Itaú BBA - Trade war risks escalate and turbulence goes on

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Trade war risks escalate and turbulence goes on

July 6, 2018

The turbulence goes on in the global scenario, with higher risks of a trade war. In Brazil, uncertainties hinder the economic recovery

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

Global Economy
Risk of a trade war escalates
U.S. and China moved closer to a full-blown trade war, but we expect no escalation beyond the initial round of tariffs. Global financial conditions have tightened since the start of 2018, but remain consistent with above-potential world GDP growth.

LatAm
Turbulence continues
Global conditions continue to put currencies in the region under pressure. Countries with fewer vulnerabilities are recovering, while economic activity in Brazil and Argentina has been a disappointment, leading us to reduce our growth forecasts for both countries.

Brazil
Uncertainties hamper the recovery
We trimmed our GDP growth forecasts to 1.3% in 2018 (from 1.7%) and 2.0% in 2019 (from 2.5%), given the continued deterioration of financial conditions. We also revised our year-end forecasts for the exchange rate to BRL 3.90 per USD in 2018 and 2019 (from 3.70 previously) to reflect greater internal and external risks.

Argentina
Fighting market instability
President Macri appointed Luis Caputo as central bank governor. The new authorities tightened monetary conditions to stabilize the exchange-rate and announced that changes in monetary policy instruments will likely be implemented very soon.

Mexico
Political change as trade war looms
AMLO won Mexico’s elections with a wide margin, and his coalition gained control of both houses in Congress. The odds of drastic economic policy changes are low, but there is a risk of measures that may hold back investment in specific sectors.

Chile
Rate hikes on the horizon
Strong growth and the recent weakening of the currency mean lower risks for inflation convergence to the target. We now expect a monetary policy normalization to begin at the end of this year rather than in early 2019.

Peru
Return of political noise
President Vizcarra’s approval rate fell by 15 pp in June. His loss of popularity, in our view, is mainly explained by the population’s dissatisfaction with the excise tax hikes and their growing perception of the government’s fragility.

Colombia
End of the cycle
Iván Duque won the elections, as expected. The new administration will face fiscal and peace-agreement-related challenges. Meanwhile, recovering economic activity and inflation slightly above 3% reduce the appeal for further monetary easing.


 


Trade war risks escalate and turbulence goes on

The last weeks saw an escalation of trade-related risks, with the U.S. and China moving closer to a full-blown trade war that could potentially reduce global growth ahead.  We expect no escalation beyond the initial round of tariffs, but since president Trump’s political rhetoric is not likely to change before the mid-term elections in November, this is a risk that will continue to loom over the coming months. 

Nonetheless, global growth remains healthy. International financial conditions have tightened since the start of 2018, but remain consistent with above-potential economic expansion, leading us to keep our global GDP growth forecasts unchanged at 3.9% for this year and 3.7% for 2019.

In Latin America, external conditions continue to put currencies under pressure. Countries with fewer vulnerabilities are recovering, while activity in Brazil and Argentina has been a disappointment, leading us to reduce our growth forecasts for both countries. As a general rule, the monetary policy stance is tightening across the region. Mexico’s central bank resumed interest rate hikes, while in Argentina the central bank tightened monetary policy further. In Chile, Colombia and Peru, central banks are indicating more clearly that there is no room for further easing. In Mexico, the anti-establishment candidate Andrés Manuel López Obrador (AMLO) won the presidential elections with a wider-than-expected margin, and his coalition gained control of both houses in Congress. In our view, the odds of drastic changes in economic policies are low, but there is a risk of measures that might hold back investment in specific sectors, curbing GDP growth in Mexico.

In Brazil, uncertainties are taking a toll on economic activity. The continued deterioration of financial conditions – as seen in higher interest market rates, rising country risk, falling equity indexes and a more depreciated exchange rate (we revised our forecast to BRL 3.90 per USD in 2018 and 2019) – led us to reduce our GDP growth forecasts to 1.3% in 2018 and 2.0% in 2019 (from 1.7% and 2.5%). Due to the weaker BRL and a larger-than-expected adjustment in electricity tariffs, we lifted our inflation forecasts to 4.1% in 2018 and 4.2% in 2019. As for monetary policy, greater uncertainties, anchored expectations and low inflation readings reinforce the outlook for stability of the benchmark Selic interest rate until year-end.


