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Global Recovery Poses Risks to Emerging Economies

January 17, 2014

The U.S. economy is surprising in the upside and the outlook in China also seems better in 2014.

Global Economy
Better Growth and Still Accommodative Monetary Policies (at Least for Now)
The U.S. economy is surprising in the upside and the outlook in China also seems better in 2014. For now we see this as mostly benign as monetary policy remains accommodative in the advanced economies. But this could change, in particular, if growth surprises more to the upside.

Global Growth Does Not Improve Domestic Outlook
Better global growth limits the downside risks to economic growth. Given the uncertainties in the global and domestic scenarios, we expect a weaker currency now.  

A Far-Reaching Energy Reform
Mexico’s government approved a far-reaching energy reform in December. With the reform, foreign capital flows and growth will likely increase, but not in the short term.

Investment-Led Slowdown
Chile’s economy will likely continue to grow below potential this year and next. Inflation will not be as low as before, but it will be comfortable enough to allow for additional rate cuts.

Signs of Recovery
The economy picked up in 4Q13, and the prospects for the economy this year have improved because of a better global outlook. Humala´s popularity fell further in December.

A Temporary Rebound
GDP grew at a solid pace during 3Q13. Growth, however, was heavily influenced by volatile construction activity, so we expect a reversal in 4Q13. We expect a policy rate cut of 25 bps in 1Q14.

Time to Act
The government lost popularity following a series of strikes, looting, blackouts and an erratic economic policy. Given the absence of significant tightening in the monetary policy, the downward trend of international reserves will likely persist.

Less Pronounced Decline This Year
We raised our price forecasts for non-precious metals in 2014 but we still expect a drop in prices. In energy we see a looser balance in the short term and renewed risks from Iraq. Few changes in fundamentals for agricultural commodities.

Global Recovery Poses Risks to Emerging Economies

The outlook for global growth keeps improving. We revised upward our GDP estimates for the U.S. and China in 2014. This scenario is benign, but not without risks. If better growth in the U.S. is not accompanied by productivity gains, the Fed could increase interest rates earlier than expected, affecting global liquidity and capital flows.

Stronger global activity favors emerging markets, particularly the exporters of manufactured goods. But if financial conditions in the U.S. tighten more quickly than anticipated, the negative effect of lower liquidity could precede the benefits of faster economic growth, especially for fragile economies, which would require weaker exchange rates and tougher monetary and fiscal policies.

The specific fundamentals of each country gain relevance in this context. In Latin America, nations which have inflation under control – Mexico, Chile, Peru and Colombia – are finding room to expand monetary policy in response to the recent economic slowdown. We expect a rebound next year. In Mexico in particular, a far-reaching energy reform improves the outlook for foreign investment in coming years.

In Brazil, in contrast, inflationary pressures arising from a still-tight labor market and a weaker currency demand a tighter monetary policy. Fiscal policy remains expansionary. Taking into account global and domestic uncertainties, we revised our year-end exchange-rate forecast to 2.55 reais per U.S. dollar in 2014 and 2015.

In Argentina, economic and political tension is becoming more intense. The government lost popularity following a series of strikes, looting, blackouts and an erratic economic policy. It is time to act. In the absence of significant tightening in monetary conditions, reserves will continue to fall, increasing the pressure on the exchange rate.

Global Economy
Better Growth and Still Accommodative Monetary Policies (at Least for Now)

•           The U.S. economy is improving. For now we see this as benign because monetary policy will remain accommodative despite the start of tapering.

•           China is still moderating, but we see a better outlook than before for 2014.

•           This is a benign scenario, but not without risks. If better growth in the U.S. is not accompanied by productivity gains, the Fed could increase interest rates earlier than expected.

•           Better world growth benefits EM economies, especially manufacturing exports like Mexico.

•           But if better global growth results in tightening in global financial conditions, the “pain precedes the gain.” The latter effect would dominate in the short run. In particular, for more fragile economies, that would require more depreciated exchange rates and tighter fiscal and monetary stances to face the global scenario.

