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The Fed Brings Temporary Relief to Latin America

October 4, 2013

The Federal Reserve’s decision to delay the tapering of stimuli in September opened room for two alternative scenarios.

Global Economy
A Stimulative Delay
We see the tapering delay as a cautious pause and believe the central bank will gain enough confidence in the recovery to start the QE tapering in December.

Brazil
Less Pressure on the Currency
A stronger currency and lower inflation in recent months led us to revise down our forecast for the IPCA. The balance of risks for growth has improved due to the recovery of some financial indicators.  

Mexico
Fiscal and Monetary Policies Come to Help
After a very weak first half, activity data suggest better growth momentum. Exchange-rate depreciation, tax increases and weather-related supply shocks are upside risks to inflation.

Chile
Consumption Continues to Post Rapid Growth
Although the activity indicators for August suggest weak GDP growth during the month, consumption has sustained a rapid pace, supported by the tight labor market.

Peru
Business Confidence Continues to Slide
We reduced our forecast for GDP growth this year to 5.0% from 5.4%. We also lowered our forecast for the sol by the end of this year.

Colombia
A Temporary Rebound?
GDP grew strongly in the second quarter, after a weak Q1. However, confidence surveys and leading indicators indicate that the economy will decelerate in the second half.

Argentina
Worrisome Trend in International Reserves
We leave unchanged our base scenario of weak economic performance, high inflation and currency depreciation in both the formal and informal markets for 2013 and 2014.

Commodities
Lower Forecasts for Agricultural Prices
We revised down our forecasts for corn and wheat. We maintain our forecasts for metals and energy. Metal prices retreated in September, and we expect an additional 5% drop this year.  

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The Fed Brings Temporary Relief to Latin America

The Federal Reserve’s decision to delay the tapering of stimuli in September opened room for two alternative scenarios. The Fed may have chosen to slightly postpone the tightening process in order to gather further evidence that the economy is in fact recovering. In this scenario – the likelier one, in our view – a window of liquidity relief opens up for Latin America, but only up to December, when the tapering of the asset purchases may effectively start.

The Fed tapering could also be postponed for a longer period of time, until mid-2014, for instance. In this case, the effects would be more prolonged, and the Fed would run the risk of falling behind the curve, likely being forced to reverse its policies more quickly in the future. The extended calm could end with greater stress.

Meanwhile, the activity data continue to improve, not only in the U.S., but also in Europe and China, suggesting that global growth is gaining momentum. And, because they are temporary, the current fiscal stalemate and partial government shutdown in the U.S. should not alter this trend.

The Fed’s decision, along with the improved growth signs from China and Europe, provided relief for emerging markets. We revised our forecasts to reflect the more appreciated currencies in Peru, Chile, Colombia and Brazil expected by year-end. However, our exchange-rate forecasts for 2014 remained virtually intact, as we expect this relief to be temporary.

In Brazil, a stronger currency this year has reduced risks, easing the pressure on the Central Bank. The improved global environment and slightly better confidence levels reduce the downside growth risks.

In Mexico, the government presented a tax reform proposal, aiming to increase revenue and expenses. The monetary authority surprised the market by reducing the benchmark interest rate in response to the low growth in the first half of the year. However, we expect no further cuts, given the early signs of a rebound in economic activity.

Global Economy
A Stimulative Delay

•           While the partial shutdown of the U.S. federal government and the approaching debt ceiling pose risks, we expect the political stalemate to be resolved. The market’s focus will then return to monetary policy and economic recovery in the U.S.

•           We see the tapering delay as a cautious pause and believe the central bank will gain enough confidence in the recovery to start the QE tapering in December.

•           The FOMC also provided a forward guidance of very low fed fund rates. We lowered our forecast for the 10-year Treasury to 2.8% and 3.4% by the end of 2013 and 2014, respectively (from 3.0% and 3.5%).

•           We see a possible alternative, with easier financial conditions, in which the Fed maintains the pace of monetary stimulus until mid-2014. 

•           Our baseline scenario calls for the tapering to start this year, providing emerging economies a window of opportunity. In our alternative scenario, the “good times” return for a while longer.  

In the short term, the focus in the U.S. will remain on the partial shutdown of the federal government and the approaching debt ceiling. However, although they pose risks, we expect the political stalemate to be resolved. The market focus will then return to the monetary policy and economic recovery in the U.S.

After all, the U.S. Federal Reserve didn’t start to taper its quantitative easing policy in September. The central bank was cautious given the sluggish 3Q13 growth, recent tightening of financial conditions, uncertainty regarding restrictive fiscal policies, and risks related to the upcoming fiscal debates.

We see this as a pause, and expect the tapering to begin in December. By then, the FOMC should be more confident about the recovery, and the short-term political risk posed by the U.S. Congress should be over.

