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Latam Macro Monthly Scenario Review

March 18

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.

Global Economy

USD rebound should be temporary 4

The USD appreciation against most DM and EM currencies last month seems to be mostly driven by temporary factors. As the

global economy continues to recover, we see a weaker USD ahead.

LatAm

A bumpier but still-benign external environment 9

Volatility in external markets increased recently, but LatAm asset prices have remained broadly resilient.

Brazil

Easing cycle: another cut, followed by a pause 10

We expect the Copom to cut rates again to 6.5%, due to downward surprises with inflation data. After that, the benchmark rate

is set to stay flat for the rest of the year.

Argentina

The drought takes its toll 15

We revised our 2018 GDP growth forecast to 2.8% from 3.5% due to the severe drought’s impact on agriculture. For 2019, we

now forecast 3% expansion (3.2% previously).

Mexico

Setting the stage for a pause 18

We see the recent communication from the central bank as consistent with our view that a pause in April is likely. On the

political front, the tides are moving in favor of the anti-establishment candidate, Andrés Manuel López Obrador (AMLO).

Chile

Gaining momentum 22

Chile´s economy is rebounding, supported by external and domestic tailwinds. We now expect 3.6% GDP growth this year

(against 1.6% in 2017), with risks tilted to the upside.

Peru

Metal prices and macro policy stimulus to the rescue 25

We maintain our view that the increase in metal prices and macro policy stimulus will offset the uncertainty associated with

politics and boost GDP growth to 4% in 2018, from 2.5% in 2017.

Colombia

Uncertain recovery 28

Soft activity readings at the end of 2017, weak labor market, and political uncertainty ahead of the presidential election

suggest that the recovery this year is not exempt from risks. Despite the central bank’s indication of the end of the easing

cycle, we expect two further 25-bp rate cuts, to 4.0%, in the coming months.

Macro Research – Itaú Mario Mesquita – Chief Economist Tel: +5511 3708-2696 – E-mail: [email protected]

http://bit.ly/ENG0318

Latam Macro Monthly – March 9, 2018

Emerging markets show resilience amid a bumpier external

environment

The external environment might have become bumpier, but it still seems to be favorable for EMs.

In February, the USD found some support against most currencies, as rates and equities continued to adjust to

normalizing inflation, global economic indicators receded a bit from record highs and the risk of a trade war

between the U.S. and important trade partners increased.

However, these factors seem to be mostly temporary, likely leading the USD to resume its weakening trend in the

coming months. While we believe the FOMC does need to adjust financial conditions to limit macro-economic

risks, we think the US economy is in late cycle, which does not support the USD. The cyclical recovery in Europe

is set to continue despite political risks, and in China a well-managed slowdown remains our baseline scenario.

Finally, as of now, the risk of wider trade war still seems limited.

Emerging markets have shown resilience amid the recent volatility, evidence that their economies have less

imbalances and that financial conditions remain benign, while global growth continued to support commodity

prices. The external environment might have become bumpier, but it still seems, on the whole, to favor EMs.

In Latin America, the recovery has become uneven, despite the stronger, more synchronized growth abroad.

Recent growth figures have disappointed in Peru and remained weak in Colombia, but we still believe both

countries are set to accelerate this year, in spite of political risks. In Mexico, remaining uncertainties regarding the

NAFTA and the course of economic policy after elections are hurting investment, while in Argentina a severe

drought takes its toll on agriculture. In Chile, the economy is recovering faster than previously expected and

started 2018 on a high note, helped by the positive effects of the political scenario on confidence levels and

external tailwinds.

In Brazil, GDP growth was weak in 4Q17, but underlying activity – as indicated by private internal demand –

confirms that the recovery is on track. We continue to expect 3.0% growth this year, after advancing 1.0% in

2017. We have also maintained our exchange-rate and inflation forecasts for 2018 and 2019. On the fiscal front,

results continue to improve and reinforce our call that, despite the still-unaddressed medium-term challenges, the

deficit target for 2018 will be easily met. Finally, the Selic rate is set to stay near its current levels for the rest of

the year, with modest increases only in 2019, as the slack in the economy is only gradually reduced.

Hope you enjoy,

Mario Mesquita and Macro Team


Current Last month Current Last month Current Last month Current Last month

GDP - % 4.1 4.1 4.0 4.0 GDP - % 2.2 2.4 2.8 2.9


GDP - % 3.0 3.0 3.7 3.7 GDP - % 1.8 2.1 2.0 2.4

BRL / USD eop 3.25 3.25 3.30 3.30 MXN / USD eop 18.50 18.50 18.00 18.00

Monetary Policy Rate - eop - % 6.50 6.75 8.00 8.00 Monetary Policy Rate - eop - % 7.00 7.00 6.00 6.00

IPCA - % 3.5 3.5 4.0 4.0 CPI - % 3.7 3.7 3.3 3.0


GDP - % 2.8 3.5 3.0 3.2 GDP - % 3.6 3.3 3.5 3.5

ARS / USD eop 23.00 23.00 27.00 27.00 CLP / USD eop 620 620 625 625

BADLAR - eop - % 22.00 22.00 18.00 18.00 Monetary Policy Rate - eop - % 2.50 2.50 3.50 3.50

7-day Repo rate - eop - % 24.00 24.00 19.00 19.00 CPI - % 2.5 2.5 2.8 2.8

CPI - % 20.0 19.0 17.0 17.0


GDP - % 2.5 2.5 3.2 3.2 GDP - % 4.0 4.0 4.0 4.0

COP / USD eop 3000 3000 3030 3030 PEN / USD eop 3.25 3.25 3.30 3.30

Monetary Policy Rate - eop - % 4.00 4.00 4.50 4.50 Monetary Policy Rate - eop - % 2.75 2.75 3.25 3.25

CPI - % 3.3 3.3 3.0 3.0 CPI - % 2.2 2.2 2.6 2.6

Latin America and Caribbean

Mexico

2018 2019

Scenario Review

World

Brazil

Argentina

2018 2019

2018 2019 2018 2019

2018 2019 2018 2019

Colombia Peru

Chile

2018 2019 2018 2019


Global Economy

USD rebound should be temporary

• The USD found some support against most DM and EM currencies last month as U.S. rates and equities adjust to

normalizing inflation, with global economic indicators coming off record highs and the risk of a trade war increasing.

• We believe the FOMC still needs to adjust financial conditions to better balance macro-economic risks. But we see the

economy in a late cycle, which doesn’t support the USD.

• In Europe, cyclical recovery remains in place despite political risks.

• In China, high-frequency data was distorted by the New Year’s holiday. Policymakers seek stability amid risk reduction, and

hence a modest, manageable slowdown remains our baseline

• Risk of global trade war is important but it still seems limited.

• Emerging markets have shown resilience amid the recent volatility, indicating that their economies are better adjusted and

global financial conditions remain supportive.

USD recovery likely to be temporary

The USD has recovered a little from the recent low

earlier in the year. In February, the dollar gained about

2.5% and 1.3% against a basket of developed and

emerging market currencies, respectively.

A few factors have supported the USD recently. First,

U.S. rates and equities are adjusting to the risk that

strong growth could push the already tight labor market

too far, in a moment when inflation is starting to

normalize. Accordingly, the FOMC new chairman Jay

Powell´s early official statements suggest, in our view,

that he will likely increases his “dots” at the March

meeting. Second, data in Europe declined a bit from

strong levels, and China’s Purchasing Managers Index

(PMI) plummeted in February. Finally, U.S. tariffs on

steel and aluminum increased the risk of trade wars.

But as we discuss in the sections below, all these

factors seem temporary, and hence we expect the

USD to depreciate until the end of the year. As the

global economy recovers, we see a USD depreciation

trend, which gives back part of the large gains the USD

seen between 2011 and 2016, when the word economy

was very weak. The February rebound in the USD could

continue a little longer, but it doesn’t appear to reverse

this trend (see chart).

USD depreciation trend

Source: Bloomberg, Itaú

Fed tightening to better balance the macro

risks

Exports and fiscal policy have become tailwinds for

the U.S. economy. Financial conditions have eased,

despite the gradual Fed tightening since December 2015,

and indicate that U.S. GDP growth could exceed 3%,

from the 2.2% average since 2010.

GDP growth at 3% for the next two years would lead

to further decline in the unemployment rate and raise

the risk of a hard landing. In the 1960s, when the U.S.

central bank did not respond properly to extremely low

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USD-EMUSD DM (rhs)

Index


unemployment rates, wages and inflation expectations

eventually increased and pushed inflation above the

desired levels. If inflation dynamics started to spiral up,

the Fed would not make the same mistake again, and we

are unlikely to see the return of 1960s or 1970s levels of

inflation, but it would be too late fora soft landing.

There are signs of inflation normalization. While core

PCE inflation at 1.5% remains below the Fed’s 2% target,

it has been rising at a 2.0% annualized pace in the past

six months (see chart). Wage inflation is reaching 3%

yoy. The Phillips curve seems relatively flat, but the very

low unemployment rate is generating higher wage gains.

