Latam Macro Monthly. Macro Research Itaú Mario Mesquita Chief Economist. Scenario Review. June 18

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1 Latam Macro Monthly Scenario Review June 18 Global Economy Stronger growth momentum in the U.S., for now 4 Growth is stronger in the U.S. than in the rest of the world, favoring the USD. However, improving business survey readings in China (and Emerging Asia in general) bode well for global exports and commodity prices. LatAm Central Banks react to a more adverse scenario 7 Strains in external financial markets come at a time in which many countries face a risky political scenario and macro imbalances, putting strain on EM central banks. Argentina hiked interest rates aggressively, while in Brazil the central bank started to intervene in the exchange rate market. We expect Mexico s central bank to increase interest rates in June. Brazil Increasingly challenging scenario 8 Tighter financial conditions and the impacts of the truck drivers' stoppage led us to trim our growth forecasts to 1.7% in 2018, from 2.0%. In the wake of the dollar-strengthening trend, we revised our exchange rate forecast to 3.70 reais per dollar at the end of 2018 and 2019 (against 3.50) Argentina We have a deal 13 The necessary adjustments are leading to a deceleration of the economy. We expect GDP to expand by 1.5% this year, down from 2.0% in our previous scenario (and expectations of 3.8% at the turn of the year). While the political scenario is becoming more uncertain, our baseline scenario for Argentina is still a constructive one. Mexico Navigating more turbulent waters 16 The lastest polls show that AMLO s odds of gaining a majority in congress are increasing and NAFTA renegotiations took a turn for the worse. In this context, risks for inflation have intensified and the central bank will likely increase rates by 25 bps at its June meeting. Additional tightening can t be ruled out and we do not expect to see cuts this year. Chile Looking bright amid darkening global clouds 20 Activity is rebounding and the recovery is widespread. With confidence up, copper prices still elevated, inflation low and monetary policy still expansionary, a recovery to 3.8% this year is expected, from 1.5% last year. External factors, such as the possibility of trade wars, are the main risks for the economy. Peru Government takes steps toward fiscal consolidation 24 The government has carried out meaningful actions to narrow the fiscal deficit, whilst also passing measures to achieve the ambitious 17.5% growth target for public investment in In view of this policy package, we have revised our nominal fiscal deficit forecasts for 2018 (to 2.9% of GDP, from 3.2%) and 2019 (to 2.7% of GDP, from 3%). Colombia Down to two 28 Iván Duque and Gustavo Petro will face each other in a runoff vote on June 17. Recent simulations show that Duque, backed by former President Uribe, would comfortably emerge as the winner. The next administration will face fiscal challenges and the implementation of the peace deal. 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 Central Banks react to market turbulence The USD continued to appreciate against most currencies, favored by a combination of stronger growth momentum in the U.S. and slightly weaker activity in the rest of the world. However, this growth mix tends to revert as business surveys in China (and emerging Asia in general) are improving, which bodes well for emerging markets in general, because it tends to bolster global exports and support commodity prices. Global financial conditions also became tighter over the recent weeks on the back of heightened political risks in Italy. Uncertainty will likely continue to pressure financial markets and reduce growth in the country, because while the formation of a government reduced the risk of a new election that could morph into a proxy Euro referendum, concerns about the new government s fiscal stance and political sustainability remain high. In a more complex environment, we reduced our expectations for the EUR relative to USD and lowered our Eurozone growth forecasts for this year and the next, but still expect the ECB to end its asset purchases this year. The China-U.S. trade dispute, another factor that has been driving market sentiment of late, remains a risk. China seems willing to cooperate and has offered several concessions, but U.S. response has so far been mixed. We believe that an escalation will be avoided because China can offer President Trump enough benefits to produce a perception of a trade victory before the midterm elections. The conditions for emerging markets continues to be turbulent, prompting some central banks to act: Argentina and Turkey hiked rates agressively, while India, Indonesia and the Phillipines also delivered some tightening. Within LatAm, currencies of countries with vulnerabilities such as Argentina and Brazil have underperformed. The Mexican peso also suffered some depreciation, while in Chile, Colombia and Peru, high commodity prices and lower political risks shielded the currencies from more intense losses. The recent wave of depreciation is pressuring central banks in the region. After hiking rates to 40% pa, Argentina s central bank will likely stay on hold for now. In Mexico, the central bank is set to increase the policy rate by 25 bps in June. In Brazil, the central bank has started to intervene in the exchange rate market through swaps, but Selic rate hikes are still unlikely in the short term. Monetary policy rates in Chile and Peru are likely to stay at their current levels, while in Colombia we think there is room for one final rate cut (by 25 bps), before the easing cycle ends. In Brazil, the scenario is becoming increasingly challenging. The continuation of the dollar strengthening trend, in an environment of volatility in international markets, pressures the exchange rate and motivates us to revise our forecast to 3.70 reais per dollar by the end of 2018 and 2019 (from 