Itaú BBA - Strong growth and still low inflation in 2018

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Strong growth and still low inflation in 2018

January 12, 2018

Broad global economic growth, moderate inflation and cautious central banks support low volatility.

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

Global Economy
Goldilocks scenario continues
Broad global economic growth, moderate inflation and cautious central banks support low volatility, risky asset prices and EM inflows.

LatAm
Growth to improve further in 2018
With the still-favorable external environment, growth in Latin America is improving and a pick-up is expected in most countries we cover, with the exception of Mexico.

Brazil
A better fiscal reading, for now
We revised our estimate for the primary budget deficit in 2017 to 1.9% of GDP from 2.3%, but the structural fiscal rebalancing still depends on reforms.

Argentina
A monetary policy U-turn
The government has announced higher inflation targets for 2018 and 2019. While the new targets seem more credible than the previous ones, the decision to increase them will likely make disinflation even harder to achieve, as inflation expectations will likely rise further.

Mexico
Resuming the tightening cycle
Banxico resumed the tightening cycle in December and another rate hike in February is likely. We expect the policy rate to peak at 7.5%. We forecast GDP growth of 2.1% for both 2017 and 2018 – down from 2.9% in 2016 – and a moderate acceleration to 2.4% in 2019.

Chile
Turning the page
Former president Sebastian Piñera will return to La Moneda in March with the promise of returning Chile to a path of sustainable growth, while fine-tuning some of Michelle Bachelet’s key reforms. Higher copper prices strengthened the CLP and help boost growth to 3.0% this year and 3.5% next year.

Peru
Political crisis poses negative growth risk
We revised our GDP growth forecasts down to 4% from 4.2% for 2018, as a consequence of the political crisis, which we believe will curb investment growth. Low inflation, coupled with the downside risk for growth, will likely push the central bank to cut rates further.

Colombia
More monetary easing ahead
Disappointing activity figures and the weak labor market underscore risks to the expected recovery and will likely lead the central bank to resume its easing cycle. We see a terminal policy rate of 4.0%, before 2H18.

Commodities
Higher oil prices in 2018
Given the recent decline in inventories, we have revised our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent.


 


Strong growth and still low inflation in 2018

Easy monetary conditions in developed markets (DM), lower political risks in Europe and a soft landing in China are supporting a more synchronized global recovery. We expect global GDP growth at 3.8% in 2018, the same as in 2017, with just a modest slowdown to 3.6% in 2019.

As growth remains above potential in developed countries, the output gap will turn positive gradually, pushing inflation up, particularly in the U.S., but we see little risks of inflation overshooting central banks’ targets this year. More broadly, DM central banks will use the global recovery to assure inflation converges to 2% (or a bit above it) and hence remove monetary accommodation in a very gradual fashion. An adjustment to the monetary policy framework is an increasingly plausible move in the U.S.

Emerging countries other than China are just starting to recover and should accelerate to 4.2% from 3.7%. LatAm growth, in particular, may speed up to 2.5% in 2018 from 1.2% in 2017, spurred by the lagged effects of monetary policy. Also, the external environment for Latin America remains favorable, supporting export prices, sovereign risk and exchange rates. We expect a growth pickup in 2018 in most LatAm countries within our coverage, with the exception of Mexico. Helped by negative output gaps and exchange-rate strengthening, most countries are facing low (or falling) inflation, allowing for further interest rate cuts. However, in Mexico – where inflation has surprised to the upside – the central bank resumed interest rate hikes. Inflation in Argentina is also high, but the government set higher targets for inflation, leading the central bank to cut interest rates modestly.   

In Brazil, the recovery in activity continues, while the inflation outlook remains benign: our growth forecasts are 3.0% in 2018 and 3.7% in 2019, while for inflation we estimate 3.8% this year and 4.0% in 2019. We expect a 25bp-cut in the benchmark Selic interest rate in February and another 25bp-cut in March, ending the monetary easing cycle at 6.5% p.a. The Brazilian currency tends to depreciate somewhat: we forecast 3.50 reais per U.S. dollar by YE18 and 3.60 by YE19. We revised our estimate for the primary budget deficit in 2017 to -1.9% of GDP from -2.3%, but the structural fiscal rebalancing still depends on reforms.


 


Global Economy
Goldilocks scenario continues

• Global growth to remain at 3.8% in 2018. Growth in developed countries should remain a bit above 2.0%. A modest slowing in China, to 6.3% (from 6.8%), is a soft landing. Beyond China, EM growth will broaden and accelerate to 4.2% (from 3.7%).

• As growth remains above potential in developed countries, the output gap will turn positive, gradually pushing inflation up, particularly in the U.S., but we see little risk of inflation overshooting central banks’ targets this year.

