Itaú BBA - Markets remain volatile, what are the risks for Latam?

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Markets remain volatile, what are the risks for Latam?

February 5, 2016

Growth remains weak across the region, but momentum is mixed.

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

Global Economy
Central banks react; Risks remain
The major central banks are reacting to financial markets turbulence. This action should maintain financial risks under control. In our view, China remains the main risk to the global economy.

Sailing in troubled waters
Growth remains weak across the region, but momentum is mixed, with some economies recovering, some deteriorating and only Chile is relatively stable. The currencies more linked to oil weakened significantly during the past month.

We forecast a 4% drop in GDP and lower interest rates in 2016
Brazil’s economic activity has not yet stabilized, we forecast now a deeper recession this year. In our scenario of falling activity and inflation, we see the Selic rate ending 2016 at 12.75%.

Undergoing adjustments
Inflation seems to be behaving orderly after the devaluation. Argentina is advancing on tapping financial resources from abroad.

Another victim of cheap oil
Despite the country’s decreased dependence on oil, the decline in oil prices is negatively affecting activity, fiscal revenues, exports and the exchange rate.

Starting the year on the back foot
A weak end to 2015 resulted in a more unfavorable carry-over, leading us to reduce our growth expectation for this year. Amid weak confidence, we see lower growth also in 2017.  

A one-horse race to Miraflores?
We expect growth to accelerate in 2016, boosted by higher mining production, stronger public investment and a lower contraction of private capital spending.  Keiko Fujimori remains the clear front-runner of the presidential elections.

The long-term consequences of the oil shock
With the fall in oil prices, Colombia’s economy is going through adjustments. In our baseline scenario, Colombia continues to perform fine. In a stress scenario for oil prices, growth suffers and the potential rise of external debt is a risk.

Oil fundamentals suggest a rebound in oil prices starting by mid-year
We expect the oversupply in the oil market to vanish by the middle of the year, supporting a recovery in prices. We have reduced our price forecasts for sugar and coffee due to favorable conditions for the next crop in Brazil.


Markets remain volatile, what are the risks for Latam?

Markets have remained volatile since the beginning of the year. The world’s main central banks are taking steps to calm markets. The FED has said it is monitoring global financial conditions. We believe the FED will not hike the Fed Funds rate in March, as we expected before.  The European Central Bank (ECB) has signaled fresh stimulus measures and the Bank of Japan cut interest rates into negative territory.

The steps taken by central banks will tend to limit short-term financial risks, but are unlikely to avoid further market volatility. Markets should become calmer when positive (or stable) data on global activity becomes available.   

In our view, China remains the biggest risk to the global economy. In the short term, China needs to reduce capital outflows and stabilize its currency to reduce the perception of risk. In the medium term, China needs to implement a reform agenda to help rebalance the economy and guarantee a gradual slowdown.

Against this backdrop, Latin America continues to navigate trouble waters. Exchange rates remain volatile, although only currencies with closer ties to oil prices – Colombia and Mexico – depreciated significantly in January.  Regional activity remains weak but the outlook is mixed: there are signs of improvement in Mexico and Peru, whereas Brazil faces a deepening recession.  With inflation under pressure, most Central Banks remain on tightening mode.  However, the weak global economy could lead some central banks to resist further hikes, as in Brazil.

Brazil’s economic activity has not yet stabilized. We are now forecasting a 4.0% GDP contraction in 2016 (-2.8% previously). Government finances remain Brazil’s core problem. In addition to the recession, which is weighing on tax revenues, there is a structural trend for mandatory spending to rise faster than GDP. Faced with global uncertainty, lower inflation and a deep recession, we now expect the Central Bank to cut rates in the second half of the year.

Adjustments continue in Argentina. The government has abandoned most controls and allowed the exchange rate to float. Significant currency depreciation has yet to have an impact on inflation.  The Central Bank has been reducing the speed of monetary expansion in efforts to achieve this year’s inflation target (maximum 25%).  However, relative prices adjustments, particularly energy and the exchange rate, suggest this is no easy task.  We forecast a 0.5% GDP contraction this year and a 3% recovery in 2017.


