Broad global economic growth, moderate inflation and cautious central banks support low volatility, risky asset prices and EM inflows.

Transcription

1 Latam Macro Monthly Scenario Review January 18 Global Economy Goldilocks scenario continues 3 Broad global economic growth, moderate inflation and cautious central banks support low volatility, risky asset prices and EM inflows. LatAm Growth to improve further in With the still-favorable external environment, growth in Latin America is improving and a pick-up is expected in most countries we cover, with the exception of Mexico. Brazil A better fiscal reading, for now 9 We revised our estimate for the primary budget deficit in 2017 to 1.9% of GDP from 2.3%, but the structural fiscal rebalancing still depends on reforms. Argentina A monetary policy U-turn 14 The government has announced higher inflation targets for 2018 and While the new targets seem more credible than the previous ones, the decision to increase them will likely make disinflation even harder to achieve, as inflation expectations will likely rise further. Mexico Resuming the tightening cycle 18 Banxico resumed the tightening cycle in December and another rate hike in February is likely. We expect the policy rate to peak at 7.5%. We forecast GDP growth of 2.1% for both 2017 and 2018 down from 2.9% in 2016 and a moderate acceleration to 2.4% in Chile Turning the page 22 Former president Sebastian Piñera will return to La Moneda in March with the promise of returning Chile to a path of sustainable growth, while fine-tuning some of Michelle Bachelet s key reforms. Higher copper prices strengthened the CLP and help boost growth to 3.0% this year and 3.5% next year. Peru Political crisis poses negative growth risk 26 We revised our GDP growth forecasts down to 4% from 4.2% for 2018, as a consequence of the political crisis, which we believe will curb investment growth. Low inflation, coupled with the downside risk for growth, will likely push the central bank to cut rates further. Colombia More monetary easing ahead 30 Disappointing activity figures and the weak labor market underscore risks to the expected recovery and will likely lead the central bank to resume its easing cycle. We see a terminal policy rate of 4.0%, before 2H18. Commodities Higher oil prices in Given the recent decline in inventories, we have revised our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent. 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 Strong growth and still low inflation in 2018 Easy monetary conditions in developed markets (DM), lower political risks in Europe and a soft landing in China are supporting a more synchronized global recovery. We expect global GDP growth at 3.8% in 2018, the same as in 2017, with just a modest slowdown to 3.6% in As growth remains above potential in developed countries, the output gap will turn positive gradually, pushing inflation up, particularly in the U.S., but we see little risks of inflation overshooting central banks targets this year. More broadly, DM central banks will use the global recovery to assure inflation converges to 2% (or a bit above it) and hence remove monetary accommodation in a very gradual fashion. An adjustment to the monetary policy framework is an increasingly plausible move in the U.S. Emerging countries other than China are just starting to recover and should accelerate to 4.2% from 3.7%. LatAm growth, in particular, may speed up to 2.5% in 2018 from 1.2% in 2017, spurred by the lagged effects of monetary policy. Also, the external environment for Latin America remains favorable, supporting export prices, sovereign risk and exchange rates. We expect a growth pickup in 2018 in most LatAm countries within our coverage, with the exception of Mexico. Helped by negative output gaps and exchange-rate strengthening, most countries are facing low (or falling) inflation, allowing for further interest rate cuts. However, in Mexico where inflation has surprised to the upside the central bank resumed interest rate hikes. Inflation in Argentina is also high, but the government set higher targets for inflation, leading the central bank to cut interest rates modestly. In Brazil, the recovery in activity continues, while the inflation outlook remains benign: our growth forecasts are 3.0% in 2018 and 3.7% in 2019, while for inflation we estimate 3.8% this year and 4.0% in We expect a 25bp-cut in the benchmark Selic interest rate in February and another 25bp-cut in March, ending the monetary easing cycle at 6.5% p.a. The Brazilian currency tends to depreciate somewhat: we forecast 3.50 reais per U.S. dollar by YE18 and 3.60 by YE19. We revised our estimate for the primary budget deficit in 2017 to -1.9% of GDP from -2.3%, but the structural fiscal rebalancing still depends on reforms. Hope you enjoy, Mario Mesquita and Macro Team Scenario Review World Latin America and Caribbean Current Last month Current Last month Current Current Last month Current Last month Current GDP - % GDP - % Brazil Mexico Current Last month Current Last month Current Current Last month Current Last month Current 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 Current Last month Current Last month Current GDP - % GDP - % ARS / USD eop CLP / USD eop BADLAR - eop - % Monetary Policy Rate - eop - % day Repo rate - eop - % CPI - % CPI - % Colombia Peru Current Last month Current Last month Current Current Last month Current Last month Current GDP - % GDP - % COP / USD eop PEN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % CPI - % CPI - % Page 2

3 1q95 1q97 1q99 1q01 1q03 1q05 1q07 1q09 1q11 1q13 1q15 1q17 1q19 Latam Macro Monthly January 12, 2018 Global Economy Goldilocks scenario continues Global growth to remain at 3.8% in Growth in developed countries should remain a bit above 2.0%. A modest slowing in China, to 6.3% (from 6.8%), is a soft landing. Beyond China, EM growth will broaden and accelerate to 4.2% (from 3.7%). As growth remains above potential in developed countries, the output gap will turn positive, gradually pushing inflation up, particularly in the U.S., but we see little risk of inflation overshooting central banks targets this year. DM central banks will use the global recovery to assure inflation converges to 2% (or a bit above it) and hence remove monetary accommodation in a very gradual fashion. An adjustment to the monetary policy framework is an increasingly plausible move in the U.S. Broad global economic growth, moderate inflation and cautious central banks support low volatility, high-risk asset prices and EM inflows. With risk appetite still quite keen, central banks may eventually feel compelled to deploy macroprudential measures to mitigate systemic risks. Goldilocks effect from broader global growth and moderate inflation Easy monetary conditions in DM, lower political risks in Europe and a soft landing in China are supporting a more synchronized global recovery. We expect GDP at 3.8% in 2018, the same as in 2017, with just a modest slowdown to 3.6% in Growth is becoming more widespread amid emerging economies. China will see a modest slowdown in 2018, while other emerging markets are just starting to recover and should accelerate to 4.2% from 3.7%. LatAm growth, in particular, may speed up to 2.5% in 2018 from 1.2% in 2017, spurred by the lagged effects of monetary policy. The risk of DM inflation overshooting the targets remains low and asymmetric, so DM central banks can and should remain very cautious in reducing monetary accommodation. After a decade of low inflation, long-term inflation expectations are somewhat below most DM inflation targets. The output gaps are just turning positive in 2018, and they are unlikely to put much pressure on inflation. And, even if inflation does rise a bit faster than expected, central banks can better control higher than lower inflation in a low- to neutral-rate environment (see U.S. discussion). All this means a benign U.S. economic outlook for risk assets. In our econometric model, given the positive growth, moderate private leverage and easy Fed policy, the VIX should remain low and rise only gradually in the next couple of years (see chart). Market volatility is likely to continue at low levels contribution in pp Private levverage Economic growth Monetary policy VIX (rhs) Error Source: Bloomberg, Itaú 30-day option implied volatility This environment fosters risk-taking, with asset price valuations reaching successive new highs. This is most clear in credit markets where spreads are at record low levels (see chart). Equity prices have risen significantly last year with price-to-earnings reaching above average levels, but not as expensive. OECD house prices have been recovering from the financial crisis, but on average house-prices-to-income do not look expensive, except in a few countries, like Canada, Australia and Sweden. In this context, central banks may feel compelled to deploy, or at the very least to study deploying, macroprudential regulations aimed at mitigating systemic risks Page 3

4 HP/Income in AUS, CAD & SEK CDS Global* CDS EM* VIX* EUR Inv. Grade Credit * US High Yield Credit* US Inv Grade Spread* EUR High Yield Credit* EM Stock P/E S&P500 P/E Oil (real price) Eurostoxx P/E EZ Periphery Credit Ibovespa P/E Nasdaq P/E OECD HP/Income US HP/Income Latam Macro Monthly January 12, 2018 Asset prices becoming expensive, especially in the credit space U.S. A cautious Fed is still warranted in % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% percentile rank for actual values We forecast U.S. GDP growth to accelerate to 2.4% in 2018 from 2.3% in 2017, supported by easy financial conditions and a moderate fiscal impulse. In 2019, growth could slow to a still-healthy 2.1%, as the Fed reduces the monetary stimulus and the output gap becomes positive. Fiscal policy is likely to become a tailwind for private demand. The tax bill approved by Congress should cut taxes by USD 150 billion (0.75% of GDP) in 2018, and government spending is likely to rise by USD 50 billion this year. Hence, we expect a 0.5-pp contribution from fiscal policy to GDP growth. Source: Bloomberg, OECD and Itaú * We multiply these series by -1. In fact, periods of synchronized global growth are usually associated with low volatility (see chart), as it helps alleviate fears of a negative foreign shock to U.S. growth. Periods of synchronized global growth are associated with low volatility Diffusion Index (# countries above 5y growth average, rhs, reversed) VIX (year average) Inflation expected to rise gradually, to 2%. Given the U.S. GDP outlook, we forecast that the unemployment rate will decline to 3.5% by the end of 2019, one percentage point below the estimate of full employment (4.5%). Linear regression estimates a 0.2-pp rise in inflation due to such a positive unemployment gap, but below-target inflation expectations and inertia are likely to keep pushing inflation down by 0.1 pp. In sum, we forecast that core inflation could gradually rise from 1.5% in 2017 to 2.0% in 2018 and to 2.1% in We foresee three 25-bp Fed rate hikes in 2018, with balanced risks in the current inflation target regime. Given the benign inflation outlook and low neutral rates, the Fed can tighten monetary policy gradually. There could, however, be a fourth hike in First, we could see a bigger (non-linear) impact of the unemployment gap on wages and inflation. Second, GDP could grow faster as a result of better global growth (financial conditions) and fiscal stimulus and/or an increase in productivity Source: IMF, Bloomberg, Itaú Only two rate hikes in 2018 are also possible. The unemployment gap may have less impact on inflation and inflation expectations, in which case the Fed may allow the unemployment rate fall further. In addition, there is a real possibility that the new chairman, Jerome Powell, may change the Fed s monetary policy framework. Fed members and U.S. academics are studying: i) Price-level or nominal GDPlevel targeting; and/or ii) raising the inflation target to 3%. The Fed wants to better anchor inflation expectations, as in a low real rates environment, its policy is expected to be more often constrained by a zero interest-rate lower bound. In any event, a change in the Fed s monetary Page 4

