Local election results represent a victory for the current administration, but political risks linger for the 2018 presidential election.

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1 Latam Macro Monthly Scenario Review June 17 Global Economy Less inflation, low risks 3 Global growth is holding up in the second quarter, while inflation is going through a soft patch in developed markets and will likely become mixed in China. With less inflation, the pressure on global interest rates is modest. LatAm External tailwinds fail to lift growth 7 Even as the external environment remains favorable, growth in the region is not robust. Brazil A setback for reforms and a more challenging scenario 8 A more turbulent political scene tends to delay reforms in Congress, making fiscal rebalancing more difficult and, consequently, affecting confidence levels and asset prices. Argentina Moderate growth, bumpy disinflation 13 A gradual (and still unbalanced) recovery continued in the first quarter. Inflation fell in May, but remains under pressure, reducing space for monetary policy. Mexico Politics in the spotlight 18 Local election results represent a victory for the current administration, but political risks linger for the 218 presidential election. Chile Ending the easing cycle, despite economic weakness 22 The central bank has signaled that the current cycle of monetary easing has ended, but we see risks of further interest rate cuts this year. Peru Falling inflation provides room for interest rate cuts 26 Inflation surprised to the downside in May, thus making room for more aggressive monetary policy Colombia Parked on the runway 3 Activity in the first quarter of the year was the worst since the global financial crisis. However, signs of persistent inflation suggest that the pace of interest rate cuts tends to be slower throughout the rest of the year. Commodities Cheaper oil in We maintain our yearend Brent forecast of USD 54/bbl (WTI: USD 52.5/bbl). However, for 218, we decreased our yearend Brent forecast for USD 51/bbl (WTI: USD 5/bbl), due to lower marginal cost of US shale oil producers. 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 LatAm still struggles despite favorable global environment. Global growth is holding up in the second quarter, while inflation is going through a soft patch in developed markets and will likely become mixed in China. With slower reflation, the pressure on global interest rates is modest. Steady growth, modest private-sector leverage and a still-easy monetary-policy stance sustain risk appetite. This favorable global environment makes life easier for LatAm countries, but growth in the region is still far from robust. 1Q17 growth was strong in Brazil and Argentina, but not widespread. Given the political uncertainties in Brazil, we reduced our growth forecasts for the country and, consequently, for Argentina as well. The Mexican economy is losing dynamism, as inflation reduces real wages and uncertainty over trade relations with the U.S. affects investment decisions. Growth in Chile, Colombia and Peru has been weak, even when excluding specific factors such as El Niño in Peru and strikes in the Chilean mining sector. We have reduced our growth forecast for Colombia as well. Back to Brazil, the main problem that arises with the complex political situation is that it will probably delay much needed reforms that require congressional approval. This increases the challenge to regain fiscal equilibrium, with negative impacts on asset prices and business and consumer confidence. We reduced our GDP growth forecast to.3% this year and 2.7% in 218, and now anticipate a weaker exchange rate, at 3.5 reais per U.S. dollar by the end of 217 and 3.6 in 218. In light of recent favorable releases, we have trimmed our forecast for the IPCA consumer price index in 217 to 3.7%, but lifted our call for 218 to 4.1% from 3.8% due to the expectation of exchange-rate depreciation. The Selic rate is now expected to reach 8.% by the end of this year. Hope you enjoy, Mario Mesquita and Macro Team Scenario Review World Latin America and Caribbean Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % Brazil Mexico Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % BRL / USD eop MXN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % IPCA - % CPI - % Argentina Chile Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % ARS / USD eop CLP / USD eop BADLAR - eop - % Monetary Policy Rate - eop - % day Repo rate - eop - % CPI - % CPI - % Colombia Peru Current Last month Current Last month Current Last month Current Last month GDP - % GDP - % COP / USD eop PEN / USD eop Monetary Policy Rate - eop - % Monetary Policy Rate - eop - % CPI - % CPI - % Page 2

3 Global Economy Less inflation, low risks Inflation is going through a soft patch in developed markets, and will likely become mixed in China. With slower reflation, the pressure on global interest rates is still modest. Global growth is holding up in 2Q17, with activity recovering in the U.S., solid in Europe, improving in Japan, and moderating only gradually in China. Political risks remain a worry both in DM and EM, but in Europe, risks have become more symmetric. Despite the high level of global political uncertainty, steady growth, modest private-sector leverage and a still-easy monetary policy stance sustain a low VIX (an index of volatility of the U.S. S&P stock market index) in the U.S. And this environment supports the appetite for EM assets. Less global inflation, but growth holding up well Inflation (headline and core) indices in the U.S. and in the euro area are going through a soft patch (see chart). The end of energy-price base effects, calendar distortions in Europe, and idiosyncratic shocks in the U.S. explain most of the weakness. We expect this to fade and inflation to resume its gradual rise, responding to closing output gaps, by the end of 3Q17. In China, producer price inflation has probably seen its peak and will soften from here (see chart). We expect producer inflation to continue to decelerate as commodities prices flatten, but without returning to negative territory. Less inflation in US, Eurozone and China 2.% 1.8% 1.6% 1.4% 1.2% 1.%.8%.6% yoy yoy 1% 8% 6% 4% 2% % -2%.4% -4%.2% US Core PCE Deflator EZ Core CPI -6%.% China PPI (rhs) -8% Mar-13 Oct-14 May-16 Dec-17 With slower inflation, at least in the short term, major central banks can remain accommodative. We believe that the U.S. Fed will continue to normalize policy and the ECB will start to adjust its forward guidance. But, with modest inflation, both can afford to proceed cautiously. Finally, monetary conditions have tightened in China, but the PBoC is likely to maintain a prudent stance, adjusting its policy as necessary to prevent a soft lending from becoming something more bumpy. Meanwhile, activity is holding up well. In 2Q17, a pick-up in the U.S. and a steady pace in Europe will compensate for a modest slowdown in China (see chart). Activity is holding up well 4.5% 4.% 3.5% 3.% 2.5% 2.% 1.5% 1.%.5% contribution on yoy growth.% Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 Source: Haver, Itaú Rest of the world China USA Euro Area Japan Source: Haver, Itaú Page 3

4 U.S. Moderate growth, soft inflation We estimate GDP growth of 3.% qoq/saar in 2Q17, an improvement from 1.2% in the first quarter. There have been some mixed prints in construction spending and vehicle sales, but economic and financial conditions should support moderate growth (2.%-2.5%) of domestic demand in the second half of the year. Hence, we continue to forecast U.S. GDP growth of 2.3% in 217 and 2.4% in 218. Payroll growth appears to have moderated a bit this year, but remains fast enough to push the unemployment rate down. Payroll grew 162k on average year to date, down from 19k last year. The combination of slower payroll and faster GDP growth indicates a pick-up in productivity growth this year. Given the decline in labor-market slack, the recent inflation soft patch should be transitory. In fact, the Core PCE deflator deceleration, to 1.5% YoY (from 1.7%), can be partially explained by transitory factors like a company-specific phone-plan discount. Meanwhile, the slack in the labor market continues to shrink, with unemployment dropping from 4.7% in December to 4.3% in May. We expect the FOMC to continue to normalize monetary policy gradually. Although labor markets appear to have little slack, wages are sluggish (2.5% yoy) and long-term inflation expectations are below historical norms. We see a rate hike in June and September, and the announcement of a balance-sheet reduction in December. Given the soft patch in inflation, the risk is that the Fed doesn t hike in September. Finally, we continue to assume that President Trump can pass a modest fiscal stimulus (1% of GDP) by year-end. Investors have low expectations about any significant policy move. Modest tax cuts are likely because Republicans in Congress must show results for their electorate in the mid-term elections (4Q18). However, given Congress s tight schedule, the contours of the tax reform should only become clear in 4Q17. Europe Stronger growth to continue as political risks have become more symmetric Emmanuel Macron s supporters are expected to have a strong performance in the June National Assembly elections (June 11 and June 18). With most polls suggesting that Macron s camp is likely to have an absolute majority, alongside collaboration from Les Republicans (which is set to be the second-largest party in Parliament), Macron should be able to undertake the necessary labor-market reforms in order to structurally reduce unemployment in France. In addition, his reformist agenda is set to help foster Franco-Germanic partnerships that can advance his pro-european agenda. Germany s Angela Merkel has recently said that she would be willing to show more flexibility, which has sparked a debate on Germany being more prone to pursuing fiscal integration within the EU. Europe still faces political risks, particularly in Italy. The country is contending with a worrisome combination of high migration flows, high unemployment and low growth, all of which could fuel Europopulism (see Macro Vision: Has Europopulism been stopped?) Though risks of an early election have increased, we understand that anticipation cannot take place before late 3Q17. This is because Italy s congress needs to approve changes to the electoral law before President Sergio Mattarella dissolves parliament and calls for general elections. In such an event, we expect Renzi s DP to form an unstable alliance with Berlusconi s FI in order to achieve a governing majority and halt ascension from the Eurosceptic 5 Star Movement (see chart). Italy elections are the biggest political threat in Europe % Jan-16 May-16 Sep-16 Jan-17 May-17 Source: Pollsters, Itaú M5S PD FI LN MDP CP Meanwhile, activity remains strong. Euro zone GDP was revised to.6% from.5% qoq in 1Q17, a solid pace for the region. The purchasing managers index (PMI) reached 56.8 in May, its largest figure since April Page 4

5 211. Improving financial conditions, slightly expansionary fiscal policies and a milder external drag have broadened the recovery in the euro zone. The ECB changed its guidance, recognizing a neutral assessment of the balance of risks and, as a consequence, removing its bias to further lowering interest rates. Nonetheless, the ECB will continue stressing the need to maintain its accommodative stance for now. We believe the central bank to be preparing the ground for a gradual removal of stimulus, likely by year-end. We expect that in 218 the ECB will raise the deposit rate to.% from -.4%, while also reducing the monthly pace of assets purchases to EUR 3-4 billion from EUR 6 billion. We raised our 217 GDP growth forecasts for the euro zone to 1.8% from 1.7% due to the upwards revised 1Q17 print, while maintaining 218 forecast at 1.5%. Japan The economy underperforms in 1Q17 We expect economic growth will continue to weaken in 2H17, due to tighter economic policy. However, we don t expect the current economic slowdown in China to have an impact on global markets. First, the economy is in a good position in the cycle, hence less prone to hardlanding scares. Second, economic policy can be adjusted, if necessary, to avoid a bumpier landing. Finally, capital outflows have diminished. We maintain our forecast of 6.5% GDP growth for 217 and 5.8% growth for 218. Political uncertainty has not changed the fundamentals for low risk, so far. Measures of risks, like the VIX, have decoupled from measures of Economic Policy Uncertainty (see graph). This decoupling has puzzled market observers. Our analysis (see next paragraph) suggests that economic-policy uncertainty has to first cause a deterioration of economic fundamentals in order for it to lead to higher volatility over time. But political events, at least in developed countries with strong institutions, are low-frequency dynamics and hence, spikes in volatility caused by political surprise have so far faded fast. VIX decoupled from Global Economic Policy Uncertainty Japan s economy is showing healthier signs, but 1Q17 growth disappointed at 1.% saar. Slowly improving soft data, in line with strong industrial production and a lagged weak-yen effect boosting exports, supports our view that the Japanese economy is set to grow faster than its potential rate this year. Additionally, a tightening labor market unemployment stayed at 2.8% in April should give a boost to consumption ahead S&P5 3-day option volatility Index Our GDP growth forecasts for Japan remain unchanged at 1.4% in 217 and 1.% in 218. China A modest policy-driven slowdown Economic activity in China started to slow down in April. Industrial production growth decreased 1.1 pp to 6.5% yoy, fixed investment came at 8.9 % yoy YTD, and retail sales decelerated to 1.7% yoy. The official manufacturing PMI suggests that economic activity remained broadly stable from its April level. 2 1 VIX 5 Global Economic Policy Uncertainty (rhs)* May-97 May-1 May-5 May-9 May-13 May-17 * Baker, Bloom & Davis Source: Bloomberg, Itaú, 1 Despite high policy uncertainty, low private-sector leverage, steady GDP growth and the U.S. Fed s monetary-policy stance explain the currently low VIX level (see graph). According to our econometric analysis, these are the main drivers of the VIX, not political uncertainty. Of course, the latter can at some point affect these fundamental drivers (growth, leverage, monetary policy) and hence the VIX. But so far it hasn t. Page 5

