Emerging markets face the challenge of higher U.S. rates, but broader global financial conditions indicators are well behaved and provide a buffer.

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1 Latam Macro Monthly Scenario Review December 16 Global Economy A tricky scenario unfolds 3 Emerging markets face the challenge of higher U.S. rates, but broader global financial conditions indicators are well behaved and provide a buffer. LatAm Monetary policy easing amid external volatility 8 Activity has surprised to the downside, while inflation has evolved below expectations. In this environment, monetary-policy stances are becoming looser in spite of the more challenging external scenario. Brazil Lower growth, higher risks 10 We have reduced our GDP growth forecast for 2016 and Fiscal reforms continue to move ahead, however political uncertainty has increased. Argentina Monetary policy to the rescue? 16 The central bank is. Mexico Calibrating the monetary policy response 18 As the central bank switched its focus to the pass-through from the Mexican peso depreciation, it is unlikely that the central bank will hike significantly more than the Fed does. Chile About to cut 22 As long as financial conditions for emerging markets do not deteriorate significantly more, the central bank would start cutting rates in January, taking the policy rate to 2.5% by the end of next year from 3.5% this year. Peru No rebalancing of growth sources yet 26 Economy remains strong, even though internal demand growth is poor. We expect activity to improve a bit more in 2017, but the fact that private investment is failing to recover is a risk. Colombia A second chance for peace 29 The updated peace deal was ratified by congress and the tax-reform debate has kicked off, with potential short-term inflationary impact. Commodities OPEC reaches a deal 33 Coordinated action by the cartel will likely balance the oil market as early as January With falling inventories and rising prices, the response by U.S. shale producers will be the main driver acting against further oil price increases Macro Research Itaú Mario Mesquita 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 A tricky scenario unfolds The scenario of higher interest rates in the US continues to gain strength. The Trump administration is - j immigration. In that case, GDP growth will speed up, unemployment rate will decline and inflation will rise. This supports our case for a faster tightening cycle by the Fed in the next two years. In Europe, political risks dominate, but economic indicators have been resilient, so that we upgraded slightly our GDP forecast for the euro zone this year. However, it is also clear that the economic recovery relies heavily on continued monetary easing. China has been able to sustain a stable growth trend, and we expect this stability to extend into Private sector investment will benefit from higher profits, and the public sector still has the means and R developed countries that create pressure for capital outflows. In Latin America, as U.S. interest rates rise we expect the currencies to weaken some more, and the Mexican peso will take time to get back to its fundamental levels. Activity in the region has disappointed recently, and while we still expect a recovery in 2017, risks are tilted to the downside. As inflation falls, monetary-policy stances are becoming looser. In Brazil, fiscal reforms continue to move ahead, but political uncertainty has increased. Economic activity disappointed to the downside so we have reduced our 2017 GDP forecast. Inflation continues to fall, the exchange rate remains close to its equilibrium value, and we expect the Central Bank to accelerate the pace of interest rate cuts in January. Hope you enjoy, Mario Mesquita 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 - % (City of Buenos Aires) 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 A tricky scenario unfolds Global manufacturing surveys reached record-high levels in the recent cycle. U.S. interest rates will continue to rise and the USD to strengthen as the Trump administration pursues expansionary policies in an economy close to full employment. In Europe, political risks will remain high, but we note that recent developments have been balanced. In Japan, strong third-quarter GDP and post-trump yen depreciation counterbalance the TPP s demise. China s activity remains stable but the pressure from capital outflows and protectionism from the U.S. are important risks. Commodities: OPEC reaches a deal; better metal-price outlook, but current levels are stretched. Emerging markets face the challenge of higher U.S. rates, but broader global financial conditions indicators are well behaved and provide a buffer. Global manufacturing reached record levels in the current cycle increased to 51.0 from 50.8, continuing a slow recovery after the slowdown seen from 2013 to The Global manufacturing Purchaser Manager s Index (PMI) increased to the highest level in two years (see graph). The index rose to 52.2 from 51.8, maintaining an upward trend after bottoming in the beginning of the year. Global PMI Manufacturing in 2-year highs Index 49 Nov-13 Nov-14 Nov-15 Nov-16 Source: Itaú Global PMI Both developed-market (DM) and emerging-market (EM) PMIs are rising. In November, the developed , increases in the U.S. ISM (to 53.2 from 51.9) and Euro A PMI ( ) E PMI U.S. Interest rates will continue to rise The Trump administration is signaling a big selffinanced fiscal stimulus while avoiding, for the time being, major disruptive policies related to trade or immigration. His cabinet appointments have mixed loyal campaign advisers with establishment Republicans. Importantly, Trump made sure to secure good jobs for the political affiliates of the House and Senate leaders. Trump has been gathering support for his fiscal agenda. The appointed Treasury Secretary, Steven Mnuchin, said that the number-one priority is the tax reform. He argues that the corporate tax cuts to 15% is crucial to raising GDP growth to 3%-4% and will be selffinanced. Meanwhile, the post-election rhetoric on trade and immigration has reduced concerns about disruptive measures T -one priorities will be to withdraw from the TPP, negotiate bilateral trade deals and ask to investigate visa abuses, all much softer than the campaign promises. The next Commerce Secretary, Wilbur Ross, dismissed the idea of an immediate imposition of import tariffs instead, tariffs could be the outcome if negotiations to expand U.S. exports fail. Nevertheless, recent events indicate that the next presidency is likely to be louder on foreign policy. T T less respect for traditional diplomatic protocols. These Page 3

4 kinds of event may occur more often and raise the risk,. He later criticized China on trade and military policies in his Twitter account to justify his phone call. Altogether, we continue to see fiscal expansion (1.1% of GDP within 18 months) speeding up GDP growth, to 2.2% and 2.4% in 2017 and 2018, respectively, up from 1.6% in This GDP growth outlook is consistent with steady payroll growth at 180 thousand jobs per month, pushing the unemployment rate to 4.1% by 4Q18 (see graph) and the core PCE deflator to 2.1% yoy in 4Q18. Trump's Fiscal plan to push unemployment close to 4.0% 5.6% 5.4% 5.2% 5.0% 4.8% 4.6% 4.4% 4.2% 4.0% Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Source: Haver, Itaú Itau-Unibanco FOMC (Sep/16) Forecast This supports our case for a faster tightening cycle by the Fed in the next two years. We believe that the FOMC will need to raise the Fed Funds rate seven times in the next two years, once in 2016, twice in 2017 and four times in This forecast means the Fed Funds -range will be 2.125% in 4Q18, essentially a zero ex-ante real interest rate in a slightly overheated economy. Finally we see risks tilted toward three hikes 2017, if the fiscal measures are approved more expeditiously than expected. Markets currently price in between four and five hikes by end The market catch-up with our call may occur in 1Q17, as President Trump unveils his fiscal proposal and the FOMC raises its interest-rate forecasts. Europe Politics dominate the debate Economic indicators have been resilient in Europe. GDP growth has stayed constant at 0.3% qoq in 3Q16. The leading indicators for 4Q16 are strengthening, with credit data continuing to show the positive effect of the E B Nonetheless, the need for continued monetary easing is still strong. The economic recovery relies heavily on favorable financial conditions, especially for the periphery, where a spike in yields could compromise fiscal sustainability. Accordingly, the ECB announced in December a nine-month extension of its current QE program. Despite reducing the monthly pace to EUR 60 billion the Central Bank vowed to adjust the rhythm as needed in order to maintain a loose monetary policy stance. Political risks still dominate the European scenario, but recent news is not all bad. In the UK, the Brexit Minister David Davis has hinted that a negotiation appro S exit is being discussed within the government. In France, the Republican primaries have surprisingly resulted in former PM François Fillon becoming their candidate ahead of the 2017 presidential elections. Fillon has a reformist policy program that is also conservative on immigration issues, which makes him the favorite to win the election next year. Additionally, President François Hollande has decided not to run in the Socialist primaries, which N F Marine Le Pen becomes president next year. In Germany, Angela Merkel has confirmed her intention to seek a fourth term as chancellor. In Austria, the presidential election yielded a positive surprise with the defeat of far-right candidate. Finally, in Italy the referendum on constitutional reform turned out to be a PM M R z W 69%, N mp had 59% of votes whereas Y 41% Though Mr. Renzi has decided to resign, we do not expect early elections given the political establishment s aversion to facing a possible win by populist forces. We raised our GDP forecast for the euro zone to 1.6%, from 1.5%, in 2016 (stronger fourth-quarter data) and kept it at 1.3% for Page 4

5 Japan Strong third quarter and post- Trump yen depreciation offset TPP s demise. Japan s 3Q16 GDP growth amounted to 2.2% qoq/saar. Net exports, contributing 1.8 pp, were the major driver of this strong result. Despite U.S. President- D T pull out of the Trans- Pacific Partnership (TPP), we expect the damage to the Japanese economy to be more than offset by an 9 2% depreciation following the U.S. election and the Chinaled Regional Comprehensive Economic Partnership (see graph). Yen weakened on the aftermath of Trump`s Election JPY/USD US Elections 51.7, suggesting positive economic-activity figures for the remainder of 4Q16. We expect this growth stability to extend into First, there is room for fiscal stimuli and a leadership transition in the Fall that increases the willingness to maintain the growth pace. Second, real estate investment will remain strong in 1H17, before regulatory tightening takes effect. Third, higher corporate profits (weaker currency and higher producer prices) support investment. Finally, the government is still able to control the timing of painful adjustments. Nonetheless, higher interest rates in developed countries and a stronger USD increase the pressure of capital outflows and pose risks to China. Local interest rates in China are rising (see chart), a movement that can be explained by capital outflows affecting domestic liquidity and upward pressure from A instruments to deal with capital outflows (direct and indirect capital controls, large foreign reserves), an undesired tightening of financial conditions can be negative. Local rates on the rise since October Oct 15-Oct 29-Oct 12-Nov 26-Nov Source: Bloomberg, Itaú % We raised our GDP estimates to 0.8% from 0.6% due to base effects in 2016 and for 1.2% from 0.7% in 2017 (0.3 pp from base effects and 0.2 pp from yen depreciation) d repo Govt bonds (1y) Govt bonds (5y) 1.5 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Source: Bloomberg, Itaú China Stable economic activity; renewed capital outflows Economic activity continues to show steady growth. Industrial production and fixed investment are roughly stable at, respectively, 6.1% yoy and 8.8% yoy in October (see graph). Real estate private-led investment offset a small slowdown in public investment. In November, the official manufacturing PMI rose further to We maintain our GDP forecasts for China at 6.6% for 2016 and at 6.3% for Emerging Markets What are the global financial conditions that matter? Higher interest rates in the U.S. will likely put pressure on EM currencies and local rates. Page 5

