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Risks that alert

July 15, 2015

The Greek crisis and the correction in the Chinese stock market are reminders of the risks still surrounding the global scenario.

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

Global Economy
A month to remind us about risks
The Greek crisis and the correction in the Chinese stock market are reminders of the risks still surrounding the global scenario. Higher volatility and the chance of lower global GDP growth add downward risks to EM growth in general, including Latin America.


LatAm
Struggling to recover
The LatAm economies are facing the challenge of recovering from weak activity in a global context that includes Chinese deceleration, commodity price corrections and the prospect of higher interest rates in the U.S.


Brazil
Recession continues
Economic indicators suggest that the decline in activity may be longer, and steeper, than we expected. There are signs that the economy is reacting to the economic policy shift. But many challenges remain, especially on the fiscal side.


Mexico
Rate hikes only after the Fed
The Central bank announced a change to the calendar of its monetary policy meetings, so the board will now announce its decisions right after the Fed’s. Despite the calendar synchronization, we believe that the central bank will start its tightening cycle only in 1Q16, after the Fed’s liftoff in December.  


Chile
A further deterioration in the growth-inflation trade-off
Amid higher-than-expected inflation and lower-than-expected growth, we continue to anticipate no policy rates changes, both this year and in 2016.


Peru
The public expenditure drag
We expect a modest economic recovery this year, and some acceleration in 2016. The pickup will most likely be supported by improved natural resource activity. Fiscal stimulus will also help, but for now public expenditures have been a drag on growth.   


Colombia
Growing impatience over the peace agreement
The Colombian peso underperformed most currencies, due – in our view – both to lower oil prices and the wide current account deficit. Approval of a peace deal dropped, as negotiations are taking much longer than initially anticipated.


Argentina
Casting a long shadow?
Even though President Kirchner has decided not to run for any post in October elections, she could remain influential in a potential Scioli administration through Carlos Zannini, the appointed vice-president candidate.    


Commodities
Downside risks to oil prices; upside risks for grains
Metal and oil prices have fallen sharply in recent days, reflecting both supply and demand factors. We have lowered our price projections for some metals and see downside risks to our oil-price forecast. We have not changed our forecasts for agricultural prices, but we recognize that the unfavorable weather in the U.S. poses (upside) risks.


 


Risks that alert

The global scenario has become more complex. In Europe, the Greek crisis, even if the worst is averted, highlights the incomplete institutional framework of the monetary bloc. At the same time, the significant volatility of Chinese stock market indicates risks to the smooth rebalancing of the economy,  although it still remains the most likely scenario.

In the U.S., the Fed will most likely start hiking rates this year (probably in December), as a result of more consistent economic recovery.

In this environment, prices for commodities such as oil and iron ore declined again, particularly affecting Latin America. The result is weaker activity and currencies in the region.

The Latin American economies have already decelerated in the recent past. Economic conditions in Chile, Colombia and Brazil deteriorate even further in the second quarter of this year.

Currencies in the region depreciated, especially the Colombian peso, which reacted to the drop in oil prices and the high current account deficit.

As for LatAm monetary policy, we do not expect significant changes this year. Most central banks will probably keep interest rates stable (Chile, Colombia, Mexico and Peru), while Brazil’s central bank will likely end its tightening cycle.

In Brazil, the economic indicators suggest that the decline in activity may be longer, and steeper, than we expected. The recession impacts government revenue, which makes the fiscal adjustment more difficult. Inflation remains under pressure this year, still affected by the correction in regulated prices.

There are signs that the Brazilian economy is reacting to the shift in policies. The current account deficit has been narrowing and long-term inflation expectations have been converging toward the target. However many challenges remain, especially on the fiscal side.

In Argentina, the ruling party's candidate, Daniel Scioli, and his vice president, Carlos Zannini, continue to lead the polls for the presidential elections in October, which could enable the current president to have some influence in the future. Nonetheless, we expect that the new government will have to depreciate the exchange rate in real terms and make changes in monetary and fiscal policies next year.


 


Global Economy

A month to remind us about risks

• Greece is finally moving towards a deal after coming close to a euro exit. This risk should fade in the short term without a significant impact to euro-zone growth. However, medium-term risks remain, and the crisis reminds us of the peril of an incomplete framework for the monetary union.

• A correction in the Chinese stock market is underway. It will likely not impact growth, but it is a reminder of the financial imbalances in the country.

