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Stagnation fears

January 19, 2016

Recent market moves are a fresh reminder of the significant, ever-present, risks for the world economy.

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

Global Economy
New year?, old fears
Fears about growth in the global economy resurfaced as the CNY devalued against the USD and the Chinese stock exchange crashed. In the U.S., we expect a second rate hike by the Fed in March.

Hiking in a low-growth environment
Activity growth has been stable (at low levels) in some countries, improving somewhat in others and remains negative in Brazil. In spite of weak growth, inflation remains under pressure, forcing central banks in the region to tighten monetary policy.

A challenging fiscal and activity scenario continues
Economic activity continues to disappoint, suggesting that the recession will persist in 2016. The depressed economic activity makes the fiscal adjustment even more challenging.

Life post-devaluation
The new administration removed many exchange-rate controls in its first days in office, allowing for a sharp depreciation in the currency. The new central bank governor has allowed interest rates to rise and revealed plans to implement an inflation-targeting framework.

Growth picking up but challenges remain    
The economy continues to improve, mainly led by private consumption. However, the slow recovery of U.S. industrial production, the ongoing fiscal consolidation and low oil prices pose important challenges.

Stabilization at last?
With the growth rate hovering at around 2%,  we expect a modest recovery in economic activity in 2015 and 2017, insofar as copper prices recover.   

Supply-side recovery on track
We expect GDP growth in 2016. The increase in copper production and the anticipated rebound of subnational government investment coupled with the stabilization of private investment should help improve economic activity

A harder-to-adjust current account deficit
The latest fall in oil prices added to the already-wide current account deficit, putting additional pressure on the exchange rate. This will delay the convergence of inflation toward the target, likely causing the central bank to continue to raise rates.

We expect a partial reversal of the price declines
We forecast a partial recovery of international commodity prices by YE16. Our view is based on  an adjustment of the oil market in 2H16, lower future supply of commodities in China and a waning of “China risk” to around the levels seen in 4Q15.


Stagnation fears 

It has been an uneasy beginning of the year. The fixing of a more-depreciated yuan led to market turmoil, showing fears of a hard landing in China and global stagnation. Commodity prices dropped again, approaching the levels registered in the early 2000s. Stock markets and emerging-market currencies also fell.

The nervous market mood should be temporary. Economic data from China continue to indicate a gradual slowdown, while the fundamentals suggest some recovery in commodity prices going forward, particularly oil. However, recent market moves are a fresh reminder of the significant, ever-present, risks for the world economy.

Global uncertainties will not prevent the Federal Reserve from continuing to raise interest rates this year. The U.S. labor market is recovering steadily, despite moderate GDP growth. We expect a very gradual increase in interest rates, albeit faster than markets are pricing in.

Given the turmoil at the start of the year, currencies in Latin America depreciated earlier than expected. Now, we expect currencies to remain relatively stable at these new levels in Mexico, Chile and Colombia, notwithstanding the rate hikes in the U.S.

In Latin America, growth has stabilized at a much lower level than in the recent past. The exception is Brazil, where the recession has not yet reached a bottom.

The impact of currency depreciation on inflation remains a concern, forcing central banks to continue their policy tightening.

In Brazil, the scenario is complex. Economic activity continues to disappoint, suggesting that the recession will persist in 2016. The depressed economic activity makes the fiscal adjustment even more challenging. Inflation expectations continue to rise, reflecting fiscal uncertainties and a sharper adjustment in regulated prices. Although the recession is deepening, the central bank is signaling that once again it will raise its benchmark interest rate.

In Argentina, the new administration is working on correcting the economic distortions it inherited. The exchange rate depreciated rapidly following the lifting of many controls, as we anticipated. The central bank raised interest rates and announced that it will adopt an inflation-targeting regime. Although the economy will still suffer this year, we expect a gradual rebound in economic activity, with fewer distortions, starting in 2017.


Global Economy

New year‎, old fears

• Old fears about growth in the global economy resurfaced as the CNY devalued by about 1.5% against the USD and the Chinese stock exchange dropped by 17% YTD.

• China's economic data remains consistent with moderate, but slowing growth. Hence, the global risk-off from the start of the year is likely to recede. But the recent events remind us that concerns over hard landing risks may resurface from time to time.

• In the U.S., we expect a second rate hike by the Fed in March as the labor market remains strong 

• In the euro area, the recovery remains steady, while in Japan growth has been bumpy. In both regions risk to inflation remain to the downside and might require additional easing from the central banks.