The U.S. economy is surprising on the upside. For now we see this as mostly benign. Despite starting to taper its bond-purchasing program, the Fed is far from raising interest rates. As a consequence, we see better growth with still-loose monetary policy.

This is not a scenario without risks. If better growth in the U.S. is not accompanied by productivity gains, unemployment might fall too fast or, even worse, signs of inflation might emerge. Both can force the Fed to raise rates earlier. At the moment, the situation seems under control, but risks of tighter financial conditions could increase during the year.

The outlook in China also seems better in 2014. We still expect a gradual moderation in growth, but less than before, as activity was good in 4Q13, reforms advance and authorities have been signaling a "stable policy." Here there are also risks. Reforms, like financial liberalization, might create a bumpy road with higher and more volatile interest rates. A danger combination in a still leveraged economy.

The scenario of moderate growth in the euro area remains on track. The European Central Bank (ECB) remains on alert though, ready to further stimulate the economy given downside risk to activity and the threats of low inflation.

Japan will see more of the same in 2014. The stimulative policies are working, but there is still work to be done.  We expect the Bank of Japan (BoJ) to continue to ease its monetary stance.

Emerging economies that export to the advanced economies will outperform while those with weak internal fundamentals need to adjust to tighter external financial conditions. While commodity exporters will not be helped by terms of trade gains as we see energy and non-precious metals prices declining in 2014, those with solid domestic fundamentals will continue to encounter a smooth slowdown.

U.S. – better growth and still-accommodative monetary police (at least for now)

The U.S. economy performed significantly better in 2H13. GDP growth was revised up to 4.1% (seasonally adjusted annualized rate - saar) from 3.5% in 3Q13. We estimate it expanded another 3.2% (saar) in 4Q13, about 2 percentage points above our forecast just a month ago. Stronger consumption was the main surprise. But private investment and exports also accelerated, suggesting a broad-based improvement in final private demand. In addition, the U.S. Congress has approved the 2014 Budget Law, reducing the fiscal drag and uncertainties. The non-farm payroll was weak in December, but we believe it was a one-off event in an overall positive trend.

The Federal Reserve successfully started to reduce the asset purchase program without tightening financial conditions. It reduced its purchases by USD 10 billion to USD 75 billion per month. It also signaled similar reductions in the next meetings, as long as the economy continues to perform well. The FOMC qualitatively strengthened its forward guidance, saying that federal funds rate will remain low well past the time that the unemployment rate declines below 6½ percent, especially if projected inflation continues to run below the Committee’s longer-run objective. Initially, the 10-year U.S. Treasury yield increased 20 basis points, to 3.0%, but there was no tightening in overall financial conditions. Short-term interest rates remain well anchored, while house, equity and corporate credit prices are up.

We revised our GDP forecast up to 1.9% (from 1.6%) in 2013 and up to 3.0% (from 2.5%) in 2014, and we expect it to maintain a strong 3.1% pace in 2015. Risks to this growth outlook seem balanced.

This stronger growth scenario brings with it the risk of tighter monetary policy in the U.S. — sooner than expected.

We see an alternative risk scenario in which labor productivity (per hour worked) does not pick up and the unemployment rate could decline too fast. In our baseline scenario, productivity growth moves up to 1.5%, in line with the average seen before the boom brought by information technology in the late 1990s and early 2000s (see graph). In this case, the unemployment rate would reach 6.0% in mid-2015, a couple of quarters ahead of the latest FOMC summary of economic projections, but still too far way to create worries of an early increase in interest rates now. However, labor productivity expansion was well below the 1.5% average in the past three years (see graph). If we assume it moves up to 1.0% instead of 1.5%, the unemployment rate could hit 6.0% already by the end of 2014. We note that these computations already assume some stabilization in the labor force participation rate, which has been in a downward trend. Overall, we believe the U.S. Fed would not overreact to a faster decline in the unemployment rate. But the fall would still likely lead to an increase in interest rates in U.S. markets.

