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Emerging markets show resilience amid a bumpier external environment

March 9, 2018

Emerging market assets have performed well during the recent turbulence.

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

Global Economy
USD rebound should be temporary
The USD appreciation against most DM and EM currencies last month seems to be mostly driven by temporary factors. As the global economy continues to recover, we see a weaker USD ahead.

LatAm
A bumpier but still-benign external environment
Volatility in external markets increased recently, but LatAm asset prices have remained broadly resilient.

Brazil
Easing cycle: another cut, followed by a pause
We expect the Copom to cut rates again to 6.5%, due to downward surprises with inflation data. After that, the benchmark rate is set to stay flat for the rest of the year.

Argentina
The drought takes its toll
We revised our 2018 GDP growth forecast to 2.8% from 3.5% due to the severe drought’s impact on agriculture. For 2019, we now forecast 3% expansion (3.2% previously).

Mexico
Setting the stage for a pause
We see the recent communication from the central bank as consistent with our view that a pause in April is likely. On the political front, the tides are moving in favor of the anti-establishment candidate, Andrés Manuel López Obrador (AMLO).

Chile
Gaining momentum
Chile´s economy is rebounding, supported by external and domestic tailwinds. We now expect 3.6% GDP growth this year (against 1.6% in 2017), with risks tilted to the upside.

Peru
Metal prices and macro policy stimulus to the rescue
We maintain our view that the increase in metal prices and macro policy stimulus will offset the uncertainty associated with politics and boost GDP growth to 4% in 2018, from 2.5% in 2017.

Colombia
Uncertain recovery
Soft activity readings at the end of 2017, weak labor market, and political uncertainty ahead of the presidential election suggest that the recovery this year is not exempt from risks. Despite the central bank’s indication of the end of the easing cycle, we expect two further 25-bp rate cuts, to 4.0%, in the coming months.


 


Emerging markets show resilience amid a bumpier external environment

The external environment might have become bumpier, but it still seems to be favorable for EMs.

In February, the USD found some support against most currencies, as rates and equities continued to adjust to normalizing inflation, global economic indicators receded a bit from record highs and the risk of a trade war between the U.S. and important trade partners increased. 

However, these factors seem to be mostly temporary, likely leading the USD to resume its weakening trend in the coming months. While we believe the FOMC does need to adjust financial conditions to limit macro-economic risks, we think the US economy is in late cycle, which does not support the USD. The cyclical recovery in Europe is set to continue despite political risks, and in China a well-managed slowdown remains our baseline scenario. Finally, as of now, the risk of wider trade war still seems limited.

Emerging markets have shown resilience amid the recent volatility, evidence that their economies have less imbalances and that financial conditions remain benign, while global growth continued to support commodity prices. The external environment might have become bumpier, but it still seems, on the whole, to favor EMs.

In Latin America, the recovery has become uneven, despite the stronger, more synchronized growth abroad. Recent growth figures have disappointed in Peru and remained weak in Colombia, but we still believe both countries are set to accelerate this year, in spite of political risks. In Mexico, remaining uncertainties regarding the NAFTA and the course of economic policy after elections are hurting investment, while in Argentina a severe drought takes its toll on agriculture. In Chile, the economy is recovering faster than previously expected and started 2018 on a high note, helped by the positive effects of the political scenario on confidence levels and external tailwinds.

In Brazil, GDP growth was weak in 4Q17, but underlying activity – as indicated by private internal demand – confirms that the recovery is on track. We continue to expect 3.0% growth this year, after advancing 1.0% in 2017. We have also maintained our exchange-rate and inflation forecasts for 2018 and 2019. On the fiscal front, results continue to improve and reinforce our call that, despite the still-unaddressed medium-term challenges, the deficit target for 2018 will be easily met. Finally, the Selic rate is set to stay near its current levels for the rest of the year, with modest increases only in 2019, as the slack in the economy is only gradually reduced.


 


Global Economy
USD rebound should be temporary

• The USD found some support against most DM and EM currencies last month as U.S. rates and equities adjust to normalizing inflation, with global economic indicators coming off record highs and the risk of a trade war increasing.

• We believe the FOMC still needs to adjust financial conditions to better balance macro-economic risks. But we see the economy in a late cycle, which doesn’t support the USD. 

• In Europe, cyclical recovery remains in place despite political risks.