5 policy framework along with those being discussed means a promise of looser monetary policy now or in the future. While macroeconomic considerations may suggest an even shallower angle of policy normalization than what is currently priced in, prudential concerns might argue otherwise. Given that one policy instrument should not seek two alternative goals, this disconnect means that the moment when macroprudential measures start to be discussed may not be too far off. Anyhow, the impact of modestly higher U.S. interest rates on financial conditions should remain contained by better-synchronized global growth and the tax cut. Better global growth means other DM central banks are likely to follow the Fed s footsteps, leaving interest-rate differentials nearly unchanged and the USD stable. Recent tax cuts offset the deterioration of the private balance sheets from higher interest rates. We expect the UST 10-year yield to rise by 50 bps, to 2.9%, by YE18, which is 30 bps more than the U.S. Treasury forward yield curve. Europe Good growth, low inflationary and political risks We expect Eurozone GDP to expand 2.1% in 2018 and 2019, after an estimated 2.3% in Easy monetary policy, easier fiscal policies, tentative signs of structural reforms and a reduction in political risk are boosting the region s growth. Current economic indicators, like the PMIs, even indicate a small upward risk to this economic forecast. With a better economic outlook, the ECB will likely end its asset purchases in 2018 but raise interest rates only in We think that better growth will justify the end of QE. However, a more sustained rise in inflation (core inflation currently at 0.9%) will be required before the central bank raises interest rates. Political risks seem relatively low. EU-UK Brexit negotiations could see progress this year. Italy s election could present some significant downside risk, but this is unlikely to lead to a euro breakup, while a pro-european Grand Coalition in Germany could even give a push to Macron s agenda in France, which is positive for the EU. Japan BoJ to avoid a decline in 10-year real rates Japan s GDP is forecast to grow 1.4% in 2018, after 1.8% in 2017, spurred by easy financial conditions and healthy global growth. The unemployment rate is likely to decline to 2.5% by 4Q18 from 2.8% in 4Q17, pushing up wages and the core CPI (ex-food & energy) to 1.0% in 4Q18, from 0.2% in 4Q17. We believe that the BoJ will raise its 10-year JGB target to 0.2% (from 0.0%) in 2H18 without harming the positive outlook for growth and inflation. The improving inflation outlook may allow the BoJ to modestly adjust its 10-year yield target to keep longterm real yields from falling (currently -0.5%). In addition, the Fed rate hikes and the ECB s QE end should maintain interest rate differentials, leaving the JPY broadly stable. China Soft-landing is manageable Economic activity in China has been slowing down gradually. In November, industrial production fell by 0.1 pp, to 6.1% yoy, while year-to-date fixed investment came in at 7.2% yoy and retail sales growth accelerated to 10.2% yoy. Regarding property data, both sales and new construction showed some recovery during the month. For December, the manufacturing PMI softened slightly, to 51.6 from 51.8, but this level is still consistent with steady growth at the end of We maintained growth forecasts at 6.8% for 2017 and at 6.3% for For 2019, we expect growth to moderate further, to 5.9%. China s government can likely manage a soft landing. The credit-to-gdp ratio remains high but has started to stabilize with more rigid financial regulations on alternative credit products. Also, the government is managing a gradual reduction in state-owned enterprise (SOE) debt, which is the main problem. The low level of public debt allows some degree of freedom for the government to manage the SOE debt over time. Private demand has been increasingly driven by consumption, and the outlook for investment has also improved, with housing inventories better balanced and exports turning into a tailwind. And, if needed, the PBoC could loosen monetary policy, given that CPI inflation remains at 2%, one percent below its target. Page 5

6 Commodities Higher oil prices in 2018 The Itaú Commodity Index (ICI) has risen by 5.0% since the end of November agriculture (2.3%), metals (7.1%) and energy (5.4%) as global economic activity keeps up the strong pace. Higher oil prices forecast for WTI prices rose 8%, to USD 61/bbl last month, due to larger-thanexpected decline in U.S. inventories and renewed geopolitical risks. We estimate that oil prices in the range of USD 45-55/bbl can stabilize the U.S. rig investment and help to balance the supply and demand this year. Given the recent decline in inventories, we have moved our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent, the higher end of this range. Fine-tuning our forecast for metal prices. Metal prices continued to rally in December, but we still see a correction ahead as the Chinese economy slows a bit. We raised our year-end estimates for copper prices to a modest USD 6,500/mt (USD 6,200/mt previously) and for iron ore prices to USD 60/mt (USD 58/mt previously). For agricultural prices, there are no major changes in our scenario, despite the risks associated with La Niña. For sugar, we increased our year-end 2018 price forecast to USD 0.152/lb from USD 0.144/lb due to the adjustment in oil prices. Forecasts: World Economy F 2018F 2019F 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 6

7 LatAm Growth set to improve in 2018 The external environment for Latin America remains favorable, supporting export prices, sovereign risk and exchange rates. Growth is improving in most countries within our coverage, and a pickup is expected in 2018, with the exception of Mexico. Helped by negative output gaps and exchange-rate strengthening, most countries are facing low (or falling) inflation, allowing for further interest rate cuts. However, in Mexico where inflation has surprised to the upside the central bank resumed interest rate hikes. Inflation in Argentina is also high, but the government set higher targets for inflation, leading the central bank to cut interest rates modestly. A benign external environment, including strong global growth, low interest rates in developed markets, the perception of lower political risks in Europe and a soft landing in China, continues to benefit LatAm asset prices. Prices of important commodities for the region (such as copper and oil) increased further. The sovereign risk, measured by the CDS, recently reached multi-year lows. Currencies strengthened against the dollar in the first days of 2018 (although in some cases this only offset the depreciation observed at the end of December). The Argentine peso has been an exception and has weakened in recent weeks: this is partly due to uncertainty over monetary policy and partly because the current account deficit is reaching uncomfortable levels (suggesting currency overvaluation). Still, some depreciation ahead is likely, as the Fed increases interest rates and China s economy gradually slows (pulling commodity prices down). In 2018, we expect growth to improve in almost every country within our coverage. The only exception is Mexico, where we expect the economy to expand at the same 2.1% pace as we estimate for In any case, Mexico would still grow around trend, supported by a dynamic U.S. economy and a solid domestic labor market. On the other hand, risks related to presidential elections and trade policies in the U.S. will continue to hold investment back. Argentina s economic recovery lost momentum in early 4Q17, but we see this as temporary. Besides the favorable environment for emerging markets, the solid victory obtained by the ruling coalition in the midterm elections (and the fast approval of economic reforms) will likely boost confidence and investment, leading to an economic expansion of 3.5% this year (from an estimated 2.9% in 2017). In Brazil, output will likely remain stable between 3Q17 and 4Q17, but still consistent with 1.0% gain in 2017 (far better than the 3.0% contraction observed the previous year). We expect the economy to grow by 3.0% this year, helped by monetary stimulus. A key anchor for our forecasts for Brazil is the perception that Congress will resume fiscal reforms after presidential elections. In Chile, higher copper prices and a favorable outcome of elections will likely support confidence and investment, boosting an economic recovery that has been incipient so far. We now expect Chile s economy to expand by 3.0% this year. Higher copper prices are also favorable for Peru (actually, mining investment is already rebounding there), but a severe political crisis almost led to the impeachment of the president and will likely curb the recovery somewhat (we reduced our forecast for this year from 4.2% to 4.0%). Unlike other countries in the Andean region, in Colombia there is still no sign of economic improvement. In our view this is partly a result of the lagged effects of monetary policy, which only recently was moved to a neutral stance. In spite of faster growth, output gaps remain negative and the favorable external environment is pulling tradable inflation down. So, the central banks of Brazil, Colombia and Peru will likely ease monetary policy somewhat further. In Brazil, we expect two 25-bp rate cuts, and in Peru we see one additional rate cut. The central bank of Colombia has been data-dependent and paused the easing cycle in December, also to watch how asset prices behave following the sovereign rating downgrade by S&P. Still, given weak growth, exchangerate appreciation and a narrowing current account deficit (an important variable for monetary policy decisions there), we expect the cycle to be resumed soon (we forecast three additional 25-bp rate cuts). Argentina s central bank also reduced its reference rate recently, following an increase of inflation targets by the government. But it cut rates by less than expected (by 75-bps), as the inflation environment is challenging even if measured under the new targets. As (and if) there is progress on disinflation, further easing will likely come, but the upcoming data on inflation and expectations substantially curb the room for monetary easing in the very short term, also considering this is the time of the year when wage adjustments take place. Page 7

8 , Latam Macro Monthly January 12, 2018 Political events will take the spotlight in the region this year. Presidential elections in Brazil, Mexico and Colombia will be important drivers of asset prices. Besides elections, Mexican asset prices will also be heavily influenced by NAFTA renegotiations. In fact, as we highlighted in the Mexico section, our baseline scenario assumes that NAFTA survives and the economic policy framework is left broadly untouched by the incoming administration. If at least one of these assumptions does not hold, a scenario of lower growth, weaker currency, higher inflation and tighter monetary policy is likely. In Peru, the dust of the most recent political crisis is far from settled, so politics can also be a source of volatility. In Chile, the strong showing of antiestablishment candidate Beatriz Sanchez in the presidential race suggests that pressure for more aggressive changes in the pension and education systems will continue, so it will be important to watch how president-elected Sebastian Piñera balances these pressures with budget constraints and his willingness to promote business-friendly reforms. Finally, the political calendar in Argentina is less packed this year, as the most important reforms in the pipeline were already approved by Congress in December. Consequently, the focus of the markets will be on the ability of the government now to meet its fiscal targets. Page 8

9 Latam Macro Monthly January 12, 2018 Brazil A better fiscal reading, for now We revised our estimate for the primary budget deficit in 2017 to 1.9% of GDP from 2.3%, but the structural fiscal rebalancing still depends on reforms. The activity recovery continues: our growth forecasts are 3.0% in 2018 and 3.7% in The Brazilian currency tends to depreciate somewhat: we forecast BRL 3.50 per USD by YE18 and 3.60 by YE19. The inflation scenario remains benign: we estimate 3.8% this year and 4.0% in We expect a 25-bp cut in the benchmark Selic interest rate in February and another 25-bp cut in March, ending the monetary easing cycle at 6.5% p.a. Better primary result in 2017 does not change the challenging fiscal picture We revised our estimate for the primary budget result in 2017 to -1.9% of GDP (or BRL -120 billion) from -2.3% of GDP (or BRL -150 billion), vs. a target of BRL -163 billion (or -2.5% of GDP). The revision was driven by surprises in extraordinary revenues, particularly under tax amnesty program Refis, as well as in results from states and municipal governments. Notwithstanding the reversal of BRL 25 billion in spending freezes announced throughout 2017, the public sector should post a better primary result than both the target and our previous estimate. However, the revision does not mean a permanent improvement in fiscal readings. Large extraordinary revenues in 2017 will not be repeated in 2018, while results from states and municipalities will probably remain relatively stable compared with a year earlier, given the challenging fiscal situation faced by many Brazilian states. For 2018, we maintain our expectation of a deficit of 2.1% of GDP (BRL 150 billion), compared with the target of BRL -161 billion (or -2.3% of GDP). Compliance with this year s target depends on approximately BRL 15 billion (0.2% of GDP) in government measures, which could come from BRL 31 billion (0.45% of GDP) in adjustment proposals that were sent to Congress but were not yet approved, or from a discretionary spending freeze. As spending is fixed exactly at the constitutional spending ceiling, results above these BRL 15 billion in revenues such as better economic growth than assumed in the budget law (our 3.0% call vs. the government s 2.5%) or faster progress in the agenda of asset sales would imply a better reading than the primary deficit target. For 2019, we expect a primary deficit of 1.0% of GDP (BRL 80 billion). Compliance with the spending cap for the year requires an adjustment of approximately BRL 30 billion, which, in our view, will be executed through additional reductions in discretionary spending and the reversal of the payroll tax exemption. Unfavorable debt dynamics: reforms are urgent 75% 70% 65% 60% 55% 50% 45% % of GDP Source: BCB, Itaú General government gross debt Despite the very wide primary deficit and the continuous increase in public debt (see chart above), reflecting the very delicate fiscal situation, uncertainty over approval of the pension reform persists. Congressional debates on the reform are scheduled to resume in late February, after the legislative summer break, but there are doubts as to whether there will be political consensus for approval. Without the reform, the government is less likely to comply with the constitutional spending cap after 2019, jeopardizing the Page 9