6 Latam Macro Monthly June 12, 217 Low VIX due mainly to easy monetary policy contribution in pp Private levverage Economic growth Monetary policy VIX (rhs) -15 1q95 2q1 3q7 4q13 1q2 Source: Bloomberg, Itaú 3-day option implied volatility Commodities Lower oil prices in 218 The Itaú Commodity Index (ICI) fell by 3.7% in May, driven by metal and energy price indexes. The former plummeted 8%, led by a 2% drop in iron ore price. Meanwhile, energy prices declined 3.2% with a correction in oil prices OPEC s deal and the decline in U.S. inventories should provide support to oil prices only in the short term. Even with the extension of OPEC s deal, we believe that the deficit will continue during the year. We maintain our year-end Brent forecast of USD 54/bbl (WTI: USD 52.5/bbl). However, for 218, we decreased our year-end Brent forecast to USD 51/bbl (WTI: USD 5/bbl), due to lower marginal costs of U.S. shale-oil producers. Firmer global growth limits declines in metal prices. The downside risks to improvement in the global manufacturing cycle seem limited at the moment, even with a slowdown in China. If the global Manufacturing PMI remains close to its current levels, metal prices are unlikely to enter a downward trend. This is consistent with our forecast of a 3% decline in the ICI Metals from its current level, with iron ore prices falling to USD 55/mt by the end of the year. Finally, agriculture prices have remained broadly stable since the end of April, despite of the sharp fall of 11.3% in sugar. The drop was mainly caused by a stronger-than-expected supply x demand balance. Therefore, we lowered our price forecast for sugar. Soy and wheat decreased 3.6% and.4%, respectively, over the same period. We expect the ICI to gain 2.8% from its current level by the end of 217. The increase will stem mainly from higher oil and agricultural prices. Forecasts: World Economy F 218F 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 External tailwinds fail to lift growth While financial conditions continue favorable to emerging markets, the Brazilian real weakened because of rising political uncertainties, with negative spillovers to the Argentine peso. Meanwhile, the Mexican peso continues to overperform, recently boosted by a positive outcome in the local elections. Even with a favorable external environment, growth in the region is far from robust. In particular, the recovery in Brazil and in Argentina still seems fragile. While we see more interest-rate cuts ahead in most countries, the room for monetary easing seems narrower in some of them. In Mexico, the tightening cycle is likely near its end. While financial conditions continue favorable to emerging markets, the Argentine peso and Brazilian real weakened over the past month. Renewed political turbulence in Brazil increased uncertainty about reforms, widening the sovereign CDS and depreciating the currency. Because Brazil is an important trade partner of Argentina, the Argentine peso was negatively affected, leading the BCRA (Argentina s central bank) to interrupt its aggressive dollar purchases, which had been initiated just days before the new political crisis in Brazil began. We now expect a weaker currency in Brazil relatively to our previous scenario and see more-balanced risks for our forecast for the Argentine peso (18 pesos to the dollar by the end of this year). Meanwhile, the Mexican peso continues to overperform the other currencies of the region, trading stronger than it was right before the election of Donald Trump to the U.S. presidency. The results of the regional elections in Mexico (in which the PRI candidate defeated the candidate supported by the leftwing leader Andrés Manuel López Obrador in the State of Mexico, the most populated state) contributed to the good mood. But in our view, many other factors are supporting the currency: the perception of lower protectionism risks in the U.S., monetary-policy tightening, a still-solid growth rate, the stabilization of public debt and a narrower current-account deficit. Even with a favorable external environment, growth in the region is not robust. Sequential growth in Brazil and Argentina was solid in 1Q17, but far from widespread. Due to the uncertainties about the political scenario in Brazil, we reduced our growth forecasts for Brazil and, consequently, in Argentina. In Mexico, growth was solid in 1Q17, but there are signs that consumption is losing momentum as inflation erodes real wages and investment decisions are put on hold due to remaining uncertainties over trade relations with the U.S. In Chile, Colombia and Peru, supply-side factors (such as El Niño in Peru and mining strike in Chile) have contributed to economic weakness in 1Q17, but even excluding these effects, activity has been poor (in fact, we further reduced our growth forecast for Colombia). In most countries of the region, interest rates will continue to fall, although the room for monetary easing seems narrower in some countries. In Brazil, the central bank indicated that it will reduce the pace of rate cuts, amid higher uncertainties about reforms. We now expect a higher terminal Selic rate than in our previous scenario. In Colombia, inflation has been stickier (although annual headline inflation is falling, due to dissipation of shocks including El Niño and exchangerate depreciation), leading the central bank to revert to a 25-bp rate cut in May (following a 5-bp move in April). We see pauses in Colombia s easing cycle during the second half of the year, with the policy rate reaching 5.5% before the end of 217 (75 bps below the current level). Chile s central bank delivered the fourth 25-bp rate cut of the cycle somewhat earlier than we were expecting, and removed the easing bias. In Argentina, the current level of ex-ante real policy rate (using different measures of inflation expectations) is above the 4%-5% range that the central bank deems consistent with a disinflation path. However, given the uncertainty over the inflation outlook there (and the recent CPI upside surprises), we see the BCRA lowering rates only when data gives a more clear indication that inflation is on a downward trend. On the other hand, in Peru we now expect more rate cuts than previously, as the effect of El Niño on food prices is reverting rapidly. In Mexico, part of the board (likely the majority) sees the cycle ending soon (we expect only two additional 25-bp rate hikes). Page 7

8 Brazil A setback for reforms and a more challenging scenario A more turbulent political scene tends to delay reforms in Congress, making fiscal rebalancing more difficult and, consequently, affecting confidence levels and asset prices. We now anticipate a weaker exchange rate, at 3.5 reais per U.S. dollar in 217 and 3.6 in 218. We revised our forecast for the IPCA consumer price index downward for 217 to 3.7% from 3.9%, but raised our call for 218 to 4.1%, from 3.8%, due to exchange-rate depreciation. We maintained our estimate for the benchmark interest rate by YE17 at 8.%. We expect the pace of rate cuts to slow down to 75 bps in the July meeting. A complex scenario, more uncertainties surrounding reforms and a milder decline in interest rates outline a challenging situation and should weigh on economic activity. We thus reduced our estimates for GDP growth to.3% this year and 2.7% in 218. The international environment and mitigating factors such as international reserves, Treasury funds held by the central bank and falling inflation have cushioned the reaction of asset prices to the deterioration of reform prospects. For now, a situation of financial stress seems to be at bay. However, financial stability is a necessary not sufficient condition for a consistent recovery in economic activity. The cost of uncertainty is stagnation. Delayed reforms make fiscal rebalancing more difficult and uncertainties intensify With the significant intensification in political uncertainties, Congress will likely delay processing the pension reform. The proposal needs greater political consensus before being voted on in two rounds on the main floor of the Lower House, so it can then proceed to the Senate. Now, these votes may only take place in the second half of the year. Doubts about the approval of reforms heighten uncertainties about the outlook for public-debt stabilization. The delay affects confidence levels and pressures local asset prices, consequently undermining the outlook for a rebound in economic growth and further declines in interest rates (in response to greater fiscal equilibrium), and fueling more growth in public debt. Without reforms, the government is less likely to meet the constitutional spending cap over time and public debt would remain in an upward trend (see chart). Without reforms, the adjustment in public accounts in the long run would materialize in the form of higher inflation or alternative measures with a negative impact on the economy. For instance, the fiscal imbalance in Greece produced a 32% contraction in the economy from 28 and effectively caused the removal of social rights. Among feasible remedies, an increase in the tax burden of more than 4 pp would be very likely, in order to finance growing deficits in the pension system and the public sector as a whole, significantly decreasing the chances of a sustainable economic recovery. Importantly, this would not be an increase in the tax burden in order to bankroll more capital expenditures (lifting growth capacity in the economy). It would simply amount to resources being transferred from one generation to another, without impact on potential growth. Unsustainable increase in public debt: Reforms are urgent 8% 75% 7% 65% 6% 55% 5% 45% % GDP Source: BCB, Itaú General government gross debt 7% 77% 75% Page 8

9 Amid greater uncertainty, meeting fiscal targets will be even more difficult, delaying the gradual reversal of the country s fiscal imbalance. Our estimate for the primary deficit in 217 is 2.4% of GDP (157 billion reais), missing the current target of 2.2% of GDP (142 billion reais). The expectation of slower economic growth in 217 means that tax revenues will be shorter by 15 billion reais (.2% of GDP), causing fiscal needs to meet the target to rise by 9 billion reais (1.4% of GDP). In this context, despite significant efforts in terms of spending freezes and extraordinary revenues (such as repatriation of funds held by residents overseas, concessions and several tax regularization programs), we regard the current primarydeficit target as ambitious. However, given the economic team s strong commitment to the target, we do not rule out additional spending cuts and higher revenues (with tax hikes, for instance), to compensate for the disappointing tax revenues. Our estimate for the primary deficit in 218 is 2.1% of GDP (147 billion reais), also above the target of 1.8% of GDP (131 billion reais). Weaker economic growth and difficulties in terms of cutting discretionary expenses further, raising taxes amid political uncertainty, and a third consecutive year of large extraordinary revenues tend to produce a more gradual convergence to primary-budget surpluses that are compatible with stability in public debt. Greater risks pressuring the BRL Higher risk premiums and a weaker BRL Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Bloomberg, Itaú BRL CDS (RHS) All-time-high trade surpluses in the first months of the year help to keep the current-account deficit at low levels. The current-account deficit over 12 months narrowed to USD 2 billion or 1.1% of GDP. A weaker exchange rate and slower activity led us to revise our forecasts for the current account in the coming years. We now forecast a USD 6 billion trade surplus 1 in 217 and USD 5 billion in 218 (vs. USD 4 billion previously). For the current account, we forecast a USD 23 billion deficit in 217 (vs. USD 25 billion) and USD 37 billion deficit (vs. US$ 5 billion) in 218. Political uncertainties pressured the Brazilian currency during the month. Although the external environment remains favorable to emerging-market currencies, political events intensified the uncertainties about the approval of reforms and increased risk premiums. Brazil s CDS spread jumped to more than 265 bps from 2 bps in a single day, but later stabilized around 24 bps. The exchange rate behaved similarly, sinking to about 3.4 reais per dollar from 3.1 in a day, but it is again trading around 3.25, thanks to the central bank s interventions in the FX market. During the past month, the monetary authority sold USD 1 billion in FX swap contracts, to foster calm and make sure that the market continues to function well. We revised our exchange-rate forecasts to 3.5 reais per dollar by YE17 (from 3.25) and 3.6 by YE18 (vs. 3.35). Uncertainties about adjustments and reforms have intensified in the past month. A bleaker outlook tends to lift risk premiums, weakening the Brazilian currency. We revised our inflation forecast downward for 217 and upward for 218 For 217, our forecast for the IPCA consumer price index has been revised downward to 3.7% from 3.9%. Well-behaved inflation at the margin more than offset the effect of our revised estimate for the exchange rate. We expect year-over-year inflation to recede to 3.2% in June, bottoming at 2.9% in August and rebounding to 3.2% in September. Importantly, disinflation may pave the way for a welcome debate about reducing the inflation target. The National Monetary Council (CMN) will meet in June to confirm the inflation target of 4.5% for 218 and set the target for the following year. 1 As per MDIC Page 9

