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Tapering anticipation impacts Emerging Markets

December 6, 2013

The Fed has been signaling a cautious approach to the removal of stimuli (QE).

Global Economy
Tapering – Less Threatening, but Still Likely to Affect Emerging Economies
While a better global growth outlook is likely to boost expansion in emerging economies, the reduction in the pace of monetary expansion in the U.S. is still likely to affect emerging markets.

Brazil
Monetary Tightening Closer to the End, Fiscal Result Still in Decline
Our estimates for GDP growth were reduced to 2.2% from 2.4% for 2013 and maintained at 1.9% for 2014.  

Mexico
A Bolder Energy Reform Is Back on the Table
Politicians have hinted that the energy bill would be more aggressive than the PRI’s original proposal. The economy rebounded during 3Q13.

Chile
Waiting for the Run-Off
Michelle Bachelet and Evelyn Matthei will compete in the presidential run-off. The central bank cut the interest rate for the second consecutive time in November and we expect more cuts ahead.

Peru
Slower Growth and Lower Interest Rates
The central bank surprisingly reduced the policy rate in November, after months of monetary easing through lower reserve requirements.

Colombia
President Santos Seeks Re-Election
According to several polls, President Santos is the leading candidate. His decision follows promising progress in peace negotiations with the FARC.

Argentina
Cabinet Reshuffle
President Kirchner has returned to office. Her first act was to appoint a new Chief of Ministers, Minister of Economy and President of the Central Bank.

Commodities
Higher Iron Ore, Lower Crude Oil Prices
We are raising our iron ore price forecasts due to stronger-than-expected demand and lower capacity from high-cost producers. A better outlook for the supply of agricultural commodities is being partially offset by stronger demand.

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Tapering anticipation impacts Emerging Markets

Inflation is low in various parts of the world, opening room for looser monetary policy. Central banks in Europe and many emerging countries, including Latin America, have cut rates. Monetary stimuli in different parts of the world, combined with other factors, have improved the global growth outlook for next year.

In the U.S., inflation is also low. The Fed has been signaling a cautious approach to the removal of stimuli (QE) and is likely to reinforce the indication of low interest rates for an extended period of time. Therefore, the (partial) removal of stimuli in the U.S., expected to take place by March, tends to generate a limited impact on markets, particularly because the impact has already been partially anticipated.

With the market pricing in an earlier normalization of U.S. monetary policy, the dollar is strengthening against emerging-world currencies sooner than expected. We anticipate a more depreciated exchange rate by year-end 2013, relative to our previous forecast for Chile, Peru, Mexico and Colombia; and maintained our exchange-rate forecasts for year-end 2014 in most of these countries. We consequently see part of the dollar’s strengthening in recent weeks as an anticipation of our previous scenario.

The pressure for depreciation has not prevented central banks, facing low growth and controlled inflation, from stimulating their economies. The Chilean Central Bank cut interest rates for the second consecutive month in November. In Peru, the central bank surprised the market by reducing the monetary rate by 0.25% - we expect additional cuts throughout 2014. In Mexico and Colombia, central banks have indicated that interest rates will remain at the current level, which is already quite stimulative. Moreover, in Colombia, we expect the next rate movement to be a drop.  

In Argentina, which is less financially integrated with the rest of the world, the government has allowed the peso to depreciate faster and interest rates to rise.

Local issues have gained importance in Latin America. In Mexico, a bolder energy reform is back on the table. In Chile, Bachelet is likely to win the presidential election in a run-off. Colombia is discussing the agreement with the FARC, while President Humala in Peru faces low approval ratings. In Argentina, the highlights are the ongoing drop in reserves and the shuffling of key government positions.

In Brazil, economic policy management has drawn attention. On the fiscal side, the government’s primary surplus fell short of expectations in October, for the second consecutive month. On the monetary side, the COPOM indicated that the cycle of rate hikes is close to an end. Finally, GDP growth has missed expectations despite the progress in infrastructure concessions.

Global Economy
Tapering – Less Threatening, but Still Likely to Affect Emerging Economies

•               We expect the U.S. Fed to start tapering its asset purchase program in March, at the latest.