• DM central banks will use the global recovery to assure inflation converges to 2% (or a bit above it) and hence remove monetary accommodation in a very gradual fashion. An adjustment to the monetary policy framework is an increasingly plausible move in the U.S.

• Broad global economic growth, moderate inflation and cautious central banks support low volatility, high-risk asset prices and EM inflows.

• With risk appetite still quite keen, central banks may eventually feel compelled to deploy macroprudential measures to mitigate systemic risks.

Goldilocks effect from broader global growth and moderate inflation

Easy monetary conditions in DM, lower political risks in Europe and a soft landing in China are supporting a more 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.

Growth is becoming more widespread amid emerging economies. China will see a modest slowdown in 2018, while other emerging markets are just starting to recover and should accelerate to 4.2% from 3.7%. LatAm growth, in particular, may speed up to 2.5% in 2018 from 1.2% in 2017, spurred by the lagged effects of monetary policy. 

The risk of DM inflation overshooting the targets remains low and asymmetric, so DM central banks can and should remain very cautious in reducing monetary accommodation. After a decade of low inflation, long-term inflation expectations are somewhat below most DM inflation targets. The output gaps are just turning positive in 2018, and they are unlikely to put much pressure on inflation. And, even if inflation does rise a bit faster than expected, central banks can better control higher than lower inflation in a low- to neutral-rate environment (see U.S. discussion). 

All this means a benign U.S. economic outlook for risk assets. In our econometric model, given the positive growth, moderate private leverage and easy Fed policy, the VIX should remain low and rise only gradually in the next couple of years (see chart).

This environment fosters risk-taking, with asset price valuations reaching successive new highs. This is most clear in credit markets where spreads are at record low levels (see chart). Equity prices have risen significantly last year with price-to-earnings reaching above average levels, but not as expensive. OECD house prices have been recovering from the financial crisis, but on average house-prices-to-income do not look expensive, except in a few countries, like Canada, Australia and Sweden. In this context, central banks may feel compelled to deploy, or at the very least to study deploying, macroprudential regulations aimed at mitigating systemic risks.

In fact, periods of synchronized global growth are usually associated with low volatility (see chart), as it helps alleviate fears of a negative foreign shock to U.S. growth. 

U.S. – A cautious Fed is still warranted in 2018

We forecast U.S. GDP growth to accelerate to 2.4% in 2018 from 2.3% in 2017, supported by easy financial conditions and a moderate fiscal impulse. In 2019, growth could slow to a still-healthy 2.1%, as the Fed reduces the monetary stimulus and the output gap becomes positive. 

Fiscal policy is likely to become a tailwind for private demand. The tax bill approved by Congress should cut taxes by USD 150 billion (0.75% of GDP) in 2018, and government spending is likely to rise by USD 50 billion this year. Hence, we expect a 0.5-pp contribution from fiscal policy to GDP growth.

Inflation expected to rise gradually, to 2%. Given the U.S. GDP outlook, we forecast that the unemployment rate will decline to 3.5% by the end of 2019, one percentage point below the estimate of full employment (4.5%). Linear regression estimates a 0.2-pp rise in inflation due to such a positive unemployment gap, but below-target inflation expectations and inertia are likely to keep pushing inflation down by 0.1 pp. In sum, we forecast that core inflation could gradually rise from 1.5% in 2017 to 2.0% in 2018 and to 2.1% in 2019. 

We foresee three 25-bp Fed rate hikes in 2018, with balanced risks in the current inflation target regime. Given the benign inflation outlook and low neutral rates, the Fed can tighten monetary policy gradually.

There could, however, be a fourth hike in 2018. First, we could see a bigger (non-linear) impact of the unemployment gap on wages and inflation. Second, GDP could grow faster as a result of better global growth (financial conditions) and fiscal stimulus and/or an increase in productivity.

Only two rate hikes in 2018 are also possible. The unemployment gap may have less impact on inflation and inflation expectations, in which case the Fed may allow the unemployment rate fall further.

In addition, there is a real possibility that the new chairman, Jerome Powell, may change the Fed’s monetary policy framework. Fed members and U.S. academics are studying: i) Price-level or nominal GDP-level targeting; and/or ii) raising the inflation target to 3%. The Fed wants to better anchor inflation expectations, as in a low real rates environment, its policy is expected to be more often constrained by a zero interest-rate lower bound. In any event, a change in the Fed’s monetary policy framework along with those being discussed means a promise of looser monetary policy now or in the future. 

While macroeconomic considerations may suggest an even shallower angle of policy normalization than what is currently priced in, prudential concerns might argue otherwise. Given that one policy instrument should not seek two alternative goals, this disconnect means that the moment when macroprudential measures start to be discussed may not be too far off. 

