Itaú BBA - Ending the easing cycle, despite economic weakness

Scenario Review - Chile

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Ending the easing cycle, despite economic weakness

June 8, 2017

Government expenditure prevented a technical recession in 1Q17, and a meaningful recovery remains elusive.

Please see the attached file for all graphs.

• Activity was weak in the first quarter of the year, and a technical recession was only prevented by front-loading government expenditure. There remains no evidence of a clear catalyst to spur a meaningful recovery. We see growth of 1.6% this year, stable from last year. 

• The central bank cut the policy rate by 25 bps to 2.5% at its May meeting, and the monetary policy report published shortly afterward gave clear indication that the current easing cycle has concluded. With inflation set to stay low and activity faltering, there remains a possibility that further easing may materialize before a normalization process begins.

Weak core activity

Growth in 1Q17 was the lowest since 3Q09 as the economic slowdown intensifies. Activity in the quarter expanded just 0.1% from one year ago, down from 0.5% in 4Q16. Fires that affected broad areas of the country, a month-and-a-half long labor strike at Chile’s largest mining operation and unfavorable calendar effects weighed on activity at the start of the year.

In spite of the headline slowdown, consumption picked up. Total consumption grew 2.5% (from 2.3%), as public expenditure saw a sharp acceleration to 5.1% (1.7% in 4Q16). Meanwhile, the 2.0% growth in private consumption was the weakest since 4Q15, despite durable goods consumption expanding 10.2% in the quarter (4.4% in 2016, -0.8% in 2015), which is likely temporary given the continued loosening of the labor market. Gross fixed investment was a drag, as it contracted for a third consecutive quarter (-2.4%), with construction falling 6.0%, while machinery and equipment resumed expansion (+3.9%). Meanwhile, exports fell by 4.9%, reflecting the strike in the mining sector. 

Looking ahead, the outlook for consumption remains poor. A weakening labor market will remain a drag on private consumption, while the structural-balance-rule target leads to a slowdown in government expenditure. The unemployment rate came in at 6.7% in the quarter ending in April, up 0.3 percentage points from one year before. Job growth is still overwhelmingly of lower quality, and more recently has been supported by the public sector (which is also unlikely to last, given the fiscal-policy tightening). Consumer confidence has continued to edge up from its levels of one year ago and in previous months, but remains entrenched in pessimistic territory (<50).

In fact, in spite of the end of the mining strike, the second quarter is off to a slow start. According to the Imacec (monthly proxy for GDP), activity grew a mild 1.3% year over year (adjusted for calendar effects). Growth in the first four months was only 0.5% (also calendar adjusted). 

We expect activity growth of 1.6% this year, stable from 2016. An expansionary monetary policy, low inflation and higher copper prices (on average vs. last year) will aid activity, but confidence will be a drag, amid lingering uncertainties over reforms and elections. In this context, investment will continue to underperform the other components of demand. For 2018, we expect 2.5% growth.

Temporary widening of current-account deficit 

The current-account deficit increased to USD 1.0 billion in 1Q17 (USD 0.4 billion surplus in 1Q16), affected by temporary factors (particularly, the mining strike’s impact on copper exports). As a result, the rolling-four-quarter current-account deficit rose to USD 5.0 billion (1.9% of GDP), from USD 3.6 billion in 2016 (1.4%). Our own seasonal adjustment shows that the annualized current-account deficit increased at the margin, to 3.4% of GDP (0.9% in 4Q16), hampered by the strike related mining export drag.

Net direct investment fell short of fully financing the current-account deficit. Foreign direct investment of USD 2.5 billion was the lowest quarterly direct investment into Chile since 2Q13 (USD 1.1 billion), and down from the USD 3.9 billion in 1Q16. Over the last four quarters, foreign direct investment into Chile fell to USD 10.8 billion, from USD 12.2 billion in 2016 (USD 20.5 billion in 2015). As Chilean direct investment abroad remained robust, net direct investment fell to USD 3.2 billion (the lowest level since 2004).  

We expect the current-account deficit to retreat in the remainder of the year as internal demand stays weak and mining production recovers. Hence, we see Chile’s current-account deficit broadly stable around the 1.4% recorded in 2016. With internal demand likely to show some recovery next year, a widening to 1.7% is expected.

Low inflation

Consumer price inflation remained low in May as expected. Inflation remained below the center of the 2%-4% range around the target for the eighth consecutive month with tradable inflation falling further on the back of a stable currency, while non-tradable inflation picked-up slightly (to a still moderate level). Annual inflation came in at 2.6%, slightly down from the 2.7% recorded in the previous month. Tradable inflation slowed to 1.7% from 2.0%. Meanwhile, non-tradable inflation ticked up to 3.6% (3.5% previously). Core inflation is comfortably at 2.5%.

We expect inflation to stay low for the remainder of the year. We continue to see inflation ending the year at 2.8% (2.7% in 2016) and to be at the 3% target by year-end 2018.

Earlier-than-expected cut ends cycle 

At its May monetary policy meeting, the central bank of Chile surprised most in the market by cutting the policy rate by 25 basis points for a second consecutive month, to 2.5%. While the cut came a month earlier than we were expecting, the lowering of the policy rate is in accordance with our call from late last year of a 100-bp easing cycle from the 3.5% starting point. Moreover, the central bank removed the easing bias from its statement.

The publication of the 2Q17 Inflation Report (IPoM) confirmed that the central bank’s baseline scenario does not include further easing, amid balanced risks for inflation and activity. The central bank sees the policy rate remaining at the current 2.5% level for at least one year, before initiating a gradual normalization process. Overall, the board appears content to wait and observe how the economy unfolds given the monetary stimulus already implemented. Moreover, the head of the technical team highlighted that only significant deviations from the current baseline scenario would trigger additional easing ahead.

Our baseline scenario considers no further easing, while the start of a normalization process is likely by year-end 2018 as internal demand recuperates. However, activity is weak and the composition of 1Q17 growth hints that the risk of further weakening ahead is not negligible. Amid low inflation, if this scenario materializes, additional rate cuts later in the year are a possibility. 

Piñera’s road to La Moneda not a given

The CEP public-opinion survey for the April-May period confirms that former president Sebastian Piñera is expected to win the November 19 first-round vote without the majority required to avoid a runoff in December. From the survey conducted at the close of 2016, Piñera gained 3 pp (to 23.7%) of the first-round voting intentions. Guillier – the independent senator and former journalist, and likely candidate representing the governing coalition – dropped just over 1 pp to 12.8%. Manuel José Ossandón picked up 3.4 pp, to 5.4%, and will be the closest competitor to Piñera in the upcoming center-right primary (July 2). Meanwhile, Beatriz Sánchez (journalist and far-left candidate) appeared for the first time with 4.8%, and will pose the greatest threat to Guillier in the November election. Sánchez and Guillier hold the highest favorability ratings among all the candidates. Undecided voters dropped from 49% in the December survey to 41.6%, still at a high level that will keep uncertainty elevated in the lead-up to the election. 

In the most likely runoff scenario, Piñera leads Alejandro Guillier by just over 4 pp. As the Chilean political circle has been laden with scandals, it is no surprise that the public is placing honesty and credibility at the forefront of requirements for the next president. Piñera’s inability to build a significant lead could result in business sentiment remaining subdued as uncertainty persists in the lead-up to the election.


 

João Pedro Bumachar

Vittorio Peretti

Miguel Ricaurte


 

Please see the attached file for all graphs.



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