Itaú BBA - Latin America Faces a New Scenario

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Latin America Faces a New Scenario

March 14, 2014

The reduced stress in emerging markets over the past month was largely driven by the lower interest rates in the U.S.

Global Economy
Activity in U.S. is Warming Up, while China and Ukraine Pose Risks
The reduced stress in emerging markets over the past month was largely driven by the lower interest rates in the U.S. However, U.S. rates are likely to begin to rise again and that the risks associated with China and Ukraine have been increasing.

Brazil
The Risks of Implementing the Fiscal Target
There are risks associated with the implementation of the 2014 target. We maintain our GDP growth forecast at 1.4% this year, despite the stronger expansion in activity in 4Q13. We maintain our 2014 year-end estimate for the exchange rate at 2.55 reais to the dollar.  

Mexico
Still not Rebounding
The economy has not rebounded yet. The disappointing activity figures and the well-behaved inflation support our view that no policy rate moves will come this year.

Chile
A Sharper Deceleration and Further Rate Cuts
Chile’s economic activity has continued to slow, led by investment and private consumption. We now expect a deeper monetary policy easing cycle, with the policy rate at 3.5% before the end of this year.

Peru
Another Cabinet Reshuffle
Prime Minister Villanueva resigned last month; he was the fourth official to occupy this position since President Humala took office. The economy continues its recovery, but private investment is still sluggish.

Colombia
Higher Growth and the Start of a Tightening Cycle in 2014
We have raised our GDP estimates to 4.1% in 2013 and 4.5% in 2014. Due to our higher GDP estimates, we now expect the central bank to begin the tightening cycle this year.

Argentina
Temporary Relief
We see the recent stabilization of reserves, the exchange rate and the interest rate as temporary. We maintain our view that the government will have to allow for more depreciation of the peso and further hikes in interest rates.

Commodities
Agricultural Prices Up, Metals Down
Unfavorable weather in Brazil is driving agricultural prices upward, and lower growth outlook in China is driving metals prices downward. The crisis in Ukraine is affecting several commodity prices.


Latin America Faces a New Scenario

The stress in emerging markets eased in February, largely because of lower interest rates in the U.S. But concerns over the slowdown-risk in China are now affecting commodity prices and some emerging market currencies. The crisis in Ukraine has also added risk to the scenario.

We believe that emerging economies will still likely face volatility ahead. Interest rates in the U.S. are expected to rise again as the temporary effects of the harsh winter cease to affect U.S. growth. And the risk in China and Ukraine may continue for some time, although resolutions in each country without major trauma are more likely in both cases.

As long as global themes drive the asset dynamics of emerging markets, local fundamentals will remain important.

In Latin America, growth in Mexico and Chile has been disappointing despite the strong fundamentals of these two economies. In both cases, monetary policies remain expansionary, as inflation is under control. This stance contributes to the weakening of currencies in the region, especially in Chile.

In Colombia and Peru, on the other hand, economic activity is recovering. We now expect the Colombian central bank to initiate a cycle of interest rate hikes in the second half of this year. In Peru, we continue to expect unchanged interest rates, but the central bank may again stimulate the economy via macroprudential measures, in order to ensure a swifter economic recovery.

In Brazil, the government is trying to signal a more austere fiscal policy stance, but there are risks to the implementation of the announced spending cuts. Weather events generate concerns over the energy supply and add pressure on inflation. Activity data are slightly better, but the fundamentals still suggest limited growth ahead.

In Argentina, the relatively calmer global environment and specific government measures have eased pressure on the parallel FX market and reduced reserve losses. However, in our view, the country will be forced to make additional adjustments in exchange and interest rates, especially if the volatility in global financial markets surges again.

Global Economy
Activity in U.S. is Warming Up, while China and Ukraine Pose Risks
The reduced stress in emerging markets over the past month was largely driven by the lower interest rates in the U.S. However, U.S. rates are likely to begin to rise again and that the risks associated with China and Ukraine have been increasing.

• Activity in the U.S. is likely to rebound in 2Q14, as the temporary effects of a harsher winter begin to fade. As the economic data improves, the rise in U.S treasury yields should exceed current market expectations.

• China’s economy decelerated during the first two months of the year. We revised down our forecast for 2014 GDP to 7.2% from 7.5%.

• The reduced stress in emerging markets over the past month was largely driven by the lower interest rates in the U.S. However, given that U.S. rates are likely to begin to rise again and that the risks associated with China and Ukraine have been increasing, we expect renewed pressure on emerging economies with weaker domestic fundamentals.