Anyhow, the impact of modestly higher U.S. interest rates on financial conditions should remain contained by better-synchronized global growth and the tax cut. Better global growth means other DM central banks are likely to follow the Fed’s footsteps, leaving interest-rate differentials nearly unchanged and the USD stable. Recent tax cuts offset the deterioration of the private balance sheets from higher interest rates.

We expect the UST 10-year yield to rise by 50 bps, to 2.9%, by YE18, which is 30 bps more than the U.S. Treasury forward yield curve.

Europe – Good growth, low inflationary and political risks

We expect Eurozone GDP to expand 2.1% in 2018 and 2019, after an estimated 2.3% in 2017. Easy monetary policy, easier fiscal policies, tentative signs of structural reforms and a reduction in political risk are boosting the region’s growth. Current economic indicators, like the PMIs, even indicate a small upward risk to this economic forecast.

With a better economic outlook, the ECB will likely end its asset purchases in 2018 but 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 relatively low. EU-UK Brexit negotiations could see progress this year. Italy’s election could present some significant downside risk, but this is unlikely to lead to a euro breakup, while a pro-European Grand Coalition in Germany could even give a push to Macron’s agenda in France, which is positive for the EU.

Japan – BoJ to avoid a decline in 10-year real rates

Japan’s GDP is forecast to grow 1.4% in 2018, after 1.8% in 2017, spurred by easy financial conditions and healthy global growth. The unemployment rate is likely to decline to 2.5% by 4Q18 from 2.8% in 4Q17, pushing up wages and the core CPI (ex-food & energy) to 1.0% in 4Q18, from 0.2% in 4Q17.

We believe that the BoJ will raise its 10-year JGB target to 0.2% (from 0.0%) in 2H18 without harming the positive outlook for growth and inflation. The improving inflation outlook may allow the BoJ to modestly adjust its 10-year yield target to keep long-term real yields from falling (currently -0.5%). In addition, the Fed rate hikes and the ECB’s QE end should maintain interest rate differentials, leaving the JPY broadly stable. 

China – Soft-landing is manageable

Economic activity in China has been slowing down gradually. In November, industrial production fell by 0.1 pp, to 6.1% yoy, while year-to-date fixed investment came in at 7.2% yoy and retail sales growth accelerated to 10.2% yoy. Regarding property data, both sales and new construction showed some recovery during the month. For December, the manufacturing PMI softened slightly, to 51.6 from 51.8, but this level is still consistent with steady growth at the end of 2017. 

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%.

China’s government can likely manage a soft landing. The credit-to-GDP ratio remains high but has started to stabilize with more rigid financial regulations on “alternative” credit products. Also, the government is managing a gradual reduction in state-owned enterprise (SOE) debt, which is the main problem. The low level of public debt allows some degree of freedom for the government to manage the SOE debt over time. Private demand has been increasingly driven by consumption, and the outlook for investment has also improved, with housing inventories better balanced and exports turning into a tailwind. And, if needed, the PBoC could loosen monetary policy, given that CPI inflation remains at 2%, one percent below its target.

Commodities – Higher oil prices in 2018

The Itaú Commodity Index (ICI) has risen by 5.0% since the end of November – agriculture (2.3%), metals (7.1%) and energy (5.4%) – as global economic activity keeps up the strong pace. 

Higher oil prices forecast for 2018. WTI prices rose 8%, to USD 61/bbl last month, due to larger-than-expected decline in U.S. inventories and renewed geopolitical risks. We estimate that oil prices in the range of USD 45-55/bbl can stabilize the U.S. rig investment and help to balance the supply and demand this year. Given the recent decline in inventories, we have moved our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent, the higher end of this range. 

Fine-tuning our forecast for metal prices. Metal prices continued to rally in December, but we still see a correction ahead as the Chinese economy slows a bit. We raised our year-end estimates for copper prices to a modest USD 6,500/mt (USD 6,200/mt previously) and for iron ore prices to USD 60/mt (USD 58/mt previously).

For agricultural prices, there are no major changes in our scenario, despite the risks associated with La Niña. For sugar, we increased our year-end 2018 price forecast to USD 0.152/lb from USD 0.144/lb due to the adjustment in oil prices.


 


LatAm
Growth set to improve in 2018

• The external environment for Latin America remains favorable, supporting export prices, sovereign risk and exchange rates. Growth is improving in most countries within our coverage, and a pickup is expected in 2018, with the exception of Mexico. 