10 Below-target inflation 2% 18% 16% 14% 12% 1% 8% 6% 4% 2% yoy IPCA Market-set prices (76%) Regulated prices (24%) Source: IBGE, Itaú 1.7% 6.3% Forecast 3.7% 4.1% % Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Breaking down the IPCA, we anticipate increases of 3.2% in market-set prices and 5.2% in regulated prices. Among market-set prices, we forecast a 2.% increase for food prices consumed at home, after a 9.4% jump last year. The outlook for large crops in Brazil and other large global producers has been prompting declines in wholesale agricultural prices since September 216 and affecting retail food prices favorably during the year. Wholesale agricultural prices (measured by Getulio Vargas Foundation s IGP-M) show 8.7% deflation in the last 12 months (13.5% in the past nine months). Sharp disinflation in food prices this year is set to provide relief of 1.2 pp to the IPCA reading almost half of the estimated retreat in inflation during this period. For industrial prices, we expect a 1.7% increase this year (4.8% in 216). For services, our call stands at 4.8% (6.5% in 216). Adverse conditions in the labor and real estate markets, dissipation of the inertia effect of past inflation, and a smaller adjustment in the minimum wage have moderated wage and rent costs. In that sense, they will contribute to lower service inflation in 217. As for regulated prices, we forecast - 3% for landline phone service; -3% for gasoline; 5% for medication; 7% for electricity; 7% for urban bus fares; 7% for bottled cooking gas; 8% for water and sewage tariffs; and 13.5% for health insurance premiums. We revised our estimate for 218 inflation upward to 4.1%, from 3.8%. Our expectation of a weaker exchange rate more than offset the downward effect related to a slower rebound in economic activity and an even higher unemployment rate. Breaking down the estimate, we expect market-set prices to rise 3.5% and regulated prices to climb 5.8%. The main factors behind our below-target forecast are the negative output gap, lower inertia from 217 inflation and anchored expectations. As already mentioned in this report, inflation below the target range midpoint starting in 2Q17 and inflation expectations below 4.5% create an opportunity to consider a reduction in the inflation target for 219. We regard a 4.25% target as appropriate, given that expectations stand at that level. Falling inflation expectations 5.6% 5.4% 5.2% 5.% 4.8% 4.6% 4.4% 4.2% Source: BCB (Focus Survey) Median inflation expectations (IPCA) % 4.25% 4.25% 4.% 3.9% 3.8% Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 The main risk factors for inflation are still tied to domestic politics. Heightened political uncertainties hinder reforms and needed adjustments in the economy, potentially causing additional impact on risk premiums and the exchange rate. Along with a negative effect on economic activity, setbacks in terms of approving reforms may also require alternative fiscal measures, such as tax hikes and/or the reversal of tax breaks, which tend to have an upward impact on inflation, at least in the short term. As for the external scenario, notwithstanding more favorable signs at the margin, there are still risks related to possible changes in economic policy in the main developed nations, which could eventually lift risk premiums and depreciate the local currency. Substantial slack in the economy may contribute to a sharper decline in inflation. The negative output gap (difference between potential and effective GDP) may prompt faster disinflation in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial products. Inflation readings in recent months showed evidence of a more Page 1

11 widespread disinflation process, which has been affecting these segments in particular. As for prices for food consumed at home, given the favorable supply shock and the recent evolution of agricultural retail prices, we cannot rule out seeing even more beneficial behavior than our current call. A lower inflation target for 219 would reinforce the outlook for lower inflation and anchored expectations. The median of inflation estimates for the year, measured by the Central Bank s Focus survey, declined to 3.9% from 4.%, although the currency depreciated during the past month. The median expectation for 218 was unchanged at 4.4%. Median estimates for 219 and 22 remained at 4.25%, probably already assuming the possibility of a lower inflation target for the 219 calendar year. Monetary policy: Heightened uncertainties should prompt a slower easing pace The minutes of the Monetary Policy Committee (Copom) in May stressed that the effects of heightened uncertainties surrounding reforms on the prospective inflation path are not trivial. High levels of uncertainty for long periods may have a disinflationary impact by hurting economic activity, but also affect estimates for structural interest rates. In that context, the Copom felt the need to reduce uncertainties about the future path of monetary policy by signaling a moderate deceleration in the pace of rate cuts in its next meeting, in July. We expect the Copom to slow the pace to 75 bps in July and to 5 bps in the following meetings, moving at that speed until the Selic rate reaches 8% by year-end. Activity: Uncertainties lead to a slower rebound GDP expanded 1.% in 1Q17, after eight consecutive quarters of declines. The result was deeply influenced by strong agricultural production and favorable statistical carryover from industrial production. Nevertheless, the report showed that improved fundamentals (falling interest rates, better corporate balance sheets, higher commodity prices since 1Q16 and confidence levels) were benefiting the economy. For 2Q17, GDP is likely to contract slightly, by -.2% qoq/sa. Our forecast is based on a mild decline in agricultural GDP and unfavorable statistical carryover from several GDP components after weak readings in March. Coincident indicators for April and May point to a scenario of stability that does not reverse the unfavorable statistical carryover effect during the quarter. We revised our estimate for GDP growth in 217 to.3% from 1.%, given the outlook for a slower rebound in the second half. The prospect of slower growth is consistent with the complexity of the scenario, uncertainties surrounding reforms. Furthermore, our new forecast incorporates slightly weaker figures in 1H17. Growth to rebound more slowly as uncertainties rise 1.5% 1.%.5%.% -.5% -1.% -1.5% -2.% -2.5% 213.IV 214.IV 215.IV 216.IV 217.IV 218.IV Source: IBGE, Itaú quarter-over-quarter Realized Forecast Our forecast for GDP growth in 218 now stands at 2.7% of GDP. The revision (from 4.% previously) was prompted by the same events that will affect 2H17, as well as a significantly less favorable statistical carryover due to a slower recovery in 217. Destruction of formal jobs slows down gradually. According to the Labor Ministry s Caged registry, 59,9 jobs were destroyed in net terms in April. The seasonally adjusted three-month moving average receded to -56, from -62, and continues to slow down (see chart). The unemployment rate measured by PNAD was virtually stable at 13.2% (applying our seasonal adjustment). Both readings were slightly better than anticipated. Page 11

12 Destruction of formal jobs slows down in April thousands, 3-month moving average Assessing the outlook for the labor market, our economic expectations are consistent with the unemployment rate at 14.% by YE17 (13.8% previously) and 14.3% by YE18 (13.6% previously). We expect the unemployment rate to peak in 3Q18, at 14.3%. Unemployment will continue to climb when the recovery begins, because the contracting cycle in economic activity has not yet had a full impact on the labor market Apr-9 Apr-11 Apr-13 Apr-15 Apr-17 Source: Caged, Itaú Forecast: Brazil F 218F Economic Activity Real GDP growth - % Nominal GDP - BRL bn 4,376 4,815 5,332 5,779 6,1 6,267 6,649 7,178 Nominal GDP - USD bn 2,612 2,463 2,468 2,455 1,82 1,797 2,17 2,2 Population (millions) Per Capita GDP - USD 13,234 12,362 12,278 12,16 8,811 8,721 9,711 9,656 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 12

13 Argentina Moderate growth, bumpy disinflation A gradual (and still unbalanced) recovery continued in 1Q17. We expect the economy to grow 2.5% this year and 2.8% in 218 (down from 2.7% and 3%, respectively, in our previous scenario). The new forecasts are consistent with downward revisions in our growth estimates for Brazil. In spite of positive news on May, the inflation target for this year (12%-17%) remains a tough challenge. We expect 22% inflation by December. In our view, the consolidation of a disinflation process will likely lead the Central Bank to lower the reference rate, even if the target is not met, as long as the deviation is limited. We expect the 7-day repo rate at 22% by end The central bank put its purchases of U.S. dollars on hold, as the peso weakened rapidly after the political events in Brazil. We still expect the exchange rate to hit 18 pesos to the dollar by December, in spite of the expected weakening of the Brazilian real. The treasury will likely meet its primary-fiscal-deficit target this year (4.2% of GDP). Tough control on subsidies and the economic recovery will likely offset higher pension payments and capital expenditures. The government will face an important political test in October when Congress members will be partially renewed. The focus will likely be on the Province of Buenos Aires, especially if former president Cristina Kirchner finally decides to run. The economy will likely recover this year at a modest pace Activity continued to recover in 1Q17. The economy has posted three consecutive sequential gains since 3Q16, adjusted for seasonality, and the first (albeit mild) year-over-year increase since 1Q16. The EMAE (official monthly GDP proxy) posted a 1.9% increase between February and March, partially offsetting a 2.6% decline the previous month. Activity consequently grew 2.4% qoq/saar and.1% year over year in 1Q17. The official national accounts will be available on June 21. Agriculture and Construction have been the main engines of growth. These sectors registered positive year-over-year gains in 1Q17 (5.8% and 2.1%, respectively). However, according to our seasonal adjustment, Agriculture lost momentum at the margin (1.% qoq/saar) while Construction increased by 27.1% qoq/saar, led by public works. Manufacturing output is still declining (-2.% year over year in 1Q17) but improved at the margin (6.6% qoq/saar). The IGA (a GDP proxy produced by OJF consulting firm) increased.3% between March and April (3.1% year over year), hinting that the recovery continued into 2Q17. Going forward, consumption will likely benefit growth. The available data suggests that consumption remains weak. Retail sales fell 3.5% yoy in real terms in the quarter ending in May, while Supermarket sales dropped 9.1% yoy in real terms in 1Q17, although the evolution of VAT collection (adjusted by inflation) indicates a better performance of consumption. In any case, employment is recovering, which together with wage agreements (in the range of 2%-25%) should lift the real wage bill, benefiting households. While we expect the recovery to continue, led by higher real wages, investment and a strong agricultural sector, our new forecasts for the Brazilian economy led us to reduce our forecasts for Argentina. We now expect GDP to grow 2.5% this year, followed by 2.8% in 218 (down from 2.7% and 3%, respectively, in our previous scenario). Slow recovery %,GDP growth -4 I-16 II-16 III-16 IV-16 I-17* *EMAE Source: INDEC YoY QoQ/sa Page 13