If rapidly falling unemployment creates tightening expectations, signs of an upturn in inflation would amplify them significantly. Currently, we believe inflation will converge slowly towards the FOMC’s target of 2%. Despite being in a downward trend, unemployment currently provide no sign that labor market is tight. Moreover wage prices are highly inertial in a low inflation country like the U.S. We think this dynamic could continue even with a steeper decline in the unemployment rate. Still, any signs of rising inflation would increase the upside potential for inflation.  If this risk materializes, the U.S. monetary policy will be well behind the curve, surprising the market, since the Fed might need to increase interest rates already in 2014 and early 2015. This is a tail-risk scenario that could generate turbulence.

China – Still moderating but with a better outlook for 2014

Activity slowed down in December, but it still maintained a good pace in 4Q13. Indeed the NBS manufacturing Purchasing Managers Index (PMI) declined to 51.0 December from 51.4 in November, but the indicator averaged 51.3 in 4Q13, compared with 50.8 in 3Q13. All in all, we believe GDP was up 7.7% yoy in 4Q13, marginally below the 7.8% in the 3Q13.

Although we still see some gradual moderation ahead, the outlook for 2014 has improved.  The economic reforms proposed in the Third Plenum are advancing swiftly so far.  While some initiatives may cause short-term pain and risks, the overall effect on growth should be positive. Importantly, policymakers are signaling that they intend to maintain stable policies, suggesting they might be comfortable with a small slowdown, but will act promptly if they see risks of a more pronounced decline in growth.

Nonetheless, risks of a stronger slowdown are still present. In particular, the move towards financial liberalization is resulting in higher and more volatile interest rates. This raises concern over the stability of some of the firms in the Chinese financial system and has led to moments of stress in interbank markets. So far, the People’s Bank of China has been able to intervene and calm the situation. And we expect it will continue to do so. However, China remains a leveraged economy with high debts in local governments and in the private sector. This is a dangerous background to promote financial liberalization.

We kept our 2013 GDP growth forecast at 7.7% and revised it up to 7.5% from 7.3% in 2014. We expect this gradual moderation to continue in 2015, when we expect GDP growth at 7.3%.

Europe – Gradual recovery is on track, but low inflation will persist

The modest recovery in the euro area remains on track. The manufacturing PMI continues to increase and ended 2013 at 52.7, the highest level since mid-2011. Overall the pace of activity remains modest though, and downside risk remains as several countries in the region are just leaving their prolonged recession.

We maintain our GDP forecasts at -0.4% and 0.9% in 2013 and 2014, respectively. We see growth picking up to 1.3% in 2015.

Inflation will remain low though, with risk slightly tilted to the downside. Consumer price inflation was still fairly low at 0.8% yoy in December. We expect inflation to remain below 1% in the next few months before gradually increasing. Risks seem to tilting to the downside, though. The pace of recovery is not enough to rapidly close the output gap.  And the deleveraging in the periphery has pushed inflation to very low levels. This necessary adjustment – where prices in the periphery increase less than in the core to reverse the opposite movement that occurred prior to the crisis (see graph) – will continue to put downward pressure on the inflation rate in the euro area as a whole.

Given this scenario, we believe that the ECB will maintain its accommodative stance and remain ready to act. The central bank has been highlighting that it is ready to act if the medium-term inflation outlook deteriorates or if it sees unwarranted increases in money market rates.  In our baseline scenario, the ECB will stay on hold, but the risk of a new rate cut in 2Q14 is high if by then there is no sign that inflation will move above 1%.

Japan – More of the same

The stimulative policies to end years of deflation are working, but there is still more to be done.  Inflation reached 1.6% yoy in November, with measures of core inflation above 1% for the month (see graph). The aggressive quantitative and qualitative easing promoted by the BoJ is working. We expect the central bank to continue with its easy policy this year. We also believe that the BoJ will very likely need to announce additional policies to compensate for the negative impact of the higher consumption tax in 2014.

Activity should pick up in 1Q14, ahead of to the increase in the consumption tax (from 5% to 8%) scheduled for April 2014. Retail Sales already show signs of faster growth and expanded a strong 1.9% mom/sa in November, after contracting 0.9% in October. We expect the trend to continue in December and 1Q14.

We maintain our GDP forecasts at 1.8% and 1.5% for 2013 and 2014, respectively. For 2015, we expect 1.1%.

