Itaú BBA - Easing cycle under the microscope

Scenario Review - Chile

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Easing cycle under the microscope

March 9, 2017

A treacherous year will call for more policy support.

Please see the attached file for all graphs. 

• The Chilean labor market continues to weaken as more salaried jobs are destroyed. Confidence levels are still constrained, and the upcoming election has added a new element of uncertainty. Activity in 1Q17 will be negatively affected by supply shocks from an extended labor strike at the country’s largest copper mine as well as extensive forest fires. In this environment, we expect only a modest recovery from the previous year, helped by higher copper prices, the beneficial effect of lower inflation on real wages and low real interest rates.

• We have revised our copper price forecast upwards and now expect a stronger currency by year-end (675 pesos per dollar, down from 685 previously). The improved copper prices, along with limited internal demand, will help ensure that Chile’s current account deficit remains low (our 2017 current account deficit forecast has been lowered to 1.6% of GDP, down from 1.8% previously).

• The central bank left the policy rate unchanged in February, following a cut at its January meeting. However, the minutes reveal that the board is not questioning whether or not it should implement a second cut in the cycle, but rather whether the full cycle needs to be larger than 50 bps. We foresee a rate cut this month and two other 25-bp cuts later in the year, taking the policy rate to 2.5% by year-end.

First quarter activity likely to disappoint

Industrial production was weak at the start of 2017, reinforcing our view that the Chilean economy will fall short of expectations in the first quarter of the year. Manufacturing production declined from one year ago, while utilities activity limited the weak performance of industrial production overall. Meanwhile, mining activity indicators have been mixed, with INE’s sector indicators pointing toward a contraction even before the extended labor strike at Chile’s largest copper mine. Meanwhile, the monthly GDP proxy showed a weak expansion in January, and given the month-long strike at the Escondida mine, further deterioration in February and March is likely.

Retail activity is still robust, but there was a wholesale slowdown in January. New sector indices released by the national statistics institute (INE) show that retail activity remained robust in January. Retail and vehicle sales continued to rise, which is partly attributable to the increase in consumption tourism. In addition to these historically reported series, the revamped commercial activity indicators now include wholesale activity. The new commercial activity index, aggregating the three components, showed moderate growth dragged down by slower wholesale activity.

Overall, the monthly GDP proxy for January came in above market expectations, but was still weak. Imacec grew by 1.7% year over year. The January data uses a new national accounts framework and is not comparable with recent historical numbers. The central bank will publish the 2013-rebased national accounts data on March 20, with revisions to activity data for 2014-16. Our analysis of the sector data points toward an upward revision to 2015 GDP (on the back of higher mining, industrial and commercial activity) and a slightly negative bias for 2016.[1] 

The unemployment rate rose again in the quarter ending in January, as the labor market continued to loosen in response to the protracted economic slowdown. The quarterly unemployment rate came in at 6.2%, up 0.4 percentage points from one year before. The labor market in the quarter was characterized by a decline in formal job creation. Self-employment remained the driving force behind employment gains, increasing by 5.5% year over year (+4.6% in 4Q16). In contrast, salaried employment contracted by 1.2% from one year earlier (-0.1% in 4Q16), marking the greatest annual decline since the introduction of the new survey in 2010. Meanwhile, jobs without contracts were up 6.5% in the quarter, exceeding the 4.6% gain posted in 4Q16.

Meanwhile, the prolonged slump in business confidence does bode well for future activity.The think-tank Icare published its business confidence index for February, which came in at 46.0 (50 = neutral), down from 46.4 one year ago (44.9 in January). Confidence has now been in pessimistic territory for 35 consecutive months.

We expect a modest improvement in economic growth this year, to 2.0%, up from the 1.5% growth rate anticipated for 2016; however, risks remain tilted to the downside. As average copper prices improve, inflation declines and interest rates fall, the economy will likely react favorably. However, the political uncertainty leading up to the general election in November could keep private sentiment and investment subdued, while supply shocks in the mining sector could impede the recovery.

Inflation remains low

Consumer price inflation was broadly in line with expectations in February. Our diffusion index continues to point at contained inflationary pressures, with roughly the same amount of goods showing price increases above the 3% target as showing lower increases.