In the U.S., we expect a rebound in activity in 2Q14, as the temporary effects of a harsher winter begin to fade. The underlying fundamentals continue to support growth, and we remain confident in the U.S. recovery this year. The colder winter weather was the main culprit behind the weak activity indicators at the beginning of the year, leading us to believe that the economic data is likely to rebound in 2Q14. We reduced our GDP forecast to 2.8% (from 3.0%) in 2014, but maintained our 3.1% estimate for 2015.

U.S. treasury yields should rise as the activity data improves. We maintain our forecast of a 3.45% yield for the 10-year treasury by the end of 2014, which is higher than the market is pricing in at the moment.

China’s economy decelerated during the first two months of the year. Industrial production growth averaged 8.6% yoy in January and February, down from an average pace of 10.1% yoy in 2H13. Given the weaker start of the year, we revised down our forecast for 2014 GDP to 7.2% from 7.5%.

The recovery in the euro zone is well under way. The composite Purchasing Managers Index (PMI) reached 53.3 in February, up from 52.1 at the end of 2013. Investment is picking up after a long period of negative growth. The region faces some downside risks if the crisis in Ukraine (and Russia) escalates to a military confrontation and/or meaningful economic sanctions, which we believe is unlikely at the moment. We revised our GDP forecast for the region up to 1.1% in 2014 and 1.5% in 2015, from 0.9% and 1.3%, respectively.

There were mixed signals in Japan, including a below-expectation 0.3% qoq GDP growth in 4Q13 and 4.0% mom industrial production growth in January. Domestic demand has improved with the ongoing monetary and fiscal stimuli, but imports increased significantly, absorbing part of the rise and reducing GDP growth in 4Q13. Nonetheless, the start of the year was strong, with industrial production up 4.0% in January, partly in anticipation of the VAT increase in April. We adjusted our GDP forecasts to 1.3% in 2013, 1.2% in 2014 and 1.3% in 2015, from 1.8%, 1.5% and 1.1% respectively.

The stress in emerging markets eased in the past month, as the lower interest rates in the U.S. prevailed over the weaker data in China and the crisis in Ukraine. In the past month, exchange rates appreciated in countries such as Brazil, Turkey, Indonesia and South Africa (see graph) – the same countries in which exchange rates depreciated significantly last year, with the onset of the QE tapering talk in the U.S. The weakest performance in the month was in Russia, which is directly involved in Ukraine crisis. 

Recent dynamics indicate that the outlook for monetary policy in the U.S. continues to be the key determining factor for several emerging markets. Meanwhile, the slowdown in China is becoming worrisome, particularly due to lower commodity prices, such as iron ore. The pressure is likely to return as U.S. interest rates begin to rise again.

U.S. – Activity data to rebound in 2Q14

The harsher winter in the U.S. caused several activity indicators to decline in February. The national average temperature was 2.6 standard deviations below the historical average for the month of February. The National Oceanic and Atmospheric Administration registered two big snowstorms in the northeast, where one third of the U.S. population lives. We believe that the below-average temperatures limited vehicle sales, which increased to 15.3 million (annualized) in February from 15.2 million in January, but remained low relative to trend. The ISM manufacturing index came in at 53.2 points, only slightly above the weak 51.3 January reading, while the ISM non-manufacturing survey declined to 51.6 from 54.0. Finally, the Fed’s Beige Book was full of anecdotal evidence to support the view that the unusually severe weather affected activity in several regions.

Taking into account the extended weather-related soft patch, we reduced our 1Q14 GDP estimate to 2.0% SAAR (seasonally-adjusted annualized rate), from 2.4%.

However, given that the underlying fundamentals continue to support growth, we remain confident in a U.S. recovery this year. The U.S. economy continues to be supported by easy financing conditions, a fading fiscal drag, improving private-sector balance sheets and stronger export growth.

We expect activity to rebound in the second quarter, as winter comes to an end. We revised our 2Q14 GDP forecast up to 3.2% SAAR, from 2.9%, and maintained our growth rate estimate at 3% for 2H14.

A similar dynamic was observed in past episodes of extreme winter weather: deceleration in first quarter, with a bounce-back in the second. In five of the last six harsh winters, GDP accelerated in the second quarter (see table). The only exception was the winter of 1978/79, when the economy failed to accelerate in the spring because the Fed had raised interest rates in response to an oil shock.

