Itaú BBA - Increased volatility puts a (temporary) strain on emerging markets

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Increased volatility puts a (temporary) strain on emerging markets

May 11, 2018

Uncertainties associated with the U.S. late cycle and trade relations with that country brought financial volatility back

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

Global Economy
Late cycle in U.S. and trade war risks increase financial volatility
We see signs that the U.S. is advancing into a late-cycle stage, when the probability of an economic downturn tends to rise, bringing relevant implications for asset prices.

LatAm
When fundamentals matter
Uncertainties regarding the U.S. economy and trade brought financial volatility back, hitting the more-vulnerable emerging markets harder. As we expect external risks to moderate, the weakening trend of LatAm currencies is unlikely to persist.

Brazil
A more complex scenario
We’ve trimmed our GDP growth forecasts to 2.0% in 2018 and 2.8% in 2019 (before, 3.0% and 3.7%), incorporating weaker data in 1Q18 and the limited room for acceleration that comes from uncertainties regarding reforms ahead. We also forecast now a more depreciated exchange rate, incorporating the impact of the interest rate differential, currently at historical lows.

Argentina
The end of gradualism?
The recent deterioration of financial conditions forces a faster tightening of macro policies, which will likely lead to a deceleration of the economy over the next few quarters. We expect the recent measures to ease market concerns, but note that Argentina remains vulnerable, given the wide current account deficit and low international reserves.

Mexico
NAFTA and political risks approaching key dates
Less than two months before elections, anti-establishment candidate AMLO leads by a wide margin, but seems unlikely to form a majority in Congress. Meanwhile, Mexico, U.S. and Canada are aiming to announce a NAFTA framework deal in May.

Chile
Recovery consolidates
The activity recovery advanced in the first quarter of the year, driven by mining as well as an improvement in other sectors and upbeat confidence levels.

Peru
Better political conditions support the growth outlook
Interim President Vizcarra’s government helped ease political uncertainty, improving the prospects for growth and reforms. Activity is picking up, albeit gradually. Below-target inflation leaves room for the central bank to add more stimulus if the expected economic recovery fails to materialize.

Colombia
Headed to the polls
Iván Duque continues to lead the presidential race. His victory would likely be welcomed by markets, but his administration would face challenges including fiscal adjustments and implementation of the peace deal. Activity continues to show mild signs of improvement, while risks stemming from the weak labor market remain.


 


Increased volatility puts a (temporary) strain on emerging markets

The U.S. economy seems to be advancing into a late-cycle stage, with somewhat poorer growth composition. While activity is set to accelerate in 2Q18, we believe this pick-up is largely driven by fiscal stimulus – which temporarily lifts consumption and government spending – and forecast now GDP gains for 2018 and 2019 that are still robust, but softer than previously expected. Above-potential growth is taking unemployment to new lows and bringing gradual pressure on wages and inflation, which should allow the Fed to continue increasing rates. 

This scenario has three implications for asset prices in the U.S. First, yields will keep rising, as the Fed continues to raise rates. Second, equity prices seem to have limited upside, given the headwinds of higher interest rates, late cycle dynamics and geo-political risks. Third, the greenback might have gained some support from higher interest rates, but this tends to be temporary because the growth outlook for the rest of the world still looks good.

In Europe, growth is set to recover after a weak 1Q18, with solid fundamentals for a rebound in the coming quarters – broadly favorable financial conditions, looser fiscal policies and robust external demand. In China, economic activity continues at a good pace. 

At this juncture, US-China trade disputes seem unlikely to see a quick resolution. China has demonstrated it is willing to make concessions, but the current U.S. demands seem implausible. Hence, the US Treasury is likely to move forward with its proposed barriers to China. After the first round of trade and investment restrictions, by end-May or early-June, the US and China may negotiate a more palatable solution for both parties.

Looking at Latin America, the return of external uncertainties brought financial volatility back, hitting hard the more vulnerable countries. As we expect external risks to moderate the weakening trend of LatAm currencies is unlikely to persist. Growth in the region is improving, but remains bumpy. Still, slack persists in many countries and, coupled with past exchange-rate appreciation, is bringing inflation down and/or maintaining it at low levels everywhere but in Argentina. Central banks in Brazil, Chile, Colombia and Peru are keeping an expansionary monetary policy, while additional rate hikes in Mexico are unlikely.  