With inflation expectations anchored, the strong labor

market will likely pull inflation back to 2%.

Core PCE reached 2% annualized in Jan/18

Source: Haver, Itaú

With this economic outlook, we believe the FOMC

will increase the fed fund rate in March and raise the

median dots to four hikes in 2018 and three hikes in

2019 (from 3+2 in December). This pace of hikes

would likely maintain GDP growth above potential

growth, but tighten financial conditions to gradually cool-

off the economy. We think this is a prudent monetary

policy strategy that increases the probability of a soft

landing. We see signs that Powell has a similar view,

and we think he will steer the FOMC in the direction of

“further” gradual hikes.

We raised our 10-year U.S. Treasury target to 3.25%

(from 3.0%) for YE18.

We continue to foresee a weaker USD, despite the

higher Fed policy rates. The U.S. current account deficit

is likely to rise due to fiscal stimulus coupled with higher

income payments. And the relative attractiveness of U.S.

assets to finance this bigger deficit is deteriorating, given

the unsustainable U.S. fiscal stance and better global

outlook.

Europe – Cyclical recovery remains in place

despite political risks

Although data indicators moderated in February,

growth should remain strong. PMIs and other

confidence surveys all decreased from very high levels in

January but still point to a strong rate of growth in 1Q18

(see chart). We continue to expect the Eurozone GDP to

grow by 2.6% in 2018 and 2.4% in 2019, boosted by an

easy monetary policy, more loose fiscal policies in some

countries and favorable external demand.

Euro area growth and PMI


Political risk increased in the region after an

outperformance of populists in Italy. The chance of

populist parties taking part in the government increased

and the process to form a government should be long.

The chance a pure populist coalition, with parties from

the extreme right and the left joined in an anti-euro

rhetoric, is still small. Consequently, Italy’s new

government will likely have less commitment to fiscal

adjustment and structural reforms, but the risk of “Italy

euro exit” remains low. Negotiations should take weeks,

and prospects of possible coalitions might emerge by

the end of the month.

However, the end of the gridlock in Germany is

positive, and it clearly offsets Italy’s negative

outcome. SPD members approved the grand coalition

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ForecastHoH SAAR YoY

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GDP (qoq, rhs)Composite PMI

index, %


by a wide margin, and Merkel will be reelected for

another four-year term by mid-March. The new

government should be marked by a looser fiscal policy

and a more pro-euro stance.

Finally, the strong economic outlook keeps the ECB

on track to end its asset purchases in September

and raise interest rates in 2019. The central bank will,

though, proceed with caution. Communication and

forward guidance should be adjusted only gradually, as

underlying inflation still rises slowly but is far from 2%.

China – A moderate and manageable

slowdown

China’s Manufacturing PMI dropped 1 pt, to 50.3 in

February, due to the Chinese New Year distortions.

The fall was exaggerated by production cuts prior to the

Chinese New Year. The output component, which is

affected by the curbs, plummeted, while unemployment

softened but by a much smaller degree (see chart). In

addition, the Caixin PMI, which has a higher share of

export-oriented companies, increased to 51.6 in

February from 51.5 in January.

NBS PMI Components


Looking ahead, we see moderation in growth, to 6.5%

this year compared with 6.9% in 2017, as policy has

become tighter. Last year, the PBoC has allowed market

interest rates to rise (average lending rate increased by

about 125 bps, to 4.25%), which is likely to affect the

economy this year. In addition, fiscal policy will likely be

tighter with the federal government deficit target reduced

to 2.6% of GDP in 2018 from 3.0% in 2017. Finally, the

National People’s Congress has set this year’s growth

target at "around 6.5%," compared to last year’s target of

"around 6.5%, and we aim to achieve better results if

possible”. The change confirms that the government will

tolerate a moderate slowdown in growth.

We believe that this policy is manageable and

positive for global stability because it reduces

financial risk and produces a more sustainable

growth path in China. Indeed, the credit-to-GDP ratio in

China remains high but has started to stabilize with more

rigid financial regulations on “alternative” credit products.

Also, the government is managing a gradual reduction in

state-owned enterprise (SOE) debt, which is the main

problem. The low level of public debt allows some degree

of freedom for the government to manage the SOE debt

over time. Private demand has been increasingly driven

by consumption, and the outlook for investment has also

improved, with housing inventories better balanced and

exports turning into a tailwind. And, if needed, the PBoC

has flexibility to adjust monetary policy, given that CPI

inflation remains at 2%, one percent below its target.

We maintain our growth forecasts at 6.5% for 2018

and at 6.1% for 2019.

Limited risk of global trade war

We continue to foresee a limited risk of a broad global

trade war, despite President Trump’s recent import

tariffs hikes (steel, aluminum, washing machines, and

solar panels). The U.S. investigations into China’s

intellectual property and technology transfer is likely to

lead to China FDI restrictions and industry-specific import

tariff hikes, while NAFTA renegotiation should settle U.S.

commerce relations with Canada and México.

A global trade war would essentially amount to a

negative productivity (or supply) shock, resulting in

higher inflation in the short run and lower longer-run

growth. It hurts all consumers and benefits a few

industrials, and so politicians should be hurt over the

medium term, including President Trump. The Federal

Reserve should look through an eventual spike in inflation,

but can only reduce the number of rate hikes when and if

to offset a tightening of financial conditions.

The response from European Union and China to

President Trump’s recent import tariff hikes has been

carefully targeted, showing their intent to safeguard

global trade. In particular, we are encouraged by

policymakers in China, who seem to understand clearly

that a trade war would be harmful to their economy and

rebalancing efforts.

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OutputEmployment (rhs)

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Despite the tough rhetoric and recent measures,

President Trump seems to understand that an

across-the-board import tariff hike would harm him.

Last year, he scrapped the idea of a Border Adjusted

Tax, as he received negative feedback from interested

parties, and this time should be no different.

Emerging market resilience

Emerging market assets have performed well during

the recent turbulence. For example, as mentioned

above, in February the dollar gained about 2.5% against

a basket of developed currencies, but it gained just

about half of that (1.3%) against a basket of emerging

market currencies.

First, global liquidity remains high, and hence

financial conditions remain easy. In fact, the stress in

the U.S. equity volatility index (VIX) seems exaggerated,

compared with other asset performance (see chart).

This indicates that global growth remains on track and

financial conditions are easy.

VIX far above the implicit by other financial assets


Second, emerging markets outside China have

generally improved their macro positions. Current

accounts have adjusted; inflation has declined, allowing

interest rates to be lowered; and growth is resuming. All

these signs point to a better macro balance. And in

several economies the recovery is still in its early

stages, and capital flows are just starting to come back.

Commodities – Global growth continues to

sustain commodity prices

The Itaú Commodity Index (ICI) has fallen 0.5% since

the end of January. The small move in the aggregate

index hides a divergence between its components.

Agricultural prices rose 7.1%, driven by weather-related

risks. Meanwhile, energy-related prices fell 6.4%,

affected by a combination of currencies (stronger dollar),

technical factors (the unwinding of long positions held by

hedge funds) and fundamentals (signs of stronger crude

production in the U.S.). Finally, metal prices sustained

earlier gains, helped by the outlook for strong global

growth.

We see global growth as a sustainable driver that

could prevent weakness across hard commodities.

Hence, we have increased our metal price forecasts on

stronger demand, raising our year-end price estimate for

copper to USD 6,800/mt (from USD 6,700/mt, extending

a previous upward revision), together with additional

upward adjustments for other base metals.

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* VIX consistent with financial conditions of 43 assets

VIXVIX consistent with other

financial assets*

MA 5 days


Forecasts: World Economy

GDP Growth

World GDP growth - % 3.5 3.5 3.6 3.4 3.2 3.8 4.1 4.0

USA - % 2.2 1.7 2.6 2.9 1.5 2.3 2.9 2.6

Euro Area - % -0.8 -0.2 1.4 2.0 1.8 2.5 2.6 2.4

Japan - % 1.5 2.0 0.0 1.4 0.9 1.8 1.6 1.2

China - % 7.9 7.9 7.2 6.8 6.7 6.9 6.5 6.1

Interest rates and currencies

Fed Funds - % 0.2 0.1 0.1 0.2 0.7 1.4 2.4 3.2

USD/EUR - eop 1.32 1.37 1.21 1.09 1.05 1.20 1.25 1.30

YEN/USD - eop 86.3 105.4 119.8 120.4 117.0 112.7 105.0 100.0

DXY Index* - eop 79.8 80.0 90.3 98.7 102.2 92.1 87.7 84.6Source: IMF, Bloomberg and Itaú

2019F2018F2017F2012 2013 2014 20162015

* 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.


LatAm

A bumpier but still-benign external environment

• Volatility in external markets increased recently, but LatAm asset prices have remained broadly resilient.

• Activity recovery in the region is not yet broad-based. We lowered our growth forecasts for Argentina and Mexico, but now

see higher growth in Chile.

