The global outlook remains favorable
Positive economic momentum continues, with a pick-up in activity indicators.
Financial conditions and economic growth remain disconnected
The global environment is still supportive for LatAm assets. Nonetheless, economic activity remains weak in South America, while in Mexico it remains resilient.
Inflation continues to fall, Central Bank increases pace of easing
We have trimmed our inflation forecast to 3.9%, from 4.1%. With lower, current and expected, inflation, the BCB has increased the pace of easing to 100bps.
Hawks in the Sky
There has been no further progress in disinflation despite the favorable exchange rate. The central bank has increased the policy rate amid higher inflation expectations and with an eye on the ongoing wage negotiations.
A brighter outlook
The uncertainties over trade relations with the U.S. remain, but they have diminished recently. We have revised our GDP growth forecast for 2017 to 1.8% (from 1.6%).
A cautious central bank
The central bank signaled that only one more 25-bp rate cut is on its way. We expect two additional rate cuts in 2017 taking the interest rate to 2.5%, due to economic weakness and low inflation.
Fallout from the “coastal El Niño”
Destructive flooding and landslides are having a severe effect on activity and causing inflation to spike. We have revised our GDP growth forecast for 2017 to 3.3% (from 3.8%).
Risks tilted to the downside
Activity began the year on a weak footing amid a weakening labor market and oil production that is becoming less supportive of activity. We expect a modest recovery in activity to 2.3% this year (from 2% for 2016), but the risks are tilted to downside.
Falling commodity prices are not a sign of global weakness
Commodity prices decrease in March, but this movement is related to specific factors and not a sign of weak global economy.
Positive global growth momentum continues
Positive momentum is still in place, with a pick-up in activity indicators. In the U.S., our analysis shows that a further disappointment with the Trump administration agenda poses limited risks to the economy and asset prices. We expect growth in the U.S. to pick up in 2Q17. In Europe, all eyes are on the French election, which is an important short-term risk for the global economy – geopolitical tension in the Middle East and Asia also seems to be increasing. Meanwhile, growth remains solid in the euro area. In China, the activity outlook remains stable.
This still positive global environment is supportive for LatAm assets, and the Mexican peso has outperformed its peers. Nonetheless, and somewhat at odds with our earlier view, economic activity remains weak in South America, while in Mexico it remains resilient. We have reduced our growth forecasts for this year for Peru, Chile and Colombia, but have increased them for Mexico. There is an easing bias for monetary policy in most South American countries (Argentina is an exception), while in Mexico the central bank has reduced the pace of interest-rate hikes.
In Brazil, GDP will register positive growth in 1Q17 driven by a sharp increase in agricultural production. On the fiscal side, discussions on the pension reform will intensify in April. We expect its approval on the Lower House in 2Q17. We maintain our exchange rate forecasts (3.35 reais per dollar at the end of 2017 and 3.45 at the end of 2018). We have lowered our inflation forecast for 2017 to 3.9% (from 4.1%). For 2018, we maintain our forecast at 3.8%. The central bank increased the pace of interest rate cuts to 100 bps. We expect the Selic rate at 8.25% by the end of 2017.
The global outlook remains favorable
• Global growth positive momentum continues, with a synchronized pick-up in activity indicators.
• In the U.S., a further disappointment with Trump administration´s agenda poses limited risks to the economy and asset prices. We expect growth to pick-up in 2Q17.
• In Europe, all eyes are in the French election, which is an important short term risk for the global economy – geopolitical tensions are also rising in the Middle East and Asia. Meanwhile, growth remains solid in the euro area.
• China outlook remains stable.
• The fall in metal prices is not a sign of a weakening global economy.
Activity indicators remained solid in March
The manufacturing cycle remained favorable in March. The global manufacturing PMI increased to 54.6 in the month from 54.5 in February. The rise has been synchronized across all the main regions (US, Europe, China, Japan, EM ex-China – see chart).