The initial non-farm payroll estimate for February already indicated some resilience, showing an increase of 175 thousand (vs. consensus of 149 thousand), despite the negative weather effect. The reading was close to the two-year trend of 185 thousand per month and we expect job creation to improve further in March.

All in all, we reduced our 2014 GDP forecast to 2.8% (from 3.0%) due to lower base effects (4Q13 GDP was downwardly revised to 2.4% SAAR, from 3.2%), but maintained output growth at 3.1% in 2015.

Given that the economic outlook has not changed significantly, we believe the FOMC will continue to taper its quantitative easing program. NY Fed President Bill Dudley recently stated that the Fed should continue to taper its asset purchase program unless the economic data changes significantly, which does not appear to be the case.

We expect the FOMC to move from the unemployment threshold to a qualitative forward guidance for the Fed funds rate. The unemployment rate is rapidly declining, reaching 6.7% in February, which is near the 6.5% unemployment threshold. FOMC members have been signaling that it would not be prudent to raise the Fed funds rates until 2H15. We therefore believe that the Fed will need to change its forward guidance to better communicate this intention. The preferred option seems to be a qualitative guidance, based on a wider range of labor market indicators that provides greater flexibility to decide when to begin raising interest rates.

Despite the FOMC’s reluctance to raise rates soon, we believe that the 10-year U.S. treasury yield is too low. The reacceleration of economic activity in 2Q14, together with a gradual increase in consumer price inflation, should prompt the market to anticipate its expectations of a normalization of the Fed funds rate. As a result, we continue to expect the 10-year U.S. Treasury yield to reach 3.45% by the end of 2014, about 30 basis points above current market expectations.

China – Growth decelerate, lingering credit concerns

Industrial production growth decelerated to 8.6% yoy at the beginning of the year, from a 10.1% average during the second half of last year. Other data also indicate a slowdown. The NBS PMI came in at 50.2 points in February and 50.5 points in January, down from a 51.0 average in 2H13. Fixed-asset investment growth also came at of 17.9% yoy, down from 19.6% in 2013.

In the meantime, the Chinese Communist Party (CCP) maintained the 2014 growth target unchanged at 7.5% but suggested it might be flexible. Other indicator targets were also maintained, including the CPI (at 3.5% yoy) and fiscal deficit (at around 2.1% of GDP). The CCP continued to emphasize the need for continued economic reform and detailed its plans for urbanization and housing policy, fiscal reform and the liberalization of the exchange rate, among others. The overall message of stable growth and policies remains, while reforms are advanced. But it appears to be some flexibility about the growth target, and authorities might be comfortable with GDP growth in the 7.0% to 7.5% range.

Credit-quality issues in Chinese markets remain at the forefront, following the first onshore bond default, which occurred this month. A solar energy company failed to repay the full interest on its debt, triggering what seems to be the first onshore bond default in China. This was no big surprise given that the bond’s trading had been halted by the company after a couple of years of losses. The market reaction was moderate, with an increase in local bond yields but relative calm in the rest of the country’s financial system. 

Given the weaker start of the year, we revised down our forecast for 2014 GDP to 7.2% from 7.5%.

Euro Zone – Slightly stronger growth

Growth in the region has strengthened somewhat. The composite PMI reached 53.3 points in February, up from 52.1 at the end of 2013. The recovery after almost two years of recession seems to be gaining a little steam. Following several quarters of steady decline, investment has increased in the last three quarters, to 1.1% qoq in 4Q13 (see graph). 

Inflation remains low despite the better growth, but not enough to trigger any measures by the European Central Bank (ECB). The significant slack in the economy and energy prices have been dragging inflation, which is expected to improve only slowly starting in 2H14. Given the central bank’s apparent growing confidence in this outlook, we expect the ECB to remain on hold this year.

The tensions in Ukraine pose a downside risk for growth in the euro zone. About 5.8% of euro-zone exports go to Russia and Ukraine. Meanwhile, roughly 9% of the energy consumed by Germany comes from Russian gas. The equivalent figure is 7.6% for Italy and 2.7% for France. And the financial system in the region is exposed to markets in Russia and Ukraine. However, we expect the negative effects of the crisis to be small, unless it escalates to military confrontation and/or meaningful economic sanctions, which we believe is unlikely at the moment.

 We have raised our GDP growth forecasts for the euro zone to 1.1% in 2014 (from 0.9%) and 1.5% in 2015 (from 1.3%).