3.50). Domestically, we reduced our GDP growth expectations to 1.7% from 2.0% in 2018 and to 2.5% from 2.8% in 2019, due to worsening financial conditions (exchange rate depreciation, higher market rates and lower asset prices) and the effects of the truck drivers' stoppage. If, on the supply side, the stoppage tends to have a punctual impact on the production of goods and services, on the demand side it increases the uncertainty in the economy and increases the fiscal risk, leading to a longer lasting effect on entrepreneurs and consumers confidence levels. From the fiscal point of view, slower economic growth and the measures taken to meet drivers demands which are only partially offset by cuts in spending and tax increases increase short-term risks, but we continue to expect that the primary deficit target will be met in In the inflation front, the truckers stoppage should have only a temporary impact on monthly IPCA readings, but the exchange rate depreciation exerts a pressure on our year-end forecasts, which were revised to 3.8% in 2018 and 4.1% in 2019 (from 3.7% and 4.0%). In this context, the central bank is still likely to keep the Selic rate at 6.5% by the end of the year. We believe that the exchange rate dynamics can influence the next decisions if there is a relevant impact on inflation expectations. Hope you enjoy, Mario Mesquita and Macro Team Page 2

3 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 3

4 May-10 Nov-10 May-11 Nov-11 May-12 Nov-12 May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Nov-16 May-17 Nov-17 May-18 Dec-12 May-13 Oct-13 Mar-14 Aug-14 Jan-15 Jun-15 Nov-15 Apr-16 Sep-16 Feb-17 Jul-17 Dec-17 May-18 Latam Macro Monthly June 8, 2018 Global Economy Stronger growth momentum in the U.S., for now Growth momentum is stronger in the U.S. than in the rest of the world, favoring the USD. However, business surveys in China (and Emerging Asia in general) also improved, which bodes well for global exports and commodity prices. In the U.S., with unemployment well below full employment and core inflation at about 2%, the Fed will continue to raise interest rates in an attempt to slow the economy toward potential growth. Political uncertainty in Italy has tightened financial conditions in Europe. We reduced our GDP forecasts for the euro area to 2.3% for 2018 (from 2.5%) and 2.0% for 2019 (from 2.4%). The U.S.-China trade-war risk remains, but China s offer to lower tariffs, increase imports and protect property rights provides an opportunity for a deal without escalation. Commodity prices remain resilient, despite the stronger USD. Growth momentum is stronger in the U.S., but has also started to recover in China and Emerging Asia The strong growth momentum in the U.S. has persisted, while the rest of the world has slowed down a bit. The ISM Manufacturing Index has fluctuated, but remains close to this year s high, while the PMI ex-u.s. has steadily declined, from 55 to 53 (see chart). During this period, the growth gap between the U.S. and the rest of the world widened. On the positive side, PMIs in China and across Emerging Asia have recovered over the past couple of months, which bodes well for EM growth in general. It is true that PMIs in other EM regions (CEMMEA and LATAM) declined in May. But the recovery in EM Asia indicates that global exports have not lost much momentum (see chart), and good global trade is a positive sign for most emerging markets. Manuf. PMI: US momentum stronger than rest of the world index US ISM Manufacturing Global PMI ex-us EM Asia PMI points to Global Exports increase index EM Asia Manuf. PMI (lhs) World Exports (rhs) %, yoy 25% 20% 15% 10% 5% 0% -5% % -15% Source: Haver, Itaú Source: Haver, Itaú This growth mix explains the recent USD strength. The USD gained 5.4% against DM currencies and 7.6% against EM currencies between January and May. Page 4

5 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Mar-19 Jun-19 Sep-19 Dec-19 Latam Macro Monthly June 8, 2018 U.S. Domestic Strength keeps the Fed on track for interest rate hikes GDP growth is tracking 3% in 1H18, due to strong domestic demand supported by still easy financial conditions, tax cuts and government spending. Consumption is growing at a rate of 2.7% YoY and private fixed investment is running at 4.5% YoY. Government spending is also set to accelerate to above 3% YoY over the next few quarters. The domestic strength in the U.S. more than offsets the international risks. Trade-war risks, volatility in emerging markets and political uncertainty in Italy have not had a meaningful impact on U.S. financial conditions so far. The unemployment rate will consequently continue to fall, while wages and inflation will continue to rise. The unemployment rate fell to 3.75% in May, well below the median Fed estimate of NAIRU (4.5%). With the economy growing close to 3%, job creation will remain at around 200k and the unemployment rate will continue to drop (see chart). In response to the tight labor market, wages will continue to gradually increase. Meanwhile, core inflation is already near 2% and will continue to rise as wages increase. Strong job growth and unemployment dropping well below NAIRU 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Source: Haver, Itaú % of labor force Unemp. rate thous. Payroll, MA6 (rhs) NAIRU: 4.5% Forecast With falling unemployment and rising inflation, the Fed will continue to raise interest rates. If payroll growth remains at the 200k per month for much longer, the unemployment rate would drop below 3% by YE19, increasing the risk of stronger wages prompting a significant overshoot of the 2% inflation target. The U.S. economy is in the late stages of the business cycle, when the Fed must tighten its policy stance, leading GDP and job growth to slow to their longer-run trends. This limits equity price appreciation and suggests that the USD strength may not last much longer. We continue to forecast four Fed fund rate hikes in 2018, followed by three hikes in We expect