Itaú BBA - No option but to cut

Scenario Review - Chile

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No option but to cut

February 9, 2017

Monetary loosening would continue amid elusive growth.

Please see the attached file for all graphs. 

• There was a weak end for activity in 2016. A combination of supply shocks and limited demand led to the slowdown. A mild recovery is expected this year, to 2.0% (from 1.5%), as average copper prices improve, inflation declines and interest rates fall. However, uncertainty over the outcome of the presidential elections will have an unfavorable effect. 

• A stronger currency combined with muted demand pressures, means additional monetary easing is likely. We expect the policy rate to reach 2.5% by year-end, from the current 3.25%.

• The 2016 fiscal deficit came in below expectations, but rating agencies remain concerned about the continued increase of public debt. S&P’s latest negative outlook reflects a 33% chance of a rating downgrade this year or in 2018.

No activity relief

Last year, shrinking mining and manufacturing characterized activity, leading to another year of below-potential growth. In the final quarter of 2016, retail sales posted 4.7% growth, up from 4.0% in 3Q16, bringing full-year growth to 4.0% last year, from 2.5% in 2015. Falling prices, alongside an influx of consumption tourism, were likely the leading factors behind the recovery in sales in 2H16. Meanwhile, industrial production – which aggregates manufacturing, utilities and mining – fell 2.8% in 4Q16 (+0.2% in the previous quarter), resulting in a decline of 1.7% in full-year 2016 (-0.3% in 2015). Mining contracted 2.8% in 2016 (-0.6% previously), while manufacturing shrank 1.1%, after the 0.7% drop in 2015. Supply shocks (a drop in the salmon and trout populations, and mining strikes) have affected activity in the year, but moderating demand has also contributed to the slowdown.

According to the Imacec (a monthly proxy for GDP), activity likely declined 1.0% qoq/saar in 4Q16 (+2.3% in 3Q16), resulting in a modest 1.5% increase in the year (2.3% in 2015).Looking ahead, activity in the first quarter of this year will likely remain suppressed in spite of a favorable carryover effect. Icare’s business confidence for January is still below the 50-point neutral level at 44.9 points, stable from one year ago. Once the volatile mining sub-index is removed, business confidence is down to 40.6 points (40.7 in January 2015). The lack of a recovery in business confidence, the likely occurrence of a significant mining strike in February, and the impact of the wildfires on the forestry industry will all weigh on activity.

The unemployment rate picked up in the final quarter of last year, bringing the average 2016 unemployment rate to the highest level since 2012. The prolonged economic slowdown has led to a gradual loosening of the labor market. The 4Q16 unemployment rate came in at 6.1%, up 0.3 percentage points from one year before. Therefore, the unemployment rate averaged 6.5% in 2016 (6.3% in 2015). Despite the seemingly small rise in unemployment, there are additional indications that the labor market is loosening further. In virtually every month of 2016, the participation rate was lower than in 2015. Job creation is near historical lows; new jobs are almost entirely in low-quality roles and temporary in nature.

While we expect a recovery in activity this year (to 2.0% from the likely 1.5% last year) due to higher average copper prices, declining inflation and lower interest rates, uncertainty on the local political stage could hamper a significant private-sentiment recovery, stifling an investment bounce-back.

Higher inflation, but outlook unchanged

Consumer price inflation surprised to the upside in January. Inflation partly rose on the back of one-off increases (cigarette prices), while the trend for inflation remains downward. Our diffusion index continues to moderate, with roughly the same amount of goods posting inflation above the 3% target than below it.

Annual inflation came in at 2.8%, up from 2.7% in December, still below the central bank’s target range. More notably, non-tradable inflation fell to 3.4%, from 4.0%, the lowest reading since the inception of the 2013 basket and since July 2013 historically, while tradable inflation came in at 2.3%, (1.7% in December). Inflation excluding food and energy prices came in at 2.5%, continuing to moderate from the 2.8% in the previous month. Core services inflation, better reflecting domestic inflationary pressures, slowed to 3.4% (4.0% previously).

Despite the upside surpise in inflation, we continue to see inflation within the lower half of the central bank’s 2%-4% target throughout 2017. Inflation would end this year at 2.8%, and be near the 3% target by year-end 2018.

Expected start of the easing cycle

As widely predicted, the Chilean Central Bank started the year with a 25-bp rate cut after being on hold for a full year. The decision to lower the policy rate to 3.25% followed a sustained period of weak activity and faster-than-expected disinflation. The press release announcing the decision retained the same loosening bias introduced in the previous month, while the minutes revealed that only rate cuts (including a 50-bp option) were discussed. Overall, this supports the expectation of more easing ahead.

Inflation surprised to the downside at the close of 2016. However, the minutes show that the central bank’s medium-term inflation forecasts depend significantly on the assumption of an activity recovery. We note that activity has continued to disappoint and there are growing signs that a notable recovery is less likely. Meanwhile, the market has started to price in more than the 50-basis-point cycle outlined in the 4Q16 IPoM.