The FOMC also provided a forward guidance of very low fed fund rates. We therefore lowered our forecast for the 10-year Treasury to 2.8% and 3.4% by the end of 2013 and 2014, respectively (from 3.0% and 3.5%).

In our baseline scenario, the global outlook after the Fed surprise remains similar: the U.S. recovers, China stabilizes, the recession in the euro area comes to an end, and a gradual normalization of monetary policy in developed countries begins.

However, we see a possible alternative scenario, with easier financial conditions, where the Fed maintains the pace of monetary stimulus until mid-2014. The FOMC showed greater risk aversion to economic outcomes due to the low inflation environment. If GDP growth remains slightly below 2.0% (seasonally adjusted annualized rate – SAAR) in 4Q13, the QE tapering could be delayed until mid-2014. The U.S. 10-year Treasury would return to 2.5% by the end of 2013. Meanwhile, the world recovery would remain virtually unchanged. The Fed could risk falling behind the curve and needing to tighten policy much faster at some point. However, until then, the outlook for risk assets would be bullish.

In our baseline scenario, emerging economies gain a window of opportunity. The Fed’s dovish forward guidance for U.S. rates also helps. Those countries that use the opportunity wisely will perform better when the tapering begins at the end of the year.

In our alternative scenario, emerging economies enjoy a return of the “good times” for a while longer. Their exchange rates would appreciate considerably and the interest rates would decline, at least until the reversal in the U.S.

U.S. – A stimulative delay

In the short term, the focus in the U.S. will remain on the partial shutdown of the federal government and the approaching debt ceiling. As a result of Congress’s failure to agree on a continuing resolution, all non-essential functions of the federal government were either completely or partially shut down on October 1. The shutdown has a limited direct impact on 4Q14 growth – we estimate a drag of around 0.2% in annualized terms if it lasts a week, and 0.4% if it lasts two weeks – but the political stalemate that led to the shutdown raises concerns that an agreement will also not be reached on the debt ceiling, which the U.S Treasury estimates would be reached on October 17. The stakes are higher here. It could result in the U.S. government defaulting on its debt and take a significant toll on the economy.

Although these fiscal issues pose risks, we expect an agreement, and the market’s focus will then return to the monetary policy and economic recovery in the U.S.

The U.S. Federal Reserve didn’t start to taper its quantitative easing policy in September. The central bank argued that it would rather wait for further evidence that the recovery is on track, given the sluggish 3Q13 growth (GDP is tracking at 1.7% - SAAR), recent tightening of financial conditions, uncertainty regarding restrictive fiscal policies, and risks related to the upcoming fiscal debates (government shutdown and debt ceiling).

There are reasons to believe that the FOMC will gain confidence over the next few months. First, we expect growth to accelerate to 2.3% (SAAR) in 4Q13, as the fiscal drag eases. Second, Congress is expected to settle the fiscal debates over the next couple of months.

Although data dependent, we expect the FOMC to start tapering its asset purchases by USD 10 billion at the December meeting. If confirmed, the tapering delay in September would mark a brief pause that should have a limited impact on the overall economic scenario.

However, the non-tapering was not the only surprise of the September meeting; the FOMC also provided a forward guidance of very low fed fund rates. The median FOMC member believes it is appropriate to keep the fed fund rate below 2.0% until year-end 2016, despite the fact that they expect: i) the unemployment rate to return to the non-accelerating inflation rate of unemployment and ii) inflation to be near the target by that year. Bernanke added that it would likely take another two to three years, after 2016, for the fed fund rate to reach the 4% long-term neutral level.

We therefore lowered our forecast for the 10-year Treasury to 2.8% at the end of 2013 and 3.4% at the end of 2014 (from 3.0% and 3.5%, respectively). Indeed, this was part of the Fed’s strategy: reinforce its guidance to minimize the interest-rate impact of the tapering, when it occurs. Note, however, that our fed fund rate estimate is still higher than both the FOMC’s forward guidance and the current market pricing (see graph).

We also see risks of a possible alternative scenario, with easier financial conditions, in which the Fed maintains its asset purchases at the current pace until mid-2014.   First, the FOMC showed greater risk aversion to weaker economic outcomes due to the low inflation environment, stressing that the path of the asset-purchase program is data dependent. Second, Janet Yellen is likely to become the next Fed chairman, and we believe her stance to be at least as dovish as Ben Bernanke’s.

This alternative scenario would become more likely if 4Q13 recovery is less strong than anticipated, which wouldn’t take much. If growth stays slightly below 2.0% (SAAR) in 4Q13, as opposed to our expectation of 2.3%, it might be enough for the Fed to postpone the QE tapering and maintain the monetary stimulus at full speed in 1H14.

In this scenario, the economic growth outlook for the U.S. would remain virtually unchanged, while monetary conditions would be easier. The 10-year Treasury could then hover at around 2.5% and 3.0% by the end of 2013 and 2014, respectively. The Fed could risk falling behind the curve and needing to eventually tighten its policy much faster, but monetary conditions would be very easy in 1H14.