6 But broader financial conditions also matter, and they remain well behaved, helped by better global growth and commodity prices. Indeed, we have statistically computed (principal component analysis) summaries of financial conditions in both EM and DM economies. For DM we obtain two factors, one that summarizes sovereign yields (which are mostly related to monetary policy) and another related to credit, equity and volatility conditions. We find that the financial conditions that matter most for growth in EM are mainly related to this second factor, which tracks DM equity, credit and volatility conditions and has remained well behaved due to better global growth data since the US election (see graph). The global financial conditions that matter most for EM remain well behaved % -10 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 Source: Itaú EM Financial Conditions DM Yields DM Credit/Equity/Vol The continuation of this behavior (U.S. yields up, well behaved broader financial conditions) is important to allow monetary policy easing across LatAm. In this environment, Argentina will continue to cut interest rates, but at a slower pace. If there is no additional volatility in global markets, we expect an acceleration of the pace of interest rate cuts in Brazil at the beginning of next year. Chile and Colombia are likely to start monetary easing cycles in On the opposite, M F and raise interest rates by 25 bps this month. Commodities OPEC reaches a deal. Better metal-price outlook, but current levels are stretched The Itaú Commodity Index (ICI) has risen by 7% since the end of October, driven by higher oil (ICIenergy: 11%) and metal (15%) prices, while the agricultural sub-index fell 2%. Oil prices rose as OPEC successfully reached a deal to cut output by 1.2 mbd. The cartel expects non- OPEC countries to join with additional 0.6 mbd cuts, but in our view Russia is the only likely source of cuts (-0.3 mbd). Regardless of the reaction of other countries, the deal is enough to balance the market as soon as it becomes effective (January 1), and global inventories will likely begin to fall afterward. We maintain our Brent price forecast at USD 54/bbl for YE2017, a level that allows some additional response from US production to I he short term, we see balanced downside (non-compliance risks) and upside (non-opec countries joining the cut, lagged reaction in the U.S.) risks. The recent metal-price rally will partially fade in Stronger demand (particularly in China), upward adjustments of inventory and tighter supply discipline have led metals to outperform other commodities in 2016 W 2017, housing market will cool down and as higher metal prices will lead to some reaction from marginal producers. Nonetheless, we expect prices to remain well above the 2016 lows in 2017, providing better economic conditions for major global suppliers. Stronger USD and favorable weather conditions have caused agricultural prices to drop. Weather conditions have been roughly favorable for the ongoing crop in the Southern Hemisphere. In addition, sugar and coffee underperformed, as both are more affected by the weaker BRL and had overbought technical position by hedge funds around mid-november. We believe that the prices of both commodities may recover, as the supply deficit comes back as the major driver. We expect ICI to remain stable from its current level until the end of 2016 and then drop 2% in 2017due to metal prices. Page 6

7 Forecasts: World Economy F 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 * The DXY is a leading benchmark for the international value of the U.S. dollar, measuring its performance against a basket of currencies that includes the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona. Page 7

8 LatAm Monetary policy easing amid external volatility As interest rates in the U.S. rise, the currencies of South America are expected to weaken some more while the Mexican peso will take time to get back to its fundamental levels. Activity in the region disappointed in November and remains weak. We expect a recovery in 2017, but risks are tilted to the downside. As inflation falls, monetary-policy stances are becoming looser. Adjusting to Trump The foreign exchange market continues to digest the consequences and uncertainties associated with the election of Donald Trump. In this environment, the Chilean peso and the Peruvian sol have performed well, almost flat from their respective pre-election levels, because the expectation of fiscal stimulus in the U.S. contributes to push copper prices up. But as oil prices rebounded strongly on the back of the OPEC deal, the, -account deficit leaves its currency vulnerable to higher U.S. Treasury yields. The Mexican peso remains the underperformer, but the Brazilian real has also weakened substantially, with uncertainties over fiscal reforms contributing to deteriorating sentiment. Finally, faster-than-expected monetary easing in Argentina and an even wider fiscal deficit in the country added to the worsening of the external environment and put pressure on the Argentine peso. As interest rates in the U.S. rise, the South American currencies are expected to weaken some more. In Brazil, Chile, Colombia and Argentina, interest-rate cuts will contribute to the depreciation. Meanwhile, we expect Mexico to appreciate slightly in 2017, as uncertainty over protectionism in the U.S. diminishes only gradually. According to our estimations for equilibrium exchange rates, the Mexican peso would remain weaker than its fundamentals suggest, while the Colombian peso needs to depreciate further so the currency can recouple with its fundamentals. Meanwhile, the Brazilian real, the Peruvian sol and Chilean peso are already around their fair values. In M V Estimating sustainable exchange rates in Latin America, we calculated the exchange rate that is consistent with bringing the current-account deficit to sustainable levels for each country within our coverage. As an assumption for current-account sustainability, we used the average of the past 20 years. Under this methodology, the Argentine peso is also overvalued, but as we discussed in the report, there are good reasons to believe that Argentina can live with wider current-account deficits than they have in the past. Further activity disappointment Activity in the region disappointed in November and remained weak. Our Itaú Activity Surprise Index returned to negative territory in November. Colombia was the country that disappointed the most, while Peru surprised positively. Overall, economies in the region remain weak, with Brazil and Argentina still failing to emerge from their recessions, while growth in Colombia and Chile is not clearly bottoming-out. Growth has been around trend in Mexico, which is low. While growth has been stronger than expected in Peru, internal demand continues to be very weak, as private investment has yet to recover. Itaú Surprise Index Index is measured as the number of standard deviations from its historical value (3MMA) Source: Bloomberg, Itaú Inflation Activity May-10 Jul-12 Sep-14 Nov-16 Page 8

9 While we expect a recovery in the region in 2017 (mostly because we expect Argentina and Brazil to come out of their recessions), we see the balance of risks tilted to the downside. Besides the risk of protectionism and lower capital inflows (due to higher interest rates in the U.S.), idiosyncratic factors can also limit growth next year. Disinflation allows for looser monetarypolicy stance The positive news is that disinflation is under way in many countries and has been faster than expected by the market. Our Itaú Inflationary Surprise Index registered in November, down from in October. Inflationary pressures continue to recede in, B z major player pulling down on the index, while Mexico recorded a positive surprise (due to the Mexican peso weakening). The more favorable evolution of currencies (compared with the previous years), together with weak activity and the waning of some supply shocks, is supporting disinflation in the region. In this environment, monetary-policy stances are becoming looser. We expect Brazil to increase the pace of rate cuts. In Chile and in Colombia, we see an easing cycle in In Argentina, we also expect the easing cycle to continue, but at a more moderate pace as further disinflation becomes more challenging. On the other hand, we continue to see rate increases in Mexico, in lockstep with the Fed, but even there the appetite of the central bank for hikes beyond those determined by interest parity considerations is clearly diminishing as highlighted in recent communication. Average current account deficit in the last 20 years Equilibrium exchange rate** Appreciation (-) / Depreciation (+) needed to achieve the average current account deficit* Brazil 2.10% % Colombia 2.60% % Chile 0.80% % Mexico 1.60% % Peru 2.80% % Argentina 0.00% % *Average in December relative to equilibrium **The equilibrium exchange rate for each country was based on the current level of the terms of trade. In the event of a positive (negative) shock in the terms of trade, the equilibrium exchange rate will be stronger (weaker). Page 9

10 Brazil Lower growth, higher risks Third-quarter GDP figures confirmed the weakness of economic activity. We have revised our 2017 growth forecast to 1.5% (down from 2.0%). Fiscal reforms continue to move ahead, however political uncertainty has increased. Inflation continues to fall. Our 2016 IPCA forecast has been revised to 6.6% but remains stable for 2017 at 4.8%. The exchange rate remains close to its sustainable, or equilibrium value. The pace of interest-rate cuts is likely to increase (to 50 bps per meeting) in January. Falling inflation creates an opportunity for larger interest-rate cuts Economic activity seems to have weakened in the recent months. However, fundamentals (lower interest rates, higher commodity prices, reduced company leverage and falling inventories) continue to suggest a moderate rebound in economic activity. Scenario risks have been increasing. In addition to a more complex external scenario, there has been a recent upswing in political uncertainty in Brazil. We maintain our view that the fiscal reforms (Social Security and the spending cap) will be approved by Congress, however there is a greater level of risk. Fiscal reforms continued to make headway last month despite increasing political uncertainty. The spending cap was approved in the first round of Senate voting and the second round is scheduled for the end of this year. Inflation continues to be better than expected. We have reduced our forecast for the Extended National Consumer Price Index (IPCA) to 6.6%, compared with 6.8% in the previous report. We have maintained our exchange-rate forecast of BRL 3.40 to the dollar at the end of 2016 and BRL 3.60 to the dollar at the end of The outcome of the U.S. elections has pressured emerging currencies; however, approval of domestic reforms supports the BRL, which also benefits from higher commodity prices. Interest-rate cuts likely to accelerate in January. Falling inflation and weaker activity are creating an opportunity for larger interest-rate cuts. We expect that the cycle will move to a pace of 50 bps per meeting, with a final cut of 25 bps, until the Selic rate reaches 10.00%. Modest return to growth in 2017 GDP shrank 0.8% in the third quarter. This result shows further deterioration in economic activity. On the positive side, the drop in family consumption has decelerated 1. Additionally, GDP remains below aggregate demand (-1.1% over the past four quarters) because of companies efforts to reduce inventories. GDP shrank again in 3Q index, sa 1995=100 GDP III 2006.III 2008.III 2010.III 2012.III 2014.III 2016.III Source: IBGE, Itaú Diffusion worsened at the margin. Our diffusion index which shows the number of rising indicators, based on a wide dataset including business and consumer confidence, retail sales and credit demand remains volatile, which is characteristic of economic inflection points. The index s three-month moving average will probably end November at around 41%, 1 See Macro Brasil: GDP fell 0.8% in the third quarter 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 December 9, 2016 after reaching 56% in July. The index continues to suggest that activity will improve as we move ahead, but with less intensity. Diffusion index worsened at the margin 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Nov-07 Feb-10 May-12 Aug-14 Nov-16 Source: Itaú Level 3mmavg A slight rise in industrial confidence. Industrial confidence rose slightly in November, remaining above the levels observed during the first half of the year. We estimate that demand remains higher than the output (measured by the capacity utilization). This situation should normalize when inventories achieve the desired level. Industrial demand continues to outstrip production Weaker short-term GDP, but fundamentals are stable. Recent reports have shown a lower-thanexpected level of activity. Incorporating the 3Q16 GDP figures and a review of the historic series, we expect GDP to remain broadly stable in the fourth quarter of We have therefore amended our 2016 GDP forecast to -3.3% from -3.2%. Although the statistical inheritance for 2017 will likely be worse than previously forecast, we believe the fundamentals continue to suggest moderate GDP growth next year. Commodity prices are likely to increase in 2017 after falling for the past two years. Monetary-policy easing and company deleveraging are likely to provide some relief for aggregate demand. Additionally, inventory normalization should contribute positively to GDP 2. We have therefore revised our 2017 economic activity growth forecast to 1.5% (compared with 2.0% previously). GDP likely to be broadly stable in 4Q16 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% Actual Forecast qoq/sa -0.9% -2.3% -0.5% -1.1% 0.5% 0.0% -0.4% -0.8% 1.0% sa Z Score -2.5 Industrial demand Capacity Utilization -3.0 Nov-04 Nov-06 Nov-08 Nov-10 Nov-12 Nov-14 Nov-16 Source: IBGE, Itaú Formal employment shrank less at the margin. In October, a net 75 thousand formal jobs were destroyed (Caged). Without accounting for seasonal effects, the contraction affected 79,000 jobs, a milder decline at the margin than in 1Q16, when 145,000 jobs were destroyed (three-month moving average). Although widely spread across sectors, destruction of formal jobs appears to be slowing in the manufacturing industry and retail sectors. Source: FGV, Itaú 2 See Macro View: We forecast GDP growth of 1.5% in 2017 Page 11

