Itaú BBA - Weak activity and stable currencies leave room for further monetary easing in Latam

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Weak activity and stable currencies leave room for further monetary easing in Latam

September 4, 2017

A benign global environment continues to benefit emerging markets.

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

Global Economy
Busy agenda ahead won’t derail global recovery
Attention turns to fiscal deadlines in the U.S. and the Fed’s announcement of balance sheet reduction, but we don’t see these events derailing the global recovery.

LatAm
Benign external environment leaves room for further monetary easing
Economic slack and well-behaved exchange rates mean there is still room for further monetary easing in most countries.

Brazil
Signs of a rebound amid fiscal deterioration
Economic activity data are improving, and we revised our 2017 GDP growth forecast upwards. The unsustainable public debt dynamics continues to be the economy’s main vulnerability.

Argentina
Renewed political momentum
Argentina’s ruling coalition (Cambiemos) obtained a better-than-expected result in the primaries for the mid-term elections (due in October), increasing the likelihood of reforms and fiscal adjustment.

Mexico
Fundamentals improve, but politics pose risks
The shocks battering the economy (uncertainty over trade relations, inflation spike and falling oil output) seem to be moderating, which, coupled with a solid U.S. economy, will likely sustain growth during the second half of the year.

Chile
Sluggish growth persists
Activity in the first half of the year confirmed a lethargic Chilean economy. We now expect growth of 1.3% for this year (1.6% previously).

Peru
Sour lemonade
The central bank’s Chairman, Julio Velarde, warned that August’s inflation would be pressured by a supply shock, which he dubbed the “lemonade effect,” that is, a combination of sharp rises in regulated water tariffs and lemon prices.

Colombia
A pause in the cycle
The central bank is likely nearing a pause in its easing cycle, given inflation is set to accelerate towards year-end due to a lower base of comparison. Nevertheless, inflationary pressures will fade ahead, so additional rate cuts are likely next year.

Commodities
Metals rally unlikely to last
In our view, the metal rally will fade as the Chinese economy decelerates in 2H17. We forecast iron ore prices at USD 60/mt and copper prices at USD 5700/t by the end of the year.


 


Weak activity and stable currencies leave room for further monetary easing in Latam

A benign global environment continues to benefit emerging markets. In the U.S., activity remains solid as attention turns to fiscal deadlines (government shutdown, debt ceiling) and the Fed’s announcement of balance sheet reduction in September. In the euro area, Germany’s elections are a non-event, activity is healthy, the exchange rate is not yet appreciated and the ECB is on track to announce, in October, a cautious reduction of its asset purchases for 2018. In China, we expect a gradual economic slowdown. The 19th Party Congress in October is unlikely to trigger either a sharp change in policy or a steep economic slowdown.

In Latam, well-behaved exchange rates and economic slack mean there is still room for further monetary easing in most countries in the region. In Brazil, we expect another 100-bp rate cut at the BCB’s September meeting. In Chile, we expect the policy rate at 2% by year-end, from the current level of 2.5%. Colombia’s central bank has indicated a pause in the easing cycle, but we expect further cuts in 2018 as inflationary pressures fade. In Peru, we continue expecting the BCRP to deliver two more 25-bp rate cuts in 2017, taking the reference rate to 3.25%.

In Brazil, the government decided to increase its fiscal deficit targets, so the public debt dynamics becomes even more unfavorable. Economic activity data, on the other hand, are improving, and we revised our 2017 GDP growth forecast upwards to 0.8% (from 0.3%). For 2018, we continue to expect 2.7% growth. We also reduced our average unemployment rate forecast in 2018 to 12.4% from 13.3%. Inflation remains low, reflecting substantial slack in the job market, a well-behaved currency, and the drop in food prices. We reduced our IPCA inflation forecast to 3.2% this year (from 3.4%) and maintained 4.0% for 2018.


 


Global Economy
Busy agenda ahead won’t derail global recovery

• In the U.S., activity remains solid as attention turns to fiscal deadlines (government shutdown, debt ceiling) and the Fed’s announcement of balance sheet reduction in September.

• In the euro area, Germany’s elections are a non-event, activity is healthy, the exchange rate is not yet appreciated and the ECB is on track to announce, in October, a cautious reduction of its asset purchases for 2018.

• For Japan, we revised our growth forecasts to 1.9% in 2017 and 1.4% in 2018, from 1.4% and 1.0%, respectively.

