Itaú BBA - Easing cycles closer to an end in Latam, in a context of improving global growth

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Easing cycles closer to an end in Latam, in a context of improving global growth

November 7, 2017

Mixed inflation pictures are leading to diverging monetary policy responses in the region.

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

Global Economy
The global cycle is changing
Global growth is improving and we believe global inflation will start to gradually normalize, as the output gap in developed economies turns positive and deflationary pressure from China eases.

LatAm
Easing cycles closer to an end
Activity in the region is gradually recovering, but mixed inflation pictures are leading to diverging monetary policy responses. Still, we note that easing cycles, where ongoing, are coming closer to an end. 

Brazil
Getting closer to the end of the cycle
In a context of gradual economic recovery and less benign inflation at the margin, the central bank signaled another interest rate cut in December, but left the February decision wide open.

Argentina
Renewed optimism faces no shortage of challenges
The administration emerged stronger from the mid-term elections, which will allow the ruling coalition, led by president Macri’s Cambiemos, to seek tactical alliances to pass key fiscal reforms.

Mexico
Domestic and external uncertainties return
The latest round of NAFTA renegotiation raised the odds of a break-up.  In addition, PAN party has split, benefiting the ruling PRI and anti-establishment candidate Andrés Manuel Lopez-Obrador.

Chile
Easing-cycle discussion still alive
Expansionary monetary policy, improving private sector sentiment and higher global growth will all aid an activity recovery. Limited inflationary pressures mean that further rate cuts cannot be ruled out.

Peru
More than just green shoots
Peru’s activity is showing more than just green shoots, with indicators pointing towards a strong pick-up in coming quarters. Inflation is falling faster and we believe the central bank will seize the opportunity to deliver the final (25-bp) rate cut of its easing cycle in November.

Colombia
Rate cut comes ahead of schedule
In a split decision, the central bank surprisingly cut the policy rate by 25 bps in October, to 5.0%, on the back of a more favorable inflation outlook. We still expect the easing cycle to end with a policy rate of 4.5%.

Commodities
Higher copper prices, lower agricultural prices
Commodity prices rose in October, boosted by 4.4% increase in its energy subcomponent. We increased our yearend copper and nickel forecasts. On the other hand, we lowered our forecasts for agricultural prices.


 


Easing cycles closer to an end in Latam, in a context of improving global growth

Global growth is improving but still has room to become more widespread. We raised our GDP growth estimates for the U.S., Europe and China, increasing our global projection to 3.8% for 2017 and 2018, from 3.6% and 3.7% respectively. We believe global inflation will start to gradually normalize as the output gap in developed economies turns positive and deflationary pressure from China eases. The main risk is an accelerated correction in DM interest rates due to a rapid approval of tax cuts or inflation pressures in the U.S, thanks to the eventual revival of Philips Curve dynamics, but these risks do not seem worrisome at the moment.

With higher U.S. treasury yields, most LatAm currencies weakened in October. The Mexican peso underperformed, reflecting noise over presidential elections next year and NAFTA renegotiations, while rising copper prices supported the Chilean peso and the Peruvian sol. Activity in the region is gradually recovering, but mixed inflation pictures are leading to diverging monetary policy responses. In October, two central banks surprised expectations: in Colombia, the policy rate fell by 25 bps following a downside surprise in inflation, and in Argentina there was a 150 bps hike in response to inflation stickiness. Still, even in countries that are reducing interest rates, easing cycles are coming closer to an end. 

In Brazil, the Monetary Policy Committee cut the Selic rate by 75 bps in October, as widely expected, and signaled a 50-bp cut in December, but left the February decision wide open. Our year-end forecasts for the Selic rate were maintained at 7.0% for 2017 and 6.5% for 2018. We increased our 2017 inflation forecast to 3.3% due to greater pressure from regulated prices, but our estimate for 2018 inflation remains at 3.8%. We anticipate GDP growth of 0.8% in 2017 and 3.0% in 2018, but we do see risks: domestic factors have a negative bias, while the stronger global environment works in the opposite direction. Our forecast for unemployment at year-end 2018 was revised downward, to 11.8% from 12.0%. Exchange rate forecasts were unchanged, at BRL 3.25 per USD in 2017 and 3.50 in 2018.


 


Global Economy
The global cycle is changing

• Global growth is improving and still has room to become more widespread. We raised our forecast for the U.S., Europe and China, increasing our world GDP estimate overall to 3.8% for 2017 and 2018, from 3.6% and 3.7% respectively.

• We believe global inflation will start to gradually normalize as the output gap in developed economies turns positive and deflationary pressure from China eases.

