Global growth gathers momentum (but will it last?)
Activity indicators improved further. But some caution is warranted as better growth will bring higher interest rates in developed economies; political risks remain in Europe; we still expect a slowdown in China to pressure metal prices.
Growth and financial conditions decoupled for now
Market conditions continue supportive for South America and improved for Mexico, but this is yet to translate to higher economic growth across the region.
We now expect a Selic rate of 8.25% in 2017
The Central Bank of Brazil (BCB) has signaled the possibility of further interest rate cuts and frontloading the easing cycle. We now expect a year-end Selic rate of 8.25% for both 2017 and 2018.
Inflation scenario still cloudy
Inflation expectations for this year remain high. Teachers went on strike and we believe the wage negotiations will play a key role in improving the inflation outlook.
Out of the woods?
We expect GDP growth to slow in 2017. Higher inflation, tighter macro policies, and the uncertainties surrounding trade relations with the U.S. will weigh down internal demand, while exports will be a buffer.
Easing cycle under the microscope
The Central Bank 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.
All eyes on domestic demand
We expect a recovery of domestic demand, supported by stronger terms of trade and higher confidence.
The surprise factor
In spite of the February surprise rate cut, we still expect a policy rate at of 5.5% by the end of this year.
China’s hawks undermine metal
We expect our commodity index to fall by 5% from current levels in 2017 due to a slowdown in China (by mid-year) and supply responses to current prices, particularly for oil (U.S. shale producers) and iron ore.
Positive global environment, but for how long?
Global activity indicators improved further, especially, in developed economies. Stronger global growth is positive for emerging markets. But three words of caution are warranted: First, higher interest will follow stronger growth in developed economies. At the moment, among major central banks, only the U.S. Fed is tightening policy (we now expect a rate hike in March). But by the end of the year, the European Central Bank might also start to remove monetary stimulus. Second, political risks in Europe remain. Third, we still expect China to slow down, which should bring metal prices down.
The recent positive developments in the global economy have yet to benefit South America’s activity. Growth remains weak in most countries in the region, although activity is clearly improving in Argentina, a consequence of higher agricultural output, recovery of real wages and access to international capital markets. In Mexico, growth was still solid by the end of 2016. A slowdown this year is still likely, due to uncertainty over U.S. trade policies and because of the negative impact of higher gasoline prices and a weaker currency on real wages. Manufacturing exports have been a buffer. Authorities in Mexico announced a foreign exchange intervention program that helped the Mexican peso to outperform its peers, reducing risks that Mexico’s central bank will be more aggressive than the Fed ahead.
In Brazil, economic activity indicators show incipient recovery. On the fiscal side, Social Security reform is likely to be approved (albeit with some amendments) by Congress in the second quarter of 2017. Inflation has been falling faster than we expected. Thus, we lowered our inflation forecast for 2017 to 4.1% (previously, 4.4%). We left our exchange-rate forecasts of BRL 3.35 per dollar for 2017 and BRL 3.45 for 2018. The central bank has signaled more interest cuts and a frontloading of the easing cycle. We now expect the Selic rate to be 8.25% at the end of 2017 and in 2018.
Global growth gathers momentum (but will it last?)
• The positive momentum for global manufacturing continued in February with a strong purchasing managers’ index (PMI) result.
• The PMI gains were stronger in developed economies than in emerging markets.
• Stronger global growth is positive for emerging markets.
• Some caution is warranted, however, because: i) stronger growth will likely lead to higher interest rates in developed economies; ii) there continue to be political risks in Europe; and iii) we still expect a slowdown in China to put pressure on metal prices.
Activity indicators improved further, particularly in developed economies…
The manufacturing cycle continued to improve in February. The global manufacturing PMI increased to 54.0 in the month from 53.2 in December, reaching its highest level since 2011.
PMIs gains have been stronger in developed economies than in emerging markets (see graph).The activity gains in the developed economies have been broad-based, while in emerging markets economic performance has been mixed.
…but caution is warranted, on three countsFirst, higher interest rates are likely to follow stronger growth in developed economies. At the moment, among major economies, the U.S. is the only one with a tightening monetary policy (which is still being underpriced by the market – see below). But by the end of the year, the European Central Bank (ECB) might have also started to withdraw monetary stimulus.