12 Smaller contraction in formal employment during October Oct-02 Feb-05 Jun-07 Oct-09 Feb-12 Jun-14 Oct-16 Source: Caged, Itaú Rising trend for unemployment continues. In October, the nationwide unemployment rate posted its twenty-third consecutive increase and rose from 11.8% to 12.1%, based on our seasonal adjustment. We have maintained our unemployment forecast of 12.5% for end the year and 12.2% in December of Since the PNAD Contínua series is relatively short, the forecasts are quite uncertain. Unemployment remains high thousands sa %, 3mmavg sa 6.0 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Source: IBGE, Itaú PNAD Cont. Reforms advance, but political uncertainty increases Fiscal reforms continued to move ahead last month. In November, the Senate approved the constitutional amendment for the spending cap (PEC 241/55) in its first round of voting. The second round, the final stage in bill s passage through Congress, is scheduled for the end of the year. If the spending cap is approved, it will represent a structural change in Brazil s fiscal management. If implemented, the cap will reverse the 20-year trend of uninterrupted real increases in primary federal expenditure and will gradually correct the fiscal imbalance as the economy returns to growth 3. Continuing the structural fiscal adjustment, the government has sent its Social Security reform bill to Congress. The bill is likely to be debated throughout the first half of It sets a minimum retirement age of 65 and unifies the rules on access to Social Security benefits for men and women, publicsector and private-sector workers and residents in urban and rural areas. Changes to Social Security are essential in order to comply with the spending cap over the next several years. Social Security expenditure represents 40% of the federal government s total primary expenditure (8.0% of GDP) and will increase in real terms over the next several years as the population ages. The proposed reforms would bring the federal budget into line with Brazil s current demographic situation. It would also reduce the need for significant cuts to the rest of the budget and support spendingcap compliance for a longer period. We believe that, if approved, these measures will be critical for stabilizing medium-term public debt. We are forecasting that the federal government will only be able to achieve a primary surplus again in However, a return to growth and structural drop in interest rates following implementation of the reforms will significantly reduce the speed of annual public-debt increases over this period. More specifically, we believe that by complying with the spending cap, public debt will remain stable at around 80% of GDP until 2023, when it should start to fall as the government achieves larger primary surpluses. 3 See Macro View: FAQs: The Spending Cap (PEC 241) Page 12

13 Without a reform, social security would make the spending ceiling unviable 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% % of central government primary expenditure Social Security expenditure 40% Source: National Treasure, Itaú 50% 65% We have marginally improved our primary deficit forecast for 2016 from 2.5% (BRL -158 billion) to 2.4% of GDP (BRL -151 billion). The revision results from spending BRL 4 billion less than we had previously expected and a result from the states and municipalities that should be 3 billion BRL higher than we had anticipated. The primary result should beat the annual target of -2.6% of GDP (BRL -164 billion), despite the expected BRL 16 billion in payments from previous fiscal years ( restos a pagar ), due to the BRL 64 billion in extraordinary revenues raised from asset repatriation and hydroelectric auctions. We have maintained our forecast for a primary deficit representing 2.2% of GDP in 2017 (BRL 142 billion), in line with the government target. We have included BRL 10 billion raised under the new foreignasset repatriation program, which is likely to offset the shortfall in revenues from worsening growth forecasts. In addition to the repatriation revenues, we expect BRL 37 billion in additional extraordinary revenues from energy-permit auctions, infrastructure concessions and IPO taxation, in line with the government budget. The inflation scenario remains positive We are forecasting a 6.6% variation in this year s IPCA, below the 6.8% forecast in our previous report. We are forecasting a 7.0% increase in market prices (compared with 8.5% in 2015). Looking at the market-price components, we estimate an increase of 10.0% for food at home (12.9% in 2015), 5.2% for industrial prices (6.2% in 2015) and 6.8% for services (8.1% in 2015). We are forecasting a 5.6% increase in regulated prices (compared with 18.1% in 2015). The announcement that the green tariff flag will be activated in December which means there will be no additional charges on electricity bills will have a -0.1 pp impact on December s IPCA. Food-at-home prices have also reacted more favorably than previously expected. For the time being, we are forecasting an increase of around 0.55% in the December IPCA. Inflation in the last month of the year will come under pressure from the transportation (reflecting higher airline ticket and fuel prices), food and personal expenses groups. On the other hand, the housing group should post a negative rate as electricity bills fall. We continue to forecast that IPCA inflation will fall to 4.8% in Next year s drop in inflation will reflect less inflationary inertia, lower inflation expectations, more favorable weather conditions, the high level of idle capacity still seen throughout the economy and a smaller effect from tax increases. On a disaggregated basis, we are forecasting a 4.6% rise in market prices and a 5.6% increase in regulated prices. Among market prices, we are forecasting a 4.0% increase for food at home as major agricultural producers are likely to see bumper crops, reflecting improved weather conditions as the effects of El Niño taper off. In other segments, we are forecasting a 5.4% increase in service prices and a 3.7% increase in industrial prices. Among regulated prices, we are forecasting an increase of 8% for electricity, 3% for gasoline, 11% for health plans, 5% for urban bus and 5% for medicinal drugs. The main risk in the inflation scenario is posed by the external scenario and domestic political uncertainty. Greater uncertainty abroad could see risk premiums increase, which could result in exchangerate depreciation. Besides any further difficulties moving ahead with the necessary reforms and adjustments could also put additional pressure on risk premiums and exchange rates. Additionally, this situation could also trigger attempts to adopt alternative fiscal measures, such as tax hikes and removal of certain tax breaks, which would slow down the disinflation process. The high level of idle capacity in the economy is also likely to drive inflation down further. Albeit subject to a level of uncertainty and errors of Page 13

14 measurement, the negative output gap could lead to faster market-price disinflation over the next few months, particularly for industrial products and services. Similarly, progress on fiscal reforms could improve the outlook for inflation, either through exchange-rate and inflation expectations, or switching from the current expansionary policies to neutral or even contractionary fiscal policies. Anchored expectations strengthen the scenario of falling inflation. According to the Focus survey of market analysts, inflation expectations for 2016 retreated again last month to 6.7% while inflation expectations for 2017 remain unchanged at 4.9%. Median expectations for 2018 and further ahead remain solidly at the center of the target (4.5%), reflecting an increasing conviction that the central bank will take steps to ensure that the IPCA will indeed converge on target in a timeframe that will allow monetary policy to have a greater effect. Inflation continues to fall 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% yoy IPCA Market-set prices (76%) Regulated prices (24%) Source: IBGE, Itaú 18.1% 10.7% 8.5% 6.6% forecast 4.8% 0% Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 The central bank intensified its interventions in the FX market. The monetary authority announced a pause in its reverse-fx swap auctions to assess market conditions and rolled over the entire batch of USD 6.5 billion maturing in December. Additionally, a further USD 2.45 billion in new FX swaps were offered. At the end of November, the central bank s short position in FX swaps stood at USD 27 billion. In December, the CB has already begun the process of rolling over contracts maturing in January. We have maintained our exchange-rate forecast of BRL 3.40 per dollar at the end of 2016 and BRL 3.60 per dollar at the end of On one hand, higher U.S. interest rates may maintain pressure on the BRL ahead. On the other hand, our scenario is based on approval of the fiscal reforms, a gradual increase in U.S. interest rates and the outlook for higher average metal commodity prices than last year. This exchange-rate trend is in line with a scenario of slight growth in current-account deficits, albeit at low levels, not compromising external sustainability. External accounts are stable at the margin. The current-account deficit has settled at a higher level than observed during the first half of the year. In October, the seasonally adjusted, annualized, threemonth moving average was stable at a deficit of around USD 25 billion. Currency appreciation in recent months helps explain the more-modest results. However, in 2016, the current-account deficit is already down 68% from the same period last year (USD 17.0 billion compared with USD 53.5 billion), the lowest year-to-date deficit since External accounts: stability at the margin 0-20 billion dollars The BRL depreciates following the U.S. elections Over the past month, higher U.S. interest rates have pressured emerging-market currencies, including the BRL. The exchange rate reached an intraday peak of BRL 3.54 to the dollar, its highest rate since July this year, but fell back as November progressed MMA sa annualized Over 12 months -120 Oct-08 Oct-10 Oct-12 Oct-14 Oct-16 Source: BCB, Itaú Page 14