• Most monetary policy cycles in South America are coming to an end, given the already expansionary monetary policy and

recovering activity. In Mexico, we foresee no further interest rate hikes, but uncertainty over the macro outlook (including

interest rates) remains high.

Volatility in external markets increased recently, but

LatAm asset prices have remained broadly resilient.

In fact, at the end of February, most LatAm currencies

were showing small year-to-date gains against the USD,

while sovereign spreads were stable. One exception is

Argentina, where uncertainties over monetary policy and

deteriorating external accounts have had a negative

impact on the price action. For most of the currencies

we cover, we expect some depreciation against the USD

as monetary policy normalization in the U.S. continues

and commodity prices show some moderation.

Despite the stronger, more synchronized growth in

developed economies, activity recovery in the region

is not yet broad-based. In Chile, the economy is

recovering faster than we previously expected, helped by

the positive effects of the political scenario on confidence

levels; we now expect growth of 3.6% this year (from

3.3%). In Brazil, GDP growth was weak in 4Q17, at 0.1%

QoQ, but underlying growth (as indicated by internal

demand dynamics) suggests that the recovery is on-track

(we continue to expect a 3.0% expansion this year). In

Peru, growth has disappointed – partly due to the recent

political crisis – and market participants are revising their

growth forecast for this year down. While we

acknowledge that the current political scenario in Peru is

shakier, and an impeachment of the President is possible,

we maintain our view that the solid increase in metal

commodity prices will drive growth to 4.0% in 2018 (from

2.5% in 2017). In Colombia, growth also remains weak,

but we believe that will change due to the external

scenario as well as the recent decline in inflation (largely

reflecting the fading effect of supply-side shocks) and

interest rate cuts. However, the political scenario in

Colombia is a risk. In Mexico, we revised our growth

forecasts for this year down to 1.8% (from 2.1%), given

weaker-than-expected investment, reflecting the

uncertainties related to NAFTA and the direction of

economic policy after the presidential elections. In

Argentina, the weakening of the economy in 4Q17 and

the drought affecting the key Agriculture sector led to a

reduction of our growth forecast for this year to 2.8%

(from 3.5% in our previous scenario).

With the exception of Argentina, inflation is falling in

the region – reflecting economic slack and

exchange-rate strengthening – and is below the

center of the target in Brazil, Chile and Peru. Recent

CPI data for Mexico and Colombia has also been more

encouraging.

Most monetary policy cycles in the region are

coming to an end. Despite the low inflation, recovering

activity and an already-expansionary monetary policy

suggest that additional rate cuts are unlikely in Peru and

Chile; in Brazil, we foresee only one additional 25-bp

rate cut. In Colombia, lower-than-expected activity and

inflation data, amid a narrower current account deficit (a

key vulnerability of the economy), support our view that

more rate cuts are likely (we expect two 25-bp rate cuts

in the first half of this year). In Argentina, the weaker

currency and higher inflation expectations make

disinflation even more challenging, leading the central

bank to become more conservative, signaling no room

for additional cuts in the near future (it remained on hold

at both meetings in February). We believe that new rate

cuts will follow an eventual resumption of the downtrend

in inflation in Argentina, even if the disinflation path is

not fast enough to meet the new inflation targets. Finally,

Mexico’s central bank is preparing for a pause in the

tightening cycle by attributing lower importance to the

Fed in its upcoming decision. Although uncertainty over

the macro outlook in Mexico is high, our base-case

scenario is that the next rate move in Mexico will be a

cut, likely in the second half of this year.

,


Brazil

Easing cycle: another cut, followed by a pause

• We reduced our estimate for the primary budget deficit in 2018 to 1.9% of GDP from 2.0%, reaffirming our expectation that

the government will easily meet its target.

• GDP expanded 0.1% in 4Q17, consolidating the recovery, notwithstanding a seemingly weak reading. Our growth

forecasts are for 3.0% in 2018 and 3.7% in 2019.

• We maintained our exchange-rate forecasts at BRL 3.25 per USD for YE18 and 3.30 for YE19.

• We maintained our inflation forecasts at 3.5% for 2018 and 4.0% for 2019.

• We expect the Monetary Policy Committee to reduce the Selic rate to 6.5%, given surprises in the latest economic data,

which are substantial enough to warrant a final rate cut in March.

Fiscal readings continue to improve, but

their sustainability depends on reforms

Short-term fiscal results continue to improve

We reduced our estimate for the primary budget

deficit in 2018 to 1.9% of GDP (BRL 137 billion) from

2.0% of GDP (BRL 145 billion). This supports our

belief that meeting the target of BRL 161 billion (2.2% of

GDP) and the spending cap will be less challenging this

year. Fiscal results in 2018 will benefit from larger

extraordinary revenues, particularly those related to tax

amnesty programs (Refis), and lower mandatory

spending on subsidies.

Debt dynamics and the “golden rule” will not be a

source of concern this year. As development bank

BNDES repays BRL 130 billion to the National Treasury,

the government will be able to comply with the so-called

golden rule this year. Notwithstanding still-negative

primary results, this repayment, better economic growth

and lower real interest rates will contribute to keep gross

debt as a share of GDP virtually stable in 2018.

However, without reforms, fiscal results will slip back

into a deteriorating trend from 2019 onward. The

pension reform, a prerequisite for rebalancing public

accounts, is no longer being pushed through Congress

and, most likely, will only get back on the table in the next

administration. If controlling public expenses (as set by

the spending cap) is not made feasible, gradual

convergence to primary surpluses that are compatible

with public debt stabilization will be halted. If the currently

unsustainable trend in public debt is maintained, the

rebound in economic activity and sustainability of interest

rates at historically low levels will be in jeopardy.

Gross debt may remain relatively stable in 2018

Source: National Treasury, Itaú

For 2019, we estimate the primary deficit at 0.9% of

GDP (BRL 80 billion). Compliance with the spending cap

will require an adjustment of about BRL 30 billion, which,

in our view, will come in the form of discretionary

spending cuts and a reversal of payroll tax breaks.

Activity: 4Q17 GDP consolidates the

rebound

GDP expanded 0.1% qoq/sa in 4Q17 and 2.1% yoy, in

line with our estimate (0.1%) and below the median of

market expectations (0.3%).

Notwithstanding a seemingly weak reading at the

margin, 4Q17 GDP led to 1.0% growth in 2017 and

consolidated the rebound in economic activity.

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General Government Gross Public Debt

% of GDP


Importantly, weaker GDP growth in seasonally adjusted

terms in the second half of 2017 is related to the

accounting treatment of the huge crop in the first half.

Consequently, GDP readings for the beginning of the

year were much higher than underlying growth, while

the opposite occurred in the second half.

The dynamics in domestic demand (consumption

and investment) picked up in the second half,

providing evidence that the rebound in economic

activity is consolidating (see chart).

Domestic demand is stronger than the aggregate result for 2H17 GDP

Source: IBGE, Itaú

Additionally, our preliminary forecast for GDP

growth in 1Q18 is 1.0% qoq/sa (2.4% yoy). If

confirmed, this reading would reinforce our view that the

seemingly weak result in 4Q17 merely reflects noise in

the data rather than a change in trend.

Our growth estimates are 3.0% in 2018 and 3.7% in

2019, but we see downside in the balance of risks.

These forecasts assume that reforms will continue in the

future. If an interruption occurs or if there is a perception

that the reform process is reversing, then the recovery in

economic activity may be threatened.

According to the national household survey (PNAD

Contínua - IBGE), Brazil’s nationwide unemployment

rate rose to 12.2% in the quarter ended in January

from 11.8% in 4Q17. Using our seasonal adjustment,

unemployment rose 0.1 pp, to 12.5%, due to a 0.1 pp

increase in the participation rate (ratio of the labor force

to the working-age population).

The contribution coming from the self-employed has

become less significant to the decline in

unemployment. Informal employment was virtually

stable in seasonally adjusted terms in the last two

monthly reports, halting a sequence of eight increases

during 2017. PNAD Contínua shows an additional

modest decline in formal employment in the private

sector, but another indicator, the CAGED registry,

reveals a net creation of about 50,000 jobs per month.

The chart below shows that such decoupling trends are

being reversed and fall in line with CAGED figures.

Recovery in the formal job market

Source: Caged, IBGE (monthly Pnad Contínua), Itaú

Using models that take into account the sensitivities

of different occupations to the pace of economic

activity and our GDP scenario, we expect the

unemployment rate (using our seasonal adjustment)

to recede to 11.7% by YE18 and to 10.7% by YE19,

as formal jobs generate an increasing contribution. Our

forecasts for the average unemployment rate are 12.0%

for 2018 and 11.0% for 2019 (2017: 12.7%).

Stable BRL despite global volatility

Notwithstanding the recent volatility in international

markets, the Brazilian currency remained range-

bound in the past month (BRL 3.20-3.30 per USD).

