Itaú BBA - Volatility Ahead

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Volatility Ahead

August 14, 2014

Following months of high liquidity and low volatility, August began with turbulence in global financial markets.

Global Economy
A crucial second half of the year

With the improving U.S economy, we maintain our expectation for the 10Y Treasury yield at 2.90% in the end of 2014 and 3.45% in 2015. Emerging market growth was so far lackluster this year, but we see early signs of improvement lead by the cyclical upturn in China.

Brazil
Activity Stalls; Inflation Wanes

We reduced our forecast for GDP growth in 2014 and 2015, given the slow recovery after the World Cup and low business confidence levels. We also reduced our forecast for the IPCA inflation in 2014.

Mexico
Congress Approves Energy Reform Bylaws

The secondary legislation of the energy reform was approved, after a heated debate in Congress. The peso depreciated recently, but once markets price in the capital flows associated with the reform agenda, we expect the peso to outperform its peers.

Chile
Weaker Growth, Lower Interest Rates

Activity continues to disappoint. We lowered our GDP growth forecast for 2014 and now expect a softer rebound in 2015. Under this scenario, the central bank will likely bring the interest rate to 3.0% before the end of this year.

Peru
Growth Disappoints Further

Peru’s economy shows no signs of rebounding. We reduced our GDP growth estimate for 2014 and 2015. Still, likely due to external volatility, the central bank kept the policy rate unchanged in August.   

Colombia
Is a Pause in the Hiking Cycle Near?

As the economy continues to be robust, the central bank raised the interest rate in its July monetary policy meeting, and we expect additional increases in the second semester and in 2015.

Argentina
Heaven Can Wait

Argentina defaulted after failing negotiations with holdouts. In our view, the default will likely last longer than the market is pricing in.     

Commodities
Seeking the Bottom for Agricultural Prices

We have lowered our forecast for agricultural commodities, due to the consolidation of a stronger supply scenario. Improved sentiment toward China has led to an increase in the prices of non-precious metals.


More Volatility Ahead 

Following months of high liquidity and low volatility, August began with turbulence in global financial markets. The resurgence of geopolitical tensions prompted a flight for safe assets, particularly U.S. Treasury bonds. The U.S. dollar appreciated, especially against emerging market currencies.

Higher volatility may be ahead of us. In the U.S., GDP is finally growing at rates that are consistent with the strong results posted by employment numbers. As economic activity consolidates and the unemployment rate falls, U.S. monetary policy will likely normalize, after a prolonged period of zero interest rates. We believe that the Fed will eventually signal a faster rate hike trajectory than is currently expected by the market, which tends to increase market volatility and strengthen the dollar. Emerging-market economies will probably face outflows of capital, depreciation of their currencies, higher risk premiums and higher market interest rates. Improved economic activity in China - which help other emerging markets to recover - might soften this trend, but will not halt it.

The potential increase in volatility would be coming at a time when Latin American countries are showing mixed economic performance. On the one hand, the performance of Colombia’s economy has been solid, and Mexico seems to be recovering. On the other hand, the economies of Chile and Peru have been growing significantly more slowly than their historical trends. This divergence in economic performance also translates into opposing trends in monetary policy among the countries in the region, with rising rates in Colombia and rate cuts in Chile.

Growth remains particularly weak in Brazil. We have reduced our GDP growth forecasts again, to 0.6% for 2014 and 1.3% for 2015. The difference now is that the economic slowdown may be starting to moderate inflation, so we have reduced our inflation forecasts to a level slightly below the upper bound of the target range. The relief from inflationary pressures that might result from the weak economic activity would be helpful. However, pressure on regulated prices in 2015 and the probable depreciation of the Brazilian real are likely to hamper future monetary easing.

Finally, Argentina continues its quest for economic equilibrium. The failure of its negotiations with the holdouts and the consequent default will likely lead to a partial reversal of recent advances. We now see this year’s recession extending into next year.

Global Economy

A Crucial Second Half of the Year

• The U.S. economy improved in 2Q14, and recent indicators suggest that the country might finally sustain a 3% (cyclical) growth pace in 2H14.

• With the improving U.S economy and a gradual rise in wages and prices, we maintain our expectation for the 10-year Treasury yield at 2.90% in the end of 2014 and 3.45% in 2015.

