Itaú BBA - Still favorable global environment

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Still favorable global environment

May 6, 2016

The external environment remains supportive for Latam currencies.

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

Global Economy
Global environment remains supportive for emerging markets

The recent appreciation of emerging market currencies seems appropriate because it reflects the stability in China, commodity prices that have reached a bottom, and a cautious U.S. Fed that is taking into account the global environment.

LatAm
Extended relief

The external environment remains supportive for Latam currencies. We now expect stronger exchange rates than estimated in our previous scenario. Low growth and the exchange-rate evolution in the region suggest continued disinflation and a stable monetary policy stance.

Brazil
Fresh efforts to push through adjustments and reforms

We expect fresh efforts to push through reforms and adjustments in the months ahead. It is not enough to avoid recession this year, but we increased our forecast for the primary surplus and GDP growth for 2017.

Argentina
Turning the page on default

The government paid the holdouts after issuing bonds for a record USD 16.5 billion in the international markets. We expect GDP to contract this year due to the adjustment in relative prices, but to recover in 2017.

Mexico
Reducing the fiscal deficit

The Mexican economy continued to grow at a moderate pace in 1Q16. The government announced new expenditure cuts, in response to rising net public debt.

Chile
The debate on labor reform goes to the justice

We expect the economy to grow 1.8% this year, as the economy is affected by poor confidence and low copper prices. The labor reform bill was finalized, but parts of it were deemed unconstitutional by the highest court in the country.

Peru
A political lift

The presidential election will be decided in a run-off on June 5. The available polls show Keiko Fujimori and Pedro Pablo Kuczynski statistically tied. Both candidates are welcomed by the markets.

Colombia
Higher inflation, more monetary tightening

As inflation continues to rise, the central bank increased the pace of rate hikes to 50 bps, bringing the policy rate to 7.0%. We now expect the tightening cycle to end with the policy rate at 7.5% (vs. 7% in our previous scenario).

Commodities
Agricultural prices go up

Commodity prices continued to climb, still driven by a favorable macro environment. Prices for crude oil, iron ore, corn and soybeans rose more sharply due to specific factors. We expect additional gains in crude oil prices and lower prices for iron ore.


 


Still favorable global environment

The environment remains auspicious for emerging markets.  The Fed has signaled it will not raise interest rates until it has greater confidence that global risks are subsiding.  There is less pessimism over China’s performance, as the economy is now in a cyclical, investment-driven acceleration. Commodity prices have recovered in a move apparently backed by fundamentals (except iron ore, the price of which may fall back).

In this environment, we now expect stronger exchange rates than estimated in our previous scenario. Economic activity has been stabilizing throughout the LatAm region, although it is still weak.  With low growth and less pressure on exchange rates, the balance of risks for inflation improves.  We expect no further rate hikes in Chile, Peru or Mexico, and we expect rate cuts in Brazil during the second half of the year.  Interest rates are only likely to continue rising in Colombia, where inflation shows no sign of improving.

In Brazil, the likelihood of a new push to promote fiscal reform and adjustments is increasing, leading us to improve our forecast for the primary result next year. Some of the market gains made by domestic asset prices reflect the constructive view towards these new fiscal efforts.  However, some risks (both domestic and global) remain. Anyway, improving financial conditions and the expected interest rate cut will likely have a positive impact on activity.  We have raised our 2017 growth projection to 1.0% from 0.3%.

Argentina is back to the international capital markets and has paid the holdouts.  The new government’s market-friendly policies allied with favorable conditions for emerging markets have helped to reduce sovereign spreads, creating an opportunity for both provinces and companies to issue debt. We forecast GDP will fall 1% this year as a result of the adjustment, but we are also forecasting a 3% improvement for 2017.


 


Global Economy
Global environment remains supportive for emerging markets

Two conditions must be met in order for the U.S. Fed to raise interest rates again: a pick-up in activity in the U.S., after the moderation in 4Q15 and 1Q16, and concrete signs that the decline in global risks will be sustained. While these conditions are likely to be met throughout the year, June might be a little early. We continue to expect two rate hikes in 2016, but postponed the first one to July from June. 

Growth remains modest in mature economies. We maintain our 2016 GDP forecasts for the U.S., Europe and Japan at, 2.0%, 1.5% and 0.4%, respectively.

