Itaú BBA - Outlook for emerging markets remains benign, despite trade war risks

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Outlook for emerging markets remains benign, despite trade war risks

April 13, 2018

Global growth has kept up a good pace, supported by easy financial conditions and fiscal policies

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

Global Economy
Global growth on track, trade risk to fade
Global growth has kept up a good pace, supported by easy financial conditions and fiscal policies. U.S.-China trade-war risk remains limited, and will likely dissipate in the next couple of months.

 

LatAm
When idiosyncratic factors matter
The recent evolution of LatAm currencies has been driven by idiosyncratic factors. Economies are growing stronger, but the recovery is bumpy.

Brazil
Higher uncertainties
We maintained our GDP growth forecasts at 3.0% for 2018 and 3.7% for 2019. But the balance of risks is tilted toward disappointment, amidst higher uncertainties for the political and macroeconomic scenario, both internal and external.

Argentina
Central bank faces tough choices
The central bank is keeping the reference rate unchanged but indicated a rate hike is on the table. We think the odds of a hike are significant given the fast depletion of already-low reserves and uncomfortable inflation figures.

Mexico
A NAFTA deal within reach?
We continue to expect that a successful renegotiation of NAFTA will be announced in 2Q18. Notably, the renegotiation talks seem to have gained significant momentum recently.

Chile
Looking at global factors
We expect GDP growth of 3.6% this year, more than doubling the 1.5% posted last year. Risks to our forecast come from the potential escalation of global trade tensions.

Peru
Political uncertainty eases
Pedro Pablo Kuczynski (PPK) announced his voluntary resignation amid lack of support in Congress. Markets welcomed the new government, led by PPK’s Vice-President Martín Vizcarra because it implies continuity for market-friendly policies and less confrontation with Congress.

Colombia
Faster disinflation paves the way for additional easing             
Faster-than-expected disinflation in March, together with the still weak activity, strengthens our base-case scenario that the central bank will resume rate cuts this month (to 4.25%).


 


Outlook for emerging markets remains benign, despite trade war risks

Global growth has kept a good pace, supported by easy financial conditions, slightly expansionary fiscal policies and better-adjusted emerging markets. The gradual rise in inflation in Developed Markets economies allows central banks to reduce accommodation cautiously. In the U.S., we forecast 2Q GDP growth to accelerate to 3.5%-4.0% qoq/saar from 2% in 1Q, supporting our view that the Fed will likely raise the Fed Funds rates four times this year. In Europe, growth slowed somewhat in 1Q18 due to temporary factors, but it will likely recover in 2Q18. The outlook for emerging markets remains benign, except for trade-war risks. But we expect tensions related to the U.S.-China trade dispute to dissipate in the next couple of months, as a more moderate negotiated solution seems likely. For commodities, we maintain our price forecasts for year-end 2018 despite the heightening of risks, which include a potential trade war, the possibility that the U.S. will pull out of the Iran nuclear agreement, and OPEC´s meeting to discuss the renewal of its ongoing deal.

In Latin America, idiosyncratic factors have led currencies on divergent paths over the past few weeks. The Mexican peso and the Colombian peso have outperformed, reflecting a higher probability of a NAFTA deal for the former and a strong showing by center-right parties in the congressional elections for the latter. The Brazilian real weakened, given the uncertainty over fiscal policy after the presidential elections as well as an historically low interest-rate differential with the U.S. Finally, the Argentine peso has been broadly stable at the cost of relatively heavy interventions. Economic growth in the region is gradually improving, but the recovery remains bumpy. Inflation is low in Brazil, Chile and Peru, and it is falling faster than before in Mexico and Colombia. In Argentina, the outlook for inflation remains challenging. In this context, the central banks of Brazil, Chile, Colombia and Peru are able to maintain loose monetary policy, while in Mexico, additional rate hikes are unlikely, and in Argentina we now expect rate hikes.