10 gradual return to primary budget surpluses that would be compatible with public debt stabilization. Maintenance of the currently unsustainable path of public debt means increasing uncertainty over the consistency of the economic recovery and the sustainability of historically low interest rates. Activity: Gradual recovery continues We reduced our forecast for GDP growth in 4Q17 to 0.0% qoq/sa, down from 0.2% (2.1% yoy). The adjustment incorporates somewhat disappointing data for October. This forecast is below what fundamentals and confidence surveys suggest (back to levels see chart) due to two factors: i) agricultural GDP is still providing a negative contribution, after a strong reading in 1Q17; and ii) persistent weakness in some service components. Nevertheless, our forecast for 2017 GDP growth stands at 1.0%. Confidence back to levels Industry Commerce Services Construction been improving gradually since 2Q16. Importantly, seasonality is also likely to cause net destruction of formal jobs in December, a result that would not affect our assessment of labor market dynamics. According to the national household survey (PNAD Contínua - IBGE), Brazil s nationwide unemployment rate fell to 12.0% in the quarter ended in November from 12.2% in the quarter ended in October. Using our seasonal adjustment, unemployment slid 0.1 pp, to 12.5%. Two details in the report caught our attention: Informal jobs are still the big driver of the unemployment decline on a quarterly basis, but their contribution is now smaller than in 3Q17. Formal jobs in the private sector weakened again, contrasting with CAGED figures. The chart below shows that such decoupling tends to reverse toward CAGED data. Gradual recovery leads to labor market improvement net formal job creation, thousands, 3-month moving average General register of employees (CAGED) National household survey (PNAD contínua) Seasonally adjusted Nov-11 Nov-13 Nov-15 Nov-17 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17 Source: Caged, IBGE (Pnad contínua mensal), Itaú Source: FGV, Itaú We forecast 3.0% GDP growth for 2018 and 3.7% for 2019, but the balance of risks is tilted to the downside. These forecasts assume that the reform agenda will continue going forward. If an interruption or even reversal of this process is anticipated, the recovery in activity will be in jeopardy, particularly if the tapering of global monetary stimulus becomes more intense. The gradual recovery in the labor market continues. In November, 12,300 formal jobs were eliminated in net terms (according to the Ministry of Labor s CAGED registry). However, the seasonally adjusted quarterly moving average rose to 21,000 from 13,000 and has We expect the seasonally-adjusted unemployment rate to decline to 11.8% by YE18 and to 10.9% by YE19, compared with 12.5% in the quarter ended in November. In our view, the decline in unemployment will be increasingly driven by formal jobs rather than informal positions. Thus, unemployment is set to remain higher than its neutral level (which we estimate at 10%, but this may drop further due to the labor reform; see Macro Vision Labor Reform: Potential Impacts), at least until the end of Therefore, we do not anticipate inflationary pressures arising from the labor market during this period. Page 10

11 Latam Macro Monthly January 12, 2018 A weaker currency in the coming years The exchange rate ended 2017 near BRL 3.30 per USD. The external environment was favorable for risky assets during the past year, but domestically, political uncertainties remained high, particularly those related to reform approvals. This week, Standard & Poor's downgraded Brazil's sovereign credit rating from BB to BB- and changed the outlook to stable (from negative). The agency highlighted the difficulties related to the fiscal reform agenda and the perspective of higher political uncertainties throughout Our forecasts for the exchange rate are unchanged, at BRL 3.50 by YE18 and BRL 3.60 by YE19. The increase in interest rates in the U.S. (albeit gradual) and the corollary tightening in financial conditions will reduce global risk appetite, supporting a weaker exchange rate in the coming years. Domestic uncertainties over adjustments and reforms tend to persist, pressuring risk premia. This path for the exchange rate is compatible with a slightly wider current account deficit, but not to the point of compromising external sustainability. There are upside and downside risks to our call. Domestically, the biggest risk is the progress of the reform agenda. If the agenda advances more quickly or more extensively than we anticipate, there may be a swift appreciation of the Brazilian real. On the other hand, a reversal may trigger a depreciating trend. Overseas, the evolution of U.S. inflation tends to determine the number of interest rate hikes (we anticipate three in 2018). Sharp inflation acceleration may require a fourth rate hike, pressuring emerging market currencies, including the real. However, if inflation expectations remain subdued, the Federal Reserve may lift rates only twice in In 2017, the trade balance posted a USD 67 billion 1 surplus, an all-time high in the historical series. Good exports performance, supported by higher commodity prices and strong crops, as well as imports at low levels (despite the year-over-year increase), were behind the largest trade surplus on record. However, the domestic demand recovery and lower commodity prices (on average) will likely produce weaker readings in the next years. December figures already point in that direction. Our forecasts for the trade surplus are USD 55 billion in 2018 and USD 50 billion in As per the Ministry of Trade (MDIC) All-time high trade surplus in billion dollars, year-todate trade balance Source: MDIC, Itaú We maintain our expectation of a gradual increase in the current account deficit in 2018 and 2019, but not to the point of compromising Brazil s external sustainability. Our estimates for the deficit are now USD 31 billion in 2018 (vs. USD 34 billion previously, in a revision triggered by the new timetable for interest expenses published by the central bank) and USD 45 billion in We estimate inflation at 3.8% this year and 4.0% in 2019 Consumer price index IPCA climbed 0.44% in December, ending the year with a 2.95% increase, down substantially from 6.29% in 2016 and also below the lower-bound of the inflation target range (3.0%). Market-set prices rose 1.3% in 2017 (6.6% in 2016), contributing 1.0 pp to the inflation reading (5.0 pp in 2016). Regulated prices advanced 8.0% (5.5% in 2016), contributing 1.9 pp to annual inflation (1.3 pp in 2016). For 2018, our call for the IPCA is unchanged, at 3.8%. Breaking down the estimate, we anticipate advances of 3.5% in market-set prices and 4.8% in regulated prices. Our below-target forecast for inflation this year is driven by: lower inertia from past inflation, anchored expectations and a still-negative output gap. Among market-set prices, we expect prices for food consumed at home to rise 4.5% after falling 4.9% in In addition to a low comparison base, our scenario assumes weather conditions that are less favorable than those seen last year, as well as a weaker exchange rate. For industrial Page 11

12 Centenas Latam Macro Monthly January 12, 2018 prices, we anticipate about 2.6% increase, after an unusually low reading of 1.0% in We expect service inflation to recede again, to 3.6% from 4.5%, largely due to lower inflationary inertia. As for regulated prices, we anticipate moderated price increases for gasoline, bottled cooking gas and electricity, more than offsetting the sharper hike expected for urban bus fares. Our 2019 forecast for the IPCA remains around 4.0%, with market-set prices advancing 3.9% and regulated prices climbing 4.2%. Below-target inflation 12.0% 10.5% 9.0% 7.5% 6.0% 4.5% 3.0% 1.5% yoy IPCA Target Source: BCB, IBGE, Itaú. 10.7% 6.3% 2.9% Forecast 3.8% 4.0% 0.0% Dec-12 Feb-14 Apr-15 Jun-16 Aug-17 Oct-18 Dec-19 The main risk factors for the inflation scenario are still tied to domestic politics and the evolution of the international scenario. Increasing political uncertainty has hindered progress in reforms and adjustments required for the economic rebound particularly the pension reform and at some point it may worsen risk premia and impact the exchange rate. A setback in reforms, despite its negative effect on economic activity, could also require alternative fiscal measures, such as tax hikes and/or reversal of tax breaks. As for the external situation, despite still-favorable signs at the margin (with sustained risk appetite for emerging market assets), there are policy risks in developed economies that could eventually cause deterioration in risk premia, impacting the local currency and domestic inflation. Substantial slack in the economy may contribute to a sharper decline in inflation in The negative output gap and, consequently, unemployment above its equilibrium level for a longer period, notwithstanding some recent improvement, may cause faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items. More favorable inflation inertia also presents downside risk to 2018 inflation. The sharp slide in agricultural and retail food prices last year, thanks to a favorable supply shock, contributed to an increase in the IPCA (2.9%) below the floor of the tolerance range (3.0%) and to even-lower readings for other inflation indicators, particularly the INPC (2.1%) and the IGP-M (-0.5%). The INPC, whose basket is focused on a tighter income bracket of households earning up to five monthly minimum wages, is used to calculate adjustments in the minimum wage and is also a benchmark for most wage adjustments in the private sector. Hence, lower yearover-year readings for the INPC than for the IPCA, which should be observed at least until mid-year, may cause even more favorable inertial effects for inflation in Some favorable effects should also arise from low readings for the IGP-M, used to adjust certain regulated prices and home rental contracts. Inflation expectations remain anchored, with breathing room in relation to the 2018 target. The median of market expectations for inflation, as per the central bank s Focus survey, slid to 3.95% from 4.02% in The median estimates for 2019 and 2020 remained at 4.25% and 4.00%, respectively, anchored on the targets set for these years. Inflation expectations remain anchored 4.9% 4.7% 4.5% 4.3% 4.1% 3.9% 3.7% 3.5% Source: BCB (Focus Survey) Median inflation expectations (IPCA) 4.25% 4.00% 3.95% 3.3% % % % 2.7% Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Page 12