U.S. – Improving fundamentals limits downside risks of disappointments in the Trump agenda
We believe the U.S. GDP will accelerate to 3% qoq/SAAR in 2Q17 from 1.5% in 1Q17. The pick-up will likely come from a rebound in consumption in 2Q17 as rising income and wealth supports spending. The weakness in consumption in 1Q17 was, in our view, transitory and explained by lower energy consumption in a mild winter and seasonal adjustment issues.
Would a further disappointment with the implementation of President Trump´s agenda harm the U.S. economy and asset prices? We still expect President Trump to enact a fiscal stimulus of 1% of GDP in the 2H17. But how big is the risk if he fails to pass these measures in the Congress?
It is true that consumer sentiment looks too high compared to fundamentals. Labor income and financial wealth justify a high level of confidence. But our models indicate that the current level of consumer confidence is too high compared to these fundamentals (see graph), indicating an excessive optimism among households.
However, business confidence doesn’t seem stretched and mainly reflects the improvement in the global economy. Indeed, the rise in the U.S. Manufacturing ISM closely tracked the increase in the global manufacturing PMIs (see graph).
Putting all together, we estimate that a correction for excessive optimism about president Trump’s agenda would reduce our Current Activity Index (CAI) to 3% from 4% (see graph). This index tracks GDP growth well and has shoot up to above 4% after Trump’s victory in November. It should be noted that a fall to a 3% is still a solid pace and it is in line with our forecast that GDP will accelerate to 3.0% in 2Q17 and end 2017 at 2.3%.
According to this analysis, the U.S. GDP growth would remain above 2% even without any fiscal stimulus.
But how would asset prices react? Our econometric analysis indicates the high yield credit spreads and the S&P equity index reflect, in part, expectation of higher growth ahead. But the scope for disappointment seems limited.
In particular, we find that if the CAI falls to 3% from 4%, high yield credit spreads (measured by the CDX HY index) would rise about 40bps and the S&P500 would drop less than 5%. We think a correction of these magnitudes would result only in a modest tightening of financial condition in U.S.
We continue to forecast US GDP to grow 2.3% and 2.4% in 2017 and 2018. The analysis above suggests that, given the ongoing momentum and still supportive financial conditions, failure by the Trump administration to enact a fiscal stimulus poses only a modest downside risk to these forecasts.
Europe – All eyes on the French elections
As we approach the French election’s 1st round on April 23th, markets are likely to become volatile as investors hedge against a negative outcome.
The risk of a second round between far-left Jean-Luc Mélenchon and far-right Marine Le Pen has been growing. Mélenchon has been steadily rising in the polls after strong performances on the live debates (see graph). A second round between Le Pen and Mélenchon would be market unfriendly. Not only is Mélenchon the least competitive candidate against Le Pen, his economic program is not market friendly either: among other things by proposing that the ECB should be allowed to finance governments. The risk of a Mélenchon-Le Pen runoff is boosted by the fact that pollsters indicate Emmanuel Macron’s voter fidelity is one of the lowest among presidential candidates (Le Pen: 79%, Fillon: 74%, Mélenchon: 60%, Macron: 55%, Hamon: 41%).
Nonetheless, our baseline remains that Le Pen and Macron will advance to the second round and that the latter will win the election. Macron has been consistently 20ppt above Le Pen in run-off polls.
If the French election does not bring along a negative surprise, the outlook for Europe will brighten for the rest of the year. Current data points to GDP growth of 0.5% qoq in 1Q17. Without a political shock, this pace is likely to continue with improving financial conditions, slightly expansionary fiscal policies and a milder external drag. Despite this improving outlook, the ECB is likely to stick to its accommodative stance for now. But we do expect its forward guidance to gradually change towards a neutral assessment of the balance of risks. This would be akin to preparing ground for stimulus removal by year end.
In addition, Europopulist support appears to have peaked and might fall ahead. In a recent study, we argued that the economic recovery, falling unemployment, and lower number of asylum applications are likely to reduce support for populist and Eurosceptic parties ahead. Nonetheless, country-specific situation still poses risks (see Macrovision: Has Europopulism been stopped?)
