Itaú BBA - Will the Rally Resist a Hike?

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Will the Rally Resist a Hike?

August 11, 2016

A interest hike by the Fed in 2016 is unlikely to change the favorable global environment for emerging markets.

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

Global Economy
Focus back on the U.S. Fed

After two months of strong job creation, the odds of an interest-rate hike in the US have increased. But a lone interest hike in 2016 is unlikely to change the favorable global environment for emerging markets.

Central bankers get by with a little help from their friends

LatAm currencies continue to perform well, sustained by the global environment. The stronger exchange rates and weak activity improve the inflation outlook in the region.

Clearer recovery signs

Economic activity has been showing increasing signs of a recovery.  However, any recovery will be sustainable only if the proposed fiscal reforms are approved.

Disinflation does not come easily

Inflation is falling, but at a slower-than-expected pace. We now expect inflation to end this year at 44% year over year.

Slowing down amid weaker fundamentals

Fundamentals are weakening due to lower oil prices. The Mexican peso has depreciated sharply, also influenced by concerns over U.S. politics.

Nearing a neutral stance

The central bank has kept the policy rate unchanged since the beginning of the year. We expect stable rates ahead, but we cannot rule out some monetary loosening next year.

Gaining traction

After two years of weak growth, mostly due to falling investment, Peru’s economy is gaining traction in 2016. We continue to expect GDP growth at 4.0% next year, a acceleration from 3.8% in 2016, as higher business confidence takes private investment growth out of negative territory.

Another hike ahead

In its most recent inflation report, the central bank expressed more concern about the inflation outlook and downplayed the recent weak activity data. We now expect one final interest-rate hike, to 8%.

Drop in oil prices likely to be short-lived

We expect oil prices to rebound to USD 50/bbl by year-end. Despite downside shocks, the market needs U.S. producers to respond to reach equilibrium, and a consistent U.S. response will only materialize with higher prices.


Will the Rally Resist a Hike? 

After two months of strong job creation in the U.S., the odds of an interest-rate hike in 2016 have increased. Although September seems a bit early given the balance of risks, we now expect the Fed to raise the fed fund rate by 25 bps in December.

Emerging markets (EM) have been enjoying a good global environment, with still-ample global liquidity and clearer signs of economic recovery. Asset prices have, for the most part, benefited, posting significant rallies year to date. While a lone interest-rate increase by the Fed is, in our view, unlikely to change this picture, it could support the USD in 2H16, preventing a further broad-based appreciation of EM exchange rates and helping to depreciate currencies with stretched valuations.

LatAm currencies continue to perform well, sustained by a stable global environment. Activity in the region remains weak, but we expect a recovery in 2017, with Brazil and Argentina emerging from their slumps. The stronger exchange rates and weak activity have favored disinflation, leaving central banks in a more comfortable position. The exception is Colombia, where the inflation outlook remains challenging, leading us to expect one additional interest-rate increase in August before the end of the tightening cycle. Although inflation remains low in Mexico, we now also expect an additional 25-bp interest-rate hike by the central bank in December, along with the Fed.

Economic activity in Brazil, particularly the industrial sector, has shown increasing signs of a recovery.  This means that economic growth could be stronger than expected in 2H16. However, any recovery in economic activity will be sustainable only if the proposed fiscal reforms are approved, leading to the implementation of a spending ceiling and social security reform. An improved fiscal outlook, along with the current declining inflation trend, will open room for a monetary easing cycle beginning in 4Q16.


Global Economy
Focus Back on the U.S. Fed

• In the U.S., after two months of strong job creation, the odds of an interest-rate hike in 2016 increased. September seems early given the balance of risks and the lack of previous signaling from the Fed. But we now expect the Fed to raise the federal funds rate by 25 bps in December. 

• In Europe, Brexit has hit the UK economy, but so far has had limited impact in the euro area.

• In Japan, the government announced a modest fiscal package and the Bank of Japan (BoJ) disappointed with less stimulus than expected. Nevertheless, taking into account recent data releases, we raised our GDP forecast modestly to 0.4%, from 0.3% in 2016, but are keeping it at 0.7% in 2017. 

• China’s data remains consistent with a muddling-through scenario. With stable growth, the government has shifted its focus to curbing asset-price bubbles. 

• Emerging markets (EM) face a better environment, with still-ample global liquidity, a halt in the strong USD trend, a pick-up of commodity prices, stability in China and some signs of better growth in emerging economies ex-China. 

• One interest increase by the Fed should not change this picture; nonetheless, it can support the USD in 2H16, prevent further broad-based appreciation of EM exchange rates and help depreciate those currencies with stretched valuations.

U.S. – Focus back on the Fed

Conditions for an interest-rate increase are aligning as the labor market strengths, the inventory-correction cycle moves toward its conclusion and financial conditions improve. 