13 Monetary policy: Fine-tuning the end of the cycle In December, the central bank s Monetary Policy Committee (Copom) delivered the widely expected outcome, a 50-bp rate cut, taking the Selic to 7.0% p.a., an unprecedented low. The committee signaled, quite clearly, that unless the economy surprises in a major way, it will reduce the Selic by 25 bps, to 6.75% in its next policy meeting, on February 6-7. In the Copom s view, the main downside risks to inflation are secondround effects of the shock to food prices (no longer present) and inertial effects arising from low levels of current inflation. Upside risks include disappointments with the reform agenda and a possible reversal of the external scenario, both pressuring inflation through the exchange rate channel. Furthermore, in its Quarterly Inflation Report, the Copom published forecasts until 4Q20. Estimates for 2018 the dominant horizon for monetary policy are below the target in each of the four presented scenarios. The market s scenario (with market estimates for the interest and exchange rates) points to 4.2%, thus below the 4.5% target. While the December IPCA climbed 0.44% in December, topping the highest of market expectations, the 12-month inflation rate ended 2017 at 2.95%, below the lower bound of the inflation target range (3%). As required by the inflation targeting regime in Brazil, the president of the central bank, Ilan Goldfajn, released an open letter to the Finance Minister, Henrique Meirelles, describing in details the reasons for the infringement. Fairly enough, a great emphasis was placed on food inflation, which has dropped from 16.79% at its peak in August 2016 to -4.85% at the end of 2017 and has experienced the sharpest 12-month drop of the series starting in That exceptional behavior stemmed mostly from food supply shocks which, as repeatedly argued by the central bank, should only require a response by monetary policy if they produce secondary effects on other prices. Looking forward, Governor Goldfajn argues that the trajectory of inflation is already pointing in the direction of the target in 2018, as suggested by the rise of 0.49 p.p. of 12-month inflation at the end of 2017 relative to the bottom reached in august of the same year. He also emphasizes that the projections of the central bank (conditional on the Focus Survey path for the Selic rate and exchange rate) indicate the inflation rate will reach 3.2% by the end of the first quarter of 2018, above the 3% lower limit of the tolerance band. This creates an important guidepost: if inflation is significantly below the floor of the tolerance band in March, the central bank may add further to the monetary stimulus. For the moment, we stick to our call that the central bank will cut the Selic rate by 25bps in February and again in March, but we concede that this final cut has become less likely after the higher-thanexpected IPCA reading. Forecast: Brazil F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - BRL bn 4,815 5,332 5,779 5,996 6,259 6,585 7,096 7,670 Nominal GDP - USD bn 2,463 2,468 2,455 1,800 1,795 2,063 2,052 2,158 Population (millions) Per Capita GDP - USD 12,362 12,278 12,106 8,804 8,710 9,934 9,810 10,243 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 13

14 Argentina A monetary policy U-turn The government has announced higher inflation targets for 2018 and While the new targets seem more achievable and thus credible than the previous ones, the decision to increase them will likely make disinflation even harder to achieve, as inflation expectations will probably rise further. Given the new targets, the central bank cut its policy rate, but by less than expected (75 bps) and the statement announcing the decision maintained a cautious tone. We have adjusted our inflation forecast for 2018 to 19% from 18%. We do not expect significant disinflation in 2019; our inflation forecast for that year stands at 17%. The challenging inflation environment leaves little room for cutting interest rates in the short term. We still expect a repo rate of 24% in For 2019, we forecast a rate of 19%. Congress worked at full throttle up to the end of the year. The package of legislation it passed included a fiscal responsibility law, the fiscal pact between the federal government and the provinces, a pension reform, a tax reform and the 2018 budget. We expect the treasury to meet the primary fiscal deficit targets for 2017 and 2018 (4.2% and 3.2% of GDP, respectively). For 2019, we forecast a primary deficit of 2.4% of GDP, slightly above the official target (2.2%). We expect economic growth to consolidate ahead, led by investment. Our growth forecasts stand at 2.9%, 3.5% and 3.2% for this year, 2018 and 2019, respectively. Based on our expectation of solid internal demand growth and a strong currency, we now forecast current account deficits of 5.5% of GDP in 2017 and 5.7% in 2018, down from 4.5% and 4.7%, respectively, in our previous scenario. The wide external deficits will make further real exchange rate gains unlikely. We now forecast exchange rates of 23 pesos to the dollar at the end of this year (up from 21 in our previous scenario) and 27 pesos to the dollar at the end of Higher targets make disinflation even more challenging The government increased its inflation targets for 2018 and 2019 in the last days of December The central bank will now target higher inflation rates for both years: 15% for 2018 and 10% for 2019 (without tolerance ranges), compared with the previous targets of 10% ± 2% and 5% ± 1.5%, respectively. For 2020 on, the target is 5%. The decision was surprising. Two days before the announcement, the central bank had ratified its commitment to meet the target for 2018 in a monetary policy meeting at which it had left the reference rate unchanged at 28.75%. The executive power set the new targets. The new goals were announced by Nicolás Dujovne (Minister of the Treasury), in a press conference with Marcos Peña (Chief of Cabinet of Ministers), Luis Caputo (Minister of Finance) and Federico Sturzenegger (Governor of the Central Bank). Dujovne added that central bank financing for the treasury will fall to 0.5% of GDP in 2019, from 1.1% in 2018 and 1.5% in 2017, adding credibility to the inflation targets, in his view. The previous targets had been announced by former Minister of Economy Alfonso Prat Gay in January 2016 and reaffirmed by the central bank in September of last year. Greater expectations % 5 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Source: Central Bank survey Median Inflation expectations for 2018 New Target Old inflation target range In the press conference announcing the target changes, Governor Sturzenegger suggested that they left room for lower interest rates. In fact, on the very day of the announcement, the central bank started to supply its short-term sterilization bills (Lebacs) at lower rates (with cuts of bps along the curve from 30 to 270 days). Page 14

15 In the first policy decision of the year, the central bank cut the policy rate (7-day repo rate) by 75 bps, less than market expectations ( bps). Furthermore, in the concluding remarks of the statement announcing the decision, the central bank said that it will be cautious in adjusting the monetary policy to the new targeted disinflation path a tone that was certainly focused on controlling the damage to inflationary expectations. While the central bank reaffirmed that the new targets mean a less contractionary monetary policy, interest rate reductions would come only if inflation data confirms the desired disinflation pace. Thus, rate cuts in the next meetings remain a possibility (perhaps matching the yield paid by Lebacs), but the probability of aggressive action by the central bank seems low at this point. While the new inflation targets seem more credible than the previous ones, they will make disinflation even harder to achieve. Before the new targets were set, inflation expectations for 2018 had reached 17.4%, up from 16.6% the previous month. This was the eighth consecutive increase since March, when surveyed participants forecasted 14% inflation for The new targets, added to recently announced hikes in transportation tariffs, will likely increase inflation expectations further during the key wage-bargaining season. We now expect 19% inflation by the end of this year (up from 18% in our previous scenario). For 2019, we expect consumer prices to climb by 17%, markedly above the new inflation target for that year. As inflation remains sticky, we have kept our 24% year-end forecast for the policy rate for While uncertainty over monetary policy in Argentina has increased, we think that the upcoming news on inflation (which will likely be unfavorable) mean that the bulk of monetary easing that we expect for 2018 will come only in the second half of the year. Activity slows in early 4Q17 Argentina s GDP grew at a solid pace in 3Q17 on a year-over-year basis. GDP grew by 4.2% yoy, up from a revised 2.9% in 2Q17 (2.7% before the revision). On a sequential basis, output increased by 0.9% adjusted for seasonality, following a revised 0.8% gain in the previous quarter (0.7% before the revision). Domestic demand accelerated in 3Q17, again driven by gross fixed capital formation. Domestic demand (excluding inventories) grew by a solid 5.7% yoy, up from 4.4% in 2Q17 and led by a 13.9% increase in gross investment (7.7% in the previous quarter). Growth is broad-based across sectors and is being led by construction activity, financial intermediation and manufacturing. Economic activity continued to improve in October on a year-over-year basis, but weakened at the margin. The EMAE (official monthly GDP proxy) grew by 5.2% yoy in October, following a downward revision to 3.2% in September (from 3.8%) and a 4.3% gain in August. At the margin, activity increased by 1.1% qoq/saar, down from 3.5% in the quarter ending in September. According to our seasonal adjustment, the sequential deceleration affected all sectors except construction. Manufacturing production fell by 5% qoq/saar in October. Service output decelerated to 1.6%, from 4.4% in the previous quarter, while primary production activities contracted by 2.5%. On the other hand, construction activity rose by 15.3% qoq/saar. We see the slowdown as temporary. In our view, higher confidence following a favorable outcome of the midterm elections combined with a favorable external environment for emerging markets will likely sustain growth. We forecast GDP growth rates of 3.5% in 2018 and 3.2% in 2019, from an estimated 2.9% in Current account deficit widens further The current account deficit widened considerably in 3Q17, to USD 8.7 billion, significantly higher than the USD 2.9 billion deficit posted in the same quarter of The result was worse than our forecast and market expectations according to Bloomberg, both of which were at USD 7.0 billion. The deficits registered in 1Q17 and 2Q17 were revised upward, worsening the four-quarter accumulated deficit to 4.4% of GDP (from 3.6% in the year ended in 2Q17). This is the widest deficit since 1998, when it reached 4.5% of GDP. The trade deficit continued to widen in 4Q17 due to strong imports and weak exports. At the margin, the three-month annualized deficit widened to USD 13.0 billion in November (seasonally adjusted) from USD 10.5 billion the previous month. The current account deficit is financed by net portfolio investment, chiefly debt issuances from the public sector, which totaled USD 6.5 billion in 3Q17. The rolling four-quarter portfolio account registered cumulative inflows of USD 36.5 billion. As a consequence, external debt jumped to USD billion or 36.1% of GDP, up from 33% in 3Q16. Page 15

16 We now forecast deficits of 5.5% of GDP and 5.7% for 2017 and 2018, respectively. For 2019, we forecast a deficit of 5% of GDP, consistent with a lower fiscal deficit. Importantly, we expect financing to gradually migrate from hard-currency debt issuance to foreign direct investment, so the pace of external debt increase would be lower. In a context of deteriorating external accounts, we now expect exchange rates of 23 pesos to the dollar at the end of 2018 (up from 21 in our previous scenario) and 27 pesos to the dollar at the end of Reforms advance In its last session of the year, the Senate passed into law the 2018 budget and the tax reform bill. The budget confirms a primary fiscal deficit of 3.2% of GDP (down from an estimated 4% deficit for 2017). The tax reform bill seeks to reduce the tax burden and labor costs for companies, thereby encouraging them to invest. Its main changes include a gradual reduction in the corporate income tax rate for retained earnings (to 25% from 35%) starting in 2019, a cut in payroll taxes and the phasing out of the tax on financial transactions (use of checks) over the next five years. To partially offset the fiscal cost of the bill, the country will see increased levies on alcoholic (excluding wine) and sweetened beverages and the introduction of a tax on earnings from financial assets (deposits, bonds) held by individuals. Still, the government estimates a fiscal cost from the reform that will peak at 1.5% of GDP in five years and is relying on a higher growth rate as an offsetting factor. Besides the tax reform, a fiscal responsibility law, a fiscal pact between the federal government and the provinces and a pension reform were also approved. The fiscal responsibility law caps the real growth of provincial and federal primary expenditures at zero, while the fiscal pact involves an agreement between the federal government and governors of provinces to cut local corporate taxes (and compensation for the province of Buenos Aires, worth 0.2% of GDP, to end a tax-sharing revenue dispute with the federal government). The pension reform establishes a new formula for adjusting payments to pensioners, which should generate fiscal savings of around 0.4% of GDP in A capital-markets bill and labor reform are in the legislative pipeline. The capital-markets bill was already passed by the Lower House and sent to the Senate for debate this year. The reform will eliminate the government s authority to intervene in companies in which it has a stake. Meanwhile, the labor reform bill, also scheduled for legislative debate, targets a reduction in severance payments and the introduction of more flexibility in labor contracts. The pension and fiscal responsibility bills, combined with fast subsidy cuts, will likely allow the government to meet its 3.2% of GDP deficit target this year. For 2019, tax cuts will work against fiscal consolidation, so we expect a 2.4% of GDP deficit, somewhat higher than the official target. Page 16