14 The inflation target for the year remains compromised Inflation decelerated in May after three shaky months. Consumer prices increased 1.3% mom in May after averaging 2.5% in February-April. Core inflation, which had spiked to 2.3% in April, fell to 1.6% in May. Annual inflation fell to 24.%, from 27.5% in April, and will likely continue its downward trend in June. We note that, at the margin, the three-month moving average of core inflation fell to 25.7% annualized, after peaking at 26.6% in April. Despite the positive news, the inflation target for 217 (12%-17%) remains a tough challenge. Accumulated inflation in the first five months of the year has already reached 1.5%. So, it would be necessary to reduce inflation to an average of.82% per month during the rest of the year just to hit the upper band. The latest survey of inflation expectations in Argentina showed analysts revising their forecasts up for this year and the next, likely as a response to the higher-than-expected CPI in April. We note that despite the deterioration in inflation expectations for the year, analysts forecasts are still consistent with a gradual disinflation process. For 217, inflation expectations now stand at 21.6%, while for 218 the median forecast is 15% (also above the 8%-12% target range for next year). The central bank made clear from the beginning of the inflation-targeting regime that the accomplishment of the inflation target will be evaluated using the CPI with the broadest regional coverage. The current CPI covers prices in what is called the Greater Buenos Aires area (City of Buenos Aires and surrounding counties), but INDEC, the official statistical agency, will publish a new national CPI index on July 11 (also continuing the production of the current CPI). The statistics institute will provide year-to-date data, so the central bank will not have to chain the new index with the previous one when targeting 217 inflation. We note that the new CPI index will not make the central bank s life much easier. While regulated inflation has been higher in Buenos Aires than in other parts of the country, the difference between national CPI and the current index will probably be small, as no significant tariff hikes are scheduled for the rest of the year. Our estimated proxy for a national CPI posted a 35.6% annual inflation in December 216, five points lower than the 41% registered by the CPI maintained by the City of Buenos Aires in that year. But the difference has narrowed steadily in 217 (from 3% in January to % in April). Consistent with this view, analysts surveyed by the central bank do not see a meaningfully different inflation at the national level than in the Greater Buenos Aires area (21.4% vs 21.6% respectively). Disinflation %, yoy Headline Core Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 May-17 Source: INDEC and City of Buenos Aires Government Vigilant Central Bank Inflation range target Note: Calculated using INDEC CPI and CABA CPI when the former is not available The central bank left the monetary policy rate unchanged at 26.25% for the third consecutive time at its second meeting in May (following the 15-bp rate hike in early April). The statement announcing the recent decision suggests that high-frequency indicators for inflation in May (anticipating the resumption of a disinflation process) are behind the decision to remain on hold. The central bank had tightened the monetary policy in March and April after recognizing that overconfidence generated by the lower inflation readings in December 216 and January 217 might had led the institution to ease monetary policy somewhat early in the year. But a tightening bias remains, so rate hikes in the near term are a possibility. The central bank continues to pledge that it will act if necessary to ensure a disinflation process. Looking further ahead, we still believe that a new easing cycle is likely before the end of this year as inflation gradually falls, even though meeting the Page 14

15 217 inflation target is unlikely policy decisions in Argentina happen at by-monthly frequency, which helps add flexibility to policy implementation in the very earliest stages of the new regime. We expect the repo rate to fall to 22% before the end of this year. For 218, we see the reference rate falling to 16% by December. Peso weakens, driven by intervention and recent political events in Brazil Following the announcement of a reserveaccumulation program, the central bank purchased dollars from the market in the first two weeks of May. Previously, the central bank indicated that the increase in reserves would come mostly through direct transactions with the non-financial public sector (that is, mostly purchases from the dollars originated in the debt issuances of the federal government). The monetary authority bought USD 1.1 billion between May 3 and May 17 in the foreign-exchange market. The recent political events in Brazil triggered a weakening of the currency, which was likely behind the decision to stay away from the foreign-exchange market. In real terms, the multilateral real exchange rate weakened 3.2% between April 17 and May 31 (3.5% against the dollar, partially offset by a.7% strengthening against the real). Even so, the Argentine peso remains strong. In our view, the central bank will likely resume dollar purchases as volatility falls in the exchange market. The target is to lift the gross reserves-to-gdp ratio to 15% in approximately two years. However, this target is clearly subordinated to the goal of bringing inflation down, so the central bank is unlikely to intervene during risk-off episodes. We now see more balanced risks to our forecast for the exchange rate (previously tilted to further strengthening). We expect the exchange rate to hit 18 pesos to the dollar, stronger in (bilateral) real terms relative to the end of 216. For December 218, we expect an exchange rate of 2.5 pesos, similar in real terms to the rate we expect for the end of this year. The strong currency and the recovery in internal demand will likely further deteriorate the current account balance. Imports picked up 9.1% yoy in the first four months of the year, while exports gained a modest 1.8%. On a seasonally adjusted basis, the last- 12-month trade surplus fell to USD.6 billion in April, from USD 2.3 billion in December 216. The travel account (on a cash basis) also deteriorated to a deficit of USD 3. billion in 1Q17, from a deficit of USD 2.2 billion in the same quarter one year ago. We forecast a trade deficit of USD 2.3 billion this year and a current-account deficit of 3.5% of GDP, mostly financed by debt. Still strong May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Source: BCRA Dec15=1, real exchange rate Multilateral US-Bilateral BRL- Bilateral Primary-deficit target for this year remains on track The government set a path of declining primaryfiscal-deficit targets until 219. The goals are 4.2% of GDP for 217, 3.2% for 218 and 2.2% for 219. The government also seeks to reduce primary expenditure in real terms over the coming years, while revenues are likely to grow in line with economic activity. We expect the government to meet its primarydeficit target this year. While the primary deficit worsened in April, relative to last year, the numbers remain in line with the target for 217. The primary deficit accumulated over the last 12 months rose to ARS 347 billion (estimated at 4.% of GDP), from ARS 339 billion in March (3.9% of GDP). The treasury maintains a tough control on subsidies, to curb expenditure growth, but faces higher pension payments and is increasing capital expenditures. Expenditures before interest payments accelerated to 35.8% year over year in the first four months of 217 (approximately 6% in real terms). Page 15

16 Capital expenditures grew 44.6%, while pension payments increased by 39.8% due to pension adjustments. Subsidies have risen by just 7% year to date (a sharp contraction in inflation-adjusted terms). However, meeting the 218 fiscal-deficit target will be more challenging. The government will not have the benefit of penalty collections, while pensions will continue to be adjusted based on past inflation. We forecast a primary deficit of 3.8% of GDP for 218, above the 3.2% target. Federal public debt will grow from relatively low levels. Argentina s gross federal debt hit 56.8% of GDP in 216, in part explained by the regularization of arrears with holdouts. However, government obligations with the private sector and multilateral institutions are estimated at 27.% of GDP (we exclude here the debt with the central bank and public-sector agencies, which has low roll-over risk). We estimate that this measure of net debt will reach 32.5% of GDP by end-219, a still-comfortable level. Gradual adjustment % of GDP, fiscal balance, rolling 12 months Nominal Balance Primary Balance II-1 II-11 II-12 II-13 II-14 II-15 II-16 Apr- 17 Source: Ministry of Treasury Mid-term elections are coming The government will face an important political test in October, when Congress composition will be partially renewed (one-third of the Senate and half of the Lower Chamber). It is likely that the current composition (with no party holding a majority) will not change significantly. The opposition Peronists have more seats at stake than the ruling party. As so many seats will be at stake throughout the country, it is difficult to find a single metric to define the winning coalition of the mid-term elections. The focus will likely be on the Province of Buenos Aires, especially if former-president Cristina Kirchner finally decides to run. The incumbent (Frente Cambiemos coalition) looks well-positioned for the mid-term elections. Macri s approval rating is at 52% according to Poliarquía s latest survey. His positive image is 44%, while that for the current governor of the Province of Buenos Aires, María Eugenia Vidal (who is also part of the government coalition), is much higher: 6%. According to a poll conducted by the consulting firm Aresco, Esteban Bullrich (a potential candidate from the ruling party) leads the voting intention for Senator in the Province of Buenos Aires, with 33% of votes. The same survey reveals that if Cristina Kirchner decides to run for the Senate, her list would receive 31.5% of the votes in the province of Buenos Aires. In any case, the lists of candidates of each coalition will be defined in an open and mandatory primary election on August 13, and the names of participants in the primaries must be announced on June 24 (See Macro Vision: A closer look at Argentina s October mid-term election). Page 16

17 Forecast: Argentina F 218F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 12,786 13,888 14,478 13,215 14,616 12,56 13,492 14,3 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 * From 216 excludes central bank tranfer of profits. Sources: Central Bank, INDEC and Itaú Page 17