Hard to stay confident about China

The new year started with a sharp global risk sell-off driven by concerns about global growth. Abrupt moves in the Chinese financial markets fueled these concerns: year to date, the CNY has dropped by about 1.5% against the USD and the Shanghai composite has fallen by 17%. In the U.S., the VIX has spiked to 27 (from 16 at the end of 2015) and the S&P 500 index declined by 8.5% at the worst moments of the month.

The risk-off episode mostly reflected fears about the Chinese economy. Regulatory changes, rather than weaker economic data, might have been the trigger for the sell-off in China’s equity market. But still, what matters most is investor confidence in China’s ability to manage its slowing economy.

Investors also look at policy decisions by Chinese authorities as signals about the state of the economy. A depreciation of the renminbi, for example, is read as a sign of weakness.

The uncertainty has been magnified by fears of global secular stagnation in the United States. U.S. GDP growth slowed to 1.00% qoq/saar in 4Q15 even as the non-farm payroll grew by an average of 284,000 jobs per month, highlighting the economy’s slow productivity growth.

In addition, oil prices have declined further, signaling a bigger energy supply glut. The WTI has fallen by a further 19% this year, to about USD 30.

‎‎Looking ahead, we continue to expect a moderate slowdown‎ in China, and we believe that the PBoC will keep the CNY fairly stable against a basket of currencies. ‎Capital outflows are putting pressure on the CNY at the moment but are likely to fade as investors gain confidence in the country’s new FX policy (see discussion below). Also, the PBoC has USD 3.3 trillion in international reserves to help it avoid major FX disruptions‎.

Hence, we believe that the New Year’s sell-off will subside soon.‎ ‎In addition, U.S. productivity is likely to rebound in 2016, and we expect oil prices to hit a floor of around USD 35 in 1H16 before rising to USD 52 by year-end. Both factors would contribute to improving sentiment toward the world economy over the course of the year.

However, as these recent events show, fears of a hard landing in China and worries about global growth are likely to resurface from time to time.

China – Renewed concerns may soon fade, but rebalancing risks remain

The new year started with another sharp global risk-off episode triggered by abrupt moves in the CNY and Chinese stock markets. The Shanghai composite fell by 7% on the first day of 2016, triggering a newly created trading circuit breaker, and has taken further losses since then. The PBoC has set the CNY fix 1.5% weaker since the beginning of the year, renewing fears of a sharp currency depreciation.

Investors also look at policy decisions by Chinese authorities as signals about the state of the economy. A depreciation of the renminbi, for example, is read as a sign of weakness. Still, the decline in asset prices appears disconnected from short-term economic indicators for now. In November, industrial production was up 6.2% yoy and retail sales grew by 11.2% yoy, slightly better than the respective 5.6% and 11.0% yoy growth rates seen in the previous month. Fixed investment growth improved to 10.8% yoy from 9.3% yoy in October, according to our estimates from official YTD figures. Finally, the PMIs suggest that underlying growth remained stable through December.

The renewed capital outflows seem rather to be a function of portfolio rebalancing caused by the recent changes in financial regulations by the Chinese authorities.

The PBoC changed its FX policy in mid-December. It now aims to stabilize the CNY against a basket of currencies (the CFETS Index) instead of mainly against the U.S. dollar. The move was well received at first but has since increased the ex-ante USD-CNY volatility, eventually leading to some capital outflows. In addition, some concerns have been raised about the real intentions behind the PBoC’s move. So far, the recent depreciation of CNY against the USD has been consistent with a stable CFETS Index (see graph), but it remains a source of uncertainty that is contributing to the global risk-off movement.

The sharp decline in stock prices was apparently triggered by investors’ anticipation of the scheduled end of sales restrictions that had been imposed on major shareholders. These restrictions on equity sales by major shareholders were put in place in July and August to limit the decline of stock prices from unsustainable levels.

Again, we think that the PBoC has the tools and the willingness to stabilize the situation, at least enough to reduce the “China risk” factor to 4Q15 levels. It has USD 3.3 trillion in international reserves to help it absorb capital outflows while maintaining a stable CNY against the basket of currencies mentioned above. In addition, stock price volatility will probably decrease as valuations become more attractive after the price correction. The equity price correction is unlikely to have a meaningful impact on consumption because the wealth effect in China is small.