Our GDP growth forecasts for Europe remain at 1.6% and 1.3% for 2017 and 2018, respectively. We see upside risks to our forecast if indeed the French election does not bring a negative surprise.
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 (albeit with a lag) support our view that the Japanese economy is set to grow faster than its potential rate this year. Additionally, a tightening labor market – unemployment fell to 2.8% in February – should give a boost to consumption ahead.
We expect no changes from the BoJ at least until core CPI reaches 1.0% yoy. The BoJ has been repeatedly reinforcing its commitment to the QQE with Yield Curve Control strategy, which involves keeping the short term interest rate at -0.1% and the 10-year yield target at “around 0.0%”. It is important to note that the BoJ might want to reduce the pace of purchases, which are currently at 80 trillion JPY per year, with the aim of avoiding bond scarcity. This would be in line with the flexibility that the new policy framework gives and should not be seen as tightening.
Our GDP growth forecasts for Japan remain unchanged at 1.4% in 2017 and 1.0% in 2018.
China – Steady growth continues
Economic activity in China remained steady in March. The official manufacturing PMI rose to 51.8, advancing to the highest level since July 2014. The Caixin manufacturing PMI did fall to 51.2 from 51.6 but still remain at a sound level (see chart).We estimate GDP growth at 6.8% yoy (the same pace as 4Q16), while nominal GDP growth has likely accelerated to 11.6% YoY (vs. 9.6% YoY in 4Q16) on continued PPI reflation.
We still expect economic growth in China to weaken in 2H17, as the government tightens policy. First, 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. Although the monetary tightening is aimed at avoiding financial risks, it still creates some headwinds for activity.
We forecast 6.4% GDP growth for 2017, with a slowdown in 2H17, and 5.8% growth for 2018.
Commodities – Falling commodities prices are not a sign of global economic weakness
The Itaú Commodity Index (ICI) has fallen by 3.1% since the end of February.
Agriculture prices were down 4.3% due to a stronger soybeans crop in the U.S. and weaker sugar demand from India in U.S. We lowered our price forecasts for both commodities. However, we raised our price forecasts for corn and wheat due to lower crops in U.S. and the higher probability of an El Niño anomaly in the Pacific Ocean from 2Q17.
Our ICI-Metal index dropped 7.4% with a 15.4% fall in iron ore prices. At the moment we believe this decline reflects high iron ore inventories instead of weak global demand. Indeed, our index of metal related activity in China likely remained at solid level in March (see chart). Nonetheless, we continue to expect iron ore prices to drop to USD 55/ton by year-end (implying a more than 25% shift from current levels), mainly driven by slower Chinese activity in 2H17.
The ICI-Energy component declined by 2.6% in March but has gained 4.1% since then, with both moves driven by oil prices. Despite the decline seen in early March, prices have returned to the USD 50 to 55/bbl range with almost full compliance of the deal, in line with our scenario.
Looking forward, we expect the ICI to decline by 4.0% 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 agriculture price estimates).
Financial conditions and economic growth remain disconnected
• The global environment remains supportive for LatAm assets, and the Mexican peso has outperformed its peers.
• At odds with our earlier view, economic activity remains weak in South America, but is still resilient in Mexico. We have reduced our growth forecasts for this year for Peru, Chile and Colombia, but increased them for Mexico.
• There is an easing bias for monetary policy in most South American countries with exception of Argentina, which increased its interest rate, and Mexico, where the central bank reduced the pace of interest-rate hikes.
The global environment remains supportive for LatAm assets. The Mexican peso and Mexico’s sovereign credit spread outperformed peers in March, as U.S. policymakers recently took a more constructive stance toward NAFTA. Specifically, by the end of March, the Mexican peso was 15% stronger than its weakest level, which had been reached in mid-January. The combination of higher commodity prices, stronger global growth and low interest rates are benefiting the assets of other countries in the region too. Our Itaú Market Conditions Index shows that financial conditions have improved for Mexico (bringing the index into positive territory) and remain supportive for the rest of the region.