17 Forecast: Argentina F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 13,888 14,478 13,215 14,643 12,506 14,075 13,624 13,440 Unemployment Rate - year avg Inflation CPI - % (*) 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 Primary Balance - % GDP (**) Nominal Balance - % GDP (**) Gross Public Debt - % GDP Net Public Debt - % GDP (***) (*) National CPI for 2017 and (**) Excludes central bank transfer of profits from (***) Excludes central bank and social security holding. Sources: Central Bank, INDEC and Itaú Page 17

18 Mexico Resuming the tightening cycle Banxico resumed the tightening cycle in December (hiking 25-bps, to 7.25%), after staying on hold for the past three meetings. The guidance in the statement suggests another rate hike in February is likely. We expect the policy rate to peak at 7.5%. Given the recent supply shocks in non-core prices and stronger-than-expected inertia, we have revised our inflation forecast for 2018 to 3.7%, from 3.3%. Still, our forecast remains consistent with a meaningful disinflation (from 6.8% in 2017), driven by lower exchange-rate pressure (we see the peso at 18.5 to the dollar by the end of this year) and normalization of non-core inflation (energy and non-processed food). We expect GDP growth of 2.1% for both 2017 and 2018, down from 2.9% in 2016, and a moderate acceleration to 2.4% in While uncertainty over NAFTA and economic policies post-elections is a drag on investment, strong U.S. manufacturing performance, a still-solid labor market and recovering real wages are buffers. Our forecasts are subject to a high degree of uncertainty. They are based on the assumption that NAFTA will continue and economic policies will not change meaningfully after the presidential elections. If these assumptions do not hold, a scenario with lower growth, weaker currency, higher inflation and tighter monetary policy is likely. Central Bank takes hawkish turn Mexico s central bank increased its policy rate by 25- bps in the last meeting of the year, as expected by us and an almost evenly split consensus (according to Bloomberg, a large minority expected the policy rate unchanged). Thus, Banxico resumed the tightening cycle after a pause that lasted for the previous three meetings. In the statement announcing the decision, the board highlights that the outlook for inflation has become more challenging, given the pressures on the currency coming from the Fed s monetary policy decisions and NAFTA renegotiation, besides the higher-than-expected inflation prints. In this context the board considers that the balance of risks to inflation has deteriorated, and felt necessary to increase the policy rate. The decision was split, with one board member voting for a larger 50-bp rate increase. Importantly, the last paragraph of the statement ends with a more hawkish sentence than in the previous meeting, as the board mentions the intensification of risks for the inflation outlook and pledges to take if needed corresponding actions as soon as necessary to ensure inflation expectation anchoring and inflation convergence to the target. Considering risks related to NAFTA, U.S. monetary policy and presidential elections; the higher-thanexpected inflation readings; and, of course, the clear hawkish tweak in recent communications we expect a 25-bp rate hike in February (to 7.5%). While we expect the policy rate to peak at 7.5% in 2018, the risks are clearly tilted towards more rate hikes. Assuming risks dissipate, we expect the board to deliver two 25-bp rate cuts in the second half the year, taking the reference rate back to 7% (and further down to 6% in 2019). Inflation subject to new supply shocks Inflation was pressured by more supply shocks in the last two months of The spike of the liquefied petroleum gas price (not smoothed out through excise tax adjustments, unlike gasoline) driven by higher international prices and a weaker Mexican peso coupled with big increases for a few non-core food items (mainly tomatoes and eggs) exerted significant upward pressure in November and December. Moreover, the minimum wage hike (10.4%) entered into force in December, in contrast with the customary practice of implementing it on the first day of each year. Against this backdrop, annual inflation reached 6.8% in December (from 6.6% in November), while core inflation stood broadly unchanged at 4.90% during the same period. Within the core index, core goods (tradables) stood at 6.2% and core services ran at 3.8%. (both unchanged with respect to November). Turning to non-core inflation (12.6%, 12% previously), the large increase was explained both by higher energy prices and by agricultural items. While inflation at the margin is running much lower than the year-over-year figure, prices also picked-up speed on a sequential basis. On seasonally-adjusted terms, inflation accumulated in three months reached 5.36% (annualized) in 4Q17, compared with 4.1% in 3Q17. The pick-up was broad-based. Page 18

19 Given the recent evolution of inflation and the resulting inertia, we have revised up our inflation forecast for 2018 (to 3.7%, from 3.3%). Still, our forecast remains consistent with a meaningful disinflation (from 6.8% in 2017), driven by lower exchange-rate pressure and normalization of non-core inflation (energy and non-processed food). For 2019, we see inflation at the 3% target. Inflation picked-up Activity likely rebounded in 4Q17, led by services %, qoq/saar 10 %, seasonally-adjusted, 3-month annualized Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Source: INEGI, Itaú Headline Core Core goods Core services Growth likely rebounded in 4Q17 Domestic demand slowed down meaningfully in 3Q17, battered by the natural hazards. The growth of domestic demand weakened to 0.9% qoq/saar (from 1.9% in 2Q17), with private consumption the engine of activity throughout 2017 expanding at a less vigorous pace (2.7% qoq/saar, from 3.4% in 2Q17). Fixed investment fell by 1% qoq/saar in 3Q17 (from a 1.3% contraction in 2Q17), with private investment (-1.3% qoq/saar, 1.9% previously) underperforming public investment (3.5% qoq/saar, -8.7% previously). Exports were also hit in 3Q17. Data available for 4Q17 shows the economy is recovering, as expected, after the transitory hit it underwent in the previous quarter. The monthly proxy for GDP (IGAE) gained 0.11% between September and October, lifted by a 0.4% increase in Service output. Nominal manufacturing exports (measured in U.S. dollars) were up by 4.9% qoq/saar as of November. -4 IGAE Industry Services -6 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Apr-17 Oct-17 Source: INEGI, Itaú We expect GDP growth of 2.1% for both 2017 and 2018, down from 2.9% in 2016, and a moderate acceleration to 2.4% in Factors playing against economic growth in the short-term are tight macro policies (fiscal and monetary) and uncertainty over policy direction after the elections and trade relations with the U.S. However, we note that fiscal drag will be smaller in 2018 relative to More importantly, a dynamic U.S. industry will likely sustain Mexico s exports (also considering the competitive exchange rate). Finally, the solid labor market and the expectation of lower inflation support consumption. Twin deficits narrowing The trade deficit is narrowing as the effects of natural hazards (hurricanes and earthquakes) dissipate. At the margin, both the energy and non-energy balances improved substantially. The seasonally-adjusted 3-month annualized deficit narrowed to USD 11.2 billion (from USD 17.2 billion in October), as the same measure for the energy deficit and non-energy surplus posted USD 20.7 billion (from USD 22.3 billion) and USD 9.6 billion (from USD 5.1 billion), respectively. This is consistent with a low current account deficit (we expect 1.6% of GDP this year and 1.7% in 2019). Page 19

20 Non-energy surplus standing at historical high seasonally-adjusted, 3-month, annualized, USD billions -25 Nov-12 Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 Source: INEGI, Itaú Total Energy Non-energy On the fiscal side, the deficit is also narrowing amid rising revenues and falling expenditures. The recent increase of oil prices is boosting revenues, while fiscal consolidation continues running its course with the government slashing spending (especially investments in physical capital). In fact, even if 70% of the amount of the windfall dividends sent by the Central Bank to the government are excluded (as the remaining 30% is directed to stabilization/sovereign funds, and therefore recorded as both revenues and expenditures), the 12- month rolling primary balance reached a MXN 129 billion surplus in November (0.6% of GDP, according to our calculations), from a MXN 107 billion surplus at the end of 3Q17. Likewise, using the same metric (ex-dividend), the 12-month nominal fiscal deficit narrowed to MXN 380 billion (1.7% of GDP), from MXN 414 billion in 3Q17. Public debt to GDP ratios also continued trending down, with net debt posting MXN 9,550 billion in November (43.6% of GDP, according to our calculations, from 44.1% of GDP in 3Q17) and gross debt at MXN 10,159 billion (46.3% of GDP, from 47.2% of GDP in 3Q17). Political landscape taking shape The most recent polls show Lopez Obrador (AMLO) still leading the presidential race by a significant margin. Since December, unlike in the previous months, the political chessboard underwent a crucial change, as it finally became clear who would be the presidential candidates running under the banner of the main political forces; AMLO for Morena, José Antonio Meade for the ruling party PRI (stepping down as Finance Minister in early December), and Ricardo Anaya for the PAN-PRD right-center-left alliance (officially announcing his candidacy in mid-december). Former first-lady Margarita Zavala will likely run as independent. Taking an average of four pollsters that we track (El Financiero, Reforma, Mitofsky, and El Universal), AMLO led the race as of December (31% of vote intentions, from 32% in November), followed by Ricardo Anaya (23%, from 20.3%), José Antonio Meade (16%, from 17.7%) - who still has very low name recognition and will likely improve in coming months as the PRI deploys its well-organized political machinery and Margarita Zavala (10% vs. 11.3% in November) begins with Mexico more willing to compromise on NAFTA The last NAFTA meetings of 2017 marked progress on a number of non-controversial topics, dispelling the perception of deadlock, but did not address the issues that could potentially cause the negotiations to fall apart. The next NAFTA round to be held in Montreal on January will be critical as it will give more clarity on whether it is feasible to conclude negotiations by March 2018 (target according the trilateral press statements) and thus avoid the overlapping of the NAFTA talks with Mexico s presidential race. Mexico s Head Negotiator Ildefonso Guajardo signaled that Mexico might be willing to offer more substantial concessions to the US at the 6 th round. These concessions would come for two of the most thorny issues: dispute settlement and rules of origin. On dispute settlement, Guajardo said that there is a possibility for opt-in and opt-out on Chapter 11 (which is one of the U.S. key demands). Specifically, NAFTA s Chapter 11 contains an investor-versus-state dispute settlement mechanism whereby private investors can bring cases to arbitration panels and obtain retroactive compensation. With this opt-in, opt-out proposed clause, if a private party presents an arbitration claim within the framework of NAFTA, then the defendant (government of US, Mexico, or Canada) would have the option to be subject to the arbitration process (opt-in) or refuse to participate (opt-out). Finally, on rules of origin, Guajardo stated that the solution is, without doubt, a strengthened regional content rule in for the auto sector. Page 20