 


Global Economy
Risk of a trade war escalates

• Global growth remains healthy, with stronger U.S. momentum, an environment that is favorable for the USD.

• While global financial conditions have tightened since the start of 2018, they are still consistent with above-potential world GDP growth.

• A full scale trade war between the U.S., China and Europe could reduce global GDP by 0.4 pp. We expect no escalation beyond the initial tariffs imposed by the U.S. and China on goods worth USD 50 billion.

• We lowered our estimate of agriculture prices, given that China imposed tariffs on U.S. soy exports. The outlook for other commodities remains unchanged, in line with steady global growth forecasts.

Healthy global growth, stronger in the U.S.

We have left our world GDP forecast unchanged, at 3.9% for 2018 and 3.7% for 2019. Despite an increasing tail risk of a trade war, which we discuss in detail in the next section, global financial conditions have been tightening gradually, but remain consistent with above-potential growth.

Growth momentum is stronger in the U.S. than in the rest of the world. ISM manufacturing above 60 highlights the stronger U.S. growth momentum. Meanwhile, PMI ex-U.S. stabilized at around 53 in June, two points below its peaks of 55 (see chart).

We expect U.S. GDP to expand by 4.1% qoq/saar in 2Q18 and by 2.9% in 3Q18. Tax cuts and increases in public spending are boosting GDP in this midpoint of the year.

As the fiscal impulse to GDP fades and interest rates rise, U.S. growth should start to decelerate between 4Q18 and 1Q19. With the unemployment rate at 3.8%, below the Fed’s 4.5% estimate for the NAIRU, and core inflation at 2%, the Fed will keep tightening policy to a neutral zone, so growth will likely keep converging down toward its longer-run GDP growth estimate (1.75%).

For now, we leave our GDP forecast at 2.7% for 2018 and at 2.3% for 2019. We continue to believe that the Fed will raise the Fed Funds rates four times in 2018 and three times in 2019, so the 10-year UST will rise to 3.25% by YE18 and to 3.50% by YE19. If these rate hikes fail to slow economic activity down (in our view, a relevant risk), then U.S. interest rates will have to rise further.

In China, authorities have loosened monetary and fiscal policy. The policy change aims to prevent excessive credit tightening amid trade-war risks. As a consequence, we expect growth to slow down only gradually.  Manufacturing PMI will likely remain around 51.5. The negative surprise in last month’s retail sales was likely a blip. Public FAI should also recover as credit conditions start to stabilize. Hence, we left our China GDP growth forecast unchanged, at 6.5% for 2018 and 6.1% for 2019.

The looser monetary policy led us to reduce our yuan forecast. PBoC reduced its Reserve Requirements Ratio (RRR) by 50 bps and has moved to a more proactive policy stance. In addition, it showed less willingness to defend the yuan (CNY) in a trade dispute with the U.S. We forecast the CNY/USD at 6.5 (from 6.3) by YE18 and at 6.5 (from 6.1) by YE19.

In the Euro area, the composite PMI at 54.9 and economic fundamentals continue to support a growth rebound in 2Q and above 2% this year. Political uncertainty remains in Italy and Germany, but seems contained for now. The U.S. plan to impose 20% tariffs on EU autos is a risk, as discussed below. Because growth remains above potential and underlying inflation is slowly increasing, but still below the target, we expect the ECB to raise interest rates only in 3Q19. Our GDP forecast for the Eurozone remains at 2.3% for 2018 and 2.0% for 2019.

A full scale trade war could reduce global growth by 0.4 pp by year-end 2019

U.S. and China have moved closer to a full-blown trade war. The U.S. has imposed 25% tariffs on USD 34 billion worth of Chinese imports and could implement tariffs on another USD 16 billion. China responded with tariffs on USD 34 billion worth of U.S. exports, including soybeans, cars and aircrafts, and has pledged to retaliate proportionally against U.S. measures. President Trump has requested the USTR to study a second list of USD 200 billion in imports from China to be subject to 10% tariffs. If China retaliates as it has pledged, Trump said he could also impose the 10% tariffs on a third list of Chinese imports worth USD 200 billion.

