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1 LatAm Macro Monthly Scenario Review February 2016 Global Economy Central banks react; Risks remain 3 The major central banks are reacting to financial markets turbulence. This action should maintain financial risks under control. In our view, China remains the main risk to the global economy. LatAm Sailing in troubled waters 7 Growth remains weak across the region, but momentum is mixed, with some economies recovering, some deteriorating and only Chile is relatively stable. The currencies more linked to oil weakened significantly during the past month. Brazil We forecast a 4% drop in GDP and lower interest rates in Brazil s economic activity has not yet stabilized, we forecast now a deeper recession this year. In our scenario of falling activity and inflation, we see the Selic rate ending 2016 at 12.75%. Argentina Undergoing adjustments 17 Inflation seems to be behaving orderly after the devaluation. Argentina is advancing on tapping financial resources from abroad. Mexico Another victim of cheap oil 20 Despite the country s decreased dependence on oil, the decline in oil prices is negatively affecting activity, fiscal revenues, exports and the exchange rate. Chile Starting the year on the back foot 24 A weak end to 2015 resulted in a more unfavorable carry-over, leading us to reduce our growth expectation for this year. Amid weak confidence, we see lower growth also in Peru A one-horse race to Miraflores? 27 We expect growth to accelerate in 2016, boosted by higher mining production, stronger public investment and a lower contraction of private capital spending. Keiko Fujimori remains the clear front-runner of the presidential elections. Colombia The long-term consequences of the oil shock 30 With the fall in oil prices, Colombia s economy is going through adjustments. In our baseline scenario, Colombia continues to perform fine. In a stress scenario for oil prices, growth suffers and the potential rise of external debt is a risk. Commodities Oil fundamentals suggest a rebound in oil prices starting by mid-year 35 We expect the oversupply in the oil market to vanish by the middle of the year, supporting a recovery in prices. We have reduced our price forecasts for sugar and coffee due to favorable conditions for the next crop in Brazil. Page Macro Research Itaú Ilan Goldfajn Chief Economist Tel: macroeconomia@itaubba-economia.com Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.

2 Markets remain volatile, what are the risks for Latam? Markets have remained volatile since the beginning of the year. The world s main central banks are taking steps to calm markets. The FED has said it is monitoring global financial conditions. We believe the FED will not hike the Fed Funds rate in March, as we expected before. The European Central Bank (ECB) has signaled fresh stimulus measures and the Bank of Japan cut interest rates into negative territory. The steps taken by central banks will tend to limit short-term financial risks, but are unlikely to avoid further market volatility. Markets should become calmer when positive (or stable) data on global activity becomes available. In our view, China remains the biggest risk to the global economy. In the short term, China needs to reduce capital outflows and stabilize its currency to reduce the perception of risk. In the medium term, China needs to implement a reform agenda to help rebalance the economy and guarantee a gradual slowdown. Against this backdrop, Latin America continues to navigate trouble waters. Exchange rates remain volatile, although only currencies with closer ties to oil prices Colombia and Mexico depreciated significantly in January. Regional activity remains weak but the outlook is mixed: there are signs of improvement in Mexico and Peru, whereas Brazil faces a deepening recession. With inflation under pressure, most Central Banks remain on tightening mode. However, the weak global economy could lead some central banks to resist further hikes, as in Brazil. Brazil s economic activity has not yet stabilized. We are now forecasting a 4.0% GDP contraction in 2016 (-2.8% previously). Government finances remain Brazil s core problem. In addition to the recession, which is weighing on tax revenues, there is a structural trend for mandatory spending to rise faster than GDP. Faced with global uncertainty, lower inflation and a deep recession, we now expect the Central Bank to cut rates in the second half of the year. Adjustments continue in Argentina. The government has abandoned most controls and allowed the exchange rate to float. Significant currency depreciation has yet to have an impact on inflation. The Central Bank has been reducing the speed of monetary expansion in efforts to achieve this year s inflation target (maximum 25%). However, relative prices adjustments, particularly energy and the exchange rate, suggest this is no easy task. We forecast a 0.5% GDP contraction this year and a 3% recovery in Hope you enjoy, Ilan Goldfajn and Macro Team Scenario Review World Latin America and Caribbean Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % Brazil Mexico Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % BRL / USD eop MXN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % IPCA - % CPI - % Argentina Chile Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % ARS / USD eop CLP / USD eop BADLAR - eop - % Monetary Policy Rate - eop - % Lebac 35 days - eop - % CPI - % CPI - % (Private Estimates) Colombia Peru Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % COP / USD eop PEN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % CPI - % CPI - % Page 2

3 Global Economy Central banks react; Risks remain The major global central banks are reacting to financial markets turbulence. The fear is that worsening financial conditions affects recovery in the real economy. The BoJ lowered its interest rate into negative territory. The ECB signaled a new round of easing. And the Fed wrote that it is carefully monitoring financial conditions. We now see the Fed on hold in March. The actions of the central banks should keep financial risks under control. We see moderate GDP growth in the U.S. (2016F: 2.2%), euro area (2016F: 1.7%) and Japan (2016F: 1.0%). China remains the main risk to the global economy. In the short term, a slowdown in capital outflows and a stable currency are necessary to stabilize risk sentiment. For the medium term, China needs to continue its reform agenda to allow the rebalancing of its economy and gradual slowdown (we maintain our GDP forecast at 6.3% in 2016). We expect fundamentals to support an oil-price recovery around mid-year. Until then, downside risks remain. U.S. Fed on hold while it closely monitors global economic and financial developments The FOMC is unlikely to raise the Fed Funds rates in March while it is closely monitoring the implications of global economic and financial developments on the balance of risks to the outlook. In January, the committee left the fed fund rate range unchanged at 0.25%-0.50%, as widely expected. The statement indicated that the FOMC needs to reassess the balance of risks to the U.S. economy in the light of global and financial developments. This a prudent approach by the Fed, consistent with its message that the tightening cycle will be gradual and data dependent and that it will take into account overall financial conditions. Hence, we now believe that the Fed will delay the second rate hike from March to mid-year, as the uncertainties are likely to linger for longer than previously anticipated. We expect the next 0.25 p.p. interest-rate increase to occur in June, and now see three hikes in 2016 instead of four. We see the fed fund rate range at 1.00%-1.25% (instead of 1.25%-1.50% previously) at the year end. However, growth in the U.S. is holding up and some of the investors concerns will likely dissipate ahead. We left our GDP growth forecasts unchanged at 2.2% in 2016 and 2.1% in exports will remain a drag, domestic demand is likely to pick up. Non-residential investment should rebound in the first half of 2016, as it declined almost exclusively due to renewed spending cuts by the oil supplychain industries. And, if consumption continues to grow, it should continue to spur investment in nonresidential investment (ex-energy). Moreover, the recent decline in oil prices should provide another boost to consumption in the next couple of quarters. Consumption slowed down to 2.2% qoq/saar (from 3.0%), but mainly due to lower energy consumption (which contributed a decline of 0.5 pp) in a mild winter. Besides, household economic fundamentals remain healthy, with solid jobs, real income growth and available credit, which all translate into high consumer confidence. Second, the credit problems in the energy sector can be absorbed by the financial system and hence are unlikely to propagate to the rest of the economy. Credit to the energy sector represents only 1.5% of the U.S. credit markets. The exposure of U.S. banks is even smaller, 1.0% of total assets. As an example, and a key distinction from the 2008 financial crisis, mortgages represent about 30% of the credit markets in the country. Credit spreads for financial institutions remain contained despite the stress in the energy sector (see graph), which is a good sign. First, the slowdown in 4Q15 was temporary and the economy should accelerate 1Q16. U.S. real GDP slowed to 0.7% qoq/saar in the fourth quarter, well below the 2.4% yoy seen in While net Page 3

4 Financial corporates untainted by higher energy credit spreads Corporates CDX Energy Financials Senior 0 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Source: INEGI, Itaú Finally, economic expansions simply do not die of old age. The current expansion cycle has already lasted 26 quarters, compared with 20 quarters on average since the Great Depression of Some investors seem to take this as a sign that a downturn is upon us. Not so fast! There is no such a thing as a time-dependent-theory of business cycles. In fact several important indicators, such as moderate leverage of the private sector, indicate that chances of a recession in the U.S. remain small. Once it becomes clear that U.S. growth remains around 2.0%, we think that the Fed will be able to resume the hiking cycle. The pace will need to be gradual though, as growth in this recovery is slow by historic norms and global risks, in particular from China, will remain significant. We think that another 0.10 p.p. cut to the deposit rate, bringing it to -0.40%, is likely at the next meeting. An extension of the asset-purchase program, by another six months (from until March 2017 to September 2017), is also possible. These are likely to aid the inflation outlook through a more-depreciated currency and some stabilization in inflation expectations. Importantly, it also helps to stabilize financial markets and avoid risks emanating from tightening financial conditions. On economic activity, we see data in line with moderate growth. We keep our 2016 GDP forecast at 1.7% and 2017 at 1.6% Japan BoJ goes negative (and that is positive) The BoJ cut interest rates into negative territory (to -0.10% from 0.10%), reinforcing its commitment to end deflation. The decision to follow some European central banks and adopt negative rates (see graph) came at a moment of mixed signs in activity, declining inflation expectations and financial-market instability. The central bank also announced that could cut rates further if needed, reaffirming that still has tools available and that will do whatever it takes to counter the Japanese deflationary mindset. The BoJ movement surprised most investors. Japan joinning the negative rates club 0.0% -0.2% Europe Another shot of monetary stimulus The ECB indicated that it is likely to ease policy further in March in response to downside risks to the inflation outlook. ECB president Draghi pointed to heightened uncertainty in emerging economies, along with volatility in financial and commodities markets. In addition, lower oil prices reduce current inflation and generate risks of second-round effects beyond this year. As a consequence, the ECB indicated that it would possibly reconsider its policy stance. -0.4% -0.6% -0.8% -1.0% -1.2% % Source: Central Banks, Itaú Central bank interest rates Together with the Fed and the ECB, the BoJ s aggressive move should help stabilize financial markets and avoid an unwarranted tightening of financial conditions. Page 4