Synchronized global growth and lower global risk

aversion have supported the currency, even during a

correction in some global asset prices.

-0.9%

-0.4%

-1.0%

-0.6%

0.2%

0.5%

1.1%

0.7%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17

Domestic demand(C + G + I)GDP

qoq s.a.

-400

-300

-200

-100

0

100

200

300

400

500

600

Jan-12 Jan-14 Jan-16 Jan-18

Net formal job creation, thousands, 3-month moving average

General register of employees (CAGED)National household survey (PNAD contínua)


BRL and CDS remained range-bound in February despite global volatility


We maintain our exchange rate forecasts at BRL 3.25

per USD by YE18 and BRL 3.30 by YE19. Stronger and

more widespread global growth will continue to support

risk assets, including emerging market currencies.

Domestically, although uncertainty remains high

(especially over the approval of fiscal reforms), meeting

the fiscal target in 2018 will be less challenging, thanks to

the rebound in economic growth. Risk premiums required

for investment in Brazil (measured by CDS spreads) tend

to remain at moderate levels, and the BRL will likely be

somewhat stable over the next quarters.

The greatest risk to our forecast is the domestic

environment, particularly the fiscal reform agenda. If

this agenda advances more quickly than we anticipate,

the local currency could appreciate suddenly. On the

other hand, a reversal or expected setback could lead to

a falling trend in the exchange rate.

External accounts remain benign. February data

showed a stronger trade surplus at the margin. Exports

increased, led by the pro forma export transaction of an

oil-drilling rig. Imports picked up in recent months but

remain at historically low levels. Excluding the rig, the

quarterly moving average of the trade surplus points to

stability at the margin.

For the next few years, we expect larger current

account deficits, but not to the point of

compromising Brazil’s external accounts. In our view,

the rebound in domestic demand will produce wider

current account deficits. Trade surpluses, which were

behind low current account deficits in recent years, are

set to weaken in the future. We estimate trade surpluses1

of USD 55 billion in 2018 and USD 42 billion in 2019. For

the current account, we anticipate deficits of USD 32

billion in 2018 and USD 51 billion in 2019.

We maintain our inflation forecasts at 3.5%

for 2018 and 4.0% for 2019

For 2018, our forecast for the consumer price index

IPCA remains at 3.5% Throughout the year, we expect

increases of 0.8% in 1Q18 (2.7% yoy), 1.2% in 2Q18

(3.7% yoy), 0.6% in 3Q18 (3.8% yoy) and 0.9% in 4Q18.

Breaking this down further, we anticipate increases

of 3.1% in market-set prices (1.3% in 2017) and 4.7%

in regulated prices this year (8.0% in 2017). We

expect the following: inflation still to track below the

target due to lower inertia from past inflation; a relatively

stable exchange rate; 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

3.7% hike in costs for food consumed at home, after a

4.9% slide in 2017. We project that industrial prices will

climb 2.1% (following an unusually low reading of 1.0%

in 2017), with some cost pressure due to higher steel

prices (already reflected in producer prices), especially

in the automotive and appliance segments. Service

prices are likely to slow down again, to 3.4% from 4.5%,

largely because of lower inflationary inertia. Regarding

regulated prices, the main products are set to post

smaller increases than in 2017, particularly gasoline,

bottled cooking gas, electricity, and water and sewage

tariffs. Looking at electricity in particular, we assume that

the tariff flag system will be in yellow mode by December

2018. For gasoline, we expect it to be impacted by a

decline in oil prices from current levels, to USD 58/bbl for

Brent crude by year-end.

For 2019, our forecast for the IPCA remains at 4.0%.

We expect market-set prices to rise 3.7% and regulated

prices to climb 4.6%.

The main risk factors for the inflation scenario are

still tied to domestic politics and the evolution of

the international scenario. Uncertainties over the

political/election scenario may disappoint expectations

regarding the approval of reforms and other

adjustments needed to revive the economy. This could

trigger deterioration in risk premiums and impact the

exchange rate and the inflation path. A setback in

reforms, despite the negative effect on economic

activity, could also require alternative fiscal measures in

the future, such as tax hikes and/or a reversal of tax

130

145

160

175

190

205

220

235

250

265

280

3.00

3.05

3.10

3.15

3.20

3.25

3.30

3.35

3.40

Mar-17May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18

BRL CDS (rhs)


breaks. As for the external situation, there are

promising signs, including the outlook for stronger and

synchronized global growth and sustained risk appetite

for emerging market assets, but one cannot rule out

economic policy changes in the developed world and

tighter global financial conditions eventually.

Below-target inflation rate

Source: BCB, IBGE, Itaú

Substantial slack in the economy may contribute to a

sharper decline in inflation in 2018. The negative

output gap and, consequently, unemployment above its

equilibrium level for a longer period (despite some recent

improvement) could cause more persistent disinflation in

market-set prices, particularly those more sensitive to the

economic cycle, such as services and industrial items.

More favorable inflation inertia also presents

downside risk to 2018 inflation. The sharp slide in

agricultural and retail food prices last year, thanks to a

favorable supply shock, contributed to a 2.9% increase in

the IPCA, which came in below the lower bound of the

inflation target range, as well as to even-lower readings

for other inflation indicators, particularly the INPC (2.1%)

and IGP-M (-0.5%). The INPC – whose basket is focused

on a tighter income bracket of households earning up to

five monthly minimum wages – is used to calculate

adjustments in the minimum wage and is also a

benchmark for most wage adjustments in the private

sector. Certain favorable effects are also likely to arise

from low readings for the IGP-M, used to adjust some

regulated prices and home rental contracts. Hence, year-

over-year inflation readings below those captured by the

IPCA, which should prevail at least until mid-year, may

cause an even more favorable inertial effect on headline

inflation in 2018.

Inflation expectations remain anchored, with

breathing room in relation to the 2018 target. The

median of market expectations, as per the central bank’s

Focus survey, slid to 3.70% from 3.94% in 2018 and

remain well below the 4.50% target. The median estimate

for 2019 receded to 4.24% from 4.25% and remained at

4.00% for 2020, and both were anchored on the targets

set for these years.

Anchored inflation expectations

Source: BCB (Focus Survey)

Monetary policy: Another cut, followed by a

pause

In February, the Central Bank’s Monetary Policy

Committee (Copom) signaled that the end of the

cycle is near, after it reduced the benchmark Selic

rate to a new all-time low of 6.75% p.a. The main

message of the minutes from the meeting was that the

Copom had the intention to keep the rate unchanged in

its next decision (on March 21), unless inflation readings

are continually lower than anticipated.

Data released since then seem to have provided

enough surprise to convince the Copom to move

away from its flight plan and add a final boost in its

next meeting. Hence, we revised our call and we now

expect the central bank to reduce the Selic rate to 6.5%

in March and interrupt the cycle right after that. While

weaker-than-anticipated inflation and activity figures

justify this final cut, we do not expect the monetary

policy rate to fall below 6.5%, as the Copom will likely

continue to see convergence toward the target in 2019

(which gradually becomes the meaningful horizon for

10.7%

6.3%

2.9%

3.5%

4.0%

0.0%

1.5%

3.0%

4.5%

6.0%

7.5%

9.0%

10.5%

12.0%

Dec-12 Feb-14 Apr-15 Jun-16 Aug-17 Oct-18 Dec-19

yoyForecast

IPCATarget

3.70%

4.24%

4.00%

3.6%

3.7%

3.8%

3.9%

4.0%

4.1%

4.2%

4.3%

4.4%

4.5%

4.6%

Mar-17 Jun-17 Sep-17 Dec-17 Mar-18

Centenas Median inflation expectations (IPCA)

20182019 2020


monetary policy). This decision is also likely to be based

on the recovery in economic activity, the lagged effects

of monetary policy (which will continue to provide a

boost to the economy) and the balance of risks in the

international scenario, which became less favorable

recently due to the outlook for additional interest rate

hikes in the U.S. and election-related uncertainties in

Europe.