18 Mexico Politics in the spotlight The regional and municipal elections were a victory for the political establishment, with the ruling party retaining control over the State of Mexico the country s most populated state and Coahuila. In Nayarit and Veracruz, the remaining states at stake, the right-wing party (PAN) emerged as the winner. However, this is not to say that Andrés Manuel López Obrador s (AMLO) chances to become President in 218 have decreased. The performance of his party, Morena (founded only three years ago), has surpassed all expectations, almost defeating the PRI in its historical Mexico stronghold. Growth surprised to the upside in 1Q17, but we see signs of weakening at the margin. Investment is already deteriorating, amid the uncertainty surrounding bilateral relations with the US and fiscal consolidation, which will likely have negative second-round effects in the labor market. If this happens, consumption is also bound to slow down. Stronger exports, in contrast, due to higher growth in the U.S., will act as a buffer. We expect GDP growth to slow down to 2% in 217 (from 2.3% in 216), while a modest pick-up (to 2.1%) is likely in the next year. There is disagreement in the Banxico board on the timing to end the tightening cycle. Two board members embrace the view that Banxico is getting close to the end and that there is space to decouple from the U.S. Fed. Conversely, two other members argue that inflation must actually start to trend down before evaluating the possibility of ending the tightening cycle. In fact, inflation has consistently surprised to the upside in the first five months of 217. We expect Banxico to deliver two more 25-bp hikes in 217 (the next one in June, in lockstep with the Fed). Political establishment wins regional elections The political establishment, meaning the dominant center and right wing political parties, PRI and PAN, won the regional and municipal elections of 217. To provide some background, elections in the 31 states (+ Mexico City) and thousands of municipalities of Mexico are scheduled in different years. Last Sunday (June 4), the constituencies of four states went to the ballots to elect a new regional governor (State of Mexico); regional governor, mayors, and regional parliament (Coahuila and Nayarit); and mayors (Veracruz). The ruling party s (PRI) candidate, Alfredo del Mazo (33.7%), won in the State of Mexico, followed by AMLO s protégée, Delfina Gomez (3.8%). Standing third was Juan Zepeda (17.8%), from the PRD (center-left party), and Josefina Vázquez (11.3%), from the PAN (right-wing party), was in fourth position. Coahuila was retained by the ruling PRI party. Nayarit and Veracruz, however, were clear victories for the PAN. The markets eyes were clearly on the State of Mexico. The importance of this gubernatorial election stems from the fact that the State of Mexico is the country s most populated state (accounting for 14% of voters) and the ruling party s historical stronghold, where it has ruled for 9 years. It is Enrique Peña Nieto s home state, in which he ruled as Governor before taking office as President of Mexico in 212. However, as the popularity of the federal government has reached historical lows amid growing anti-establishment sentiment (embodied by the left-wing leader AMLO), market participants were focusing on this election as a rehearsal for the presidential elections to be held next year. In fact, AMLO campaigned aggressively in favor of Delfina Gómez. Despite the defeat, the results of the regional and municipal elections do not weaken AMLO s prospects to become president in 218. Granted, winning the State of Mexico would have strengthened AMLO by giving Morena the opportunity to use this regional government as a platform to boost the presidential campaign. However, our main takeaway from the results is that Morena a party created only three years ago stood up to the mighty political machinery of the PRI and almost defeated them in the core of their supporting base. Looking ahead, López Obrador s candidacy will likely continue benefitting from corruption scandals involving the PRI and the low GDP growth in spite of the reforms approved during Peña Nieto s term. But he will face tough competition in next year s presidential election. According to the average of the latest polls (April), AMLO only has a 1 pp lead over Margarita Zavala (the PAN s likely presidential candidate, although this still needs to be decided in the party s primaries). As there is no run-off in Mexico, and historically AMLO has faced a high rejection rate, a significant number of PRI supporters might end up voting for the PAN. Page 18

19 Growth slowdown ahead Growth surprised to the upside in 1Q17. After a robust flash estimate, which surprised market expectations, Mexico s GDP growth for 1Q17 was revised up (to 2.8% year over year). Adjusting for calendar effects, GDP growth was 2.6% year over year, up from 2.3% in 4Q16. Growth rested on the shoulders of the service sectors (3.8% year over year, 3.4% in 4Q16), while industrial sectors contributed negatively. Looking at the breakdown of industrial sectors, manufacturing was the bright spot (4.4% year over year in 1Q17, from 2% in 4Q16), which is consistent with the acceleration of manufacturing exports observed in the trade balance data. In contrast, construction activity fell for the first time in over a year (-.2% year over year in 1Q17, 3% previously), hit by the ongoing fiscal consolidation. Moreover, mining contracted at a sharper pace (-1.5% year over year, from -9.9% in 4Q16), dragged by falling oil output. At the margin, however, the monthly GDP proxy (IGAE) has posted two consecutive monthly contractions, and gross fixed investment is weakening considerably. Adjusting for calendar effects, gross fixed investment fell 1.8% year over year in 1Q17, after expanding 1.3% in the previous quarter, and posted a quarter-over-quarter annualized contraction of 6.2% (from a 2.4% qoq/saar expansion in 4Q16). This weakness, in our view, is attributable to both the fiscal consolidation and the uncertainty surrounding bilateral relations with the U.S. (which puts investment decisions on hold). We believe that formal employment creation will eventually deteriorate as investment slows down, which together with rising inflation, will reduce consumption growth. Moreover, other fundamentals of private consumption (credit, remittances expressed in pesos and consumer confidence) have turned less supportive. We expect GDP growth of 2% in 217, down from 2.3% in 216, and a modest pick-up to 2.1% in 218. In the short term, uncertainty surrounding bilateral relations with the U.S. (discouraging investments), higher inflation (affecting real wages), tighter macro policies (rising rates and fiscal consolidation), and falling oil output will weigh on growth. Stronger manufacturing exports, conversely, boosted by higher industrial growth in the U.S. and a competitive real exchange rate, will act as a buffer. Weaker investment will hurt employment %, yoy -4 Total gross fixed -8 investment (calendar-adjusted) -2 Formal employment (Rhs) Q99 2Q1 3Q3 4Q5 1Q8 2Q1 3Q12 4Q14 1Q17 Source: INEGI, IMSS, Itaú Tightening cycle coming to an end? The Central Bank of Mexico published the minutes of May s monetary policy meeting, in which the Board decided to increase the policy rate by 25 bps (to 6.75%). The minutes are clear-cut about the reasons that led Banxico to hike rates in May; the document explicitly reads that all board members decided to vote for tightening monetary policy with the purpose of preventing contagion in the price-formation process and anchoring inflation expectations (in other words, avoiding second-round effects). Likewise, all board members agreed that the balance of risks on inflation has deteriorated. So, bottom line, May s hike was largely about deteriorated inflation conditions. In fact, the latest readings on inflation show that price increases are becoming more generalized across the consumer basket. Mexico s CPI fell between April and May, as it normally does during this time of the year (because of the seasonality of electricity prices). But it fell much less than in the previous year, thereby pushing annual inflation to 6.2% (from 5.8% in April). Overall, we see more generalized pressure. In fact, a diffusion index that tracks the percentage of items in the CPI basket with annual inflation higher or equal to 4% (the upper bound of the tolerance range around the Central Bank s 3% target) increased to 75% in May (from 51% in December 216). Looking ahead, we nevertheless expect inflation to decrease to 5.4% by the end of 217. Inflation would move down because of the lagged effects of peso appreciation (12% year to date, compared to the 19% depreciation observed in 216) and, to a lesser extent, weaker activity Page 19

20 Against this inflation backdrop, there are contrasting views about the future path of monetary policy. The minutes revealed that some board members consider that, provided the absence of new inflationary shocks, Banxico is getting close to the end of the tightening cycle. Moreover, one of these board members argued that, given the substantial monetary adjustment carried out so far (375 bps since December 215), Banxico must not necessarily match future U.S. Fed rate hikes with similar moves. In fact, in a recent interview, Deputy Governor Díaz de León took this view one step further by arguing that monetary policy should be loosened if inflation converges to the target. On the other end of the table, other members believe that inflation must start to trend down before evaluating the possibility of ending the tightening cycle. One member, in fact, mentioned that given the high levels of inflation and impending Fed hikes, more rate hikes in Mexico are likely in the next months. Banxico has hiked 375-bps since December % -1 May-9 May-11 May-13 May-15 May-17 Source: Banxico, Bloomberg, Itaú Market-based (TIIE swap 1yr - 12m inflation expectations) Monetary policy rate - 12m inflation expectations Monetary policy rate (rhs) We expect Banxico to deliver two more 25-bp hikes in 217 (the next one in June, in lockstep with the Fed). There are balanced risks for our call: while the fact that some board members see the cycle ending soon increase the probability of only one additional 25-bp rate hike, the behavior of inflation may end up forcing the central bank to raise interest rates by a bit more than we are currently expecting External and fiscal accounts improve Mexico s current-account deficit has narrowed, on the back of an improving trade balance and solid remittances. The central bank revised the annual current-account deficit recorded in 216, to USD 22.4 billion (2.1% of GDP) from USD 27.9 billion (2.7% of GDP). In the first quarter of 217, the CAD came in at USD 6.9 billion, which brought the four-quarter rolling deficit to USD 22 billion (2.1% of GDP) compared with USD 27.8 billion one year before. At the margin, the seasonally adjusted CAD was 2.2% of GDP in 1Q17. Higher growth in the U.S. and the more competitive exchange rate are more than offsetting the loss of oil exports. We have revised our current-account deficit forecast for 217 (to 1.7% of GDP, from 2.3%) and 218 (to 1.6% of GDP, from 2.2%). The CAD will likely continue narrowing as the economy experiences a rebalancing in its sources of growth (with stronger exports and weaker domestic demand). From a funding perspective, the risk of NAFTA renegotiation escalating into protectionism is falling, but will likely affect FDI; while given the current benign environment for emerging-market financial assets portfolio investment is expected to remain solid. FDI is weakening amid uncertainty about U.S. protectionism rolling 4- quarters, % of GDP FDI Foreign investment in domestic government bonds -1. 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17 Source: Banxico, Itaú Mexico s fiscal accounts are following a consolidation path, beyond the windfall effects of the Central Bank s dividend. In March 217, the government received a whopping MXN 322 billion (1.6% of GDP) dividend from the Central Bank the outcome of exchange rate gains on international reserves during Page 2

21 the previous year which exceeded the MXN 239 billion (1.2% of GDP) dividend received in April 216. But we note that fiscal accounts are improving even if the dividends are excluded. In fact, excluding 7% of the amount of the dividends (as the rest is directed to stabilization/sovereign funds, and therefore recorded as both revenues and expenditures), the 12-month rolling primary deficit narrowed to MXN 22 billion (.1% of GDP) in April, from MXN 24.5 billion in March. Also importantly, the gross and net debt of the public sector has decreased to MXN 9,88 billion (from MXN 9,934 billion) and MXN 9,244 billion (from MXN 9,693 billion) in April and at the end of 216, respectively. Our take is that the developments on the fiscal front (and the perception of lower risks for NAFTA) reduce the odds of a sovereign-rating downgrade and, thus, provide support to the valuation of Mexican financial assets. Nevertheless, the three main rating agencies maintain a negative outlook on Mexico s sovereign debt, and will be watchful if the proceeds of the dividend are fully used to accommodate more spending (and reduce the pace of fiscal consolidation), which is not farfetched considering the proximity of the presidential elections (to be held in mid-218). We forecast the public-sector nominal deficit at 2.1% of GDP in 217 (from 2.6% in 216), lower than the fiscal target set for 217 (2.4%) before the dividend announcement. It is also highly likely that the government will meet its other fiscal targets (.4% of GDP primary surplus, and 2.9% public-sector borrowing requirements). Forecast: Mexico F 218F Economic Activity Real GDP growth - % Nominal GDP - USD bn 1,172 1,187 1,262 1,298 1,153 1,47 1,124 1,21 Population (millions) Per Capita GDP - USD 1,133 1,142 1,658 1,846 9,521 8,554 9,36 9,62 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 %.%.%.%.%.%.% Source: IMF, Bloomberg, INEGI, Banxico, Haver and Itaú Page 21