• In China, we expect a gradual economic slowdown. The 19th Party Congress in October is unlikely to trigger either a sharp change policy or a steep economic slowdown.

• Emerging markets continue to benefit from a benign global environment, and also from an improvement in their fundamentals.

U.S. – Economy remains resilient amid political risks

The U.S. economy will likely grow 2.7% in 2H17, a bit faster than the 2.1% seen in 1H17. Consumption is tracking at 2.5%, non-residential fixed investment and exports could expand between 4% and 5%, and inventory accumulation may provide an extra boost. Vehicle sales, parts of commercial real estate, and housing are soft spots amid generally solid private-spending signals.

We continue to forecast U.S. GDP to grow 2.1% in 2017 and 2.3% in 2018. A still-low Fed funds rate and stronger global outlook are fostering positive financial conditions and optimism.

Inflation remains lows, although part of this year’s softness seems transitory. As the economy will keep growing above potential, we expect core PCE to rise to 2.0% yoy in 4Q18 (from 1.5% in 2Q17).

The Fed remains on track to begin the balance-sheet run-off in September and continue with gradual rate hikes in the following quarters. The next interest-rate hike, in December, depends on firmer inflation in 2H17, which seems likely in our view. We expect three additional hikes in 2018.

The market does not price enough increases in the Fed fund rate, in our opinion. Investors believe that the fall in inflation is permanent, and fear that the economy cannot sustain its current above-potential pace for much longer. We disagree with both opinions.

Despite brief spikes in volatility, the U.S. economy has remained resilient to constant political headlines. On the domestic front, there are two separate issues: the budget, which could cause a government shutdown, and the debt limit. North Korea remains the main geopolitical risk.

A temporary government shutdown is possible, but unlikely to threaten the economic expansion. President Trump has threatened a shutdown if Congress does not fund a Mexican border wall, which Democrats are unlikely to accept. A short-term government shutdown could happen, but the economic impact is modest.

The risk of not raising the debt limit, which would have bigger economic impact, seems low. The Treasury’s ability to fund deficit reaches its limit in the end of September. Risks rise significantly in the first two weeks of October. Trump, Republicans and Democrats are unlikely to risk breaching the debt limit, given the potentially large economic consequence. The Treasury would have to default temporarily on its obligations, including Treasury securities. There is no cross-default among Treasury securities, so financial instability may still be avoided. However, government spending and transfers will shrink sharply and policy uncertainty should spike and negatively affect private spending.

On the positive side, tax reform could make a comeback. Republican leaders and Trump’s economic advisers seem to have made advances recently. The House and Senate may be getting ready to reach a deal on the budget resolution for 2018 that sets the parameters for tax cuts with a simple majority in the Senate.

On the external front, North Korea has become a permanent risk, but a war remains unlikely. The country has made clear advances in its nuclear program. President Trump has preemptively drawn a line, threatening a strong military response if there is any North Korean aggression to an allied territory, which limits the risk of a war. Meanwhile, the U.S. is likely to keep pushing for increased economic sanctions and improving the military defense capacity of South Korea and Japan.

Europe – Booming?

Euro-area business surveys indicate that growth remains solid in 3Q17. August’s Purchase Manager’s Index (PMI) indicates GDP growth of about 0.5% qoq in 3Q17, continuing the cyclical recovery in the region.

With a better economic outlook, the ECB will likely announce a reduction in its asset purchases in October. We expect the ECB to reduce its monthly asset purchases to EUR 40 billion (from EUR 60 billion) in 1H18.

The euro is appreciating in response to the stronger outlook, but is far from being at an expensive level. Indeed, the real effective exchange rate remains below its long-term average (see graph).

Finally, Angela Merkel will likely be reelected as Germany’s Chancellor, with a pro-Europe coalition. If confirmed, that will be her fourth term; her first term started in 2005. The most likely coalitions are a continuation of the current CDU/CSU+SPD or a CDU/CSU+FPD+Greens alliance. Both will allow Merkel to pursue deeper integration in the European Union.

We maintain our GDP forecasts at 2.0% and 1.7% for 2017 and 2018, respectively.

Japan – Stronger growth

Japan’s GDP grew a solid 4.0% qoq/saar in 2Q17, after growing 1.5% in 1Q17 (see graph). Domestic demand grew an outsized 5.2%, while net exports had a small (-0.3 pp) negative contribution. Private consumption grew 3.7%, residential investment 6.0%, capital investment 9.9% and public demand 5.1%. Such a brisk pace of domestic demand is unlikely to be sustained in 2H17, but overall financial conditions and the rest of the world’s growth remain supportive to above-potential growth.

