Itaú BBA - Recovery across LatAm

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Recovery across LatAm

October 5, 2017

The benign external environment is now fueling activity in LatAm more clearly.

Please open the attached pdf to read the full report and forecasts.
Global Economy
Rising uncertainty in a still-favorable global environment
The global economy continues to perform well, while business surveys indicate upside risks to growth. In the U.S., the odds are rising that Congress will pass a fiscal package that could give a small boost to growth. U.S. interest rates will likely adjust to this scenario.

LatAm
Recovery across the region
The benign external environment is now fueling activity in LatAm more clearly.

Brazil
Falling inflation paves the way for marginally lower interest rates
Well-behaved inflation and the latest central bank communications led us to reduce our estimate for the terminal Selic rate to 6.5% from 7.0%.

Argentina
A stronger government faces challenging imbalances
The ruling coalition (Cambiemos) is well positioned for the mid-term elections. With enhanced electoral power and an increased representation in Congress, the government will push for reforms and other measures to reduce the fiscal deficit.

Mexico
After the earthquakes
Growth surprised to the upside in 1H17, but recent earthquakes could be a (temporary) drag on GDP growth in 2H17, posing downside risk to our 2.3% growth forecast for 2017.

Chile
No further rate cuts
We revised our interest rate forecast to 2.5% by year-end (same as today), from 2.0%, as board members do not see the need for further easing, while activity starts to recover.

Peru
GDP gains traction amid fragile political situation
The good news is that GDP growth is gaining traction, but, for the first time in history, The Congress has ousted the whole ministerial cabinet. Increased confrontation between government and Congress compromises the implementation/approval of reforms.

Colombia
Signs of recovery in activity
Activity is improving at the start of 3Q17, and higher real wages, lower interest rates and stronger global growth will help support the economy going forward. We expect 1.6% GDP growth this year and 2.5% in 2018.

Commodities
Reality check for metal prices
Commodity prices increased in September, as the rise in agricultural and energy prices compensated for the drop in metal prices. We forecast iron ore prices at USD 60/mt and copper prices at USD 5,700/t by the end of the year.


Recovery across LatAm

Global economy activity continues to perform well, and business surveys indicate that there are upside risks to growth. In the U.S., the odds are rising that Congress will pass a fiscal package that could give a small boost to growth. U.S. interest rates will likely adjust to this scenario. Who will lead the Fed next year is still unknown, but the final choice will likely be neutral. In the euro zone, the political risks seem modest, while the cyclical recovery is firming up. In China, the slowdown is manageable and 19th Party Congress is unlikely to change this scenario. North Korea remains the main risk to the global outlook.

The benign external environment is now more clearly fueling activity in LatAm. In Brazil, growth is becoming widespread, in line with an acceleration towards the end of this year and into 2018. In Mexico, growth surprised to the upside in 1H17, but recent earthquakes could be a (temporary) drag in 2H17. In Chile and Colombia, activity is showing signs of improvement in 3Q17. Still, there is slack in the economy that is unlikely to disappear soon, so there is no imminent demand-side inflationary pressure, while currency appreciation is helping to bring tradable-price inflation down. Accordingly, the central banks of Brazil, Colombia and Peru will likely engage in further monetary easing in the near term. Conversely, we do not expect further rate cuts in Chile, and the central banks of Argentina and Mexico will likely wait before engaging in further easing.

In Brazil, the increase in extraordinary revenues and the economic rebound should allow the government to meet its fiscal targets in 2017 and 2018. We revised our forecast for the exchange rate to 3.25 reais per U.S. dollar by YE17 (from 3.35), given the recent behavior of foreign currency flow. Our call for YE18 remains at 3.50. We reduced our forecast for inflation to 3.0% from 3.2% in 2017 and to 3.8% from 4.0% in 2018. Well-behaved inflation and the latest Central Bank communications led us to reduce our estimate for the terminal Selic rate to 6.5% from 7.0%. We lifted our forecast for GDP growth in 2018 to 3.0% from 2.7%, due to even-lower interest rates. Our estimate for 2017 remains at 0.8%. 


 


Global Economy
Rising uncertainty in a still-favorable global environment

• Business surveys indicate that there are upside risks to global growth.

• In the U.S., the odds are rising that the Congress will pass a fiscal package that could give a small boost to growth. U.S. interest rates will likely adjust to this scenario. 

• Who will lead the Fed next year is still unknown, but the final choice will likely be neutral.

• In the euro zone, the political risks seem modest, while the cyclical recovery is firming up. 

• Japan’s PM Abe is likely to win the snap congress election scheduled for October 22, but he could lose some support in the house, which could jeopardize the continuation of his economic agenda.