In Brazil, the scenario is becoming more complex. The BRL lost ground during the last month, in the wake of the global dollar strengthening movement, but also affected by domestic uncertainties and the record-low interest rate differential (the gap between internal/external rates), which favors an increase in the demand for FX hedging instruments. We believe that these factors justify a more depreciated currency than previously expected, so we revised our exchange rate forecast to 3.50 BRL/USD by the end of 2018 and 2019 (versus 3.25 and 3.30, respectively). The environment of uncertainty also seems to be weighting on the economic recovery, by limiting the room for a stronger activity pick-up. Coupled with weaker-than-expected 1Q18 data, this prompted a revision of our GDP growth forecasts, for 2.0% in 2018 and 2.8% for in 2019 (from 3.0% and 3.7%, respectively). This changing landscape brings relevant – but ambiguous – implications for monetary policy. Weaker activity weighs in the direction of a new cut, while the BRL depreciation works in the opposite direction. Given Copom members’ recent communication, we expect the committee to stick to its plan and deliver a final 25-bp cut next week.


 


Global Economy

Late cycle in U.S. and trade war risks increase financial volatility

U.S. GDP will likely accelerate in 2Q18, but we see signs that the economy is advancing into a late-cycle stage, when the probability of an economic downturn tends to rise, which increases asset price volatility. We revised down our GDP growth forecasts to 2.7% from 2.9% in 2018 and to 2.3% from 2.6% in 2019.

In Europe, growth will likely recover after a weak 1Q18. We expect the Eurozone to grow 2.5% in 2018 (initial estimates called for 2.6%). For 2019, we continue to expect 2.4% growth.

In China, growth continues at a good pace.

US-China trade dispute unlikely to see a quick resolution. 

Supply-side risks leading to higher commodity prices.

U.S. late cycle signals

The U.S. GDP will likely accelerate in 2Q18. After expanding 2.3% qoq saar in the 1Q18, we expect GDP to rise 3.2% in 2Q18, as fiscal stimulus lifts consumption and government spending. 

But we see increasing signs that the U.S. economy is advancing into a late-cycle stage, when the likelihood of a downturn tends to increase. 

Above-potential growth has taken the unemployment rate to 3.9%. We expect it will drop further to 3.7% and 3.4% by the end of 2018 and 2019, respectively

As a consequence, wages and inflation will continue to rise gradually. We see the employment cost index, a broad measure of wages, rising to 3.2% by 4Q19 from 2.7% in 1Q18. Meanwhile, the core PCE, the Fed’s preferred inflation measure, already reached 1.9% yoy in March. We forecast it will rise to 2.2% by 4Q19 (see chart).

With low unemployment and inflation broadly at its target, the Fed will continue to lift interest rates. We expect to see 6 additional rate hikes by YE19, while market expectations call for 4. Furthermore, our forecasts expect Fed fund rates to reach 3.25%, a level that will no longer be accommodating.

For asset prices, we see three late-cycle implications.

First, US yields will continue to rise. Both short term rates, as the Fed continues to raise rates, and the 10-year yield, as the curve is already very flat.  

Second, S&P500 upside seems limited. Despite still strong GDP growth and corporate tax cuts, higher interest rates and late cycle risks are important headwinds. For example, inflation risks are likely to increase as the unemployment rate continues to fall. Additionally, geo-political risks, like US-China trade negotiations (see below), are unlikely to fade soon.

Finally, the USD might have gained some support from higher interest rates, but this may be temporary because growth outlook outside the U.S. still looks good. Among developed economies, the Euro depreciated on softer growth and inflation data in the Eurozone in 1Q18, which should revert in 2Q18 (see below). Furthermore, with pressure from financial conditions, U.S. private demand growth will likely decelerate to 2%, while the U.S. current account deficit widens in line with the rising public deficit.

We revised down our GDP growth forecasts to 2.7% from 2.9% in 2018 and to 2.3% from 2.6% in 2019. Higher volatility and less buoyant financial markets should permeate this stage of the cycle and limit the strength of growth ahead.

Europe – growth to recover after a weak first quarter

GDP slowed down in the 1Q18. Unfavorable weather and a soft patch following previously strong numbers pushed GDP growth to 0.4% qoq. 

However, good fundamentals make the case for a GDP rebound to 0.6/0.7% in the coming quarters. Broadly supportive financial conditions, looser fiscal policies in some countries and favorable external demand, which should offset the effects of a higher euro, sustain the case for a rebound.

Business and consumer confidence surveys also began to stabilize in April, a good sign for our expectations of growth recovery in 2Q18. PMIs and other confidence indicators remain high and consistent with strong growth. Consumer confidence indicators maintained their highs (see chart).