President Trump has also threatened to impose 20% tariff on imports of autos and parts, a major source of the U.S. trade deficit. U.S. imports USD 275 billion of autos products, mainly from NAFTA (53%), Japan (18%), Germany (14%) and South Korea (8%). Europe has officially threatened to raise tariffs on up to USD 300 billion of U.S. goods imports in response.

If these measures are imposed, global growth could drop by 0.4 pp after four quarters. We used a Vector Auto Regression (VAR) model with five variables (U.S., China and EU GDPs, a factor representing DM interest rates and one with broader financial conditions). We assume the U.S. would impose an average 12% tariff on USD 450 billion of Chinese imports and a 20% tariff on USD 40 billion of European car imports. China would raise 25% tariffs on USD 130 billion of U.S. imports, while Europe would raise 20% tariffs on USD 40 billion of U.S. imports. The VAR allows us to sum the direct GDP effect of each tariff with the indirect impacts of the concurrent GDP slowdown, through iterations from trade and financial channels. Importantly, in the VAR, we allow DM interest rates to decline by less than historical norms as the Fed has less policy space to absorb a shock at this point of the cycle, and the ECB has little scope to further cut rates or expand QE. Accounting for both trade and financial channels is important and adding all the impact we estimate global growth could decline by 0.4 pp (see table at the end of the section).

The U.S. GDP (-0.25) would be less affected than China (-0.40) and Europe (-0.46). Although a trade war would be centered on U.S. action, its economy is less open than others and a large share of exports is composed by commodities, for which it is easier to find new buyers. Hence, it is less affected by the trade channel. Meanwhile, China’s GDP would be hurt by the tariffs, but its economy is less integrated to global financial markets and hence less affected by the financial channel. Finally, for the Euro area both the trade and the financial channels matter and the region would be the worst hit.

A full scale trade war remains a higher risk for now, as president Trump’s political rhetoric won’t likely change before the mid-term elections on November 6. And this hawkish rhetoric could have unintended consequences of harming consumer and business confidence, thus reducing consumption and investment. However, a negotiated deal still leads to a better economic outcome and so should be reached by the parties.

Commodities – agricultural prices hit by the first round of tariffs and stronger expected supply

The Itaú Commodity Index (ICI) has fallen 2.5% since the end of May. The decline was mainly driven by agricultural prices: the agricultural sub-index fell 8.8%. In addition, metal prices declined 3.1%, while oil-related prices rose 2.5% over the same period.

The decline in agricultural prices was driven by several factors:

  • China’s tariff hike will cause U.S. soybean prices to trade at heavy discounts relative to other producing regions. This drop in soybean prices should lead producers to shift planted area towards corn, reducing its prices, which in turn affects wheat prices, as corn and wheat are partial substitutes. Tariffs will also affect the U.S. cotton market.
  • In addition, USDA published updated acreage estimates that increased expected corn and soybean output in the U.S.
  • Coffee prices fell further, amid favorable weather and a weaker BRL.

Oil prices rose as new supply constraints continue to feed uncertainty over OPEC’s plan to raise output by approximately 600kb/d. There is a conjunction of supply constraints because of Libya’s output interruptions, the oil export embargo on Iran and the falling trend in Venezuelan production, which increases uncertainty if OPEC indeed meets its target by YE18. We continue to expect oil prices to correct downwards, as Saudi Arabia and other OPEC countries can increase output in 2H18 to offset those setbacks. 

We lowered our soybean, corn, wheat and cotton price forecasts to adjust for the abovementioned first round of tariffs between the U.S. and China. We maintain our metal price forecasts roughly unchanged, recognizing that metal markets will only be affected if the trade war deepens and hurts global growth, particularly in China. Following the revisions, our YE18 forecasts see agricultural prices rising slightly from current levels, metal prices staying stable and oil-related prices declining.