•           The Fed is likely to be cautious and could reinforce its forward guidance to prevent a tightening in financial conditions.

•           A better balance of risk in China, economic expansion in Japan and reasonably stable Europe are also positive.

•           While a better global growth outlook is likely to boost expansion in emerging economies, the reduction in the pace of monetary expansion in the U.S. is still likely to affect emerging markets.

We maintain our expectation of a likely reduction in the U.S. Fed’s asset purchase program in March, at the latest. Labor market indicators strengthened in October and should maintain a good pace going forward as the U.S. economy accelerates in early 2014. We therefore believe the economic conditions will support a slight reduction in the pace of monetary stimulus in 1Q14.

However, the Fed is likely to be extra cautious in order to avoid risking the derailment of the economic recovery. Essentially, the FOMC seems comfortable with only a slight reduction in stimulus and very modest tightening in financial conditions, at least during the initial steps of its long policy normalization process. We therefore expect the Fed to reinforce its forward guidance once the QE tapering begins.

This tapering outlook is, in our view, less threatening, and markets are already pricing in a possible tapering in the coming months. As a result, we now expect the 10-year Treasury bond yield to reach 3.3% (from 3.4%) in December 2014, and remain at around 2.7% until the end of 2013.

The outlook for other major economies is also positive. The balance of risk in China has improved, with activity faring well and a prospect of reforms in the medium term. Japan’s economy continues to expand, responding to the stimulus implemented at the beginning of the year. Europe remains relatively stable, with modest growth and a chance of further monetary stimulus due to disinflation pressures.

The better global growth outlook is likely to boost expansion in emerging economies. This is the case for some Asian nations with a high share of exports to developed markets as well as Central European countries with exposure to the euro zone. In Latin America, this effect is particularly evident in Mexico, where we expect GDP growth to accelerate to 3.6% in 2014 (from 1.3% in 2013), largely due to the recovery in the U.S. The direct impact for other countries in the region is smaller, given that their exports are concentrated in commodities.

Still, despite the seemingly less threatening scenario, the reduction in the pace of monetary expansion in the U.S. is nevertheless likely to affect emerging markets. The U.S. dollar is strengthening against EM currencies. In most cases, the devaluation against the dollar is below the peak of the selloff that occurred in the middle of the year; however, the losses for the local currencies of several EM countries remain high so far this year (see graph).

Among Latin American countries, we see a more depreciated currency for Chile, Peru, Mexico and Colombia than previously forecasted. We maintain our 2014 exchange rate forecasts for these countries, which imply depreciation relative to our year-end forecasts for 2013.

Nonetheless, the currency depreciation has not kept central banks facing low growth and controlled inflation from stimulating the economy. The Chilean Central Bank reduced its policy interest rate for the second month in a row in November. In Peru, the central bank surprised expectations when it reduced rates by 0.25% – and we expect more cuts in 2014. In Mexico and Colombia, the central banks have indicated that interest rates will remain at the current levels, which are already quite stimulative; but we expect new cuts in Colombia.

U.S. – Tapering in March, at the latest, with a stronger forward guidance

The better-than-expected economic growth in the U.S. in 3Q13 – 3.6% QoQ (SAAR – seasonally adjusted annual rate) was mainly due to the transitory effects of higher inventory building and government spending. We believe these gains will be partially reversed in 4Q13 and have consequently revised our growth forecast down to 1.0% in the fourth quarter (from 2.0% previously). Meanwhile, private demand has expanded at a moderate pace, with consumption and investment increasing 1.4% and 5.4%, respectively.

All in all, we revised our growth forecast up to 1.7% in 2013 (from 1.5% previously), and continue to expect GDP to accelerate to 2.5% in 2014.

Labor market indicators strengthened in October, with the non-farm payroll report showing the addition of 204 thousand jobs in the month. The data for the two previous months was also upwardly revised. The three-month moving average rose to 202 thousand per month, from 143 thousand in September, before the new releases. Non-farm payrolls have improved since the middle of the year (see graph), showing no negative impact from the partial shutdown of the U.S. federal government in October.

