Itaú BBA - Outlook for growth is still favorable, but monetary policy remains mixed in LatAm

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Outlook for growth is still favorable, but monetary policy remains mixed in LatAm

December 8, 2017

Friendly external environment helps countries cope with domestic political risks

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

Global Economy
Solid global growth and higher interest rates in 2018
Despite less-accommodative monetary policy in developed countries, we expect broad global financial conditions to remain favorable in 2018, sustained by good growth and little recession risk.

LatAm
Friendly external environment helps countries cope with domestic political risks
With gradual monetary policy normalization in developed markets, most exchange rates in the region will likely weaken moderately against the dollar in 2018. Domestic factors can play an important role in the exchange rate path, especially in countries holding elections (such as Brazil, Mexico and Colombia).

Brazil
Economy improves amid greater risks
We increased our forecast for GDP in 2017 to 1.0% from 0.8%. We estimate growth at 3.0% for 2018 and 3.7% for 2019, but we see downside risks. We trimmed our forecast for inflation this year to 2.8%. For 2018 and 2019 we forecast inflation at 3.8% and 4.0%, respectively. Finally, we expect stable interest rates in 2018, with increases only in 2019.

Argentina
Congress at work
The administration sent a battery of new legislation to Congress, aimed at reducing fiscal deficits and increasing economic competitiveness. The Senate has already given the green light to some of these initiatives.

Mexico
Rate hikes on the horizon
We expect a 25-bp interest rate hike in December, matching the likely move by the Fed. Moreover, given the risks related to NAFTA and the presidential elections, we think the central bank of Mexico will not want to decouple from the Fed in the short term, so an additional interest rate hike in the first half of the year is likely.

Chile
Neck-and-neck presidential race
The general election will reshape the political landscape, with available polls showing the election is too close to call. Meanwhile, we expect a stable policy rate for most of 2018. Nevertheless, low inflation along with some concern over the robustness of the activity recovery mean that further monetary easing cannot be ruled out.

Peru
On the way to a Goldilocks economy
Higher terms of trade and macro policy stimuli (mainly fiscal, but also monetary) would drive growth in 2018. Disinflation is running its course, driven by falling food prices. After delivering the fourth 25-bp rate cut of the easing cycle, we expect the central bank to remain on hold in 2018.

Colombia
Easing cycle extended
The lower-than-expected inflation numbers and disappointing growth open room for more expansionary monetary policy. The central bank has lowered the policy rate faster than expected, and further rate cuts are likely, bringing the policy rate to 4%.

Commodities
Stable prices in 2018
Commodity prices continued to rise in November, boosted by energy and metals. For 2018, we expect commodity prices to remain broadly stable, as firmer global growth limits the downside risks and China's growth, led by consumption and services, limits the risk of a commodities boom.


 


Outlook for growth is still favorable, but monetary policy remains mixed in LatAm

In 2018, as growth remains above potential in developed countries, the output gap will turn positive and inflation is likely to start normalizing gradually (led by the U.S.). As a consequence, global monetary policy will also become less accommodative in 2018. With gradual monetary policy normalization in developed markets, most exchange rates in LatAm could weaken moderately against the dollar in 2018. Domestic factors can play an important role in the exchange rate path, especially in countries holding elections (Brazil, Mexico and Colombia). The friendly external environment is helping to increase activity in LatAm, and recovery is underway in most countries we cover. But monetary policy remains mixed in the region.

In Brazil, we increased our forecast for GDP in 2017 to 1.0% from 0.8%, after incorporating a revision of the historical series and the results for 3Q17. We estimate growth at 3.0% for 2018 and 3.7% for 2019, but we see downside risks if the outlook for public sector reforms changes. The government introduced a watered-down version of the pension reform, but there is still uncertainty regarding its approval in congress – although a last ditch effort was being made at the time of writing. The Monetary Policy Committee (Copom) reduced the Selic rate by 50 bps in December and signaled, quite clearly, it intends to cut the Selic by 25bps, to 6.75% in its next policy meeting, in February 2018. For now we expect the Copom will cut the Selic to 6.5%, in two 25bps increments, in February and March. But we reckon that absence of progress on the fiscal adjustment and reform agenda would make the second 25bps cut less likely. We expect stable interest rates in 2018, with increases only in 2019, when it should reach 8.0%.