22 Chile Ending the easing cycle, despite economic weakness Activity was weak in the first quarter of the year, and a technical recession was only prevented by front-loading government expenditure. There remains no evidence of a clear catalyst to spur a meaningful recovery. We see growth of 1.6% this year, stable from last year. The central bank cut the policy rate by 25 bps to 2.5% at its May meeting, and the monetary policy report published shortly afterward gave clear indication that the current easing cycle has concluded. With inflation set to stay low and activity faltering, there remains a possibility that further easing may materialize before a normalization process begins. Weak core activity Growth in 1Q17 was the lowest since 3Q9 as the economic slowdown intensifies. Activity in the quarter expanded just.1% from one year ago, down from.5% in 4Q16. Fires that affected broad areas of the country, a month-and-a-half long labor strike at Chile s largest mining operation and unfavorable calendar effects weighed on activity at the start of the year. Recession avoided, but core activity remains weak % construction falling 6.%, while machinery and equipment resumed expansion (+3.9%). Meanwhile, exports fell by 4.9%, reflecting the strike in the mining sector. Looking ahead, the outlook for consumption remains poor. A weakening labor market will remain a drag on private consumption, while the structuralbalance-rule target leads to a slowdown in government expenditure. The unemployment rate came in at 6.7% in the quarter ending in April, up.3 percentage points from one year before. Job growth is still overwhelmingly of lower quality, and more recently has been supported by the public sector (which is also unlikely to last, given the fiscal-policy tightening). Consumer confidence has continued to edge up from its levels of one year ago and in previous months, but remains entrenched in pessimistic territory (<5). Government expenditure and durable goods drove consumption YoY YoY, ex. inventories QoQ/SAAR %, yoy, contributions Services Non-durable goods Total consumption Durable goods Government C. Source: BCCh, Itaú. 1.5 In spite of the headline slowdown, consumption picked up. Total consumption grew 2.5% (from 2.3%), as public expenditure saw a sharp acceleration to 5.1% (1.7% in 4Q16). Meanwhile, the 2.% growth in private consumption was the weakest since 4Q15, despite durable goods consumption expanding 1.2% in the quarter (4.4% in 216, -.8% in 215), which is likely temporary given the continued loosening of the labor market. Gross fixed investment was a drag, as it contracted for a third consecutive quarter (-2.4%), with Source: BCCh, Itaú. Page 22

23 In fact, in spite of the end of the mining strike, the second quarter is off to a slow start. According to the Imacec (monthly proxy for GDP), activity grew a mild 1.3% year over year (adjusted for calendar effects). Growth in the first four months was only.5% (also calendar adjusted). Public-led employment sustains job growth Total Self-employment -1 Private Salaried Public Salaried -15 Rest Apr-14 Apr-15 Apr-16 Apr-17 Source: INE, Itaú yoy, Thousands We expect activity growth of 1.6% this year, stable from 216. An expansionary monetary policy, low inflation and higher copper prices (on average vs. last year) will aid activity, but confidence will be a drag, amid lingering uncertainties over reforms and elections. In this context, investment will continue to underperform the other components of demand. For 218, we expect 2.5% growth. Temporary widening of current-account deficit The current-account deficit increased to USD 1. billion in 1Q17 (USD.4 billion surplus in 1Q16), affected by temporary factors (particularly, the mining strike s impact on copper exports). As a result, the rolling-four-quarter current-account deficit rose to USD 5. billion (1.9% of GDP), from USD 3.6 billion in 216 (1.4%). Our own seasonal adjustment shows that the annualized current-account deficit increased at the margin, to 3.4% of GDP (.9% in 4Q16), hampered by the strike related mining export drag. Net direct investment fell short of fully financing the current-account deficit. Foreign direct investment of USD 2.5 billion was the lowest quarterly direct investment into Chile since 2Q13 (USD 1.1 billion), and down from the USD 3.9 billion in 1Q16. Over the last four quarters, foreign direct investment into Chile fell to USD 1.8 billion, from USD 12.2 billion in 216 (USD 2.5 billion in 215). As Chilean direct investment abroad remained robust, net direct investment fell to USD 3.2 billion (the lowest level since 24). Still low current account deficit Rolling-4Q, % of GDP Source: BCCh, Itaú. We expect the current-account deficit to retreat in the remainder of the year as internal demand stays weak and mining production recovers. Hence, we see Chile s current-account deficit broadly stable around the 1.4% recorded in 216. With internal demand likely to show some recovery next year, a widening to 1.7% is expected. Low inflation Current Account Current Account + Net FDI Consumer price inflation remained low in May as expected. Inflation remained below the center of the 2%-4% range around the target for the eighth consecutive month with tradable inflation falling further on the back of a stable currency, while non-tradable inflation picked-up slightly (to a still moderate level). Annual inflation came in at 2.6%, slightly down from the 2.7% recorded in the previous month. Tradable inflation slowed to 1.7% from 2.%. Meanwhile, non-tradable inflation ticked up to 3.6% (3.5% previously). Core inflation is comfortably at 2.5%. Page 23

24 We expect inflation to stay low for the remainder of the year. We continue to see inflation ending the year at 2.8% (2.7% in 216) and to be at the 3% target by yearend 218. Earlier-than-expected cut ends cycle At its May monetary policy meeting, the central bank of Chile surprised most in the market by cutting the policy rate by 25 basis points for a second consecutive month, to 2.5%. While the cut came a month earlier than we were expecting, the lowering of the policy rate is in accordance with our call from late last year of a 1-bp easing cycle from the 3.5% starting point. Moreover, the central bank removed the easing bias from its statement. The publication of the 2Q17 Inflation Report (IPoM) confirmed that the central bank s baseline scenario does not include further easing, amid balanced risks for inflation and activity. The central bank sees the policy rate remaining at the current 2.5% level for at least one year, before initiating a gradual normalization process. Overall, the board appears content to wait and observe how the economy unfolds given the monetary stimulus already implemented. Moreover, the head of the technical team highlighted that only significant deviations from the current baseline scenario would trigger additional easing ahead. Expansive monetary policy in the forecast horizon % Our baseline scenario considers no further easing, while the start of a normalization process is likely by year-end 218 as internal demand recuperates. However, activity is weak and the composition of 1Q17 growth hints that the risk of further weakening ahead is not negligible. Amid low inflation, if this scenario materializes, additional rate cuts later in the year are a possibility. Piñera s road to La Moneda not a given The CEP public-opinion survey for the April-May period confirms that former president Sebastian Piñera is expected to win the November 19 firstround vote without the majority required to avoid a runoff in December. From the survey conducted at the close of 216, Piñera gained 3 pp (to 23.7%) of the firstround voting intentions. Guillier the independent senator and former journalist, and likely candidate representing the governing coalition dropped just over 1 pp to 12.8%. Manuel José Ossandón picked up 3.4 pp, to 5.4%, and will be the closest competitor to Piñera in the upcoming center-right primary (July 2). Meanwhile, Beatriz Sánchez (journalist and far-left candidate) appeared for the first time with 4.8%, and will pose the greatest threat to Guillier in the November election. Sánchez and Guillier hold the highest favorability ratings among all the candidates. Undecided voters dropped from 49% in the December survey to 41.6%, still at a high level that will keep uncertainty elevated in the lead-up to the election. In the most likely runoff scenario, Piñera leads Alejandro Guillier by just over 4 pp. As the Chilean political circle has been laden with scandals, it is no surprise that the public is placing honesty and credibility at the forefront of requirements for the next president. Piñera s inability to build a significant lead could result in business sentiment remaining subdued as uncertainty persists in the lead-up to the election. 2.5 Policy rate Itaú Fin. Operators Analysts Asset prices(*) (*) As of May 29, 217 Source: BCCh, Itaú Page 24

25 Forecast: Chile F 218F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 14,214 15,291 15,615 14,464 13,181 13,88 14,175 14,56 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 %.%.%.%.%.%.% Source: IMF, Bloomberg, BCCh, INE, Haver and Itaú Page 25

26 Peru Falling inflation provides room for interest rate cuts Inflation surprised to the downside in May, falling by almost 1 bps (to 3%) in just two months as the effects of El Niño on food prices are reverting much faster than expected. Hence, we have revised our inflation forecast for 217 to 2.6%, from 3%. The Central Bank made a risky move in May cutting rates to counter the economic downturn when CPI inflation and inflation expectations were standing above the tolerance range around the target and then decided to pause in June. The recent improvement of the inflation outlook, however, provides room for further rate cuts. Moreover, the national accounts data showed that domestic demand contracted in 1Q17. So we now expect the BCRP to deliver four 25-bp cuts in 217 (rather than two, as in our previous scenario), taking the reference rate to 3.25%. Given robust exports and the shocks battering domestic demand (El Niño and paralyzed infrastructure projects due to corruption scandals), the current-account deficit was surprisingly low in 1Q17. Considering recent dynamics, we have revised our forecast for Peru s current account deficit to 1.5% of GDP for both 217 and 218 (from our previous forecasts of 2.6% and 2.5%, respectively). Inflation falls as El Niño fades More rate cuts to come Peru s CPI fell for a second consecutive month, as the agricultural supply shock caused by the coastal El Niño continued to revert. The CPI fell.42% month over month in May. Destructive flooding and landslides had caused a spike in food inflation in March (food inside home up by 3%), which reverted partially in April (-1.3%) and almost completely in May (- 1.5%). As a result, headline inflation has fallen to 3% year over year (from 4% in March) with the temporary shock unwinding much faster than expected, so that second-round effects become much less likely. Meanwhile, core inflation (CPI ex food & energy) also decreased, to 2.5% year over year (from 2.8% in April), possibly reflecting the weakness of domestic demand and a stable currency. Given May s negative inflation surprise, we have revised our inflation forecast for 217 to 2.6% (from 3%). Headline inflation will likely continue moving down as the effects of El Niño on food prices finish reverting and the weaker economy translates into less demand pressure on prices. Nevertheless, a moderate depreciation of the PEN (to 3.4), from the current level of 3.27, would exert some upward pressure. This depreciation would be driven by the narrowing of the interest differential with the U.S., as we expect the BCRP and the Fed to adjust monetary policy in opposite directions (loosen and tighten, respectively) in the coming months. The recent fall of inflation and inflation expectations, coupled with poor coincident indicators for activity, make more rate cuts in the short-term likely. According to the last BCRP survey (May), inflation expectations fell for 217 (to 3%, from 3.2%) and the next 12 months (to 2.9%, from 3.1%). Longer-term measures, however, showed mixed results, with inflation expectations unchanged for 218 (2.8) and increasing for 219 (to 2.7%, from 2.5%). Regarding activity, speaking at a recent conference in Lima, Chairman Velarde made pessimistic remarks about the performance of the economy, saying that the [activity] numbers of the second quarter are not so different to the ones recorded in the first quarter; perhaps they are even slightly below. However, the BCRP s board decided to pause in June (after cutting the reference rate by 25-bps in May). Interestingly, during the inter-meeting period, the IMF published the preliminary statement of Peru s 217 Article IV report, and argued that fiscal policy should be the first line of defense to tackle the economic slowdown, while monetary policy should continue carefully [ ] monitoring inflation expectations for any signs of persistent drift. Page 26