Forecast: Brazil

Economic Activity

Real GDP growth - % 1.9 3.0 0.5 -3.5 -3.5 1.0 3.0 3.7

Nominal GDP - BRL bn 4,815 5,332 5,779 5,996 6,259 6,560 7,060 7,613

Nominal GDP - USD bn 2,463 2,468 2,455 1,800 1,795 2,055 2,177 2,323

Population (millions) 199.2 201.0 202.8 204.5 206.1 207.7 209.2 210.7

Per Capita GDP - USD 12,362 12,278 12,106 8,804 8,710 9,896 10,404 11,027

Nation-wide Unemployment Rate - year avg (*) 7.4 7.1 6.8 8.5 11.5 12.7 12.0 11.0

Nation-wide Unemployment Rate - year end (*) 7.5 6.8 7.1 9.6 12.7 12.4 11.7 10.7

Inflation

IPCA - % 5.8 5.9 6.4 10.7 6.3 2.9 3.5 4.0

IGP–M - % 7.8 5.5 3.7 10.5 7.2 -0.5 3.8 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 3.25 3.30

Trade Balance - USD bn 19 2 -4 20 48 67 55 42

Current Account - % GDP -3.0 -3.0 -4.2 -3.3 -1.3 -0.5 -1.5 -2.2

Direct Investment (liabilities) - % GDP 3.5 2.8 3.9 4.2 4.4 3.4 3.9 3.5

International Reserves - USD bn 379 376 374 369 372 382 382 382

Public Finances

Primary Balance - % GDP 2.2 1.7 -0.6 -1.9 -2.5 -1.7 -1.9 -0.9

Nominal Balance - % GDP -2.3 -3.0 -6.0 -10.2 -9.0 -7.8 -7.0 -5.6

Gross Public Debt - % GDP 53.7 51.5 56.3 65.5 70.0 74.0 74.2 74.0

Net Public Debt - % GDP 32.3 30.6 33.1 36.0 46.2 51.6 55.2 56.6Source: IBGE, FGV, BCB and Itaú

2019F

(*) Nation-wide Unemployment Rate measured by

PNADC

2017F2015 20162012 2013 2014 2018F


Argentina

The drought takes its toll

• We revised our GDP growth forecast downward for this year, to 2.8% from 3.5% in our previous scenario, due to an expected

negative impact on activity because of the severe drought. For 2019, we now forecast a 3% expansion (3.2% previously).

• Inflation is under pressure due to hikes in regulated prices and higher core item prices, while wage negotiations advance

slowly in this challenging scenario. We adjusted our inflation forecast for 2018 to 20% from 19% in our previous scenario. For

2019, we maintain our forecast at 17%.

• The central bank left the monetary policy unchanged, at 27.25% in February, and it adopted a more cautious tone. Given the

expectation of high readings for the upcoming CPI data, and also because a new round of regulated price increases is

scheduled for April, we expect the central bank to leave the policy rate unchanged in both its March and April decisions.

• In spite of the pause in the easing cycle, the peso continued to weaken amid deteriorated external accounts. We forecast

the peso at 23 to the dollar by the end of 2018 (meaning a real exchange rate depreciation relative to year-end 2017) and

at 27 to the dollar by the end of 2019.

Drought to trim GDP growth in 2018

Activity slowed in 4Q17. The EMAE (official monthly

GDP proxy) expanded 2.0% yoy (0.6% mom/sa) in

December. During 4Q17, activity gained 3.6% year over

year (4.2% in 3Q17) and 1.2% qoq/saar (3.6% in 3Q17).

As a result, growth reached 2.8% in 2017, slightly below

our GDP forecast of 2.9%. construction was the most

dynamic sector in 2017, increasing 10% during the year,

driven mostly by public sector infrastructure expenditures.

Agriculture and primary activities increased by 4.8%,

followed by the service sector (3.1%) and manufacturing

(2.8%). The EMAE left a statistical carryover of 1.4% for

2018. Indec, the official statistics agency, will publish the

national accounts for 2017 on March 21.

According to our seasonal adjustment, all sectors

except manufacturing decelerated sequentially in

4Q17. Construction rose 3.7% QoQ/saar, down from

28.2% in 3Q17. Primary activities slipped 0.2% (+0.3%

in 3Q17). Services fell 0.5%, following a 5.2% expansion

in 3Q17. On a different note, manufacturing grew 11.8%,

up from 10% in the previous quarter, helped by the

recovery in Brazil.

The recent activity data (and the resulting carryover

for this year) together with a smaller harvest due to

the severe drought will likely lead to lower growth in

2018 than we previously expected. We estimate a

negative contribution from primary activities to GDP

growth of 0.7%, which will partially offset the benefits of a

better global economic outlook (including a recovery in

Brazil) and lower political risks (following the strong

showing of the government coalition in the mid-term

elections). We now expect GDP to increase 2.8% this

year, down from our previous projection of 3.5% growth.

For 2019, we now forecast a 3% expansion (3.2% before).

Agricultural drag

Source: EMAE, Itaú

We expect the negative impact of a lower harvest on

exports to be offset by liquidation of soy stocks

hoarded in 2017. In January, the strong performance of

imports worsened the deficit, despite a recovery in

exports, taking the 12-month trade balance to a record

deficit of USD 9.4 billion, from USD 8.5 billion in 2017. At

the margin the deficit is running even wider, at USD 11.7

billion (accumulated in three months and annualized),

although this represents a narrowing from the USD 13.3

billion posted in 4Q17. We maintain our forecast of a

negative rade imbalance of USD 10 billion for this year,

with a current account deficit of 5.5% of GDP.

-30

-20

-10

0

10

20

30

40

50

-9

-6

-3

0

3

6

9

12

15

20

05

20

06

20

07

20

08

20

09

20

10

20

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20

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20

13

20

14

20

15

20

16

20

17

20

18F

EMAE excluding agriculturalAgricultural sector (rhs)

yoy yoy


Inflation pressure at the beginning of the

year

Headline inflation is under pressure due to hikes in

regulated prices and higher core item prices. Inflation

in January was 1.8% mom. In February, it likely reached

2.6%, according to private estimates (Elypsis consulting),

reflecting the impact of adjustments in electricity, water

and transportation fares as well as higher core item prices

(estimated at 2% mom, following a 1.5% gain the

previous month). Looking ahead, a new round of utility

price increases (gas and again in transportation) is

scheduled for April, while the weaker currency will likely

add to the second-round effects of utility price increases,

keeping core inflation at high levels.

Wage negotiations advance slowly in a challenging

inflation scenario. The government pushes for

agreements with nominal increases in line with the

inflation target of 15% and without automatic

compensations for higher inflation. The major unions,

including the powerful teachers’ unions, rejected the

initiative, and negotiations remain open amid strike

threats. The few agreements reached so far involve a

clause that allows reviewing the contract when inflation

exceeds the wage adjustment. We note that the outcome

of wage bargaining is key to diminishing inflation inertia

and facilitating a disinflation process.

We adjusted our inflation forecast for 2018 to 20%

from 19% in our previous scenario. For 2019, we

maintain our forecast at 17%. Both figures, while implying

some disinflation relative to 2017, are markedly above the

inflation targets for this year and the next (15% and 10%,

respectively).

No room for further monetary easing in the

near term

The central bank left its benchmark interest rate (7-

day repo rate) unchanged, at 27.25%, in both

meetings held in February. In the latest statement, the

monetary authority cited the expected unfavorable CPI

data for February (in particular for core items) and

issued a press release with a clearly more conservative

tone than the previous one.

The central bank stated that it will act with extreme

caution and will wait for disinflation signals before

easing monetary policy further. We expect the central

bank to stay put in its next policy decision in March and

April. While rate hikes seem unlikely, especially given

the recent activity figures, in our view the central bank

will resume interest rate cuts only when there is more

positive news on inflation (even if the disinflation is not

fast enough to meet the inflation target set for this year

and the next). We see the monetary policy rate at 24%

by year-end. For 2019, we expect the reference rate at

19%.

Gradual fiscal consolidation on track

The last 12-month primary deficit stayed unchanged,

at 3.9% of GDP in January. However, excluding one-

off penalties collected as part of the tax amnesty program

in the same month of last year, the fiscal balance

improved by 0.1% of GDP.

Solid revenue growth supports fiscal results. Total

revenues, excluding the above mentioned extraordinary

revenues, grew 27.7%, or 2.2% in real terms. Primary

expenditures rose 19.5% YoY, as higher pension

payments (35.1%), social benefits (28.8%) and payroll

(20.4%) were partly offset by a 40.1% reduction in capital

expenditures. In this context, primary expenditures fell by

4.4% in real terms.

We expect the government to meet the fiscal deficit

target this year, in spite of the downward revision to

our growth forecast. Last year, the treasury posted a

deficit of 3.9% of GDP, 0.3% lower than the official target

of 4.2%. The government’s goal is to reduce the primary

deficit to 3.2% of GDP this year. Excluding tax-amnesty

revenues in 2018, this would imply a fiscal deficit

reduction of 1.1% of GDP. In our view, the recent

changes in the pension-adjustment formula, continued

efforts to slash subsidies and higher tax collection due to

the economic recovery will play a key role in achieving

further fiscal consolidation.

Presidential approval rating stabilizes

President Mauricio Macri’s approval rating stabilized

in February. According to Poliarquía consulting, the

index improved a tad, to 49%, after posting two

consecutive drops amid negative perception of the

pension reform bill passed in December last year and

the latest tariff hikes.

Sentiment indicators showed mixed signals. While

the positive assessment of the country’s current situation

improved to 25% from 23%, the positive expectations for

2018 continued to slide, now 6 points, to 38%. We note

that, according to the Poliarquia survey, inflation is now

the top concern among Argentineans.


President Macri addressed Congress in the opening

of the legislative session and ratified the gradual

approach to reduce fiscal deficit and inflation. Macri

also urged the congress to discuss the pending capital

market bill, which encourages the development of

domestic capital markets and the operation of asset

management firms in the country. In addition, he

presented a social agenda that included sensitive issues

like decriminalization of abortion and the gender pay

gap.