In Argentina, the administration sent a package of new legislation to Congress aimed at reducing the fiscal deficit and increasing economic competitiveness. The Senate has already given the green light to some of these initiatives. In Chile, the general election will reshape the political landscape, with available polls showing the presidential election is too close to call. We expect a stable policy rate in the country for most of 2018, but low inflation, along with some concern over the weakness of the activity recovery, mean that further easing cannot be ruled out. In Colombia, the lower-than-expected inflation numbers and disappointing growth open room for more expansionary monetary policy. The Colombian central bank has lowered the policy rate faster than expected, and further rate cuts are likely, bringing the policy rate to 4%. In Mexico, we expect a 25-bp interest rate increase in December, matching the likely Fed move. Moreover, given the risks related to NAFTA and the presidential elections, we think the central bank of Mexico will not want to decouple from the Fed in the short term, so one additional interest rate hike in the first half of the year is likely. In Peru, higher terms of trade and macro policy stimuli (mainly fiscal, but also monetary) are likely to drive growth in 2018. Disinflation is running its course, driven by falling food prices, and after the central bank delivered the fourth 25-bp rate cut of the easing cycle, we expect it to remain on hold in 2018.

Commodity prices continued to increase in November, pushed up by energy and metal subcomponents. For 2018, we expect commodity prices to remain broadly stable, as firmer global growth limits the downside risks and China's economy’s growth, led by consumption and services, curbs the risk of a commodities boom.


 


Global Economy
Solid global growth and higher interest rates in 2018

• We expect global growth to continue at 3.8% in 2018 (the same as in 2017), with expansion in developed countries remaining a bit above 2.0%, China slowing to 6.3% from 6.8%, and other emerging markets accelerating to 4.2% from 3.7%.

• As growth remains above potential in developed countries, the output gap will turn positive and inflation is likely to start normalizing gradually (led by the U.S.).

• Global monetary policy will also become less accommodative in 2018: we see i) three interest rate hikes in the U.S., with balanced risks; ii) the end of QE in the euro area (but interest rate increases only in 2019) and iii) in Japan, an increase of 20 bps in its 10-year JGB target (but no change in its short term rate).

• In China we see a soft landing scenario. 

• Despite less-accommodative monetary policy, we expect broad global financial conditions to remain favorable, sustained by robust growth and little recession risk.

Solid global growth to continue, inflation to start normalizing

Global growth will likely remain strong in 2018. Easy financial conditions in DM, the abatement of political risks in Europe and better chances of a soft landing in China are supporting a synchronized global recovery. We expect GDP at 3.8% in 2018, the same as in 2017, with just a modest slowdown to 3.6% in 2019 (see chart).

We note that growth will become more widespread in emerging economies. Although China will see a moderate slowdown in 2018 (see below), other countries are just starting to recover. We expect growth in LatAm to accelerate to 2.5% in 2018 from 1.2% in 2017. Emerging markets ex-China will likely see acceleration to 4.2% from 3.7%. 

Given better growth, we believe that global inflation will gradually normalize. First, the output gap in developed economies will turn positive next year for the first time since the financial crisis in 2008-09. This should pull up DM core inflation (see chart). Second, the deflationary pressures from China are ending. The producer price index, which had been negative in China from 2012 to 2016 (yearly average: -2.9%), just stabilized in positive territory this year (6.5%). 

U.S. – Three interest-rate hikes in 2018, with balanced risks

We forecast GDP growth of 2.4% in 2018 after 2.3% in 2017, a benign outlook supported by a modest tax cut (0.6% of GDP), expansionary monetary policy and positive global outlook. For 2019, we see GDP decelerating to 2.1% with lesser monetary stimulus and a positive output gap. 