• In China, the slowdown is manageable and the 19th Party Congress is unlikely to change this scenario.

• Emerging markets have seen an improvement in current accounts, a fall in inflation and, as consequence, lower interest rates. All allow for a better growth outlook ahead. 

• North Korea remains the main risk to the global outlook.

Business surveys indicate that there are upside risks to global growth

The manufacturing cycle remained favorable in September. The Global PMI rose to 56.1 in September from 55.3 in August – well above the neutral threshold. The rise was synchronous across all the main regions (U.S., Europe, China, Japan, EM ex-China). In fact, the current PMI is the highest since February 2011.

The PMI level suggests that there are upside risks to global growth. World GDP is currently growing at a 3.6% pace. The PMI reaching 56 suggests that growth could accelerate to above 4.0% in the next few quarters (see chart). 

U.S. – Renewed chances of fiscal stimulus 

The higher probability of a tax reform bill being passed, coupled with better inflation news, may lead to a modest additional correction in U.S. Treasury yields and the USD. A modest fiscal stimulus would likely reduce the downside risks to the 2018 growth outlook. Hence, if inflation continues to normalize, Fed funds futures would likely price in three additional rate hikes by the end of 2018, more than the two hikes currently expected, but still short of the FOMC’s median dots of four hikes. 

U.S. GDP is on track to grow by a solid 2.6% SAAR in 2H17, up from 2.1% in 1H17, despite a severe hurricane season. Consumption may grow by 2.5% in 2H17 (2% in 3Q17 and 3% in 4Q17). Confidence levels at home and abroad continue to point to solid 5% growth in non-residential investment and exports. Inventory accumulation is another positive contribution for 2H17. Real estate (6.5% of GDP) and vehicle sales (2.5% of GDP) are underperforming, but post-hurricane rebuilding might also boost durables and construction spending in the next few quarters. 

This above-trend GDP growth will continue to tighten the labor market. GDP growth running at about 2% is consistent with net payroll changes of 175,000 per month and the unemployment rate declining to 3.9% by the end of 2018 – compared with a NAIRU of 4.6%. 

In this scenario, inflation will probably rebound from its soft patch. The September inflation figures were mixed, with a higher CPI but PCE still on the weak side. Nonetheless, tightening labor markets will eventually put upward pressure on wages and inflation. We still expect the core PCE deflator to rise to 1.9% yoy in 4Q18.

Fed Chair Janet Yellen continues to indicate that gradual rate hikes are likely. Of course, Yellen admitted that there is a risk of inflation model misspecification, and if low inflation persists, the Fed may adjust its rate-hiking path. A few more firm underlying inflation figures are still needed to increase confidence that the inflation outlook is broadly consistent with the Fed’s views.

In parallel, a tax cut is likely to further reduce the downside risks to the U.S. economic outlook. Congressional Republicans are likely to pass a budget resolution by the end of October that is consistent with the recent Senate draft, allowing for an increase in the Federal deficit of USD 1.5 trillion over 10 years (0.6% of GDP per year). If this tax cut is focused on corporate taxes, it would have a relatively small multiplier (0.3) and thus would likely raise GDP by a small 0.2 pp, lowering the unemployment rate by 0.1 pp by the end of 2018. This would make it more likely that the Fed would deliver its four rate hikes until the end of 2018, but it would not change our outlook on U.S. monetary policy.

Who will be chosen to be the next Fed Chair is uncertain, but the final choice will likely be neutral. President Trump will likely choose by late October. There is not a single hawk in the list of candidates released by the press, which includes: i) Janet Yellen, the current Chair of the Federal Reserve; ii) Gary Cohn, Chair of the National Economic Council; iii) Jerome Powell, a current Federal Reserve Board Governor; and iv) Kevin Warsh, a former Federal Reserve Board Governor.

Europe – Firming growth amid political noise

Euro-zone business surveys indicate that growth remained solid in 3Q17. The Composite PMI increased to 56.7 from 55.7 in September. The survey suggests that the region’s GDP growth likely remained close to 0.5% qoq in 3Q17.

With a better economic outlook, we expect the ECB to announce a reduction in its asset purchases at its October meeting. We expect the ECB to reduce its monthly asset purchases to EUR 40 billion (from EUR 60 billion) in 1H18.

Angela Merkel’s reelection as Germany’s Chancellor is a source of stability. Voter support for her CDU/CSU party and the center-left SPD was weaker than in previous elections. As a consequence, a grand coalition between these two factions is no longer viable, and Merkel will likely end up leading a three-party coalition (CDU/CSU+FPD+Greens). Forces in this coalition could slow – but are unlikely to halt – a Merkel/Macron push for further integration in the European Union. 