• The better growth scenario, with gradually rising DM interest rates, is supportive of global financial conditions and is good news for EM economies.

• The main risk is an accelerated correction in DM interest rates due to a rapid approval of tax cuts or inflation pressures in the U.S. These risks do not seem worrisome at moment.

The global cycle is changing

Global growth is picking up. Easy monetary policy in DM, the abatement of political risks in Europe and better chances of a soft landing in China are supporting a synchronized global recovery. We raised our world GDP expectation to 3.8%, both in 2017 and 2018, from 3.6% and 3.7%, respectively.

We note that better growth will still become more widespread in emerging economies. The share of EM economies growing below the DM average remains high, and according to the IMF WEO, it will decline sharply in 2018 (see chart). This should be expected given that, from the three global shocks of the past ten years – 2008-09 financial crisis, 2011-13 euro debt crisis and the 2014-2016 commodities collapse – the latter was the most recent and most important for emerging markets, which have just recently adjusted to a world of lower commodity prices environment.

Given better growth, we believe global inflation will gradually normalize. First, the output gap in developed economies will likely turn positive next year for the first time since the financial crisis in 2008-09. This should pull DM core inflation up (see chart). Second, the deflationary pressures from China are ending. The producer price index, that had been negative in China from 2012 to 2016 (yearly average: -2.9%), has just stabilized in positive territory this year (6.5%). 

U.S. – Gradual adjustment in interest rates to continue

GDP expanded 3% in the last two quarters and may remain at the same pace in Q4. Private demand could grow 3%, boosted by easy monetary policy (consumption 2.5%, business investment plus exports 5%). 

Looking ahead to 2018, growth will likely decelerate from the current 3.0% pace but remain above 2.0%. Inventory accumulation also contributed to growth in 3Q17 and will fade ahead. In addition, growth continues to be limited by sluggish productivity and government spending. This forecast already assumes that the Congress will approve in 1Q18 a USD 1.5 trillion tax cut over the next 10 years. 

We revised our GDP forecast to 2.3% from 2.1% in 2017 and to 2.4% from 2.3% in 2018. 

Growth above potential will likely raise wages and inflation. We expect unemployment rates to decline, to 3.9% from the current 4.2% by year-end 2018. Consequently, wages will likely rise further and push the core inflation up to 1.9% yoy in 4Q18 from 1.3% in September. 

We still believe investors are currently underpricing the number of Fed hikes next year. We expect four additional 25 bps Fed Funds Rate hikes by year-end 2018, in line with the FOMC’s dots. Meanwhile, markets seem to have priced in a little more than two increases in the same period, as the consensus remains too bearish on the inflation outlook.

But the upward move in U.S. yields will likely be gradual. First, inflation will only rise gradually as inflation expectations are 25 bps below the Fed’s 2% target. It will likely take better wage and core inflation numbers to increase investor confidence in the inflation convergence to 2%. Second, the approval of the GOP tax bill should come next year, and there is still the risk that it will not be approved. Third, the new Fed Chairman, Jerome Powell, recently appointed by President Trump and still to be approved by Congress, is unlikely to change the gradual course of monetary policy.

There are two risks for this scenario. 

First, the tax bill could be approved this year. This would extend the current upward move in U.S. rates, forcing investors to reassess their forecasts. This is more a question of timing than magnitude. 

Second, inflation could rise faster than we anticipate. Our estimate of the Philips Curve indicates that it is close to an inflection point, where wages could pick up at a faster pace (see chart). If this also translates into faster inflation, the FOMC might need to increase U.S. rates more than expected to slow down the U.S. economy.

We continue to expect the UST 10-Y at 2.6% and 2.9% at the end of 2017 and 2018. 

Europe – Strong growth

Eurozone GDP expanded 0.6% q/q in 3Q17, maintaining a solid growth pace. Easy monetary policy, easier fiscal policies, tentative signs of structural reforms and a reduction in political risk are boosting the region’s growth. 

The Catalonian independence movement and EU-UK Brexit negotiations are sources of anxiety in the Eurozone. But none seem to pose an immediate risk to the region or to the global economy. 

But there was some positive news in Italy. Growth has improved in the country, and the new electoral law, which favors pre-election coalitions, reduced the chance of the anti-establishment 5 Stars party, which is unlikely to enter any coalition, coming into power. The 10-year Italian government bond yield has declined to 1.80% from 2.20% in the past month.

We raised our Eurozone GDP forecasts to 2.3% (from 2.0%) and 2.1% (from 1.7%) for 2017 and 2018, respectively.