5 We maintain our GDP forecasts at 0.6% in 2015, 1.0% in 2016 and 0.9% in China One (necessary) step back Economic activity data released in mid-january indicates some stabilization in growth. The 4Q15 GDP headline slowed to 6.8% yoy from 6.9% yoy in the previous quarter, but only due to a lower (and less distorted) contribution from the financial sector. Industry and other services kept the same pace. December s figures also show that the economy is roughly at the same pace through the second half of the year. We maintain our scenario of a gradual slowdown, to 6.3% GDP growth in 2016 from 6.9% in Despite activity data showing tentative signs of stabilization, investors remain nervous about downside risks in China and see large capital outflows as a sign of problems in the country. We believe that in the short term, the government s focus will be on keeping a stable currency and avoiding capital outflows, even if this represents a step back in China s reform agenda. We already see signs that this is a policy priority at the moment. First, the PBoC has been maintaining the CNY stable since mid-january. The central bank is setting the CNY value against the USD below the previous spot closing price, and intervening in the spot and forward market. These actions also help to anchor expectations about the central bank s intention to keep the CNY stable against a basket of currencies and not promote depreciation. Second, the PBoC is refraining from broad-based additional monetary stimuli that could pressure the CNY. Instead of a cut to the required reserve ratio, the central bank is using a variety of instruments and hence avoiding large broad-based liquidity injections. Finally, China is taking a step back in its gradual opening of capital accounts, with a discreet approval of major central banks and the IMF. Even though this helps to improve the short-term outlook, it is another signal of the difficulties in achieving a successful rebalancing without a hard landing. We believe that China will be able to stabilize capital outflows and reduce the pressure on foreign reserves. For now, a sustainable pace of capital outflow should be consistent with monthly sales of foreign reserves of around USD 20 billion in the next couple of years, compared with USD 133 billion in December. This would take the decline in foreign reserves (excluding exchange-rate valuation effects) to USD 250 billion in 2016, compared with USD 342 billion in Adding a current-account and net FDI surplus totaling USD 385 billion, this would allow net capital outflows of up to USD 630 billion, compared with USD 742 billion seen in We note that, besides the measures mentioned above, a decline in external liabilities (excluding direct investment and equity) to an estimated USD 1.2 trillion in 2015, from USD 1.6 trillion in 2014, should already reduce some of the capital outflow pressure. Meanwhile, the outflow by residents can be controlled by a combination of controls and guidance to the state-owned enterprises. Commodities Fundamentals support oilprice recovery around mid-year Commodity prices have risen 5.0% since mid- January (according to the Itaú Commodities Index ICI), driven by higher oil and metal prices. Agricultural prices have not followed the increase, but are still outperforming oil-related and metallic commodities year-to-date. The aggregate increase was not enough to fully offset the initial losses in the year, and the ICI is still down 2.8% year-to-date. The oil market has been one of the main drivers of asset prices around the globe this year. The daily correlation between Brent and the S&P 500 has increased to 0.43 in the last 60 days, compared to 0.19 in the first half of Oil (Brent) prices remained between USD 30 and USD 35/bbl, as oversupply persist. A tentative rebounded occurred with news of a coordinated supply cut by key producers. The news came from Russia and Venezuela, countries with no track-record of actively cutting supply. Hence we don t see the news as reflecting the strategy of Saudi Arabia and its close allies, which are the countries that have actually cut production in the past. We expect fundamentals, driven mostly by changes in the U.S. supply, to support oil-price recovery around mid-year. We estimate that lower production in the U.S. (to 8.7 mbd in 4Q16 from 9.2 mbd in 4Q15) will offset increased exports from Iran (to 1.7 mbd in 2016 from 1.1 in 2015). This should keep global oil production stable while demand growth maintains its upward trend, closing the current excess supply by 3Q16 (see chart). Our historical analyses also suggest that prices reach a minimum in the Page 5

6 quarter before the market shifts from surplus to deficit (in this case, the minimum price would occur in 2Q16). Oil: end of oversupply will support price recovery mb/d % of consumption 3% 2% We expect crude oil prices to rise to USD 55/bbl (Brent) by 2016 year-end. For other commodities, we maintain our forecasts for metal commodities (implying some increase from current levels). We lowered our forecasts for sugar and coffee due to favorable weather conditions in Brazil, maintaining our forecasts for soybean and grain prices amid weak news flow % 0% -1% Demand Supply Global Balance -2% 88-3% Jun-11 May-12 Apr-13 Mar-14 Feb-15 Jan-16 Dec-16 Source: INEGI, Itaú Forecasts: World Economy F 2016F 2017F GDP Growth World GDP growth - % USA - % Euro Area - % Japan - % China - % Interest rates and currencies Fed Funds - % USD/EUR - eop YEN/USD - eop DXY Index* - eop Source: IMF, Bloomberg and Itaú Page 6

7 LatAm Sailing in troubled waters With an uncertain global scenario, volatility continues to affect LatAm economies. The currencies that are more linked to oil weakened significantly during the past month. We expect most currencies to remain broadly stable from the end-of-january levels, as lower uncertainty about global growth and the expected recovery of commodity prices (especially oil) neutralize the impact of rate hikes in the U.S. Growth remains weak across the region, but momentum is mixed, with some economies recovering, some deteriorating and only Chile being relatively stable. But even where there is a recovery (Mexico and Peru), it still seems fragile. Inflation remains high, despite weak activity, mostly a result of pass-through from currency depreciation. The convergence of inflation to the middle of targets will be gradual. With inflation remaining at uncomfortable levels, most central banks in the regions are still raising interest rates. The exception is Brazil, where we now expect rate cuts this year. For the rest of the countries, some additional monetary-policy tightening is likely. But any relief on the inflation front could translate into early termination of the hiking cycles. Finally, in Argentina, the government has succeeded in adjusting the economy so far. The exchange market was freed from most controls and is currently floating. The large depreciation has affected inflation only moderately, and interest rates are now down from their peak. The government has also announced a series of significant measures, such as a cut in energy subsidies, a deal with a group of Italian holdouts and a sizable credit line with a pool of international banks. Volatility persists Exchange rates in the region continue to be volatile, consistent with the uncertainties about the global scenario. Since the beginning of January, the Mexican peso and the Colombian peso which are linked to oil have underperformed. But the Mexican peso depreciated even more than the Colombian peso in January (unlike what happened in much of 2015), in spite of being much less exposed to oil (at the margin, Mexico became a net energy importer due to the continuous decline of oil production.) The remaining currencies of the region ended January close to their respective yearend 2015 levels. We expect most currencies in the region to remain broadly stable from the end-of-january levels. Lower uncertainty over global growth and some recovery of commodity prices (especially oil) will mostly neutralize the impact of any eventual rate hike in the U.S. Volatility persists Local currency per dollar; Index 100=3Q2013 BRL CLP COP MXN PEN 95 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Source: Bloomberg, Itaú Not all recoveries are equal Activity momentum in the region is mixed. In Brazil, recession continues. In Colombia, retail sales and confidence data hint that consumption (which has been supporting the economy) is about to slow, consistent with the impact of rising inflation and higher interest rates. Activity indicators in Chile show that growth is stabilizing around 2%. Finally, the economies of Mexico and Peru are recovering slowly, driven almost exclusively by private consumption and mining production, respectively. Page 7

8 Brazil in recession, the rest decelerated 8% 6% 4% 2% 0% -2% Monthly GDP yoy ma3m -4% Brazil Chile -6% Colombia Mexico Peru -8% May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 Source: Haver, Itaú We changed our growth forecasts for Chile, Peru and Brazil. In Brazil we now expect a deeper recession (-4%) this year, as the economy had deteriorated by more than we were expecting by the end of 2015, generating a larger negative carry-over. The most recent leading and coincident indicators point to another contraction in 1Q16. In Chile, we now expect growth at 2.0% this year, the same rate estimated for 2015 and only slightly above the expansion registered in In Peru, mining production had increased much faster than expected by the end of 2015, leading us to revise our estimates upward for growth last year. We also see upside risks for our forecast for this year. Finally, we continue to expect a moderate slowdown in Colombia this year, due to lower oil prices and to the tightening of macro policies (which will be partially offset by the investments associated with the 4G PPP program). In Mexico, we expect the economy to continue to recover, but there are downside risks (the U.S. industry continues sluggish, oil output is not clearly stabilizing and lower oil prices limit the benefits of the energy reform.) Inflation remains a concern Inflation remains above the upper-bound of the target in most countries. The exception is Mexico, where inflation is record low, despite the recent uptick in the beginning of the year, influenced by an unfavorable base of comparison and a rebound of volatile agricultural prices. In Peru, Colombia and Brazil, inflation has yet to start a downward trend, as exchange-rate depreciation and inertia from past inflation continue to pressure prices. In the three countries, inflation expectations continue at high levels for the relevant policy horizons. In this context, inflation in the region will fall gradually due to weak growth. In fact, in Peru and Colombia inflation hasn t peaked yet. In Brazil, the favorable base effects from the harsh utility-price increases in 1Q15 will likely lead to a decline in yearover-year inflation already in 1Q16 (though to a level still far above the upper bound of the target). In Chile, inflation will continue to be pressured in the short term too, also due to inertia (education and energy prices will be readjusted with 2015 inflation) and tax increases, with lower gasoline prices partly offsetting these factors. Policy rates will not get much higher With inflation remaining at uncomfortable levels, most central banks in the regions are raising interest rates. In Peru and Colombia, central banks are raising rates faster, as inflation kept deteriorating. The central bank of Chile is moving more gradually. In Mexico, in spite of low inflation and the incipient recovery, rates are also moving higher, in tandem with the Fed. In Brazil, the sharp deterioration of activity coupled with the uncertainty over global growth outweighed concerns about inflation, leading the central bank to rethink its guidance for higher interest rates. The policy rate was kept unchanged in January. We now expect interest-rate cuts in Brazil this year, while some additional rate increases in the other countries are likely. In Brazil, as inflation falls, the economy continues to contract and the exchangerate remains at around current levels, we believe that the Central Bank of Brazil will start an easing cycle in August. However, if the exchange rate weakens more than expected due to domestic or external uncertainties, the room for easing could disappear. In Peru and Colombia, we expect two additional 0.25 p.p. hikes in the near term, ending the cycle. In Chile, the central bank is signaling some additional tightening, but not in the near term. We also expect two additional 0.25 p.p. hikes, but between the 2Q16 and 3Q16. With weak growth (domestic and globally), inflation falling and well-anchored inflation expectations, the risk is that the central bank stays put. Finally, in Mexico we reduced our year-end policy rate forecast, in line with our revision for the monetary policy in the U.S. Page 8

9 So far, so good In Argentina, the government has succeeded in adjusting the economy so far. The exchange market was freed from most controls and is currently floating. The large depreciation has affected inflation only moderately, and interest rates are now down from their peak. The government also announced a series of significant measures, such as a cut in energy subsidies, a deal with a group of Italian holdouts and a sizable credit line with a pool of international banks. Page 9

10 Brazil We forecast a 4% drop in GDP and lower interest rates in 2016 Brazil s economic activity has not yet stabilized. The economy shrank significantly at the end of last year and leading indicators suggest that it continues to retreat during the first part of this year. Looking only at last year s carry-over, we would expect GDP to fall 2.6% in Adding in a probable 1% contraction during the first quarter, GDP for the year could shrink 3.6%. As we believe that the economy is likely to stabilize only in the second half of the year, we are now forecasting a 2016 contraction of 4.0% (previously -2.8%). In 2017, we expect a moderate economic recovery, depending on the economic policy reaction and international shocks, with GDP rising 0.3% (previously 0.0%). The labor market is likely to have a lagged reaction to negative GDP growth. Unemployment will probably continue to rise, reaching 13.0% in 2016 and 13.4% in Fiscal accounts are still Brazil s core problem. At the end of 2015, the primary deficit was 1.9% of GDP (0.9% excluding delayed expenditure), after a deficit of 0.6% of GDP in We have revised our projection of the primary balance in 2016 to -1.5% from -1.4%, but we maintain our -2.0% projection for Brazil s external accounts are adjusting fast, in line with current weaker exchange rate. The current account deficit fell to 3.3% of GDP in 2015 (compared with 4.3% in 2014). The current account deficit should continue to improve and end 2017 close to zero. We are maintaining our dollar exchange rate projections at 4.50 reais per dollar at the end of this year and 4.75 per dollar at the end of With a stable exchange rate, inflation will probably present a long-term downward trend. Our inflation projections for this year (7.0%) and 2017 (5.0%) remain unchanged. The central bank has backed down and held interest rates stable, based on global risks and the domestic recession. In our scenario of falling activity and inflation, we now expect to see the Selic benchmark interest rate ending 2016 at 12.75%, with three 0.5 percentage point cuts from August onward. Contracting activity and falling inflation create opportunity for interest-rate cut Data on economic activity from the last quarter of 2015 were worse than expected. The first quarter of 2016 is also likely to reveal negative growth. Fundamentals suggest difficulties moving forward. Domestic demand is set to weaken further, while any positive contribution from external demand is likely to be limited. The fiscal situation worsens. Future stabilization of economic activity and resulting improvement in tax revenues will be insufficient to stabilize debt dynamics, because of a structural tendency for mandatory spending to rise faster than GDP. Without reforms to reduce these expenditures, gross public debt will continue to rise. Brazil s external accounts have been improving consistently, providing relative stability for the Brazilian real. The current-account deficit is converging to zero in However, the global outlook and deteriorating fiscal situation may lead to further depreciation. We believe that inflation has embarked on downward trend. Less pressure from regulated prices will help ease the IPCA this year. The impact of the economic slowdown on inflation, particularly in the Service sector, should become clearer later in the year. The main risk in this scenario is a stronger depreciation of the BRL. We expect the Selic benchmark interest rate to fall in The central bank has communicated its concerns about global and domestic activity. We believe that inflation will fall throughout the year and push the central bank into a rate-cutting cycle in the second half of A little light at the end of the tunnel. There are incipient signs of economic activity stabilizing in the second half of the year. The downward trend in Page 10