The labor market is improving, and after another strong month, jobs growth averaged 190k in the three and six months up to July. Public-sector payroll (30k per month in the last three months) may be overstating the recent trend, but the underlying payroll growth may well be on the high end of our expectations (150k-175k). The unemployment rate remained at 4.9%, indicating that the economy is close to full employment. Finally, wages are gradually accelerating, expanding 0.3% mom in July to reach 2.6% yoy.

The disappointment in the 2Q16 GDP (1.2% qoq/saar vs. our forecast of 2.8%) was mostly due to the inventory cycle, as consumption remains firm. Inventories subtracted 1.2 pp from the second-quarter growth. Importantly, consumption posted a solid 4.2% qoq/saar print.

We reduced our GDP forecast to 1.5% from 1.9% in 2016, but upgraded to 2.1% from 1.9% in 2017. We now see stronger growth in 2H16 (up to 2.5% from 2.0%), due to inventory rebuilding.

Finally, financial conditions have also improved more than we expected since the Brexit referendum. The S&P 500 has reached new highs and corporate credit spreads remain low, despite the recent decline in oil prices. It remains to be seen, though, how much of this gain is sustainable as Brexit economic effects spread throughout the world economy and as the Fed at some point signals it is shifting its policy stance.

Risks to economic growth remain tilted to the downside, though. The global economy remains weak, which could create spillovers to the U.S. Domestically, non-residential investment has declined for the last three quarters (see graph), and could reduce job creation and consumption. We expect non-residential investment to improve ahead, based on still easy financial conditions, oil prices and USD stabilization. These factors depend on the Fed stance. In particular, the USD remains very sensitive to changes in the U.S. Treasury yields in the current global context (see graph).

Meanwhile, risks of inflation and financial stability still look modest. Inflation measures are on gradual upward path, but still at modest levels. The core PCE deflator is hovering around 1.6% yoy, while the average hourly earnings are at 2.6% yoy. There are some spots of asset-price overvaluation; but the lower overall leverage in the financial system reduces the risk of financial instability. Still, the Fed can ill afford to let another bubble emerge this close to the previous, devastating, one.

As consequence, the case for a December rate hike has become more compelling, but the balance of risks favors patience and staying on hold in September. We revised our call from on-hold to a 25-bp hike in December, increasing the federal funds rate to 0.63%. For 2017, we maintain a 50-bp move, reaching 1.13% by year-end. Rates will probably go up, but will remain at historically very low levels until end-2017.

Europe – Brexit effects largely contained to the UK, at least for now

The initial data shows a marked slowdown in UK post the EU membership referendum. The manufacturing Purchasing Managers Index (PMI), an important leading indicator, plummeted to 48.2 in July, the weakest level since the euro crisis (see graph). In response the Bank of England has cut interest rate by 25 bps to 0.25%, hiked its quantitative easing (QE) Program by GBP 70 billion and created a new lending facility for banks. It may act further on these three fronts if data continues to deteriorate.

So far, the Brexit impact on the euro area seems modest The region’s manufacturing PMI declined to 52.0 in July from 52.8 in June. Other confidence indicators were also resilient.

One should not conclude, though, that Europe is safe. We see the Brexit’s impact and other risks in Europe as low-frequency events that combine weak activity with growing political fragmentation. The negotiations to take the UK out of the European Union in the next 2-3 years add to these risks. The fact that the drop in PMIs was bigger in the periphery than in the core countries (see graph) lights up a warning that the Brexit shock can have spillover effects to the Euro area.

We maintain our GDP forecast for the euro area at 1.5% and 1.3% in 2016 and 2017, respectively.

Japan – Struggling to find the right policy mix

The BoJ disappointed with a weaker-than-expected easing package in July. The central bank doubled its purchases of exchange-traded funds, but investors expected cuts in interest rates and further expansion of the QE package. Indeed, there is a case for stronger easing as inflation expectations are weakening, in part, with the yen appreciation (see graph).

The fact is that the BoJ is struggling to expand its already very accommodative stance. Negative interest rates might hurt banking-sector profitability, more in Japan than in other regions, and the pace of government bond purchases might be unsustainable.

The central bank said that it will release a comprehensive assessment of its policy in September. Investors’ expectations about what could result are wide: from introducing helicopter money in one extreme to abandoning QE and negative rates in the other. BoJ officials have clarified, though, that their comprehensive review aims to study the transmission of the current monetary-policy instruments to find the best way to reach the 2% inflation goal as soon as possible. A yen-dollar peg is apparently not being discussed, at least not in the public debate, but might be a way to lean on the Fed’s credibility to deliver low but positive inflation.