Japan – Abenomics stays

Prime Minister Shinzo Abe coalition renewed its two-third majorities in the snap election, relieving the fear of a change in its economic policy strategy. BoJ is likely to keep the Yield Curve Control through Quantitative and Qualitative Easing. Fiscal policy is unlikely to change in 2018. And Abe is expected to push for economic reforms to enhance GDP potential.

We continue to forecast an above potential GDP growth of 1.6% for 2017 and 1.4% for 2018. In 3Q17, private domestic demand seems to have decelerated a bit, but it should be offset by net exports. Moreover, consumer and business confidence indicate that the slowdown in domestic demand should be transitory.

China – Soft landing scenario

China’s GDP grew by 6.8% yoy in 3Q17, a tad lower than in 1H17 but still a robust pace. Moreover, in September, the economy recovered a bit from weaker numbers in July and August. Industrial production and fixed-asset investment grew by 6.6% yoy and 7.5% yoy so far this year. Retail sales rose by 10.3% yoy in the same period. Finally both home sales and construction continued to show a moderation during the month.

We believe a soft landing scenario for the Chinese economy seems more likely. First, the economy is slowing from a solid position in the cycle. Second, the slowdown is coming from tighter economic policy, which can be adjusted to smooth the process. Third, the credit-to-GDP ratio continues at a high level, but recently it has started to stabilize due to more rigid financial regulations focused on “alternative” credit products (see chart below). Finally, the Housing sector is more balanced, and inventories continued their downward trend (see chart below).

On the political side, the Party Congress did not produce any major changes in leadership or policy, as expected. President Xi Jinping and Premier Li Keqiang are going to continue for another term. The next key event to watch is the Central Economic Working Conference in December. 

We increased our growth forecast slightly, to 6.8% from 6.7% in 2017, and we maintained our projection at 6.3% for 2018.

Emerging Markets – Easy global financial conditions support EM growth.

Global financial conditions that matter most for EM remain easy. We have statistically computed (principal component analysis) summaries of financial conditions for both EM and DM economies. For DM we obtain two factors, one that summarizes sovereign yields (which are mostly related to monetary policy) and the other related to credit, equity and volatility conditions. We find that the financial conditions that matter most for growth in EM are mainly related to this second factor, which tracks DM equity, credit and volatility conditions and has remained well behaved (see chart), reflecting better global growth and higher commodities prices. 

Commodities – Higher copper prices, lower agricultural prices

The Itaú Commodity Index (ICI) has increased by 1.4% since late September, boosted by its energy subcomponent. Metal and agricultural prices remained broadly stable in the period.

Higher copper and nickel prices forecasts. Copper and nickel prices rose by 5.9% and 11.2%, respectively, in October. This rally is explained by the promising in demand growth due to electric vehicles. However, this movement was offset by a 6.0% drop in iron ore prices.  For copper prices, we raised our yearend forecast to USD 6500/mt (USD 5900/mt, previously) and to USD 11,000/ton (USD 10,200/ton, previously) for nickel prices .  We maintain our yearend forecast for iron ore at USD 60/mt. Nonetheless, we still forecast a 3.1% decline in the ICI Metals as the Chinese economy continues to decelerate in 4Q17.

Fine-tuning our Brent and WTI yearend forecasts. Oil prices continued to rally in October, boosted by geopolitical risks. We still estimate that the WTI range of $45-50/bbl can stabilize the US rig count and helps to balance the market in 2018. Due to the recent recovery in oil prices, we slightly rose our yearend WTI price forecasts to USD 50/barrel (from USD 47/bbl) and our yearend Brent forecast to USD 53/bbl (from USD 49/bbl). For 2018, we maintain our forecasts at USD 45/bbl for WTI and at USD 47/bbl for Brent.

Agricultural prices remained broadly stable in October, as the drops in corn (-2.7%) and in wheat (-6.6%) prices were offset by increases in other agricultural commodities. We therefore slightly lowered our price forecasts for corn (to USD 3.6/bushel from USD 3.85/bushel) and wheat (to USD 4.4/bushel from USD 4.6/bushel), incorporating the recent decreases. We also adjusted our yearend forecast coffee (to USD1.23/lb from USD 1.35/lb) prices.

We expect the ICI to drop 5.3% from its current level by year-end, due to lower metal and energy prices.


 


LatAm
Easing cycles closer to an end

• With higher U.S. treasury yields, most LatAm currencies weakened in October. The Mexican peso underperformed, reflecting noise over presidential elections next year and NAFTA renegotiations, while rising copper prices supported the Chilean peso and the Peruvian sol.  