However, despite the progress, there are lingering doubts about the state of the U.S. economy, leading us to believe that the FOMC will remain very cautious about withdrawing any stimulus. Indeed, several FOMC members have suggested that they need further evidence of a pick-up in activity in 2014. Meanwhile, inflation remains low. The core personal consumption expenditure deflator, the Fed’s preferred measure, is hovering at around 1.2% YoY, well below the FOMC’s 2% long-term goal. Low inflation is a good argument for a continuation of the stimulus, or at least gives the Fed ample room to remain cautious. Finally, there is no major evidence that the quantitative easing is creating risks for financial stability. Overall, the current economic conditions allow for a wait-and-see approach by the Fed.

We therefore continue to believe the FOMC will start tapering its asset-purchase program in March 2014, when we expect it to be more confident about the economic outlook.

We also believe the FOMC will be extra careful, strengthening its forward guidance for the fed fund rate once the QE tapering begins. The crux of the game is financial conditions. We believe the Fed is only comfortable with a very modest tightening in financial conditions, at least during the initial stages of its monetary policy normalization, in order to not risk derailing the economic recovery. According to the minutes of the October FOMC meeting, strengthening the forward guidance seems likely to be the tool of choice for such a goal. Indeed, recently published papers by Fed staff researchers favor lowering the unemployment threshold to 5.5% or 6.0%, from the current 6.5%, before the first interest rate hike.

A stronger forward guidance should partially mitigate the impact of the QE tapering on financial markets. As a result, we now expect the 10-year Treasury bond yield to reach 3.3% in December 2014 (from 3.4%) and remain at around 2.7% until the end of 2013.

China – A better balance of risks

Activity in China started the fourth quarter on a fairly good footing. Industrial production in October was 10.3% higher than one year ago, compared with 10.2% in September. Urban fixed-asset investment has grown 20.1% year to date, compared with 20.2% the previous month.

We expect a slight moderation in activity toward year-end. Credit expansion decelerated to RMB 856 billion (USD 141 billion) in October, from an average of about RMB 1500 billion in August and September. Moreover, the People’s Bank of China (PBoC) seems intent on maintaining a monetary stance that is less loose than the one it had adopted in 3Q13. The ongoing strength of the increases in home prices might justify a more neutral stance by the central bank. Beijing, Shanghai, Shenzhen and other smaller cities have already issued measures to cool down the current price dynamics. Local authorities are attempting to increase supply while providing firms with “guidance for reasonable pricing.” If the current buoyant property-market dynamics continue, the PBoC might tighten its policy beyond the adjustment to a more neutral stance.

However, the overall activity indicators in China remain more supportive of global activity in this second half of the year, with limited short-term risks. We therefore maintain our growth forecasts at 7.7% for 2013 and 7.3% for 2014.

Moreover, China appears to be entering a period of reform that could also improve the balance of risks in the medium term. The overall theme of the proposals unveiled at the Communist Party’s Third Plenum was increasing the role of markets in the economy. The issues addressed span the financial sector, the economy’s ownership composition, a more competitive marketplace, reorganization of government structure and fiscal responsibilities, property rights and social issues. These reforms have the potential to improve productivity and rebalance the economy toward domestic consumption. They encompass changes deemed necessary to ensure that the growth in China remains sustainable by correcting economic imbalances and avoid a hard landing. The risk is now in the implementation, as these are guidelines with no details as to how the proposals will be put into practice.

Japan – Ongoing activity expansion continues

Although Japan’s GDP posted a greater-than-expected deceleration in 3Q13, to 1.9% QoQ (SAAR) from 3.8% in 2Q13, the expansion trend continues. Despite the lower growth in 3Q13, the result confirmed an activity-expansion trend driven by the economic stimulus implemented at the beginning of the year. We expect a reacceleration of growth in 4Q13 and 1Q14 fueled by advanced purchases due to the increase in consumption tax (from 5% to 8%) scheduled for April 2014.

We expect the negative impact of the higher consumption tax in 2014 to be partially offset by a new stimulus package worth about JPY 5 trillion (USD 49 billion). The details of the program should be published together with the supplementary budget due on December 12.