the 10-year U.S. Treasury yield to rise to 3.25 by YE18 and 3.50 by YE19. Europe Italy s risk tightens financial conditions and lowers growth prospects The Euro area Composite PMI dropped 1pt to 54.1 in May. This level indicates growth of around 0.5% QoQ in 2Q18, below our previous expectation of 0.7%. Furthermore, political uncertainty in Italy will likely continue to pressure financial conditions and reduce growth in the country. The risk of a new election that could morph into a proxy Euro referendum was reduced by the formation of the populist government. However, uncertainty about the new government s fiscal stance and political sustainability remains high. Fiscal proposals could add up to 6% of GDP to the deficit (EUR 100 billion). And although we believe that such a marked fiscal deterioration is unlikely, discussions about the budget to be presented to parliament in September could drive the yields of the 10-year Italian bond back to around 3.0%. In Spain, on the other hand, we see low risk from the change in government. If Pedro Sanchez (PSOE/center-left) remain in power or new elections are held this year (fiscal responsible/pro-eu parties are ahead in polls), the current macro policies will remain in place. Spain will therefore continue to show good macro performance with: i) strong growth, above the euro zone s average; ii) a current account surplus; iii) close to primary fiscal balance; and iv) a downtrend in public debt. This outlook will still lead the ECB to end its asset purchases this year. Despite political uncertainty, we still expect a cautious approach that should lead to a small tapering from September to December, as growth remains above 2% and underlying inflation will rise slowly but remain below the target. Page 5

6 We lowered our GDP forecast for the Eurozone to 2.3% for 2018 (from 2.5%) and 2.0% for 2019 (from 2.4%). We also reduced our EURUSD expectations to 1.20 this year (down from 1.25) and 1.25 next year (from 1.30). U.S.-China trade dispute remains a risk Despite the risk, we still believe that a U.S.-China trade deal will be reached without escalation. It seems that additional concessions from China may be needed soon, and the U.S. must back off from its threat to raise import tariffs on June 15. We nevertheless believe that an escalation can be avoided because China can offer President Trump enough benefits to sell as a trade victory before the midterm elections. China seems cooperative in order to avoid a trade war. The country has offered to increase imports from the U.S. of agriculture and energy goods, to expand trade to other manufactured goods and services, and to enhance protection of U.S. technology. China also announced the reduction of auto import tariffs to 15% from 25%. U.S. response has been mixed. Treasury Secretary Steven Mnuchin initially said that the U.S. would put on hold its plan to raise tariffs on USD 50 billion in Chinese import goods scheduled for end-may. However, the White House later renewed its threat to release the list of tariffs on the USD 50 billion in Chinese import goods by June 15 and to impose it shortly thereafter. The White House has also threatened China with investment restrictions to be announced by June 30. In response, China recently stated that any trade concessions would only be granted if the US did not impose any trade sanctions, including tariff hikes. China has also pledged to respond to any U.S. import tariff hike. Commodities Fundamentals remain good The Itaú Commodity Index (ICI) has risen 2.2% in May. All sub-indexes posted gains in the period: Agriculture (2.1%), Metals (0.5%) and Energy (3.3%). The increase in commodity prices, despite a stronger USD, reflects good fundamentals across the three components. In agricultural commodities, the first estimates from USDA suggest a decline in the stock-to-use ratio in the crop year. Metals continue to benefit from strong growth in China and stronger supply discipline and risks (sanctions targeting Russia and stricter environmental rules in China). For oil, we see some correction lower around the OPEC meeting, but prices should remain above USD 60/bbl given that the market will still need the ongoing increase in U.S. shale production regardless of additional output from OPEC members in 2H18. We raised our wheat and cotton price forecasts to adjust for the abovementioned USDA estimates, but maintained our assumptions for metal and energy. Following the revisions, our YE18 forecasts see agricultural rising slightly from current levels, stable metal prices and a small decline in oil-related prices. Forecasts: World Economy F 2019F GDP Growth World GDP growth - % USA - % Euro Area - % Japan - % China - % Interest rates and currencies Fed Funds - % USD/EUR - eop YEN/USD - eop DXY Index* - eop Source: IMF, Bloomberg and Itaú * The DXY is a leading benchmark for the international value of the U.S. dollar, measuring its performance against a basket of currencies that includes the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona. Page 6

7 LatAm Central Banks react to a more adverse scenario Strains in external financial markets come at a time many countries face a risky political scenario and macro imbalances. Relative to our previous scenario, we now expect weaker currencies in Argentina, Brazil and Mexico. We expect slower growth in Brazil, and recently reduced our activity forecasts for Argentina. The economy in Mexico has been surprisingly resilient, and an acceleration in 2018 is likely. Recent market developments are pressuring central banks. The Central Bank of Argentina significantly increased interest rates, while the central bank in Brazil has started to intervene in the exchange rate market. We expect Mexico s central bank to raise interest rates in June. The more adverse scenario for emerging markets continues. Within LatAm, currencies of more vulnerable countries, such as Argentina (wide twin deficits and low reserves) and Brazil (worrisome public debt dynamics), have