• Activity in the region is gradually recovering, but mixed inflation pictures are leading to diverging monetary policy responses. In October, two central banks surprised expectations: in Colombia, the policy rate fell by 25 bps following a downside surprise in inflation, and in Argentina there was a 150-bp hike in response to inflation stickiness. Still, we note that even in countries that are reducing interest rates, easing cycles are coming closer to an end.  

Higher U.S. treasury yields pressured LatAm currencies in October. The Mexican peso was the underperformer due to both domestic and external factors. On the domestic front, the decision of former first lady Margarita Zavala to leave PAN and run in the next presidential elections as an independent benefits the anti-establishment Andrés Manuel Lopez-Obrador (AMLO) candidate, as there is no run-off in Mexico’s electoral system. In addition, the renegotiation of NAFTA is becoming noisier as parties fail to reach consensus. We note that the Mexican peso’s fundamentals seem stronger now than last year, when the currency sold off: the carry is much higher after the central bank implemented an aggressive tightening cycle; the current and fiscal account deficits narrowed substantially; and a USD 20 billion FX swap facility is in place. In spite of rising oil prices, the Colombian peso also depreciated significantly, as higher interest rates abroad meet a more expansionary monetary policy at home and a wide current account deficit. Meanwhile, the Chilean peso and the Peruvian sol outperformed, both recording a modest appreciation against the dollar and supported by rising copper prices. With the strong performance of Argentina’s ruling coalition in the mid-term elections and the resulting upgrade by the rating agency S&P, the sovereign 5-year CDS narrowed by 42 bps in October. Furthermore, the central bank surprisingly tightened monetary policy further. Still, the Argentine peso depreciated in nominal terms, likely staying flat in real terms, highlighting that the wide current account deficit is constraining real exchange-rate gains. Our forecasts for the Fed fund rates are consistent with a further widening of U.S. treasury yields, so in most countries we cover some additional depreciation is likely. 

Activity in the region is gradually recovering. Argentina is the country exhibiting higher year-over-year growth rates, which we read as a combination of greater confidence, higher real wage growth (from negative levels in 2016) and a rebound of public sector capital expenditures. We now expect higher growth in Argentina: the diminished likelihood of policy disruption over the next years, as indicated by the results of mid-term elections, will likely help to boost confidence and investment further. In Brazil, although we forecast only a modest quarter-over-quarter expansion in 3Q17, the breakdown of the data will likely confirm a recovery in private consumption and investment. Non-natural resource sectors in Peru, which are more linked to cyclical conditions than the commodity sectors, are also gaining momentum, helped by rising terms of trade, fiscal stimulus and the resumption of infrastructure projects previously paralyzed by corruption investigations. Chile’s economic expansion is largely due to a strong recovery in mining output (partly a payback from a strike in the sector earlier in the year and partly due to higher copper prices), but excluding mining there is gradual improvement too. On the other hand, Mexico’s economy weakened in 3Q17 due to the earthquakes that hit the country in September. Beyond transitory factors, we expect that the solid momentum of U.S. industry will offset the negative impact of uncertainties over protectionism in the U.S. and over the domestic political scenario, sustaining growth at around the 2% potential.      

Mixed inflation pictures in the region are leading to diverging monetary policy responses. But central banks are signaling there is not much room for further cuts. In Brazil, annual inflation still runs below the lower bound of the target. However, with a narrower output gap next year and less support from exchange rate and food prices, the central bank forecasts inflation close to the 4.5% target in 2018 (using market consensus on interest rates), signaling that the easing cycle could be close to an end. In Peru, the central bank tweaked the language in the press statement announcing the latest policy decision, suggesting a “softer easing bias,” consistent with our expectation of one additional 25-bp rate cut before the cycle ends. In Colombia, economic growth is still a concern for policy makers and, with the downward September inflation surprise, the central bank enjoyed the opportunity to resume the easing cycle a few months before expected. However, in the press statement the Colombian central bank mentioned the external scenario (likely U.S. monetary policy) as a restriction for counter-cyclical policy. In Chile, the central bank seems unwilling to deliver further stimulus, considering the already low level of policy rate and the economic recovery. Nevertheless, it adopted an easing bias, given the persistently low inflation. On the other hand, Argentina’s central bank surprisingly increased its reference rate by 150 bps as a response to inflation stickiness. In fact, with expected strong growth and without much room for further real exchange-rate gains (given the fast deterioration of external accounts), disinflation in Argentina will remain challenging, so new policy rate increases are not off the table. Finally, in Mexico uncertainty over NAFTA, presidential elections and the Fed stand in the way of rate cuts, and two board members (out of five) do not rule out further rate increases.

 

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



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