21 Forecast: Mexico F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - USD bn 1,202 1,274 1,314 1,171 1,077 1,221 1,293 1,429 Population (millions) Per Capita GDP - USD 10,265 10,764 10,980 9,675 8,808 9,888 10,368 11,346 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% Source: IMF, Bloomberg, INEGI, Banxico, Haver and Itaú Page 21

22 Chile Turning the page Former president Sebastian Piñera will return to La Moneda in March following a convincing runoff victory against Alejandro Guillier. His main campaign promise is to return Chile to a path of sustainable growth, while fine-tuning some of Michelle Bachelet s key reforms. Activity likely closed 2017 on a strong footing, with the non-mining component showing improvement. The improved carryover effect and upwardly revised copper prices, combined with the expectation that confidence will continue to rise, have led us to expect growth of 3.0% this year (from 2.7% in our previous scenario and an estimated 1.5% last year). The consolidation of the investment- and export-driven recovery will see growth rise to 3.5% next year. The recent strengthening of the Chilean peso can be mostly explained by the performance of copper. The persistence of current exchange-rate levels in the short run will lead to less tradable inflation, and we now see inflation for 2018 at 2.5% (2.8% previously). Nevertheless, we expect some weakening of the exchange rate before year-end as the Federal Reserve continues its monetary-policy normalization while copper prices retreat. So, we forecast 635 pesos per dollar by the end of this year (660 previously). With low inflation and a still-negative output gap, we expect the central bank to keep its policy steady at 2.5% this year. A normalization process would start next year, taking the rate to 3.5% before year-end. President Piñera 2.0 Former president Sebastián Piñera ( ) emerged victorious in Chile s presidential runoff vote on Sunday, December 17. Leading up to the vote, the few polls published after the first-round result indicated that the race was too close to call. However, Piñera (center-right) obtained a wide margin in his favor. Former-President Piñera (37% of the first-round vote) triumphed with 54.6%, a 9.2 pp lead over Alejandro Guillier (whose candidacy was supported by the parties in the current governing coalition and who received 22% of the first-round vote). Unexpectedly, participation increased to close to 49%, from 46.7% in the first round. Guillier fell short of fully capturing a fragmented center-left that included Frente Amplio (whose candidate Beatriz Sanchez received 20% of the firstround vote), the Christian Democrats Carolina Goic (5.9% of the first-round vote) and Marco Enríquez- Ominami (5.7%). Meanwhile, Piñera appears to have successfully seized some centrist voters in addition to voters in favor of José Antonio Kast (independent, right; 7.9% in the first round). Piñera will take office on March 11. The center-right coalition (supporting him) does not have a majority in Congress (44% of the senate and 47% of the lower house), so the advancement of policy will require negotiation. He campaigned on fine-tuning Michelle Bachelet s reform agenda, rather than a more aggressive reversal of the changes implemented during the current administration. While Piñera would like to see a decreased tax burden, the fiscal deficit limits the space to lower taxes, so a milder simplification of the tax law is more likely. The incoming government will also have to tackle the hot topic of pension reform. Piñera is in favor of establishing an additional employer contribution rate of 4% (compared with the 5% proposed by Bachelet s government) directed to private accounts, while in Bachelet s proposal, the added contribution would have been split between individual savings accounts and a collective savings system. Additionally, Piñera s government will attempt to address some ambiguities and add flexibility to the implementation of the labor reform. Piñera will take the reins of the economy aided by improving global factors (higher copper prices and increasing global demand). Still, the former president must be mindful to not alienate too many political players (especially from the so-called social movements) given the importance of negotiation in Congress. Since winning the election, Piñera has shown a conciliatory tone, meeting with various officials of the current administration and praising some policy proposals from other parties. He has also noted that he would work to form a broad cabinet that includes some continuity, but allows for change. Regarding economic policy, some members of president-elect Piñera s economic team (and potential candidates for key posts within the administration) include former central bank governor Rodrigo Vergara, Felipe Larraín (the Finance Minister in his first governing term), Juan Andrés Fontaine (former Economics Minister) and Rodrigo Cerda (macroeconomic coordinator in his first government). Page 22

23 Recovery firms up Available data suggests that activity in the final quarter of 2017 likely ended on a high note. Activity for the quarter ending in November came in at 2.6% year over year, up from 2.2% in 3Q17 and 1.0% in 2Q17. The non-mining component grew 2.2%, the highest rolling-quarter annual growth rate since July Mining activity continues to moderate at the margin, but higher copper prices will likely support mining production in The strong end to 2017 boosts the carry-over effect which alongside elevated copper prices, higher global growth, expansionary monetary policy, low inflation and improved private sentiment led us to increase our 2018 growth forecast to 3.0% (2.7% previously). This would follow estimated growth of 1.5% for 2017 (1.6% in 2016). We have revised our average copper price forecast for 2018 up by 8%, as well as our medium-term outlook, which transmits into a consolidation of the expected investment recovery this year (following four years of contraction). The drivers of private sentiment consolidation. We forecast the unemployment rate to average 6.7% this year, remaining broadly stable from last. The expected activity recovery will likely lead to a recomposition of jobs rather than a large-scale increase in employment. Public sector job boost annual change, thousands -50 Total Non-Salaried -100 Private Salaried Public Salaried -150 Rest Source: INE, Itaú 5.0 USD/lb 50 = neutral 70 Large trade surplus in Copper Business ex-mining confidence (rhs) Consumer confidence (rhs) Source: BCCh, Bloomberg, Icare, Adimark. A risk to the activity scenario comes from the weakness of the labor market. The unemployment rate came in at 6.5% in the quarter ending in November, 0.3 percentage points above that recorded one year ago. However, public salaried posts continue to prop up employment growth, while the formal private sector lacks strength. Going forward, the boost from the public sector (134 thousand jobs created year-to-date) is unlikely to persist given the expected fiscal Mining exports remain robust, but industrial goods are also performing well. Overall, the trade surplus is sizable and Chile s external vulnerabilities are limited. The trade balance recorded a USD 1.1 billion surplus in December, taking the trade surplus for the year to USD 6.9 billion (USD 5.3 billion in 2016), the highest since Our seasonally adjusted series shows that, at the margin, the trade balance surplus is running even higher, but dipped to USD 9.6 billion (annualized) in the final quarter of the year (USD 12.8 billion in 3Q17), partly due to a widening of the energy deficit. With copper prices set to remain high for most of 2018 (11% on average higher than in 2017), we expect the current account deficit to stay at low levels. We expect a narrowing to 1.3% of GDP, from the 1.5% expected for As internal demand recovers through 2019, we see some widening of the deficit to a still-low 1.8% next year. The Chilean peso ended 2017 at a stronger-thanexpected level, boosted by elevated copper prices alongside improving business sentiment ahead of a change in the political cycle. The recent performance of copper explains the bulk of the peso s strengthening Page 23

24 since early December. We expect the recent rally to persist for some time, but do see some weakening before year-end as the Federal Reserve continues with its monetary policy normalization, while copper prices retreat to fair value. Nevertheless, we see a more appreciated currency vs. our previous scenario (635 pesos per dollar, compared with 660 previously). Copper the key driver behind recent currency dynamics The recent strengthening of the Chilean peso, stillmild inflationary pressures and inertia mean inflation will run below 2% in the first half of this year. We now expect inflation to end 2018 at 2.5% (2.8% previously) as the pick-up from tradable inflation is slower than we were previously anticipating. Moreover, as indexation mechanisms operate, we see only a gradual acceleration to 2.8% by the end of Steady course for rates Copper (rhs, inverted) USDCLP USDCLP - MM 180 Days The central bank s latest inflation report (IPoM) for 2017 changed little from the preceding quarter s edition. Following the implementation of a 100-bp easing cycle (to 2.5%) in the first five months of the year, the baseline outlook sees inflation staying near the lower bound of the central bank s 2%-4% target range during 1H18. Thereafter, inflation would reach the 3% target only in 1H19, while core inflation converges during 2H19. Overall, the risks for these inflation forecasts are deemed to be balanced. USDCLP Source: Bloomberg. Temporary inflation pick-up USD c/lb 335 Inflation for 2017 came in at 2.3%, down from 2.7% in The December print was the highest in 2H17, but is likely due to an unfavorable base effect. The breakdown shows that tradable inflation continues to be less of a drag (1.9% vs. 1.0% in November), whereas non-tradable inflation moderated further to 3.0% (3.1% previously). Core inflation (excluding food and energy prices) is at a low 1.8%. Our expectation is that core inflation will stay near the lower bound of the central bank s 2%-4% target range throughout The board remains vigilant on the behavior of shortterm inflation. In the current scenario of still-low growth (in spite of the recovery), limited inflationary pressures and some measures of inflation expectations below the 3% target, deviations to the downside of inflation in the short term could still result in more interest-rate cuts. In fact, the central bank still maintains an easing bias. We expect the policy rate to remain unchanged at 2.5% throughout this year. A normalization process would start only next year, as the output gap narrows. Yet in an environment of low inflation, if the incipient recovery does not gain momentum, additional easing is likely. Page 24

25 Forecast: Chile F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 15,291 15,615 14,464 13,181 13,808 14,580 15,735 16,248 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% Source: IMF, Bloomberg, BCCh, INE, Haver and Itaú Page 25