Inflation will continue to increase gradually, despite near-term volatility. Core inflation was down to 0.7% yoy in April, mainly due to base effects, but will return to 1.0% and gradually accelerate over the year.

Political risk contained despite proximity of a populist government in Italy. Populist parties seem close to a deal for government formation, which will be negative for fiscal and reforms outlook in the country, but the risk of Euro exit is still low.

Given this outlook, the ECB will keep on track to end its asset purchases this year and raise interest rates in 2019. We still expect a cautious approach that should lead to a small tapering to December and a rate hike by mid-2019. Communication and forward guidance should be adjusted only gradually in upcoming meetings, as underlying inflation will rise slowly but remain well below 2%.

We now expect the Eurozone to grow by 2.5% in 2018 (down from 2.6%) due to a weaker 1Q18. For 2019, we continue to expect 2.4%. 

China – growth continues at a good pace

China’s Manufacturing PMI remained healthy in April. The indicator was almost unchanged from 51.4 last month. After some volatility in 1Q18, the PMI remains within the healthy range seen since early 2017 (see chart).

Policymakers are signaling a more neutral stance, compared to the tightening seen last year. In April, the PBoC lowered the required reserve ratio by 1pp. Meanwhile, the Politburo held a meeting on macro policy. It ended the meeting with a statement indicating that policy should continue to aim “to accelerate structural adjustments,” but also seek to “expand domestic demand.” The mention of demand was the first since 2015, when policy was in an easing mode.

We believe the policy change is preemptive, due to external risks and not a sign of current activity weakness. Indeed, it seems that China is preparing itself to face, if necessary, a long trade war against the U.S. (see discussion below). Hence if the external outlook becomes less favorable, the government will likely support domestic demand to avoid a sharp slowdown.

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

US - China trade dispute unlikely to see a quick resolution

US trade demands to China seem implausible. China has offered to open its economy, raise auto import quotas and liberalize foreign auto investment, to enhance intellectual property rights and allow foreigner’s higher equity stakes in the financial sector. But, US negotiators have asked China for a plan to reduce its bilateral trade deficit by $200bn by 2020 and reduce China’s subsidies to its strategic domestic “Made in 2025” tech plan, both of which are implausible.

Hence, the US Treasury (USTR) is likely to move forward with its proposed trade and investment barriers to China under Section 301. On May 21, the USTR should release the list of Chinese investment restrictions. The deadline for post-hearing comments on the USTR list of $50bn of Chinese imports subject to 25% import tariffs is May 22. China should respond immediately to any such unilateral measure. The USTR may release the list of an additional $100bn in Chinese goods that may be subject to import tariffs.

After this first round of trade and investment restrictions by end-May or early-June, the US and China may negotiate a more palatable solution for both parties.

Commodities – supply risks leading to higher prices

The Itaú Commodity Index (ICI) has risen 5.5% since the end of March, as all sub-indexes rose over the period: agricultural (5.6%), metals (4.2%) and energy (6.2%). The only negative highlight was sugar, falling further amid new upward revisions to the ongoing global market surplus.

The price increase was driven by supply risks. Agricultural supply risks stem from delayed corn planting in the U.S., lack of rainfall in corn producing areas in Brazil and unfavorable weather in wheat-producing regions in Eastern Europe. Metal supplies are threatened by U.S. sanctions against Russia and risks of tariffs on scrap metals imported by China from the U.S., which may shift the aluminum supply curve toward higher prices. Finally, uncertainty over the Iran Nuclear Deal continues to increase the geopolitical risk on Brent prices. 

We made several adjustments to our price forecasts for the year end. First, we lifted oil prices (Brent to USD 68/bbl from USD 58 and WTI to USD 63/bbl from USD 55), as we expect stable global crude stocks in 2H18 (even if OPEC increases production quotas), but with some decline in geopolitical risk in 4Q18. Second, aluminum prices will likely remain high and hence we boosted our forecasts by 13%, to USD 2,400/t. Finally, we lowered our sugar price forecasts to USD 0.125/lb (down 8.1% from our previous scenario) because the ongoing surplus will lead prices to exhibit a stronger discount relative to Brazil’s ethanol producer prices.

With the revisions, our 2018YE forecasts see agricultural and metal prices close to current levels, with a slight decline in oil-related prices.


 


LatAm

When fundamentals matter

Uncertainties associated with the U.S. late cycle and trade relations with that country brought financial volatility back, hitting the more-vulnerable emerging markets harder. As we expect external risks to moderate, largely because global growth remains strong, the weakening trend of LatAm currencies is unlikely to persist.