Despite the higher GDP-growth forecast, we believe the BoJ will keep its current yield-curve control policy. Signs of inflation pressures remain scant. And the JPY should be very sensitive to an unexpected tightening in policy, probably killing the chances of pushing inflation expectations back to the 2% target.

As a result, we revised our GDP growth forecasts for Japan up to 1.9% (from 1.4%) in 2017 and to 1.4% (from 1.0%) in 2018.

China – A mild slowdown in 2H17

Economic activity moderated in July from its previous strong level. Industrial production decreased 1.2 pp to 6.4% yoy, year-to-date fixed investment came in at 8.3% yoy and retail sales growth slowed to 10.4% yoy. Both house sales and new starts fell in the month. Credit data continued to show a deceleration in the segment of “alternative” products, while new loans to households and corporations remained at robust levels.

We believe that the economy will slow gradually in 2H17, but with risks under control. A gradual economic slowdown in China is unlikely to impact global markets as it did in 2013-16. First, the economy is slowing from a solid position in the cycle. Second, the slowdown is coming from tighter economic policy, which can be adjusted to smooth the process. Finally, capital outflows have diminished because of stiffer internal controls, the better-adjusted RMB and the global weakness of the U.S. dollar.

The 19th Party Congress in October is unlikely to trigger either a sharp change policy or a steep economic slowdown. First, the power reshuffle tends to be relatively smooth, as President Xi is consolidating his power. Second, policy has already been tightening in order to control financial risks, and we do not see any clear signs that it has to be tightened further.

We maintain our forecast of 6.7% GDP growth for 2017 and 6.3% growth for 2018.

Emerging Markets – Interest-rate differential falling as inflation gap declines

The EM-DM interest-rate spread is falling as their inflation gap declines (see graph). The fall in the EM-DM inflation gap reflects recent EM exchange-rate strength, but also stronger policy by central banks in several emerging economies, which have focused in bringing their inflation to target. The fall in inflation has allowed a fall in interest rates, which is starting to support better growth. Financial inflows to EM usually rise in line with better EM-DM growth differential. As long as the process of interest increases in developed countries remains gradual, inflows to EM should continue.

Commodities – Metals rally unlikely to last

The Itaú Commodity Index dropped 1% in August, as the rally in metal prices was offset by drops in agricultural and energy prices. In this period, the energy ICI has dropped 1%, the agricultural ICI has fallen by 7.3% and the metals ICI has risen by 6.7%.

Metals rally is unlikely to last. In our view, the rally will fade as the Chinese economy decelerates in 2H17. We forecast iron ore prices at USD 60/mt and copper prices at USD 5700/t by the end of the year.

Oil prices fell with arrival of Hurricane Harvey in the Texas Gulf Coast. Oil demand’s impact tends to outweigh the supply-side impacts, as the refineries were more affected than the crude production area. We maintain our year-end forecasts of USD 45 (WTI) for both 2017 and 2018.

We lowered our price forecasts for soybeans and wheat. Improvement in weather conditions reduced the uncertainty about grain productivity in the U.S.

We expect the ICI to drop 4.8% from its current level by year-end, due to lower metal and energy prices.


 


LatAm


 

Benign external environment leaves room for further monetary easing

• The external environment remains favorable for emerging markets, benefiting LatAm asset prices.

• Economic slack and well-behaved exchange rates mean there is still room for further monetary easing in most countries in the region.

Solid growth in the core economies, higher commodity prices, lower political risks in Europe and low interest rates in the developed world continue to benefit LatAm assets. In August, the Chilean peso was the best-performing currency, because of rising copper prices. The Peruvian sol, which is also positively influenced by copper, has been broadly stable, as the central bank keeps purchasing dollars in the market (USD 1.5 billion in August and USD 4.0 billion year-to-date in the spot market). The Argentine peso also recorded a significant appreciation (especially in real terms) helped by the pro-government results of the primary elections for congress (the five-year sovereign CDS narrowed by around 60-bps after the primaries, reaching its lowest level since 2007), and the central bank is once again accumulating reserves (through dollar purchases from the Treasury), after selling dollars aggressively in the weeks prior to the primaries. The Colombian peso has also strengthened slightly, in spite of its weakening fundamentals (wide twin deficits and low growth) and lower interest rates.

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