Itaú BBA - Falling inflation allows for lower inflation target and interest rates in Brazil

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Falling inflation allows for lower inflation target and interest rates in Brazil

July 3, 2017

A lower inflation target for 2019 and 2020 reinforces the outlook for lower inflation results and anchored expectations.

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

Global Economy
Inflation Pessimism
Lower oil prices have intensified inflation pessimism in developed markets. Lower inflation likely reflects a positive supply shock and, thus, should be transitory and net positive for DM countries.

LatAm
A more supportive monetary policy stance
While inflation outlook is challenging in some countries, monetary policy is turning more accommodative, amid weak growth.

Brazil
Falling inflation paves the way for lower interest rates and a lower inflation target
Political uncertainty remains high, postponing the reform process. Despite this, the inflation decline allowed the authorities to set the 2019 and 2020 targets at 4.25% and 4%, respectively, compared with 4.5% currently, and leaves room for additional interest rate cuts. We left our Selic rate projection at 8.0% in 2017, but reduced that for 2018 to 7.5%.

Argentina
Electoral season begins
Former president Cristina Kirchner will run for senator in the Province of Buenos Aires. GDP growth in 1Q17 was stronger and broader-based than expected. We expect the central bank to resume gradual cuts in the reference rate as the disinflation process consolidates.

Mexico
Monetary tightening ends, but easing is distant
The central bank has indicated that the tightening cycle is likely over, even if the Fed continues hiking rates. Therefore, we have revised our monetary policy rate forecasts for 2017 and 2018 to 7% (from 7.25%) and 6.50% (from 6.75%), respectively

Chile
Waiting for a glimmer of hope
Activity is weak but will likely show some improvement through the remainder of the year as the mining drag subsides. More clarity on the reform agenda after the presidential elections is key for a meaningful rebound of confidence and investment.

Peru
Waiting for macro policies to help
Temporary shocks have weakened Peru’s growth prospects for 2017. However, we expect GDP growth to pick up gradually on the back of higher terms of trade, expansionary macroeconomic policies and the positive effects of market-friendly reforms.

Colombia
Fundamentals worsening
The government has raised its fiscal deficit targets not only for this year but also for 2018. Meanwhile, the current account deficit is still high, underlying inflation measures remain sticky, and economic growth is deteriorating. In this context, the risk of a ratings downgrade has increased.

Commodities
Oil: How low can it go?
Commodity prices continued to decline in June, led by energy and agricultural prices. We have reduced our year-end WTI price forecasts to USD 45/barrel (from USD 52.5/barrel), and our year-end Brent price forecasts to USD 47/barrel (from USD 54/barrel).


 


Falling inflation allows for lower inflation target and interest rates in Brazil

Lower oil prices have intensified inflation pessimism in developed markets. But this probably reflects a positive supply shock and, thus, should be transitory and a net positive for EM economies. Importantly, economic growth has remained stable and confidence high, meaning financial conditions are still well behaved, though U.S. data have been on the soft side.

In LatAm, the recent drop in commodity prices (oil and iron ore) together with idiosyncratic factors are leading to a mixed performance for currencies. While the inflation outlook is challenging in some LatAm countries, monetary policy is turning more accommodative, as the central banks of Brazil, Colombia and Peru will likely continue to cut interest rates while the central banks of Argentina and Mexico hint that additional interest rate hikes are unlikely. In Chile, the central bank is communicating a neutral bias for its next decisions, with a meaningful monetary stimulus already in place.

In Brazil, political uncertainty remains high, which will likely delay the passage of Social Security reform in the Lower House. We expect 0.3% GDP growth for 2017 and 2.7% for 2018, which is consistent with a gradual recovery and the slower pace of reforms. We have maintained our exchange rate forecast for year-end 2017 at 3.25 BRL/USD and at 3.60 BRL/USD for 2018. These are slightly weaker levels than those observed today, due to the expectation that the gradual tightening of global financial conditions will moderately pressurize emerging currencies. In light of recent favorable releases, as well as adjustments in the scenario for some agricultural prices and oil, we have trimmed our forecast for the IPCA consumer price index in 2017 to 3.3% (from 3.7%). For 2018, we have slightly reduced our inflation forecast, to 4.0% from 4.1%, given a small adjustment in the regulated prices estimate. In our view, falling inflation opens the door for further interest rate cuts. The Selic rate is expected to reach 8.0% by the end of this year and 7.50% by the end of 2018.