Emerging Markets – Manufacturing exporters will outperform; fundamentals differentiate commodity exporters

Better world growth benefits EM economies, especially countries with significant exports to the advanced world, for example, Mexico, South Korea and Poland. Indeed, we see growth improving in these countries. And in the past twelve months, when most emerging market currencies depreciated with the tapering prospect in the U.S., these remained broadly stable (see table).

Higher global growth led us to increase our year-end forecasts for some commodity prices, but we still see energy and non-precious metal prices declining in 2014 compared with 2013. So terms of trade gains will not help commodity exporters.  

In addition, the tightening in global financial conditions that comes with better growth is important for EM economies, especially  for a group of fragile emerging economies that need to finance a significant current account deficit (see table) in a less liquid world.

In general, these fragile economies need better fiscal accounts, more depreciated exchange rates and higher interest rates. Part of the currency and interest rate adjustment has already occurred in the past twelve months (see table), but more will probably be needed. In the case of interest rates, long term rates have increased more than shorter ones (see table). This yield-curve steepening suggests that investors are requiring higher premiums to hold assets in these countries. If financial conditions in the U.S. tighten at a gradual pace, as in our baseline scenario, domestic conditions in the emerging markets will determine the size of the adjustment ahead. If, however, the risk of a faster increase in interest rates in the U.S. materializes, these economies will face tougher financial conditions.

Within LatAm, Mexico – a manufacturing exporter with close trade ties with the U.S. – benefits the most from higher U.S. growth.

But domestic fundamentals also matter. Although Chile, Colombia and Peru are commodity exporters, they are experiencing a smooth slowdown. Those three countries took advantage of the strong capital-flow years to significantly increase their investment ratios. In addition, their previous moderate use of fiscal and monetary policies means that currently their policymakers have room to stimulate the economy. In Chile and Peru, the central banks are loosening monetary policy, and in Colombia the central bank is maintaining the policy rate at an expansionary level. Meanwhile, in Brazil high inflation and a weaker currency have forced the central bank to tighten monetary policy, even in a low-growth environment.

Commodities – Less pronounced decline this year

The Itaú Commodity Index (ICI) fell 2.3% since the end of November. All three sub-indexes declined during the month, with mixed performances within which sub-index. Idiosyncratic factors explained the performance of each commodity.

Looking ahead, we are revising upward our forecasts for the ICI metals sub-index on a better global growth outlook. Nevertheless, we still forecast falling prices for metals and energy-related commodities throughout 2014.

Despite the 3.9% drop in our agricultural price index since late November, agricultural commodities had a mixed performance. Soybean, wheat and sugar prices fell, while corn, cotton and coffer rose over this period. The price changes are consistent with the adjustments to supply and demand for each commodity, except sugar and coffee. The USDA’s January report, unlike previous years, failed to reveal significant changes to the supply-and-demand estimates. As a consequence, we are maintaining our year-end 2014 price forecasts for agricultural commodities.

We are revising upward our forecasts for non-precious metals for the end of 2014, but we still see a decline during the year. The ICI metals sub-index fell 1.6% since late November, driven by lower iron ore prices (despite weather-related delays in shipments from Brazil and Australia). Meanwhile, copper, zinc and lead prices rose on a lower supply outlook (for example, the approaching Indonesian ore export ban).  Despite this recent weak performance, we revised the ICI metals sub-index upward, to a level 2.4% higher than our previous estimate for YE14. In particular, we now forecast YE14 iron ore prices at USD 107/ton (previously 105) and copper prices at USD 6,940/ton, based on a better global growth outlook and lower production throughout the year. Regardless of the upward revision, we still expect prices to fall during 2014.

In energy, we see a looser balance in the short term and renewed risks from Iraq. The ICI energy index fell 1.7% since late November, driven by lower Brent crude prices following the resumption of oil production in Libya. Looking ahead, we are maintaining our price forecasts for year-end 2014 (Brent prices at USD 105/bbl), still expecting the supply growth to mitigate the impact of stronger global growth. Finally, the conflict in Iraq has not affected oil infrastructure, but it does generate some upside potential for prices in the short term.

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

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