We revised our 2013 GDP forecast, to 1.8% from 1.9%, due to the weaker 3Q13, and are maintaining our 2014 forecast at 1.4%.

Europe – Weak growth and focus on deflation risks

GDP in the euro zone registered a meager 0.1% QoQ expansion in 3Q13, following a 0.3% increase in 2Q13. Germany and Spain’s GDP grew 0.3% and 0.1%, respectively. Italy continues to stabilize, but contracted 0.1% in 3Q13, extending its recession to nine quarters. France disappointed, with a 0.1% GDP decline in 3Q13, after a 0.5% expansion in 2Q13.

Given the weak growth and ongoing adjustments in the periphery, disinflation pressures have increased in the region. Inflation declined to 0.7% YoY in October, from 1.1% in September, and recovered slightly, to 0.9%, in November (see graph). However, inflation remains well below the European Central Bank’s (ECB) target of below but near 2%. While energy and food prices led the decline in October, core measures are also on a downtrend (see graph). As expected, inflation is lower in the periphery, where the drop in labor costs (without help from the exchange-rate depreciation) is a necessary part of the adjustment in the region.

The ECB, which responded with an unexpected 25-bp rate cut in November, could do more if the disinflation deepens. Our baseline scenario assumes that the ECB will remain on hold given our expectation of a gradual increase in inflation going forward. However, the risks are reasonable. Another negative inflation surprise could lead the central bank to respond by using non-standard instruments such as negative interest rates and asset purchases.

Commodities – Higher iron ore, lower crude oil prices

Itaú’s Commodity Index (ICI) remained roughly flat in November, rising 0.2% throughout the month. The breakdown shows slight changes in all sub-indexes: Agriculture (-0.8%), Metals (0.1%) and Energy (0.9%).

Our price forecasts remain broadly in line, despite several small adjustments. We revised our price scenario for the Agriculture and Energy sub-indexes to 0.6% and 3.4% below our previous forecast for 2014, respectively (end-of-period: eop). Meanwhile, we expect the Metal sub-index to come in 2.0% above our previous forecast. With these adjustments, our new forecasts remove part of the divergence between the previous outperformers (energy-related commodities) and underperformers (non-precious metals) among the ICI sub-indexes.

Agricultural prices continue to suffer negative effects as favorable weather generates higher expected supply, but is partially offset by stronger demand, particularly for corn and soybeans. While we maintain our forecasts for these grains, we are revising our forecast for cotton down to USD 0.76/lb (from USD 0.80) in 2014 (eop) due to the greater-than-expected planted area in both the U.S. and Brazil. We expect coffee prices to fall to USD 1.15/lb (from USD 1.25) in 2014, amid a sizeable surplus outlook. Sugar prices posted the largest decline in the period, given the clearer global surplus outlook for 1H14, in line with our previous report.

The ICI metals sub-index remained roughly flat in November, amid a divergence between rising iron ore prices (up 3.6%) and a decrease in other non-precious metals (down 3.7%). A surprisingly tight balance in the iron ore market – due to a decrease in high-cost mining capacity and stronger-than-expected demand in China, Japan and Europe – pushed prices above USD 130/ton, far from our forecast of USD 118/ton in 2013 (eop). However, the overall fundamentals for metals remain consistent with falling prices. We are revising our iron-ore price forecast up to USD 105/ton (from USD 102) in 2014 (eop), leading to a lower decline in ICI metals throughout 2014.

The interim nuclear deal between Iran and the G5+1 countries poses additional downside risk for crude oil prices in 2014. The agreement is a first step that may eventually lead to the normalization of diplomatic relations between Iran and western countries. While the deal is unlikely to lead to increased crude oil exports from Iran in the coming months, it does add another upside risk for oil supply in 2014 – other risks include potential improvements in the currently constrained production in Iraq, Libya and Nigeria. A 1 million b/d supply increase from these countries is becoming a more likely scenario that, if confirmed, could render OPEC unable to sustain Brent prices close to the current level (USD 110/bbl). We are therefore revising our 2014 forecasts (eop) for Brent prices down to USD 105/bbl (from USD 108) and WTI to USD 101 (from USD 105).

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



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