• Helped by negative output gaps and exchange-rate strengthening, most countries are facing low (or falling) inflation, allowing for further interest rate cuts. However, in Mexico – where inflation has surprised to the upside – the central bank resumed interest rate hikes. Inflation in Argentina is also high, but the government set higher targets for inflation, leading the central bank to cut interest rates modestly.   

A benign external environment, including strong global growth, low interest rates in developed markets, the perception of lower political risks in Europe and a soft landing in China, continues to benefit LatAm asset prices. Prices of important commodities for the region (such as copper and oil) increased further. The sovereign risk, measured by the CDS, recently reached multi-year lows. Currencies strengthened against the dollar in the first days of 2018 (although in some cases this only offset the depreciation observed at the end of December). The Argentine peso has been an exception and has weakened in recent weeks: this is partly due to uncertainty over monetary policy and partly because the current account deficit is reaching uncomfortable levels (suggesting currency overvaluation). Still, some depreciation ahead is likely, as the Fed increases interest rates and China’s economy gradually slows (pulling commodity prices down).   

In 2018, we expect growth to improve in almost every country within our coverage. The only exception is Mexico, where we expect the economy to expand at the same 2.1% pace as we estimate for 2017. In any case, Mexico would still grow around trend, supported by a dynamic U.S. economy and a solid domestic labor market. On the other hand, risks related to presidential elections and trade policies in the U.S. will continue to hold investment back. Argentina’s economic recovery lost momentum in early 4Q17, but we see this as temporary. Besides the favorable environment for emerging markets, the solid victory obtained by the ruling coalition in the mid-term elections (and the fast approval of economic reforms) will likely boost confidence and investment, leading to an economic expansion of 3.5% this year (from an estimated 2.9% in 2017). In Brazil, output will likely remain stable between 3Q17 and 4Q17, but still consistent with 1.0% gain in 2017 (far better than the 3.0% contraction observed the previous year). We expect the economy to grow by 3.0% this year, helped by monetary stimulus. A key anchor for our forecasts for Brazil is the perception that Congress will resume fiscal reforms after presidential elections. In Chile, higher copper prices and a favorable outcome of elections will likely support confidence and investment, boosting an economic recovery that has been incipient so far. We now expect Chile’s economy to expand by 3.0% this year. Higher copper prices are also favorable for Peru (actually, mining investment is already rebounding there), but a severe political crisis almost led to the impeachment of the president and will likely curb the recovery somewhat (we reduced our forecast for this year from 4.2% to 4.0%). Unlike other countries in the Andean region, in Colombia there is still no sign of economic improvement. In our view this is partly a result of the lagged effects of monetary policy, which only recently was moved to a neutral stance.

In spite of faster growth, output gaps remain negative and the favorable external environment is pulling tradable inflation down. So, the central banks of Brazil, Colombia and Peru will likely ease monetary policy somewhat further. In Brazil, we expect two 25-bp rate cuts, and in Peru we see one additional rate cut. The central bank of Colombia has been data-dependent and paused the easing cycle in December, also to watch how asset prices behave following the sovereign rating downgrade by S&P. Still, given weak growth, exchange-rate appreciation and a narrowing current account deficit (an important variable for monetary policy decisions there), we expect the cycle to be resumed soon (we forecast three additional 25-bp rate cuts). Argentina’s central bank also reduced its reference rate recently, following an increase of inflation targets by the government. But it cut rates by less than expected (by 75-bps), as the inflation environment is challenging even if measured under the new targets. As (and if) there is progress on disinflation, further easing will likely come, but the upcoming data on inflation and expectations substantially curb the room for monetary easing in the very short term, also considering this is the time of the year when wage adjustments take place.

Political events will take the spotlight in the region this year. Presidential elections in Brazil, Mexico and Colombia will be important drivers of asset prices. Besides elections, Mexican asset prices will also be heavily influenced by NAFTA renegotiations. In fact, as we highlighted in the Mexico section, our baseline scenario assumes that NAFTA survives and the economic policy framework is left broadly untouched by the incoming administration. If at least one of these assumptions does not hold, a scenario of lower growth, weaker currency, higher inflation and tighter monetary policy is likely. In Peru, the dust of the most recent political crisis is far from settled, so politics can also be a source of volatility. In Chile, the strong showing of anti-establishment candidate Beatriz Sanchez in the presidential race suggests that pressure for more aggressive changes in the pension and education systems will continue, so it will be important to watch how president-elected Sebastian Piñera balances these pressures with budget constraints and his willingness to promote business-friendly reforms. Finally, the political calendar in Argentina is less packed this year, as the most important reforms in the pipeline were already approved by Congress in December. Consequently, the focus of the markets will be on the ability of the government now to meet its fiscal targets.


 

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



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