Above-potential growth should gradually raise wages and inflation. The unemployment rate should fall below 4% in 2018, pushing Average Hourly Earnings to 3.2% in 4Q18 from 2.7% in 4Q17. Consequently, services inflation should push up the core PCE deflator to 2.0% in 4Q18 from 1.5% in 4Q17. 

This economic outlook is consistent with the Fed raising interest rates in December and three additional 25-bp hikes in 2018. Markets continue to price in about two rate increases in 2018. 

As consequence, we expect the UST 10-year yield to rise to 2.9% by YE19 from 2.4% in YE18, which is 20 bps above the U.S. Treasury forward yield curve. 

Other major central banks – ECB and BoJ – should follow the Fed’s footsteps. Hence, the U.S. dollar should remain broadly stable relative to the DM currencies – although in the Japanese case, the authorities will probably shift the longer rate rather than the short one, which used to be key to the policy stance.

We see balanced risks for our 2018 Fed interest-rate outlook.

A non-linear response of wages to unemployment diving below 4%, or a pick-up in productivity could require a fourth hike in 2018. The former would be negative for risky assets, as the Fed would need to slow down the economy. But the latter would be positive, as faster rate hikes will not happen unless global growth improves further.

To the downside, persistently low inflation expectations could remain a drag on inflation and lead the Fed to hike only twice in 2018. In this scenario, the unemployment rate would undershoot the neutral rate further, but the Fed would use this to try to push inflation expectations upward. We note that this scenario could occur even without an inflation shortfall, as the Fed might adopt, for example, a Price Level Target framework to prepare for the next recession – this is an ongoing debate among FOMC participants.

Europe – ECB to end QE in September 2018 but increase interest rates only in 2019

Eurozone GDP expanded 0.6% qoq in 3Q17, maintaining a solid growth pace. Easy monetary policy, easier fiscal policies, tentative signs of structural reforms and a reduction in political risk are boosting the region’s growth. 

We expect eurozone GDP to expand 2.3%, 2.1% and 2.1% in 2017, 2018 and 2019, respectively.

With a better economic outlook, the ECB will likely end its asset purchases in 2018, but will raise interest rates only in 2019. We think that better growth will justify the end of QE. However, a more sustained rise in inflation (core inflation currently at 0.9%) will be required before the central bank raises interest rates. 

Political risks seem balanced. The Catalonian regional election on December 21 is unlikely to revive its unilateral independence declaration. EU-UK Brexit negotiations could see progress next year. Italy’s election is an important downside risk, while the renewed chance of the (pro-European) Grand Coalition in Germany could give a push to France’s Macron’s EU agenda and hence be positive for the region.

Japan – BoJ to follow the Fed and ECB and adjust policy in 2018

We believe that the BoJ will raise its 10-year JGB target to 0.2% (from 0.0%) in the 2H18 without harming the positive outlook for growth and inflation. 

With current financial conditions and a positive global outlook, we see Japan’s GDP at 1.4% in 2018. This would follow the expansion of 1.8% in 2017 and maintain growth above the country’s potential level. The unemployment rate should drop to 2.5% by 4Q18 from 2.8% in 4Q17, thus pushing up wages and the core CPI (ex-food & energy) to 1.0% in 4Q18, from 0.2% in 4Q17.

A rise in core inflation could push inflation expectations up and allow for an increase in the 10-year yield target. The central bank has indicated a goal of keeping 10-year real yields at about -1.0%. As inflation improves, the BoJ will likely adjust its 10-year yield target. Within the context of the Fed interest-rate increases and the ECB ending its QE, the BoJ increase wouldn’t cause JPY appreciation. Hence, the BoJ would just aim to keep Japanese financial conditions from easing further as the economic recovery leads the Japanese economy closer to its monetary goals.

China – Soft-landing scenario

Economic activity in China continued to moderate. In October, industrial production fell by 0.4 pp, to 6.2% yoy, while year-to-date fixed investment came at 7.3% yoy and retail sales growth decelerated to 10.0% yoy. Regarding property data, both sales and new construction continued to slow down in the month. For November, the manufacturing PMI increased to 51.8, staying in a good range and pointing to steady economic activity. 