underperformed since early May. In Mexico, uncertainties related to the elections and trade relations with the U.S. intensified recently, contributing to the negative performance of its currency. On the other hand, high commodity prices and lower political risks in Chile, Colombia and Peru have been shielding their currencies, which have recorded more moderate weakening against the USD recently. In this context, we now expect weaker exchange rates than in our previous scenario for Argentina, Brazil and Mexico. As a result, we are raising our inflation forecasts for all three countries. Mixed activity in the region. The economy in Brazil had been gradually recovering until April. However, tightened financial conditions and the trucker strike in May will have both temporary and more permanent (through confidence) effects, leading to a reduction of our growth forecasts to 1.7% for this year (from 2.0%) and 2.5% for 2019 (from 2.8%). In Argentina, lower real wages, tighter macro policies and weaker confidence will add to the effects of the severe drought. Although Argentina s economy expanded at a robust pace in 1Q18 (generating significant carryover), a contraction in the second and third quarter of this year is likely, leading us to recently lower our GDP growth estimate for this year to 1.5% (from 2.0%). On the other hand, the economy in Mexico has performed surprisingly well, despite the considerable uncertainties. Growth in the first quarter of the year was solid, partly due to transitory factors (reconstruction efforts following the natural disasters that hit the country in 2H17). However, the strong U.S. economy and the solid labor market in Mexico have so far offset the effects of macro policy tightening and uncertainties over NAFTA and the elections. The recovery in Chile and Peru is on track. Activity in Colombia has been sluggish, but we expect the more expansionary monetary policy, higher oil prices and the outcome of the presidential election to support a recovery of activity. The recent exchange rate weakening has pressured central banks. Argentina s central bank increased interest rates aggressively in three inter-meeting decisions since the end of April, bringing the policy rate to 40%, where it was maintained at the two subsequent meetings. While rate cuts in Argentina are likely once the market stabilizes, there is currently no room for rate reductions, also considering the sharp increase in inflation expectations. In Mexico, the central bank will likely increase the policy rate by 25 bps in June, after remaining on hold at the last two meetings. The Brazilian central bank has started to intervene in the exchange rate market through swaps. Still, near-term Selic rate hikes seem unlikely given that inflation is below target and there is considerable spare capacity in the economy meaning that the recent BRL weakening so far poses no threat to the benign inflation outlook. Meanwhile, inflation in Chile has run below the target for some time, although the external environment reduces the likelihood of a convergence of inflation toward the target, thus decreasing the odds of rate cuts (but there is also no rush for hikes). In Peru, the chances of further rate cuts are also lower given the external environment, the partial dollarization of the economy and the on-going recovery even though inflation is below the target. Finally, in Colombia, we see room for one final rate cut (25 bps) before the cycle ends, but recent comments by board members on its willingness to add stimulus have been mixed Page 7

8 Brazil Scenario gets increasingly challenging We lowered our GDP growth forecasts to 1.7% from 2.0% in 2018 and to 2.5% from 2.8% in 2019, due to tighter financial conditions and the impact of the truckers stoppage. Our forecasts for the primary result worsened to -2.1% of GDP from -1.9% in 2018 and to -1.4% from -1.2% in 2019, incorporating government measures to end the truckers stoppage and lower economic growth. We revised our year-end estimates for the exchange rate to 3.70 reais per U.S. dollar in 2018 and 2019 (from 3.50). We lifted our inflation estimates slightly, to 3.8% this year and 4.1% in The truckers stoppage will likely cause just temporary pressure on inflation, but FX depreciation tends to exert moderate upward pressure on prices. The central bank is set to keep the benchmark Selic interest rate unchanged at 6.5% until year-end. Upcoming decisions may be influenced by FX dynamics only if inflation expectations are materially impacted. Truckers stoppage will probably affect growth The economy sustained a gradual recovery until April. GDP expanded 0.4% qoq/sa in 1Q18. Breakdown analysis outlines a slightly better picture for domestic demand, with household spending advancing 0.5% and fixed capital investments climbing 0.6%. Industrial production rose 0.8% mom/sa in April, and we estimate a 1.0% increase in core retail sales. There is evidence of interruptions in supply and production chains starting on May 23. This situation tends to cause a lot of volatility in activity data in May (decline due to the stoppage), June (increase due to normalization and compensation) and July (decline as compensation takes a back seat). High-frequency indicators suggest significant impact on industrial production, leading us to estimate a 6.4% mom/sa decline in May. Power usage provides evidence of shortterm impact, and it fell sharply starting on May 23 (see chart). Retail sales were probably affected as well, but to a lesser extent. The stoppage s effect on annual GDP growth may be broken down into two channels: - Direct impact on aggregate supply, which will not be compensated after transportation normalizes. This is an immediate effect. The main shock is felt by industrial production (and related services, such as transportation and storage), but there is also evidence of losses in services provided to households and in agriculture. High-frequency data in June will be key to assessing the magnitude of the impact