Annual inflation inched down to 2.7%, compared with 2.8% in January, and thus remained comfortably within the central bank’s target range. More notably, non-tradable inflation remained broadly stable at 3.4%, while tradable inflation came in at 2.2% (2.3% in January). Inflation excluding food and energy prices continued to slow down to 2.2%, compared with 2.5% the previous month. Core services inflation, better reflecting domestic inflationary pressures, was unchanged at 3.4%.

We continue to see inflation staying in the lower half of the central bank’s 2%-4% target range throughout 2017. Inflation would end this year at 2.8% and be near the 3% target by year-end 2018.

A strategic pause

At its February monetary policy meeting, the central bank of Chile left its policy rate at 3.25%, as had been expected by a narrow market majority (according to Bloomberg) and by us. The press release announcing the decision retained a loosening bias, signaling that further easing would continue in the short term.

The minutes of the meeting reveal a unanimous decision to leave the policy rate unchanged following the beginning of an easing cycle the previous month. At the meeting, the technical staff proposed either cutting the policy rate by 25 bps or leaving rates unchanged as the two relevant options. This marks a change from the January meeting, when only rate cuts of varying magnitudes were considered. The discussion recorded in the minutes reflects a cautious approach from the central bank, though with an acknowledgment that the second rate cut envisioned in the 4Q16 inflation report (IPoM) is indeed necessary. Delivering that cut in February would have raised a communication problem: leaving the easing bias could lead market participants to expect excessive easing ahead, whereas removing the bias (and consequently shutting the door on further easing in the short run) could be premature, given the cyclical position of the economy.

We see the next rate cut coming in March, with the easing bias being retained. Overall, we still see a full easing cycle of 100 bps being implemented this year, taking the policy rate to 2.5%. In spite of the strong inflation readings expected for 1Q17, the likelihood that inflation will languish near the floor of the 2%-4% target range persists. The firming of the Chilean peso and a widening output gap increase the likelihood of a further deceleration of inflation and support calls for additional monetary easing.

Higher copper prices support external accounts

Given the expectation that average copper prices will exceed last year’s levels and the fact that internal demand remains weak, Chile’s current account deficit is likely to stay low this year. We now estimate a current-account deficit of 1.6% of GDP this year (our previous forecast was 1.8%), narrowing from the 1.7% deficit estimated for last year. As the local economy recovers, a modest widening to 1.9% is likely for next year.

The expectation that the Fed will raise rates this month has led to some weakening of the Chilean peso. However, considering our revisions to copper-price estimates, we now expect an exchange rate of 675 pesos per dollar by the end of the year (down from our previous estimate of 685 pesos per dollar), with a further weakening to 695 pesos per dollar by the close of 2018.

Piñera pulls ahead

According to Adimark’s February public opinion survey, former president Sebastián Piñera has improved his position in recent polling. In January,Alejandro Guillier overtook Piñera for the first time since voting intentions for the November election began to be polled last August. However, one month later, Guillier’s support had dropped three percentage points, to 25% (his first monthly decline), while Piñera’s had increased by two percentage points, to 29%. Piñera has yet to formally announce his candidacy (expected this month), but he is likely to be the candidate for the center-right coalition and nearly half of the surveyed respondents expect him to succeed Michelle Bachelet.

On the left, Guillier, the independent senator and former journalist who entered the political fray in 2013, remains far and away the leading candidate. Part of Guillier’s appeal is his distance from the political class that many voters view with disillusionment. Nevertheless, Guillier’s association with the ruling Nueva Mayoría coalition could partly explain his approval decline this month. The government was castigated for its slow reaction to the wildfires that swept parts of the country in late January and early February, and the survey also likely captured some of the frustration that accompanied recent water shortages (due to landslides) that affected millions of homes in Santiago. A quarter of respondents still had not decided on a candidate favorite in the most recent survey, meaning that regardless of the lead Piñera currently has over Guiller, a significant portion of the public still needs convincing. These undecided voters will be key players in the outcome of the one-shot presidential race.

[1] Refer to summary table at the end of the Chile report.


João Pedro Bumachar

Vittorio Peretti

Miguel Ricaurte


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