We expect GDP to moderate in 2018, in line with a soft-landing scenario. First, the economy is slowing from a solid position in the cycle. Second, the slowdown is coming from tighter economic policy, which can be adjusted to smooth the process. Third, the credit-to-GDP ratio continues at a high level, but has recently started to stabilize due to more rigid financial regulations focused on “alternative” credit products. Also, the debt problem is concentrated in state-owned enterprises (SOEs) and the government has signaled its focus on SOE deleveraging. Fourth, Chinese economic growth is now more consumption/services driven and less dependent on investment. Finally, the housing sector is more balanced, and inventories continued their downward trend. 

We maintained growth forecasts at 6.8% for 2017 and at 6.3% for 2018. For 2019, we expect growth to moderate further to 5.9%.

Emerging Markets – Easy global financial conditions support EM.

Global financial conditions that matter most for EM will likely remain easy. We have statistically computed (principal component analysis) summaries of financial conditions for both EM and DM economies. For DM we obtain two factors, one that summarizes sovereign yields (which are mostly related to monetary policy) and the other related to credit, equity and volatility conditions. We find that the financial conditions that matter most for growth in EM are related mainly to this second factor, which tracks DM equity, credit and volatility conditions and has remained well behaved (see chart), reflecting better global growth and commodities prices. 

Commodities – Stable prices in 2018

The Itaú Commodity Index (ICI) has increased by 2.1% since October, boosted by its energy and metals subcomponents. Commodity prices are up by 2.7% year to date.

We expect prices to remain broadly stable in 2018. On the one hand, firmer global growth limits the downside risks to commodities, even with a slowdown in China. On the other hand, Chinese economic growth is now more consumption/services driven and less dependent on investment, which limits the risk of a commodities boom.

Energy prices rose 2.6% in November, but we expect a correction from recent highs. Oil prices continued to rally in November, supported by inventory draws and the OPEC agreement to extend its cuts until the end of 2018. However, prices above USD 50/bbl over recent months have started to stimulate shale-oil investment in the U.S. We estimate that the WTI range of USD 45-50/bbl can stabilize the U.S. rig count and help to balance the market in 2018 – as a result we maintain our forecasts at USD 45/bbl for WTI and at USD 47/bbl for Brent. 

Stable metal prices in 2018. The Metals ICI increased 3.2% in the past month, due to a strong performance in iron ore. We expect metal prices to stay close to 2017 year-end levels in 2018. We forecast copper prices at USD 6200/mt and iron ore prices at USD 57/mt by the end of the next year.

The Agricultural ICI remained broadly stable in November, as the increases in soybean and sugar prices were offset by drops in other agricultural commodities. 

For 2018, we expect a scenario of stability for agricultural prices. However, risks associated with La Niña for planting regions in Argentina and Southern Brazil have increased, pushing up the chances of losses in grain crops.


 


LatAm
Friendly external environment helps countries cope with domestic political risks

• With a gradual monetary policy normalization in developed markets, most exchange rates in the region will likely weaken moderately against the dollar in 2018. Domestic factors can play an important role in the exchange rate path, especially in countries holding elections (such as Brazil, Mexico and Colombia).

• The friendly external environment is helping to increase activity in the region, and a recovery is seen in most countries we cover. We expect higher growth rates in 2018 (relative to 2017) in Argentina, Brazil, Chile, Colombia and Peru. Mexico will likely grow at the same pace as estimated for this year.

• Monetary policy in the region remains mixed. Argentina and Mexico will likely tighten monetary policy further, while additional rate cuts are likely in Brazil and Colombia. In Chile and Peru, the central banks still have an easing bias, but rate cuts are unlikely in our baseline scenario.