through this channel. - Impact via aggregate demand due to falling confidence. This effect will be felt in the next few months. Concessions by the government to end the stoppage have fiscal impact. Halted production, albeit temporarily, intensifies economic uncertainties. The consequence is a decline in business and consumer confidence. Power usage suggests that the strike had a deep impact on industrial production Source: Itaú GWmed -8.8% -8.9% 7-22/May 23-29/May Working days Saturdays Sundays -10.0% We lowered our GDP growth forecasts to 1.7% from 2.0% in 2018 and to 2.5% from 2.8% in 2019, due to tighter financial conditions and some impact from the truckers stoppage on this year s growth via supply (-0.1 p.p.) and demand (-0.1 p.p.). We lifted our estimates for the unemployment rate, in line with lower GDP growth. Using models that contemplate our GDP call and the sensitivities of various Page 8

9 kinds of occupations to the pace of economic activity, we increased our forecasts for the unemployment rate under our seasonal adjustment to 12.2% by YE18 (12.1% previously; 1Q18: 12.5%) and to 11.8% by YE19 (11.5% previously). Our forecast for average unemployment in 2018 remains at 12.3%, but our estimate for 2019 was revised upward to 12.0% (11.7% previously). Short-term fiscal risks increase The government adopted several measures in negotiations to end the truckers stoppage, generating a negative fiscal impact of 6 billion reais in net terms on the primary result for Firstly, diesel prices will be lowered by 46 cents per liter until year-end, generating a negative impact of 14 billion reais. 30 cents will come from a subsidy program for Petrobras and other diesel suppliers, with an estimated impact of about 10 billion reais. The program will be accounted as an expense that is not subject to the constitutional spending cap (known as an extraordinary credit). The remaining 16 cents will be achieved through a reduction of Cide and PIS/Cofins taxes on the fuel, with an impact of 4 billion reais by year-end. Secondly, to compensate this fiscal setback, the government took measures that add up to 8 billion reais in A total of 4 billion reais will be obtained through the reversal of payroll-tax breaks for some industries, the end of the Reintegra tax-incentive program for exporters and the Special Regime for the Chemical Industry (Reiq), as well as adjustments to taxes applied to input used by the beverage industry. The other 4 billion reais will come from discretionary spending cuts. Announced measures to end the truckers stoppage Impact in 2018 (BRL billions) Net impact = Costs - Compensations -6 Costs -14 Reduction of Cide and PIS/Cofins taxes -4 Subsidy program for Petrobras and other diesel suppliers -10 Compensations 8 Discretionary spending cuts 4 End of the Reintegra tax-incentive program 2 Reversal of payroll tax breaks 1 Taxes adjustments applied to input used by the beverage industry 1 End of the Special Regime for the Chemical Industry (Reiq) 0.2 Source: Itaú, Ministry of Finance Notwithstanding higher risks, we continue to believe that the government will meet its primary-deficit target for the year (2.2% of GDP or 161 billion reais). We revised our estimate for the primary budget deficit in 2018 to 2.1% of GDP (146 billion reais) from 1.9% of GDP (137 billion reais), based on 6 billion reais related to the abovementioned measures and 3 billion reais related to the downward revision in our growth forecast, which will be partly compensated by better current data for the year. For the central government specifically, we anticipate a deficit of 2.1% of GDP (155 billion reais) vs. a target of 2.2% of GDP (159 billion reais), so that further disappointment with economic growth would increase the risk of missing the annual target. If all the measures are maintained, the net negative impact in 2019 will be 11 billion reais. However, we assume that, regarding the reduction in diesel prices, only the decline in the Cide and PIS/Cofins rates will be permanent, as they were announced with an indeterminate timetable, while the subsidy program was created by a temporary decree that sets its deadline by the end of Furthermore, the program is accounted for in 2018 as an extraordinary credit to the public budget. If it becomes permanent, the government will have trouble meeting the spending cap for the year, as the program would probably need to be incorporated in the budget as a recurring expense. Without the subsidy program, measures taken would have a positive impact of 5 billion reais in For 2019, we revised our estimate for the primary deficit to 1.4% of GDP (102 billion reais) from 1.2% of GDP (94 billion reais). The abovementioned positive impact of 5 billion reais will be more than offset by the impact of 10 billion reais caused by downward revisions in GDP growth and a reduction of 3 billion reais in results for states and municipalities. A stronger dollar around the world pressures the BRL The Brazilian real continued to depreciate against the dollar during the past month, reaching its weakest level since March The exchange rate spent most of May near 3.70 per dollar. Volatility remains high, due to the international as well as the domestic background. Concerns related to sharper interest-rate hikes by the U.S. Federal Reserve continued to pressure emerging market assets. 10-year Treasury yields topped 3% for the first time since late 2013/early There are uncertainties Page 9