The Catalonian independence movement and EU-UK Brexit negotiations are sources of uncertainty for the euro zone. But none seem to pose an immediate risk to the region or to the global economy. We continue to view Italy’s election next year as the biggest downside risk in Europe.

We maintain our euro-zone GDP forecasts of 2.0% and 1.7% for 2017 and 2018, respectively.

Japan –Abe is likely to win the election, but he could lose some support in the house

Prime Minister Shinzo Abe has called a snap parliamentary election for October 22. He aims to bolster his political power amid improved polling (after a cabinet reshuffle) and heightened tensions between Japan and North Korea.

PM Abe’s coalition, which comprises the Liberal Democratic and Komeito parties, is likely to attain a simple majority. The risk that new Party of Hope leader, Yuriko Koike, decides to run and win the election seems small. Koike has repeatedly denied that she will enter the competition race (the deadline to decide is October 10).

The main risk is that, although winning, Abe’s coalition loses some support in the congress. Abe need 233 seats to hold the simple majority in the house (currently he has 287). If the number of seats drop by more than 30 it could signal Abe’s weakness and question his economic agenda. The chance of a change in the ultra-loose BoJ stance would rise and Kuroda might not be reappointed when his term end in April/2018.

China – A manageable slowdown

Economic activity in China continued to slow in August. Industrial production fell by 0.4 pp, to 6.0% yoy, while year-to-date fixed investment came in at 7.8% yoy and retail sales growth decelerated to 10.1% yoy. On the other hand, both house sales and new housing starts showed modest improvement in the month. Credit data continued to show a deceleration in the “alternative” products segment, while new loans to households and corporations remained at robust levels.

We believe that the Chinese economy will continue to slow in 4Q17, but with controlled risks. A gradual economic slowdown in China is unlikely to affect global markets as much as it did in 2013-16, for several reasons. First, the economy is slowing from a strong pace of growth in 1H17. Second, the slowdown stems from tighter economic policy, which can be adjusted to smooth the process. Finally, capital outflows have diminished because of stiffer internal controls, the better-adjusted RMB and the global weakness of the U.S. dollar.

The 19th Party Congress, which will take place on October 18, is unlikely to produce a sharp change in policy or trigger a steep economic slowdown. First, the party leadership reshuffle will likely not be complete until March of next year and is expected to be relatively smooth, as President Xi has been consolidating his power. Second, policy has already been tightened as the government seeks to control financial risks, and we do not see any clear signs that it will have to be tightened further.

Our GDP growth forecasts for China remain unchanged at 6.7% in 2017 and 6.3% in 2018.

North Korea – The biggest risk to the global outlook

The possibility of a military conflict between North Korea and the United States has become a present risk, given that North Korea is close to becoming – if it is not already – a full-fledged nuclear power. Year-to-date, North Korea has successfully tested two intercontinental ballistic missiles (ICBMs) and an underground hydrogen bomb. U.S. intelligence agencies are said to believe that North Korea can now miniaturize a nuclear warhead.

In response, the United States and the United Nations have significantly increased the economic sanctions on North Korea for not complying with U.N. non-proliferation resolutions. In addition, President Trump has threatened a strong military response if North Korea attacks any U.N. ally.

North Korea is quite unlikely to end its nuclear program in response to the U.N. economic sanctions, as its leader, Kim Jung Un, likely fears regime changeif he acceded to U.N. demands. Many analysts believe that Kim wants North Korea to be recognized as a nuclear power (like India and Pakistan) so that his regime can extract better economic concessions in a future deal with its adversaries, an implausible scenario. On the other hand, Kim is also unlikely to purposely attack, which would give Trump an excuse to attack him back. 

However, there is a present risk that some miscalculation will lead to a military conflict that could cause real economic damage not only to the Asian region, but to the world. 

Emerging Markets – In better shape

We see three reasons why emerging markets today are in better shape to handle corrections in U.S. yields.

First, their current accounts have improved in the past few years. These improvements have occurred mostly in CEMEA and LatAm (see chart). With better current accounts, the risk of currency depreciation is smaller. 

Second, the EM-DM interest rate spread is falling as a result of the decline in EM inflation (see chart). The fall in the EM-DM inflation gap reflects not only the recent strength of EM currencies, but also good policy by central banks in several emerging-market countries, which have focused on bringing inflation closer to targets. 

Finally, the decline in inflation has allowed interest rates to fall, which is starting to support better growth. The stabilization in commodity prices has also helped. Financial inflows to EM usually rise in line with a better EM-DM growth differential (see chart). As long as the process of interest-rate increases in developed countries remains gradual, inflows to EM are likely to continue.