In China, we see an investment-led cyclical uptick in growth. We raised our growth forecast to 6.5% from 6.3% for 2016, but maintain our expectation of a deceleration to 6.0% in 2017. 

For commodities, we believe that the rise in oil prices is sustainable, but that iron ore prices are likely decline again. 

The recent appreciation of emerging market currencies seems appropriate because it reflects the stability in China, commodity prices that have reached a bottom, and a cautious U.S. Fed that is taking into account the global environment. However, it remains to be seen whether these tailwinds will translate into better growth.

U.S. – The Fed is in no rush to hike again

The U.S. Fed remains cautious about the improvement in global risks, indicating no rush to raise interest rates again. The statement following the April FOMC meeting did not restate that global economic and financial developments continue to pose risks. However it also did not go as far as to define the balance of risks as “nearly balanced”. Instead, it says that the FOMC continues to closely monitor global economic and financial indicators.

To raise rates again, the Fed might need to see: i) a pick-up in activity after the recent moderation in GDP (1.4% QoQ/SAAR in 4Q15 and 0.5% in 1Q16) and ii) concrete signs that the decline in global risks will be sustained.

In our view, growth will improve given that the financial conditions have eased, further supporting an already-positive consumption outlook. Financial conditions are now less tight than in December 2015, when the Fed first raised interest rates. With a strong labor market, high consumer confidence and increasing credit supply to households, these easing financial conditions further support consumption. We expect consumption growth to rebound to 3% throughout the rest of the year, after rising by just 1.9% QoQ/SAAR in 1Q16.

Easing financial conditions could also fuel gross fixed investment. Credit spreads have declined, equity prices are up, and the USD has weakened as a result of the Fed’s dovish stance – all of which favor business investment. The ISM Manufacturing indicator increased to 50.8 in March, from 49.5 in February, providing an early sign of improvement.

But when will the Fed be confident that the improvement in global risks will be sustainable? This is harder to judge, but we believe that the Fed is willing to take the risk of the U.S. economy running a bit hot, instead of prematurely raising rates and hurting the uncertain outlook for the global economy.

What about inflation? Won’t it force the Fed to raise rates soon? 

For now, we believe the Fed will be satisfied that risk of persistent low inflation is declining but will not be pressured to raise rates quickly because of inflation. The core PCE deflator averaged 0.22% MoM in the first two months of 2016, reaching 1.7% YoY for the first time since 2012. Service inflation is rising gradually, while the weaker USD and recent rise in oil prices help inflation; the pace of improvement, however, is gradual. We expect both the headline and core PCE deflator to reach 1.80% by the end of 2016.

All things considered, we continue to expect two rate hikes in 2016, but postponed the next move to July from June.

We also maintain our forecast of 2.0% GDP growth for the U.S. in both 2016 and 2017.

Europe – Transitory factors boosted GDP in 1Q16; probability of brexit declined

GDP in the euro zone increased 0.6% QoQ in 1Q16, up from 0.3% in 4Q15 helped by transitory factors. Weaker oil prices drove consumption, while a milder winter boosted construction. We expect the former to fade and the latter to pay back in 2Q16. We therefore expect growth to return to the current trend of 0.4% QoQ per quarter throughout 2016.

We maintain our GDP growth forecast for the euro zone unchanged at 1.5% for 2016 and 1.6% for 2017.

The risk of the UK leaving the European Union has declined, with polls showing gains in the “stay” votes. The UK-EU referendum is scheduled for June 23. The latest polls suggest that 49% of the voting intentions favor staying in the EU, while 39% favor leaving. The absence of a major increase in immigration flows to Europe so far this year (see graph) and the start of the official campaign have driven the momentum for the “Stay” camp.

Japan – BoJ cautious about effects of negative interest rates

The BoJ preferred to continue to monitor the effects of its policies instead of adding stimulus in April. Weak growth, low inflation and the risk of a stronger yen justified further easing. However, contrary to our expectations, the Central Bank chose to stay put and continue to monitor the impacts of its negative-rate policy.

We maintain our GDP forecasts for Japan at 0.4% in 2016 and 0.7% in 2017.