• In China, high-frequency data was distorted by the New Year’s holiday. Policymakers seek stability amid risk reduction, and hence a modest, manageable slowdown remains our baseline

• Risk of global trade war is important but it still seems limited.

• Emerging markets have shown resilience amid the recent volatility, indicating that their economies are better adjusted and global financial conditions remain supportive.

USD recovery likely to be temporary

The USD has recovered a little from the recent low earlier in the year. In February, the dollar gained about 2.5% and 1.3% against a basket of developed and emerging market currencies, respectively.

A few factors have supported the USD recently. First, U.S. rates and equities are adjusting to the risk that strong growth could push the already tight labor market too far, in a moment when inflation is starting to normalize. Accordingly, the FOMC new chairman Jay Powell´s early official statements suggest, in our view, that he will likely increases his “dots” at the March meeting. Second, data in Europe declined a bit from strong levels, and China’s Purchasing Managers Index (PMI) plummeted in February. Finally, U.S. tariffs on steel and aluminum increased the risk of trade wars. 

But as we discuss in the sections below, all these factors seem temporary, and hence we expect the USD to depreciate until the end of the year. As the global economy recovers, we see a USD depreciation trend, which gives back part of the large gains the USD seen between 2011 and 2016, when the word economy was very weak. The February rebound in the USD could continue a little longer, but it doesn’t appear to reverse this trend (see chart). 

Fed tightening to better balance the macro risks

Exports and fiscal policy have become tailwinds for the U.S. economy. Financial conditions have eased, despite the gradual Fed tightening since December 2015, and indicate that U.S. GDP growth could exceed 3%, from the 2.2% average since 2010. 

GDP growth at 3% for the next two years would lead to further decline in the unemployment rate and raise the risk of a hard landing. In the 1960s, when the U.S. central bank did not respond properly to extremely low unemployment rates, wages and inflation expectations eventually increased and pushed inflation above the desired levels. If inflation dynamics started to spiral up, the Fed would not make the same mistake again, and we are unlikely to see the return of 1960s or 1970s levels of inflation, but it would be too late fora soft landing.

There are signs of inflation normalization. While core PCE inflation at 1.5% remains below the Fed’s 2% target, it has been rising at a 2.0% annualized pace in the past six months (see chart). Wage inflation is reaching 3% yoy. The Phillips curve seems relatively flat, but the very low unemployment rate is generating higher wage gains. With inflation expectations anchored, the strong labor market will likely pull inflation back to 2%. 

With this economic outlook, we believe the FOMC will increase the fed fund rate in March and raise the median dots to four hikes in 2018 and three hikes in 2019 (from 3+2 in December). This pace of hikes would likely maintain GDP growth above potential growth, but tighten financial conditions to gradually cool-off the economy. We think this is a prudent monetary policy strategy that increases the probability of a soft landing. We see signs that Powell has a similar view, and we think he will steer the FOMC in the direction of “further” gradual hikes.

We raised our 10-year U.S. Treasury target to 3.25% (from 3.0%) for YE18.

We continue to foresee a weaker USD, despite the higher Fed policy rates. The U.S. current account deficit is likely to rise due to fiscal stimulus coupled with higher income payments. And the relative attractiveness of U.S. assets to finance this bigger deficit is deteriorating, given the unsustainable U.S. fiscal stance and better global outlook. 

Europe – Cyclical recovery remains in place despite political risks

Although data indicators moderated in February, growth should remain strong. PMIs and other confidence surveys all decreased from very high levels in January but still point to a strong rate of growth in 1Q18 (see chart). We continue to expect the Eurozone GDP to grow by 2.6% in 2018 and 2.4% in 2019, boosted by an easy monetary policy, more loose fiscal policies in some countries and favorable external demand.

Political risk increased in the region after an outperformance of populists in Italy. The chance of populist parties taking part in the government increased and the process to form a government should be long. The chance a pure populist coalition, with parties from the extreme right and the left joined in an anti-euro rhetoric, is still small. Consequently, Italy’s new government will likely have less commitment to fiscal adjustment and structural reforms, but the risk of “Italy euro exit” remains low. Negotiations should take weeks, and prospects of possible coalitions might emerge by the end of the month.

