Itaú BBA - Central Banks react to market turbulence

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Central Banks react to market turbulence

June 8, 2018

Strains in external financial markets come at a time in which many countries face a risky political scenario and macro imbalances

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

Global Economy
Stronger growth momentum in the U.S., for now
Growth is stronger in the U.S. than in the rest of the world, favoring the USD. However, improving business survey readings in China (and Emerging Asia in general) bode well for global exports and commodity prices.

 

LatAm
Central Banks react to a more adverse scenario
Strains in external financial markets come at a time in which many countries face a risky political scenario and macro imbalances, putting strain on EM central banks. Argentina hiked interest rates aggressively, while in Brazil the central bank started to intervene in the exchange rate market. We expect Mexico’s central bank to increase interest rates in June.

 

Brazil
Increasingly challenging scenario
Tighter financial conditions and the impacts of the truck drivers' stoppage led us to trim our growth forecasts to 1.7% in 2018, from 2.0%. In the wake of the dollar-strengthening trend, we revised our exchange rate forecast to 3.70 reais per dollar at the end of 2018 and 2019 (against 3.50)

Argentina
We have a deal
The necessary adjustments are leading to a deceleration of the economy. We expect GDP to expand by 1.5% this year, down from 2.0% in our previous scenario (and expectations of 3.8% at the turn of the year). While the political scenario is becoming more uncertain, our baseline scenario for Argentina is still a constructive one.

Mexico
Navigating more turbulent waters
The lastest polls show that AMLO’s odds of gaining a majority in congress are increasing and NAFTA renegotiations took a turn for the worse. In this context, risks for inflation have intensified and the central bank will likely increase rates by 25 bps at its June meeting. Additional tightening can’t be ruled out and we do not expect to see cuts this year.

Chile
Looking bright amid darkening global clouds
Activity is rebounding and the recovery is widespread. With confidence up, copper prices still elevated, inflation low and monetary policy still expansionary, a recovery to 3.8% this year is expected, from 1.5% last year. External factors, such as the possibility of trade wars, are the main risks for the economy.

Peru
Government takes steps toward fiscal consolidation
The government has carried out meaningful actions to narrow the fiscal deficit, whilst also passing measures to achieve the ambitious 17.5% growth target for public investment in 2018. In view of this policy package, we have revised our nominal fiscal deficit forecasts for 2018 (to 2.9% of GDP, from 3.2%) and 2019 (to 2.7% of GDP, from 3%).

Colombia
Down to two
Iván Duque and Gustavo Petro will face each other in a runoff vote on June 17. Recent simulations show that Duque, backed by former President Uribe, would comfortably emerge as the winner. The next administration will face fiscal challenges and the implementation of the peace deal.


 


Central Banks react to market turbulence

The USD continued to appreciate against most currencies, favored by a combination of stronger growth momentum in the U.S. and slightly weaker activity in the rest of the world. However, this growth mix tends to revert as business surveys in China (and emerging Asia in general) are improving, which bodes well for emerging markets in general, because it tends to bolster global exports and support commodity prices.

Global financial conditions also became tighter over the recent weeks on the back of heightened political risks in Italy. Uncertainty will likely continue to pressure financial markets and reduce growth in the country, because while the formation of a government reduced the risk of a new election that could morph into a proxy Euro referendum, concerns about the new government’s fiscal stance and political sustainability remain high. In a more complex environment, we reduced our expectations for the EUR relative to USD and lowered our Eurozone growth forecasts for this year and the next, but still expect the ECB to end its asset purchases this year.

The China-U.S. trade dispute, another factor that has been driving market sentiment of late, remains a risk. China seems willing to cooperate and has offered several concessions, but U.S. response has so far been mixed. We believe that an escalation will be avoided because China can offer President Trump enough benefits to produce a perception of a trade victory before the midterm elections.

The conditions for emerging markets continues to be turbulent, prompting some central banks to act: Argentina and Turkey hiked rates agressively, while India, Indonesia and the Phillipines also delivered some tightening. 