Forecast: Argentina

Economic Activity

Real GDP growth - % -1.0 2.4 -2.5 2.6 -2.2 2.9 2.8 3.0

Nominal GDP - USD bn 579.6 611.0 563.9 631.6 545.1 623.9 611.1 615.2



Unemployment Rate - year avg 7.2 7.1 7.3 6.5 8.5 8.3 8.0 7.8

Inflation

CPI - % (*) 25.6 26.6 38.0 26.9 41.0 24.8 20.0 17.0

Interest Rate

BADLAR - eop - % 15.44 21.63 20.38 27.25 19.88 23.25 22.00 18.00

Lebac 35 days - eop - % - - - 33.00 24.75 28.75 24.00 19.00

Repo rate 7 days - eop - % - - - - 24.75 28.75 24.00 19.00

Balance of Payments

ARS / USD - eop 4.92 6.52 8.55 13.01 15.85 18.77 23.00 27.00

Trade Balance - USD bn 12.0 1.5 3.1 -3.0 2.0 -8.5 -10.0 -9.5


Foreign Direct Investment - % GDP 2.4 1.5 0.8 1.7 0.9 1.7 2.4 2.5

International Reserves - USD bn 43.3 30.6 31.4 25.6 38.8 55.1 65.0 70.0

Public Finances

Primary Balance - % GDP (**) -1.2 -2.4 -3.4 -4.0 -4.3 -3.9 -3.2 -2.4

Nominal Balance - % GDP (**) -2.1 -2.0 -2.4 -3.9 -5.9 -6.1 -5.3 -4.5

Gross Public Debt - % GDP 43.4 46.6 47.4 56.4 56.8 61.3 64.8 67.6

Net Public Debt - % GDP (***) 22.0 23.0 22.0 25.8 28.2 32.4 35.7 38.4

(*) National CPI for 2017 and 2018.

(**) Excludes central bank transfer of profits from 2016.

(***) Excludes central bank and social security

holding.Sources: Central Bank, INDEC and Itaú

2019F2018F2017F2012 20162013 2014 2015


Mexico

Setting the stage for a pause

• The tides are moving in favor of the anti-establishment candidate, Andrés Manuel López Obrador (AMLO), who widened his

lead in February (according to polls) and is showing a lower rejection rate than his rivals.

• Recent trade tariffs imposed by the U.S. excluded Mexico and Canada. While risks are significant, we still think a NAFTA

deal is likely in 1H18.

• We have revised our GDP growth forecasts downward for 2018 (to 1.8%, from 2.1%) and 2019 (to 2%, from 2.4%).

• We see the recent communication from the central bank as consistent with our view that a pause in April is likely. The

board, or at least most of its members, seems less willing to be as reactive to the Fed and the Mexican peso as before,

focusing instead on the future path for inflation.

AMLO is getting stronger

The tides are moving in favor of the anti-

establishment candidate, Andrés Manuel López

Obrador (AMLO), who widened his lead in February

(according to polls). The average of the four most

reliable polls (Mitofsky, Buendía Laredo, El Financiero,

and Reforma) indicated that AMLO widened his lead over

the runner-up, Anaya, by 2.5 pp (from 4.6% in January to

7.1% in February)1. Specifically, the results were as

follows: AMLO (29.7% in February, from 27.8% in

January), Anaya (22.6%, from 23.2%), Meade (16.2%,

from 17.1%), and Zavala (4.7%, from 4.4%).

Moreover, two recent developments cast doubt on

whether “tactical voting” (which played against AMLO

in the past) will materialize with similar strength as in

previous elections: the decrease of AMLO’s rejection

rate, and the heightened confrontation between the

ruling party (PRI) and the PAN/PRD alliance. The polls

that publish rejection rates (Reforma, El Financiero,

Buendía Laredo) show a falling trend for AMLO (26.5% in

February, from 33% in October) and an increase for

Meade (39%, from 13%) and, to lesser extent, for Anaya

(30%, from 25%). So the polls published in February 2018

are the first ones to show a lower rejection rate for AMLO

relative to his competitors. In the PRI’s camp, it is proving

hard for Meade to decouple from the high PRI’s rejection

rate (which stands around 50% according to most polls).

Also, we note that the heightened confrontation between

the PRI and PAN/PRD is risking the images of both

political forces, while AMLO remains on the sidelines.

1 It is worth mentioning that El Financiero presents the results

adding up to 100%, without counting the percentage of “no

answers” (published in a footnote). So we adjust these results

by multiplying them by the factor “1 minus the percentage of

no answers” in order to make them comparable with other

polls.

AMLO ‘s average rejection rate has fallen below that of competitors

Source: El Financiero, Reforma, Buendía Laredo

NAFTA 7th round: tarnished by threat of

global protectionism

The 7th

round of NAFTA renegotiations – held in

Mexico City between February 25 and March 5 –

continued finalizing deals on additional chapters and

breaking the ice on the more controversial issues,

but it was tarnished by news that the U.S. will impose

tariffs on steel and aluminum on imports from the

rest of the world. These tariffs, unlike the U.S.

safeguards on solar panels and washing machines

announced in January, would be implemented under the

“national security exception,” which is codified not only in

the U.S. Trade Law but also in NAFTA and the WTO. We

note the “national security exception” is rarely used (the

last time the U.S. imposed tariffs by invoking it was in the

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Nov-17 Nov-17 Dec-17 Jan-18 Feb-18

Rejection (bars,LHS) Name recognition (lines,RHS)

AMLOAnayaMeade

% %


Reagan administration) and could lead to retaliation from

big economies such as China and the EU. Nevertheless,

President Trump granted an exemption to Mexico and

Canada which, he argued, could be made permanent or

revoked depending on the outcome of the NAFTA

renegotiation. In any case, the NAFTA 7th round finalized

the deal on regulatory practices, sanitary & phytosanitary

measures, and transparency (6 of 30 negotiation points

have now been completed) and continued the back and

forth on the controversial issues (mainly dispute

settlement and rules of origin). We highlight that the tone

of negotiators from the three sides, at the closing press

conference, was constructive.

Our base case is that a NAFTA deal will be reached

during the first half of this year. The Mexican Senate

will enter a recess in May, but special commissions will

continue to operate and could ratify a renegotiated

NAFTA agreement anytime until the last day of August

2018 (before the new Congress starts on September 1).

However, the fact that talks will likely overlap with

Mexico’s presidential campaign season and the new

trade measures announced by the Trump administration

are risks (at least for timely completion of a deal), even

though the AMLO camp’s tone on NAFTA has been

more positive.

Moderate growth ahead, amid elections and

NAFTA uncertainty

Mexico’s GDP growth slowed down in 2017 – in the

midst of uncertainty (with NAFTA renegotiation and

the forthcoming presidential elections standing out

as key risks), plunging oil output and the doubling

of inflation (which ate through real wages). The

monthly GDP proxy (IGAE) grew 1.1% year over year in

December, and GDP growth for 4Q17 posted 1.5%

(below the flash estimate published by INEGI last

month). According to calendar-adjusted data reported by

the Statistics institute (INEGI), GDP expanded 1.5%

year over year in 4Q17 (from 1.6% in 3Q17). Looking at

the full-year figures, we note that in 2017 GDP growth

slowed to 2% (from 2.9% in 2016), with slower

expansion across all the main sectors: Services (3%,

from 3.9%), with retail sales weakening substantially;

Industrial production(-0.6%, from 0.4%), with

manufacturing outperforming mining and construction;

and the small and volatile primary sectors (3.3%, from

3.8%), which basically represent agriculture.

At the margin, GDP recovered momentum, as

expected, following a weak 3Q17 when the country

was hit by natural disasters. In December, the

seasonally-adjusted monthly GDP proxy gained 0.7%

from the previous month and quarter-over-quarter

annualized growth jumped to 3.2% (from -0.7% qoq/saar

in 3Q17). Importantly, this rebound is not only about the

normalization of oil output (which bore the brunt of the

hurricanes and earthquakes in 3Q17) but also visible in

GDP growth excluding mining and the volatile primary

sectors (3.4% qoq/saar in 4Q17, from 0.1% in 3Q17).

Granted, the service sector, particularly retail, also took a

hit from the natural disasters.

Growth recovered from the natural disaster in 4Q17

Source: INEGI, Itaú

We have revised our GDP growth forecasts

downward for 2018 (to 1.8%, from 2.1%) and 2019 (to

2%, from 2.4%). The factors playing against economic

growth in the short-term are tight macro policies (fiscal

and monetary) and the uncertainties associated with

NAFTA and elections (which put investment decisions on

hold). On the plus side, we note that the fiscal drag will be

smaller in 2018 relative to 2017. Moreover, a stronger

U.S. economy will likely stimulate Mexico’s manufacturing

exports. Finally, we see lower inflation improving the

growth of real wages.