15 Recent results are consistent with our outlook of a small current-account deficit in We have maintained our forecast of a USD 47 billion surplus in 2016 and a USD 46 billion surplus in For the current account, we are forecasting a USD 21 billion deficit in 2016 and a USD 29 billion deficit in BCB opens the door to faster cuts In November, the central bank delivered its second rate cute, another 25-bp move, taking the Selic to 13.75%. In the minutes, the BCB did not pre-commit to trim the Selic by 50 bps in the January meeting. But it makes quite clear that this is now the base case. In fact, some elements of the text hint that the central bank could have opted for a faster pace of easing, had it not been for the surprise in the U.S. election and its market aftereffects, We believe the domestic scenario continues to support monetary policy easing First, the fiscal reforms are still making progress, despite rising uncertainty. Second, economic activity remains weak, reducing inflationary risks. Third, inflation is likely to continue falling. And finally, the lag in monetary policy effects will encourage the CB to switch its focus to 2018 instead of 2017 inflation. In our opinion, all of these factors tip the scales toward speeding up the easing cycle.... and developments abroad are unlikely to change this. According to the CB, there is no direct relationship between the external scenario and domestic monetary policy. External uncertainties may result in exchange-rate depreciation, which could hamper the disinflation process. However, the favorable evolution of commodity prices and possible impacts on domestic activity could mitigate the negative outcomes. We believe that the CB communication and our expectations for the economy over the next few months are consistent with our scenario of a faster cycle of interest-rate cuts, starting at the January meeting. We forecast 50-bp cuts throughout 2017 and a final 25-bp cut, with the Selic ending the year at 10.00% p.a. Forecast: Brazil F 2017F Economic Activity Real GDP growth - % Nominal GDP - BRL bn 3,886 4,376 4,815 5,332 5,779 6,001 6,262 6,631 Nominal GDP - USD bn 2,208 2,612 2,463 2,468 2,455 1,802 1,794 1,890 Population (millions) Per Capita GDP - USD 11,292 13,234 12,362 12,278 12,106 8,811 8,704 9,102 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 Gross Public Debt - % GDP Net Public Debt - % GDP Source: IBGE, FGV, BCB and Itaú (*) Nation-wide Unemployment Rate measured by PNADC Page 15

16 Argentina Monetary policy to the rescue? We expect a 2.4% GDP contraction in 2016 and a recovery of 2.7% in The risks to our growth forecasts are tilted downward. The central bank is easing monetary policy at a faster pace than we expected. While there has been no additional progress in disinflation, concerns about weak activity and a strong currency are likely behind the interest rate cuts. Lower domestic interest rates amid higher U.S. treasury yields have had a negative impact on the peso and may made disinflation more challenging. Fiscal policy remains lax. Acceleration in fiscal expenditure growth led us to raise our fiscal deficit forecasts. Still no recovery Activity has yet to bottom out in Argentina. The EMAE (monthly GDP proxy calculated by the INDEC) fell by 3.7% year over year in September, from a 2.1% decline in August. On a sequential basis, activity fell by 0.9% qoq/sa in 3Q16, after a 2.1% contraction in 2Q16. The unemployment rate was at 8.5% in 3Q16. The IGA (GDP proxy estimated by private consulting firm OJF) fell by 0.1% mom/sa and 4.5% yoy in October. Consumer confidence (as reported by Universidad Di Tella) fell by 4.6% mom in November, offsetting the 6.3% gain of the previous month. We expect a 2.4% GDP contraction this year, but anticipate a recovery to 2.7% in While the recent data implies downside risk to our expectation of positive growth rates from 4Q16 on, a pick-up in activity is still likely due to a recovery in real wages, increased access to capital markets (relative to the past) and market-friendly policies. Faster-than-expected monetary policy easing The central bank cut its monetary policy rate (35-day Lebac rate) by 200 bps, to 24.75%, in November and left it on hold in the first week of December. The reduction was carried out despite the higher-thanexpected inflation in October, while inflation expectations for 2017 remain far above the central bank s 12%-17% target range. As a result, the annualized real interest rate (using inflation expectations for the following month) now stands at 5.7% (vs. 9.1% in October). Concerns about weak activity and the real appreciation of the peso were probably behind the recent monetary decisions. We expect the central bank to cut rates by another 100 bps in December, bringing the Lebac rate to 23.75% (vs. 25.5% in our previous scenario), which would be consistent with an annualized ex-ante real interest rate of around 4.0%. We expect a reference rate of 20% by year-end 2017 (vs. 22% previously). Monetary policy easing amid higher U.S. interest rates is negative for the currency. The peso weakened by around 5% (in nominal terms) in November. We now expect the exchange rate to hit 19.2 pesos to the dollar by December 2017, from 18.7 in our previous scenario and 16 by the end of this year (implying a stable real bilateral exchange rate next year). Loosening monetary policy % % 0 20 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Source: Central Bank, UTDT Ex-ante real interest rate* 35-day Lebac rate (RHS) *35-day Lebac rate against expected inflation for similar period (core inflation for October) In this environment, further disinflation becomes more challenging. According to INDEC (official statistics agency), consumer prices rose 2.4% mom in October, following a 1.1% increase in September. Although the increase was mainly due to the impact of Page 16

17 the new gas tariff, core inflation (a measure that excludes seasonal products and regulated prices) also rose to 1.8%, from 1.5% in the previous month. The city of Buenos Aires reported a 2.9% mom increase in consumer prices in October, up from 1.3% in September. As a result, annual inflation rose to 44.7% (from 43.1% in September), while annual core inflation remains at 40.2%. While the estimates of Elypsis consulting firm call for a deceleration in consumer price inflation, to 1.5% mom, in November, inflation expectations for 2017 remain above the upper bound of the 12%-17% target set by the central bank. Our inflation forecast for December remains unchanged at 41% yoy, but we now expect 22% inflation by December 2017 (up from 20% previously) due to looser monetary policy and a weaker currency. Our forecast is nevertheless still conditional on wage settlements in 1Q17 that are closer to expected than to observed 12 months inflation. Higher fiscal deficit will test a challenging external environment Looser monetary policy adds to a lax fiscal policy. The federal government reported a fiscal deficit of ARS 77.5 billion in October, marking a considerable increase from the ARS 21.7 billion deficit reported one year ago. The primary fiscal deficit was ARS 63.0 billion, also surpassing the ARS 26.8 billion deficit registered a year earlier. Primary expenditures grew 51.5% yoy in October, mostly due to higher transfers to provinces (112% yoy), expenses for public works (80.4% yoy) and transfers to the private sector (66.3% yoy). Tax collection increased by a modest 22.9% yoy in nominal terms. Despite this result, the administration reaffirmed its commitment to a primary deficit of 4.8% of GDP in 2016, which is still achievable given the revenue from the first stage of the amnesty for undeclared assets. Still, the nominal fiscal deficit is likely to reach 5.1% of GDP this year (vs. 5% in our previous scenario). A narrower nominal deficit in 2017 is unlikely. We expect strong expenditure growth to continue in 2017 with the proximity of the mid-term elections. Congress is currently discussing changes in the income tax, which may cost between 0.4% and 0.8% of GDP. While this reform is considered in our forecasts, the primary deficit and nominal deficit are likely to rise to 5.2% and 6% of GDP, respectively, in 2017 (vs. 5.7% in our previous scenario), assuming 0.7% of GDP in revenue related to the amnesty for undeclared assets in 2017 (USD 4.0 billion). Further deterioration of fiscal accounts at a time at which external financing is more challenging. The yield on 30-year dollar-denominated bonds has risen by 130 bps, to 8.2%, since the first week of November. In addition to the fiscal deficit, the government will have to deal with USD 8.2 billion in maturities in the international market next year, and a similar amount in peso bonds in the domestic market. The positive news is that the treasury may count that the inflows from some repatriation of assets will be used to invest in public bonds. Forecast: Argentina F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 10,412 12,786 13,888 14,478 13,215 14,616 12,718 12,997 Unemployment Rate - year avg Inflation CPI (City of Buenos Aires) - % Interest Rate BADLAR - eop - % Lebac 35 days - eop - % Repo rate 7 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 17

18 Mexico Calibrating the monetary policy response We expect GDP growth to slow down from 2.6% in 2015 to 2.1% in 2016 and to 1.8% in The Trump shock is likely to perpetuate uncertainty about protectionism (particularly harmful for investment in Mexico s manufacturing). Higher growth in the U.S. (due to fiscal stimulus) is a buffer. A prolonged period of uncertainty over U.S.-Mexico trade relations will likely keep the Mexican peso at week levels. We see inflation at 3.7% by the end of next year (up from an upwardly revised 3.4% in 2016). As the central bank switched its focus to the pass-through from the Mexican peso depreciation (instead of the Mexican peso itself), we expect rate hikes to move in lockstep with the Fed. That is, three 25-bp rate hikes before the end of The fiscal accounts have shown signs of improvement in early 4Q16, which is why we have lowered our public deficit forecast for 2016 to 2.7% of GDP (from 3%). Fiscal consolidation is making headway. Activity was cyclically firmer when the Trump shock hit Mexico s economic activity accelerated in 3Q16, supported by strong growth in the service sector and an incipient pickup in manufacturing output. The monthly GDP proxy (IGAE) expanded by 1.6% year over year in September, leaving the GDP growth rate of 3Q16 at 2% year over year (consistent with the previously released flash estimate). Adjusting for calendar effects, GDP growth was also 2% year over year up from 1.4% in 2Q16 thereby marking an acceleration. In fact, at the margin GDP advanced 4.1% qoq/saar (from 0.2% qoq/saar in 2Q16). GDP growth accelerated in 3Q16* GDP (%, y/y) Construction Services Manufacturing -1 Mining Rest of sectors 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 *Adjusted for working days Source: INEGI, Itaú Growth is uneven across sectors, with mining and construction contributing negatively to activity. Working-day adjusted figures show that the growth of services picked up from 2.5% year over year in 2Q16 to 3.4% in 3Q16, while industrial production growth slipped to -0.8% year over year (from -0.6% previously) during the same period. Looking at the breakdown of Industrial sectors, however, we highlight that manufacturing output improved (0.7% year over year in 3Q16, from 0.4% in 2Q16), which is consistent with the acceleration of manufacturing exports in the trade balance data. Conversely, mining output (-7.4% year over year in 3Q16 vs. -4.9% in the previous quarter) and construction activity (0% in 3Q16 vs. 1.2% previously) worsened, probably dragged down by the fiscal consolidation of the government (whose budget cuts are concentrated in PEMEX s capex). We expect GDP growth of 2.1% in 2016, but our forecast for 2017 implies a deceleration, to 1.8%, in response to the Trump shock. In 4Q16, manufacturing output will likely continue gaining traction, helped by the pickup in U.S. industrial output and a competitive exchange rate. But the prospects for 2017 have deteriorated, considering that the uncertainty over protectionism will take a toll on investment in the Manufacturing sector. For the service sector, we expect a moderate slowdown as inflation increases (eroding real wages) and tighter fiscal and monetary policies have a negative effect on consumers. Inflation is fueled by depreciation The outlook for the exchange rate is contingent upon the course of U.S. policies on issues such as trade, immigration and remittances. As uncertainty over these issues is expected to diminish only gradually, Page 18