11 2013.I 2013.II 2013.III 2013.IV 2014.I 2014.II 2014.III 2014.IV 2015.I 2015.II 2015.III 2015.IV 2016.I 2016.II 2016.III 2016.IV 2017.I 2017.II 2017.III 2017.IV LatAm Macro Monthly February 2016 business and consumer confidence has ended, and ticked up in January. Inventories are high, but they are being adjusted. Other leading indicators, such as our diffusion index, still suggest that economic activity will slow down, but the deceleration will be less dramatic. Activity contracts at the end of 2015 and beginning of 2016 The contraction in economic activity was stronger than we expected at the end of last year. For example, real revenues in the Service sector fell 6.6% year over year in November. Industrial output disappointed in December, retreating 0.7%. In the fourth quarter, it fell 3.9%. Retail sales surprised to the upside in November, but coincident indicators pointed toward a reversal in December, suggesting a 2.2% reduction in sales during the fourth quarter of With GDP falling further in 2015, the carry-over for 2016 stands at -2.6%. In other words, this is the extent that GDP will fall if it remains stable throughout the year. However, economic fundamentals suggest that GDP will fall further in early The first quarter of 2016 is also likely to see negative growth. The first coincident indicators for economic activity (vehicle sales and energy demand) fell in January. Industrial inventories remain high. Additionally, our Itaú-Unibanco monthly GDP index suggests a negative carry-over into 1Q16. Based on this, we are now projecting that GDP will shrink 1.1% during the first quarter. As a result, GDP would retreat 3.6% this year if it remained stable from the second quarter onward. Economic fundamentals suggest that challenges remain. Uncertainties, pressure on production costs and high levels of idle capacity are likely to drive investment down further. The significant drop in commodity prices in international markets has reduced profitability in certain sectors, further discouraging investment. Last year s downward trend in spending is likely to continue. The deteriorating job market will continue to weigh on consumer decisions. Following the currency depreciation, exporters are likely to continue making a positive contribution to growth, as in However, modest global growth will limit any impact. Confidence shows early signs of stability. In January, business and consumer confidence indices surprised positively. Despite this improvement, it is not yet clear whether this represents a fundamental change in attitude at the moment, it s clear that confidence generally remains low. Still, these figures suggest relative stability for economic activity in the second half of the year. Confidence increases, but remains at low levels index, sa 50 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Source: FGV, Itaú We are now forecasting that GDP will fall 4.0% in 2016 (compared with -2.8%). On the demand side, the drop in GDP will be led by domestic consumption and investment, whereas the negative highlights on the supply side will be industry and services. We are forecasting a 0.3% rise in GDP (previously 0.0%) in A slight loosening in monetary policy should contribute some growth next year. Another sharp GDP contraction in next quarter 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% qoq/sa Actual Forecast Source: IBGE, Itaú Construction Industry Services Retail Consumer -0.8% -2.1% -1.7% -1.1% -1.5% -0.2% -0.3% -0.4% 0.4% 0.6% 0.3% 0.1% Page 11

12 Fundamentals remain negative in the labor market. In December, there was a net loss of 596,000 formal jobs (CAGED). Removing seasonal effects, we calculate that 118,000 jobs were lost. Job destruction has lessened in recent months but remains close to historical minimum levels. The rate of unemployment in the six metropolitan regions surveyed by the Monthly Job Survey (PME-IBGE) also rose less than expected in December. Weak economic activity is likely to continue driving up unemployment. Additionally, the proportion of people reporting difficulty finding a job, a leading indicator of unemployment, rose from 89.0% in December to 91.7% in January. We forecast that the national unemployment rate reached 10.0% at the end of 2015 and will rise to 13% by the end of this year. We have reduced our 2017 projection slightly, to 13.4% (from 13.7%). We expect the rate of unemployment (PME-IBGE) to reach 11.4% by the end of this year, and we have revised our 2017 projection down to 11.8% (previously 12.4%). Unemployment rate upward trend will continue 3.4%. Overall, interest rates and average spreads declined. Fiscal deterioration continues The primary deficit was 1.9% of GDP in 2015 (0.9% excluding delayed expenditure), compared with a deficit of 0.6% of GDP in The discretionary spending cuts and tax increases throughout the year proved insufficient to offset the drop in tax revenues and increase in mandatory expenditure. The central government registered a primary deficit of BRL 117 billion (1.9% of GDP), of which BRL 56 billion represented December payment of delayed expenses. Regional governments ended 2015 with a surplus of BRL 9.7 billion (0.2% of GDP). However, regional governments recorded a deficit of BRL 9.8 billion in December, confirming the assessment that positive news throughout the year was only temporary, partly reflecting delayed spending. Central government primary surplus deteriorating %, 3mmavg sa PME PNAD Cont. (rhs) Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec % 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% % of full-year GDP 2015 avg Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: IBGE, Itaú Source: National Treasury, Itaú Total outstanding loans fell 3.7% in real terms in The daily average of new non-earmarked loans fell 2.5% in December (mom/sa in real terms), while the daily average of new earmarked loans fell 4.3%. Total outstanding loans continued to decline in terms of real annual growth, falling 3.7% (-2.8% in November). The drop in non-earmarked credit intensified to -6.3% from -5.9%. Earmarked outstanding loans also shrank, falling 0.8% (0.6% in November). Overall delinquency remained stable, at We forecast a primary deficit of -1.5% of GDP in 2016 (revised from -1.4%). Some of the pressure has been taken off government expenditure because delayed expenses were paid off in 2015; however, the downward trend in tax revenues and the rise in mandatory spending especially on social security will continue. We project that social security spending will rise from 7.4% of GDP in 2015 to 8.0% and 8.3% in 2016 and 2017, respectively. Page 12

13 Regional governments corrected the positive surprises in December 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% -0.1% -0.2% Source: Central Bank, Itaú The public debt and nominal deficit continue to deteriorate. The nominal deficit rose from 6.0% to 10.3% of GDP between 2014 and Even excluding currency-swap expenses (totaling 1.5% of GDP in 2015), the nominal deficit rose from 5.7% to 8.8% of GDP, reflecting an increase in interest expenditure from 5.2% to 7.0% of GDP, excluding income from swaps. Interest expenses excluding swaps are likely to remain under pressure because of the growing size of the debt. We believe that interest expenditure excluding swap losses will represent 7.6% of GDP in 2006, increasing the nominal deficit to 9.0% of GDP. Nominal deficit on the rise 12% 10% 8% 6% 4% % of full-year GDP 2015 avg Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 12M, %GDP Excluding FX swap gains/losses Headline Interest payments excluding FX swap gains/losses Rapid external accounts adjustment The current account deficit fell from 4.3% of GDP in 2014 (USD 104 billion) to 3.3% of GDP in 2015 (USD 59 billion), driven by the positive contribution from the trade balance, which swung from a 2014 deficit to a 2015 surplus. The income and services deficit also decreased in Foreign investment is consistent with the current adjustment. Direct investment in Brazil (USD 75 billion in 2015) should be more than sufficient to cover the entire current-account deficit. Current account deficit went down in 2015, as well as external financing availability billion dollars, over 12 months 50 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Source: BCB, Itaú Current account deficit Capital and financial account We have maintained our foreign exchange projection of 4.50 reais per dollar at the end of 2016 and 4.75 reais per dollar at the end of This exchange rate trend is consistent with the current, swift adjustment to external accounts. The currency depreciation and weaker economic activity will help to improve the balance of trade in 2016 and We are maintaining our forecast of a USD 42 billion trade surplus in 2016 and USD 56 billion surplus in In turn, the current account deficit should drop from 1.4% of GDP in 2016 to 0% of GDP in % 0% Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Source: Central Bank, Itaú Page 13

14 We project 7.0% inflation this year and 5.0% in 2017 We believe that inflation will fall to 7.0% this year. We are projecting a 7.0% increase for both market and regulated prices. Regarding the latter, we reduced our forecast for electricity but upped our projections for new-vehicle registrations fees. We forecast a 2.5% increase in the IPCA inflation during the first quarter (compared with 3.8% in 2015), with the 12-month rate falling back to 9.3% (10.7% at the end of 2015). At the beginning of the year, inflation comes under pressure from foodstuffs (particularly price increases for fresh fruits and vegetables, reflecting the climate effects of El Niño), rising public-transport costs in a number of cities, tax hikes in several states and higher school fees. On the other hand, electricity prices rose 36% in the first quarter of 2015, but they will not rise this year and should fall by March. As a result, regulated price increases should slow to 1.9% in the first quarter, compared with 8.5% during the same period last year, resulting in a 1.5 percentage-point drop in inflation. For the remainder of the year, we are projecting a 1.4% increase in the IPCA for 2H16 (2.3% in 2015), rising 1.0% in the third quarter (1.4% in 2015) and 1.9% in the fourth (2.8% in 2015). Projection for market-price inflation stays at 7.0%. Projected inflation for the various market-price components includes a 5.5% increase in industrial prices (6.2% in 2015), a 7.4% rise in services (8.1% in 2015) and 8.5% hike for food at home (12.9% in 2015). Despite last year s stronger resistance to inflation from services, we stand by our assessment that the deteriorating job market and real estate industry, which mitigate salary and rent costs, should help to drive down service inflation this year. However, the inertia from the higher rate of inflation in 2015 may restrict expected service disinflation following the 11.7% increase authorized for the minimum salary and the likelihood of higher school fees at the start of the year. Our basic scenario for foodstuffs is based on better weather conditions than in previous years, despite the risks associated with El Niño, which could reduce supplies of certain agricultural products. Apart from a supposedly more-benign climate for crops, particularly grains, relative exchange-rate stability and lower cost variations for energy and fuel will likely help reduce foodstuff price increases during the year. We continue to project a 7.0% increase in regulated prices this year, with changes in its composition. We have revised our projection of a 2% increase in electricity prices down to zero, following the reduction in the tariff-flag prices issued by the National Electrical Energy Agency (Aneel). Accordingly, we continue to expect a switch from the red-flag to the yellow-flag tariff from March onward, as demand on thermal power plants is expected to ease. Based on the new price for the yellow-flag tariff BRL 1.50 per 100 kwh (kilowatt-hour) (previously BRL 2.50) electricity bills should fall by 5.5% when the current red-flag tariff switches to yellow, instead of the 3.6% improvement we previously estimated. Additionally, our simulations indicate that as reservoir levels recover more quickly, there is an increasing likelihood of green-flag tariffs being adopted by the end of the year, which could further lighten electricity bills and have an impact of -0.1 percentage points on the IPCA. Some of the items that put significant pressure on industry costs in 2015 will now help stabilize electricity bills this year, after last year s 51% increase: the Itaipu tariff will fall; we expect a smaller deficit in industry charges for the Energy Development Account (CDE); and there will be less demand on thermal plants, which will feed through to tariff-flag colors and prices. On the other hand, we have revised our forecast for vehicle registration fees upward, based on increasing IPVA rates (motor vehicle ownership tax) in some states. This means that we expect to see this item rise 9% in 2016, compared with our previous 2% forecast. This year, we are projecting the following changes for other regulated prices that have a significant influence on inflation: water and sewage fees (16%); health plans (12%); city buses (9.5%); medicines (8%); bottled gas (7%); gasoline (4.5%); and fixed-line telephony (-1%). The 16% price increase forecast for water and sewage fees reflects changes in the incentive program intended to reduce water consumption in São Paulo, which are likely to make it difficult to reduce tariffs. The 4.5% rise in gasoline prices includes a 5% price increase at refineries at the end of the year and some state tax increases. For the time being, we expect no increase in the Contribution for Intervention in the Economic Domain (Cide) that applies to gasoline, which remains a risk factor for inflation. The fiscal accounts pose a risk for inflation this year. As government finances deteriorate, we could see an even more intense and prolonged price realignment than forecast by our inflation projections. Further currency depreciation, the need to raise taxes and/or further increase regulated prices, or worsening inflation expectations, could all have an impact on inflation. Weaker economic activity, however, should help drive inflation down in The other side of this coin is the deepening economic recession, which, despite easing inflationary pressure on the demand Page 14