Within LatAm, currencies of countries with vulnerabilities such as Argentina and Brazil have underperformed. The Mexican peso also suffered some depreciation, while in Chile, Colombia and Peru, high commodity prices and lower political risks shielded the currencies from more intense losses. The recent wave of depreciation is pressuring central banks in the region. After hiking rates to 40% pa, Argentina’s central bank will likely stay on hold for now. In Mexico, the central bank is set to increase the policy rate by 25 bps in June. In Brazil, the central bank has started to intervene in the exchange rate market through swaps, but Selic rate hikes are still unlikely in the short term. Monetary policy rates in Chile and Peru are likely to stay at their current levels, while in Colombia we think there is room for one final rate cut (by 25 bps), before the easing cycle ends.

In Brazil, the scenario is becoming increasingly challenging. The continuation of the dollar strengthening trend, in an environment of volatility in international markets, pressures the exchange rate and motivates us to revise our forecast to 3.70 reais per dollar by the end of 2018 and 2019 (from 3.50). Domestically, we reduced our GDP growth expectations to 1.7% from 2.0% in 2018 and to 2.5% from 2.8% in 2019, due to worsening financial conditions (exchange rate depreciation, higher market rates and lower asset prices) and the effects of the truck drivers' stoppage. If, on the supply side, the stoppage tends to have a punctual impact on the production of goods and services, on the demand side it increases the uncertainty in the economy and increases the fiscal risk, leading to a longer lasting effect on entrepreneurs’ and consumers’ confidence levels. From the fiscal point of view, slower economic growth and the measures taken to meet drivers’ demands – which are only partially offset by cuts in spending and tax increases – increase short-term risks, but we continue to expect that the primary deficit target will be met in 2018. In the inflation front, the truckers’ stoppage should have only a temporary impact on monthly IPCA readings, but the exchange rate depreciation exerts a pressure on our year-end forecasts, which were revised to 3.8% in 2018 and 4.1% in 2019 (from 3.7% and 4.0%). In this context, the central bank is still likely to keep the Selic rate at 6.5% by the end of the year. We believe that the exchange rate dynamics can influence the next decisions if there is a relevant impact on inflation expectations. 


 


Global Economy
Stronger growth momentum in the U.S., for now

• Growth momentum is stronger in the U.S. than in the rest of the world, favoring the USD. However, business surveys in China (and Emerging Asia in general) also improved, which bodes well for global exports and commodity prices.

• In the U.S., with unemployment well below full employment and core inflation at about 2%, the Fed will continue to raise interest rates in an attempt to slow the economy toward potential growth.

• Political uncertainty in Italy has tightened financial conditions in Europe. We reduced our GDP forecasts for the euro area to 2.3% for 2018 (from 2.5%) and 2.0% for 2019 (from 2.4%).

• The U.S.-China trade-war risk remains, but China’s offer to lower tariffs, increase imports and protect property rights provides an opportunity for a deal without escalation.

• Commodity prices remain resilient, despite the stronger USD.

Growth momentum is stronger in the U.S., but has also started to recover in China and Emerging Asia

The strong growth momentum in the U.S. has persisted, while the rest of the world has slowed down a bit. The ISM Manufacturing Index has fluctuated, but remains close to this year’s high, while the PMI ex-U.S. has steadily declined, from 55 to 53 (see chart).

This growth mix explains the recent USD strength. The USD gained 5.4% against DM currencies and 7.6% against EM currencies between January and May. During this period, the growth gap between the U.S. and the rest of the world widened.

On the positive side, PMIs in China and across Emerging Asia have recovered over the past couple of months, which bodes well for EM growth in general. It is true that PMIs in other EM regions (CEMMEA and LATAM) declined in May. But the recovery in EM Asia indicates that global exports have not lost much momentum (see chart), and good global trade is a positive sign for most emerging markets.

U.S. – Domestic Strength keeps the Fed on track for interest rate hikes

GDP growth is tracking 3% in 1H18, due to strong domestic demand supported by still easy financial conditions, tax cuts and government spending. Consumption is growing at a rate of 2.7% YoY and private fixed investment is running at 4.5% YoY. Government spending is also set to accelerate to above 3% YoY over the next few quarters. 

The domestic strength in the U.S. more than offsets the international risks. Trade-war risks, volatility in emerging markets and political uncertainty in Italy have not had a meaningful impact on U.S. financial conditions so far.