19 our exchange rate forecasts for 2016 and 2017 are 20.5 MXN/USD and 19.5, respectively. The real effective exchange rate looks undervalued, but a prolonged period of uncertainty over U.S.-Mexico trade relations can exert protracted pressure on the MXN, keeping the currency far away from fundamentals. We have increased our inflation forecast for 2016 (to 3.4% from 3.2%) and maintained the forecast for 2017, at 3.7%. Exchange-rate pass-through and the increase of non-core inflation have been more significant than we expected. However, we note that part of the recent increase in year-over-year inflation is attributable to the reversal of a base effects associated with the telecom reform. As of October 2016, we estimate that mobile telephone costs (falling by 28.5% year over year) were subtracting 31 basis points from annual inflation, but this negative contribution shrank to 18 basis points in the first half of November (and would fall to 14 basis points in December, assuming mobile telephone prices remain constant from November). For 2017, we believe that the lagged effects of the sharp peso depreciation triggered by the U.S. presidential election, and to lesser extent the liberalization of gasoline prices, will exert upward pressure on consumer prices. Settlements (BIS). In our view, Carstens successor will be another technocrat with strong academic and professional credentials, just like every other member of the board, so it is unlikely that the quality of monetary policymaking will change. Banxico has built strong credibility over the past decades, which is reflected in the taming of inflation (significantly down from the 1990s), well-anchored inflation expectations and low exchange-rate pass-through. The inflation mandate guarantees discipline, and governance is already strong. Looking ahead, our call is that Banxico will hike rates in lockstep with the Fed. The short-term interest rate differential between Mexico and the U.S. is mentioned in the policy documents as a major variable to be monitored. We expect Banxico to hike by 25 bps in December, assuming the Fed makes a similar move, and then deliver two similar hikes next year (also following the Fed), bringing the reference rate to 5.5% and 6.0% by the end of 2016 and 2017, respectively. In fact, according to the minutes of the last board meeting, one deputy governor highlighted that, under current conditions, Banxico has little room to decouple from the Fed. Central bank calibrates its policy response The Trump election has been a game-changer for the Central Bank, whose discourse has changed by acknowledging that the economy is facing a real shock, rather than just volatility, which makes a difference in the calibration of the appropriate policy response. During the presentation of the quarterly inflation report, Governor Carstens argued that the uncertainty over Mexico s economic outlook warrants real exchange-rate depreciation, stressing that the latter acts as shock absorber and represents the most efficient adjustment mechanism under these circumstances. The takeaway is that the central bank will be less reactive to potential new currency sell-offs (at least if linked to protectionism developments), and that its focus is on preventing second-round effects on inflation (from the weakening currency). Recently, Central Bank Governor Agustín Carstens resigned from his position, but we do not expect this event to have negative implications for governance nor for the credibility of Mexico s monetary policy. Agustín Carstens presented a resignation letter to President Peña Nieto and will leave Banxico in July 2017 to lead the Bank for International External and fiscal imbalances will likely narrow The current account deficit remained stable in 3Q16 (rolling 4Q: 2.9% of GDP), in spite of a narrower trade deficit (which was offset by a deterioration in the income balance). Manufacturing exports are recovering, and the weaker currency is hitting nonenergy imports. A downside risk, nevertheless, is the extent to which the fiscal consolidation plan of the government will affect the energy balance (by cutting PEMEX s capex and hence oil output). Funding of the current account deficit is challenging: net FDI (rolling 4Q: 2.2% of GDP) is not enough to fully fund the deficit. Overall, FDI has held up well, but flows into the domestic bond market (a key source of financing) are scarcer. The price action of financial assets, after the U.S. election (and the sharp peso depreciation), suggests there were outflows of portfolio investment. We expect the current account deficit to narrow from 2.9% of GDP in 2015 to 2.8% in 2016 and to 2.4% in 2017 as the substantial real exchange-rate depreciation and slower growth of the Mexican economy will likely affect the demand for imports. At Page 19

20 the outset, we expect manufacturing exports to accelerate, driven by a pickup in U.S. industrial output and a competitive exchange rate, and domestic demand to weaken. From a funding perspective, the risk of protectionism could be another drag on foreign direct investment (especially to the tradable sectors), while higher U.S. treasury yields could mean further outflows from the domestic bond market. Fiscal accounts improve Public balance Net debt (RHS) 4-quarter rolling, % of GDP % of GDP Oct-11 Oct-12 Oct-13 Oct-14 Oct-15 Oct-16 Source: SHCP, INEGI, Itaú On the fiscal front, there are signs of improvement in early 4Q16. The 12-month public deficit narrowed from MXN billion (2.4% of GDP) in 3Q16 to MXN billion (approximately 1.9% of GDP) in October. In fact, the Treasury (SHCP) has narrowed its estimate for the primary deficit for 2016 from 0.4% of GDP (estimate presented in September s budget) to 0.3% of GDP, although it still expects public sector borrowing requirements of 3% of GDP. Given these better-thanexpected results, we have revised our estimate of the public deficit for 2016 to 2.7% of GDP (from 3%). It is also worth noting that the net debt of the public sector decreased from 47.6% of GDP in 3Q16 to 46.8% of GDP in October. Nevertheless, net debt is expected to increase significantly in the last months of 2016, considering the increase in the local currency value of foreign debt (as a result of the sharp peso depreciation) and the federal government s purchase of the National Electricity Company s (CFE) pension liabilities for up to MXN 160 billion (0.8% of GDP). Looking ahead, a large dividend from the central bank (due to exchange-rate gains on international reserves) could be a windfall for fiscal accounts in Finally, we highlight that the Mexican government successfully carried out the fourth set of oil field auctions ( Round 1.4 ) of the energy reform, which represents positive news for economic activity, capital inflows and fiscal sustainability in the medium-term. Round 1.4 can be considered a success in the sense that it awarded 8 of the 10 blocks auctioned (without counting PEMEX s Trion project), thereby doubling the goal set by the Ministry of Energy (SENER). Indeed, the Energy Minister, Pedro Joaquín Coldwell, had said that awarding 4 of the 10 blocks would be a positive outcome. Given these results, foreign direct investment commitments from Round 1.4 would add up to approximately USD 43 billion (around 4% of current GDP) over time. Notably, the first three rounds (1.1, 1.2 and 1.3) only got investment commitments of USD 7 billion. So this marks a more important milestone towards the liberalization of the energy sector (whose market has been historically captive for state-run monopolies). Moreover, PEMEX s partnerships with private firms aim at improving the profitability of the firm, and hence its financial soundness, which will have positive implications on Mexico s fiscal position. Page 20

21 Forecast: Mexico F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn 1,106 1,119 1,223 1,264 1,270 1, ,041 Population (millions) Per Capita GDP - USD 9,677 9,671 10,448 10,676 10,611 9,110 8,036 8,405 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 21

22 Chile About to cut A weak beginning to the fourth quarter adds a downside risk to our growth forecast. Low private confidence still stands in the way of a meaningful activity recovery. Inflation would slow to 2.8% by the end of next year from 3.0% in December 2016 as the exchange rate remains stable and the output gap remains negative. In this environment, as long as financial conditions for emerging markets do not deteriorate significantly more, the central bank would start cutting rates in January, taking the policy rate to 2.5% by the end of next year from 3.5% this year. The Chilean peso has recently outperformed its peers because of higher copper prices, but rate hikes in the U.S. and a loosening cycle in Chile would put some pressure on the currency in The 2017 presidential election is becoming a two-horse race as surprise candidate Alejandro Guillier gains ground on former President Piñera. Short-lived stabilization of activity Economic activity remained weak in the third quarter of the year, dragged down by investment. The demand-side breakdown shows a mild pick-up in private consumption, while there was some moderation of public consumption. Net exports made a positive contribution to growth. GDP expanded 1.6% year over year in 3Q16, while there were upward revisions of 0.1 percentage points both in 1Q16 (to 2.3%) and in 2Q16 (to 1.6%). Weak investment put an end to the gradual recovery of final domestic demand (2.0% year over year, from 2.8% in previously). Gross fixed investment fell 1.2%, after a 3.0% increase in 2Q16 as expenditure in machinery and equipment slowed down sharply, while construction activity continues to contract. With the end of the tax incentive that favored a housing boom and overall business confidence remaining low, the outlook for investment remains gloomy. Consumption expanded 2.9% (2.8% in 2Q16), with the private consumption component picking up, offsetting the public-consumption slowdown. On the external front, lower sales of manufactured goods led the deceleration of exports from 0.9% in 2Q16 to 0.5%. Meanwhile, imports of goods and services declined, so net exports contributed positively to growth. The economy showed some (probably temporary) improvement in 3Q16. GDP increased 2.5% qoq/saar, recovering from the 1.4% qoq/saar decline in 2Q16. However, activity in the 4Q16 got off to a weak start. The monthly GDP proxy (Imacec) contracted 0.4% year over year in October, below expectations. Activity in the month was dragged down by the 7.1% year over year decline in mining and the slowdown of non-mining activity, which was pulled down by manufacturing. With the disinflation process unfolding at a faster-thanexpected pace, real wage growth has picked up and is likely supporting consumption. At the margin, activity in the quarter was near flat. Activity takes a dip 4 2 %, yoy, 3mma Source: BCCH, Itaú IMACEC Mining Non-Mining Additionally, the continued loosening of the labor market could limit the performance of consumption. While unemployment (6.4%) remains low, the composition of employment growth and the continued exit of workers from the labor market point to a deterioration of broad labor-market conditions. Waged employment was flat in the quarter ending in October Page 22