China – Growth improved with higher investment in infrastructure and property

Economic activity picked up in March, fueled by property and infrastructure investment. Strong credit growth boosted expansion in both sectors. Property investment (up 7% YoY in March vs. -1.2% YoY in January and February) was also helped by a reduction in housing inventory. Retail sales improved slightly from already good levels. The pickup in demand boosted industrial production to 6.8% YoY in March, from 5.4% in January and February.

The improvement in housing construction is likely to extend to the rest of this year. Housing sales, which tend to lead new constructions in six to 12 months, indicate a continuation of the good momentum in the sector (see graph).

We have revised our GDP forecast for 2016 up to 6.5%, from 6.3%, but maintain our expectation that growth will decelerate to 6.0% in 2017. 

Emerging Markets – Does the recent currency appreciation reflect fundamentals?

Against a basket of equal-weighted EM currencies, the USD has declined to mid-2015 levels (see graph), driven by improvements in the external backdrop for EMs. After mid-2015, the pessimism surrounding China skyrocketed (particularly after the PBoC changed its FX policy) and oil prices plummeted to new lows. We believe that the former was excessive and see the latter as something from the past (we expect oil prices to rise to USD 55 by year-end). Furthermore, the Fed is now paying closer attention to the global economy, and the risk of normalization in U.S. monetary policy in a weak global economy has declined. All of these factors are beneficial for EM currencies.

Commodities – The increase in oil price is sustainable, but the iron ore one is not.

The gains in commodity prices extended in April, rising 12% according to the Itaú Commodity Index (ICI). All three components posted gains: oil-related commodities (19%), metals (12%) and agriculture (7%).

The rebound in oil prices is sustainable and likely to continue. Oil prices rose above USD 45/bbl despite the failure by major producers to reach an agreement regarding the freezing of output at the meeting in Doha. The ongoing decline in U.S. oil investment and production has led to a reduction in global oversupply and supports the outlook for oil prices. We estimate that the seasonally-adjusted global surplus declined by 50% in 1Q16 compared with 4Q15. This process is expected to continue in 2Q16, and the market is likely to be balanced by 3Q16. We forecast a Brent price of USD 55/bbl by year-end.

However, iron ore prices will likely decline ahead. The rise in iron ore prices occurred because of a pick-up in construction in China at the same time that metals inventories were low in the country. The inventory impact is temporary, and the pick-up in construction is not strong enough to end the excess supply in the sector. Iron ore inventories in China seem to be rising (see graph) and prices could start to decline soon.

Finally, we have increased our forecasts for agricultural commodities, recognizing that the recent gains reflect bullish fundamentals. 

Our scenario implies the ICI will rise 6% by year-end from current levels.


 


LatAm
Extended relief

• The external environment remains supportive for Latin American currencies. We now expect stronger exchange rates than estimated in our previous scenario.  

• Recent activity numbers indicate that economic growth is stabilizing, albeit at low levels. For 2017, we raised our growth forecast for Brazil and lowered our GDP forecast for Colombia.

• Low economic growth and the exchange-rate evolution in the region suggest continued disinflation. There is consequently less need for interest-rate hikes. We expect no further rate hikes this year in Chile, Peru or Mexico. In Colombia, the tightening cycle is likely to continue, while an easing cycle in Brazil is likely in the second half of the year. 

• The Argentine government issued USD 16.5 billion in international capital markets. The new administration’s market-friendly policies and the better external environment for emerging markets have led to a compression in Argentina’s sovereign spread, which will likely allow provinces and corporates to issue debt abroad as well.

Ongoing rally

The external environment remains supportive for Latin American currencies. The loose monetary policy stance in the U.S., the recovery in oil prices and the perception of reduced risk in the Chinese economy caused further exchange-rate appreciation in the region in April, although to a lesser extent than in the previous month. The Colombian peso was particularly benefited by the oil-price recovery, as evidenced by its outperformance in April. Domestic factors also helped some currencies. The Peruvian sol was boosted by the outcome of the presidential elections, which left two candidates praised by the markets to compete in a second round in June. In Brazil, the market is pricing in higher odds of fiscal reform, while the central bank is reducing its short-dollar position in the NDF market.