Emerging Markets – Temporary relief

The stress in emerging markets eased in the past month, as the lower interest rates in the U.S. prevailed over the weaker data in China and the crisis in Ukraine. In February, exchange rates appreciated in countries such as Brazil, Turkey, Indonesia and South Africa. It is no coincidence that these countries have suffered significantly since the onset of the QE tapering talk in the U.S.

The pressure on emerging market currencies is likely to return if U.S. interest rates begin to rise again. We now expect the currencies of Colombia, Chile and Mexico to end the year weaker than previously estimated. We also continue to expect a weaker Brazilian real by the end of the year.

While U.S. treasury yields continue to be the key driver, domestic stories will also play a role.

Surprisingly, Mexico and Chile, both emerging markets with sound fundamentals, are slowing down. Mexico’s economy weakened in the last quarter of 2013, and the initial indicators for this year are not encouraging. While the adverse weather in the U.S. could be weighing on the Mexico’s recent export performance, the deteriorating trend began when the U.S. economic data was still robust.

The monetary policies in both countries are able to remain loose due to controlled inflation. In Mexico, we only expect rate hikes in 2015. In Chile, we now expect more interest rate cuts than previously forecasted. In fact, Chile’s local yield curve has narrowed substantially over the past few weeks.

The Colombian economy is a positive highlight in the LatAm region that is exceeding our expectations.  As a result, we now expect rate hikes during the second half of the year.   

With different economic momentum, domestic monetary and exchange-rate policies are also influencing the paths of exchange rates in LatAm. In fact, following a weak performance this year, the exchange-rate depreciation in Chile has outpaced that of Brazil since May 2013, when the Fed QE tapering talk began. The former has the strongest fundamentals in the region, but its central bank is cutting interest rates as growth continues to disappoint and inflation remains under control; the latter suffers from weakening fundamentals, but the central bank is selling dollars and raising interest rates to fight inflation.

Commodities – Agricultural prices up, metals down

The Itaú Commodity Index (ICI) has risen 0.4% since mid-February, once again driven by higher agricultural prices (11.3%) and renewed concerns regarding agricultural production in Brazil. Meanwhile, metal prices have fell 7.8% (-12.9% year-to-date) and energy prices dropped 1.8% over the same period. We are revising our ICI forecast up to -1.9% yoy (from -2.4% yoy) with an upward revision to agricultural prices and downward revision to the metals sub-index. Meanwhile, we are maintaining our forecasts for the energy sub-index.

The crisis in Ukraine generates upside price pressure for several commodities. Russia is a key global exporter of crude oil and natural gas to Europe. Moreover, both Russia and Ukraine are relevant grain exporters, which means that the conflict increases the hedge demand for corn and wheat. Some metals are also affected because Russia is a key global palladium supplier, while gold (and other precious metals) prices may rise due to its safe-haven status.

Agricultural prices are rising as multiple weather shocks lead to a worse supply outlook. On the one hand, excessive rainfall in Brazil’s Center-West region is delaying the soybean harvest and the planting of the second corn crop. On the other hand, the drought in Brazil's South and Southeast regions between January and mid-February is leading to downward revisions of crop estimates for coffee, sugarcane, corn and soybean. We are maintaining our year-end forecasts for these commodities because the next crop in the northern hemisphere may offset the effect on corn and soybean prices. However, lower production in Brazil will have a lasting impact on the global balance of sugar and coffee. We are therefore revising our ICI agricultural sub-index up to 9.5% yoy in 2014 (from 4.9%) due to the higher price forecasts for both commodities.

Metal prices falling on lower growth outlook for China. The drop in prices is consistent with fundamentals (demand slowdown and growth in supply). Based on the revision of China’s growth estimates for 2014 (to 7.2% from 7.5%), we revised downward our year-end forecasts for iron ore (to USD 101/ton from USD 107) and copper (to USD 6,700/ton from USD 6,940). We now forecast the ICI-metals to drop 12.4% yoy in 2014 (previously: -9.3%).

Energy-related commodities registered a mixed performance over the past month. WTI prices have traded sideways since mid-February, still affected by the slightly lower oil production in the U.S. and the increased outflow capacity from the Cushing region in Central United States. Meanwhile, Brent prices continue to slide: the fundamentals suggest a drop throughout 2014. However, the crisis in Ukraine has led to an increase in the implied “geopolitical risk” on prices. Our current base case is that the conflict will be resolved sometime over the next few months, with no lasting impact on the commodities commerce. We maintain our year-end forecasts for Brent (USD 105/bbl) and WTI (USD 101/bbl) prices.

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



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