Meanwhile, Abe’s administration has released a new fiscal package. The total size seems large: JPY 28 trillion (USD 275 billion; 5.6% of GDP). The actual value of new spending is more modest though: JPY 7.5 trillion (USD 74 billion; 1.5% of GDP). We foresee further coordination between monetary and fiscal policy in Japan as Prime Minister Abe attempts to revitalize his plans to rid Japan of deflation.

We raised our GDP forecast modestly to 0.4%, from 0.3%, in 2016 but we are keeping it at 0.7% in 2017.

China – Stable growth shifts government focus to curbing asset bubbles

China’s data remains consistent with a muddling-through scenario.

Fixed investment remains sluggish (7.3% yoy in June vs 10.7% in 1Q16) and poses a downside risk to activity. The breakdown by sector shows mining and manufacturing as the major sources of weakness, and only a small part is attributable to sectors facing overcapacity (in which a decline is positive for the medium term). The strong growth pace in infrastructure and the stability in real estate have not been enough to offset the slowdown in manufacturing.

But overall data has shown some short-term stability in growth. The 2Q16 GDP headline inflation was stable at 6.7% yoy, slightly above expectations. June’s industrial production and retail sales also surprised to the upside. Finally, mixed July PMIs suggest that growth momentum will likely remain flattish through 3Q16.

With downside risks contained at the moment, the government shifted its focus to curbing asset bubbles. It has issued a statement vowing to curb “asset bubbles,” implying that measures could be taken to tighten regulations on wealth-management products and asset prices (property, stock and commodity futures markets). The statement was released after the Politburo’s semi-annual economic meeting; it also maintains a balanced policy stance between medium-term supply-side reforms (emphasized by president Xi) and short-term downward pressure (highlighted by premier Li).

We continue to expect GDP to expand 6.5% in 2016 and 6.0% in 2017.

Emerging Markets – commodity prices and currencies settle down

With the focus back on the Fed, U.S. treasury yields should move up, re-pricing the probability of federal funds rate hikes. The market current prices a 70% probability of an interest-rate hike by December 2017 (yes, 2017!). As data confirms that the Fed will indeed raise rates in 2016, we think that yields could move up by 20-30 bps.

This should provide some support for the USD and limit the room for further appreciation of EM currencies. Our analysis shows that the sensitivity to the U.S.-dollar index (DXY) and a basket of emerging-market currencies has increased in the past few years (see graph above). This is likely due to zero or negative rates, increased EM corporate leverage, unspectacular global growth and trendless commodities prices. At the moment, we estimate that a 100-bp increase in U.S. rates would make the USD rise about 8% against both DM (measured by the DXY) and EM currencies.

Within emerging markets, LatAm and CEMEA currencies are more sensitive to U.S. rates than Asian ones. It is worth noting, however, that the sensitivity has declined in LatAm (see graph), likely reflecting some advance in the external adjustment in the region (for example, in Brazil).

Commodities – Oil Prices to recover ahead

The Itaú Commodity Index (ICI) fell 4% from the end of June, dragged by lower agricultural (-5%) and oil-related (-9%) prices. Metal prices moved in the opposite direction, gaining 6% over the same period.

We expect oil prices to recover by year-end 2016 (Brent: USD 52/bbl, WTI USD 50/bbl), as the market may have overreacted to the news flow. The oil market balance turned to a deficit in 2Q16 after several quarters of large surplus, pushing prices above USD 50/bbl. The decline in oil prices seen since mid-June was driven by expectations that several demand and supply shocks will move the market back to oversupply in 2H16. We believe that this is a mistake and that the overall picture in the sector has not changed: after their deep cut in investment and supply, U.S. shale producers now need to increase their supply again for the global oil market to remain balanced by 4Q16. We do not see signs that this reaction will be strong enough with oil prices at USD 40. It is more likely that prices need to be closer to USD 50 for a consistent reaction to occur.

We remain bearish on metal prices as demand remains lackluster and supply capacity continues to rise. We have revised our 2016 year-end price forecasts upward for iron ore (to USD 45/ton from USD 42/ton) and some base metals, recognizing supply risks in the nickel market (that could linger for a while and affect other base metals) and strong apparent demand for steel in China. But our forecasts still imply a price correction in 2H16.

Agricultural prices fell due to better-than-expected weather conditions in the U.S. The favorable climate reversed earlier speculation that drought or a heat wave would reduce crop yields in the country. We have lowered our price forecasts for corn, soybean and wheat prices to take the stronger supply into account.

Our scenario implies that the ICI will rise 2% from current levels, with agricultural prices up 1%, energy up 13% and metal prices down by 12%. This means that the index will be up 15% yoy.


Central bankers get by with a little help from their friends

• The benign environment for LatAm currencies continues. As the Fed resumes rate hikes (in December 2016), some exchange rate depreciation from current levels is likely, but far less likely than the weakening seen over the past two years. 