Second, political risks persist in Europe. The eurozone economy has been resilient (see below), despite recent political shocks (Brexit, PM Renzi’s resignation in Italy). But this could change.
Third, we still expect China’s economy to slow, which would likely bring metal prices down(see below).
U.S. – A rate increase in March is a hawkish move
Fed Chair Janet Yellen signaled that the next rate hike is likely to be in March and that the process of scaling back accommodation will be faster than it was in the previous two years. She reiterated the outlook for three rate hikes in each of the next three years, which would gradually take the nominal fed funds rate up to 3%. This corresponds to a real rate of 1%, which is the Fed’s current estimate for a long-term neutral policy stance. According to Yellen, such a strategy would avoid that the Fed risk of removing accommodation too late.
Fed funds futures are still low relative to the Fed’s interest rate forecast, as investors remain cautious. Futures still imply a pace of only 1.5 hikes per year over the next three years. We understand that this cautious outlook reflects the experience of the past two years, when Fed repeatedly scaled back its forecasts for interest rate hikes.
But conditions have changed, a fact the Fed recognizes and has been communicating to the market. Investors should be aware of these significant developments.
First, global risks have diminished. There are still risks associated with Europe and China, but the overall risk has eased. In China we expect a slowdown in growth to hit global iron ore prices, but we don’t see major financial risks reemerging. And in Europe growth has remained resilient despite political uncertainty.
Second, with the Fed close to fulfilling its dual mandate and financial conditions still very loose, there is less room for scaling back interest rate hikes. Current financial conditions are consistent with a GDP growth rate of 2.75% in the U.S. in 2017, significantly above the Fed’s 2.1% forecast. This poses the risk of a very low unemployment rate and stimulus overshoot triggering inflation rates above 2%.
Finally, the prospect of three rate hikes this year does not appear to pose a major risk to the U.S. economy. There remains the question of whether the positive financial conditions and overall sentiment reflect expectations of a fiscal stimulus. However, increasing interest rates three times this year would bring the fed funds rate to 1.375%, which is equivalent to a real interest rate of -0.50% and is unlikely to cause a sharp slowdown in the economy.
In sum, we see a strong case for the FOMC to raise the fed funds rate in March and to signal three to four hikes in 2017. For now, we maintain our call for three hikes in 2017 and four hikes in 2018. But the risks are now tilted to four hikes in 2017. That is to say, we envisage at least (not at most) three rate hikes this year.
We have not changed our forecast for U.S. GDP growth rates of 2.3% in 2017 and 2.4% in 2018, which we expect to bring the U.S. unemployment rate down to 4.3% and 4.1%, respectively, and the core PCE deflator up to 1.9% and 2.1%. We assume that the Trump administration will enact a fiscal stimulus amounting to some 1.0% of GDP.
The main risk to the outlook for the U.S. continues to be the possibility of a turn to strong protectionist measures. We believe that this risk is low at the moment, but it may rise if the Trump administration is unable to pass its pro-growth fiscal agenda.
Europe – Strong activity as political risks mount
Current data points to GDP growth running at a 0.4% qoq pace in 1Q17. Improving financial conditions, slightly expansionary fiscal policies and a milder external drag are contributing to the stronger growth. Credit flows continue to improve, reflecting the positive effect of the ECB’s easing policies.
Despite the improving outlook, the ECB is likely to stick to its accommodative stance for now. Headline inflation reached 2.0% yoy in February. But core inflation remains subdue, at 0.9%. Real interest rates are therefore likely to remain low, supporting economic activity.
Upcoming political events continue to pose risks, although the odds of negative outcomes in the Netherlands and France have declined.
The Netherlands will hold general elections on March 15, and the good news there is that the Eurosceptic party has been losing ground in national polls. The party may still receive the most votes of any single one in this election, but it is very unlikely to be able to form a majority.