In Brazil, despite signs of a weak GDP in 1Q18, underlying growth indicators remain sound, and for now we maintain our GDP forecasts at 3.0% for 2018 and 3.7% for 2019. We also maintained our inflation forecasts at 3.5% for 2018 and 4.0% for 2019. For the exchange rate, our forecasts remain at BRL 3.25 per USD by YE18 and 3.30 by YE19, but we see downside risks for the Brazilian currency, given uncertainties regarding domestic reforms, geopolitical risks and historically low interest-rate differentials. On the fiscal side, we estimate the primary budget deficit at 1.9% of GDP for 2018 and 0.9% of GDP for 2019. Finally, monetary policy is likely to be eased further in May – we anticipate a 25-bp cut in the Selic benchmark rate in that meeting, ending the easing cycle at 6.25%.


 


Global Economy
Global growth on track, trade risk to fade

Global growth has kept up a good pace, supported by easy financial conditions and fiscal policies. PMIs (Purchasing Managers Index) corrected from high levels to better reflect fundamentals now, and they will likely stabilize in 2Q18.

U.S.-China trade-war risk remains limited. If negotiations advances, the VIX (a volatility index related to U.S. equities) will likely drop to lower levels of volatility implied by global assets prices.  

Strong U.S. growth in 2Q18 will support Federal Reserve interest rate increases.

In Europe, growth slowed somewhat in 1Q18, but it will likely recover in 2Q18.

If the risk of a U.S.-China trade war fades, we expect the outlook for Emerging Markets to remain benign.

Geopolitical issues create risks for commodity prices ahead, but we maintain our price forecasts for year-end 2018.

Global growth has kept up a good pace, supported by easy financial conditions

U.S. equity volatility remains elevated due to greater political risks and inflation normalization. The VIX index has risen to 20%-25%, up from 10% in early February. Greater evidence that core inflation is moving up towards 2% has limited the Fed’s room to maintain an accommodative monetary stance. In addition, U.S. political risks have increased since the Trump shifted to a more hawkish rhetoric on trade with China and reshuffled his cabinet. 

In our view, however, the VIX at 20%-25% is too high relative to global financial conditions. We have estimated a Synthetic VIX implied by a large set of global asset prices. This Synthetic VIX moved together with the actual VIX for most of the past 10 years. But, in March, the latter averaged 19%, while the former increased but stayed close to 10% (see chart). 

We believe this Synthetic VIX better reflects the global growth outlook. Indeed, our Synthetic VIX has done a good job tracking the Global Manufacturing PMI, including its recent correction (see chart). The VIX at 20% would correspond to a much bigger drop in the Global PMI.

Looking ahead, we expect Global PMI to stabilize close to current levels and the VIX to gradually fall. Still, easy financial conditions, slightly expansionary fiscal policies and better-adjusted emerging markets support global growth. Rising inflation in DM economies remains gradual, allowing central banks to reduce accommodation cautiously. In this scenario, we expect the VIX to fall back to 15%. However, at this point in the U.S. economic expansion cycle, the VIX is unlikely to drop below 15% because higher asset-price valuations would press the Fed to tighten monetary policy faster.

U.S.-China trade risk has escalated, but a negotiated deal is still likely

The U.S. and China threatened to impose reciprocal 25% import tariffs on at least USD 50 billion of traded goods from each country. In addition, President Trump has asked the USTR to study an escalation of import tariffs on an additional USD 100 billion of Chinese goods. China has vowed to respond proportionately if the U.S. follows through with these further threats. 

The chance of “tit-for-tat” tariff war is a risk for global growth, but a more moderate negotiated solution seems likely. 

At the Boao Forum, President Xi Jinping laid out plans to open up China’s economy. Specifically he announced that China intended to: i) raise foreign equity limits on banks in China; ii) provide a rules-based environment for foreign investment, including protection of intellectual property; iii) raise the limits on foreign ownership of car companies; and iv) proactively expand imports by lowering tariffs (including on autos) and hosting a first import expo in November. 

Xi’s measures could be implemented in the short term and bring China closer to meeting Trump’s targets. The U.S. appears to be aiming at reduction in the U.S.-China bilateral trade deficit of USD 100 billion (the deficit is currently at USD 375 billion). It is unclear at this point, though, whether it will be enough for President Trump to restrict the 25% import tariff to less than the initial USD 50 billion on high tech products, and whether President Xi would accept any U.S. import tariffs to be levied on Chinese high-tech products as a part of a deal.