Euro Zone – Moderate expansion remains on track

The euro zone composite Purchasing Managers’s Index (PMI) rose to 52.1 in September, from 51.5 in August. The composite PMI remains on an uptrend (see graph), evidencing that the recession in the euro zone has in fact ended. However, the pace is moderate at best, given that the remaining fiscal adjustments, bank deleveraging and structural problems are holding back the economy. Nonetheless, the outlook for the euro zone economy is more positive.

China – A temporary activity improvement

Activity improved in 3Q13, with both exports and domestic demand increasing. Exports growth rose an average of 6.1% yoy in July and August, compared with the 4.2% pace in 2Q13. Meanwhile, the fixed-asset-investment expansion improved to 20.8% yoy in July/August from 19.8% in 2Q13. The momentum is expected to continue in September. The NBS PMI improved 0.1 point, to 51.1, in September, suggesting that industrial production will maintain a pace of around the 10.4% yoy registered in August. The overall improvements in the quarterly data have led us to estimate a sequential growth acceleration, with GDP expanding 7.8% yoy in 3Q13 (see graph).

We see the pickup as temporary and maintain our expectation of a moderate growth pace in 2014 (see graph). The underlying credit expansion remains moderate, with the share of domestic-currency loans up 14.1% yoy in August, down from 14.3% in July and 14.5% in 2Q13. Moreover, the expansion in total social financing in August was mostly due to lending associated with short-term activity. Overall, we believe policymakers supported the economy by reinforcing their commitment to avoiding short-term volatility in growth rates. However, they refrained from providing broad-based stimulus and instead focused on specific measures in strategically important sectors.

After stabilizing growth, we expect policymakers to focus on structural reforms. Part of the objective is to make the economy more market oriented. The Shanghai Free Trade Zone, which was launched in September, will become a testing ground for reforms. The Third Plenary Session in November should provide further indications of the reform agenda.

We raised our growth forecast for 2013 to 7.7% (from 7.6%), due to stronger 3Q13 data, and to 7.3% (from 7.2%) for 2014, due to carry-over.

Commodities - Downward revision of agricultural price forecasts

The Itaú Commodity Index (ICI) fell 2.9% in September, driven by lower geopolitical risks, evidence of a slower restocking pace in China, and the passing of the critical period for U.S. crops. The breakdown shows declines in all sub-indexes: Agriculture (-2.7%), Base Metals (-0.9%) and Energy (-4.3%). So far, the Fed’s dovish surprise has had only a temporary impact on commodities. Prices rose initially, but most receded the following week, to the levels registered before the meeting.

We are downwardly revising our agricultural price forecasts due to declining weather-related risks. Although the USDA will probably reduce its corn- and soybean-crop estimates in its next monthly report, the adjustments have already been priced in. Moreover, the expected weather-related risks did not materialize. Overall, we expect no material changes in the grain surplus throughout the crop year. For corn, a sizable surplus in U.S. and world markets is causing prices to fall toward the producers’ cost. We are therefore downwardly revising our year-end forecasts to USD 4.6/bushel (from 5.5) in 2013 and 5.0 (from 5.6) in 2014. The revision is consistent with lower wheat prices (USD 6.6/bushel, from 6.8 in 2013) and lower soybean prices (USD 12.2/bushel, from 13.5 in 2014).

The activity pick-up in China is failing to support metal prices. The overall fundamentals are weak. We see the pickup in Chinese growth as temporary, while the fading restocking cycle in China is generating surpluses in several industrial metals. We expect metal prices to fall another 5.6% before the end of the year, and maintain our forecasts for the ICI metals sub-index at -9.7% yoy in 2013 and -7.0% yoy in 2014.

Energy prices fell 4.3% in September, due to lower geopolitical risks and prospects of a looser global balance. The likelihood of a military strike against Syria has diminished, the oil supply in Libya is recovering and the U.S. production has rebounded. The global balance is expected to be less tight in the following months, preventing Brent prices from remaining sustainably above USD 110/bbl. We maintain our forecasts for the ICI energy sub-index at 6.6% yoy in 2013 and -0.8% yoy in 2014.

The possibility of an even more dovish U.S. Fed is the main risk to our commodities scenario. We expect lower interest rates in the U.S., following the Fed’s dovish surprise (see above), but our baseline view is that the Fed has only postponed the QE tapering by a few months, until December. The commodities scenario therefore remains virtually unchanged.

We see a possible alternative scenario, in which the Fed maintains the pace of monetary stimulus until mid-2014. This would be positive for commodity prices, at least until a reversal takes place. A looser monetary policy would push commodity prices higher, due to a weaker dollar and higher inflation expectations, while the global growth outlook would remain positive. In this alternative scenario, we expect the ICI to be 5% above the base case throughout 2014.

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



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