15 side, will also delay any recovery for tax receipts, which may worsen the balance-of-risk uncertainties for inflation. We are projecting 5% inflation in 2017, measured by the IPCA. A drop in inflation next year is expected as the effects from relative price adjustments (regulated prices and the exchange rate), lower inflationary inertia and the impact from weaker economic activity dissipate, albeit with no sign of a recovery. We have also held our projections for the General Price Index Market (IGP-M) stable, at 7.0% for this year and at 5.0% for Inflation starts on a downward path 20% 18% 16% 14% 12% 10% Source: IBGE, Itaú 18.1% 10.7% 8.5% Lower pressure from regulated prices 7.0% 7.0% 7.0% 0% Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec % 6% 4% 2% yoy 6.4 IPCA Market-set prices (76%) Regulated prices (24%) Contributions (pp) forecast (p) IPCA Market-set prices Regulated prices Monetary policy: interest rate cuts on the horizon Global uncertainty has increased, and the Brazilian Central Bank (BCB) has held interest rates stable. Concerns over the global economy have led to volatility in financial markets, worrying central banks in developed countries. Against this backdrop, the BCB decided to hold the benchmark Selic rate stable at its January meeting. In the post-meeting statement, the BCB mentioned an increase in "external uncertainties. In the minutes of the meeting, the central bank added that in light of the reduced level of activity, we would highlight growing concerns about the Chinese economy and its repercussions for other economies. The BCB is also concerned about the domestic recession. In a statement, BCB chairman Alexandre Tombini said that that the reduction in the International Monetary Fund s projection for GDP growth in Brazil, now at -3.5% for 2016, was significant. In the minutes, the BCB noted the worsening labor market. These are signs that the central bank is increasingly concerned over the slowdown in economic activity. In this scenario, we expect the benchmark Selic rate to remain stable for now Based on the current high levels of inflation, we believe that the BCB will opt to keep the Selic rate where it is, to ensure that the current level of inflation does not extend into the future.... but it is set to drop in the second half. In our assessment, the unemployment rate will continue to rise, and central bank projections will point to a deeper recession this year. As a result, when 12-month inflation begins to retreat and seasonal inflationary pressures from foodstuffs dissipate, we believe that the BCB will cut rates. This would occur in the second half of the year. Overall, we now believe that the Selic rate will end 2016 at 12.75%, with three 0.5 percentage point cuts coming from August onwards. The cycle of interest rate cuts should continue in 2017, with the Selic falling to 10.5%. The most important risk for this scenario is the exchange-rate dynamics. There are substantial external risks (global deceleration) and internal risks (fiscal) that could drive a more significant depreciation of the Brazilian real, putting pressure on inflation. If this alternative scenario materializes, we believe that the BCB will not likely cut interest rates. Source: IBGE, Itaú Page 15

16 Forecast: Brazil F 2016F 2017F Economic Activity Real GDP growth - % Nominal GDP - BRL bn 3,886 4,374 4,806 5,316 5,687 5,920 6,191 6,563 Nominal GDP - USD bn 2,208 2,611 2,459 2,461 2,416 1,777 1,453 1,416 Population (millions) Per Capita GDP - USD 11,292 13,226 12,339 12,243 11,914 8,693 7,050 6,818 Unemployment Rate - year avg Unemployment Rate - year end (sa) Nation-wide Unemployment Rate - year avg (*) Nation-wide Unemployment Rate - year end (*) Inflation IPCA - % IGP M - % Interest Rate Selic - eop - % Balance of Payments BRL / USD - eop Trade Balance - USD bn Current Account - % GDP Direct Investment (liabilities) - % GDP International Reserves - USD bn Public Finances Primary Balance - % GDP Nominal Balance - % GDP Net Public Debt - % GDP % 294.3% 218.4% 171.7% -57.2% % % 0.0% Source: IBGE, FGV, BCB and Itaú (*) Nation-wide Unemployment Rate measured by PNADC Page 16

17 Argentina Undergoing adjustments Despite the sharp depreciation of the peso in December, preliminary indicators suggest that inflation is well behaved. However, pending adjustments in energy prices and wage negotiations make the inflation target set for this year (maximum of 25%) challenging. We still expect inflation to hit 34% by December 2016, with a deceleration during the second half of the year. The central bank is reducing the rate of monetary expansion. Even so, the interest rate paid on its sterilization bills (the socalled Lebacs) fell from December s peak. We expect the rates paid on short-term Lebacs to end this year at 30%, close to current levels. The exchange rate depreciated in nominal and real terms in January. Our forecast by year-end 2016 remains at 17.1 pesos to the dollar. Argentina is making progress on tapping financial resources from abroad. It obtained a short-term credit line with a consortium of banks worth USD 5.0 billion, the government negotiated a preliminary deal with a group of Italian holdouts and will likely present a proposal to NY-law holdouts in February. We expect the economy to contract by 0.5% this year due to the ongoing local adjustments, recession in Brazil and lower commodity prices. The adjustments will set the base for a 3.0% recovery in Despite some relief in January, pressure on prices will continue band target set by authorities for inflation). For 2017, we expect inflation to fall to 25%. Inflation decelerated at the margin in January, according to private estimates, suggesting a lower pass-through from the December depreciation than initially expected. Surveys by the consulting firm Elypsis point to a decreasing pace of price increases between the first and last week of January (0.7% and 0.3% respectively) after an average 0.9% per-week rate in December. As a consequence, January s inflation reading would come in at 3% in the city of Buenos Aires after printing 3.9% in December. The government announced that it will track prices in the city of Buenos Aires and those of the Province of San Luis, as Congress stopped publishing price reports and the national statistics office (INDEC) temporarily suspended its publications as part of its revamping process. However, we expect the pressure on prices to continue, due to the pending adjustment in regulated prices. The government recently announced a 300% average hike in electricity prices. Extra adjustments in electricity as well as in natural gas and transportation are expected. On top of that, upcoming wage negotiations will not be easy. Unions are asking for a 30% increase while the government targets 25% (albeit complemented by changes in income tax for the low-income bracket). Although we see a sequential deceleration of inflation in the second half of this year, we still expect inflation to hit 34% year over year by December 2016 (above the 25% upper Limiting monetary expansion The exchange rate depreciated in January amidst volatility. The peso weakened by 6.9% to 13.9 to the dollar, exceeding the expected inflation for January and depreciated further in the beginning of February. Controls on remittances of retained dividends remain. The central bank continued not intervening in the market. However, dollar-selling by grain exporters was more than 150% above the figures for the same period of last year. We continue to see the nominal exchange rate at 17.1 pesos by year-end and 21.4 by the end of 2017, thus stable in real terms relative to the end of The central bank mopped up liquidity and the monetary base growth slowed to 29% (down from 45% by mid-december). Even so, interest rates fell in January after peaking in December. The Badlar rate is close to 27% and Lebac rates are around 31% and 29% for the 30-day and 250-day terms, respectively. These rates also provide support for the exchange rate, as they are above the depreciation expectations implicit in the on-shore and off-shore NDF markets. As the central bank fights additional inflationary pressures, interest rates may rise again in the first half of this year. Afterward, we see the 35-day Lebac rate at 30% by year-end and at 25% in 2017, as Page 17

18 inflation retreats. For the Badlar, we expect a 27% rate for year-end 2016 and 23% for Hitting the brakes %, 20 days MA, yoy, chg remain at 4.7% of GDP in 2016, but with a reduction (if not elimination) of the transfers of central bank dividends. Cuts in subsidies will help the government. For 2017, we expect a lower deficit (4% of GDP). The government announced that it will present a proposal to holdouts in New York in February. A deal is crucial to open capital markets to Argentina, as well as to finance the fiscal deficit without relying on central-bank financing. Positively, the government negotiated a preliminary deal with a group of Italian holdouts and obtained a USD 5.0 billion credit line with a consortium of banks, which should contribute to boosting international reserves. Any agreement with holdouts must be ratified by Congress. 25 Monetary Base More worried consumers 20 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Source: BCRA Time to talk The fiscal deficit is unlikely to narrow much this year. With the November results, the 2015 fiscal deficit will likely come at 4.7% of GDP, above our previous forecast of 4.5% and equivalent to 6.2% once transfers of central bank dividends to the treasury are excluded. These dividends are accounted as revenues and are essentially money-printing from the valuation gains on international reserves produced by the nominal depreciation. The government set an ambitious medium-term target for fiscal consolidation (balanced primary result by 2019) but it is modest in the short run (1% cut this year). We think that the fiscal deficit will Consumer confidence index anticipates a slowdown in consumption. The index fell 1.6% month over month in January, following a 9% decline in December. The drop in confidence is bigger in willingness to purchase durable goods and real estate (-7%). The adjustment of relative prices (energy and exchange rate) and a tighter monetary policy will likely affect the overall economy. We forecast a 0.5% drop in activity this year. We think that the economy will likely start to reap the benefits of the adjustments later and grow by 3% in Lower consumer confidence contrasts with high approval rating of President Macri. His approval stands at 70% according to Poliarquía consulting, a rate similar to that achieved by former presidents Néstor Kirchner and Cristina Kirchner at the beginning of their mandates. Page 18

19 Forecast: Argentina F 2016F 2017F Economic Activity Real GDP growth (Private Estimates) - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 11,423 13,688 14,721 14,932 12,858 14,239 11,725 11,710 Unemployment Rate - year avg Inflation CPI (Private Estimates) - % Interest Rate BADLAR - eop - % Lebac 35 days - eop - % Balance of Payments ARS / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Balance - % GDP Gross Public Debt - % GDP % % % % % % % % Source: IMF, Bloomberg, BCRA, Haver and Itaú Page 19