Global Economy

Central banks react; Risks remain

• The major global central banks are reacting to financial markets’ turbulence. The fear is that worsening financial conditions affects recovery in the real economy. The BoJ lowered its interest rate into negative territory. The ECB signaled a new round of easing. And the Fed wrote that it is carefully monitoring financial conditions. We now see the Fed on hold in March.

• The actions of the central banks should keep financial risks under control. We see moderate GDP growth in the U.S. (2016F: 2.2%), euro area (2016F: 1.7%) and Japan (2016F: 1.0%). 

• China remains the main risk to the global economy. In the short term, a slowdown in capital outflows and a stable currency are necessary to stabilize risk sentiment. For the medium term, China needs to continue its reform agenda to allow the rebalancing of its economy and gradual slowdown (we maintain our GDP forecast at 6.3% in 2016). 

• We expect fundamentals to support an oil-price recovery around mid-year. Until then, downside risks remain.

U.S. – Fed on hold while it closely monitors global economic and financial developments 

The FOMC is unlikely to raise the Fed Funds rates in March while it is closely monitoring the implications of global economic and financial developments on the balance of risks to the outlook. In January, the committee left the fed fund rate range unchanged at 0.25%-0.50%, as widely expected. The statement indicated that the FOMC needs to reassess the balance of risks to the U.S. economy in the light of global and financial developments.

This a prudent approach by the Fed, consistent with its message that the tightening cycle will be gradual and data dependent and that it will take into account overall financial conditions. Hence, we now believe that the Fed will delay the second rate hike from March to mid-year, as the uncertainties are likely to linger for longer than previously anticipated.

We expect the next 0.25 p.p. interest-rate increase to occur in June, and now see three hikes in 2016 instead of four. We see the fed fund rate range at 1.00%-1.25% (instead of 1.25%-1.50% previously) at the year end.

However, growth in the U.S. is holding up and some of the investors’ concerns will likely dissipate ahead. We left our GDP growth forecasts unchanged at 2.2% in 2016 and 2.1% in 2017.  

First, the slowdown in 4Q15 was temporary and the economy should accelerate 1Q16. U.S. real GDP slowed to 0.7% qoq/saar in the fourth quarter, well below the 2.4% yoy seen in 2015. While net exports will remain a drag, domestic demand is likely to pick up.

Non-residential investment should rebound in the first half of 2016, as it declined almost exclusively due to renewed spending cuts by the oil supply-chain industries. And, if consumption continues to grow, it should continue to spur investment in non-residential investment (ex-energy).

Moreover, the recent decline in oil prices should provide another boost to consumption in the next couple of quarters. Consumption slowed down to 2.2% qoq/saar (from 3.0%), but mainly due to lower energy consumption (which contributed –a decline of 0.5 pp) in a mild winter. Besides, household economic fundamentals remain healthy, with solid jobs, real income growth and available credit, which all translate into high consumer confidence.

Second, the credit problems in the energy sector can be absorbed by the financial system and hence are unlikely to propagate to the rest of the economy. Credit to the energy sector represents only 1.5% of the U.S. credit markets. The exposure of U.S. banks is even smaller, 1.0% of total assets. As an example, and a key distinction from the 2008 financial crisis, mortgages represent about 30% of the credit markets in the country. Credit spreads for financial institutions remain contained despite the stress in the energy sector (see graph), which is a good sign.

Finally, economic expansions simply do not die of old age. The current expansion cycle has already lasted 26 quarters, compared with 20 quarters on average since the Great Depression of 1929. Some investors seem to take this as a sign that a downturn is upon us. Not so fast! There is no such a thing as a time-dependent-theory of business cycles. In fact several important indicators, such as moderate leverage of the private sector, indicate that chances of a recession in the U.S. remain small.

Once it becomes clear that U.S. growth remains around 2.0%, we think that the Fed will be able to resume the hiking cycle. The pace will need to be gradual though, as growth in this recovery is slow by historic norms and global risks, in particular from China, will remain significant.