23 from one year ago. Within waged employment, contracted workers declined 0.4% (+1.8% in 2015), hinting that jobs created could be more temporary than permanent. Self-employment, characteristic of lower quality jobs, expanded 7.0% year over year (4.2% in 3Q16 and 6.0% in 2Q16). Low quality job growth %, yoy and contributions Total employment Waged employment Rest Annual inflation came in at 2.9%, from 2.8% in the previous month, remaining near the target. The uptick is due to an unfavorable base of comparison. Tradable inflation continues to float near the lower end of the target range at 2.2% (1.9% previously). Meanwhile non-tradable inflation entered the target range, standing at 3.9% (4.1% previously), the first time this has happened since the introduction of the 2013 CPI basket. Inflation excluding food and energy prices came in at 3.0% (3.2% previously), the lowest since March Core services inflation, more closely related to domestic inflationary pressures, decelerated to 3.9%, entering the central bank s target range for the first time since December 2013 (3.8% inflation). Core inflation continues to moderate Feb-12 Oct-12 Jun-13 Feb-14 Oct-14 Jun-15 Feb-16 Oct-16 Source: BCCH, Itaú %, yoy The disappointing activity data at the start of 4Q16, alongside stagnant confidence levels, put a downward bias to our growth scenario. Following the publication of 3Q16 national accounts, we anticipated our growth forecast for this year would be revised to 1.8%. However, the weak October Imacec compensates for the upside revision to growth in the first half of the year, so we maintain our previous month s 1.5% growth forecast for 2016, down from 2.3% in We still expect a modest recovery to 2.0% next year, but acknowledge there is a downside bias to this forecast. Low inflation consolidates Inflation was once again low in November. Following a sharp depreciation of the currency over the past two years, the evolution of the peso this year has led to a tradable goods-led disinflation in recent months. Moreover, disinflation of non-tradables (a component of inflation that the central bank is closely monitoring) is indicative that there is more than transitory factors behind the fall of inflation in Chile Source: INE, Itaú Our diffusion index is still retreating and sits at its lowest level since April The bulk of the moderation came from tradable goods prices. In fact, tradable good prices are now contributing negatively to the index. We still expect inflation to slow to 2.8% by the end of next year from 3.0% in December.. Case for easing gains traction CPI CPI ex food & energy Non-tradable Tradable The tone of the November monetary-policy meeting minutes, when the central bank board voted to leave the policy rate unchanged at 3.50%, shows that the case for easing is gaining traction. The board is anticipating inflation forecasts will be adjusted down in Page 23

24 the upcoming Inflation Report (IPoM), to be published on December 19. Although the board agreed to stay on hold at the November meeting, the internal debate raised the expectation for rate cuts in the future. Several board members saw that recent data had led to a material change to the inflation trajectory (vs. 3Q16 IPoM), which increased the probability of monetary stimulus in the near term. A further board member agreed, but noted that the possible adjustment would be small and not significantly different from that seen in asset prices (between one and two 25-bp rate cuts at the time). One member went as far as saying that rates could be cut at the October meeting, but he favored not surprising the market. As long as financial conditions for emerging markets do not deteriorate significantly more, we expect the central bank to start cutting rates in January. The easing cycle would come only after the central bank lays out its new forecast scenario in the 4Q16 IPoM. We see the policy rate at 2.5% by the end of next year, but consecutive rate cuts are unlikely. In fact, we do not expect the central bank to signal a fullfledged easing cycle as early as the upcoming IPoM. Stable and low current-account deficit The current-account balance deficit is stabilizing. In the rolling four-quarter period ending in 3Q16, the deficit came in at USD 4.8 billion (-2.0% of GDP), after a USD 4.9 billion deficit as of 2Q16 (2.1% of GDP), broadly flat from the USD 4.8 billion recorded in The improvement in trade balance of goods and services compensated the deterioration in the income balance. The income deficit increased and now sits above the 2015 amount, as copper prices have picked up from the beginning of the year, likely leading to improved results for foreign mining companies. Foreign direct investment moderated in the four quarters ending in 3Q16, but mostly due to a high base of comparison. Foreign direct investment shrunk to USD 11.5 billion (4.8% of GDP), from USD 20.5 billion in 2015 (8.5% of GDP), reaching the lowest value (in dollar terms) since Meanwhile, net direct investment continues to fully finance the current-account deficit. A low current account deficit Rolling-4Q, % of GDP Source: BCCh, Itaú. Current Account Current Account + Net FDI While the current-account balance has stabilized, we do not expect much of an improvement toward yearend, so we now see a current-account deficit of 2.0% of GDP this year (1.7% previously). A slower adjustment of the income balance will lead to a wider deficit than we had expected this year. We expect the current-account deficit to remain broadly stable at 1.9% of GDP next year. With copper prices behaving favorably following the expected fiscal expansion in the U.S., the Chilean peso has mostly outperformed its regional peers. We continue to expect the currency to end this year at 675 to the dollar and at 685 by the end of The weakening would be due to the narrowing interest-rate differential with the U.S. Presidential election turning into a twohorse race The November Adimark public opinion survey showed that support for the two presidential frontrunners picked up ahead of next year s election. Voting intentions for former President Piñera increased four percentage points, to 24%. Surprise candidate Alejandro Guillier rose to 21% from 15% previously (5% two months ago). Guillier is an independent left-wing senator and former journalist who entered the political fray in The growing support for Guillier may reflect the overall discontent with the traditional political class. Page 24

25 Former president Ricardo Lagos still lags in third spot with only 7% (5% previously). While undecided voters have fallen from 47% in August to 31% in November, uncertainty remains elevated. An election between former presidents Piñera and Lagos would be seen as market friendly, meanwhile Guillier provides the element of surprise. Forecast: Chile F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 12,744 14,545 15,195 15,724 14,529 13,362 13,497 13,964 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% 0.0% Source: IMF, Bloomberg, BCCh, INE, Haver and Itaú Page 25

26 Peru No rebalancing of growth sources yet Peru s economy remains strong, even though internal demand growth is poor. We expect growth to improve a bit more in 2017, but the fact that private investment is failing to recover is a risk. The rebalancing of growth sources, with stronger net exports but softer domestic demand, has narrowed the current account deficit, from 4.8% of GDP in 2015 to 3.6% of GDP in the four quarters ended in 3Q16. We now see the deficit at 3.2% of GDP for Inflation has increased, but we view this as temporary. The central bank still has a tightening bias, yet rate hikes are unlikely. On the other hand, the likelihood of rate cuts in 2017 (not farfetched if domestic demand growth remains poor) is constrained by higher interest rates in the U.S., in a partially dollarized economy. Activity is strong, but a fiscal drag will curb growth in 4Q16 Peru s GDP grew at a strong 4.4% year over year in 3Q16, up from 3.7% in 2Q16, driven by net exports, which contributed 3.2 percentage points to growth. In fact, mining output (the main source of exports, 55% of total) expanded 17.5% year over year in 3Q16, and an unexpectedly strong first fishery season (an activity that is among Peru s top five export goods) provided an extra tailwind to external sales. However, final domestic demand weakened, growing by a modest 0.8% year over year in 3Q16, with the drag coming from private investment (-8.6% year over year). On the bright side, private consumption growth firmed up from 3.4% year over year in 2Q16 to 3.5% in 3Q16 in spite of the recent weakening of the labor market (mainly softer employment). As we had noted before, some coincident indicators for private consumption were solid in the third quarter (for instance, consumer confidence was running at high levels, following the presidential election, and consumer credit was growing at a robust pace). We expect a temporary slowdown in 4Q16. The Ministry of Finance s decree to slash central government spending (in an effort to meet the fiscal deficit target for 2016) will take a heavy toll on construction output. In fact, according to data reported by INEI (the statistics institute), construction plunged 16.5% year over year in October (the sharpest drop in 12 years) as public works fell by 32%. In addition, there is a large statistical comparison base for metallic mining (particularly in December). Based on coincident indicators, we forecast a 3% year-over-year expansion in monthly GDP in October. We still expect 4.0% GDP growth in 2017 (from an estimated 3.8% this year). For Peru, the negative impact of the U.S. election on emerging markets (mainly in the form of rising U.S. treasury yields and uncertainty over protectionism) is cushioned by the rise of copper prices (Peru s top export commodity). On the domestic front, it is worth mentioning that a pickup in private investment is key in our forecast, given that the contribution from mining will be lower next year. Although the recent performance of leading indicators for private investment (terms of trade, business confidence, stock exchange market) is consistent with an improvement ahead, we recognize that data in 3Q16 was worse than we were expecting. Growth has accelerated, led by exports GDP (%, y/y) Private Consumption Government Consumption Investment Inventories Net Exports 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 Source: BCRP, Itaú Page 26

27 A narrower current account deficit The significant narrowing of the current account deficit (close to 5% of GDP in 2015) is moderating a key vulnerability of the economy. Peru s current account deficit narrowed to 3.6% of GDP in the four quarters ended in 3Q16, from 4.3% of GDP in 2Q16. The quarterly seasonally adjusted deficit was even smaller, at 2.2% of GDP in the third quarter. The trade balance is now in surplus territory, for the first time in almost three years. The drivers of the improvement are mining export volumes (mainly copper) and the contraction of imports (amid weak domestic demand). We have revised our current account deficit forecasts for 2016 (to 3.4% from 3.6%) and 2017 (to 3.2% from 3.4%). The funding conditions of the current account deficit seem sustainable. Net FDI improved a bit with the four-quarter rolling measure increasing from 3.3% of GDP in 2Q16 to 3.4% of GDP in 3Q16 and now covers almost the entire current account deficit. The current account deficit narrows % of GDP Source: BCRP, Itaú We note that the improvement in the current account deficit came in spite of a deterioration in the fiscal balance. The fiscal deficit widened to 3.4% of GDP in the year ended in 3Q16 (from 3.1% in 2Q16). Notably, the growth of public expenditures (3.9% year over year in 3Q16) continues outstripping the growth of tax revenues (down by 0.7% in 3Q16). The latter is mainly a consequence of lower commodity revenues and weak domestic demand. Both gross public debt (22.7% of GDP in 3Q16, 22.2% in 2Q16) and net public Current account seasonally-adjusted Current account / GDP (rolling 4-quarter) -6 3Q08 3Q09 3Q10 3Q11 3Q12 3Q13 3Q14 3Q15 3Q16 debt (6.3% of GDP in 3Q16, 5.6% in 2Q16) increased a bit. Nevertheless, the government has recently shown signs of commitment to fiscal discipline. As mentioned above, the Finance Ministry passed a decree to reduce central government expenditures in an attempt to bring the fiscal deficit down to 3% of GDP for 2016 (nominal target). Against this backdrop, our forecasts remain unchanged: we foresee fiscal deficits of 3.1% of GDP and 2.6% of GDP for 2016 and 2017, respectively. Next year, a number of important tax cuts (mainly the lowering of the VAT from 18% to 17%) will take effect, but we believe that the pickup in economic activity and higher metal prices will bolster tax revenues. Moreover, the tax amnesty for undeclared assets (à la Chile, Argentina and Brazil), that will enter into force in 2017, could provide significant revenues. Inflation would end above the central bank s target range in Headline Inflation decreased a bit in November (to 3.4% year over year), but it will likely end the year above the central bank s target range (1%-3%). In November, a number of unanticipated one-off effects exerted upward pressure on inflation, namely an increase in regulated electricity tariffs, a spike in interprovincial bus fares (directly related to the three extra holidays because of the APEC meetings) and a higher excise tax on gasoline & diesel. Moreover, recent drought conditions along the Peruvian coast will likely affect food inflation in December. Therefore, we have increased our inflation forecast for 2016 (to 3.2%, from 3%). Our forecast for 2017 is unchanged, at 2.7%. We believe that a favorable base effect will drive down headline inflation in December Moreover, better-behaved food inflation (without the El Niño shock) and a pretty stable exchange rate will likely keep inflation in check over the next quarters. The evolution of inflation expectations will also help, as they now stand within the target range for all surveyed years (2016, 2017 and 2018). The Trump shock wiped out the exchange-rate appreciation seen in the first ten months of 2016, in spite of higher copper prices. The PEN is now trading around the same level as it did at the end of last year. Since the materialization of the Trump shock, the central bank has stepped in to moderate PEN volatility by issuing USD 425 million in FX swaps and USD 116 million in dollar-linked certificates of deposit. Our exchange rate forecasts for 2016 and 2017 remain unchanged, at 3.40 and 3.45, respectively. Rising Page 27