27 Room to cut opens up Domestic demand contracted in 1Q % Jun-8 Dec-9 Jun-11 Dec-12 Jun-14 Dec-15 Jun-17 Source: BCRP, INEI, Itaú Monetary policy rate 12-month inflation expectations Headline inflation June s monetary policy statement featured relevant changes; namely, a view of more benign inflation conditions, and a different guidance for future decisions (which re-affirms the easing bias, but now mentions inflation expectations and economic activity as the key variables to monitor). On inflation, the statement highlights the reversion of the supply shock (El Niño) and that headline inflation decreased to the upper bound of the +/- 1 p.p. tolerance range around the 2-percent target. Moreover, it stresses that 12-month inflation expectations are now within the tolerance range (they decreased to 2.9%, from 3.1%, according the BCRP s May survey). Regarding the policy bias of the statement, this sentence maintains a clear easing bias; as it reads: the Board is watchful of inflation and its determinants, specially inflation expectations and economic activity, to continue loosening monetary policy in the short-term. In contrast, in the past months, the policy bias sentence mentioned inflation and the reversion of supply shocks as the key variables to monitor. Against this backdrop of lower inflation and weak activity, we now expect the BCRP to deliver four 25- bp cuts in 217 (rather than two, as in our previous scenario), taking the reference rate to 3.25%. We recently revised our inflation forecast for 217 to 2.6% (from 3%) because of the reversion of El Niño. Further rate cuts (below 3.25%) are constrained by the fact that long-term inflation expectations are still hovering close to the upper bound of the tolerance range. In fact, our takeaway from June s decision is that the BCRP is still somewhat worried about inflation expectations. The Peruvian economy slumped in 1Q17, battered by El Niño and a corruption scandal that has paralyzed six of the twelve largest infrastructure projects in the country. GDP growth came in at 2.1% year over year in 1Q17. Looking beyond the shocks (which have exacerbated the weakness of domestic demand), growth sources remain as unbalanced as they were in 216: exports are strong and domestic demand is weak. Domestic demand contracted in 1Q17 (-1% year over year), for the first time since 29. Private consumption slowed down to 2.2% year over year (from 3.1% in 4Q16), amid weaker labor market conditions, higher inflation, lower consumer confidence, and negative wealth effects (i.e., property damage caused by El Niño). Private investment fell 5.6% year over year (from -6.1% in 4Q16), dragged by the plunge in infrastructure investment (as projects such as the southern gas pipeline, the irrigation projects of Olmos and Chavimochic, several tranches of the interoceanic highway, among others, ceased investments). In spite of the government s intention to counter the shocks swiftly by hiking expenditures, public demand (including government consumption and investment) fell 11% year over year (from -13.7% in 4Q16), with the destructive landslides and flooding from El Niño obstructing the execution of public works. On the bright side, exports of goods & services expanded at a strong 12.2% year over year (from 9.2% in 4Q16), while imports barely grew (.2% year over year, -1.5% previously). Thus, net exports contributed 3 pp to GDP growth in 1Q17. We forecast a modest GDP growth rate of 2.9% in 217, due to the substantial slowdown of activity in 1Q17, with a gradual recovery as the shocks dissipate. According to incoming data, activity is not improving yet. Coincident indicators for April s GDP proxy were poor; with the exception of fishing output, which expanded 11% year over year (thanks to a much larger fishing quota allotted for the first season of 217 compared with 216). Still, we expect the GDP proxy to barely grow in April (we forecast.8% year over year), which would decrease the three-month moving average growth rate to only.7% year over year (from 2.1% in March). El Niño ceased in April, but its negative wealth effects will likely weigh on consumers for a few more quarters. Paralyzed infrastructure projects will have a negative effect at least until 218 (when they are expected to re-enter the investment phase). Conversely, higher terms of trade (up by 9.9% year over year in Page 27

28 1Q17), driven by metal prices, and the fiscal stimulus package (.8% of GDP) will cushion the slowdown of the economy in 217. In 218, we expect a vigorous pickup, to 4%, as the bulk of the fiscal stimulus and reconstruction works will likely be implemented then. Monetary policy will also help activity. A much smaller current-account deficit External deficit narrows -2 % of GDP Current account seasonally-adjusted Current account (rolling 4-quarter) The cooling of activity is also reflected on a smaller external deficit. Given export-led growth and the slump of domestic demand, Peru s current-account deficit narrowed to 1.9% of GDP in the four quarters ended in 1Q17 (from 2.7% of GDP in 216). The adjustment has been substantial, as the current-account deficit has more than halved with respect to 215 (when it stood at 4.8% of GDP). In fact, according to our calculations, the quarterly seasonally adjusted deficit was even smaller, at.9% of GDP in 1Q17. The trade balance has posted surpluses for three consecutive quarters, driven by the strong growth of mining export volumes (mainly copper) and higher terms of trade (up by 9.9% in 1Q17, following five years of decline). Considering recent dynamics, we have revised our forecast of Peru s current-account deficit to 1.5% of GDP for both 217 and 218 (from previous forecasts of 2.6% and 2.5%, respectively). Finally, it is worth noting that net foreign direct investment increased to 3.8% of GDP in the four quarters ended in 1Q17 (from 3.4% of GDP in 216), doubling in size relative to the current-account deficit. Net portfolio investments, in contrast, were negative (-.5% of GDP) during the same period Q9 1Q1 1Q11 1Q12 1Q13 1Q14 1Q15 1Q16 1Q17 Source: BCRP, Itaú The improvement of the current account deficit came in spite of a bulky fiscal deficit. On the fiscal side, the slowdown of activity has affected revenues and, more importantly, has pushed the government into announcing expansionary policies, which we expect to translate into wider deficits and higher debt in the coming years. The low debt ratios allow for fiscal stimulus: the gross and net debt of the public sector decreased to 22.9% of GDP and 7.2% of GDP in 1Q17 (from 23.8% and 8%, respectively, at the end of 216). The Ministry of Finance has presented a bill to Congress, requesting an increase in the nominal fiscal deficit targets for 217 (to 3% of GDP from 2.5% previously), 218 (3.5% of GDP from 2.3%), 219 (2.9% of GDP from 2%) and 22 (2.1% of GDP from 1.5%), to converge to 1% in 221 (long-term target, unchanged). Congress will vote on this bill in the coming weeks, and it has high odds of passing, as the party that holds an absolute majority in Congress (the Fujimoristas) is also calling for fiscal expansion. Therefore, we expect the nominal fiscal deficit to widen to 3% of GDP in 217 and 3.2% of GDP in 218. However, we acknowledge the risk of a negative revision in the rating agencies outlook for Peru s sovereign rating (which is currently neutral, according to Moody s, S&P, and Fitch). Page 28

29 Forecast: Peru F 218F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 5,675 6,288 6,489 6,592 6,178 6,27 6,647 6,887 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 %.%.%.%.%.%.% Source: IMF, INEI, BCRP, Itaú Page 29

30 Colombia Parked on the runway Activity in the first quarter of the year was the worst since the global financial crisis. Depressed confidence levels, a loosening labor market and still-high interest rates have led to a consumption slowdown. We now expect growth of 1.6% this year (1.8% previously), down from the 2.% recorded last year. Headline inflation is moderating, but core inflation dynamics are uncomfortable and likely explained the central bank s reversion to a less aggressive 25-bp rate cut, to 6.25% at its May monthly meeting. Rate cuts are still expected, but the pace will likely be slow (with potential pauses). As the electoral season starts, the administration is making a final push to get the implementation of the peace accord finalized. However, the road is not free of speed-bumps and could therefore face some delays. Slowing private consumption and still-weak investment in 1Q17 Activity started 217 on a weak note after posting the lowest growth rate since 4Q8. The impact of the 214 terms-of-trade shock continues to unfold, with historically high interest rates, high inflation and increased tax rates dampening activity. Activity gained a mild 1.1% year over year in 1Q17, down from the 1.6% recorded in 4Q16. Activity grew 1.6% for the rolling-fourquarter period, down from 2.% in 216 and 3.1% in 215. On the supply side, the improvement in agricultural activity (following the end of the El Niño weather phenomenon) could not offset the shrinking construction and mining (mostly oil) output. Activity in non-natural resource sectors increased 1.4% year over year (2.2% in 4Q16), and a lower 1.2% when oilrefining is excluded. The upgraded Cartagena refinery was a key engine of growth last year, but after a year in operation, its positive impulse is moderating. Activity was dragged down in the quarter by the 1.4% contraction in construction, from +3.4% in 4Q16, meaning that the 4G PPP programs have yet to contribute meaningfully to growth. Gross fixed investment is still contracting and consumption growth is evolving at a historically low rate. The impact from high inflation and interest rates, the increased sales tax rate and a loosening labor market are likely behind the slowdown. Private consumption increased 1.1% year over year (vs. 2.3% in 4Q16). Meanwhile, the slowdown was partly offset by a pick-up in public consumption growth (2.1% vs..2% in 4Q16). Yet, total consumption growth dropped to 1.4%, from 1.8% in 4Q16. Gross fixed investment declined for the seventh consecutive quarter (-.7%), but less so than previously (-2.9% in 4Q16), due to still-weak investment in machinery (-3.9% YoY) and a sharp fall in construction (-7.5%). Transport investment (likely airplanes and thereby transitory) helped contain the investment weakness. At the margin, the 1.5% qoq/saar decline in private consumption led the weakening of total activity (-.9% qoq/saar vs. +4.1% in 4Q16). Meanwhile, gross fixed investment is still declining at the margin. A weak start to the year % Source: Dane, Itaú YoY qoq/saar Following the weak activity in the first quarter of the year and few catalysts to spur a meaningful rebound, we have reduced our growth forecast to 1.6% for this year (1.8% previously), down from 2.% in 216. Yet, we see some recovery into next year, aided by the ongoing monetary-easing cycle and the increased investment related to the 4G PPP program (we forecast 2.5% for 218). Page 3

31 Trade deficit continues adjustment in 1Q17 Imports grew in 1Q17 for the first quarter since 4Q14, but recovering export commodity prices (year over year) meant that the trade deficit continues to correct. The trade deficit came in at USD 2.2 billion in 1Q17 (USD 3.5 billion in 1Q16), narrowing the rolling 12- month trade deficit to USD 1.1 billion, from USD 11.5 billion in 216 (USD 15.9 billion in 215). The recent narrowing is explained by an energy balance surplus that is growing by more than the rise in the non-energy balance deficit. At the margin, the trade deficit widened as capital and industrial imports accelerated. Import-driven slowdown in external adjustment USD bn Trade Balance (SA, 3mma annualized) Current Account (Rolling-4Q; rhs) Rolling 12-month Trade Balance Source: Dane, Banrep, Itaú We expect the current-account deficit to narrow this year (relative to 216) due to weaker internal demand and higher terms of trade, to 3.6% of GDP, from 4.4% of GDP last year. We see some weakening of the currency ahead as the interest rate differential with the U.S. narrows (we expect 3,8 to the dollar by the end of this year and 3,175 by the end of 218). Sticky non-tradable prices % of GDP Headline inflation moderated in May, but the dynamics remain uncomfortable. Consumer prices gained.23% from April to May (.51% in May 216), leading to a fall to 4.37% in headline annual inflation (4.66% in April). This is the lowest annual inflation since February 215. Food inflation continues to pull inflation down, while non-tradable inflation remains uncomfortably high and core measures are still well above the 2%-4% target range. Our diffusion index shows that inflationary pressures are becoming less widespread, but still more than two-thirds of goods are increasing at a rate above the 3% target. With a widening output gap, loosening labor market and stable exchange rate we expect inflation to continue to moderate ahead. We see inflation reaching 4.1% by yearend (5.8% for 216), before settling comfortably within the target range next year as the impact of tax hikes fades. Gradual easing pace The Central Bank of Colombia continued with the monetary-easing cycle by cutting the policy rate by 25 bps, to 6.25%, in its May decision. The decision was the seventh consecutive split vote, with four codirectors falling in the majority, while the remaining three members preferred a 5-bp cut. This meeting marked the arrival of José Antonio Ocampo to the central bank, returning the board to its full representation of seven members for the first time since this year s January meeting. The press release announcing the decision does not vary significantly from the previous month (when a 5-bp cut was implemented). However, the removal of the reference to falling inflation expectations hints that the results from the central bank s May survey, which showed an inflation-expectation uptick at all measured areas following April inflation s upside surprise to the market, were a key factor in the return to the more conservative approach. The board notes that the risk of a further activity slowdown remains; therefore, we believe that rate cuts remain the preferred course of action. We expect the central bank to continue lowering the policy rate, but the pace of rate cuts (potentially including pauses) remains data dependent. We see the policy rate ending the year at 5.5% (75 bps below the current level). Disappointing growth and declining headline inflation will be arguments for rate cuts, while the unfavorable behavior of core and non-tradable inflation will likely generate some caution. Page 31