Europe – Another shot of monetary stimulus

The ECB indicated that it is likely to ease policy further in March in response to downside risks to the inflation outlook. ECB president Draghi pointed to heightened uncertainty in emerging economies, along with volatility in financial and commodities markets. In addition, lower oil prices reduce current inflation and generate risks of second-round effects beyond this year. As a consequence, the ECB indicated that it would “possibly reconsider” its policy stance.

We think that another 0.10 p.p. cut to the deposit rate, bringing it to -0.40%, is likely at the next meeting. An extension of the asset-purchase program, by another six months (from until March 2017 to September 2017), is also possible. These are likely to aid the inflation outlook through a more-depreciated currency and some stabilization in inflation expectations. Importantly, it also helps to stabilize financial markets and avoid risks emanating from tightening financial conditions.

On economic activity, we see data in line with moderate growth. We keep our 2016 GDP forecast at 1.7% and 2017 at 1.6%

Japan – BoJ goes negative (and that is positive)

The BoJ cut interest rates into negative territory (to -0.10% from 0.10%), reinforcing its commitment to end deflation. The decision to follow some European central banks and adopt negative rates (see graph) came at a moment of mixed signs in activity, declining inflation expectations and financial-market instability. The central bank also announced that could cut rates further if needed, reaffirming that still has tools available and that will do whatever it takes to counter the Japanese “deflationary mindset.” The BoJ movement surprised most investors.

Together with the Fed and the ECB, the BoJ’s aggressive move should help stabilize financial markets and avoid an unwarranted tightening of financial conditions. 

We maintain our GDP forecasts at 0.6% in 2015, 1.0% in 2016 and 0.9% in 2017.

China – One (necessary) step back

Economic activity data released in mid-January indicates some stabilization in growth. The 4Q15 GDP headline slowed to 6.8% yoy from 6.9% yoy in the previous quarter, but only due to a lower (and less distorted) contribution from the financial sector. Industry and other services kept the same pace. December’s figures also show that the economy is roughly at the same pace through the second half of the year.

We maintain our scenario of a gradual slowdown, to 6.3% GDP growth in 2016 from 6.9% in 2015.

Despite activity data showing tentative signs of stabilization, investors remain nervous about downside risks in China and see large capital outflows as a sign of problems in the country.

We believe that in the short term, the government’s focus will be on keeping a stable currency and avoiding capital outflows, even if this represents a step back in China’s reform agenda. We already see signs that this is a policy priority at the moment.

First, the PBoC has been maintaining the CNY stable since mid-January. The central bank is setting the CNY value against the USD below the previous spot closing price, and intervening in the spot and forward market. These actions also help to anchor expectations about the central bank’s intention to keep the CNY stable against a basket of currencies and not promote depreciation.

Second, the PBoC is refraining from broad-based additional monetary stimuli that could pressure the CNY. Instead of a cut to the required reserve ratio, the central bank is using a variety of instruments and hence avoiding large broad-based liquidity injections.

Finally, China is taking a step back in its gradual opening of capital accounts, with a discreet approval of major central banks and the IMF. Even though this helps to improve the short-term outlook, it is another signal of the difficulties in achieving a successful rebalancing without a hard landing.

We believe that China will be able to stabilize capital outflows and reduce the pressure on foreign reserves. For now, a sustainable pace of capital outflow should be consistent with monthly sales of foreign reserves of around USD 20 billion in the next couple of years, compared with USD 133 billion in December. This would take the decline in foreign reserves (excluding exchange-rate valuation effects) to USD 250 billion in 2016, compared with USD 342 billion in 2015. Adding a current-account and net FDI surplus totaling USD 385 billion, this would allow net capital outflows of up to USD 630 billion, compared with USD 742 billion seen in 2015. We note that, besides the measures mentioned above, a decline in external liabilities (excluding direct investment and equity) to an estimated USD 1.2 trillion in 2015, from USD 1.6 trillion in 2014, should already reduce some of the capital outflow pressure. Meanwhile, the outflow by residents can be controlled by a combination of controls and guidance to the state-owned enterprises.