• Activity in the region is still sluggish, but we expect a recovery in 2017, mostly because Brazil and Argentina are expected to emerge from their recessions. 

• The more favorable trend of exchange rates and weak activity are helping disinflation, which means a relief for central bankers in the region. The exception is Colombia, where the outlook for inflation remains very challenging, leading us to expect one additional interest rate increase in August before the tightening cycle ends. Although inflation continues to be low in Mexico, we now see the central bank raising interest rates further in December 2016 (by 25 bps), alongside the Fed. In Brazil, we still expect an easing cycle starting in October.  

Better external conditions continue to support risky assets

Latin American economies are enjoying a better environment that includes loose monetary policy in the core economies, some recovery in commodity prices and less uncertainty over China. However, in the U.S., after two months of strong job creation, the odds of an interest rate hike by the Fed has increased. Because we now expect the Fed to raise its reference rate by 25 bps in December (and continue to expect two rate increases in 2017), we believe that some weakening of LatAm currencies from current levels is likely. The exception is the Mexican peso. Although we acknowledge that Mexico’s macro fundamentals have deteriorated, we think the depreciation of the currency has been excessive and unduly influenced by U.S. election noise, so we expect an appreciation ahead. A further recovery in oil prices coupled with a lower probability of a Trump victory in the U.S. presidential elections could be the trigger for a partial reversal of the weakening trend.   

Still waiting for a recovery

Activity in the region was weak in 2Q16. In Argentina and Brazil, the recession deepened. In Colombia, the economy is now suffering more visibly from the negative impact of lower oil prices, which is hurting activity through tighter fiscal and monetary policies and lower real wages, besides the fact that oil companies are slashing capital expenditures. In Peru, where the economy is recovering relative to 2015, there was also a slowdown from 1Q16, as the drivers of the activity (mining output and public investment) lost momentum. Although Mexico cannot really be called a commodity exporter, low oil prices are taking their toll on the economy, mostly by forcing the government to cut expenditures to offset the decline in revenue derived from the commodity. Finally, in Chile, activity fell sequentially between the first and the second quarters of this year: besides the terms-of-trade weakening, uncertainty over domestic reforms are weighing on confidence and investment.

We expect a recovery in 2017. Argentina and Brazil will, in our view, come out of their recessions. In fact, in Argentina we expect a sequential improvement in the second half of this year as real wages are already improving and the more business-friendly environment combined with access to international capital markets are likely to attract more investment. In Brazil, confidence is rebounding together with other leading indicators. In fact, with fiscal reform growth in Brazil next year can be higher than we are currently expecting (1.0% in 2017). In Peru, we project modestly higher growth next year, which is also linked to political developments. Since the election of the PPK, business sentiment is on the rise, which could move private investment out of negative territory. The ongoing recovery of U.S. industry will likely boost Mexico’s manufacturing exports, more than offsetting an expected slowdown in consumption. In Colombia and Chile, the improvement in growth we expect to see next year is limited, and recent data suggest downside risks to our forecast.

Exchange rates are now helping central banks

As exchange rates in LatAm evolve more favorably relative to the previous two years and activity remains weak, inflation continues to fall in most countries. Annual inflation in Chile and in Peru recently reached the upper limit around the target. Inflation in Brazil remains far above the target, but it is also declining. On the other hand, in Colombia, inflation was hit by another supply-side shock (a truck strike that forced food inflation up further), bringing the headline number to its highest level since 2000. In Argentina, although inflation is already falling on a sequential basis, it reached 47.1% year over year in June in the city of Buenos Aires, reflecting the tariff hikes and the impact of past depreciation. We expect the disinflation trend in the region to continue, although the recent data in Colombia and Argentina have led us to revise our forecasts upward for the CPI in both countries.  

In this context, we expect few rate hikes in the region. We now project one additional rate increase in Mexico (of 25 bps) in December, together with the Fed, with two additional rate hikes next year (again with the expected Fed moves). We also now see one additional rate hike in Colombia in August before the cycle ends, as the outlook for inflation remains challenging  and recent communications from the central bank suggest that more monetary action is necessary to bring inflation to below 4% (the upper limit of the target) in 2017. Next year, with inflation dropping, growth low and a high policy rate (in real terms), we still think an easing cycle in Colombia is likely. In Chile and in Peru, we see rates on hold throughout the remainder of this year and the next, and we see the risk of rate cuts in Chile in 2017, when the economy will probably still be weak and inflation could be around the target. Meanwhile, an easing cycle in Brazil will likely start in October (with a 25-bp rate cut) and extend into 2017 (so the Selic rate ends next year at 10%). The central bank of Brazil is currently emphasizing that its policy decisions are aimed now at bringing inflation to the target by the end of 2017, which closes the door on rate cuts in the near future. However, as the relevant policy horizon shifts to 2018, there could be room for monetary easing.



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


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