 



LatAm
Turbulence continues

• Trade war risks and higher interest rates in the U.S. continue to put currencies in the region under pressure. Countries with lesser vulnerabilities are recovering, while activity in Brazil and Argentina has been a disappointment, leading us to reduce our growth forecasts for both countries. 

• Monetary policy stance is tightening across the region. Mexico’s central bank resumed interest rate hikes, while in Argentina the central bank tightened monetary policy further through Lebacs and reserve requirements. In Chile, Colombia and Peru, central banks are indicating more clearly that there is no room for further easing. In Brazil, the weakening of the BRL means less room for further interest rate cuts (in spite of ample spare capacity), although the outlook for inflation suggests that there is no need for rate hikes in the short term. 

Trade war risks and higher interest rates in the U.S. continue to put currencies in the region under pressure. Since the beginning of June, the Argentine peso continued to be the underperformer of the region (also in inflation-adjusted terms), in spite of the larger-than-expected IMF package. While the situation in Argentina remains quite uncertain, we note that the real exchange rate is already at a level consistent with a substantial narrowing of the current account deficit (also considering the ongoing fiscal adjustment) and yields (in domestic and foreign currency) are at high levels. These factors, together with the IMF rescue facility, should lead to a stabilization of the market. On the other hand, the Mexican peso has outperformed, in spite of a much stronger result for the anti-establishment candidate Andrés Manuel Lopez Obrador (AMLO) in the elections (his coalition will have control of both houses in Congress) and the growing uncertainty over NAFTA and the U.S. administration’s threat of boosting tariffs on auto imports. In fact, the current account deficit for Mexico is low (1.6% of GDP last year), even with falling oil production and low unemployment rates, indicating that the pricing of the Mexican peso prior to the election already embedded a significant risk premium.       

Despite the risks of a trade war and tighter financial conditions, countries in the region that have less vulnerabilities are recovering. In fact, global growth remains solid, and key commodity prices for the region (like copper and oil) stand at high levels. In this context, Peru and Chile are exhibiting high growth rates, gradually reducing their existing spare capacity. In Colombia, there are signs that the economy is picking up, generating upside risk to our forecast of a modest recovery this year. In Mexico, despite uncertainties related to the political scenario and trade relations with the U.S., the country is benefitting from the dynamism of the U.S. economy and a solid labor market, sustaining around-potential growth. 

On the other hand, countries with deeper imbalances are performing poorly. In Argentina, economic activity is already weakening, as tighter financial conditions are forcing an adjustment in fiscal and monetary policies and depressing real wages (given the pass-through from the weaker peso) and the effects of the harsh drought are kicking in. We reduced our growth forecast for Argentina to 0.5% this year, but we note this implies a technical recession (at least two consecutive quarters of negative growth). In Brazil, which faces severe fiscal imbalances and an important election this year, confidence is once again falling (partly influenced by the recent truckers’ stoppage), which poses a threat to activity ahead. We now expect GDP growth at 1.3% for Brazil this year (compared with 1.7% in our previous scenario) and 2.0% for 2019 (2.5% before).  

In this environment, the monetary policy stance in the region is tightening. In countries facing more modest exchange-rate depreciation (like Chile, Colombia and Peru), the ongoing recovery and the fact that monetary policy rates are already at expansionary levels are leading central banks to close the doors on additional easing (and Chile’s central bank is even indicating a tightening cycle starting by the end of this year). In Brazil, the weakening of the BRL means no room for further monetary easing, although with the depreciation so far there is no reason to start raising interest rates either (inflation expectations are well-anchored, and there is still ample spare capacity in the economy). In Argentina, there was a change in command at the central bank, which tightened monetary policy further (by raising reserve requirements and placing short-term Lebacs at higher yields), although the policy rate has been stable, at 40%, since early May. Finally, Mexico’s central bank resumed its tightening cycle with a 25-bp rate increase in June because it saw deterioration in the balance of risks for inflation. Furthermore, the statement announcing the decision suggested that more tightening is on the table, and we now expect one additional interest rate increase before the cycle ends.

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



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