28 treasury yields exert depreciation pressure, but the increase in metal prices provides some relief. Our call on Peru s monetary policy is unchanged: we expect the central bank to move entirely to a neutral stance and maintain the reference rate at 4.25% throughout 2016 and The central bank still has a tightening bias, but rate hikes are unlikely, given our expectation for inflation. On the other hand, the prospects of rate cuts in 2017 (if domestic demand fails to pick-up, not our base case) are constrained by higher interest rates in the U.S., in a partially dollarized economy. News on structural reforms The government enacted the first set of legislative decrees to boost private investment. These legislative decrees are part of the economics and formalization pillar of the structural reform agenda and are being enacted into laws under the framework of the 90-day fast-track authority that Congress granted President Kuczynski in late September. The main measures include: the decentralization of the National Investment Promotion Agency (Proinversión), with an eye on capacity-building at the regional and local government levels; the broadening of the Public Works in Lieu of Taxes mechanism, a facility that allows firms to pay taxes by investing in infrastructure; the streamlining of public private partnerships (PPPs), to speed them up; and the demise the National System of Public Investment (SNIP), which has been often pinpointed as a cause for delay in public investment. The emphasis is on deregulation. Notably, the cited legislative decrees are aimed at boosting private investment in the short run. Nevertheless, the trade-off is that they could also backfire by reducing the quality of investment projects and creating unanticipated fiscal costs down the road. Forecast: Peru F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 5,031 5,691 6,325 6,525 6,456 6,020 5,995 6,221 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, INEI, BCRP, Itaú Page 28

29 Colombia A second chance for peace The updated peace deal was ratified by congress. The process to disarm the rebels now begins and the tax-reform debate has kicked off as the behind-the-scenes negotiations concluded. Activity was disappointing in 3Q16 due to the weaker consumption caused by the lagged effects of monetary tightening and high inflation. Investment remains a drag in the midst of a low oil price environment. The supply shocks that helped drive inflation to record highs are unwinding at a faster-than-expected pace, which alongside weak activity will support the beginning of a monetary easing cycle. The central bank is divided on the timing of rate cuts, with some board members already voting for lower rates. A second chance for peace With peace, come taxes In a positive development for the peace process in Colombia, the government and the FARC announced a revised peace agreement following the plebiscite in which the Colombian population rejected the deal forged after six years of negotiation. For 41 days following the upset vote in early October, the government brought proposals from different social activists to the negotiating table with the FARC. This time around, while the negotiations remained restricted to the administration and the rebel group, the government kept the opposition (led by former president Uribe) informed of the advances to ensure that their opinion was being actively considered in the discussions. The FARC and the government agreed to modify 56 of the 57-point agenda. The Colombian congress gave the green light for the new peace deal. Mr. Uribe deemed that the concessions made to be insufficient and requested a public ratification of the new deal. However, authorities opted for a vote in congress, given that the law does not require that the deal be publicly ratified. The agreement was approved with 75 votes in the senate and 130 votes in the lower house and no votes against the deal in either chamber, as former president Uribe s Democratic Center party-led opposition abstained from voting. The Supreme Court must now decide whether to grant fasttrack authority to the legislation related to the agreement so that it can be swiftly discussed and voted on in congress during 1H17. Following this process, authorities hope to see most FARC members relocated to the pre-defined transition zones as the final demobilization and disarmament begins. A favorable vote is a political gain for the administration. Congress is debating the structural tax reform. The bill aims to offset the loss of oil revenues and defend the country s BBB credit rating. The administration is pushing for the bill to be approved before yearend in a process that will require a simple majority in both chambers of Congress. President Juan Manuel Santos has convoked extraordinary sessions to discuss the bill. The tax reform presented to congress is a modified version from the initial proposal announced in October. The proposed increase of sales tax rate to 19% in 2017, from 16%, remains. This has been the most controversial proposal, with some politicians vying for a gradual or lower increase at a time when consumers have been hit hard by high inflation and interest rates. Overall, the increase will likely have a one-off impact on consumer price inflation next year. Meanwhile, the originally proposed tax on sugary beverages was eliminated from the latest version of the bill. Our calculations indicate the impact on inflation could be between 0.4 and 0.6 percentage points in 2017 if the bill is approved in the proposed form. The income tax structure is set to change. The increase in the minimum threshold for personal income tax originally proposed is no longer part of the reform. The concessions made on the personal income tax front have led to a less aggressive adjustment to corporate income tax rates. The tax rate will be 33% in 2018 (currently between 34% and 40%, with the top rate previously expected to reach 43% in 2018), one percentage point above that proposed in the initial project. The amended bill does not contain any changes to tax on foreign bondholders profits. Finance minister Mauricio Cardenas has said he favored a tax reduction to the rate of its peers in the region. However, this Page 29

30 seems to be beyond the scope of this discussion. Meanwhile, the revised bill cuts proposed tax on foreigners dividends to 5%, from initial proposal of 10%. We still expect the government to pass a tax reform before yearend. However, it is possible that the reform in its current structure is watered down during the discussion process in Congress. Further changes could affect the additional revenue for next year and would likely heighten risks of a downgrade to Colombia s sovereign credit rating. Negative activity surprise The slowdown of the Colombian economy continues. Activity gained 1.2% YoY in 3Q16, down from 2.0% in 2Q16 and 3.1% in This is the weakest GDP growth since the 1.1% reported in 1Q09, when the economy was hit by the global financial crisis. The weakness is partly attributable to the negative impact of the truck strike at the start of the quarter, but investment remains a notable drag. Natural resource sectors continue to shrink. The weak performance is mainly due to the double-digit decline in oil production as the negative environment for the hydrocarbon sector persists, but was partly offset by improved coal production. Despite of the end of the El Niño weather phenomenon, the agriculture sector remains weak. Overall activity in the natural resource sectors dropped 4.0% YoY (from -3.8% previously). Meanwhile, growth in the non-natural resource sectors (more linked to demand conditions) also slowed down, to 2.0% from 2.9% in 2Q16. Activity was boosted by the 30.3% increase in oil refining (+28.8% in 2Q16), which continues to benefit from the rising production at the expanded Cartagena refinery and is likely to remain a prominent activity driver through 1Q17. There was nevertheless a broad-based weakening in manufacturing, likely related to the truck strike, leading to growth of 2.0% (from 5.6% previously). Overall, the non-natural resource sectors (excluding oil refining) slowed to 1.5% YoY, from 2.5% in the previous quarter. The demand-side breakdown shows that monetary tightening and still-high inflation has led to weaker consumption. Private consumption increased 1.2% YoY (vs. 2.5% in 2Q16) the lowest annual private consumption gain since the 0.8% registered in 4Q09. Public consumption growth remained low at 1.2% YoY (vs. 1.6% in 2Q16) amid fiscal consolidation efforts. As a result, total consumption growth moderated to 1.3%, from 2.3% in 2Q16 and 3.9% in Investment remains the main drag on activity. Gross fixed investment posted a 3.4% decline (vs. -1.9% in 2Q16) due to weak investment in machinery and transport equipment. On the flipside, construction investment grew 11.3% (up from 2.7% in the previous quarter), but favored by a low comparison base (the only quarter since the start of 2014 to register a YoY contraction). Investment has declined in every quarter of the year, an event last seen during the global financial crisis. Final domestic demand was flat from one year ago (+1.2% in 2Q16). The contribution from net exports was favorable, following a drop of 8.4% in imports (from -1.4% previously) and 1.1% in exports (+1.0% in 2Q16). Investment continues to shrink %, yoy %, yoy GDP Gross Fixed Investment (RHS) Private Consumption -2-6 Sep-08 Sep-10 Sep-12 Sep-14 Sep-16 Source: DANE, Itaú Looking ahead, deteriorating business confidence and a loosening labor market pose risks to economic recovery. The national unemployment rate came in at 8.6% in the quarter ending in October (from 8.7% one year before). However, the unemployment rate is not fully reflecting the deteriorating labor market. For the seventh consecutive month, the participation of the national labor market was below that of the corresponding period of last year. The 1.0% YoY employment expansion was concentrated in lower quality jobs Page 30