 


Global Economy

Inflation pessimism

• Lower oil prices have intensified inflation pessimism in developed markets. The decline likely reflects a positive supply shock and, thus, should be transitory and net positive for DM markets.

• Core inflation has been soft in the DM, but activity is healthy, the Phillips Curve is not dead and should eventually determine wage and price dynamics.

• Importantly, economic growth has remained stable and confidence high, meaning financial conditions have been well behaved, though U.S. data has been on the soft side.

• DM low inflation and stable growth still favor EM assets, with oil and geopolitics as the main short-term risks.

• As the global outlook improves, DM central banks do not share investors inflation pessimism and are adjusting their message in the direction of less monetary accommodation.

Oil prices to stabilize and Phillips Curve pull core inflation up

WTI prices recently approached USD 40/barrel, triggering a rise in corporate bond spreads in the high yield U.S. Energy sector. This is likely to bring discipline to oil supply, reducing oil production and investment in new oil fields.

The risk is that prices may need to dip below USD 40 in the short term to force a faster adjustment in supply and inventories.

In the U.S., the average hourly earnings have declined to 2.5% YoY in May from 2.8% in February. In addition, the core PCE deflator has declined to 1.4% YoY (from 1.8%) in the same period. Softer inflation at this point of the cycle has led to a debate about a breakdown in the relation between the unemployment rate and wages and prices. Some argue that advances in technology and globalization may be depressing profit margins.

Our Phillips Curve estimate (see chart) indicates that the correlation between wages and unemployment has been broadly consistent over the last 10 years. The current average hourly earnings at 2.5% YoY reflects labor market slack (i.e., the unemployment rate) over the last 12 months.

The Phillips Curve indicates that U.S. wage inflation should rise to 3.25% in 4Q18. In our calculations, this cost-push inflation is consistent with a rise in the core PCE deflator to 2.0% (from 1.5%).

In Europe, the Compensation per Employee is growing at 1.2% YoY in 1Q17, but as the unemployment rates keeps falling, it should eventually pull up wages and drive core inflation.

Further declines in the unemployment and higher wage inflation are likely prompt DM Central Banks to keep adjusting their message and gradually remove the excessive monetary accommodation.

U.S. – The Fed keeps to a gradual pace of tightening even amid soft inflation

GDP is on track to firm up to 2.6% qoq/saar in 2Q17, up from 1.2% in 1Q17, but it is a bit softer than last month (3%). Consumption still likely to grow a healthy +3% in 2Q17, but private investment has been less robust than previously anticipated. Importantly, confidence remains high and financial conditions loose, so the economic outlook remains broadly unchanged.

In conjunction, we reduced our assumption for President Trump’s fiscal stimulus to 0.5% of GDP (from 1%) to be enacted later this year (or early next year). Hence, we reduced our U.S. GDP growth forecast to 2.2% (from 2.3%) in 2017, and to 2.2% (from 2.4%) in 2018.

Such economic growth is enough to keep payroll growth at 150-175k per month and reduce the unemployment rate to 4.0% by 4Q18 (from 4.3% in May). And the tighter labor market should put upward pressure on wages and inflation (discussion above).

The drop in oil prices and lower core inflation should be transitory, but they could have an effect on short-term inflation dynamics by keeping long-term inflation expectations lower than the historical average. Hence, we reduced our core PCE inflation forecast to 2.0% (from 2.1%) by 4Q18.

Given that the U.S. is at full employment and the outlook seems balanced, the Fed has less incentive to postpone tightening than it did a year ago. Hence, we continue to expect the FOMC to tighten twice more in 2017. We now foresee only three rate hikes in 2018 (instead of four) due to lower fiscal stimulus.

Softer inflation is still likely to lead to a more cautious near-term stance by the Fed, which is scheduled to announce the start of balance-sheet normalization in September, and to delay the next rate hike until December. The announcement of a passive balance sheet adjustment is estimated to be equivalent to half of one rate hike, even if its effects are less certain than those of a  rate hike.