If no deal is reached, a modest U.S.-China tariff hike could morph into a trade war. In this case, the U.S. could impose 25% import tariffs on USD 200-250 billion of Chinese goods, and China would not be able to retaliate through import tariffs (it imports only USD 130 billion of U.S. goods) and would have to resort to non-tariff barriers. It could sell U.S. Treasury securities from its foreign reserve holdings and/or intervene in the FX market to devalue the yuan. This alternative scenario would keep economic policy uncertainty high, so the VIX would likely remain at 20%-25% for longer and higher trade barriers would have a significant effect on Emerging Market economies (see EM section).

Solid U.S. second-quarter GDP to support Fed hikes

We forecast 2Q GDP growth to accelerate to 3.5%-4.0% qoq/saar from 2% in 1Q. Private demand should rebound, led by consumption and exports, while private investment is expected to remain firm. Public spending will likely accelerate, as the federal government starts to allocate its FY18 budget. 

The Fed will likely raise the Fed Funds rates four times this year. With the U.S. labor market at full employment and the core PCE deflator moving close to the Fed’s 2% target in 2Q18, the Fed should keep raising the Fed Funds rates on a quarterly basis. If the U.S.-China trade war materializes, financial conditions are likely to tighten, and thus the Fed would end up delivering only three hikes.

Europe – growth moderated in 1Q18 but will likely recover in 2Q18

Economic growth moderated during 1Q18 due to temporary factors. For example, unfavorable weather affected construction and a soft patch in consumption after strong spending for most of 2017 lowered our GDP forecast to 0.3% q/q for the first quarter of the year. 

Survey indicators fell in 1Q18, but their March levels still point to growth of around 0.7%-0.8% q/q. PMIs and other confidence indicators reached exaggerated levels in January but remain high and consistent with strong growth (see chart). Consumer confidence indicators, on the other hand, kept stable at the highs. Besides that, strong fundamentals will continue to boost activity, and we still expect the Eurozone GDP to grow by 2.6% in 2018 and by 2.4% in 2019, boosted by an easy monetary policy, looser fiscal policies in some countries and favorable external demand.

In Italy, the political deadlock may continue for a while. The first round of consultations failed to form a clear picture of the future government. Differences between parties may complicate talks and delay the process for some weeks. The chance of a pure populist coalition increased but remains unlikely. As a consequence, Italy’s possible new government will likely have less commitment to fiscal adjustment and structural reforms, but the likelihood of an “Italy euro exit” remains low. The risk of new elections seems to have risen. 

We expect the ECB to stay on track, ending its asset purchases this year and raising interest rates in 2019. We foresee a cautious approach of gradual tapering in 4Q to end purchases in December, followed by a rate hike in mid-2019. Communication and forward guidance should be adjusted only gradually, as underlying inflation is still slowly on the rise but far from 2%.

Benign emerging market outlook apart from trade-war risk

Emerging markets (ex-China) have reduced their macro imbalances over the past few years, so we see a benign economic outlook. The better-adjusted current accounts supported by devalued, but more stable, currencies allowed for a drop in inflation and interest rates to more normal levels, spurring a cyclical recovery. These economic recoveries are still in the early stages, which supports our view that capital flows are just starting to come back. 

The risk is that a U.S.-China trade war could stymie global trade and have a negative impact on emerging markets. Indeed, emerging markets growth is correlated with the value of global trade. A shock to the latter would hurt the former (see chart).

Commodities – geopolitical risks ahead 

The Itaú Commodity Index (ICI) has fallen 0.9% since the end of February. An 8.8% decline in the metals sub-index has outweighed a small recovery in oil-related and agricultural prices (up 3.3% and 0.8% over the same period, respectively). For agricultural prices, the highlight was the U.S. planting report, showing lower-than-expected corn and soybean planted area for the next crop, a signal that prices must be higher in order for supply to meet the ongoing growth in demand.

Geopolitical issues create risks for commodity prices ahead. 