32 Credit rating facing increased risk The lack of a significant fiscal consolidation (in spite of higher taxes) increases the odds of a rating downgrade. The 217 fiscal budget that was originally approved included a maximum nominal fiscal deficit of 3.3% of GDP. However, earlier this year, the expert committee for the fiscal rule deemed that the economic and oil price cycles warranted an increase in the authorized deficit limit, to 3.6% of GDP. In fact, at a conference hosted by the Moody s rating agency in London, the head of Latin American Sovereigns indicated that Colombia s credit rating outlook could be cut to negative (currently Baa2 stable outlook). Of the three leading rating agencies, Moody s was the only one not to have changed the outlook from stable to negative last year, during the peace deal and tax reform negotiations (currently only S&P holds a negative outlook, while Fitch reverted to a stable outlook earlier this year). Peace deal hitches Former vice president leads the presidential pack. The Datexo survey for April-May shows former vice president Germán Vargas Lleras with 16.5% of the voting intention, up from 12.4% in the previous survey. The former vice president continues to advance among a highly fragmented group, while other candidates, such as former Bogotá Major Gustavo Petro, have lost support since the beginning of the year. Behind Vargas Lleras is former Antioquia Governor Sergio Fajardo (12.1% of the preference), close to former president Uribe. Meanwhile, Humberto Calle, the former head of the peace negotiating team with the FARC rebel group, has failed to gain significant support for the top office in the land (1.8%). While the May 218 general election is still far, the electoral landscape is shaping up, as government officials seeking to run for office must resign their posts no later than 12 months before the election. Meanwhile, complications to implementing the peace deal have arisen. At the close of May, President Juan Manuel Santos announced that the government and the FARC have agreed to extend the deadline for weapon submission to the UN and permanence in transitory zones by 2 days, to the start of August. Logistical complications explain the extension. This comes in addition to the ruling by the constitutional court that eliminated a key procedural prohibition in the fast track implementation process for the peace deal. The prohibition prevented congress from modifying peacedeal-related proposals without prior approval from the President. These developments are unlikely to derail the peace deal, but will elevate the risk of implementation delays. With the presidential election approaching, the peace deal will once again rise to the top of the political discussion. The potential delays could also raise the unease of the guerillas. Forecast: Colombia F 218F Economic Activity Real GDP growth - % Nominal GDP - USD bn Population (millions) Per Capita GDP - USD 7,287 7,939 8,65 7,936 6,57 5,751 6,8 6,21 Unemployment Rate - year avg Inflation CPI - % Interest Rate Monetary Policy Rate - eop - % Balance of Payments COP / USD - eop 1,939 1,767 1,93 2,377 3, ,8 3,175 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 %.%.%.%.%.%.%.% Source: IMF, Bloomberg, Dane, Banrep, Haver and Itaú Page 32

33 Commodities Lower Oil Prices in 218 Commodities continued to decline in May, led by metal and energy prices. OPEC s deal and the decline in U.S. inventories are expected to support oil prices, but only in the short term. We maintained our Brent forecast for YE17 at USD 54/bbl, but lowered our forecast for YE18 to USD 51/bbl due to the decline in the marginal cost of U.S. shale oil producers. We expect the ICI to gain 2.8% from its current level by the end of 217. The increase will mainly stem from higher oil and agricultural prices. The Itaú Commodity Index (ICI) fell by 3.7% in May, led by metal and energy prices indexes. Metal prices fell 8%, following a 2% drop in iron ore prices, while energy prices declined 3.2% due to a correction in oil prices. OPEC s deal and the decline in U.S. inventories are expected to support oil prices, but only in the short term. Even with the extension of OPEC s deal, the deficit is likely to continue this year. We maintained our Brent forecast for YE17 at USD 54/bbl (WTI: USD 52.5/bbl), but lowered our forecast for YE18 to USD 51/bbl (WTI: USD 5/bbl) due to the decline in the marginal cost of U.S. shale oil producers. ICI Rally Fading With Energy & Metal Prices Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Itaú Itaú Commodities Index (Jan. 216 = 1) ICI ICI Agricultural (rhs) ICI Energy ICI Metals Metals from the current level, with iron ore prices falling to USD 55/mt by the end of the year. Agriculture prices have remained broadly stable since the end of April, despite the sharp 11.3% drop in sugar (mainly caused by a stronger-than-expected supply x demand balance). We therefore lowered our price forecast for sugar. Soy and wheat decreased by 3.6% and.4%, respectively, in the same period. We expect the ICI to gain 2.8% from the current level by the end of 217. The increase will mainly stem from higher oil and agricultural prices. Scenario for 217: Prices to Remain Stable Well Above Lows Registered in Early Dec-11 Dec-13 Dec-15 Dec-17 Source: Itaú Previous Current Itaú Commodity Index (21=1) Firmer global growth limits declines in metal prices. The downside risks to an improvement in the global manufacturing cycle seem limited at the moment, even with a slowdown in China. If the global Manufacturing PMIs remain close to their current levels, metal prices are unlikely to enter a downtrend. This is consistent with our forecast of a 3% decline in the ICI Metals: China-related concerns continue to affect iron ore and copper prices Iron ore prices have dropped 19% since the end of April, possibly reflecting sector-specific factors and renewed concerns over the Chinese economy. The Page 33

34 still-high iron ore inventories in China might explain the recent decline in iron ore prices. We also expect supply increases in 217, by both big and non-traditional players, in response to the current higher-price scenario (vs. the average for 216). Copper prices have recently lost some momentum, also due to a combination of micro factors and China-related concerns. LME inventory data continued to show a significant build-up in copper inventory in May. However, weaker refined supply will likely result in a tighter market in the months ahead, supporting the high prices. We forecast a 3% decline in ICI Metals from the current level. Specifically, we expect iron ore prices to fall to USD 55/mt and copper to remain stable at USD 56/t by the end of the year. Sharp Drop in Iron Ore Prices, but Other Metal Prices Remained Stable month extension of the OPEC sdeal, the deficit is likely to continue this year. We therefore maintained our YE17 Brent forecast at USD 54/bbl (WTI: USD 52/bbl). However, we lowered our yearend Brent forecast for 218 to USD 51/bbl (WTI: USD 5/bbl), due to the decline in the marginal cost of U.S. shale oil producers. Oil Prices Have Fallen Despite OPEC Extension Prices correspond to the first future contract WTI Brent Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Itaú and Bloomberg ICI Metals ex-iron ore (rhs) Iron ore 2 5 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-17 Source: Itaú and Bloomberg Oil: Lower Oil-price forecast for 218 At the end of May, OPEC and non-opec members extended the production cut until March 218, with unchanged volumes; Libya, Nigeria and Iran are exempt. Even with the deal extension, Brent and WTI prices have dropped by 2% since the end of April. OPEC s deal extension and the decline in U.S. inventories (albeit from high levels) are expected to support oil prices in the second half of 217. We estimate that the market reached a small deficit in 1Q17. Given the impressive compliance so far and the nine 7 Grains: Soybean prices fell sharply due to the higher expected supply Corn prices have risen by 1.1% since the end of April, while soybean and wheat prices fell by 3.7% and.5%, respectively, over the same period. Expectations of a higher supply led to a drop in soybean prices, despite prospects of an increase in demand. The drop in soybean prices and the rise in corn prices is consistent with the expansion of the planted soybean area in the U.S. at the expense of corn. The soybean crop in Brazil is also expected to be higher, driving prices lower. We maintain our YE17 price forecasts for corn (USD 3.75/bushel), soybeans (USD 9.5/bushel) and wheat (USD 4.8/bushel). Page 34

35 Grains: Steeper Drop in Soybean Prices Corn (Dec-17) Wheat (Dec-17) Soybean (Nov-17) (rhs) Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 The recent drop in sugar prices may have been caused by the anticipation of a surplus in the 217/18 crop year and by the depreciation of BRL. Although a shift from deficit to surplus was expected in April, the current outlook is that the oversupply of sugar could be even larger, while the currency depreciation has also pressured prices. Sugar prices in Brazil have already reached ethanol levels, possibly causing the mills to start producing more ethanol than sugar to balance the supply and raise sugar prices. Because the price of gasoline in Brazil is currently lower than ethanol, the shift in supply could make it more competitive. Sugar Price Drop to Ethanol Levels Source: Itaú and Bloomberg The probability of an El Niño-like weather anomaly is lower, but remains our base case. For U.S. crop production, an El Niño cycle in 2H17 increases the risks of excessive rainfall, possibly delaying/jeopardizing the harvest USD cents / lb Sugar Hydrous Ethanol Anhydrous Ethanol Sugar/Coffee: Lower prices 14 International contracts for raw sugar and coffee have dropped by 11.3% and 2.6%, respectively, since the end of April Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Itaú and Bloomberg Sugar Prices in lower levels 18 USD cents / lb 17 USD cents / lb 24 We maintain our coffee price forecast at USD 1.4/lb for YE17 and expect sugar prices to average USD.17/lb in Coffee Sugar(rhs) Feb-16 Jun-16 Oct-16 Feb-17 Jun-17 Source: Itaú and Bloomberg Page 35

36 Forecast: Commodities F 218F Commodities CRB Index Itaú Commodity Index (ICI)* Agricultural Energy Metals yoy - % avg growth - % yoy - % avg growth - % a/a - % avg growth - % yoy - % avg growth - % yoy - % avg growth - % ICI - Inflation ** Source: Bloomberg and Itaú yoy - % avg growth - % * The Itaú Commodity Index is a proprietary index composed of commodity prices, measured in U.S. dollars and traded in international exchanges, which are relevant to global production. Its sub-indexes are Metals, Energy and Agriculture **The ICI-Inflation is a proprietary index composed of commodity prices, measured in U.S. dollars and traded in international exchanges, which are relevant to inflation in Brazil (IPCA). Its sub-indexes are Food, Industrial and Energy. Macro Research Itaú Mario Mesquita Chief Economist Tel: Click here to visit our digital research library. Page 36