Europe – Fewer political risks, more growth and a gradual removal of ECB stimulus

Emmanuel Macron has won an absolute majority (350 of 577 seats) in the National Assembly, which allows him to advance his labor market reform through the summer, spurring pro-European political forces all around the Eurozone. In fact, Germany’s Angela Merkel has already shown more willingness to accept more fiscal integration in the EZ.

Political risks persist in Italy, given high unemployment and low growth, but they should remain contained until the Parliamentary Elections in early 2018. The weak performance of the Five Star Movement in the latest municipal elections suggests support for Europopulism may have peaked.

Diminished political risk has led us to raise our 2017 GDP growth forecasts for the Eurozone to 2.0% from 1.8% and our 2018 forecast to 1.7% from 1.5%.

Better progress in the economy makes an ECB gradual removal of extraordinary accommodation more likely later this year. President Draghi continues to stress the need to persist with a prudently loose stance, but if the economy keeps making progress and global risks stay contained, the ECB will need to adjust its policy “parameters” to maintain its stance broadly unchanged.

In our view, the ECB’s first step is to reduce its monthly asset purchases to EUR 40 billion (from EUR 60 billion) in September. In addition, we expect the ECB to raise the deposit rate to 0.0% (from -0.4%) during 2018 (see our Macro Vision report, “ECB: The tricky road to monetary policy normalization”).

The improving economic outlook in Europe relative to the US led us to raise our USD/EUR to 1.15 from 1.10 by end-2017.

Japan – Economy underperforms in 1Q17

Japan’s economic growth disappointed (1.0% saar) in 1Q17, but the trend remains healthy. Gradually improving soft data, strong industrial production and exports support our view that the Japanese economy is set to grow faster than its originally projected rate this year. A tightening labor market – unemployment stayed at 2.8% in April – should boost consumption ahead.

Our Japan GDP growth forecasts remain unchanged, at 1.4% in 2017 and 1.0% in 2018.

China – Gradual slowdown

A slowdown in certain areas of investment, housing and credit is still consistent with firm growth. Economic growth was broadly stable in May, with industrial production rising 6.5% (the same  pace as in April), fixed investment at 8.6% yoy so far this year, and retail sales growth steady at 10.7% yoy. Property data was mixed, with an acceleration in sales but with the beginning of a slowdown in floor space. Alternative credit products continued to decelerate, while new loans to households and corporations continued to increase.

A policy induced modest slowdown in 2H17 will not likely spill over to the global markets as it did in 2013 to 2016. Chinese and many EM economies are in better economic positions. Tighter policy in China can be fine-tuned, if necessary. Therefore, there is less risk of capital outflows.

We maintain our forecast of 6.5% GDP growth for 2017 and 5.8% growth for 2018.

Commodities – Oil: how low can it go?

The Itaú Commodities Index (ICI) has retreated 2.5% since end of May, dragged down mainly by oil prices. In this period, energy ICI has dropped 6.9%, the agricultural ICI fell by 2.2% and the metals ICI has risen by 3.7%.

We reduced our forecast for WTI to USD 45/barrel (from USD 52.5/barrel) for year-end 2017 and 2018 (from USD 50/barrel), and the Brent to USD 47/barrel (from USD 54/barrel in 2017 and from USD 51/barrel in 2018). Despite the Opec production freeze, oil inventories have failed to adjust as fast as anticipated. This oil oversupply appears to stem from better productivity by U.S. shale-oil producers. However, as WTI is approaching USD 40/barrel, it has started to hurt U.S. high yield energy credit spreads, which in turn is expected to bring discipline to oil supply. Still, in the short term, there is a risk that prices may need to dip below USD 40 to force a faster adjustment.

Firmer global manufacturing demand limits a downward adjustment in metal prices. The main risk is that lower oil prices in the short term may reduce metal production and distribution costs. Iron ore prices may be already close to their target (USD 55/metric ton), but we still see a 7.0% decline in the broader ICI Metals index by year-end.