20 Mexico Another victim of cheap oil Despite the country s decreased dependence on oil, the decline in oil prices is negatively affecting activity, fiscal revenues, exports and the exchange rate. At the same time, consumers are not benefiting much, as the government prevents domestic gasoline prices from falling significantly. We expect a recovery of oil prices in the second half of this year, which would bring some relief to the economy. The economy picked up in 2015 (to 2.5%), but falling oil production, weak demand for Mexico s manufacturing exports and the ongoing fiscal tightening (induced by lower oil revenues) are slowing the recovery. We expect growth of 2.8% this year, but there are downside risks. Inflation increased somewhat in the beginning of Even so, inflation continues low (below the target center), supporting real wages and, consequently, consumption. We expect inflation to end this year at 3.0%. The Mexican peso depreciated strongly in December and January, underperforming most currencies. The fact that oil fell by more than other commodities partly explains the evolution of the currency. But in our view, softening of the exchangerate intervention also had a role. Our year-end forecast for the exchange rate stands at 17.5 pesos to the dollar, a small appreciation from the current level, as we expect oil prices to recover later this year. The central bank of Mexico is unlikely to react to the depreciation of the Mexican peso through monetary tightening, unless the driver of the weakening is the narrowing of the interest-rate differential between Mexico and the U.S. Furthermore, as we now expect the Fed to be somewhat more cautious when removing monetary stimulus, we expect fewer rate hikes in Mexico. Our year-end forecast for the interest rate is 3.75% (from 4.0% previously). The government managed to keep a moderate fiscal deficit in 2015, in spite of lower oil prices and lower oil production. However, challenges remain for this year. The oil price was hedged at USD 49 per barrel (36% lower than the price hedged in 2015). At the same time, oil production is failing to recover and could even fall further, so there are headwinds for the government s deficit-reduction targets. A gradual and unbalanced recovery The economy picked up in The GDP increased by 0.6% between 3Q15 and 4Q15, according to preliminary figures released by INEGI (the official statistics institute). As a result, the economy expanded by 2.5% in 4Q15 from a year earlier, down slightly from the 2.6% gain in 3Q15, bringing full-year growth to 2.5%, up from 2.3% in 2014 and 1.3% in In 4Q15, economic growth was led by a solid 3.5% expansion in the services sector, consistent with the strong positive evolution of private consumption. In fact, retail sales in Mexico grew by a strong 5.7% year over year in November, following a 4.8% gain the previous month. The working-day adjusted series also picked up (to 5.4% from 5.0%). Solid credit expansion (10% in December), strong growth in remittances (when converted to pesos, they grew by 29% year over year in the quarter ended in November), low inflation and strong formal employment growth (the two factors led to a real wagebill growth of 6%) are all driving consumption growth higher. However, industrial production remained weak in 4Q15 (at 0.6% year over year) as oil production contracted, the ongoing fiscal tightening hit the construction sector and manufacturing growth was dragged down by the sluggish U.S. manufacturing sector (in spite of the weaker Mexican peso). Mining production fell by 4.3% year over year in the quarter ended in November. In the same period, construction slowed to 1.5% (from 3.3% in 3Q15), as the strong expansion in housing investment was more than offset by the contraction in public capital spending. Meanwhile, manufacturing exports (in nominal dollar terms) fell by 3.6% qoq/saar in 4Q15, erasing much of the 6.9% gain seen in 3Q15 (the only quarter of positive growth in the year). In all, Mexico s economy is recovering gradually, but its growth is relying too much on rising consumption, which is unlikely to be sustainable without a recovery of the exporting sector. Page 20

21 Real wage bill supports consumption 6% 5% 4% 3% 2% 1% 0% -1% yoy 10% 8% 6% 4% 2% 0% -2% -4% -2% Real Wages -6% Real Wage Bill (rhs) -3% -8% Nov-05 Nov-07 Nov-09 Nov-11 Nov-13 Nov-15 Source: Haver, Itaú yoy by the sharp decline in telecom service prices the year before (-6.4% between the second half of December 2014 and the first half of January 2015). Core inflation stood at 2.6% (from 2.4% previously). Within core inflation, prices for core goods grew at an annual pace identical that in the second half of December 2015(2.8%), indicating that exchange-rate pressures on domestic prices are contained for now. Non-core inflation rose (in spite of lower gasoline prices) due to the volatile agricultural prices. We expect inflation at 3.0% by the end of this year, which means that inflation will increase somewhat from the current levels, but will remain benign. We expect stronger effects on domestic prices from the exchange-rate depreciation earlier this year. In addition, more unfavorable base effects related to telecom prices will emerge by the end of For 2017, our forecast also stands at 3.0%. We expect a growth rate of 2.8% for Mexico in Our base-case scenario is that the U.S. industrial sector will pick up, lifting Mexico s exports. We also expect a stabilization of oil output. Some investments associated with the energy reform would also contribute to higher economic growth this year. However, there are downside risks: the most recent U.S. ISM manufacturing data hint that a rebound of Mexico s exports in the very near term is unlikely. In addition, low oil prices may limit the success of the energy reform while at the same time reducing fiscal revenues, which would lead to more fiscal tightening, less activity in the construction sector and potentially lower oil production (as a significant portion of the adjustment in public capital expenditures is being made by Pemex). Annual inflation rises, but remains low In spite of lower gasoline prices, annual inflation rose in the first half of January. Mexico s consumer price index increased by 0.03% during the first half of January. Inflation was low, mostly due to the decline in gasoline prices, as the government introduced a new mechanism governing domestic prices linking their evolution to international prices (though price changes are constrained by a +/- 3% band centered on the year-end 2015 price). In this context, gasoline subtracted 10.5 bps from headline inflation. Even so, year-over-year inflation rose to 2.48%, from 2.3%, during the second half of December. This was a result of an unfavorable base effect created Trade balance is affected by oil Low oil prices and lower oil production widened the trade deficit in Mexico s trade balance deficit came in at USD 0.9 billion in December, bringing the deficit during the year to USD 14.4 billion, from USD 2.8 billion the previous year. In spite of the sharp weakening of the exchange rate during 2015, the non-energy deficit was slightly higher than in 2014, as manufacturing exports remained sluggish. Simultaneously, the energy balance deteriorated significantly last year (to a deficit of USD 9.9 billion, from surpluses of USD 1.1 billion in 2014 and USD 8.6 billion in 2013). Lower oil prices greatly reduced the value of Mexico s exports, while declining oil production turned Mexico into a net energy importer last year. Looking ahead, we expect oil prices to recover in the second half of 2016, but the weak oil production means that Mexico will not benefit in the short term. On the other hand, as we expect a recovery of U.S. production this year, manufacturing exports will likely recover and lift the non-energy trade balance. In this environment, Mexico s current-account balance will likely remain manageable (in the fourquarter period ended in 3Q15, it reached 2.5% of GDP). The Mexican peso depreciated strongly in December and January, underperforming most currencies. The fact that oil fell more than other commodities partly explains the evolution of the currency. But currencies of countries with higher exposure to oil (like the Colombian peso and the Page 21

22 Norway krone) performed better during the period. In our view, exchange-rate policy has a role in explaining the behavior of the peso, as by the end of November 2015 the exchange-rate commission (formed by members of the central bank and the Ministry of Finance) softened intervention. Specifically, the USD 200 million daily auctions with no minimum price were suspended, while the volume offered in the auctions with minimum price (that is, those triggered when the exchange rate depreciates at least 1% from the previous day) was increased (to USD 400 million). The exchange-rate commission announced at the end of January that it will continue intervening at least until the end of March, but it did not change the parameters of intervention (volumes and required depreciation to trigger auctions) in spite of the recent evolution of the Mexican peso. Therefore, official dollar sales will continue with no floor and with a USD 400 million daily ceiling. Our year-end forecast for the exchange rate stands at 17.5 pesos to the dollar, meaning a small appreciation from the current levels. We expect oil prices to recover later this year, as supply adjusts to lower prices. In addition, interest-rate increases in Mexico will partly offset the impact of higher interest rates in the U.S. Fewer hikes than we were previously expecting We now expect Mexico s central bank to hike the policy rate twice this year (instead of three 0.25 p.p. rate increases in our previous scenario), so our year-end forecast for the interest rate is 3.75% (from 4.0% previously). As we now expect the Fed to be somewhat more cautious when removing monetary stimulus, we expect fewer rate hikes in Mexico. In our view, the central bank of Mexico is unlikely to react to the depreciation of the Mexican peso through monetary tightening, unless the driver of the currencyweakening is the narrowing of the interest-rate differential between Mexico and the U.S. So, we do not think that the recent evolution of the currency will trigger rate movements. For 2017, our forecast for the policy rate now stands at 4.25% (from 4.5% in our previous scenario). A small deterioration of the public deficit, in spite of a large oil shock The public sector nominal deficit widened slightly in 2015, to 3.5% of GDP (from 3.1% in 2014). During 2015, oil revenues fell by 32.9% in real terms. Besides lower oil prices (-49.3% in dollars), lower oil production (-6.9%) also contributed to the decline. However, a large portion of the decline in oil revenues was offset by keeping domestic gasoline prices above international levels. The oil-price hedge was another offsetting factor (returning around USD 6.0 billion to the government by December). Finally, there were other one-off factors related to the tax reform. On the expenditure side, the government implemented budget cuts last year (in particular, public spending in fixed assets fell by 5.8% in nominal terms during the year). In sum, the government managed to keep a moderate fiscal deficit in 2015, but challenges remain for this year. The oil price was hedged at USD 49 per barrel (36% lower than the price hedged in 2015). At the same time, oil production is failing to recover and could even fall further this year. Thus, there are headwinds for the government s deficitreduction target. Page 22

23 Forecast: Mexico F 2016F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn 1,051 1,171 1,187 1,262 1,291 1,130 1,146 1,214 Population (millions) Per Capita GDP - USD 9,197 10,124 10,137 10,658 10,784 9,329 9,359 9,796 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments MXN / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Balance - % GDP Net Public Debt - % GDP % 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Source: IMF, Bloomberg, INEGI, Banxico, Haver and Itaú Page 23

24 Chile Starting the year on the back foot We reduced our 2016 growth forecast to 2.0% (from 2.3%), but we left unchanged our estimate for 2015, for which we still forecast 2.0% growth. While a weak end to 2015 was not enough to trigger a reduction of our 2015 forecast, it did result in a less favorable carryover for this year. Amid weak confidence, we now foresee a 2017 growth rate of 2.5% (down from 2.7% in our previous report). We expect the exchange rate to stand at 730 pesos per dollar at the end of 2016, and then to remain broadly stable throughout We estimate that the 2016 current-account deficit will be flat with last year s, at 1.7% of GDP, before increasing to 2.2% in 2017 as internal demand recovers somewhat and oil prices rebound. In our baseline scenario, the inflation rate ends 2016 at 3.5% and falls to 3.0% by the end of As we expect oil prices to rebound in the second half of this year, the relief for inflation caused by the recent oil-price decline is likely to be transitory. We still expect the central bank to increase interest rates gradually, taking the policy rate to 4.0% this year and leaving it there throughout But the risks are tilted in the direction of no hikes at all if the economic weakness persists and inflation continues to converge toward the target. The fiscal deficit for 2015 was significantly lower than expected due to extraordinary revenues that came in at the end of the year. Lower growth expected for 2016 Economic activity in Chile remained suppressed in 2015, so the economy is starting 2016 on the back foot. Manufacturing production fell by 0.6% in 2015, which represents an improvement from the -1.2% posted in 2014, while mining production deteriorated (dropping by 0.6% for the year, after a 1.0% increase in 2014). Retail sales growth was in line with the 2014 figure, at 2.5%. In 4Q15, manufacturing and mining production declined from one year before, while sectors linked to private consumption showed slow growth. Specifically, manufacturing production declined by 2.0% year over year in 4Q15 (vs. a 0.5% gain in 3Q15). Meanwhile, mining production declined by 0.7% in 4Q15 (vs. a 4.1% drop in 3Q15). Retail sales grew by 2.8% in the quarter, a weak figure but still higher than the 2.3% gain of the previous quarter. The unemployment rate for the final quarter of 2015 came in at 5.8%, below the 6.0% recorded one year before. This is the lowest unemployment rate for a fourth quarter since Employment growth was 1.5% year over year (vs. 2.3% in 3Q15), with wage employment decelerating to 1.4% (vs. 2.7% in the previous quarter). Growth in self-employment (arguably jobs of lower quality) also decelerated (to 3.5%, from 5.0% previously). Construction continued to be one of the largest contributors to job creation, as companies are fast-tracking housing projects in order to avoid a sales tax hike that will apply to projects completed after Employment in public administration slowed in the quarter, after strong growth earlier in the year, possibly signaling that the impact of the fiscal stimulus is fading. A year-to-forget for activity %, yoy Source: INE, Itaú Retail Mining Manufacturing We now expect a growth rate of 2.0% year over year in 2016 (down from our previous estimate of 2.3%), stable from the 2.0% growth we estimate for The weak end to 2015 will have an unfavorable carryover effect into Confidence is likely to be affected by a weaker performance of the economy this year. Hence, we now expect the recovery in 2017 to be less robust, with a growth rate of only 2.5% (down from our previous forecast of 2.7%). Externally driven volatility In our baseline scenario, we expect a current account deficit of 1.7% of GDP this year, stable Page 24