31 Self-employment keeps job growth afloat %, 3mma yoy & contributions Source: DANE, Itaú Private waged-employment Public waged-employment Rest Total Self-employment -1.5 Feb-14 Oct-14 Jun-15 Feb-16 Oct-16 We now expect GDP growth of 1.8% this year (vs. 2.0% previously), from 3.1% in The tight monetary and fiscal policies and lower investments in the oil sector have led to reduced internal demand. We still expect growth to pick up to 2.5% next year on higher oil prices and the 4G PPP investment, but the downside risks persist (partly due to the effect of the tax reform on consumption). Improved trade balance in 3Q16 The trade deficit continued to narrow in the third quarter of the year. The trade deficit came in at USD 3.1 billion in the 3Q16 (down from a USD 4.6 billion deficit one year before), resulting in a sustained narrowing of the 12-month rolling trade deficit to USD 13.9 billion from USD 15.9 billion in The improvement is attributable to the stabilization of the energy surplus, while the non-energy balance deficit continues to shrink. At the margin, the reduction of the trade deficit is also unfolding. The annualized trade deficit (using our seasonal adjustment) reached USD 11.2 billion in the quarter, down from the USD 12.6 billion deficit estimated for 2Q16. We expect the current account deficit to narrow to 4.7% of GDP this year, from 6.4% in A further narrowing next year, to a 3.9% deficit, is also likely on higher average oil prices (although falling oil production is a risk) and still-weak internal demand. We see the Colombian peso at 3,070 to the dollar by the end of this year, given that the OPEC production agreement supports current crude price levels. For next year, we see some weakening to 3,225 by the end of 2017 as the interest rate differential with the U.S. narrows. Inflation still on a downward trend Inflation continues to recede to the central bank s stated target of 4% in Annual inflation decelerated to 6.0% in November (6.5% in the previous month), the lowest reading since October Food price inflation (7.5% vs. 8.5% in October) is still the principal contributor to the still high headline print (2.5 percentage points to the headline inflation). While exchange rate stabilization has led to a moderation in tradable inflation (excluding food and regulated prices) to 5.7% (6.5% previously). Meanwhile, non-tradable inflation remains sticky as indexation mechanisms keep prices elevated (4.8%). Inflation excluding food prices was 5.3%, below the 5.6% recorded in October. According to our diffusion index, inflationary pressures continue to moderate. Inflation recedes %, yoy % Source: Dane, Itaú Headline Food CPI ex food Diffusion index (RHS)* *Diffusion Index (Price changes above 3% minus price changes below 3%) As supply-side shocks caused by the El Niño weather phenomenon and previous depreciation of the currency unwind, the disinflationary process will continue. The weakening activity will also help. We see inflation at 5.6% by yearend (6.8% in 2015). However, we acknowledge that the approval of the tax reform would likely lead to higher inflation than we currently forecast (4%) for Page 31

32 A board divided Colombia s central bank board voted to remain on hold at the November monetary policy meeting. This is the fourth consecutive month that the board has kept the policy rate unchanged at 7.75%, after carrying out an extensive 325-bp tightening cycle. However, it is the first time since the end of the tightening cycle that some board members (2 out of 7) opted for a rate cut. We see the division among the board as evidence of a move toward adopting an easing bias and eventually embarking on a loosening cycle. We expect an easing cycle next year as demandside pressures wane and disinflation continues. We expect the central bank to lower the policy rate to 6.0% from the current 7.75%. However, we do not expect rate cuts until the minimum wage adjustments and implications of fiscal reform have been clarified. Regarding the latter, the central bank is focused on the inflationary impact of not approving the bill (through a weaker currency) rather than on the short-term inflationary impact of higher consumption taxes. Colombia s central bank board will choose a replacement for Jose Dario Uribe on December 12. The new chief s four-year term will start in January. The likely candidates are a mix of current and former central bankers and other well-respected economists, which should result in a seamless transition. Forecast: Colombia F 2017F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 6,311 7,287 7,939 8,065 7,940 6,069 5,735 5,881 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 3,070 3,225 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 32

33 Commodities OPEC reaches a deal Coordinated action by the cartel will likely balance the oil market as early as January With falling inventories and rising prices, the response by U.S. shale producers will be the main driver acting against further oil price increases. We expect metal prices to decline in 2017 as China s property sector cools off and marginal producers react to high prices. Nonetheless, prices will likely remain above their recent lows, benefitting the largest global producers. Agricultural commodity prices have fallen since late October due to the strengthening U.S. dollar and favorable weather conditions. Sugar and coffee prices have dropped more sharply due to their higher correlation with the BRL and because of an excess of long positions by hedge funds. The Itaú Commodity Index (ICI) has gained 7% since the end of October, led by metals (+15%) and oil (ICI- Energy: +11%). The agriculture component, meanwhile, has fallen by 2%. Overall, commodity prices are still rising balance the market in January, when it is due to become effective. Global inventories should start to decrease from then on. We maintain our YE17 Brent price estimate at USD 54/bbl, a level that would allow an additional response by U.S. producers to partly offset the cartel s action Itaú Commodities Index (Jan = 100) ICI ICI Agricultural ICI Energy ICI Metals 2017: Decline in metal prices; stability for oil and agricultural commodities Itaú Commodity Index* (2010=100) Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Previous Current Source: Itaú. Our YE17 forecasts are unchanged. We expect the ICI to stabilize at current levels until YE16 and then slide downward gradually over the course of 2017, losing about 2% as metal prices decline note, however, that on average the ICI is expected to be 11% higher than in 2016 throughout the year Oil: OPEC cut balances the market. Crude prices climbed after OPEC announced an agreement to cut output by 1.2 mbd, the lower bound of the range of cuts suggested at a recent informal meeting. The cartel expects non-members to complement their effort with a 0.6 mbd cut, although Russia is the only viable source of such a cut (-0.3 mbd). Regardless of the reaction of other countries, the cartel s cut will likely be enough to 45 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Source: Itaú. Agriculture: Strong dollar and favorable weather prompt price drops. Weather conditions remain favorable for growing crops in the Southern Hemisphere. Sugar and coffee prices have fallen by 9% and 15%, respectively, since the end of October. The underperformance was caused by these commodities greater correlation with the BRL, as well as an excess of long positions held by hedge funds until mid-november. In our view, prices for these two commodities will rebound as the global deficit again becomes the main driver following the adjustment of technical positions. Page 33

34 Metals: Some drivers of the rally will dissipate in Metal prices rose sharply in 2016 (see chart) due to stronger demand (particularly in China), higher inventories and greater discipline among producers. We foresee falling prices in 2017, due to both demand- and supply-related factors. The Chinese property market has been the main driver of demand gains in 2016, but regulatory tightening will likely lead to a slowdown in As for supply, a stronger dollar and higher prices will likely prompt a reaction by marginal producers. Nevertheless, we expect prices to remain higher than their recent lows, benefiting the economies of the largest global producers. Metals and energy: sharp gains in 2016 Oil: Sharp gains after OPEC announced a formal agreement Prices correspond to the Brent ICE Futures first future contract Cocoa Wheat Corn ICI Agricultural Cotton Aluminum Coffee Soybeans Copper Sugar Nickel Tin WTI ICI Metals Lead Natural Gas ICI Energy Brent Zinc Iron -25% -14% -3% ytd, up to 12/02/16 3% 12% 14% 15% 18% 23% 25% 27% 29% 38% 42% 45% 46% 46% 46% Agricultural Energy Metals 70% 71% 25 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Source: Itaú and Bloomberg. OPEC s cut was larger than anticipated and will likely be enough to balance the global market. OPEC members agreed to reduce their combined output to 32.5 mbd (from 33.7 mbd currently), with specific quotas for most members. The cut would reduce production to the lower bound of the range suggested at their informal meeting in Algiers. The reduction of 1.2 mbd from October levels will be implemented starting in January and will likely be enough to end the oversupply in the global balance. Source: Itaú and Bloomberg. Oil: OPEC cut balances the market Brent prices have risen to USD 55/bbl from a low of USD 44/bbl in November. The increase in prices was a reaction to the agreement announced by OPEC on November 30. OPEC agrees on sharp production decline 34.5 mb / d OPEC monthly production Production limit after deal 29.0 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Source: Itaú and Bloomberg. Page 34

35 The cartel also announced that non-members had agreed to cut an additional 0.6 mbd, although Russia is the only viable source of such a cut (-0.3 mbd, 50% of what is needed) and the extra amount agreed upon is not necessary to balance the market. In our view, only some help from Russia is priced in. We maintain our YE17 Brent forecast of USD 54/bbl (WTI: USD 52/bbl), a level that would allow an additional response by U.S. producers to partly offset the measures taken by the cartel. In the short term, we see a neutral bias, with a balance between downside (non-compliance) and upside (non-members joining the cartel; delayed reaction by U.S. producers) risks. Deregulation in the oil industry after a new administration takes over in the U.S. may expand supply in the medium term. This potential is a downside risk for prices and should be monitored. Grains/soybeans: Mixed performance in November Source: Itaú and Bloomberg. Corn ( Mar-17) Wheat (Mar-17) Soybean (Mar -17) (rhs.) Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 OPEC agreement will lead to lower inventories in 1Q mb / d Supply Demand Global balance (rhs.) Corn and soybean export sales in the U.S. remain strong. Total contracted amounts for the crop are higher than in past years and apparently support a bottom for prices. We expect international prices for these three commodities to remain at current levels until yearend. Our YE17 forecasts are: 92 0 Corn: USD 3.6/bushel Soybeans: USD 10/bushel 90-1 Wheat: USD 4.7/bushel Mar-11 Jun-12 Sep-13 Dec-14 Mar-16 Jun-17 Source: Itaú and Bloomberg. mb / d Grains: Favorable weather and strong demand Corn, soybean and wheat prices have had mixed performance since late October (stable, +4% and -4%, respectively). Favorable weather (both for harvesting in the U.S. and planting in Latin America) and a strong dollar continue to put downward pressure on prices, but that pressure is being offset by robust demand indicators (U.S. export sales) Our scenario assumes that La Niña will last until the end of 1Q17 and will be followed by neutral weather. Hence, La Niña may affect the current crop in the Southern Hemisphere but will end before it can affect the next crop in the Northern Hemisphere or the winter corn crop in Brazil. The planting of the summer crop in the Southern Hemisphere took place under favorable weather conditions, sustaining market expectations of increased production of soybeans (Brazil) and corn (Brazil and Argentina). Page 35

36 Sugar/coffee: Prices likely to remain high in 2017 International contracts for raw sugar and coffee have fallen by more than 9% since late October, underperforming other agricultural commodities. Sugar prices have plummeted 9%, to USD /lb, and coffee prices have dropped by 15%, to USD 1.42/lb. Average prices for other commodities were flat over this period. Sugar: Prices fall with unwinding of long positions Thousand contracts (futures and options) Technical position (Hedge Funds) Price (rhs.) USD cents / lb two commodities and the BRL and of an excess of long positions held by hedge funds until mid-november. In our view, prices for both commodities will rebound as the global deficit comes back into focus following the adjustment in technical positions. We expect sugar prices to average USD 0.215/lb in We expect a deficit of 3.6 million tons in the crop year (after a deficit of 10 million in ), followed by two consecutive years of surpluses that lead to lower prices in Our YE17 price forecast for coffee stands at USD 1.70/lb. Coffee: Prices fall with unwinding of long positions Thousand contracts (futures and options) Technical position (Hedge Funds) Price (rhs.) Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Source: Itaú and Bloomberg. The underperformance of sugar and coffee is a consequence of the greater correlation between these USD cents / lb -35 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-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 ** yoy - % avg growth - % Source: Bloomberg Itaú. * 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 36

37 Macro Research Itaú Mario Mesquita 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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