Inflation is trending down

Inflation kept falling in February. Headline inflation

decreased to 5.34% year over year in February (from

5.55% in January), while core inflation decreased to

4.27% (from 4.56%) during the same period. Moreover,

-4

-2

0

2

4

6

8

4Q11 4Q12 4Q13 4Q14 4Q15 4Q16 4Q17

qoq/saarcalendar-adjusted, yoy

%


the diffusion index and measures of inflation at the margin

decreased meaningfully. The diffusion index, which tracks

the percentage of items in the CPI basket with inflation

higher or equal to four, went down to 62.5% (from 69.4%

in January), reaching the lowest level in a full year. Also,

seasonally-adjusted three-month annualized inflation

decreased to 3.41% (from 5.22% in January) for the CPI

and to 3.74% (from 4.46% in January) for the core index.

More benign inflation dynamics in 2018

Source: INEGI, Itaú

We expect inflation to reach 3.7% by the end of 2018

(below median market expectations of 4.1%,

according to the central bank’s last survey). The

more benign evolution of the currency will be the key

driver, as the backlog of exchange-rate depreciation

(60% between 2014 and 2016) has probably died out

and pass-through is now actually exerting downward

pressure. Moreover, we see further room for the

normalization of non-core inflation. Inflation for

regulated/administered items is also relevant for the

currency, and non-core food inflation is standing at a

very high level (9.7% vs. 10-year median of 5.6%).

Banxico puts more emphasis on inflation-

forecast targeting

The Central Bank of Mexico (Banxico) hiked the

reference rate by 25 bps (to 7.50%) at its first meeting

of the year, in line with our call and an almost

unanimous market consensus. Given risks related to

NAFTA, elections and monetary policy in the U.S. (amid

still high inflation readings), the central bank kept the

doors open for further hikes by saying that “monetary

policy will act, if necessary, firmly and opportunely to

ensure inflation expectation anchoring and the

convergence of inflation to the target.” Furthermore, the

board’s view on the balance of risks for inflation is

unchanged (and continues tilted to the upside).

However, when mentioning the factors it will monitor

for the upcoming decisions, the central bank did not

prioritize the relative monetary policy stance between

Mexico and the U.S. (moving it to second position).

Furthermore, the board affirmed that the February hike

already took into account the expected rate increase by

the Fed for March. Board Member Javier Guzman,

considered to be in the hawkish camp, reaffirmed the

same message.

Additionally, the central bank published the first

quarterly inflation report of the year, with a greater

emphasis on the role that inflation forecasts will play

in the board’s decision framework. The bank now

publishes the values of average annual inflation (headline

and core) that it expects for the next eight quarters,

comparing them with those in the previous report. During

his presentation, Governor Díaz de León argued that

deviations from these forecasts will be important to

determine future adjustments in monetary policy.

In all, we see the recent communication as consistent

with our view that a pause in April is likely. The board,

or at least most of its members, seems less willing to be

as reactive to the Fed and the Mexican peso as before,

focusing instead on the future path for inflation. Although

risks are significant, we expect Mexico’s next rate move

to be a cut (in the second half of the year).

Lower current account deficit

The current account deficit (CAD) narrowed by 0.5%

of GDP in 2017 (to an easily financed 1.6% of GDP).

The CAD narrowed on a record-high non-energy trade

surplus and solid transfers (driven by the pick-up of the

US economy) and a smaller net income deficit (reflecting

lower profit remittances from foreign firms operating in

Mexico). We have revised our current account deficit

forecast for 2018 (to 1.3% of GDP, from 1.6% of GDP)

and 2019 (1.4% of GDP, from 1.7% of GDP). The CAD

will likely narrow a bit more, as manufacturing exports

continue accelerating, while internal demand expands at

a more moderate pace.

0

2

4

6

8

10

Feb-14 Feb-15 Feb-16 Feb-17 Feb-18

HeadlineCore

%, seasonally-adjusted,3-month annualized


Monitor the risks

Mexico’s economic outlook is subject to an

unusually high degree of uncertainty. Besides the

risks related to the trade relations with the U.S., market

participants fear a change in the economic policy

framework after the elections. If in the near term it

becomes clear that economic policies will remain

untouched and a NAFTA agreement is reached, the

macro outlook would be more benign than we currently

forecast (with higher growth, stronger currency, lower

inflation and deeper rate cuts). On the other hand, if

Mexico moves to unorthodox policies while there is no

agreement on NAFTA, then the scenario becomes more

adverse than we currently forecast. We note that the two

sources of risk that Mexico is facing (NAFTA and

elections) are not independent. Clearly, the harsh

rhetoric of the U.S. government aimed at Mexico fuels a

more nationalistic campaign in the country. At the same

time, a change in government could derail (or postpone)

talks on NAFTA. Finally, it is important to note that

Mexico seems more prepared to deal with shocks than

in the recent past, given the substantial narrowing of the

twin deficits and the tight monetary policy (turning short

positions on the Mexican peso more expensive).

Forecast: Mexico

Economic Activity

Real GDP growth - % 3.6 1.4 2.8 3.3 2.9 2.0 1.8 2.0

Nominal GDP - USD bn 1,202 1,274 1,314 1,171 1,077 1,153 1,269 1,371




Inflation

CPI - % 3.6 4.0 4.1 2.1 3.4 6.8 3.7 3.3

Interest Rate

Monetary Policy Rate - eop - % 4.50 3.50 3.00 3.25 5.75 7.25 7.00 6.00

Balance of Payments

MXN / USD - eop 13.0 13.1 14.7 17.4 20.7 19.7 18.5 18.0

Trade Balance - USD bn 0.0 -1.2 -3.1 -14.7 -13.1 -10.9 -7.0 -9.0




Public Finances

Nominal Balance - % GDP -2.5 -2.3 -3.1 -3.4 -2.5 -1.1 -2.4 -2.2

Net Public Debt - % GDP 33.8 36.5 39.8 44.0 48.2 46.5 46.0 45.80.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: IMF, Bloomberg, INEGI, Banxico, Haver and Itaú

2019F2018F2017201620152013 20142012


Chile

Gaining momentum

• Confidence and expectations are high that Chile will rebound strongly this year, as tailwinds gain momentum. Data at the

start of the year puts the recovery on a firm footing. We now expect GDP growth of 3.6% this year (from 1.6% last year),

with risks tilted to the upside. The consolidation of investment and an export-driven recovery are likely to lead to 3.5%

growth in 2019.

• We see the exchange rate at CLP 620/USD by YE18 and CLP 625 by YE19, with some depreciation from spot levels due

to the normalization of U.S. monetary policy. The firm performance of the currency will help offset recovering internal

demand growth and keep inflation below the 3% target throughout the year.

• Low inflation means that the central bank will remain comfortable with keeping the policy rate steady at an expansionary

2.5% this year. The normalization process would likely start next year, as the output gap narrows, taking the rate to 3.5%

before year-end.

High expectations

Activity started 2018 on a high note. The monthly

GDP proxy (Imacec) increased 3.9% from one year ago

(2.6% in December and 1.6% in 2017), boosted by

mining, manufacturing and commerce. Mining will

remain a clear driver in the coming months, as copper

prices remain high and production encounters a very low

comparison base due to the extended labor strike at a

principal mine early last year. Meanwhile, recovering

internal demand and strengthening global growth will aid

a manufacturing improvement. Retail sales grew 3.8% in

the month, led by double-digit vehicle sales. Wholesale

sales also improved, led by machinery, equipment and

materials – an encouraging sign for the expected

recovery in investment this year.

Non-mining recovery

Source: BCCH, Itaú

At the margin, activity gained 0.8% from December,

building on the 0.3% rise in the previous month.

Activity accelerated to 4.3% QoQ/SAAR in the quarter,

from 2.1% in 4Q17. The improved performance was

primarily driven by non-mining production (5.2%

QoQ/SAAR, from 3.0% in 4Q17). Mining activity, however,

continued to fall (5.3% QoQ/SAAR) as production

continued to normalize following the post-strike boost

(+44.6% in 3Q17).

Looking ahead, there are some positive signs for

consumption from the improvement in private

employment. Employment in the quarter ending in

January grew 2.5% YoY – the fastest pace since the

quarter ending in February 2014. The 16.9% increase in

public salaried posts boosted overall employment

growth, while private salaried jobs grew by a modest

0.5%, interrupting a five-month job-loss period.

Private sentiment keeps improving. The central bank’s

1Q18 business perception report noted that several

respondents expect a pickup in dynamics in 2H18, while

some expect an improvement by as early as 2Q18.

Fundamentals that justify this bullish outlook include a

favorable external scenario (higher copper prices) and

expectations that the incoming administration (taking

office on March 11) will pursue business-friendly policies.

Further indication of a bright growth outlook can be

inferred from the February business confidence indicator.

Both the total business confidence indicator (57.4) and

the ex-mining measure (55.6) moved further into

optimistic territory in February (from 46.0 and 40.5 one

year before, respectively), reaching levels unseen since

early 2013. Only the construction sub-index remains in

pessimistic territory (48.6) but is substantially higher than

one year ago (24.0).