25 with However, we expect a larger 2.2% deficit in As oil prices recover later this year and internal demand becomes more favorable in 2017, some deterioration in the external accounts is likely. However, we would note that Chile s energy import bill is significant, so if oil prices remain close to their current spot prices, our estimates indicate that the current-account deficit will be 0.4% of GDP lower in Consistent with the uncertainty over the global economy, the Chilean peso has been volatile, but ended January broadly stable with its year-end 2015 level of 709 pesos to the dollar. We continue to expect a year-end exchange rate of 730 pesos to the dollar, as some additional appreciation of the dollar globally is likely this year. For 2017, we expect the exchange rate to remain broadly stable. Inflation s slow retreat We expect inflation to remain above the 3%-4% target range for most of 1H16. In the short run, the upward pressure on consumer prices will mainly come from inertia (electricity tariffs will be raised in January and February, while education prices will increase in March, with the adjustment in both cases being at least the 2015 inflation rate) and from higher taxes (particularly on tobacco and financial services), factors that will likely be only partly offset by a decline in oil prices. In this context, we expect the inflation rate to remain near 5% in 1Q16. Our forecast for the inflation rate at the end of this year stands at 3.5%. In the second half of 2016, we expect a recovery of oil prices to push up gasoline prices while the stabilization of the exchange rate and the weak economy put downward pressure on CPI growth. We note that if oil prices remain at their current levels, inflation would end the year around the midpoint of the target range (assuming that all the other variables evolve in line with our baseline scenario). For 2017, we expect an inflation rate of 3.0%. Gradually withdrawing stimulus The Central Bank of Chile s decision to leave the policy rate unchanged at 3.50% in January was unanimous, according to the minutes of the meeting. The decision followed a rate increase of 25 bps in December (the second hike in a tightening cycle that started in October). Both of the available options hiking the policy rate or leaving it unchanged were considered at the meeting. According to the minutes, a hike could have been justified by the still-high inflation and dynamic labor market, and the current policy rate is expansionary. Also, a weakening currency would continue to push up tradable prices ahead. On the other hand, holding the rate steady was deemed consistent with the scenario laid out in the inflation report (IPoM) published in December, because the board still sees inflation unfolding accordingly, and possibly even falling faster because of low oil prices. Furthermore, the central bank now sees a higher probability of the downside risks to growth materializing. We continue to expect two 25-bp hikes this year (between 2Q16 and 3Q16), taking the rate to 4% and ending the cycle. The central bank will likely continue to raise rates amid a slow deceleration of inflation. However, considering the weak domestic activity, slow growth abroad and our expectation that inflation will enter the target range in 2Q16, the risk is that the central bank aborts the tightening cycle before, leaving the policy rate at the current level. A positive fiscal surprise The central government reported a better-thanexpected 2015 fiscal balance on the back of improved collections at the end of the year. While the most recent estimates had hinted at a deficit of 3.3% of GDP in 2015, the final deficit figure was 2.2%. The key surprise was in non-mining income taxes, which grew by a staggering 26.9% compared with 2014, fueled by an amnesty that allowed taxpayers to declare capital holdings abroad. Revenues from VAT rose by 4.8%, well above the economic growth rate. On the other hand, mining revenues shrank as both tax payments from private companies (down 13.2% in real terms) and transfers to the treasury from the stateowned company Codelco (down 50.2%) fell from their 2014 levels. The overall contribution of mining to total revenue was only 6%, the lowest level since 2003 (3%) and well below the historical peak of 34% in All in all, revenues grew by 5.2% in real terms between 2014 and Expenditures grew by 7.4% in real terms, the highest real growth rate since a 16.5% increase in 2009, when fiscal policy helped Chile navigate the global financial crisis. Even so, expenditure growth was somewhat lower than had been projected in October, when the budget was updated. At that time, Page 25

26 the government was projecting 8.4% expenditure growth, meaning that the evolution of expenditures by the end of the year also helps to explain the lowerthan-expected deficit. As a result, Chile s 2015 structural deficit came in at 0.6%. The structural deficit was significantly smaller than the expected 1.6% of GDP and broadly unchanged from the 0.6% reported for We still estimate nominal deficits of 3.5% for this year and 3.2% in 2017 as low growth and still-weak copper prices continue to constrain fiscal revenue and the government receives less support from one-off revenues. Congress goes into recess Chile s congress has approved adjustments to the recent tax reform legislation (which became law in 2014), with the aim of simplifying parts of the tax code. The adjustments do not alter the tax burden but rather address specific measures that had been deemed too complex by affected parties. The changes also institute new mechanisms to discourage tax evasion. One of the key changes is the removal of the option for small companies with individual shareholders to choose between the two different tax systems. These companies will now be compelled to use the system in which shareholders cannot take the corporate income tax levied on dividends (at a 25% rate) as a credit toward individual income tax. Other companies still have a choice between the abovementioned system and the one where the 27% corporate tax rate levied is eligible to be claimed as tax credit by shareholders. But the reform process remains complex. The labor reform proposal for which the government had selfimposed a January deadline has been delayed to March, after the legislative summer recess. Disputes within the governing Nueva Mayoria coalition are behind the delay. The internal replacement of workers during strikes and extending union-negotiated benefits to non-unionized workers are some of the main sticking points between some factions in the coalition. The finance ministry continues to pursue a bill that seeks an interim balance between equality and efficiency. Meanwhile, the teaching profession bill, which seeks to improve the monitoring of teacher performance and is part of the larger project to improve the education system in Chile, has passed in Congress. Forecast: Chile F 2016F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 12,744 14,545 15,195 15,701 14,491 13,291 12,698 13,085 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments CLP / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Balance - % GDP Net Public Debt - % GDP % 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Source: IMF, Bloomberg, BCCh, INE, Haver and Itaú Page 26

27 Peru A one-horse race to Miraflores? We expect GDP growth of 3.8% this year, after the 3.0% growth we estimate for 2015 (2.8%, in our previous scenario). Growth in 2016 is likely to be boosted by higher mining production, stronger public investment and a slower contraction of private capital spending. We see the modest recovery continuing in 2017, with growth at 4.0%. Inflation ended 2015 at 4.4% and rose to 4.6% in January. We expect it to decelerate to 3.3% by year-end 2016 due to the negative output gap, lower currency depreciation and the reversal of food price shocks. For 2017 we forecast an inflation rate of 2.5%, finally back within the central bank s target range. We expect the exchange rate to end the year at 3.55 soles per dollar and to remain broadly stable in 2017, with the central bank constraining the volatility of the currency through interventions. Increased copper production and some recovery in copper prices will likely help narrow the current account deficit to 3.9% of GDP this year, after an estimated 4.3% deficit in The deficit is likely to remain broadly stable in We expect the central bank to implement two additional 25-bp rate hikes during the first half of this year, taking the policy rate to 4.5%. We foresee no further rate moves after that. As 2016 unfolds, attention will shift towards the April 10 presidential election. Keiko Fujimori remains the clear front-runner, but she is likely to need a runoff election to prevail. Metal mining flying high Economic activity in Peru is now being led by the maturation of the massive mining investments made in previous years. Metal mining production is expanding at a double-digit pace. Private consumption has been holding up well so far, supporting the service sectors. However, declining investment (both public and private) is a major drag on construction activity, and manufacturing output is also contracting, possibly reflecting weak demand for non-traditional products among Peru s trading partners. In November, the economy expanded by 4.0% year over year (up from 3.0% growth in October), with primary sectors growing by an impressive 10% (vs. 7.1% in October), while growth in the non-primary sectors picked up to a stillweak 2.5% (from 2% the previous month). In the first 11 months of 2015, mining activity grew by 7.3% year over year, a rate well above the 2.7% growth posted by the overall economy. The mining growth figure was weakened by the 12.0% decline in oil production over the same period as output was curtailed amid low oil prices, while metal mining led the growth in the sector. Meanwhile, construction-sector activity declined by 6.9% over the first 11 months of Metal mining a key factor behind activity pick-up %, 3mma yoy -5 Metal Mining -10 Construction Commerce Source: BCRP, Itaú Preliminary activity indicators for December show that natural resource sectors continue to pull up activity. Mining production rose a staggering 22.4% year over year (11.3% previously) as copper production increased 68%. With fishing production also up by an impressive 82.5% (49% previously), partly due to the low base of comparison, there will continue to be favorable spillovers to manufacturing (specifically, fishing processing). The December activity indicators are consistent with an annual growth rate that would exceed the November figure. Page 27

28 On the back of the robust natural resource-related activity in the latter part of the year, we now estimate a 3.0% GDP expansion in 2015 (2.8% in our previous scenario), and continue to see growth of 3.8% this year. Even higher mining production growth, more efficient capital spending by regional and local governments and a slower contraction of private investment will all likely support higher economic growth this year. We expect the modest recovery to continue in 2017, with growth at 4.0%. The downside risks to growth this year have moderated, as the El Niño weather phenomenon will likely be milder than anticipated. Actually, considering the dynamism of the mining sector by the end of 2015, the risks for our growth forecast for this year are tilted to the upside. Persistent supply-side pressure on inflation In January, annual inflation accelerated to 4.61% from 4.40% in December, registering the eleventh month above the central bank s 1%-3% target range. Prices were pushed by housing expenses, while food and beverage inflation sat at 5.42% (5.37% previously). Core annual inflation (which excludes food and energy prices) moderated to 3.4% (3.5% previously), but remains above the target range. In our baseline scenario, headline inflation will accelerate in the coming months, approaching 5% as the currency weakens and El Niño effects push up food prices. Thereafter, we see inflation slowing to 3.3% by year-end as the negative output gap and the subsiding of food price shocks ease the inflationary pressure. For 2017 we expect an inflation rate of 2.5%, finally back within the central bank s target range. Eyeing more rate hikes As we expected, the central bank hiked its monetary policy rate by 25 bps, to 4.00%, at its January monetary policy meeting. The decision followed a hike of the equivalent magnitude the previous month. The current tightening cycle, which started in September 2015, now totals 75 bps. The central bank s board retained a tightening bias, hinting that additional hikes could be made to ensure that inflation converges to the target. The board noted that while they see inflation converging toward the 1%-3% target range in 2016, inflation expectations remain above this range. We anticipate two additional 25-bp hikes during the first half of this year, with the policy rate then remaining at 4.50% through In our view, the timing of the next hikes will mostly be determined by incoming data, particularly on inflation. Lower reserves With low global commodity prices, the Peruvian sol has weakened. The central bank continues to intervene in the exchange-rate market. In January, the BCRP sold USD 332 million in the spot market (vs. USD 222 million in December and USD 8.1 billion in 2015). International reserves net of dollar liabilities with residents (which have increased after the raising of reserve requirements for dollar-denominated credit issuance) currently stand at USD 25.8 billion (down from their USD 49.4 billion peak in 2013 and USD 34.1 billion one year ago). Furthermore, the central bank has a net short-dollar exposure of around USD 8.0 billion in the NDF market. The central bank s firepower for intervention is diminished, though still significant. We expect the exchange rate to end the year at 3.55 soles per dollar and to remain broadly stable in The central bank will continue working to contain volatility and moderate the pace of depreciation of the sol. Higher copper-production volumes are partly offsetting the negative impact of low commodity prices on nominal exports. In the first 11 months of 2015, copper exports (in current dollars) declined by 11.3%, but volumes were up 18%. As of November, the 12-month rolling trade deficit was USD 2.7 billion (vs. USD -1.3 billion in 2014). Our own seasonal adjustment shows that there was an improvement in the trade balance at the margin for the quarter ending in November. With a weaker currency, copper production set to remain high in 2016 and copper prices showing some recovery, we expect the current account deficit to narrow to 3.9% of GDP this year after reaching an estimated 4.3% in The deficit will likely remain stable in An expansionary fiscal policy this year Because local governments failed to fully implement their share of the fiscal stimulus Page 28