Commodities – A reality check for metal prices

The Itaú Commodity Index (ICI) has gained 1.6% since late August. The index was boosted by its agriculture (2.9%) and energy (9.5%) subcomponents. Metal prices moved in the opposite direction, falling by 8.9%.

Fine-tuning our metal price forecasts. After a two-month rally, metal prices dropped in September, in line with our scenario. We maintain our year-end iron ore price forecast of USD 60/mt. For copper, we have slightly raised our year-end price forecast to USD 5900/mt (from USD 5700/mt). Nonetheless, we still forecast a 7.5% decline in the ICI Metals index as the Chinese economy continues to decelerate in 4Q17.

We are also tweaking our Brent and WTI year-end forecasts, raising them slightly. Oil prices recovered in September as the effects of hurricanes Irma and Harvey dissipated. We still estimate that WTI prices in the range of USD 45-50/bbl could stabilize the U.S. rig count and help to balance the market in 2018. Due to the recent recovery in oil prices, we have slightly raised our year-end price forecasts for WTI (to USD 47/barrel from USD 45/bbl) and Brent (to USD 49/bbl). For 2018, we maintain our forecasts of USD 45/bbl for WTI and at USD 47/bbl for Brent. We note that oil stocks remain well above their five-year average, which is likely to limit the current rally in oil prices.

Agricultural prices recovered in September on lower wheat inventories and some uncertainty about corn and soybean supply. We have left our price forecasts unchanged (projecting only small increases from current levels).


 


LatAm
Recovery across the region

• The external environment remains benign and is now more clearly fueling activity in LatAm. 

• Still, there is slack in the economy that is unlikely to disappear soon, so there is no imminent demand-side inflationary pressure, while currency appreciation is helping to bring tradable-price inflation down. Accordingly, the central banks of Brazil, Colombia and Peru will likely engage in further monetary easing in the near term. Conversely, we do not expect further rate cuts in Chile, and the central banks of Argentina and Mexico will likely wait before engaging in further easing.

In spite of some deterioration in September, LatAm asset prices continue to benefit from a benign external scenario of higher commodity prices, still low interest rates and accommodative financial conditions and, not least, strong growth in developed countries. Current account deficits are lower than historical norms in many of the region’s economies, helping to support their currencies. The exceptions are Colombia and Argentina: the former’s deficit has recently stabilized but is still high, while the latter’s external deficit has now widened to concerning levels, limiting the room for further inflation-adjusted appreciation of the Argentine peso.

As monetary policy normalization continues in the U.S., some weakening of LatAm currencies is likely. Besides monetary policy abroad, LatAm currencies are susceptible to domestic risks. Elections in Chile, Brazil, Colombia and Mexico could trigger volatility. With regard to Argentina’s upcoming midterm elections, a positive outcome for the government seems to be already fully priced in; the markets will now likely focus on how the government uses its political capital to correct the fiscal deficit, which would also help to reduce the economy’s other two major imbalances: high inflation and a wide current account deficit. 

The activity recovery in the region is now more broad-based. The recoveries in Brazil and Argentina continue to gain traction, while in Mexico the economy has shown resilience to the uncertainty over trade relations with the United States – although the recent earthquakes do not help. Now, there is also evidence that activity in Chile, Peru and Colombia is picking up. 

Still, economic slack persists and is not expected to disappear soon, so there is no demand-side inflationary pressure, while currency appreciation is helping to bring tradables inflation down. The dissipation of food-supply shocks is also helping in some countries. Inflation rates are above the range around the target only in Argentina and Mexico, although the latter’s price dynamics at the margin are encouraging. 

In this context, the central banks of Brazil, Colombia and Peru will likely engage in further monetary easing in the near term. Conversely, we have removed rate cuts from our scenario for Chile, as the economic recovery is coming at a time when its central bank is already reluctant to deliver more stimuli. In Argentina, inflation remains stubbornly high and the central bank has reaffirmed its commitment to ambitious inflation targets, so we no longer expect rate cuts, at least until the beginning of next year. Meanwhile, in Mexico, the guidance from the central bank suggests that monetary easing is unlikely in the near term: the board continues to emphasize that the interest-rate differential with the U.S. will be an important variable in its upcoming decisions, which – given our forecast of Fed rate hikes – means less room for interest-rate cuts in Mexico. The potential for volatility amid the NAFTA renegotiation and ahead of Mexico’s presidential election will likely also prompt board members to adopt a cautious approach. Finally, the fact that growth in Mexico is around potential, with little evidence of economic slack, as suggested by low unemployment, lessens the urgency of stimulating the economy.

 

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



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