Macro Research Economic outlook

Macro Research Economic outlook Macroeconomic Research Itaú Unibanco December 2017

Roadmap Global Economy Solid global growth and higher interest rates in 2018 We expect global growth to continue at 3.8% in 2018 (the same as in 2017). As growth remains above potential in developed countries, the output gap will turn positive and inflation is likely to start normalizing gradually (led by the U.S.). Global monetary policy will also become less accommodative in 2018: we see i) three interest rate hikes in the U.S., with balanced risks; ii) the end of QE in the euro area (but interest rate increases only in 2019) and iii) in Japan, a 20 bps in its 10- year JGB target (but no change in its short term rate. Despite less-accommodative monetary policy, we expect broad global financial conditions to remain favorable, sustained by robust growth and little recession risk. Brazil Economy improves amid greater risks We increased our forecast for GDP in 2017 to 1.0% from 0.8%, after incorporating the revision of the historical series and the results for 3Q17. We estimate growth at 3.0% for 2018 and 3.7% for 2019, but we see downside risks if the outlook for public accounts changes. We trimmed our inflation forecast for 2017 and maintained our call for 2018 at 3.8%. Our estimate for the consumer price index IPCA in 2019 stands at 4.0%. Our year-end forecasts for the exchange rate are unchanged, at BRL 3.25 per USD in 2017, 3.50 in 2018, and 3.60 in 2019. After cutting the Selic rate by 50 bps in early December, the Monetary Policy Committee (Copom) is set to further reduce the easing pace to 25 bps in its next meeting, in February 2018. We expect no increase in interest rates in 2018, with a rise only in 2019, when the Selic should reach 8.0%.

Global Economy: Our forecasts 2014 2015 2016 2017 2018 World 3.6 3.4 3.2 3.8 3.8 USA 2.6 2.9 1.5 2.3 2.4 Eurozone 1.4 2.0 1.8 2.3 2.1 Japan 0.0 1.1 1.0 1.6 1.4 China 7.2 6.8 6.7 6.8 6.3 Source: Itaú Unibanco, Haver Analytics

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017P 2018P 2019P 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Global growth is picking up Global growth will likely remain strong in 2018. Easy financial conditions in DM, the abatement of political risks in Europe and better chances of a soft landing in China are supporting a synchronized global recovery. We note that growth will become more widespread in emerging economies. Although China will see a moderate slowdown in 2018 (see below), other countries are just starting to recover. Given better growth, we believe that global inflation will gradually normalize. Global GDP Growth DM Output Gap and Inflation 6 5 4 % 3.8 3.8 3.6 3.0% 2.8% 2.5% 2.3% DM core inflation ex- Japan DM output gap (rhs) 3.0 2.3 1.5 0.8 3 2.0% 0.0 2 1.8% -0.8 1 1.5% 1.3% -1.5-2.3 0 1.0% -3.0-1 0.8% 0.5% -3.8-4.5 Source: Haver, Itaú

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 We believe global inflation will gradually normalize First, the output gap in developed economies will likely turn positive next year for the first time since the financial crisis in 2008-09. This should pull DM core inflation up. Second, the deflationary pressures from China are ending. The producer price index, that had been negative in China from 2012 to 2016 (yearly average: -2.9%), has just stabilized in positive territory this year (6.5%) DM output gap suggests higher core inflation in 2018 3.0% 2.8% 2.5% 2.3% 2.0% 1.8% 1.5% 1.3% 1.0% 0.8% 0.5% DM Core Inflation ex-japan DM Output Gap (rhs) 3.0 2.3 1.5 0.8 0.0-0.8-1.5-2.3-3.0-3.8-4.5 Source: IMF, Itaú

1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 U.S.: Gradual adjustment in interest rates to continue We forecast GDP growth of 2.4% in 2018 after 2.3% in 2017, a benign outlook supported by a modest tax cut (0.6% of GDP), expansionary monetary policy and positive global outlook. This economic outlook is consistent with the Fed raising interest rates in December and three additional 25-bp hikes in 2018. We see balanced risks for our 2018 Fed interest-rate outlook. A quicker response of wages to unemployment diving below 4%, or a pick-up in productivity could require a fourth hike in 2018. To the downside, persistently low inflation expectations could remain a drag on inflation and lead the Fed to hike only twice in 2018 GDP Growth %, annualized 5.5% 4.5% 3.5% 2.5% 1.5% 0.5% -0.5% -1.5% -2.5% 1.5% 2.3% 2.4% Source: Itaú, Haver Analytics QoQ Annual

1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 Europe: ECB to end QE in September 2018 but increase interest rates only in 2019 Eurozone GDP expanded 0.6% qoq in 3Q17, maintaining a solid growth pace. Easy monetary policy, easier fiscal policies, tentative signs of structural reforms and a reduction in political risk are boosting the region s growth. We expect eurozone GDP to expand 2.3%, 2.1% and 2.1% in 2017, 2018 and 2019, respectively. With a better economic outlook, the ECB will likely end its asset purchases in 2018, but will raise interest rates only in 2019. GDP Growth (Eurozone) % annualized 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% 2.3% 2.1% QoQ Annual Source: Haver Analytics, Itaú