For most of the region’s currencies, we expect only a small depreciation from the levels registered in the end of April. While we believe that some of the factors strengthening LatAm currencies are permanent (including the oil-price recovery and reduced concerns regarding China), we expect some global appreciation as the Fed resumes the tightening cycle during the second half of this year. Some reforms are now more likely in Brazil, but the Brazilian real will probably experience a sharper depreciation than other LatAm currencies as it becomes clear that stabilizing the public debt remains challenging. The wide current-account deficit in Colombia means that the Colombian peso will be among the underperformers once the Fed raises rates again, although we expect a further recovery in oil prices. In any case, we anticipate stronger exchange rates in most of the countries we cover, relative to our previous scenario.

Low growth stabilization

Recent activity numbers suggest that economic growth in many countries is stabilizing at a low level relative to the recent past. The economy in Colombia has been surprisingly resilient to the worsening terms of trade, and growth remains at around 3%. Economic growth in Mexico remains moderate and uneven, with consumption still expanding rapidly, while manufacturing exports continue to decline due to sluggish industrial production in the U.S. In Chile, the latest numbers reduced the downside risks to the growth forecasts for 2016. In Peru, the economy is actually growing faster, driven by mining production and a stabilization of investment. On the other side of the spectrum, while the sharp recession continues in Brazil, the leading indicators suggest that the county’s economy will contract at a slower pace during the second half of this year.   

For 2017, we raised our growth forecasts for Brazil and reduced our expectation of economic-growth for Colombia. In Brazil, we now expect a GDP expansion of 1.0% in 2017 (vs. 0.3% in our previous scenario). In Colombia, lower real wages, tighter macro policies and capital-expenditure cuts in the Oil sector are likely to lead to a slowdown from the current levels; we now expect a GDP expansion of 2.7% next year (vs. 3.0% in our previous scenario). The rest of our growth forecasts are unchanged.  

Some easing in inflation

Inflation remains above the upper bound of the target in Chile, Colombia, Peru and Brazil, but – with the exception of Colombia – is moderating. The impact of past exchange-rate weakening is gradually disappearing, leading to a deceleration in the pace of price increases. In Brazil, disinflation is also attributable to the fading impact of the increase in utility prices last year. In Colombia, although inflation has yet to peak, it has already reached the highest level since 2001. Mexico is still the only country in the region not facing inflation problems: headline and core inflation are running below the center of the target.      

Low economic growth and the exchange-rate evolution in the region suggest that disinflation will continue. However, inertia and a gradual easing of the labor market (in most countries) will prevent inflation from falling fast. Our forecasts call for inflation above the center of the target in every country but Mexico.

The case for rate hikes weakens

With weak growth, peaking inflation and a more supportive external environment, there is less need for tighter monetary policy. We no longer expect rate hikes in Peru this year, and continue to anticipate no policy rate changes in Chile and Mexico. However, because a tightening bias remains in all three countries, the short-term risk continues to be rate hikes. Specifically, upside inflation surprises could lead the central banks in Chile and Peru to resume a hiking cycle due to the still-uncomfortable inflation in both countries, while the central bank in Mexico may raise the policy rate again if the exchange rate has a disorderly reaction to higher Fed fund rates. In Brazil, the deep recession and declining path of inflation will probably lead to rate cuts starting in the second half of the year. However, in Colombia, the challenging inflation outlook, the wide current-account deficit and the resilient activity encouraged the central bank to increase the pace of rate hikes. We now expect the tightening cycle in Colombia to end with the policy rate of 7.5% (vs. 7% in our previous scenario).

Out of default

The Argentine government issued USD 16.5 billion in international capital markets. The proceeds from the issuance will be used to pay the holdouts. The government will also use the resources to regularize the service of restructured debt, allowing the country to emerge from the default. The new administration’s market-friendly policies and the better external environment for emerging markets have compressed Argentina’s sovereign spread, likely allowing provinces and corporates to issue debt abroad as well.

The Argentine peso strengthened further in April. In addition to the new government policies, the external environment (including the appreciation of the Brazilian real), seasonal factors related to soy exports and high interest rates have driven the appreciation. So far, the central bank has not intervened to contain the appreciation. In a recent interview, the Central Bank Governor Federico Sturzenegger emphasized that he wants to consolidate a floating exchange-rate regime in the country. Instead of intervening, the central bank is taking the opportunity to liberalize the exchange-rate market faster. In any case, we now expect a stronger exchange rate than that assumed in our previous scenario.


 

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


 



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