First, a trade war between the U.S. and China could curb global growth, affecting emerging economies and depressing demand for commodities. Even if only the tariffs already announced are implemented, some commodity prices may be distorted. In particular, the spread between Brazil and U.S. soybean prices will widen if China imposes tariffs on U.S. soybeans. Chinese importers will pay up to attract, for example, Brazilian exporters, while lowering their offers to U.S. exporters. 

Another risk comes from the possibility that the U.S. will pull out of the Iran nuclear agreement. The next deadline to waive sanctions is May 12. If the waiver is not extended, oil prices will rise. 

Finally, OPEC will meet again on June 22 to discuss the renewal of the ongoing deal. Any backtracking on the deal would put downward pressure on oil prices.

Despite upcoming risks, we maintain our price forecasts for year-end 2018. Our scenario assumes Brent and WTI prices will fall to USD 58/bbl and USD 55/bbl, respectively, while other commodity groups will be roughly at current levels.


 


LatAm
When idiosyncratic factors matter

The recent evolution of LatAm FX has been driven mostly by idiosyncratic factors. Economies are growing stronger, but the recovery is bumpy. 

Inflation remains low in Brazil, Chile and Peru, and is falling faster than before in Mexico and Colombia. In Argentina, the outlook for inflation remains challenging. 

The central banks of Brazil, Chile, Colombia and Peru are able to maintain loose monetary policy, while in Mexico, additional rate hikes are unlikely. In Argentina, we now expect rate hikes.

Idiosyncratic factors have been key drivers of LatAm currencies over the past few weeks. Since March 1, the Mexican peso (MXN) and the Colombian peso (COP) have outperformed, recording solid gains against the USD. This reflects, a higher probability of a NAFTA deal for the former and a strong showing by center-right parties in the congressional elections (and in the polls for the Colombian presidential race) for the latter. We note that the MXN appreciated despite the rising momentum for anti-establishment candidate AMLO in the polls for the presidential race. Meanwhile, the Brazilian real (BRL) weakened, reflecting uncertainty over fiscal policy after the presidential elections as well as a historically low interest rate differential with the U.S. Finally, the Argentine peso (ARS) has been broadly stable at the cost of relatively heavy intervention; the central bank has sold more than USD 2.0 billion since March, as it seeks to curb inflation and inflation expectations amid the important wage negotiation season. Looking ahead, as the Fed tightens monetary policy by more than the market is pricing in, some weakening from current levels is likely for most currencies under our coverage. Still, the synchronized global economic recovery and narrower current account deficits will be important anchors for many currencies in the region. 

Economic growth in the region is gradually improving. Economic growth has been solid in Chile and Argentina, in both cases supported by improved confidence following last year’s elections (despite the external environment). Still, a sequential deceleration in Argentina is likely given the drought affecting the country. Mexico’s economy has been a positive surprise recently, with a puzzling composition: investment improved despite the uncertainties over the economic outlook, while the manufacturing sector weakened even with the strong growth in the U.S. While we continue to expect Mexico’s economy to decelerate relative to 2017, we see recent data as an upside risk to our forecast. On the other hand, economic growth in Brazil was disappointing in 1Q18, implying downside risk to our 3.0% GDP growth forecast for this year. Activity in Peru and Colombia remains sluggish, but a recovery is likely.     

Most countries in the region nevertheless continue having spare capacity in the economy, which, coupled with pass-through effects of past exchange rate appreciation, is bringing inflation down. Inflation in Chile, Peru and Brazil is far below the target. In Mexico, annual inflation is falling gradually, but is already within the target range at the margin. Colombia’s inflation is also approaching the target. On the other hand, inflation in Argentina is rising once again, given regulated price increases and the depreciation of the ARS following the changes in inflation targets. 

In this context, the central banks of Brazil, Chile, Colombia and Peru are able to maintain loose monetary policy, while in Mexico, additional rate hikes are unlikely. In the short term, one additional 25-bp rate cut in Brazil is likely, while we expect the Central Bank of Colombia to resume interest rate cuts (ending the cycle once the policy rate reaches 4.0%). On the other hand, we now expect Argentina’s Central Bank to increase interest rates in the near term, given the uncomfortable inflation levels and the unsustainable pace of reserve sales to promote exchange-rate stability. 


 

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



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