However, the end of the gridlock in Germany is positive, and it clearly offsets Italy’s negative outcome. SPD members approved the grand coalition by a wide margin, and Merkel will be reelected for another four-year term by mid-March. The new government should be marked by a looser fiscal policy and a more pro-euro stance.

Finally, the strong economic outlook keeps the ECB on track to end its asset purchases in September and raise interest rates in 2019. The central bank will, though, proceed with caution. Communication and forward guidance should be adjusted only gradually, as underlying inflation still rises slowly but is far from 2%.

China – A moderate and manageable slowdown

China’s Manufacturing PMI dropped 1 pt, to 50.3 in February, due to the Chinese New Year distortions.  The fall was exaggerated by production cuts prior to the Chinese New Year. The output component, which is affected by the curbs, plummeted, while unemployment softened but by a much smaller degree (see chart). In addition, the Caixin PMI, which has a higher share of export-oriented companies, increased to 51.6 in February from 51.5 in January.

Looking ahead, we see moderation in growth, to 6.5% this year compared with 6.9% in 2017, as policy has become tighter. Last year, the PBoC has allowed market interest rates to rise (average lending rate increased by about 125 bps, to 4.25%), which is likely to affect the economy this year. In addition, fiscal policy will likely be tighter with the federal government deficit target reduced to 2.6% of GDP in 2018 from 3.0% in 2017. Finally, the National People’s Congress has set this year’s growth target at "around 6.5%," compared to last year’s target of "around 6.5%, and we aim to achieve better results if possible”. The change confirms that the government will tolerate a moderate slowdown in growth.

We believe that this policy is manageable and positive for global stability because it reduces financial risk and produces a more sustainable growth path in China. Indeed, the credit-to-GDP ratio in China remains high but has started to stabilize with more rigid financial regulations on “alternative” credit products. Also, the government is managing a gradual reduction in state-owned enterprise (SOE) debt, which is the main problem. The low level of public debt allows some degree of freedom for the government to manage the SOE debt over time. Private demand has been increasingly driven by consumption, and the outlook for investment has also improved, with housing inventories better balanced and exports turning into a tailwind. And, if needed, the PBoC has flexibility to adjust monetary policy, given that CPI inflation remains at 2%, one percent below its target.

We maintain our growth forecasts at 6.5% for 2018 and at 6.1% for 2019. 

Limited risk of global trade war

We continue to foresee a limited risk of a broad global trade war, despite President Trump’s recent import tariffs hikes (steel, aluminum, washing machines, and solar panels). The U.S. investigations into China’s intellectual property and technology transfer is likely to lead to China FDI restrictions and industry-specific import tariff hikes, while NAFTA renegotiation should settle U.S. commerce relations with Canada and México. 

A global trade war would essentially amount to a negative productivity (or supply) shock, resulting in higher inflation in the short run and lower longer-run growth. It hurts all consumers and benefits a few industrials, and so politicians should be hurt over the medium term, including President Trump. The Federal Reserve should look through an eventual spike in inflation, but can only reduce the number of rate hikes when and if to offset a tightening of financial conditions.

The response from European Union and China to President Trump’s recent import tariff hikes has been carefully targeted, showing their intent to safeguard global trade. In particular, we are encouraged by policymakers in China, who seem to understand clearly that a trade war would be harmful to their economy and rebalancing efforts.

Despite the tough rhetoric and recent measures, President Trump seems to understand that an across-the-board import tariff hike would harm him. Last year, he scrapped the idea of a Border Adjusted Tax, as he received negative feedback from interested parties, and this time should be no different. 

Emerging market resilience 

Emerging market assets have performed well during the recent turbulence. For example, as mentioned above, in February the dollar gained about 2.5% against a basket of developed currencies, but it gained just about half of that (1.3%) against a basket of emerging market currencies.

First, global liquidity remains high, and hence financial conditions remain easy. In fact, the stress in the U.S. equity volatility index (VIX) seems exaggerated, compared with other asset performance (see chart). This indicates that global growth remains on track and financial conditions are easy.  

Second, emerging markets outside China have generally improved their macro positions. Current accounts have adjusted; inflation has declined, allowing interest rates to be lowered; and growth is resuming. All these signs point to a better macro balance. And in several economies the recovery is still in its early stages, and capital flows are just starting to come back. 