• China’s GDP surprised on the upside in 2Q14. We revised our GDP forecasts to 7.4% in 2014 (from 7.2%) and have maintained 7.0% for 2015.

• Europe and Japan appear to have slowed down in 2Q14. We adjusted the forecasts down for both economies.

The U.S economy recovered in 2Q14 and seems headed to sustain a strong pace in 2H14. Growth averaged a paltry 1.0% QoQ/SAAR (seasonally adjusted annual rate) in 1H14. But the recovery in the second quarter and recent indicators suggest that the country might finally sustain a 3% (cyclical) growth pace in 2H14. We have revised our GDP forecast to 2.0% in 2014 from from1.6%, and are maintaining our forecast of 3.0% for 2015.

With better growth, the unemployment rate should continue to decline faster than envisioned by the Fed and inflation to converge gradually toward the Fed’s objective. In response, the central-bank rhetoric is likely to move toward preparing markets for the first interest-rate hike in mid-2015.

We maintain our forecast that the U.S. Treasury yields will be at 2.90% in December 2014 and 3.45% in December 2015.   

Europe and Japan appear to have slowed down in 2Q14. We lowered our forecast for the euro zone’s GDP to 1.0% (from 1.1%) and for Japan’s to 1.5% (from 1.7%) in 2014. For 2015, we maintain Europe at 1.5%, but reduced Japan’s GDP to 1.2% from 1.3%.

China surprised, growing 8.2% (QoQ/SAAR) in 2Q14 due to government stimuli. We expect the pace in 3Q14 to remain good but expect a slowdown in 4Q14. We have revised the GDP forecast to 7.4% in 2014 (from 7.2%) and are maintaining 7.0% for 2015.

Better growth in China may benefit, with lags, other emerging economies. We see signals that China is indeed improving activity indicators in other emerging markets. This seems concentrated in Asia for the moment. The growth outlook in in Latam remains mixed.

U.S. – A crucial second half of the year

The U.S. GDP rebounded 4.0% QoQ/SAAR (seasonally adjusted annual rate) in 2Q14. The first quarter was revised up to -2.1% from -2.9%. Growth averaged a paltry 1.0% in 1H14. While this is low, it is better than the 0% we had anticipated.

We revised our GDP growth forecast up (for the first time this year!) to 2.0% (from 1.6%) for 2014 and maintain 2015 at 3.0%.

GDP growth now looks a little less disconnected from the strong non-farm-payroll gains. The latter is rising at an average of 230 thousand jobs per month so far this year. Nonetheless, with GDP at a 1% pace, productivity growth remained sluggish in the first half of 2014.

Looking ahead, we see 2H14 as the crucial half for our call of higher U.S. interest rates than currently implied by the U.S Treasuries yield curve.

We expect the second half to confirm our view that the U.S. economy can sustain a cyclical 3.0% growth pace. In the last four years, the economy has not managed to grow at stronger pace for more than a couple of quarters (see graph) due to the prolonged headwinds of the financial crisis. Now the cyclical conditions for faster growth seem to be in place. If the economy cannot sustain a 3% pace again, it would suggest to us a more permanent and intense slowdown in productivity and potential growth. So far, the signals point to the cyclical recovery. The economy ended 1H14 on a high note. The ISM manufacturing rose to 57.1 in July, returning to the level of 2H13, when the economy grew 4% annualized. We are increasingly confident in higher growth ahead.

As a consequence of the economy’s growth, the unemployment rate should continue to decline faster than currently forecasted by the Federal Reserve. The non-farm payroll increased by 209 thousand in July, remaining above 200 thousand for the last six months. In addition, the weekly initial-claims statistics suggest that the strong labor market continued in early August.

Moreover, inflation should continue to converge gradually toward the Fed’s 2% objective. As the unemployment rate steadily declines, wages and, ultimately, price inflation will likely increase. We don’t expect jumps, but the inflation should gradually rise in the 2H14.

Finally, the improving economy should trigger a change in the Fed’s rhetoric toward preparing for the first interest-rate hike in mid-2015. Janet Yellen has emphasized that if the economy experiences a “faster convergence toward our dual mandate, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.” More recently, the Dallas Fed President Richard Fisher suggested that the FOMC members have already moved forward their expected starting dates for the Fed funds rate hiking cycle. The last FOMC meeting statement has already showed a gradual tilt, although the forward guidance continued to suggest a loose policy stance.