The unemployment rate will consequently continue to fall, while wages and inflation will continue to rise. The unemployment rate fell to 3.75% in May, well below the median Fed estimate of NAIRU (4.5%). With the economy growing close to 3%, job creation will remain at around 200k and the unemployment rate will continue to drop (see chart). In response to the tight labor market, wages will continue to gradually increase. Meanwhile, core inflation is already near 2% and will continue to rise as wages increase.

With falling unemployment and rising inflation, the Fed will continue to raise interest rates. If payroll growth remains at the 200k per month for much longer, the unemployment rate would drop below 3% by YE19, increasing the risk of stronger wages prompting a significant overshoot of the 2% inflation target. 

The U.S. economy is in the late stages of the business cycle, when the Fed must tighten its policy stance, leading GDP and job growth to slow to their longer-run trends. This limits equity price appreciation and suggests that the USD strength may not last much longer.

We continue to forecast four Fed fund rate hikes in 2018, followed by three hikes in 2019. We expect the 10-year U.S. Treasury yield to rise to 3.25 by YE18 and 3.50 by YE19.

Europe – Italy’s risk tightens financial conditions and lowers growth prospects

The Euro area Composite PMI dropped 1pt to 54.1 in May. This level indicates growth of around 0.5% QoQ in 2Q18, below our previous expectation of 0.7%.

Furthermore, political uncertainty in Italy will likely continue to pressure financial conditions and reduce growth in the country. The risk of a new election that could morph into a proxy Euro referendum was reduced by the formation of the populist government. However, uncertainty about the new government’s fiscal stance and political sustainability remains high. Fiscal proposals could add up to 6% of GDP to the deficit (EUR 100 billion). And although we believe that such a marked fiscal deterioration is unlikely, discussions about the budget to be presented to parliament in September could drive the yields of the 10-year Italian bond back to around 3.0%.

In Spain, on the other hand, we see low risk from the change in government. If Pedro Sanchez (PSOE/center-left) remain in power or new elections are held this year (fiscal responsible/pro-EU parties are ahead in polls), the current macro policies will remain in place. Spain will therefore continue to show good macro performance with: i) strong growth, above the euro zone’s average; ii) a current account surplus; iii) close to primary fiscal balance; and iv) a downtrend in public debt.

This outlook will still lead the ECB to end its asset purchases this year. Despite political uncertainty, we still expect a cautious approach that should lead to a small tapering from September to December, as growth remains above 2% and underlying inflation will rise slowly but remain below the target.

We lowered our GDP forecast for the Eurozone to 2.3% for 2018 (from 2.5%) and 2.0% for 2019 (from 2.4%). We also reduced our EURUSD expectations to 1.20 this year (down from 1.25) and 1.25 next year (from 1.30).

U.S.-China trade dispute remains a risk

China seems cooperative in order to avoid a trade war. The country has offered to increase imports from the U.S. of agriculture and energy goods, to expand trade to other manufactured goods and services, and to enhance protection of U.S. technology. China also announced the reduction of auto import tariffs to 15% from 25%.

U.S. response has been mixed. Treasury Secretary Steven Mnuchin initially said that the U.S. would put on hold its plan to raise tariffs on USD 50 billion in Chinese import goods scheduled for end-May. However, the White House later renewed its threat to release the list of tariffs on the USD 50 billion in Chinese import goods by June 15 and to impose it shortly thereafter. The White House has also threatened China with investment restrictions to be announced by June 30.

In response, China recently stated that any trade concessions would only be granted if the US did not impose any trade sanctions, including tariff hikes. China has also pledged to respond to any U.S. import tariff hike.

Despite the risk, we still believe that a U.S.-China trade deal will be reached without escalation. It seems that additional concessions from China may be needed soon, and the U.S. must back off from its threat to raise import tariffs on June 15. We nevertheless believe that an escalation can be avoided because China can offer President Trump enough benefits to sell as a trade victory before the midterm elections.

Commodities – Fundamentals remain good

The Itaú Commodity Index (ICI) has risen 2.2% in May. All sub-indexes posted gains in the period: Agriculture (2.1%), Metals (0.5%) and Energy (3.3%). 