In France, polls show diminishing odds of a Le Pen victory as independent candidate Emmanuel Macron has become the favorite. The Eurosceptic National Front candidate Marine Le Pen will most likely make it to the run-off ballot, but polls suggest that this is as far as she will be able to reach. Former PM François Fillon has been losing ground amid reports of nepotism throughout his political career. Of the two candidates running against Le Pen, Macron now appears to be the one most likely to make it to a secondround (see graph), and he got a further boost after aligning himself with centrist François Bayrou.
Finally, although it is not our baseline scenario, there is a chance of early elections in Italy. This risk could be aggravated if reformist former PM Matteo Renzi loses his bid to reunite the Democratic Party in the April 30 internal elections and/or the party continues to splinter as a result of internal divisions.
Our GDP growth forecasts for Europe remain unchanged at 1.6% and 1.3% for 2017 and 2018, respectively.
Japan – The economy gets off to a good start in 2017
Japan’s economy is showing signs of improvement. Slowly improving soft data, in line with strong industrial production and a weak yen boosting exports, supports our view that the Japanese economy is set to grow faster than its potential rate this year. February’s manufacturing PMI, a leading indicator for industrial production, hit its highest level since March 2014 having risen to 53.3 (from an already high 52.7 in January). Additionally, a tightening labor market – unemployment fell to 3.0% in January – should give a boost to consumption ahead. In fact, in January household consumption improved for the first time since September of last year, with core spending rising by 3.2% mom.
We expect no changes from the BoJ at least until core CPI reaches 1.0% yoy. The BoJ recently conducted a fixed-rate operation for 5- to 10-year JGBs for the first time in an attempt to ease 10-year JGB yields, which had surged to 0.15%. This showed the bank’s seriousness about defending its 0% 10-year yield target.
Our GDP growth forecasts for Japan remain unchanged at 1.4% in 2017 and 1.0% in 2018.
China – Growth will likely weaken by mid-2017
Economic activity in China remains steady, with the manufacturing PMI increasing by 0.3 points, to 5.6, in February. We estimate that industrial production grew by 6.1% yoy in the first two months of the year (due to distortions caused by the Chinese New Year holiday, the released production data is averaged for January-February), which would represent a slight acceleration from December (+6.0%). Finally, the services PMI has dropped slightly, to 54.2 in February from 54.6 in January, but is still at strong levels.
Nonetheless, we expect economic growth in China to weaken, particularly after mid-2017, as the government tightens policy. Three recent developments support this expectation. First, after monetary and fiscal easing starting at the end of 2S15 and most of 2016, the government initiated a policy shift in late September 2016 by implementing macro-prudential measures to cool off the property sector. Second, the central bank hiked several policy rates in early 2017. Finally, the government has lowered its GDP growth target, setting a 2017 goal of around 6.5% in 2017 from its 6.5%-7.0% target for 2016. This year’s target came with the qualification that policymakers would “in practice try to achieve a better result”, thereby giving a slightly dovish spin to the stated target of “around 6.5% yoy”.
Inflation and credit figures highlight the need for additional policy tightening. Non-food CPI inflation was 2.2% in February, well above the levels seen in 1Q16 (~1.0%), when the stimulus measures began. PPI inflation rose to 7.8% in February from -6.0% yoy in 1Q16. The combination of an upward trend in inflation (hidden in the headline CPI by moderate food prices) and strong credit growth, amid steady economic activity, highlights the need for the government to tighten its monetary/fiscal policy stance. Given the excessive level of debt in the corporate sector, it is better to implement a moderate tightening early than to have to impose steep tightening later.
Furthermore, this year’s political transition is running smoothly, allowing policymakers to focus on medium-term sustainability (which implies tolerance of lower short-term growth).The government recently announced three changes in top policymaking positions (the head of the NDRC, China’s top planning agency; the minister of commerce; and the head of CBRC, the banking regulator). The new names are aligned with President Xi Jinping or his main ally, Wang Qishan. The timing of the announcement (well ahead of the Party Congress in November) was earlier than we expected. Both factors suggest a smooth transition.
Finally, we note that, despite the strong headline number for the manufacturing PMI, its composition already signals that the index may drop. New orders minus stocks of finished inventories, a leading indicator, declined for the second straight month in February. This suggests that PMI peaked in February (still reflecting previous easing) and will start to decline from now on (see chart).