26 Peru Political crisis poses negative growth risk A political crisis erupted in December After a year of confrontation between the government and the majorityopposition Congress, domestic politics reached a critical stage when President Pedro Pablo Kuczynski (PPK) was almost impeached over corruption investigations. While PPK survived the impeachment vote, the political crisis is set to continue. We revised our GDP growth forecasts down to 2.7% from 2.9% for 2017 and to 4% from 4.2% for The revision for 2018 is a consequence of the political crisis, which we believe will curb investment growth. For 2019, we forecast 4% GDP growth. Inflation in Peru continues to fall as the negative output gap and exchange rate appreciation cause consumer prices to drop. After ending 2017 at the lowest level in almost eight years (1.4%), we expect annual CPI inflation to continue to decline until 1Q18, and then firm up to 2.3% by the end of 2018 (revised from our previous forecast of 2.5%). Low inflation coupled with a new downside risk for growth (stemming from the political crisis) will likely push the board to cut rates further. We foresee the reference rate ending 2018 at 2.75%, with the first 25-bp cut delivered in January and the second reduction before the end of the first half of this year. Political crisis After a year of confrontation between the government and the majority-opposition Congress which ousted an entire ministerial cabinet back in September the political crisis in Peru peaked in December with the near impeachment of President Pedro Pablo Kuczynski (PPK). The source of the crisis was the Lavo Jato investigation in Brazil, which had big political repercussions in Peru. Former Presidents Ollanta Humala and Alejandro Toledo are already facing incarceration and an extradition sentence, respectively, because of it. On December 21, the 78 votes in favor of impeachment fell short of the votes needed to oust PPK, triggering a positive reaction in markets, but without dissipating the shadow cast by the political crisis. In the days leading up to the vote, the impeachment movement (particularly the Fujimoristas) was vilified in the media as an attempt to set a coup against democratic institutions. Public opinion was turning against the impeachment. Crucially, during the voting, Kenji Fujimori (the youngest son of former President Alberto Fujimori) abstained from voting and persuaded nine other Fujimoristas to abstain along with him. A few days later, a presidential pardon for former President Alberto Fujimori was announced by the government. The anti-fujimori coalition composed mainly of social liberals and left-wing parties is now challenging the pardon at the Inter-American Court for Human Rights (a judicial arm of the Organization of American States, which includes most countries in the Americas). Importantly, Peru is a signatory country of the American Convention on Human Rights, which makes the rulings of the abovementioned court binding. However, the government has already announced that it will abide, above all, by the rules of the Peruvian constitution, which gives the President the right to grant humanitarian pardons. Even though less confrontation between the government and Congress seems likely, President Kuczynski s situation is very fragile, given the depletion of his political capital and the ongoing corruption investigations. According to the Constitution, if the President were impeached, the right of interim presidency would be vested in the First Vice President and then on the Second Vice President. Should the Vice Presidents refuse to accept the interim presidency, the President of Congress would assume the position, with the mandate of calling for presidential and legislative elections within the next twelve months. Also of note, throughout history all of the impeachments of Peruvian presidents (De la Riva Agüero in 1823, Billinghurst in 1914 and Fujimori in 2001) ended in early elections. This, of course, created considerable uncertainty by raising the question of whether a new government would maintain a market-friendly orientation. Disinflation accelerates Peru s disinflation is mainly driven by the normalization of agricultural output (after El Niño disrupted supply conditions in 1H17), but core inflation is also more benign. Annual headline inflation ended 2017 at the lowest level in almost eight years, below the central bank s 2% target. Headline inflation Page 26

27 decreased to 1.36% yoy in December (from 1.54% in November), while core inflation fell to 2.15% yoy (from 2.23%) in the period. Notably, core inflation has fallen consistently over the past two years, from 3.5% in December 2015 and 2.9% in December 2016, in line with the significant slowdown in domestic demand. Moreover, diffusion indexes indicate that disinflationary pressures are becoming more broad-based across the CPI basket. The 12-month rolling average of the percentage of goods and services that recorded positive monthly inflation fell to 45.3% in December (from 56.6% in November), while the measure that tracks the percentage of items with annual inflation above the 2% target dropped to 32.1% in December (from 41.5% in November). Inflation is also comfortable at the margin. The seasonally-adjusted three-month annualized variation of the CPI fell deeper into deflation terrain in December (to -1.65%, from -1.27% in November and an average of 2.31% in the first ten months of the year), while the same measure of the core index stood at 1.51% in December (from 1.72% in November and an average of 2.37% in the previous ten months). We attribute the downtrend of core inflation to the lagged effects of a negative output gap (labor market conditions improved somewhat in 3Q17, but remained soft as of 4Q17) and slight exchange rate appreciation. Significant decline of inflation at the margin %, seasonally-adjusted 3-month annualized Headline Core -3 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Source: INEI, Itaú Due to more favorable inertia, we reduced our inflation forecast for this year to 2.3%, from 2.5% in our previous scenario. Improving activity overshadowed by new growth risk Peru s GDP growth is becoming more balanced, with less momentum from natural resource sectors (volatile and mostly supply-driven) and more dynamic non-natural resource sectors (which reflect demand conditions). The GDP proxy expanded by 3% yoy in October, boosting the three-month moving average growth rate to 2.9% (from 2.5% in September). The threemonth moving average growth rate of natural resource sectors decreased to 1.5% yoy in October (from 1.9% in September), while the same measure for non-natural resource sectors (more driven by cyclical factors) picked up to 3.3% (from 2.7%). The driver for the acceleration in the non-natural resource sectors is construction activity, which is being boosted by fiscal stimulus and the increased investment in metallic mining (stimulated by higher metal prices). Mining investment continues to accelerate %, yoy %, yoy Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 Source: MINEM, BCRP, Itaú Terms of trade Nominal mining investment (rhs) At the margin, the momentum of domestic demand is much firmer than in 1H17. According to the central bank s seasonally-adjusted data, quarter-over-quarter annualized growth came in at 2.7% QoQ/SAAR in October (up from a 1.9% average in 1H17). According to our own seasonal adjustment, natural- and non-naturalresource sectors expanded by 0.2% and 3.5% QoQ/SAAR in October, respectively. Notably, the central bank s monthly proxy for domestic demand grew 6.4% in the month (up from a 0.3% average in 1H17) Page 27

28 We revised our GDP growth forecasts down to 2.7% from 2.9% for 2017 and 4% from 4.2% for The former corresponds to the delay of the second fishing season (the beginning of which was postponed to January 2018, from November 2017), an unexpected slowdown in employment growth in Lima in 4Q17, and the negative effect of the political crisis on public investment in the last two weeks of the year (as recently revealed by the Finance Minister). Similarly, the revision for 2018 is a consequence of the political crisis, which we believe will create uncertainty and thereby curb investment growth. In any case, we foresee a robust pick-up in activity on higher terms of trade (driven by metal prices), expansionary macroeconomic policies (mostly fiscal, but also monetary), and some rebound in infrastructure investment (mainly Line 2 of Lima s subway). For 2019, we expect GDP growth to remain at 4%, supported by firmer domestic demand. Central Bank cuts rates in response to political crisis The Central Bank of Peru (BCRP) decided to cut the reference rate by 25 bps (to 3%) at the first meeting of the year, in line with our call and that of the majority of analysts (only 4 out of 13 firms, surveyed by Bloomberg, expected no action). The decision came amid consistent downward surprises in inflation and board members expressing their concerns about the potential effects of the political crisis on the growth outlook. In late November, speaking at a conference in Lima, General Manager Renzo Rossini (second in command in the BCRP s institutional framework) noted that the falling inflation provides some freedom to cut rates further. The statement of January s meeting maintained the explicit easing bias, but modified the wording on inflation and economic growth. On inflation, the board highlighted that core inflation measures (the so-called inflationary trend measures shown in the presentation published on the day after every monthly meeting) continue decreasing and are expected to stay close to the 2% target during 2018 (rather than within the 1pp tolerance range around the target, as mentioned in December s statement). Regarding economic activity, board members stated that public investment disappointed in 4Q17 (an important development, considering that the fiscal stimulus is a critical assumption for the economic recovery). Also importantly, the statement mentioned that business confidence moderated in December. Yet it did not make a direct reference to the political crisis. Monetary policy already in expansionary territory % -2 Jan-09 Jul-10 Jan-12 Jul-13 Jan-15 Jul-16 Jan-18 Source: BCRP, Itaú Monetary policy rate 12-month inflation expectations Ex-ante real interest rate BCRP's estimate of neutral real interest rate Recent comments by board members indicate that they view the deterioration of domestic politics as a threat to the economic growth outlook. Chairman Julio Velarde acknowledged that the political crisis will have a negative effect on the economy, but qualified his assertion by noting that the effect would be temporary and mild if the crisis is managed within the framework of the Constitution. More recently, board member Miguel Palomino said that the BCRP s growth forecast for 2018 (4.2%) now has a negative bias because of the political crisis. From another angle, board member Elmer Cuba (who has expressed bullish views on growth over the last few months) has cited the poor labor market data in 4Q17. Low inflation coupled with a new downside growth risk (stemming from the political crisis) will likely push the board to cut rates again in 1H18. We expect the reference rate to end 2018 at 2.75%. The ex-ante real reference rate is now standing at 0.7%, below BCRP s estimate of the neutral level (1.8%, according to the updated calculation shown in the quarterly inflation report published in September 2017). Therefore, monetary policy is also expected to stimulate activity, although in lesser degree than higher metal prices and fiscal stimulus. For 2019, we expect a moderate tightening of monetary policy, which would take the reference rate back to 3.25%, assuming that inflation firms up and the economic recovery consolidates. Page 28

29 Forecast: Peru F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 6,288 6,492 6,593 6,175 6,215 6,798 7,181 7,588 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% Source: IMF, INEI, BCRP, Itaú Page 29

30 Colombia More monetary easing ahead Disappointing activity figures at the start of 4Q17 and the weak labor market underscore the risks to the expected recovery. Nevertheless, the combination of lower interest rates and stronger global growth will likely enable a pickup in activity this year (to 2.5%, from the 1.5% expected for 2017). We expect the central bank to resume its easing cycle as the current account deficit narrows, financial conditions for emerging markets remain favorable and demand pressures fade. We see the easing cycle ending with the policy rate at 4.0% before 2H18. Weak labor market underscores growth concerns Weak labor market dynamics persist, with urban employment falling 1% yoy in the quarter ending in November. Total employment growth slowed to zero, from 1.1% in 3Q17 and 2.0% in 2Q17, resulting in a rise in the unemployment rate to 8.7%, 0.6 pp higher than a year earlier. The net urban job destruction is consistent with our view that the labor market is weak and poses a risk to a consumption recovery. Unemployment on the rise mma SA, % Urban unemployment rate Total unemployment rate Rural unemployment Manufacturing remains weak, contracting by 0.3% yoy in October (-2.0% previously), despite the favorable calendar effects. At the margin, industrial production increased by 1.8% QoQ/SAAR, marking a slowdown from 3.2% in 3Q17 and 4.7% in 2Q17. Overall, industrial production appears set to continue to drag down GDP in the final quarter of the year. Disappointing activity %, yoy, 3MMA, SA Industrial Production Retail Sales excluding vehicle and fuels Retail Sales excluding fuels Source: Dane, Itaú Source: DANE, Itaú. Meanwhile, activity data at the start of 4Q17 continued to underwhelm. Industrial production posted another contraction, while retail sales have yet to benefit from lower inflation and interest rate cuts. In the quarter ending in October, retail sales fell by 0.1% yoy, weaker than the 1.2% growth registered in 3Q17. Excluding vehicle and fuel sales, sales increased by 0.2% (vs. 1.5% in 3Q17). At the margin, retail sales (excluding fuel and vehicle sales) fell by 0.7% QoQ/SAAR, from growth of 1.2% in 3Q17 and 1.3% in 2Q17. Disappointing data leads to a downward revision of our growth forecast for 2017, to 1.5% (from 1.6% in our previously scenario and 2.0% in 2016). Part of the slowdown comes from the lagged effects of the contractionary monetary policy. In fact, the ex-ante real interest rate (using 1-year inflation expectations) has only recently neared neutral levels. The recovery of oil prices is yet to benefit GDP growth. However, we continue to expect a recovery this year (to 2.5%) as higher real wage growth, stronger external demand (supporting higher average oil prices) and an expansionary monetary policy (easing cycle ending at 4%) drive a likely rebound. Regardless, the risks are still tilted downward. The uncertainty surrounding the Page 30