The increase in commodity prices, despite a stronger USD, reflects good fundamentals across the three components. In agricultural commodities, the first estimates from USDA suggest a decline in the stock-to-use ratio in the 2018-19 crop year. Metals continue to benefit from strong growth in China and stronger supply discipline and risks (sanctions targeting Russia and stricter environmental rules in China). For oil, we see some correction lower around the OPEC meeting, but prices should remain above USD 60/bbl given that the market will still need the ongoing increase in U.S. shale production regardless of additional output from OPEC members in 2H18. 

We raised our wheat and cotton price forecasts to adjust for the abovementioned USDA estimates, but maintained our assumptions for metal and energy. Following the revisions, our YE18 forecasts see agricultural rising slightly from current levels, stable metal prices and a small decline in oil-related prices.

 


LatAm
Central Banks react to a more adverse scenario

• Strains in external financial markets come at a time many countries face a risky political scenario and macro imbalances. Relative to our previous scenario, we now expect weaker currencies in Argentina, Brazil and Mexico. 

• We expect slower growth in Brazil, and recently reduced our activity forecasts for Argentina. The economy in Mexico has been surprisingly resilient, and an acceleration in 2018 is likely. 

• Recent market developments are pressuring central banks. The Central Bank of Argentina significantly increased interest rates, while the central bank in Brazil has started to intervene in the exchange rate market. We expect Mexico’s central bank to raise interest rates in June.

The more adverse scenario for emerging markets continues. Within LatAm, currencies of more vulnerable countries, such as Argentina (wide twin deficits and low reserves) and Brazil (worrisome public debt dynamics), have underperformed since early May. In Mexico, uncertainties related to the elections and trade relations with the U.S. intensified recently, contributing to the negative performance of its currency. On the other hand, high commodity prices and lower political risks in Chile, Colombia and Peru have been shielding their currencies, which have recorded more moderate weakening against the USD recently. 

In this context, we now expect weaker exchange rates than in our previous scenario for Argentina, Brazil and Mexico. As a result, we are raising our inflation forecasts for all three countries. 

Mixed activity in the region. The economy in Brazil had been gradually recovering until April. However, tightened financial conditions and the trucker strike in May will have both temporary and more permanent (through confidence) effects, leading to a reduction of our growth forecasts to 1.7% for this year (from 2.0%) and 2.5% for 2019 (from 2.8%). In Argentina, lower real wages, tighter macro policies and weaker confidence will add to the effects of the severe drought. Although Argentina’s economy expanded at a robust pace in 1Q18 (generating significant carryover), a contraction in the second and third quarter of this year is likely, leading us to recently lower our GDP growth estimate for this year to 1.5% (from 2.0%). On the other hand, the economy in Mexico has performed surprisingly well, despite the considerable uncertainties. Growth in the first quarter of the year was solid, partly due to transitory factors (reconstruction efforts following the natural disasters that hit the country in 2H17). However, the strong U.S. economy and the solid labor market in Mexico have so far offset the effects of macro policy tightening and uncertainties over NAFTA and the elections. The recovery in Chile and Peru is on track. Activity in Colombia has been sluggish, but we expect the more expansionary monetary policy, higher oil prices and the outcome of the presidential election to support a recovery of activity. 

The recent exchange rate weakening has pressured central banks. Argentina’s central bank increased interest rates aggressively in three inter-meeting decisions since the end of April, bringing the policy rate to 40%, where it was maintained at the two subsequent meetings. While rate cuts in Argentina are likely once the market stabilizes, there is currently no room for rate reductions, also considering the sharp increase in inflation expectations. In Mexico, the central bank will likely increase the policy rate by 25 bps in June, after remaining on hold at the last two meetings. The Brazilian central bank has started to intervene in the exchange rate market through swaps. Still, near-term Selic rate hikes seem unlikely given that inflation is below target and there is considerable spare capacity in the economy – meaning that the recent BRL weakening so far poses no threat to the benign inflation outlook. Meanwhile, inflation in Chile has run below the target for some time, although the external environment reduces the likelihood of a convergence of inflation toward the target, thus decreasing the odds of rate cuts (but there is also no rush for hikes). In Peru, the chances of further rate cuts are also lower – given the external environment, the partial dollarization of the economy and the on-going recovery – even though inflation is below the target. Finally, in Colombia, we see room for one final rate cut (25 bps) before the cycle ends, but recent comments by board members on its willingness to add stimulus have been mixed.

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



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