Our broad agricultural price index declined by 2.2% last month, led by sharp declines in sugar and coffee prices. The drop in sugar prices has been caused by strong supply coupled with lower ethanol demand as gasoline prices decline. International food commodities had more mixed price performance in June. Soybean prices fell by 0.5%, while wheat prices rose by 5.6%.

We expect the ICI to remain broadly stable from its current level by year-end.


 


LatAm

A more supportive monetary policy stance

• Prices for key commodities recently fell (like oil and iron ore), which together with idiosyncratic factors are leading to a mixed performance of LatAm currencies.

• While inflation outlook is challenging in some countries, monetary policy is turning more accommodative, as the central banks of Brazil, Colombia and Peru will likely continue to cut interest rates, while the central banks of Argentina and Mexico hint that additional interest rate hikes are unlikely. In Chile, the central bank is communicating a neutral bias for the next decisions, with a meaningful monetary stimulus already in place.

Prices for key commodities recently fell (like oil and iron ore), which together with idiosyncratic factors are leading to a mixed performance of LatAm currencies. In this environment the MXN continues to outperform. Besides the perception of lower protectionism risk in the U.S. and the pro-establishment results of the local elections held in early June, the on-going correction of the twin deficits and the high carry benefits the currency. Furthermore, the indication of the Mexican monetary policy committee that the tightening cycle is over could be contributing to attract inflows to the domestic bond market. The Colombian peso has weakened as oil prices fell. As we highlight in our piece on Colombia this month, macro fundamentals of Colombia are deteriorating and a sovereign downgrade is becoming more likely, which could put further pressure on the currency. The Brazilian real has also depreciated in June, but has been surprisingly resilient to the most recent political crisis. Finally, the Argentine peso has been the main underperformer, partly a spill-over from the BRL weakening. But in our view many other factors are playing against the currency: the decision of MSCI to leave the Argentine equity market´s “frontier” status unchanged, uncertainties related to the mid-term elections (especially now that Cristina Kirchner confirmed her candidacy) and the deterioration of external accounts.

Activity is weak almost everywhere. In a recent macro vision report  we explored to what extent external factors are responsible for the poor activity readings in Latin America. Although hard data in Brazil suggests a more broad-based recovery in the beginning of 2Q17, confidence indicators have retreated recently as uncertainty over the fate of the much-needed reforms increased. In Mexico, where the economy was posting solid growth, the monthly GDP proxy points to a slowdown, as internal demand weakens. In Chile, Colombia and Peru activity remains disappointing. On the positive side, Argentina’s GDP growth was stronger than indicated by the monthly GDP data and shows a broad-based recovery. Also, the available indicators for 2Q17 in Argentina show activity continues expanding.

Inflation outlook remains challenging in some countries. In Brazil, the sizable output gap and lower commodity prices led us to reduce our inflation forecast for this year (to a level slightly above the lower bound of the range around the 4.5% target). In Chile, inflation continues to edge lower and keeps running below the 3% target. In Peru, we are seeing some relief in inflationary pressures, with the end of El Niño bringing food prices down. In Colombia, annual inflation is falling too, but underlying inflation measures are more concerning. Inflation dynamics in Argentina remain inconsistent with reaching the target set for this year, although there was an improvement in month-over-month inflation in May and (likely) in June. Finally, in Mexico inflation hasn’t stabilized yet, but we expect that the strengthening of the currency will favor a disinflation process soon, with annual inflation declining sharply early in 2018 (also helped by base effects).

Monetary policy is turning more accommodative, as the central banks of Brazil, Colombia and Peru will likely continue to cut interest rates, while the central banks of Argentina and Mexico hint that additional interest rate hikes are unlikely. In Chile, the central bank is communicating a neutral bias for the next decisions, but in our view risks are tilted towards further interest rate cuts, given low inflation and weak economic growth. We note that the political crisis in Brazil and the more sticky inflation in Colombia will likely moderate further interest rate cuts in both countries. In Argentina, interest rate cuts will likely come soon, as more evidence of disinflation emerge, but easing will likely be gradual. In contrast, we do not see rate cuts in Mexico before the beginning of the 2H18, even though we expect inflation to fall meaningfully early next year.


 

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



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