Commodities – Fundamentals support oil-price recovery around mid-year

Commodity prices have risen 5.0% since mid-January (according to the Itaú Commodities Index – ICI), driven by higher oil and metal prices. Agricultural prices have not followed the increase, but are still outperforming oil-related and metallic commodities year-to-date. The aggregate increase was not enough to fully offset the initial losses in the year, and the ICI is still down 2.8% year-to-date.

The oil market has been one of the main drivers of asset prices around the globe this year. The daily correlation between Brent and the S&P 500 has increased to 0.43 in the last 60 days, compared to 0.19 in the first half of 2015.

Oil (Brent) prices remained between USD 30 and USD 35/bbl, as oversupply persist. A tentative rebounded occurred with news of a coordinated supply cut by key producers. The news came from Russia and Venezuela, countries with no track-record of actively cutting supply. Hence we don’t see the news as reflecting the strategy of Saudi Arabia and its close allies, which are the countries that have actually cut production in the past.

We expect fundamentals, driven mostly by changes in the U.S. supply, to support oil-price recovery around mid-year. We estimate that lower production in the U.S. (to 8.7 mbd in 4Q16 from 9.2 mbd in 4Q15) will offset increased exports from Iran (to 1.7 mbd in 2016 from 1.1 in 2015). This should keep global oil production stable while demand growth maintains its upward trend, closing the current excess supply by 3Q16 (see chart). Our historical analyses also suggest that prices reach a minimum in the quarter before the market shifts from surplus to deficit (in this case, the minimum price would occur in 2Q16).

We expect crude oil prices to rise to USD 55/bbl (Brent) by 2016 year-end.

For other commodities, we maintain our forecasts for metal commodities (implying some increase from current levels). We lowered our forecasts for sugar and coffee due to favorable weather conditions in Brazil, maintaining our forecasts for soybean and grain prices amid weak news flow.



Sailing in troubled waters 

With an uncertain global scenario, volatility continues to affect LatAm economies. The currencies that are more linked to oil weakened significantly during the past month. We expect most currencies to remain broadly stable from the end-of-January levels, as lower uncertainty about global growth and the expected recovery of commodity prices (especially oil) neutralize the impact of rate hikes in the U.S.

Growth remains weak across the region, but momentum is mixed, with some economies recovering, some deteriorating and only Chile being relatively stable. But even where there is a recovery (Mexico and Peru), it still seems fragile.

Inflation remains high, despite weak activity, mostly a result of pass-through from currency depreciation. The convergence of inflation to the middle of targets will be gradual.

With inflation remaining at uncomfortable levels, most central banks in the regions are still raising interest rates. The exception is Brazil, where we now expect rate cuts this year. For the rest of the countries, some additional monetary-policy tightening is likely. But any relief on the inflation front could translate into early termination of the hiking cycles.

Finally, in Argentina, the government has succeeded in adjusting the economy so far. The exchange market was freed from most controls and is currently floating. The large depreciation has affected inflation only moderately, and interest rates are now down from their peak. The government has also announced a series of significant measures, such as a cut in energy subsidies, a deal with a group of Italian holdouts and a sizable credit line with a pool of international banks.

Volatility persists

Exchange rates in the region continue to be volatile, consistent with the uncertainties about the global scenario. Since the beginning of January, the Mexican peso and the Colombian peso – which are linked to oil – have underperformed. But the Mexican peso depreciated even more than the Colombian peso in January (unlike what happened in much of 2015), in spite of being much less exposed to oil (at the margin, Mexico became a net energy importer due to the continuous decline of oil production.) The remaining currencies of the region ended January close to their respective yearend 2015 levels.     

We expect most currencies in the region to remain broadly stable from the end-of-January levels. Lower uncertainty over global growth and some recovery of commodity prices (especially oil) will mostly neutralize the impact of any eventual rate hike in the U.S.