Hence, we maintain our forecast that China’s GDP growth will decelerate to 6.3% in 2016 from 6.9% in 2015. China’s is likely to remain a two-speed economy this year, with stronger services/consumption growth and weaker industry/investment, as would be consistent with the rebalancing currently underway.

Nevertheless, the renewed capital outflows should be seen as a timely reminder of the risks of China’s current rebalancing act. The risk of a steeper deceleration remains material as the financial sector digests the misallocation of capital (excessive leverage of private corporations, bad governance of state-owned enterprises), while the government’s capacity to boost growth is diminishing by virtue of the same liberalization measures needed to achieve the rebalancing.

The recent rounds of increasing risk aversion seem to be symptoms of the structural imbalances in China’s economy. For example: the combination of artificially low returns for household savings with excessive liquidity caused stock prices to trade above fundamentals in 1H15. When the stock bubble burst, the government imposed sales restrictions to limit the decline. Finally, this year’s declines were triggered by fears of the upcoming withdrawal of some of these sales restrictions. Another example is the ongoing pressure from capital outflows, which can be partly attributed to former capital controls and to mis-investment of domestic savings.

U.S. – A second rate hike in March

As expected, the FOMC increased the federal funds rate range by 25 bps, to 0.25%-0.50%, in December, its first rate hike in a decade. In addition, the median of FOMC participants signaled that four rate hikes would be consistent with its economic forecasts for 2016. The FOMC’s 2016 economic forecasts are i) GDP growth of 2.4%, ii) the core PCE deflator at 1.6% and iii) the unemployment rate reaching 4.7%.

Economic activity and financial conditions have deteriorated since the December FOMC meeting, but the labor market remains strong and our outlook for the U.S. economy remains broadly unchanged. GDP growth probably slowed to below 2.0% in the second half of 2015. Financial conditions have also tightened a bit amid rising uncertainty about the economic outlook for China.

The recent economic slowdown in the U.S. is likely to be transitory, though. First, a one-off inventory correction likely subtracted some 0.6 pp from GDP growth in the second half of 2015. Second, a further decline in oil prices and more strengthening of the dollar have likely had some additional negative impact on investment and manufacturing activity. Those negative effects are likely to fade over the first half of 2016, while the lagging positive effects on consumption from low oil prices and the strengthening dollar are likely to kick in. Last but not least, the U.S. labor market remains quite strong. The non-farm payroll gained 284,000 jobs per month, on average, in the fourth quarter of 2015.

Hence, we have left our economic forecasts for the U.S. broadly unchanged – they remain close to the FOMC’s December median estimates – and we continue to foresee four rate hikes in 2016. We forecast real GDP growth of 2.2% in 2016, with the core PCE deflator up to 1.7% and the unemployment rate down to 4.6% by the fourth quarter.

In the short run, the economy’s progress towards the Fed’s goals is likely to be more than enough to justify a second rate hike at the March 16 FOMC meeting. The unemployment rate is likely to decline by at least 10 bps, to below 5.0%, while we expect the core PCE deflator to rise by 20 bps, to 1.5% YoY. This would justify a 40-bp rate increase based on the Fed’s standard historical reaction function.

Eurozone – Steady growth but low inflation

Eurozone economic activity remains on steady footing, supported by a positive outlook for domestic demand. This support is based on the ECB’s easy money policy, which has been leading to lower financing costs and some credit growth. Also, lower oil prices will continue to free up income for consumption and fiscal policy is likely to be marginally expansionary this year.

Low headline inflation will likely continue due to falling oil prices. A further decline in oil prices, with a rebound only likely in the second half of 2016, means that headline inflation is likely to hover just above 0% in the first half of the year. We expect base effects and slightly higher oil prices to lift inflation back above 1% in 2H16. Core inflation, in the meantime, is likely to continue its sluggish upward movement given the still-large amount of slack in the region.

The ECB has indicated that it will remain on hold after easing rates in December, but we think that this stance could change quickly if the inflation scenario deteriorates further. The ECB’s main actions in December – a 10-bp cut to the deposit rate, bringing it to -0.30%, and a six-month extension to the minimum duration of QE, to March 2017 – were (unusually for the ECB) disappointing to the market. Since then, the ECB has suggested that it will overlook the effect of recent oil price declines and would only react if it sees a more fundamental change to its inflation outlook. In our view, the main potential drivers of such a change would be economic activity flat-lining or a more pronounced decline in inflation expectations.