29 approved for 2015, Peru s fiscal deficit widened by less than the government had projected. In spite of fiscal revenues falling by 4.4% in real terms in 2015 (vs. a 5.7% gain in 2014), real expenditures rose by only 4.4% (vs. a 10.8% increase in 2014) as capital outlays by regional and local governments declined by 18%. As a result, the non-financial public sector posted a fiscal deficit of 2.1% of GDP in 2015, below the budgeted 2.7% and our 2.2% forecast but still above the 0.3% of GDP deficit posted the previous year. Since the 2015 budget was not fully executed, there is room for a sizeable increase in government expenditure this year. We see the fiscal deficit rising to 3.1% of GDP this year, with part of the increase being funded by the economic stabilization fund (FEF). This is in line with the rules that allow access to the fund when revenues are at least 0.3% of GDP below the three-year moving average. A clear front-runner for the elections leading the polls, with 33% of voter intentions, followed by Cesar Acuña and former finance minister Pedro Pablo Kuczynski, both polling at 13%. Acuña, a selfmade millionaire businessman who has been making inroads since October, has few concrete proposals but could take advantage of voters demand for a change from the Lima-based political establishment. He has been said to favor exchange-rate, food and electricity price controls. While it is unclear to what degree these statements are just vote-seeking rhetoric, political uncertainty will likely rise if Acuña continues to gain ground in the polls. With a large fraction of the electorate still undecided, two rounds of voting is the most likely scenario. Simulations show Mrs. Fujimori coming out on top against any other of the leading contenders. President Humala vetoed a bill (which arguably has a populist tilt) that allows workers to withdraw up to 95.5% of their pension fund immediately upon retirement. Legislators will seek to override Humala s veto once Congress reconvenes in March. As 2016 unfolds, attention will shift away from President Humala s diminishing political capital and toward the April 10 presidential election. According to the latest Ipsos survey, Keiko Fujimori is Forecast: Peru F 2016F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 5,027 5,685 6,323 6,541 6,440 6,089 5,904 6,084 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments PEN / USD - eop Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances NFPS Nominal Balance - % GDP NFPS Debt - % GDP % 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Source: IMF, Bloomberg, INEI, BCP, Haver and Itaú Page 29

30 Colombia The long-term consequences of the oil shock With the fall in oil prices, Colombia s economy is going through adjustments. The current-account deficit is rising further and fiscal revenues are falling. As a consequence, the exchange rate is depreciating and inflation is high, leading the central bank to increase its policy rate and the government to cut expenditures. Growth is declining, but so far only moderately. Fiscal accounts have also worsened, but remain under control. In order to investigate the longer-run impact of lower oil prices, we evaluate the resilience of the Colombian economy under two scenarios: baseline and stress. The baseline assumes oil recovering to USD 55 per barrel. In the stress scenario, oil prices fail to recover from current levels. In our baseline scenario, Colombia continues to perform credibly and sustainably, but with lower trend growth than in the past. The net public debt would remain low, net external indebtedness would stay moderate and growth would hover around 3%. In the stress scenario, fiscal and external accounts suffer and trend growth declines further. Net public debt would rise to a still-manageable level. Due to a higher current-account deficit, net external indebtedness reaches much higher levels. In this scenario, Colombia remains investment grade but risks are clearly higher. Economic growth in the long term would be only slightly above 2%. In both scenarios, trade agreements, a deal with the FARC and the implementation of the 4G PPP infrastructure program are important potential upsides to growth. In the nearer term, our scenario remains unchanged for 2016 and We expect the economy to slow to 2.5% this year and to recover to 3.0% in Inflation will continue rising before entering in a downward trend, and the central bank will raise interest rates further (we expect two additional 25-bp hikes in 1Q16, but as inflation falls, rate cuts would come in 2017). We expect the exchange rate to end this year and next at 3,350 pesos to the dollar, as the recovery in oil prices offsets the impact of higher interest rates in the U.S. Colombia s economy is adjusting to the new reality for oil prices. In spite of the sharp depreciation of the exchange rate, the current-account deficit is rising, pushing external debt up. Fiscal accounts have also worsened, but remain under control, as the government is reacting through expenditure cuts. A tax reform to reduce the fiscal deficit is also likely. Mostly as a result of the exchange-rate depreciation, inflation has yet to peak, leading the central bank to tighten monetary policy. However, growth has been a positive surprise, as the slowdown is more moderate than that experienced by other commodity exporters of the region. In order to investigate the long-run impact of the oil shock, we work with two scenarios for prices. In our base scenario, they recover in the short to medium term to USD 55 per (Brent) barrel. In this scenario, we think that Colombia performs well, in a sustainable way. In a stress scenario, in which oil prices hovers around USD 30 per barrel, the country retains its investment-grade status, but risks are higher, mostly because of the external-debt path. In both scenarios, there are potential upsides: trade agreements, a peace deal with the FARC and the ambitious 4G PPP infrastructure program. How are lower oil prices affecting the economy? From a balance-of-payments perspective, the deterioration of terms of trade associated with the decline in oil prices is leading to an increase in the current-account deficit, lower FDI and an increase in external debt. In 2014, when average oil prices were still above USD 100 per barrel, oil accounted for 53% of Colombia s exports. Adding coal also an energy commodity the share rises to 65%. The energy surplus (that is, energy exports minus energy imports) amounted to 7.4% of GDP. Oil is important to external financing too: foreign direct investment (FDI) in oil represented 29% of the total by Including FDI in other mining segments (mostly coal), the participation was 39%. With external accounts exposed to oil, the Colombian peso has depreciated by around 70% since the price of the crude fell below USD 100 per barrel (at the end of 3Q14). In spite of the exchange-rate weakening, the four-quarter rolling current-account deficit increased to 6.6% of GDP in 3Q15 (from 5.2% in 2014 and 3.3% in 2013). At the margin, we estimate that the deficit is even higher (around 7% of GDP). Furthermore, a greater proportion of the deficit has been financed by external Page 30

31 LatAm Macro Monthly February 2016 indebtedness (in the definition we use in this report, this excludes domestic debt held by foreigners). FDI is declining in dollar terms (but decreasing only slightly as a percentage of GDP). Meanwhile, portfolio investment in domestic currency instruments (stocks and domestic government securities) is retreating both in dollars and as a percentage of GDP. In this context, gross external debt reached USD billion in 3Q15, from USD 98.7 billion one year before. Also, because of the exchange-rate depreciation, the ratio external debt/gdp increased to 39.8%, from 24.9% one year before. Net of reserves, external debt was at 23% of GDP by 3Q15. Lower oil prices also have implications for public sector finances. Fiscal revenues linked to oil will likely fall to 0.4% of GDP this year, from 2.6% in 2014 and a peak of 3.3% in In addition, there are secondround effects, as oil prices are leading to lower economic growth, dragging other sources of fiscal income. Thus, the deficit of the non-financial public sector will likely reach a moderate 3.1% of GDP this year, from 1.8% in The net debt remains low, at around 27% of GDP. Lower terms of trade have an impact both on cyclical and potential growth. In the short term, lower oil prices limit the demand for investment in oil and in oil-related activities, while the weakening of the exchange rate raises inflation and inflation expectations, reducing real wages and leading the central bank to increase interest rates. As the government loses revenues, it is cutting expenditures to preserve its balance sheet. In the long term, growth is also lower. Capital-stock growth falls due to lower investment rates. But the main drag on potential growth comes from the negative impact of terms of trade deterioration on the evolution of total factor productivity. Finally, it is worth noting that besides oil prices, oil production is also a risk for Colombia. At the current production pace, oil reserves would last less than seven years. Low oil prices reduce the return on prospecting new reserves, exacerbating the problem. Just like lower oil prices, a drop in oil production has implications for the balance of payments, growth and the fiscal accounts. How the economy performs under stress In our base scenario, Brent oil prices will recover to around USD 55 per barrel, staying at this level (in real terms) until For our calculations, we will assume that the recovery takes place in the second half of this year (which we think is likely as supply adjusts to lower prices). However, our conclusions don t change meaningfully if we assume that the rebound comes within the next two to three years. In a stress scenario, oil prices would stay at USD 30 per barrel (also in real terms) over the next 10 years. In both scenarios, we believe that the currentaccount deficit would eventually converge to 2% of GDP by 2025, but the convergence is harder under the stress scenario. Considering historical currentaccount deficits of countries with Colombia s rating, we think that 2% of GDP is a good proxy for the deficit in steady state. As the average deficit of countries rated a couple of notches below Colombia is not much different, we assume that in the stress scenario there is also a convergence to 2%, through a moredepreciated exchange rate than in the baseline scenario. However, in spite of the weaker currency, the adjustment is more gradual in the stress scenario. So, even though Colombia is worse off in the stress scenario, it continues to attract foreign capital flows, due to higher yields and/or shorter maturities and foreign-currency debt. Current account deficit % GDP Baseline Stress Pre-Shock forecast Source: Haver, Itaú In the stress scenario, net external debt rises to a high level. Besides the more gradual adjustment in the current-account deficit, we assume that, in the stress scenario, a larger proportion of the deficit will be financed by hard-currency debt. So, we estimate that the net external debt would reach 41% of GDP by In contrast, we see external debt at 24% of GDP in the base scenario, for the same time-horizon. Page 31