10 related to the impact that U.S. monetary-policy normalization may have on other nations such as Italy and Argentina (a key trade partner to Brazil). Domestically, uncertainties surrounding the approval of reforms also remain high, and the historically low level of the interestrate differential seems to impact FX dynamics in Brazil. Strong dollar across the board in May Index number: jan/18 = 100 Latin America CEEMEA* Brazil country is still the main source of financing in the balance of payments, notwithstanding a decline in recent months. For the next years, we expect the current account deficit to widen slightly, but to narrower levels than we were previously expecting and not to the point of compromising Brazil s external sustainability. Our forecasts incorporate a weaker currency and slower economic activity. We anticipate trade surpluses [1] of $65 billion in 2018 ($62 billion previously) and $57 billion in 2019 ($50 billion previously). Our estimates for the current account deficit now are $19 billion in 2018 ($25 billion previously) and $36 billion in 2019 ($47 billion previously). 105 *Includes countries in Central and Eastern europe, Middle east and Africa We lifted our inflation forecasts slightly, to 3.8% in 2018 and 4.1% in Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Source: Bloomberg, Itaú The central bank stepped up interventions in the FX market to reduce volatility and correct eventual dysfunctional behavior. Along with fully rolling over contracts expiring in June and July, the monetary authority has been offering additional swap contracts. We revised our year-end estimates for the exchange rate to 3.70 reais per dollar in 2018 and 2019 (from 3.50), reflecting a more volatile global environment. Rising uncertainties regarding global growth, particularly in Europe, should favor a stronger dollar globally than previously anticipated. We acknowledge that there are risks. Internal and domestic uncertainties (especially because the pension reform was not approved) have been high and may remain so in the coming months. Add to that a very low interest-rate differential by historical standards and uncertainties related to its full impact on the FX market. Data at the margin continue to show healthy external accounts. The seasonally adjusted annualized quarterly moving average current account deficit virtually stable and at a low level (USD 5 billion) since February, benefitted by the good performance of the trade balance as well as low deficits in equipment rentals and profits and dividends accounts. Direct foreign investment in the Our call for consumer price inflation measured by the IPCA in 2018 rose to 3.8% from 3.7%, driven by the revised FX scenario. For the time being, we believe that the impact of the truckers stoppage on the supply and availability of some products particularly fresh food and fuels will cause temporary pressure on inflation. Overall, inflation remains low (headline readings and core measures alike). The IPCA is up by 1.3% year-to-date (1.4% in the year-earlier period) and 2.86% yoy. Going forward, we expect year-over-year readings to accelerate to 4.0% in June (0.95% during the month vs. -0.2% in June 2017) and 4.1% in September, as negative changes in costs for food consumed at home in 3Q17 will no longer enter calculations. Breaking down the IPCA, we anticipate increases of 3.0% in market-set prices (1.3% in 2017) and 6.2% in regulated prices this year (8.0% in 2017). We expect inflation to print still below the target due to lower inertia from past inflation; a still-favorable agricultural crop (albeit smaller than last year), ensuring good inventory levels; anchored inflation estimates; and a negative output gap. As for market-set prices, we anticipate a 4.0% hike in costs for food consumed at home, after a 4.9% slide in Although the change in costs for food consumed at home early in the year was milder than the seasonal pattern (1.0% in the January-May period), we anticipate stronger upward pressure during 2H18, due to rising grain prices and recent exchange rate fluctuations. We expect industrial prices to climb 2.1% (following an unusually low reading of 1.0% in 2017). Service prices [1] As per the Ministry of Trade (Mdic) Page 10

11 Centenas Latam Macro Monthly June 8, 2018 are expected to slow down again, to 3.1% from 4.5%, largely because of lower inflationary inertia and still-high unemployment. Regarding regulated prices, we now expect gasoline costs to rise 8% rather than 5% (10% in 2017), given our new FX outlook. For electricity, we continue to expect an 8% increase this year (10% in 2017), assuming that the tariff flag system will be in yellow mode in December. For other regulated items that are relevant to inflation calculations, we forecast increases of 12% for health insurance premiums, 7% for urban bus fares, 4% for water and sewage tariffs, and 2.5% for medication prices. For 2019, our forecast for the IPCA was hiked to 4.1% from 4.0%, also reflecting a weaker FX scenario. We expect market-set prices to rise 3.8% and regulated prices to climb 5.0%. Below-target inflation rate 12.0% 10.5% yoy 10.7% Forecast Substantial slack in the economy may contribute to better behavior of market-set prices. The slower narrowing of the negative output gap as economic momentum decreases and the unemployment rate remaining above historically normal levels for a longer period may engender more favorable behavior in market-set prices, particularly those more sensitive to the economic cycle, such as services and industrial items. Lower-than-expected service inflation last month reinforces this possibility. In that sense, still-large unused capacity in the economy may contribute to cushion eventual inflationary pressures arising from a weaker exchange rate. Inflation expectations remain anchored, with breathing room in relation to the targets for 2018 and The median of market expectations for 2018, according to the central bank s Focus survey, climbed to 3.65% (0.85 p.p. below the 4.50% target) from 3.49%. The median estimate for 2019 stayed at 4.0% (somewhat below the 4.25% target), and remained anchored at the 4.00% target for % IPCA Target Anchored inflation expectations 7.5% 6.0% 4.5% 3.0% 1.5% Source: BCB, IBGE, Itaú 6.3% 2.9% 3.8% 4.1% 0.0% Dec-12 Feb-14 Apr-15 Jun-16 Aug-17 Oct-18 Dec-19 The main risk factors for the inflation scenario are still tied to the domestic and international scenario. Uncertainties surrounding reforms and needed economic adjustments in 2019 may put further pressure on risk premiums and the exchange rate going forward, impacting the inflation path. As for the external situation, we observed some reversal in the favorable landscape for emerging economies, with slight deterioration at the margin, reflecting greater risks of economic policy changes in the developed world and tighter global financial conditions, as well as increased geopolitical tensions. The increase in such risks, along with the historically-low interest rate differential, is already pressuring the Brazilian currency. 