In this context, we continue to see some weakening of LatAm currencies this year, as the Fed gradually tightens its monetary policy. Still, we now expect a stronger Mexican peso than in our previous scenario.
Economic activity in South America remains weak. A mining strike in Chile has exacerbated the weakness. But even excluding mining activity, growth in the Chilean economy has been disappointing. In Argentina, activity began to rebound in 4Q16, but the recovery so far has been bumpy (the monthly GDP proxies recently fell on a month-over-month basis) and unbalanced (both consumption and investment continued to fall sequentially in 4Q16). In Peru, the “Coastal El Niño” is having adverse effects on economic growth. In Brazil, the economy was still in a recession during 4Q16, but strong agricultural output and a further increase in confidence indicators point to a positive quarter-over-quarter growth rate in 1Q17. On the other hand, in Mexico there have been signs of internal demand deterioration since the election of Donald Trump to the U.S. presidency, but the weakening has been more modest than we were previously expecting, maintaining a strong carry-over for this year.
Our Itaú Activity Surprise Index shows a similar story. It inched down to -0.06 in March from -0.05 in February (see the full report here). Brazil is showing another downturn, but methodology changes in some key indicators lead us to advise caution in interpreting a deterioration of results. In fact, excluding these modified series, the aggregate index would have jumped to positive. Mexico stood out in the positives, while the Andean economies are in the negatives, although Chile and Peru improved from February.
We have reduced our 2017 growth forecasts for Peru, Chile and Colombia, but have increased them for Mexico. In Argentina, we think that the risks to our forecast are balanced (previously we saw upside risks).
In some countries, inflation dynamics have become more challenging. In Colombia, although year-over-year inflation continues to fall fast, underlying inflation measures have been less well behaved. It is yet to be seen whether this is still linked to the VAT hikes or if it is simply inertia. In Peru, the “Coastal El Niño” led food inflation to spike in March, risking inflation expectations. In Argentina, core inflation remains stable at the margin and far above the upper bound of the central bank’s target in spite of a strong currency, while headline inflation is picking up due to regulated price adjustments and inflation expectations are increasing further. Inflation in Mexico continues to rise beyond the upper bound around the target. On the positive side, inflation in Chile remains below the target and in Brazil, the broad-based disinflation process continues.
Still, the easing bias for monetary policy remains in most countries of South America, while in Mexico the central bank reduced the pace of interest-rate hikes. The central bank of Brazil strongly indicated that it is ready to increase the pace of interest-rate cuts. In Chile, the central bank recently signaled more easing, although we continue to expect the central bank to cut rates by more than authorities are indicating. In Colombia, the central bank cut the policy rate by 25 bps (the third cut in the cycle) and signaled that its focus is now on meeting the 3% target in 2018 (contrasting with its previous commitment of bringing inflation to below 4% by the end of 2017). The central bank of Peru reduced the reserve requirement for local currency and strongly indicated that it will cut rates ahead, as it focuses on El Niño’s negative impact on growth instead of its consequences for inflation. Mexico’s Central Bank Governor Agustín Carstens recently stated that the board may not have to follow the Fed one-to-one in the medium term. However, Argentina’s central bank has turned more hawkish, as the monetary authority increased the policy rate by 150-bps.
We see rate cuts this year in Brazil, Chile, Colombia and now also in Peru. In Mexico, we see only two additional rate hikes after each of the next two moves by the Fed. We recently estimated Taylor rules for Chile, Colombia, Mexico and Peru, which indicate room for looser monetary policy stances in the region (see the full report here). We acknowledge that there is a risk for further interest rate increases in the near term in Argentina, but we still see the policy rate below the current levels by the end of the year, should the outcome of the ongoing wage negotiations remain closer to inflation expectations than to 2016 inflation, supporting a disinflation process.