1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 China: soft-landing scenario Economic activity in China continued to moderate. We expect GDP to moderate in 2018, in line with a soft-landing scenario We maintained growth forecasts at 6.8% for 2017 and at 6.3% for 2018. For 2019, we expect growth to moderate further to 5.9%. GDP Growth %, annualized 8.5% 8.0% 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 6.8% 6.3% QoQ Annual Source: Haver Analytics, Itaú, NBS

LatAm: friendly external environment helps countries cope with domestic political risks With a gradual monetary policy normalization in developed markets, most exchange rates in the region will likely weaken moderately against the dollar in 2018. Domestic factors can play an important role in the exchange rate path, especially in countries holding elections (such as Brazil, Mexico and Colombia). The friendly external environment is helping to increase activity in the region, and a recovery is seen in most countries we cover. We expect higher growth rates in 2018 (relative to 2017) in Argentina, Brazil, Chile, Colombia and Peru. Mexico will likely grow at the same pace as estimated for this year. 5.0% 4.0% GDP Growth 3.5% 4.0% 4.2% 3.0% 2.0% 1.6% 2.7% 2.0% 2.9% 2.5% 2.1% 1.0% 0.0% -1.0% -2.0% -3.0% -2.2% 2015 2016 2017F 2018F Argentina Chile Colombia Mexico Peru Source: Itaú

Latam: our forecasts Peru 2015 2016 2017 2018 2015 2016 2017 2018 GDP - % 3.3 4.0 2.9 4.2 PIB - % 2.6 2.3 2.1 2.1 PEN / USD (dec) 3.41 3.36 3.30 3.35 MXN / USD (dec) 17.4 20.7 18.5 18.5 Interest rates - (dec) - 3.75 4.25 3.25 3.25 Interest rates - (dec) - 3.25 5.75 7.25 7.00 IPC 4.4 3.2 1.5 2.5 IPC 2.1 3.4 6.2 3.3 Colombia 2015 2016 2017 2018 2015 2016 2017 2018 PIB - % 3.1 2.0 1.6 2.5 PIB - % 2.3 1.6 1.5 2.7 COP / USD (dec) 3175 3002 3050 3120 CLP / USD (dec) 709 670 650 660 Interest rates - (dec) - 5.75 7.50 4.75 4.00 Interest rates - (dec) - 3.50 3.50 2.50 2.75 IPC 6.8 5.8 3.9 3.4 IPC 4.4 2.7 2.2 2.8 Argentina 2015 2016 2017 2018 PIB - % 2.6-2.2 2.9 3.5 ARS / USD (dec) 13.0 15.9 17.5 21.0 Repo 7 d. (dec) - % - 24.75 29.75 24.00 IPC - % (Buenos Aires) 26.9 41.0 24.0 18.0 Mexico Chile Source: Itaú

Brazil: Our forecasts 2014 2015 2016 2017 2018 Economic Activity GDP (%) 0.5-3.5-3.5 1.0 3.0 Unemployment (%) December (PNAD cont.) 7.1 9.6 12.7 12.5 11.8 Inflation CPI (%) 6.4 10.7 6.3 2.8 3.8 Monetary Policy Selic Rate (%) 11.75 14.25 13.75 7.00 6.50 Fiscal Primary Surplus (% GDP) -0.6-1.9-2.5-2.3-2.1 Balance of Payments Exchange Rate (eop) 2.66 3.96 3.26 3.25 3.50 Current Account (% GDP) -4.2-3.3-1.3-0.7-1.6

Activity: Revised path and strong demand in 3Q17 improve GDP outlook The real GDP path since 2015 was revised upward. GDP slows down in 3Q17, but domestic demand shows robust growth. Household spending climbed 1.2%, moving up despite the end of withdrawals from inactive accounts held under the FGTS employment protection program. Gross fixed capital formation rose 1.6%, after 15 negative quarters. After we incorporated the revised numbers and adjusted our outlook for 4Q17, we increased our estimate for 2017 GDP to 1.0% from 0.8%. Brazil GDP s.a. 1995=100 GDP Growth and Domestic Demand QoQ s.a. 178 176 174 172 170 168 166 164 162 160 Sep-14 Sep-15 Sep-16 Sep-17 Source: IBGE, Itaú Previous New 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% Domestic demand(c + G + I) GDP 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17