• Oil and iron ore prices fell 10% and 21% in the past weeks, respectively. Although there ‎are idiosyncratic factors behind these declines, it is a reminder that global growth is not what it used to be. 

• These events also affect the balance of risks for the U.S. Fed. It remains a close call between September and December, but now we expect the Fed to wait until December to raise‎ rates despite better economic data.

• Higher volatility and the risk of lower global GDP growth add downward risk to EM growth in general, including Latin America.

U.S. – Economic data remains positive, but the Fed might wait until December

The U.S. GDP is on track to expand 3% qoq/saar in 2Q15.Consumption growth is rebounding, to 3% qoq/saar from 2.1% in the first quarter. Non-residential investment (ex-oil) has accelerated to a modest pace and should improve further, supported by consumption. In the oil industries, there have been tentative signs of stabilization. Residential investment growth has accelerated and exports appear to have stabilized.

We maintain our GDP forecasts unchanged, at 2.4% for 2015 and 2.5% for 2016.

Net job growth remains above 200 thousand per month and the unemployment rate resumed its decline. In the first half, the non-farm payroll growth has averaged 209 thousand per month, consistent with declining unemployment rate, which in turn ended the first half at 5.3%, on the high end of the FOMC central tendency forecast (5.2%-5.3%) for the fourth quarter (see graph).

Core inflation remains firmer as the pass-through from the FX-rate appreciation gradually fades, but it is comfortably below the 2% target.The core PCE deflator rose 0.13% month over month in May and 1.6% annualized over the past three months, but it declined to 1.2% in the last twelve months.

We now believe the FOMC might wait until December to raise interest rates, but there is a chance it could come as early as September. In the June 16-17 meeting, the FOMC’s interest rate forecast “dots” indicated that voting members are evenly split between one and two rate hikes in 2015, so September and December are likely possibilities. We have become slightly more inclined to believe it will be December, because risks to the global economy are still tilted to the downside (as indicated by Greece, the correction in China's stock markets and falling commodities prices). This slightly shifts the balance of risks to the U.S. economic outlook. Since the inflation outlook remains benign, the Fed might opt to wait a little longer.

Europe – Deal in the making, but Greek drama reminds us of risks

Euro-zone leaders came to an agreement with Greece after six months of negotiations and are in the initial stages of implementation.With the country on the brink of a banking implosion, Greek Prime Minister Alexis Tsipras finally conceded to most of his creditors’ demands, but only after a hastily organized referendum, which has shown that more than 60% of the Greek population is against further fiscal austerity. The opposition parties are in favor of a deal, so the third bailout program agreed upon this weekend is likely to go through, reducing the chance of Grexit.

However, there remains a significant implementation risk in the medium term.The Greek government still has to push through a lot of unpleasant measures, including fiscal adjustments, structural reforms and privatization in a very difficult economic environment. Normalization will take some months following the introduction of capital controls and several days of bank closures, but at least the Greek government is headed in the right direction.

The long Greek drama reminds us of the risks inherent in the euro-area countries, given the incomplete institutional framework, especially the lack of a fiscal union.Although the likelihood of a scenario similar to that of Greece being repeated in other, larger countries (like Spain) seems low, radical parties in many countries have gained traction. A Grexit seemed like a very real possibility until a few days ago, and had it occurred, it would have shown that the euro-zone is not irreversible. In the future, another country in the euro area will likely fall into recession, and the threat of a euro exit then will weigh heavily on investors’ minds.

In the short run, this risk looks low because Spain, Portugal and Ireland are growing at a good pace after a period of contraction and adjustment.Even Italy has started to grow again this year. So the Greek crisis looks unique and particular to Greece. Moreover, the region has backstops, and we expect the ECB to respond with more asset purchases if something goes wrong and there is contagion. 

Activity data, financial conditions and general economic confidence have been generally resilient despite the situation in Greece, so we expect limited economic impact. We maintain our euro-zone GDP forecasts at 1.6% for 2015 and 1.9% for 2016.

Japan – Moderate growth on track

Activity data is in line with our scenario of moderate growth in Japan. Consumption resumed its gradual recovery, with retail sales up 1.7% mom in May. Investment has been strong, and firms reported a more optimistic assessment of the economy in the 2Q Tankan survey.