4.5% 4.4% 4.3% 4.2% 4.1% 4.0% 3.9% 3.8% Median inflation expectations (IPCA) Source: BCB (Focus Survey) 4.01% 4.00% 3.7% 3.65% 3.6% % % Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Monetary policy: Selic rate stable for some time The central bank s Monetary Policy Committee (Copom) surprised many market participants when it decided to end the easing cycle by keeping the benchmark Selic interest rate unchanged at 6.5%. According to the committee s statement, the decision was based on the change in the balance of risks following a Page 11

12 reversal in the external scenario, which took away the need for additional easing to mitigate the risk of delayed inflation convergence toward its targets. In the minutes of the meeting, the Copom signaled that it would be adequate to maintain the Selic stable in upcoming meetings, given the balance of risks and inflation forecasts at comfortable levels. Regarding recent FX depreciation, the Copom emphasized that monetary policy will not react automatically to the evolution of the exchange rate. According to the committee, the focus will be exclusively on the behavior of inflation forecasts and expectations, the balance of risks and economic activity. The committee added that FX fluctuations will pass through to inflation to an extent that depends on many factors, such as the degree of slack in the economy and how anchored inflation expectations are. Hence, the next decisions will contemplate the impact of FX fluctuations on price levels and whether there is a need to implement monetary policy actions meant to fight their secondary effects on inflation expectations. In our baseline scenario, the Selic rate will remain stable at 6.5% until year-end, but the BCB s decisions will still depend on FX dynamics and, especially, its impact on inflation readings and inflation expectations, particularly for Forecast: Brazil F 2019F Economic Activity Real GDP growth - % 1,9 3,0 0,5-3,5-3,5 1,0 1,7 2,5 Nominal GDP - BRL bn Nominal GDP - USD bn Population (millions) 198,7 200,4 202,2 203,9 205,5 207,7 208,6 210,1 Per Capita GDP - USD Nation-wide Unemployment Rate - year avg (*) 7,4 7,1 6,8 8,5 11,5 12,7 12,3 12,0 Nation-wide Unemployment Rate - year end (*) 7,5 6,8 7,1 9,6 12,7 12,4 12,2 11,8 Inflation IPCA - % 5,8 5,9 6,4 10,7 6,3 2,9 3,8 4,1 IGP M - % 7,8 5,5 3,7 10,5 7,2-0,5 6,8 4,2 Interest Rate Selic - eop - % 7,25 10,00 11,75 14,25 13,75 7,00 6,50 8,00 Balance of Payments BRL / USD - eop 2,05 2,36 2,66 3,96 3,26 3,31 3,70 3,70 Trade Balance - USD bn Current Account - % GDP -3,0-3,0-4,2-3,3-1,3-0,5-1,0-1,8 Direct Investment (liabilities) - % GDP 3,5 2,8 3,9 4,2 4,4 3,4 3,9 3,5 International Reserves - USD bn Public Finances Primary Balance - % GDP 2,2 1,7-0,6-1,9-2,5-1,7-2,1-1,4 Nominal Balance - % GDP -2,3-3,0-6,0-10,2-9,0-7,8-7,2-6,1 Gross Public Debt - % GDP 53,7 51,5 56,3 65,5 70,0 74,0 75,5 76,4 Net Public Debt - % GDP 32,3 30,6 33,1 36,0 46,2 51,6 54,3 57,1 Source: IBGE, FGV, BCB and Itaú (*) Nation-wide Unemployment Rate measured by PNADC Page 12

13 Argentina We have a deal The government tightened macro policies and requested financial help from the IMF in response to the deterioration of financial conditions. The IMF will provide a three-year line totaling USD 50 billion. The agreement involves a more ambitious fiscal adjustment for 2019 than that targeted by the government (a primary deficit of 1.3% of GDP compared to 2.2% previously) and balance in The target for 2018 remains at 2.7% of GDP. We expect the current account deficit to fall to 3.8% of GDP (down from 4.8% last year) and 3.3% in We now see the exchange rate at 26 ARS/USD by December, from our previous scenario of 25 ARS/USD. We thus forecast inflation at 26.5% by the end of this year, up from 23.5% in our previous scenario. We maintained our view for the monetary policy rate at 30% by December, with rate cuts to come once the market stabilizes. The necessary adjustments are leading to a deceleration of the economy. We expect GDP to expand by 1.5% this year, down from 2.0% in our previous scenario (and expectations of 3.5% at the turn of the year). The political scenario is becoming more uncertain as Macri s popularity fell (but then recovered partially). However, Cambiemos remains the most popular political force in Argentina and the economy could be more balanced by the end of So our base scenario for Argentina is still a constructive one. Show me the money A USD 50 billion IMF package is on its way. The three-year stand-by arrangement is equivalent to eleven times the value of the Argentine quota at the IMF, currently USD 4.6 billion. There will be an immediate disbursement of USD 15.0 billion (30% of the total). We estimate Argentina s foreign currency needs - defined as amortization of federal government s foreign currency debt (excluding debt with multilaterals, which carry a low roll-over risk) plus the current account deficit - at USD 85 billion accumulated in the second half of this year, 2019 and So, the credit line added to the current level of net reserves would cover 90% of the financial needs in this period. So, while other elements of foreign currency flows (such as FDI; amortization of private sector and provinces; private sector outflows) are missing in our definition of foreign currency needs, the calculation suggests that Argentina will not need to tap heavily capital markets or face a sizable depreciation than what we expect to reach a balance-of-payment equilibrium As part of the