Gradual recovery in the labor market continues In October, 76,600 formal jobs were created (according to the Ministry of Labor s CAGED registry). The seasonally adjusted moving average improved to 17,000 from -5,000, and it has been improving gradually since 2Q16. The national household survey PNAD Contínua shows that unemployment has been receding since March. We expect the seasonally adjusted unemployment rate to decline to 11.8% by the end of 2018 and to 10.9% for 2019, compared with 12.5% in the quarter ended in October. In our view, the decline in unemployment will be increasingly driven by formal jobs rather than informal positions. Unemployment Rate %, seasonally adjusted Formal Job Creation (CAGED) 3MMA, thousands 14 13 12 11 10 12.6 12.5 11.8 250 150 9 50 8 7-50 6-150 5-250 Oct-09 Oct-11 Oct-13 Oct-15 Oct-17 Source: IBGE, Itaú, FGV

Pension reform is back on the table, but still lacks political consensus for approval The government introduced a watered-down version of the pension reform. According to our calculations, the watered-down reform would have 60% of the original government s proposal impact 1.20 pp of GDP in 2025 on private sector pensions (see chart), and 0.20 pp of GDP on public sector pensions.. However, the reform still seems to lack political consensus for approval. Without a reform, the government is less likely to meet its constitutional spending cap after 2019, negatively influencing the gradual return to a situation of primary budget surpluses that are compatible with public debt stabilization. Social Security result + BPC/LOAS %GDP 0% -1% -2% Source: National Treasury, Itaú -3% -4% -5% -6% Original reform Diluted reform Without reform -3.8% -4.1% -5.3% 2025 2024 2023 2022 2021 2020 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003

BRL depreciated amid pension reform uncertainty The BRL depreciated again in November amid uncertainties over the pension reform. Our year-end forecast for the exchange rate is unchanged, at BRL 3.25 per USD, depreciating to 3.50 in 2018 and 3.60 in 2019. The biggest risk to our call is the progress of the reform agenda, particularly the adjustment in public accounts Exchange Rate BRL/USD, monthly average 4.50 4.00 3.50 3.25 3.50 3.00 2.50 2.00 1.50 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 Source: Itaú, BCB, Bloomberg

We trimmed our inflation forecast for 2017 and maintained our call for 2018 at 3.8% The forecast was revised (3.3% in the previous report) due to lower-than-expected readings lately for food and services, as well as the definition of the red tariff flag system for electricity prices at Level 1 in December (we had assumed Level 2). Our 2018 inflation estimate stands at 3.8%. Breaking down the index, we expect market-set prices to rise 3.6% and regulated prices to climb 5.1%. Our below-target inflation estimate for next year will be driven by less inertia from past inflation, anchored inflation expectations and a negative output gap. Source: Itaú, IBGE 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% IPCA Breakdown yoy IPCA Market-set prices (76%) Regulated prices (24%) 10.7% 6.3% Forecast 2.8% 0% Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 3.8%

Monetary policy: As slow as possible In early December, the Copom delivered a widely expected 50bps rate cut, taking the Selic to 7.0%, an unprecedented low. In the post-meeting statement, the Copom indicated, quite clearly, that it will likely cut the Selic by 25bps, to 6.75% in its next policy meeting, in February 2018. For now, we expect the Copom will cut the Selic to 6.5%, in two 25bps increments, in February and March, rather than in a single 50bps move. But we reckon that absence of progress on the fiscal adjustment and reform agenda would make the second 25bps cut less likely, and hence increase the likelihood that the cycle ends with the Selic at 6.75%.. 14% Selic % p.a. 12% 10% 8.17% 8% 6.50% 7.00% 6% 2008 2010 2011 2012 2013 2015 2016 2017 2018 Itau Unibanco Forecast Yield Curve Pricing Source: Itaú, Bloomberg

Conclusion Global Economy Solid global growth and higher interest rates in 2018 We expect global growth to continue at 3.8% in 2018 (the same as in 2017). As growth remains above potential in developed countries, the output gap will turn positive and inflation is likely to start normalizing gradually (led by the U.S.). Global monetary policy will also become less accommodative in 2018: we see i) three interest rate hikes in the U.S., with balanced risks; ii) the end of QE in the euro area (but interest rate increases only in 2019) and iii) in Japan, a 20 bps in its 10- year JGB target (but no change in its short term rate. Despite less-accommodative monetary policy, we expect broad global financial conditions to remain favorable, sustained by robust growth and little recession risk. Brazil Economy improves amid greater risks We increased our forecast for GDP in 2017 to 1.0% from 0.8%, after incorporating the revision of the historical series and the results for 3Q17. We estimate growth at 3.0% for 2018 and 3.7% for 2019, but we see downside risks if the outlook for public accounts changes. We trimmed our inflation forecast for 2017 and maintained our call for 2018 at 3.8%. Our estimate for the consumer price index IPCA in 2019 stands at 4.0%. Our year-end forecasts for the exchange rate are unchanged, at BRL 3.25 per USD in 2017, 3.50 in 2018, and 3.60 in 2019. After cutting the Selic rate by 50 bps in early December, the Monetary Policy Committee (Copom) is set to further reduce the easing pace to 25 bps in its next meeting, in February 2018. We expect no increase in interest rates in 2018, with a rise only in 2019, when the Selic should reach 8.0%.

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