We expect the trend to continue. Wage hikes and the depreciated yen create conditions for firmer consumption and investment ahead.‎

We maintain our GDP forecasts unchanged, at 0.9% for 2015 and 1.6% for 2016.

China – More easing amid recovery and equity market correction

Economic activity continued to recover throughout 2Q15. Sequential GDP accelerated to 7.0% qoq/saar from 5.7% qoq/saar in 1Q15. 

A correction in the equity market is underway, reminding us of the financial imbalances in China. The Shanghai and Shenzen composite indexes declined 24% and 32% (see graph) respectively since June 12, following a rally that repeated the 2006-07 pattern and led prices to levels well above fundamentals. The excesses of China’s financial (and property) markets has been a constant source of risk, as part of the liquidity provided by the PBoC flows away from traditional bank deposits/loans looking for higher returns.

The government provided more stimuli to stabilize the economy (and stock prices). The PBoC announced both a 25-bp benchmark interest rate cut and a 50-bp required reserve ratio cut. Unlike the previous three rate cuts, this 25-bp rate cut was symmetrical, so it does not reduce the bank’s net interest margin and may have a greater effect on credit growth. The government also made regulatory adjustments to boost credit growth for small banks by scrapping the loan-to-deposit ratio ceiling. Finally, state-owned funds bought domestic ETFs, and the regulatory agencies tightened some short sale operations to smooth the ongoing correction in stock prices.

The targeted measures to help the stock market were not able to prevent a correction. The apparent failure to control the market is another signal that the capacity of the government to control the economy is being reduced as the economy gets more complex.However, the drop in stock prices is unlikely to impact economic growth, as the wealth effect is lower than in advanced economies, equity financing is not a major source of funding for the corporate sector and banks’ stocks were not affected by the recent volatility.

We believe monetary stimuli are less effective than in the past, but they are likely to be enough to maintain GDP growth around 7.0%-7.5% qoq/saar in 3Q15.Credit growth has been weak, given the monetary stimuli so far, possibly because of the already excessive leverage of the corporate sector. Nevertheless, the set of stimuli is enough to provide a modest recovery. 

Despite this mid-year improvement in growth, we maintain our below-consensus 2015 GDP growth forecast at 6.7% (consensus: 7.0%).

Emerging Markets – Another global shock would hurt their already weak growth prospects

Growth in emerging markets has already been lackluster and would suffer with another shock to the global economy. The emerging market purchasing manager's index, excluding China, has declined since the beginning of the year and is now below 50, which is the contraction-expansion threshold (see graph). Given this fragility, another shock to global growth would dent the prospects of a recovery in emerging markets. 

Commodities – Downside risk for oil prices; upside potential for grains

The Itaú Commodity Index (ICI) has declined 1.0% since the end of May, with a mixed performance across its three components. The overall decline was caused by plummeting metal prices (-11%) and oil-related prices (-8%) due to rising macroeconomic risks on Greece-EU and China. The move outweighted a sharp gain in agricultural commodities (+15%) on weather-related issues. We lowered our forecasts for the ICI-metals sub-index, recognizing no room for a sizable rebound in aluminum, nickel or tin prices. Our new scenario assumes a 5.7% increase from current ICI levels until year-end.

Metal prices plummeted recently, driven by both demand and supply factors.The demand outlook worsened, with rising woes in Greece, potentially lowering GDP growth in the eurozone and strengthening the USD against other currencies. Risks stemming from the stock selloff in China also increase risks of lower demand ahead. On the supply front, a rebound in iron ore exports from Western Australia led prices to decline further.

Both higher-than-expected production in the U.S. and the nuclear deal between Iran and the P5+1 caused a decline in oil prices.We see downside risk to our oil scenario, as there are signs that the efficiency gains in the U.S. and more supply from OPEC countries could shift medium-term equilibrium prices to lower levels.

Grain and soybean prices rose noticeably in the last few weeks due to supply in the U.S.Excessive rainfall has affected soybean planting and winter wheat harvesting, and it could hurt yields in the former two commodities, plus corn. However, it is difficult to estimate the overall impact before the harvest. Therefore, the recent rally implies a higher probability of a stress scenario (sizable crop losses and deficit in the global balance), but prices may recede to previous low levels if the crop loss is not intense. We maintain our forecasts, assuming that the impact is small, but we see material upside price risks to our scenario if the stress scenario materializes.

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



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