In spite of the unanimous decision to cut the policy rate, the board is divided on the extent, timing and signaling of further easing. At least two board members kept the door open for stimulus beyond the 50-bp cycle included in the IPoM.

We see the central bank discreetly building the expectation that easing beyond the 50-bp baseline scenario may be necessary. We do not expect any adjustment to the official communication until at least the publication of the 1Q17 IPoM. However, the weak economy in conjunction with the strengthened exchange rate will keep inflationary pressures muted. We see an easing cycle of 100 bps this year, taking the policy rate to 2.5%. The next rate cut will likely come before the end of the quarter, but the upside inflation surprise in January turns a cut in February unlikely.

Low external vulnerability

A strong improvement of the trade balance at the close of last year will see Chile’s external imbalances remaining low. We estimate a current-account deficit of 1.7% of GDP in 2016, down from a 2.0% deficit in the previous year. The recent recovery in copper prices and constrained internal demand will ensure that the current-account deficit remains at a low level this year (1.8%) and the next (1.9%).

Elevated copper prices and increased appetite for emerging-market currencies have seen the Chilean peso performing well at the start of the year. The Chilean peso has gained close to 4% since the beginning of the year. However, we see depreciation ahead as the Chilean central bank continues to lower interest rates and the Fed raises its policy rate. We expect an exchange rate of 685 pesos per dollar by the end of the year, with further weakening to 695 by the close of 2018.

Further fiscal-outlook concern

In 2016, Chile registered its fourth consecutive fiscal deficit. The fiscal deficit reached 2.8% of GDP, from 2.2% of GDP in 2015. The larger deficit can be partly explained by lower mining income. However, the deficit is smaller than the 3.1% expected by the Budget Office in October of last year. This was due to a combination of higher revenues and less expenditure.

Revenue increased 1.0% in real terms from 2015 (it grew 5.2% in 2015), hampered by almost no private mining-operation revenue and the 17.9% drop in revenue from the state-owned mining company. However, total mining revenue, in spite of the drastic deterioration, exceeded preliminary estimates, while VAT revenue rose by 2.1%, above the estimated economic growth rate.

Expenditures grew by 3.7% in real terms, down from 7.4% in 2015. The growth of government outlays was somewhat lower than had been projected in October (4.2%), hinting at a greater-than-anticipated fiscal drag for 2016.

As a result, Chile’s 2016 structural deficit came in at 1.6%, down only slightly from the 1.7% recorded in the previous year. The government has committed to narrowing the structural deficit by a quarter point each year.

We still estimate nominal deficits of 3.3% for this year and 3.0% in 2018. Low growth and still-weak copper prices would continue to constrain fiscal revenue, while the government receives less support from one-off revenue sources.

Two rating agencies now have Chile’s fiscal outlook on negative watch. Standard & Poor’s reaffirmed its AA- long-term foreign currency rating for Chile, while revising the outlook to negative from stable. The decision follows a similar move by Fitch Ratings last December. So, Moody’s is the only major rating agency with a stable outlook for Chile. S&P notes that the outlook revision reflects the risk that prolonged low economic growth could translate into larger fiscal deficits than currently projected, leading to a continued increase in government debt and weakening the sovereign’s financial profile. The agency highlights that net government debt has increased consistently in recent years. The negative outlook reflects a 33% chance of a rating downgrade this year or in 2018. We view the outlook change as unsurprising, but a rating downgrade remains outside the realm of our base-case scenario.

Outsider tops presidential poll

Although the presidential election is only in November, the race to La Moneda is consolidating into a two-horse race. The latest development is that outsider Alejandro Guillier appears to be topping the voting intentions, according to Adimark’s January public opinion survey. Guillier’s support rose to 28%, far beyond the 5% recorded only five months previously. This is the first time that former President Sebastián Piñera has not topped Adimark’s poll in the current electoral cycle. Piñera’s support inched down two percentage points from December, to 27%. Piñera has yet to formally announce his candidacy (this is expected to occur in March), but he is the best-positioned candidate to represent the center-right coalition. On the left of the political spectrum, former President Ricardo Lagos has failed to gain traction among potential voters, still only polling at 5%. Guillier, an independent senator and former journalist, appears to have the momentum that would allow the ruling coalition to retain government control in spite of low approval levels for the current administration.

There remains little information on Guillier’s views or potential government program.  However, the increasing likelihood that Guillier becomes the candidate for the left does fit the global sentiment toward electing someone beyond the traditional political class. Although there has been a notable drop in undecided voters in recent months, this group will remain a key player in the outcome of the presidential race.

Meanwhile, approval for President Bachelet remains steady at the beginning of the year. Bachelet’s approval rating ticked up one percentage point to 27%, above the 19% low in August last year; meanwhile, the disapproval rate dropped three percentage points to 68%. The approval rating for the governing coalition came in at 21%, beyond the 13% low recorded in August. The latest results come despite the criticism that the government received on the handling of the recent fire emergency.

João Pedro Bumachar

Vittorio Peretti

Miguel Ricaurte


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