We have revised our year-end exchange rate projection for 2016 to 1.05 euros to the dollar (previously: 1.02), due to a less aggressive ECB, and we are leaving our 2017 forecast at 1.02 euros to the dollar. We are leaving all of our GDP growth estimates unchanged: 1.5% in 2015, 1.7% in 2016 and 1.6% in 2017.

Japan – Downside risks to inflation remain

Softer consumer spending in November has raised concerns about the momentum of Japan’s economic recovery. Retail sales and household expenditures contracted by 2.5% m/m and 1.8% m/m. We expect this downturn to be transitory, as consumer confidence remains at high levels and wages continue to rise gradually, but we have trimmed our forecast for 4Q15 GDP to 0.4% q/q saar (from 1.0%).

Despite a weaker fourth quarter, we continue to foresee above-trend growth gradually tightening the labor market and pushing inflation to the 2% target by 2017. Our GDP forecasts remained unchanged at 1.0% for 2016 and 0.9% for 2017.

However, in the event that the balance of risks worsens, threatening the annual wage negotiations (which start in April), the central bank could further ease monetary policy. In particular, the recent ongoing declines in commodity prices and inflation expectations have added more risk to the BoJ’s task.

Commodities – We expect a partial reversal of the price decline

Commodity prices have continued to lose ground since the end of November, declining by 11% over the period. The first driver of this trend was the ongoing oversupply in the oil market, exacerbated by OPEC’s lack of coordination, which caused Brent crude prices to sink by 33% and spilled over to affect other commodities as well. The second driver was the increased concern about China’s economy, which has affected all related assets since January 4.

Looking ahead, we forecast that aggregate commodity prices will rise by 27% from mid-January levels by the end of 2016 (mostly due to a 74% rebound in oil prices). Our scenario is based on three assumptions. First, the ongoing inventory buildup in the oil market will prompt additional declines in capex, reducing future supply and balancing the market by 2H16, even with increased exports from Iran. Second, the “China risk” priced into global assets will fall back to the levels seen in 4Q15 (see related section). And third, China will address overcapacity issues by withdrawing supply from the market through the shuttering of non-profitable mines and factories; such an adjustment is being discussed by key policymakers, and if executed will be supportive of iron ore, copper, aluminum and coal prices. 

Nevertheless, current prices reflect ongoing risks in hard commodities markets arising from China and the likelihood of a slower-than-expected supply cut in the oil market. 

Conversely, we see risks tilted to the upside in agricultural prices, given the potential for unfavorable weather conditions toward the end of the El Niño cycle. 



Hiking in a low-growth environment 

Exchange rates in Latin America have weakened further recently, as commodity prices continued to fall and uncertainty related to the Chinese economy prevails, and now with higher interest rates in the U.S.

Activity growth has stabilized (at low levels) in some countries, improving somewhat in others. But remains negative in Brazil.

In spite of weak growth, inflation remains under pressure, forcing central banks in the region to tighten monetary policy.

In Argentina, the macro-adjustments have begun, with the removal of many exchange-rate controls, a sharp depreciation of the peso and higher interest rates.

Lower commodity prices bring forward the depreciation expected for this year

Lower commodity prices, uncertainty related to China and, to a lesser extent, higher interest rates in the U.S. led to an additional weakening of LatAm currencies since December. The monetary tightening cycle in many countries and intervention helped to smooth the depreciation. Within LatAm, the Mexican peso was the underperformer, as oil is suffering more than other commodities. The Colombian peso was shielded by the expectation of capital inflows from the privatization of Isagen, so it did not underperform in spite of the wide current account deficit and the reliance of exports on oil. The Brazilian real continues to be influenced by the fiscal/political crisis.

We now expect exchange rates in 2016 to be slightly weaker than in our previous scenario in Chile, Colombia and Peru, while for Mexico and Brazil our forecasts are unchanged. Nevertheless, except for Brazil, exchange rates will likely end this year not very far from current levels, mostly because we expect commodity prices to recover (especially oil), offsetting the impact of higher interest rates in the U.S. For 2017, we see exchange rates broadly stable in real terms from the forecasted value for the end of this year.

Growth: stabilizing, except in Brazil

Economic growth has been steady in Colombia and Chile and improving gradually in Mexico and in Peru. But in Colombia, the ongoing monetary tightening cycle, the impact of higher inflation on real wages and the negative effect of oil prices on investment makes a slowdown likely. Mexico’s recovery has been based on domestic demand, but it will require the exporting sector to pick up too. In Peru, the maturing of mining projects, and the resulting impact on mining output, is the driver of higher growth, while non-primary sectors (that is, those more linked to cyclical factors) remain weak. In Chile, growth hovers around 2%. Finally, there is still no sign of a bottom for the Brazilian recession.