31 outcome of the 2018 presidential election could hamper the recovery process. In any case, we expect the economy to expand by 3.2% in Current account deficit continues to narrow A USD 2.6 billion current account deficit was recorded in 3Q17, marking an improvement over the USD 3.6 billion deficit reported a year ago. The rolling four-quarter deficit narrowed to USD 11.1 billion (3.7% of GDP), from a USD 12.4 billion deficit in 2016 (4.4% of GDP). At the margin, our seasonal adjustment shows an even lower deficit of 2.9% of GDP, compared with 3.6% in 2Q17 and 4.6% in 1Q17. Current account deficit correction continues % of GDP Rolling-4Q Seasonally Adjusted annualized -8 Mar-01 Dec-03 Sep-06 Jun-09 Mar-12 Dec-14 Sep-17 Source: Banrep, Dane, Itaú. The main driver for the improvement in the quarter was the trade performance of goods and services, which showed a USD 2.5 billion deficit, narrowing from USD 3.4 billion in 3Q16. The improvement can be attributed to higher energy prices, increased exports and a low comparison base due to the transportation strike last year. The rolling-fourth-quarter balance of goods and services therefore improved to a USD 10.7 billion deficit, from USD 13.1 billion in 2016 and USD 11.7 billion in the previous quarter. The income deficit, on the other hand, continued to widen to USD 1.8 billion, from USD 1.5 billion in the same quarter of The resulting fourth-quarter-income deficit widened to USD 6.8 billion, from USD 5.1 billion at the end of Foreign direct investment showed a significant improvement from Direct investment in Colombia jumped to USD 4.9 billion in 3Q17, from USD 2.2 billion in 3Q16. The bulk of the investment in the quarter was in the transportation sector and was likely driven by spending on airplanes. The oil sector made up only 10% of total FDI in 3Q17, far below the 48% peak registered in Overall, foreign direct investment in the rolling-fourth-quarter period was USD 13.4 billion (4.4% of GDP). Net direct investment improved to USD 8.6 billion in the rolling-fourth-quarter period, but still fell short of fully funding the current account deficit. With the outlook for oil prices revised upward and internal demand still weak, we expect the current account deficit to continue to narrow this year. We forecast a current account deficit of 3.4% of GDP (3.5% previously), down from the 3.7% estimated for With only a mild activity recovery expected for 2018, a further narrowing to 3.2% is anticipated. Despite S&P s rating downgrade, weak activity and an easing cycle, the COP ended 2017 at a strongerthan-expected level, boosted by oil prices. Still, our expectation of a retreat in oil prices by year-end alongside continued monetary-policy normalization in the U.S. suggest a depreciation, although we see a more appreciated currency than in our previous scenario (3050 COP/USD for YE18, compared with 3120 previously). Inflation set to near the target For the third consecutive year, inflation ended 2017 above the 2%-4% target range, at 4.1%, but was still considerably below the 5.8% registered in 2016 and 6.8% recorded in The recent inflation readings surpassed the central bank s 2%-4% target range, partly due to a low comparison base. Inflation, excluding food prices, edged up by 5.01% (from 4.80% previously), driven by acceleration in tradable inflation. Tradable goods prices (excluding food and regulated prices) came in at 3.79%, from 3.64% in November. We expect inflation to end 2018 at 3.4%, down from 4.1% in With a negative output gap, stronger currency and less inertia, an inflation slowdown is likely. We see inflation at the 3% target next year. Page 31

32 Rate cuts to resume soon The Central Bank s board adopted a more cautious approach to monetary policy in December, after November inflation surprised to the upside, while the average of core measures halted its decline. The decision to remain on hold at 4.75% in December had the full support of the board, compared with the 5-2 split to cut the policy rate by 25 bps in October and November. The sovereign rating downgrade by S&P right before the meeting (discussed below) also contributed to the decision. Although the board acknowledges that the room for further easing is limited, there are indications that the cycle has some room to run. Inflation is still expected to progress toward the 3% target in the coming months, in part due to favorable base effects and disappointing activity. The current account deficit (a key input for monetary policy) also continues to correct, and the currency is performing favorably despite the recent downgrade of the sovereign rating. We expect the cycle to end with a policy rate of 4.0%, with a potential rate cut in January. Rating downgrade leads to spending adjustment reached by 2024, from the 3.7% deficit estimated for this year). The other two major rating agencies still rate Colombia one notch higher and two above investment grade. Following the S&P downgrade, the Finance Ministry made adjustments to spending for 2017 and 2018 to ensure alignment with the fiscal rule targets: 3.6% deficit for 2017 and 3.1% for this year. Sharp rise in gross debt since % of GDP Source: Finance Ministry Gross Debt Net Debt (3Q) Standard & Poor s rating agency lowered Colombia's long-term foreign currency sovereign credit rating by a notch, to BBB-. The agency cited the country's weakened fiscal and external profiles. S&P also noted that Colombia's economy continues to suffer from the effects of lower commodity prices, reflected in its high external debt. The agency was particularly concerned about the country s ability to meet the fiscal targets starting in 2019 (the fiscal rule has a 1% of GDP nominal deficit target to be gradually Page 32

33 Forecast: Colombia F 2018F 2019F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 7,939 8,065 7,936 6,057 5,783 6,343 6,595 6,812 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments COP / USD - eop 1,767 1,930 2,377 3, ,932 3,050 3,070 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% Source: IMF, Bloomberg, Dane, Banrep, Haver and Itaú Page 33

34 Commodities Higher oil prices in 2018 Commodity prices continued to rally in December, boosted by energy and metal subcomponents. Given the recent decline in inventories, we have revised our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent, on the higher end of this range. The Itaú Commodity Index (ICI) has risen 5.0% since the end of November namely agriculture (2.3%), metals (7.1%) and energy (5.4%) as global economic activity maintains a strong pace. Higher oil price forecasts in WTI prices rose 8% to USD 61/bbl last month, due to a larger-than-expected decline in US inventories and renewed geopolitical risks. We estimate that oil prices in the range of USD 45-55/bbl may stabilize U.S. rig investment and help balance supply and demand this year. Given the recent decline in inventories, we have revised our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent, on the higher end of this range. Fine-tuning our metal prices forecast. Metal prices continued to rally in December, but we still foresee a correction ahead as the Chinese economy slows down modestly. We raised our year-end copper prices to USD 6500/mt (from USD 6200/mt) and iron ore prices to USD 60/mt (from USD 58/mt,). For agricultural prices, there were no major changes to our scenario, despite the risks associated with La Niña. We increased our 2018 YE price forecast for sugar due to the adjustment in oil prices. ICI continued to rally in December Itaú Commodities Index (Jan = 100) ICI ICI Agricultural (rhs) ICI Energy ICI Metals Scenario for 2018: Higher than previous forecast Dec-11 Dec-13 Dec-15 Dec-17 Source: Itaú Previous Current Oil: Higher prices in 2018 Itaú Commodity Index (2010=100) Oil prices continued to rally in December, supported by inventory draws and geopolitical risks. WTI and Brent rose 8% in the month, staying close to USD 61/bbl and USD 67/bbl, respectively. However, prices above USD 50/bbl over recent months are likely to stimulate shale-oil investment in the U.S., which will translate into future production. We still estimate that the WTI range of USD 45-55/bbl may stabilize the U.S. rig count and help lend balance to the market in 2018 (see chart). Given the recent decline in inventories, we have revised our year-end forecasts to USD 52/bbl (from USD 45/bbl) for WTI and to USD 55/bbl (from USD 47/bbl) for Brent, on the higher end of this range Sep-16 Jan-17 May-17 Sep-17 Jan-18 Source: Itaú Page 34

35 Supply and demand close to equilibrium in Supply Demand Global balance (rhs.) mb / d Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Source: Itaú and Bloomberg Metals: Moderate change in our forecasts The Metals ICI increased 7.1% in the month, on strong performance in iron ore and copper. Iron ore prices rose to USD 73/ton from USD 68/ton, supported by strong steel production in China, while copper prices rose to USD 7,147/ton, from USD 6,762/ton at the end of November. Nonetheless, we still foresee a correction ahead as the Chinese economy slows down modestly. We raised our year-end copper prices to USD 6500/mt (from USD 6200/mt) and iron ore prices to USD 60/mt (from USD 58/mt). Prices continued to rally in the end of mb / d ICI Metals ex-iron ore (rhs) 20 Iron ore 50 Dec-13 Dec-14 Dec-15 Dec-16 Dec Grains: Weather-related risks in 2018 Wheat and corn prices rose 4.3% and 2.6%, respectively, in December. In the meantime, soybean prices have dropped 3.4%. Grains: Price drop Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Source: Itaú and Bloomberg The increase in wheat and corn prices stems from concerns of dryer weather in Argentina as a consequence of La Niña. We maintained our scenario for the three commodities prices. Our YE18 forecasts are: Corn (Dec-18) Wheat (Dec-18) Soybean (Mar-18) (rhs) Soybeans: USD 10.2/bushel Corn: USD 4.0/bushel Wheat: USD 5.0/bushel Our scenario assumes an active La Niña that is going to last until the end of 1Q18. As La Niña implies drier weather in the Southern Hemisphere, it may affect the next crop in Brazil and Argentina. Sugar/Coffee: Slow recovery in sugar prices International contracts for raw sugar and coffee have remained broadly stable in December, as sugar increased 0.5% and coffee decreased 0.1%. Source: Itaú and Bloomberg Page 35

36 Stable prices Ethanol prices are above the sugar level USD cents / lb USD cents / lb USD cents / lb Sugar Hydrous Ethanol Gasoline Coffee Sugar(rhs) Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Source: Itaú and Bloomberg 12 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Source: Itaú and Bloomberg The recent increase in sugar prices reflects rising oil prices. As oil prices have a direct impact on ethanol prices, when fuel prices rise, sugar prices tend to move in the same direction. Our coffee price forecast for YE18 is unchanged at USD 1.31/lb. Nonetheless, we have increased our YE18 sugar prices to USD 0.152/lb, from USD 0.144/lb, reflecting the change in oil prices. Forecast: Commodities Commodities CRB Index Itaú Commodity Index (ICI)* Agricultural Energy Metals F 2019F 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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