The positive global environment – including robust growth rates and low interest rates in developed markets – continued to benefit LatAm currencies in November. The Mexican peso outperformed in the month, as the latest NAFTA renegotiation round concluded with a more positive tone. On the other hand, the Chilean peso weakened against the dollar, partly due to a fall in copper prices (to still-high levels) and partly because of the worse-than-expected performance of the right-wing candidate Sebastian Piñera in the first round of the presidential elections. Still, the recent evolution of these two currencies should not be interpreted as the beginning of a trend. In Mexico, the outlook for NAFTA remains cloudy, as a deal in the thorniest issues is yet to be reached and the anti-establishment candidate López Obrador continues to lead in the presidential race. Meanwhile, in Chile solid macro fundamentals and the composition of the new congress (which is more likely to support moderate proposals) prevent a sharp exchange-rate depreciation. 

With a gradual monetary policy normalization in developed markets, most exchange rates in the region will likely weaken moderately against the dollar in 2018. Still, domestic factors can play an important role in the exchange rate path, especially in countries holding elections (such as Brazil, Mexico and Colombia). In Argentina, the evolution of the reform agenda and a tight monetary policy support the peso, but the wide (and widening) current account deficit caps the room for significant further real exchange-rate gains, in our view. 

The friendly external environment is benefiting activity in the region, and a recovery is seen in most countries we cover. In Argentina, activity growth keeps gaining traction, and the recovery is broad-based. In Brazil, the 3Q17 GDP expanded by a weak 0.1%, but the breakdown is encouraging because it shows a robust expansion of consumption and gross fixed investment. On the other hand, in Mexico, the economy weakened in 3Q17, but this was mostly due to the impact of natural hazards. Looking ahead, a solid U.S. economy and a thriving labor market will likely sustain Mexico’s economic growth at around trend, as these factors offset the negative influence on investment exerted by uncertainty over NAFTA and domestic politics. 

In all, we expect higher growth rates in 2018 (relative to 2017) in Argentina, Brazil, Chile, Colombia and Peru. Mexico will likely grow at the same pace as estimated for this year. As is the case for exchange-rate forecasts, we note that elections and debate over reforms are a source of risk to our growth projections for Brazil, Chile, Colombia and Mexico.  

Monetary policy in the region remains mixed. Countries with inflation above the tolerance range around the target will likely tighten monetary policy further. Argentina’s central bank recently increased its policy rate by 250 bps, and we expect more rate hikes (of 100 bps) before the end of this year as inflation expectations continue to rise in the run-up to the key wage negotiation season. In Mexico, on a sequential (and seasonally adjusted) basis inflation has already fallen considerably, but it is falling slower than expected. Furthermore, facing uncertainties over NAFTA and presidential elections, the central bank of Mexico does not seem ready to decouple from the Fed, so we expect a 25-bp rate hike in December, matching the Fed’s move. Another 25-bp rate hike in early 2018 – together with the Fed – is also likely. Meanwhile, as growth disappoints and inflation performs better than expected, the Colombian central bank continues to cut interest rates, and we expect three additional 25-bp rate cuts. At the end of the day, the wide current account deficit combined with monetary policy normalization in the U.S. is not proving to be a binding constraint for further monetary easing in Colombia. In Brazil, we expect the easing cycle to end in the beginning of the year with 25-bp rate cuts in February and March, bringing the Selic rate to a record-low 6.5%. Given the sizable output gap, we do not expect rate hikes before 2019. Evidently, the outlook for fiscal reforms will be a key input for monetary policy in the coming years. In Chile, the central bank retains an easing bias, but the guidance should be read as an insurance against deviations of activity or inflation from the baseline scenario. In this context, we do not expect rate cuts in Chile. However, because we think that noise around elections can penalize more confidence/growth than exchange-rate/inflation, we can’t rule out more easing. Finally, in Peru, the central bank likely concluded its easing cycle in November. Given that activity is gaining traction, we do not expect more stimulus, but – similar to Chile – the benign recent inflation readings allow the central bank to react if growth disappoints. In fact, the central bank of Peru still holds an easing bias. 


 

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



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