Not all recoveries are equal

Activity momentum in the region is mixed. In Brazil, recession continues. In Colombia, retail sales and confidence data hint that consumption (which has been supporting the economy) is about to slow, consistent with the impact of rising inflation and higher interest rates. Activity indicators in Chile show that growth is stabilizing around 2%. Finally, the economies of Mexico and Peru are recovering slowly, driven almost exclusively by private consumption and mining production, respectively.

We changed our growth forecasts for Chile, Peru and Brazil. In Brazil we now expect a deeper recession (-4%) this year, as the economy had deteriorated by more than we were expecting by the end of 2015, generating a larger negative carry-over. The most recent leading and coincident indicators point to another contraction in 1Q16. In Chile, we now expect growth at 2.0% this year, the same rate estimated for 2015 and only slightly above the expansion registered in 2014. In Peru, mining production had increased much faster than expected by the end of 2015, leading us to revise our estimates upward for growth last year. We also see upside risks for our forecast for this year. Finally, we continue to expect a moderate slowdown in Colombia this year, due to lower oil prices and to the tightening of macro policies (which will be partially offset by the investments associated with the 4G PPP program). In Mexico, we expect the economy to continue to recover, but there are downside risks (the U.S. industry continues sluggish, oil output is not clearly stabilizing and lower oil prices limit the benefits of the energy reform.)

Inflation remains a concern

Inflation remains above the upper-bound of the target in most countries. The exception is Mexico, where inflation is record low, despite the recent uptick in the beginning of the year, influenced by an unfavorable base of comparison and a rebound of volatile agricultural prices. In Peru, Colombia and Brazil, inflation has yet to start a downward trend, as exchange-rate depreciation and inertia from past inflation continue to pressure prices. In the three countries, inflation expectations continue at high levels for the relevant policy horizons.

In this context, inflation in the region will fall gradually due to weak growth. In fact, in Peru and Colombia inflation hasn’t peaked yet. In Brazil, the favorable base effects from the harsh utility-price increases in 1Q15 will likely lead to a decline in year-over-year inflation already in 1Q16 (though to a level still far above the upper bound of the target). In Chile, inflation will continue to be pressured in the short term too, also due to inertia (education and energy prices will be readjusted with 2015 inflation) and tax increases, with lower gasoline prices partly offsetting these factors.

Policy rates will not get much higher

With inflation remaining at uncomfortable levels, most central banks in the regions are raising interest rates. In Peru and Colombia, central banks are raising rates faster, as inflation kept deteriorating. The central bank of Chile is moving more gradually. In Mexico, in spite of low inflation and the incipient recovery, rates are also moving higher, in tandem with the Fed. In Brazil, the sharp deterioration of activity coupled with the uncertainty over global growth outweighed concerns about inflation, leading the central bank to rethink its guidance for higher interest rates. The policy rate was kept unchanged in January.

We now expect interest-rate cuts in Brazil this year, while some additional rate increases in the other countries are likely. In Brazil, as inflation falls, the economy continues to contract and the exchange-rate remains at around current levels, we believe that the Central Bank of Brazil will start an easing cycle in August. However, if the exchange rate weakens more than expected due to domestic or external uncertainties, the room for easing could disappear. In Peru and Colombia, we expect two additional 0.25 p.p. hikes in the near term, ending the cycle. In Chile, the central bank is signaling some additional tightening, but not in the near term. We also expect two additional 0.25 p.p. hikes, but between the 2Q16 and 3Q16. With weak growth (domestic and globally), inflation falling and well-anchored inflation expectations, the risk is that the central bank stays put. Finally, in Mexico we reduced our year-end policy rate forecast, in line with our revision for the monetary policy in the U.S.

So far, so good

In Argentina, the government has succeeded in adjusting the economy so far. The exchange market was freed from most controls and is currently floating. The large depreciation has affected inflation only moderately, and interest rates are now down from their peak. The government also announced a series of significant measures, such as a cut in energy subsidies, a deal with a group of Italian holdouts and a sizable credit line with a pool of international banks.


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


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