We maintain our forecast that the 10 year U.S. Treasury yield will be at 2.9% in December 2014 and 3.45% in December 2015.   

Europe – A weaker economy in 2Q14

In the euro area, activity data indicates a GDP pace in the 0.1%-0.2% QoQ range in 2Q14 instead of the 0.3% pace we had foreseen.

Industrial production was lacklustre in the period, having declined 0.4% in the quarter up to May compared with the preceding quarter. Domestic consumption maintained a steady expansion, but overall activity has been slightly weak.

At the country level, activity indicators suggest that the expected slowdown in Germany, after a strong first quarter, was more pronounced than we had assumed in our scenario. In the periphery, Spain’s GDP posted a solid 0.6% QoQ gain, but Italy disappointed and contracted 0.2% QoQ in the quarter.

Looking ahead, growth should pick up a little, to a pace of 0.4% QoQ in 2H14; nonetheless, risks seem to be on the downside. In particular, growth in Italy (and, to a lesser extent, France) might not gain momentum. Moreover, sanctions against Russia, which appear to be mild so far, could escalate and dent growth.

Due to the weaker 2Q14, we revised our 2014 GDP growth forecast to 1.0% from 1.1% previously. Our 2015 growth forecast remains unchanged at 1.5%.

China - 2Q14 GDP improves on government stimuli

Activity surprised on the upside in 2Q14, with sequential GDP growth accelerating to 8.2% (QoQ/SAAR) from 6.1% in 1Q14. The improvement relied heavily on the government stimuli announced since April, as shown by stronger infrastructure investment, government expenditure and credit growth in the quarter.

The momentum is extending into 3Q14, with monthly indicators improving further in June and July. For example, the manufacturing Purchasing Manager’s Index (PMI) reached 51.7 in July, its highest since April 2012.

We expect GDP to remain above 7.5% (QoQ/SAAR) in 3Q14 but to weaken by 4Q14. Momentum and residual effects of the recent stimuli should support the economy in the third quarter. Among other stimuli, the RMB 1 trillion lending by the PBoC to China Development Bank, which already helped the economy in 2Q14, will continued to play a role in social housing programs.

Advancing to 4Q14, we expect the economy to weaken as the effects of several stimuli fade. The current stimuli involved moving up government expenditures, investment plans in specific sectors, and targeted monetary and credit expansion. The growth targets for these variables for the whole year have not changed. Hence we should expect a reduction or even a pay back as we approach year-end. Meanwhile the property sector will continue to be a drag on fixed investment and the overall economy. Finally, the 2014 GDP growth target ought to be within range after the third quarter, diminishing the government’s incentive to promote additional stimuli.

We increased our GDP forecast to 7.4% from 7.2% in 2014 and maintained a gradual slowdown to 7.0% in 2015.

Will China boost growth in other emerging economies?

Emerging-market growth has been lackluster so far this year, but we see early signs of improvement, led by the cyclical upturn in China. The average ex-China manufacturing PMI in developing economies is starting to turn up. In the past, China’s PMI has led to improving data, with a few months lag, in other emerging markets and a similar pattern might have started in July (see graph.)

In LatAm, economic performance has been mixed. Mexico’s economy is on a recovery path, while Colombia’s data remains strong. On the other hand, Brazil, Chile and Peru are growing significantly below expectations, but we expect that some recovery in the second half. 

Commodities – Seeking the bottom for agricultural prices

The Itaú Commodity Index (ICI) has declined 5.8% since the end of June, with falling agricultural and oil-related prices. Agricultural prices are still trying to find a new equilibrium with the upsides surprises to supply and favorable weather conditions. Oil-related commodities declined as investors recognized that the conflicts around oil-rich regions are failing to affect supply. In the other direction, metal prices rose for the second consecutive month, driven by the upgrades to China’s growth and by a tight aluminum supply. 

We revised our agricultural prices down and metal prices up by the end of December. Our forecasts for oil-related commodities remain unchanged. 

As a consequence, the year-end ICI forecast is down to -5.6% YoY for 2014 (vs. -4.0% previously) and 3.0% YoY for 2015 (vs. 2.4% previously). From current levels, these revisions imply a 2.5% increase in the ICI by year-end.

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



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