32 LatAm Macro Monthly February 2016 Net external debt 45 % GDP 40 net public debt would reach 44% of GDP, while in the base scenario, we expect it to be 33%. Net public debt * Baseline Stress Pre-Shock forecast % GDP Baseline Stress Pre-Shock forecast Source: Haver, Itaú 15 With lower oil prices, the public deficit would widen more and we expect that the government would reduce the deficit more slowly. In the stress scenario, we expect the non-financial public-sector deficit to peak at 4.0% of GDP in 2017, gradually converging to 3% of GDP by In the base scenario, we see the deficit at 2% of GDP in 2025, with a peak slightly above 3% in In both scenarios, we assume that the government manages to overcome political hurdles and approve necessary reforms to ensure a deficit reduction. Nominal public deficit* % GDP * Non-financial public sector Source: Ministry Of Finance, Haver, Itaú In the base scenario, the economic slowdown remains moderate. We see growth between 3.0% and 3.5% from 2017 to In a stress scenario, the economy would grow at 1.5% both this year and the next, and slightly above 2.0% thereafter. So, even in the stress scenario, a recession would be avoided. In the short term, lower oil prices mean more exchange-rate depreciation, lower fiscal revenues and fewer investments linked to oil. In the medium to long term, lower investments translate into lower capitalstock accumulation. However, the major drag on potential growth is lower total factor-productivity expansion associated with the declining terms of trade. GDP growth Baseline Stress Pre-Shock forecast 8% 7% 6% 5% 4% % Baseline Stress Average Pre-shock forecast 3% * Non-financial public sector Source: Ministry Of Finance, Haver, Itaú 2% 1% However, even in the stress scenario, we expect the net public debt to remain at a manageable level, due to benign initial conditions. By 2025, the 0% Source: Haver, Itaú Page 32

33 Trade agreements, a peace deal with the FARC and infrastructure investment provide important potential upside to the economy in both scenarios. Colombia s government has signed a number of trade agreements over the past years (with the U.S., European Union, Mexico, Chile, Colombia, Peru etc.). In addition, a peace deal between the government and the FARC seems very close (the deadline imposed by the government is March 23) and population will very likely approve the peace agreement in a referendum. Peace benefits productivity by reducing security risks and improving the allocation of resources. Finally, the government is implementing an ambitious infrastructure program (the 4G PPP, which seeks to improve transportation in the country). This will have an impact both on cyclical growth (as the execution of the estimated USD 25 billion in capital expenditures kicks in) and in potential growth (transport is widely recognized as a key bottleneck for the economy). Finally, we note that even though the economic performance in the base scenario is fine, it is still a disappointment given expectations set as recently as two years ago. Before the oil-price shock, we were expecting average growth over the next decade to hover between 4.0% and 4.5%, only a tad lower than in the previous decade. Net public debt would end 2025 below the current levels, at 20%, while net external debt would stand at 15% of GDP in the same horizon. The economy in the near term Our forecasts for 2016 and 2017 are unchanged from our previous scenario. We expect the economy to slow to 2.5% this year and to recover to 3.0% in 2017 (from an estimated 3.0% in 2015). We expect the exchange rate to end this year and the next at 3,350 pesos to the dollar: the recovery in oil prices will offset the impact of higher interest rates in the U.S. Inflation will continue rising in the short term and the central bank will raise interest rates further. We expect a 25- bp rate increase in each of the next two meetings, ending the tightening cycle (with the rate at 6.5%). As inflation gradually falls (we expect it to end 2016 and 2017 at 4.5% and 3.2%, respectively), the central bank would find room to reduce the policy rate in 2017 (our year-end forecast for the interest rate is 6.0%). Long Term Forecasts avg avg 2025 Pre-Shock(1) Baseline Pre-Shock(1) Baseline Stress Pre-Shock(1) Baseline Stress GDP growth Inflation - % (eop) USDCOP (eop) Reserves - % of GDP Current Account - % of GDP Net External debt % of GDP NFPS Balance - % of GDP NFPS Net Debt - % of GDP (1) Pre-shock refers to the forecast scenario considered in September Source: Banrep, Ministerio de Hacienda Colombia, Itaú. Page 33

34 Forecast: Colombia F 2016F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 6,311 7,286 7,939 8,062 7,926 6,169 5,569 5,716 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments COP / USD - eop 1,908 1,939 1,767 1,930 2,377 3,175 3,350 3,350 Trade Balance - USD bn Current Account - % GDP Foreign Direct Investment - % GDP International Reserves - USD bn Public Finances Nominal Central Govt Balance - % GDP Central Govt Gross Public Debt - % GDP % 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Source: IMF, Bloomberg, Dane, Banrep, Haver and Itaú Page 34

35 Commodities Oil fundamentals suggest a rebound in oil prices starting by mid-year Oil prices stayed closed to USD 30/bbl as the market continues to be oversupplied. News suggesting a production-cut agreement involving OPEC and Russia, which we think is unlikely, had only a short lived impact on prices We expect the oversupply to vanish by the middle of the year (even without coordinated reduction by OPEC), supporting a recovery in oil prices to USD 55/bbl by YE16. We have reduced our price forecasts for sugar and coffee due to favorable conditions for the next crop in Brazil. Aggregate commodity prices (as measured by the Itaú Commodity Index ICI) have climbed by 5.0% since mid-january, driven by appreciating oil and metals. Agricultural commodities did not follow this trend but are still outperforming the other commodities this year to date because they were not affected by the risk aversion in the first two weeks of January. The recent aggregate gain was not enough to offset the losses of the beginning of the year, and the ICI is still down 2.8% YTD. Oil reverses some losses Itaú Commodities Index * (2010 = 100) Brent prices stayed between USD 30 and USD 35/bbl, compared to a low of USD 28/bbl in mid- January. Prices went up to USD 35/bbl supported by news of an eventual coordinated action by major producers and by not-so-bad economic data from the U.S. and China. The prospective supply cut would not involve countries that effectively reduced production in the past, so this news was not expected to have as strong of an impact as it did. Hence, the subsequent price increase suggested that there is an excess of short positions in the market (at least for now). The increase was not sustainable and prices remains in USD30-35 range. Gains in the oil market helped metal prices to reverse some of their recent declines. The oil market will likely adjust by 3Q16 (even without action by OPEC) 98 3% ICI Agricultural ICI Energy ICI Metals 27 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan % 1% 0% -1% Source: Itaú and Bloomberg The oil market is in the spotlight this year, affecting not only other commodities and the exchange rates of oil-producing countries but also stock prices and interest rates all over the world. Over the past 60 days, the daily correlation between changes in Brent crude prices and the S&P 500 was 0.43, compared with 0.19 in 1H Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Source: IEA and Itaú. Demand Supply Global Balance (% of consumption) -2% -3% In our view, a cut in production does not reflect the strategy of Saudi Arabia and its allies, countries which have a history of coordinated production cuts, so Page 35

36 we do expect the combined market forces to eliminate the excess supply by mid-2016 (see chart). We forecast an increase in crude prices to USD 55/bbl by YE16 (without counting on an adjustment by OPEC). Our scenario assumes that a decline in U.S. production will offset higher exports from Iran, while demand sustains its upward trend. Econometric/historical analyses suggest that prices will bottom out the quarter before the market shifts to a deficit (so in this case, the trough of the cycle would be reached in 2Q16). We have also maintained our price forecasts for metals, which project some gains from current levels. We have reduced our YE16 price forecasts for sugar and coffee (to USD 1.28/lb from USD 1.25/lb) due to favorable weather in Brazil. Our forecasts for soybeans and grains have been maintained, as fundamentals have not changed. We anticipate a partial recovery in prices in 2016 as the excess supply in the market vanishes by the middle of the year. According to our calculations, the global balance will shift from a seasonally-adjusted oversupply of 2.2 mbpd in 4Q15 to a deficit of 0.2 mbpd in 3Q16 even without coordinated action by OPEC. This transition will take place as a decline in U.S. output offsets an increase in exports from Iran due to the end of sanctions, and thus without major shocks to demand or the remaining supply. We believe that: i) demand will remain on a path that is consistent with global growth and with the drop in prices over the past two years; ii) other OPEC countries will maintain their current output levels; and iii) other world producers will remain continue their trends of recent years, as output does not react to falling prices (or declining investment). We maintain our YE16 forecast at USD 55/bbl. Oil: Excess supply likely to vanish in 2016, even without OPEC action Oil prices have recovered from their recent lows (USD 28/bbl), with the Brent crude trading in the USD 30-35/bbl range, but remaining lower than their sustainable levels. Economic data turned out to be better than had beem priced in and there was news of a prospective cut by OPEC (as discussed above). Notwithstanding this increase, prices remain much lower than their sustainable levels. The recent rise in oil prices has still not erased the losses sustained in Prices correspond to the Brent ICE Futures first future contract Price 0 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Source: Bloomberg. Softs: Favorable weather in Brazil Prices in international sugar contracts fell to around USD 0.13/lb in January from USD 0.15/lb at the end of December. The futures contract with the first due date is trading around BRL 0.128/lb in New York. Sugar prices dropped due to favorable weather in the Center-South region of Brazil, which improved the outlook for the crop and may result in a smaller deficit for the crop year. Rainfall was heavier and better distributed than last year, which along with a likely decline in ethanol demand points to higher sugar output in Brazil in Expecting a smaller deficit, we have lowered our forecast for average international sugar prices to USD 0.139/lb from USD 0.143/lb in 2016, in line with the futures curve. International coffee prices (first due date in New York, Arabica) remained between USD 1.11/lb and USD 1.25/lb, showing little reaction to currency depreciation in major producing countries. Weather in Brazil and the upward cycle in the biannuality of coffee plants in most producing states suggest that there will be a larger crop in Notwithstanding the recently favorable weather, the focus is on the evolution of weather conditions over the next months, which will define grain filling and size. Page 36

37 Our YE16 price forecast has been revised to USD 1.25/lb from 1.28/lb, in line with the futures curve. We maintain our assessment that these levels provide a good balance between downward drivers (favorable weather in Brazil and higher prices in local currency for the biggest producers) and upward drivers (the risk of crop losses). Grains: No shocks for now International prices (first due date) for corn, soybeans and wheat are little changed this year and still appear unaffected by macro concerns. The cumulative changes since the end of 2015 stand at -3.5%, 1.1% and 1.1%, respectively. Overall, the outlook for these three commodities remains the same: a relatively loose global balance in 2016, assuming that crops in the Northern Hemisphere evolve under expected conditions. We maintain our YE16 price forecasts for corn (USD 4.0/bushel), soybeans (USD 8.8/bushel) and wheat (USD 5.3/bushel). Relatively stable grain prices Corn (Mar-16) Wheat (Mar-16) Soybean (Mar-16) (rhs) 300 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Source: Itaú and Bloomberg Forecast: Commodities F 2017F Commodities CRB Index Itaú Commodity Index (ICI)* Agricultural Energy Metals yoy - % avg growth - % yoy - % avg growth - % a/a - % avg growth - % yoy - % avg growth - % yoy - % avg growth - % ICI - Inflation ** Source: Bloomberg Itaú. yoy - % avg growth - % * The Itaú Commodity Index is a proprietary index composed of commodity prices, measured in U.S. dollars and traded on international exchanges, which are relevant to global production. Its sub-indexes are Metals, Energy and Agriculture. ** The ICI-Inflation Index is a proprietary index composed of commodity prices, measured in U.S. dollars and traded on international exchanges, which are relevant to inflation in Brazil (IPCA). Its sub-indexes are Food, Industrials and Energy. Page 37

38 Macro Research Itaú Ilan Goldfajn Chief Economist Tel: Click here to visit our digital research library. Relevant Information 1. This report has been prepared and issued by the Macro Research Department of Banco Itaú Unibanco S.A. ( Itaú Unibanco ). This report is not a product of the Equity Research Department of Itaú Unibanco or Itaú Corretora de Valores S.A. and should not be construed as a research report ( relatório de análise ) for the purposes of the article 1 of the CVM Instruction NR. 483, dated July 06, This report aims at providing macroeconomics information, and does not constitute, and should not be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell any financial instrument, or to participate in any particular trading strategy in any jurisdiction. The information herein is believed to be reliable as of the date on which this report was issued and has been obtained from public sources believed to be reliable. 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