Commodities – Global growth continues to sustain commodity prices

The Itaú Commodity Index (ICI) has fallen 0.5% since the end of January. The small move in the aggregate index hides a divergence between its components. Agricultural prices rose 7.1%, driven by weather-related risks. Meanwhile, energy-related prices fell 6.4%, affected by a combination of currencies (stronger dollar), technical factors (the unwinding of long positions held by hedge funds) and fundamentals (signs of stronger crude production in the U.S.). Finally, metal prices sustained earlier gains, helped by the outlook for strong global growth. 

We see global growth as a sustainable driver that could prevent weakness across hard commodities. Hence, we have increased our metal price forecasts on stronger demand, raising our year-end price estimate for copper to USD 6,800/mt (from USD 6,700/mt, extending a previous upward revision), together with additional upward adjustments for other base metals.


 


LatAm

A bumpier but still-benign external environment

• Volatility in external markets increased recently, but LatAm asset prices have remained broadly resilient. 

• Activity recovery in the region is not yet broad-based. We lowered our growth forecasts for Argentina and Mexico, but now see higher growth in Chile.

• Most monetary policy cycles in South America are coming to an end, given the already expansionary monetary policy and recovering activity. In Mexico, we foresee no further interest rate hikes, but uncertainty over the macro outlook (including interest rates) remains high.

Volatility in external markets increased recently, but LatAm asset prices have remained broadly resilient. In fact, at the end of February, most LatAm currencies were showing small year-to-date gains against the USD, while sovereign spreads were stable. One exception is Argentina, where uncertainties over monetary policy and deteriorating external accounts have had a negative impact on the price action. For most of the currencies we cover, we expect some depreciation against the USD as monetary policy normalization in the U.S. continues and commodity prices show some moderation.  

Despite the stronger, more synchronized growth in developed economies, activity recovery in the region is not yet broad-based. In Chile, the economy is recovering faster than we previously expected, helped by the positive effects of the political scenario on confidence levels; we now expect growth of 3.6% this year (from 3.3%). In Brazil, GDP growth was weak in 4Q17, at 0.1% QoQ, but underlying growth (as indicated by internal demand dynamics) suggests that the recovery is on-track (we continue to expect a 3.0% expansion this year). In Peru, growth has disappointed – partly due to the recent political crisis – and market participants are revising their growth forecast for this year down. While we acknowledge that the current political scenario in Peru is shakier, and an impeachment of the President is possible, we maintain our view that the solid increase in metal commodity prices will drive growth to 4.0% in 2018 (from 2.5% in 2017). In Colombia, growth also remains weak, but we believe that will change due to the external scenario as well as the recent decline in inflation (largely reflecting the fading effect of supply-side shocks) and interest rate cuts. However, the political scenario in Colombia is a risk. In Mexico, we revised our growth forecasts for this year down to 1.8% (from 2.1%), given weaker-than-expected investment, reflecting the uncertainties related to NAFTA and the direction of economic policy after the presidential elections. In Argentina, the weakening of the economy in 4Q17 and the drought affecting the key Agriculture sector led to a reduction of our growth forecast for this year to 2.8% (from 3.5% in our previous scenario). 

With the exception of Argentina, inflation is falling in the region – reflecting economic slack and exchange-rate strengthening – and is below the center of the target in Brazil, Chile and Peru. Recent CPI data for Mexico and Colombia has also been more encouraging.

Most monetary policy cycles in the region are coming to an end. Despite the low inflation, recovering activity and an already-expansionary monetary policy suggest that additional rate cuts are unlikely in Peru and Chile; in Brazil, we foresee only one additional 25-bp rate cut. In Colombia, lower-than-expected activity and inflation data, amid a narrower current account deficit (a key vulnerability of the economy), support our view that more rate cuts are likely (we expect two 25-bp rate cuts in the first half of this year). In Argentina, the weaker currency and higher inflation expectations make disinflation even more challenging, leading the central bank to become more conservative, signaling no room for additional cuts in the near future (it remained on hold at both meetings in February). We believe that new rate cuts will follow an eventual resumption of the downtrend in inflation in Argentina, even if the disinflation path is not fast enough to meet the new inflation targets. Finally, Mexico’s central bank is preparing for a pause in the tightening cycle by attributing lower importance to the Fed in its upcoming decision. Although uncertainty over the macro outlook in Mexico is high, our base-case scenario is that the next rate move in Mexico will be a cut, likely in the second half of this year. 


 

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



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