious before slashing interest rates. The divergence between North and South America will continue, and the Central Bank of Mexico will likely raise interest rates by more than we had been expecting before the U.S. elections. 

Higher U.S. treasury yields and risk of protectionism weaken exchange rates

Donald Trump´s victory in the U.S. presidential elections has put pressure on emerging market currencies. Large fiscal expansion, as advocated by the president-elect, in an economy close to full employment is increasing U.S. treasury yields, which weakens LatAm currencies. The risk of protectionism is also negative for emerging markets, especially for Mexico, which has strong commercial ties with the U.S. Not surprisingly, the Mexican peso was the currency that weakened the most after the election result was announced. Countries with weak balance-of-payment position, like Argentina (which has low international reserves) and Colombia (with a wide current account deficit), are also vulnerable. Domestic imbalances leave the Brazilian real exposed too and the central bank sold dollars in the NDF market to curb the weakening. On the other hand, Chile is the less vulnerable country within our coverage, as it is a copper exporter (a commodity that is already benefiting from the expectation of infrastructure-focused fiscal stimulus in the U.S.) and has solid fundamentals (low current account deficit, sizable public sector external assets and low public debt). Peru also exports copper, but the partial dollarization of its financial system is a vulnerability to higher interest rates in the U.S.

Relatively to our previous scenario, we see weaker LatAm currencies versus the U.S. dollar. Our forecast revisions were stronger for the Mexican peso, although we still think some appreciation during 2017 is possible, if fears over protectionism gradually dissipate. In our view, an OPEC deal is still likely, which will increase oil prices and curb the depreciation of the Colombian peso. On the other hand, we expect some decline of copper prices (although to higher levels than we were previously forecasting), which will play against the Chilean peso. The Brazilian real will likely end this year weaker than our previous expectation, and we see the exchange rate at 3.60 reais to the dollar by the end of 2017, with domestic fiscal reforms helping to shield the currency.

Even with the recent weakening, most LatAm currencies are recording year-to-date gains against the U.S. dollar (the Mexican peso is the obvious exception), which together with negative output gaps and the fading impact of some shocks (such as the El Niño) is supporting disinflation in the region. In Colombia, annual inflation has fallen fast, with food inflation 720 bps below the peak reached in July (when a truckers strike contributed to lift food prices). Still, inflation there remains far above the range around the target, just like in Brazil, where disinflation is unfolding too. Inflation in Chile has also been a positive surprise, with consumer prices running below the target center for the first time since January 2014 (with tradable price inflation below the lower limit of the target range). In Argentina, there has been a lot of progress on disinflation, although in October the CPI surprised to the upside. In Peru and in Mexico inflation also increased somewhat recently, influenced in both cases by transitory factors (in Mexico, the exchange rate weakening has been particularly important).   

Postponing recovery

Economic growth remains weak. In Brazil, recent activity indicators disappointed, hinting at another strong quarter-over-quarter contraction in 3Q16. Argentina also likely remained in a recession during 3Q16. In Chile, Colombia and Mexico, there is no recession, but growth is failing to recover. In Mexico, growth rates are not far from historical averages, which is disappointing considering all the reforms approved over the past few years. In Chile and Colombia, growth is too low for historical standards. Only in Peru, we continue to see solid economic growth, but this is linked to a surge in mining output, while the non-commodity sectors are yet to react to the confidence improvement following the election of PPK.     

We revised our growth forecasts downward for Argentina, Colombia and Mexico, and acknowledge that there is a downward bias for our forecasts for Brazil. Uncertainty over protectionism will likely be an important drag on investment in Mexico (especially in the manufacturing sector). In Colombia, besides higher U.S. treasury yields, the proposed tax reform will be negative for growth in the short-term. For Brazil, we will wait for the 3Q16 national accounts data, before making revisions. Meanwhile, the improved copper prices make us more confident in our expectation of a modest recovery in Chile and Peru.

A more challenging environment for monetary policy

In a context of weak growth and falling inflation, many central banks are (or are entering) on easing mode. However, the new external environment will likely turn policy makers more cautious before slashing interest rates. The Brazilian central bank started an easing cycle in October, with a 25-bp move and we now expect another cut of the same magnitude in November (previously we were expecting the CB to move to a 50-bp per meeting pace already this month). In Colombia, we now expect the easing cycle to start only in 2Q17 (instead of 1Q17). In Argentina, more rate cuts are likely, but we see less room for monetary easing than before. On the other hand, in Chile we see more monetary easing than before next year (we now expect a 100-bp cycle, instead of 50-bps) due to faster-than-expected disinflation and a still weak economy. The divergence between North and South America will continue, and the central bank of Mexico will likely raise interest rates by more than we had been expecting before the U.S. elections.


 

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


 



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