We reduced our growth forecast for Colombia this year, while in Brazil we expect the recession to continue. In Chile, Mexico and Peru our forecasts for this year are unchanged, which means a gradual recovery of activity, consistent with a modest pickup in global growth. In 2017, the economies in the region will benefit from higher commodity prices (versus average prices in 2016), and local economies are expected to perform somewhat better.

Inflation still under pressure

In most countries of the region, inflation rose further in December and ended the year above the upper bound of the target range. The high level of inflation is putting upward pressure on inflation expectations in Colombia, Peru and Brazil. In 2016, we expect inflation to fall, as exchange rates stabilize (or weaken much less than they did in 2015), the output gap remains negative and supply-side shocks currently affecting domestic prices (like El Niño in Colombia and Peru or the regulated price correction in Brazil) dissipate. Even so, inertia will prevent inflation from falling fast, so in 2016 inflation is unlikely to reach central bank target centers in most countries.

The exception is Mexico, where inflation kept falling recently and ended the year at the lower bound of the target – the lowest level on record. But inflation is unlikely to stay so low. Factors that could push inflation up include a lesser role of Telecom reform in disinflation, stronger effects on domestic prices from the weakening peso and higher inflation for agricultural items. We expect inflation to end both this year and the next at the center of the target (3%), which is low compared with Mexico’s past levels.

More rate hikes ahead

With exchange-rate weakening and uncomfortable levels of inflation, central banks are likely to raise rates. In Chile, Colombia, Mexico and Peru, the central banks raised the policy rate by 25 bps in December. In Colombia, the central bank hiked the rate every month since it began to raise rates and is not signaling a near-term end to the cycle. In Chile, the increase of the policy rate in December (the second in the cycle) surprised most market participants, but in the inflation report (published soon after the decision), the path for the policy rate assumed in the baseline scenario was not so different from the previous report. In this context, the central bank left the interest rate unchanged in January. The central bank of Peru also delivered a second hike since it started to increase rates in September and hiked again in January. Mexico’s central bank began raising interest rates in spite of an incipient recovery and record-low inflation as it tried to curb the potential impact of the Fed’s hike on the Mexican peso and, consequently, on inflation and inflation expectations. In the four countries, a tightening bias remains. In Brazil, the central bank left the policy rate unchanged in its last decision of 2015, but it is indicating that it could resume the hiking cycle.

We expect Brazil’s central bank to raise interest rates again sometime early this year (with two consecutive 50-bp rate moves), and we now see more rate hikes than we were previously forecasting in Chile, Colombia and Peru. In Mexico, our policy rate forecast for year-end 2016 continues at 4.0%, even though we were not expecting a hike in December 2015. In our view, Mexico’s central bank will try to desynchronize from the Fed in 2016 (we expect three 25-bp rate hikes in Mexico this year versus four hikes of the same magnitude in the U.S.). However, the willingness to detach from the Fed will depend on how the Mexican peso behaves.

Important adjustments in Argentina

In Argentina, Mauricio Macri took office in December, and the macro-adjustments have begun. The peso depreciated sharply as many exchange-rate controls were removed. The new central bank governor revealed plans to implement an inflation-targeting framework, and he let interest rates rise. A hike in energy tariffs is expected, and negotiations with holdouts are starting.

We view these developments as positive, although they are likely to be painful in the short term. A weaker currency will permit the economy to recover competitiveness, while the elimination of exchange-rate controls improves business confidence, increases the supply of intermediate and capital goods and whets the appetite for Argentinean assets. Following the recent devaluation, we expect the real exchange rate to remain broadly stable from year-end 2015 levels.

Inflation is set to remain high in the coming months due to the pass-through of the depreciation and the adjustment in utility tariffs. As the central bank fights inflation, interest rates will also remain high for some time. We expect the economy to fall 0.5% in 2016 (down from a revised forecast of 1% in 2015) due to the impact of the relative price adjustments (energy and the exchange rate) on real wages, as well as a tighter monetary policy.

The adjustments will set the base for a recovery, with low imbalances. We expect a 3% GDP expansion in 2017, with lower inflation.


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


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