agreement, the Argentine authorities committed to a more ambitious fiscal adjustment in 2019 and 2020 than that targeted initially. While the treasury keeps the target of a primary deficit of 2.7% of GDP this year, down from a target of 3.2% before the recent market stress, it will pursue a deficit of 1.3% of GDP in 2019 (2.2% before) and zero deficit in 2020 (1.2% before). We think the targets are very challenging but feasible. A weaker currency and higher inflation favors a lower primary deficit in However, we note that a faster consolidation in 2019 and 2020 would likely need additional, and more structural, measures. In fact, solid revenue performance and control of discretionary expenditures are already driving the fiscal adjustment in Tax revenues, excluding extraordinary revenues linked to the tax amnesty in 2017, increased by a solid 5.3% in real terms during the first four months of the year (31.6% YoY in nominal terms), in line with the strong performance of the economy during the period. Primary expenditures fell by 6.2% YoY in real terms year to date, marking a 17.3% YoY increase in nominal terms. Pension expenditures rose by 31.4% YoY (nominal), reflecting the indexation on past inflation and on the evolution of salaries, but they were offset by cuts in subsidies and capital expenditures. As a result, the primary fiscal deficit currently stands at around 3.3% of GDP (from 3.8% in 2017). The central bank will stick to an inflation targeting scheme and floating exchange rate (keeping some flexibility to intervene in disruptive episodes). While there will no inflation target for this year (15% originally), new (and more realistic) goals were set for the next years. The monetary authority will target 17% inflation in 2019 (instead of 10%) and 13% in 2020 (5% before) and 9% in The government will send a bill to congress to prohibit central bank lending to the treasury and guarantee more autonomy to the monetary authority. Also, the central bank will not purchase more dollars directly from the treasury. Finally, the central bank plans to reduce its stock of short-term bills (Lebacs) in the next Page 13

14 three years using pre-payments of past loans to the treasury. The treasury will finance these payments issuing peso-denominated bonds. A weaker currency and lower growth of internal demand this year will likely lead to a narrowing of the external deficit. We forecast a current-account deficit of 3.8% of GDP (4.8% last year and 4.0% in our previous scenario for 2018). Weaker currency and tariffs to keep pressure on inflation The weakening of the peso is likely to keep inflation high. The Elypsis consulting firm estimates May inflation at 2.8% mom, mostly due to the exchange-rate passthrough to consumer prices. The CPI already posted a 2.7% increase between March and April, reflecting (in that opportunity) a new round of tariff adjustments. We expect the exchange rate at ARG 26 to the USD by December, meaning a peso 15% weaker than the average of 2017, in real terms. We note that the depreciation of the peso will also likely trigger additional hikes in energy tariffs as it has an effect on electricity production costs and prices paid by gas distributor companies. Consequently, we adjusted our inflation forecast for this year to 26.5% from 23.5% previously. As inflation accelerates wage negotiations may be reopened. Most of the wage contracts signed this year involve a 15% increase in salaries and a clause to review the contract later in the year if inflation surpass 15%. While this is another risk factor to inflation, we think that the expected deceleration of the economy will not leave room for significant compensations for higher inflation. On the negative side, it may lead to confrontations with the unions, adding strain to the political environment. As inflation remains high, interest rates will continue significantly higher than in the past. The central bank for the second consecutive time kept the benchmark interest rate (7-day repo rate) unchanged, at 40%, at its latest monetary policy meeting in May. Once again, the monetary authority maintained a wide corridor, with the lending rate at 47% and the borrowing rate at 33%, which it expects to normalize when market instability moderates. While our current forecast for the reference rate stands at 30% by December, we don t expect rate cuts soon. Actually, given the still challenging environment for emerging markets and Argentina s vulnerabilities, further rate hikes are not completely off the table in our view, with rate cuts to come, once the peso stabilizes. Losing steam We expect the economy to continue to decelerate markedly in the coming months. On a sequential basis, the EMAE (official monthly GDP proxy) fell by 0.1% mom/sa in March (1.4% yoy), following a 0.2% loss in February, leading to a still strong quarter-over-quarter expansion of 4.3% (annualized). The impact of the drought will be harsher in 2Q18, while tighter macro policies and lower real wages will hinder domestic demand. The international environment (Brazil s troubles and worse financial conditions for emerging markets) is also less supportive. We recently reduced our GDP growth forecast to 1.5% from 2.0%, for this year. Sudden stop Index, sa EMAE IGA (RHS) Apr-14 Apr-15 Apr-16 Apr-17 Apr-18 Source: INDEC and OJF Index, sa A more uncertain political scenario President Macri's popularity fell 9 points in May, to 36% according to a poll published by Poliarquía consulting. The drop in ratings, which was the steepest in a long series, follows the impact on popular sentiment of factors like the adjustment in tariffs, the depreciation of the peso and the beginning of negotiations with the IMF. Positively, a recent survey (also conducted by Poliarquia) indicates some popularity rebound (to 41%), although the sample is smaller than in regular polls. Still, the economic slowdown, amid tight macro policies and combined with high inflation, represents a big risk for next year s presidential Page 14