Growth in the region is improving, but remains bumpy. Still, slack persists in many countries, which, coupled with past exchange-rate appreciation, is bringing inflation down and/or maintaining it at low levels everywhere but in Argentina. Central banks in Brazil, Chile, Colombia and Peru are keeping an expansionary monetary policy, while additional rate hikes in Mexico are unlikely. 

Uncertainties associated with the U.S. late cycle and trade relations with that country brought financial volatility back to the region. Pressure on more-vulnerable countries was particularly strong. In Argentina, where the current-account deficit is wide (4.8% of GDP last year) and reserves are low (around 5% of GDP in net terms), the central bank has sold around USD 8.0 billion since March (or 20% of net reserves), increased the policy rate by 1275 bps (to 40.0%) in three inter-meeting decisions, reduced the maximum exposure of banks to the exchange rate and stated that it could intervene using futures. Additionally, Argentina’s Ministry of Treasury reduced the primary deficit target for this year, to 2.7% of GDP (from 3.2% before). Even with the recent measures, the currency has weakened by more than 10% since the beginning of April. This might have been behind the government's stated intention to begin negotiations with the International Monetary Fund (IMF) for external support. The depreciation of the BRL was also strong, as the less-friendly external environment met a low carry (the Selic rate stands at record-low levels) and uncertainties over the much-needed fiscal reforms after this year’s presidential elections. Mexico’s fundamentals have strengthened considerably since two years ago, with a narrowing of the fiscal and current-account deficits. Still, the currency weakened sharply, as there is still no concrete announcement on NAFTA (even though the tone of negotiators has been much more constructive recently) and polls show the anti-establishment candidate AMLO maintaining a wide lead in the presidential race. On the other hand, the Colombian peso has outperformed, benefited by higher oil prices as well as the domestic political scenario. In Chile and Peru, currency depreciation was more contained, anchored by strong fundamentals, high copper prices and low (or lower in the case of Peru) political risks. 

As we expect external risks to moderate, largely because global growth remains strong, the weakening trend of LatAm currencies is unlikely to persist. Still, idiosyncratic issues can be a source of volatility. The election of AMLO before a deal on NAFTA is reached could further weaken the Mexican peso. In Brazil, signs on the willingness and capacity of different presidential candidates to pass fiscal reforms will be closely watched in the coming electoral campaign, while in Argentina eyes will be on whether growth and popular/political support for Macri do not deteriorate meaningfully given the recent announcements and policies. 

Growth in the region is improving, but remains bumpy. In Brazil, we reduced our growth forecast for this year to 2.0% (from 3.0%) partly due to recent disappointing data. In Argentina, growth has been strong, but the effects of the drought, tightening macro policy, lower real wages (as the weaker peso pressures inflation) and poorer growth in Brazil will likely lead to a slowdown. So, we reduced our growth forecast to 2.0% this year (from 2.8% before). In Mexico, data has been surprisingly strong, so in spite of the uncertainties over trade relations with the U.S. and domestic politics, we increased our growth forecast for this year, to 2.0% (from 1.8% before). The fact is that the solid labor market, the strong U.S. economy and some investments associated with reconstruction efforts following last year’s natural disasters have shielded the Mexican economy. In Chile, growth remains pretty strong, while in Peru and Colombia recent data has been more encouraging.     

As recovery is only gradual and slack persists in many countries, inflation is low or trending down everywhere but in Argentina, also reflecting past exchange-rate appreciation. In Chile, Peru and Brazil, headline inflation is below central banks’ respective targets. In Mexico, inflation at the margin is already running around the target. 

Given the comfortable inflation outlook, central banks in Brazil, Chile, Colombia and Peru are keeping an expansionary monetary policy. In both Brazil and Colombia, we expect only one additional 25-bp rate cut before the easing cycle ends. In Chile and Peru, additional rate cuts this year are unlikely, but low inflation means there is no rush for interest-rate hikes even if the recovery we expect in both countries materializes. We do not expect further interest-rate hikes in Mexico unless exchange-rate depreciation intensifies. But even so, we think the bar (in terms of the Mexican peso weakening) for rate hikes is high, as board members (at least most of them) have been communicating that they will be less reactive to exchange-rate developments than in the past, focusing instead on deviation of the bank’s inflation forecasts from the target. Having said this, the probability of near-term rate cuts in Mexico is low. Finally, in Argentina the outlook for monetary policy remains quite uncertain, but our base-case scenario is that once markets stabilize, the central bank will find room to partly revert the recently implemented hikes. 


 

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



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