For China we forecast 6.4% GDP growth for 2017, with a slowdown in 2H17, and 5.8% growth for 2018.
Commodities – Hawkish tilt in China starting to weigh down metal prices
The Itaú Commodity Index (ICI) gained 2.5% in the first half of February but has declined by 3.8% since then, with both moves driven by metal prices. First, metal prices rose on supply-related issues for iron ore and copper and optimism on China. Then a more hawkish tilt from China – the government lowered its growth target for 2017 – started to pull metal prices back down.
We continue to expect iron ore prices to decline to USD 55/ton by year-end (implying a more than 30% drop from current levels), mainly driven by a slowdown in China in 2H17.
Nonetheless, the outlook for copper prices has improved.We have raised our 2017 price forecast to USD 5,600/ton from USD 4,800/ton. Despite the likelihood of a slowdown in China, planned grid projects should sustain strong copper demand. Supply, meanwhile, is likely to be constrained by weather-related mining stoppages and/or wage negotiations throughout 2017 (the current strike at the Escondida mine in Chile is an example)
Oil-related prices traded within a narrow range in February, and the ICI-agricultural rose slightly. The latter increase reflects financial-instrument effects (the rollover of futures contracts) and supply bottlenecks in Brazil (road blockages due to excessive rainfall affected the soybean market) and Argentina (the grain/soybean markets were affected by the strike at Rosario port).
Looking ahead, we expect the ICI to decline by 5% from its current level by the end of 2017. According to our forecasts, the decline will mainly stem from lower metal prices (despite the upward revision of our copper price estimates).
Growth and financial conditions decoupled for now• Market conditions remain supportive for South America and have also improved for Mexico, but this has yet to translate into higher economic growth across the region.
• The combination of weak growth and stronger currencies continues conducive to lower interest rates in South America. In Mexico, the risk for more rate hikes than we forecast (3×25 bps) has diminished.
Latin America currencies have recorded gains year-to-date, favored by an environment of low interest rates in the core economies, higher commodity prices and the positive feedback from lower credit spreads in the U.S. high-yield space on emerging-market sovereign country-risk premium. The Mexican peso has outperformed, helped by the announcement of a USD 20 billion intervention program through FX swaps and the perception of lower risks of a harsh change in U.S. trade policies. Our market conditions index for Latin America shows a supportive environment for growth (the Mexico sub-index is in negative territory, but also increased).
The positive evolution for LatAm asset prices should contribute to an economic recovery. We continue to expect a rebound in economic activity in the region, as Brazil and Argentina emerge from recession. In fact, the first activity indicators for Argentina in 1Q17 suggest that the economy continues to recover, helped by higher agricultural output, auto exports, higher real wages and access to international financing. In Brazil, 4Q16 GDP fell more than expected, but many high-frequency indicators suggest positive quarter-over-quarter growth in the first quarter of 2017. On the other hand, uncertainty over the presidential race in Chile and potential delays in infrastructure spending in Peru and Colombia represent downside risks to our growth forecasts in these economies. In Mexico, we expect a slowdown, but manufacturing exports have been strong and will likely contribute to curbing the deceleration (as long as there is no drastic change in trade relations with the U.S.).
The combination of stronger currencies and weak growth leave room for a looser monetary-policy stance. Brazil’s central bank reduced the policy rate for the fourth consecutive meeting in February. Furthermore, the recent communication from the central bank indicates that the board can further increase the pace of monetary easing. In this context, we now see the Selic rate ending this year at 8.25% (a level that we were previously expecting to be reached only next year). In Colombia, the division within the board and its changing composition make communication harder; the board decided to reduce the policy rate in February, surprising the market for the third consecutive month. Meanwhile, Argentina’s central bank has been on hold amid above-target inflation expectations, further regulated price increases and thorny wage negotiations. As/when the inflation scenario in Argentina becomes less cloudy, the board will likely resume rate cuts. In Chile, we expect the central bank to deliver more rate cuts starting this month, following a pause in February. Finally, in Mexico, as long as the more-friendly environment is sustained, the risks that the central bank will hike by more than the Fed are lower, so we continue to expect three 25-bp rate hikes this year (including one rate increase this month).