-18

-12

-6

0

6

12

-2.5

0.0

2.5

5.0

2013 2014 2015 2016 2017 2018

ImacecMining (rhs)Non-Mining

%, yoy, 3mma


We now expect GDP growth of 3.6% this year (from

3.3% previously), an improvement from the 1.6%

expected for last year. With a stronger-than-expected

start to the year, risks are tilted to an even stronger

rebound. High copper prices, strong external demand,

low interest rates and low inflation amid increased

confidence will support the recovery. For 2019, we see

growth at 3.5%.

Low external imbalances

Chile’s current account deficit remains low, as the

trade balance started the year on a strong note. The

12-month rolling trade surplus increased to USD 8.5

billion as of February, from USD 6.9 billion in 2017 and

USD 5.3 billion in 2016. Our seasonally-adjusted series

shows that, at the margin, the trade balance surplus

ticked up to a sizable USD 10.2 billion (annualized) in the

rolling quarter (USD 10.1 billion in 4Q17). Import growth

is broadly stable and high, still boosted by consumption

goods. Recovering imports of machinery is an

encouraging sign for the expected investment recovery.

Recent data shows a widespread improvement in the

export divisions, particularly mining.

With copper prices expected to remain high, robust

global growth and only a gradual improvement in

internal demand, we expect the current account

deficit to remain low. We expect the current account

deficit to narrow to 1.2% of GDP, from the 1.5%

estimated for 2017. As internal demand recovers through

2019, we see some widening of the deficit to a still-low

1.8% next year.

We see the exchange rate at CLP 620/USD by YE17,

weakening to CLP 625/USD in 2018. The expected

weakening from current levels can be attributed to the

normalization of monetary policy in the U.S. and some

moderation of copper prices.

Low inflation

Inflation is back at the bottom end of the 2%-4%

inflation target range. The dip to 2% in February (from

2.2% in January) was partly explained by food and non-

alcoholic inflation slowing to 2.8% (from 3.8%), while

housing and basic service inflation moderated to 3.3%

(4.2% previously). The lower inflation could also reflect

diminished pressures following the sustained period of a

stronger exchange rate. Core inflation (excluding food

and energy prices) was stable at 1.6%, below the central

bank’s target range, which we expect to continue

throughout the year, as the output gap remains wide.

Tradable inflation dipped to 1.3% (1.5% in January), while

non-tradable inflation moderated to 2.9%, a historically

low level. Our diffusion index has remained broadly stable

over the last three months at levels that are low and

reflect limited price pressure.

Moderate inflationary pressure

Source: INE

We see inflation remaining below the 3.0% target

during the year, with a yearend forecast of 2.5%. A

gradual acceleration to 2.8% by the end of 2019 is

anticipated once the output gap is narrowing.

Back to a full board

The Chilean central bank did not hold a monetary

policy meeting in February. Starting this year, the

central bank reduced the frequency of its monetary policy

meetings from every month to eight times per year. The

next meeting is scheduled for March 20, and the quarterly

Inflation Report will be published the following day.

Nevertheless, according to the minutes for the January

meeting, the decision to keep the policy rate at 2.5% had

the full support of the board and confirmed a

consolidation of the rates-on-hold baseline scenario.

Several board members agreed that recent data reduce

the downside risks to both activity and inflation outlined in

the 4Q17 Inflation Report. However, on retaining the

easing bias, all board members stated that attention must

be paid to how potential short-term downward deviations

in inflation could risk the convergence to the 3% target

over the policy horizon.

3

4

5

6

7

8

-1

0

1

2

3

4

5

6

7

2011 2012 2013 2014 2015 2016 2017 2018

CPICPI ex food & energyNominal wages (rhs)

%, yoy


We expect the policy rate to remain stable at 2.5% in

2018, as inflation remains low and the activity

recovery unfolds. The normalization process is likely to

start next year as the growth recovery consolidates and

the output gap narrows.

President Michelle Bachelet nominated Alberto

Naudon for the vacant central bank director post

following the end of Sebastian Claro’s term late last

year. The announcement came right at the close of the

Bachelet government, following extensive discussions

between the left and right-leaning political

representatives. The vacant post is aligned with the

political right, under the board-member-composition

agreement. The nomination of Alberto Naudon requires

congressional approval. Naudon (42) became head of

research at the central bank in September 2014. In 2013

he was chief economist at a private local bank. Before

his stint in the private sector, Naudon was head of the

macroeconomic forecasts and modelling department

and an economist in the central bank’s research

department. Naudon is an economist from the Catholic

University in Chile and holds a PhD in economics from

the University of California, Los Angeles.

Easing fiscal concerns

We expect the fiscal deficit to narrow to 1.9% of GDP

this year (from 2.8% last year), as the incoming

government moves toward fiscal consolidation.

Risk-rating agency, Fitch, recently maintained Chile’s

rating at A with a stable outlook amid better expectations

for copper prices and economic growth. Public debt

remains low in Chile, compared with its peers. However,

the rapid rise in recent years was a source of concern

for rating agencies, leading to one-notch downgrades by

Fitch and S&P last year. Recovery in copper prices and

growth will likely result in a more gradual public debt

increase and keep rating agencies at bay.

Forecast: Chile

Economic Activity

Real GDP growth - % 5.3 4.0 1.9 2.3 1.6 1.6 3.6 3.5

Nominal GDP - USD bn 267 275 258 237 251 268 298 315




Inflation

CPI - % 1.5 3.0 4.6 4.4 2.7 2.3 2.5 2.8

Interest Rate


Balance of Payments

CLP / USD - eop 479 525 606 709 670 615 620 625

Trade Balance - USD bn 2.6 2.0 6.5 3.5 5.3 6.9 8.0 6.5




Public Finances

Nominal Balance - % GDP 0.6 -0.6 -1.6 -2.1 -2.7 -2.8 -1.9 -1.5

Net Public Debt - % GDP -6.8 -5.6 -4.3 -3.5 1.0 4.4 5.5 6.20.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: IMF, Bloomberg, BCCh, INE, Haver and Itaú

2012 2019F2018F2017F201620152013 2014


Peru

Metal prices and macro policy stimulus to the rescue

• The political crisis is heating up again, with increased momentum for another impeachment vote.

• We maintain our view that the increase in metal prices and macro policy stimulus will offset the uncertainty associated with

politics and boost GDP growth to 4% in 2018, from 2.5% in 2017 (when the economy suffered two idiosyncratic shocks: El

Niño and corruption scandals that morphed into a full-blown political crisis by 4Q17).

• The central bank views the deterioration in domestic politics as a risk for activity. Furthermore, falling inflation and

disappointing activity in 4Q17 led the central bank to deliver another 25-bp rate cut in March.

Political crisis heating up again

Another impeachment vote is likely to take place in

1H18, and the risk of impeachment for President

PPK is high. The impeachment proposal, tabled by the

Nuevo Perú left-wing party in February, is on standby

due to the congressional recess (until March 8) as well

as two important upcoming events: President PPK’s

testimony in front of the Lava Jato Commission in

Congress (on March 16) and information on the

interrogation of a former CEO of a company at the heart

of the corruption scandal on February 27-28, whose

revelations are expected to be made public in mid-

March.

President’s approval rating has fallen to critical levels

Source: Peruvian Congress, Itaú

In a hypothetical post-impeachment scenario, an

interim presidency – headed by one of the Vice

Presidents – might not have negative consequences

for the economy. If PPK is impeached, Martín Vizcarra

(First Vice President) would take over as interim

President until July 2021 (end of PPK’s five-year term).

If neither Martín Vizcarra nor Mercedes Aráoz (Second

VP, and currently Head of the Ministerial Cabinet)

accept the job, the President of Congress (Fujimorista

Luis Galarreta) would become the temporary head of

government with a mandate to hold presidential

elections within the next 12 months. In our view, an

interim presidency of Vizcarra or Aráoz would not carry

negative consequences for the economy, and financial

asset prices would likely recover after an initial sell-off

following a PPK impeachment. However, an early

presidential election (less likely in our view) would

generate much more uncertainty, following the

discrediting of the more relevant political forces, with

adverse effects on the economy and asset prices.

Metal prices and macro stimulus offset

political uncertainty

Peru’s GDP growth weakened in 2017, battered by

idiosyncratic shocks such as El Niño (which not

only affected the Natural Resource sectors, but also

caused negative wealth effects) and corruption

scandals (that paralyzed some of the largest

infrastructure projects in the country and led to a

full-blown political crisis in 4Q17). According to the

Central Bank (BCRP), GDP growth was at 2.2% YoY in

4Q17 (from 2.9% in 3Q17), with annual growth of 2.5%

in 2017 (from 4% in 2016). At the margin, QoQ

annualized growth slowed to 1% in 4Q17, from 3%

QoQ/SAAR in 3Q17.

Nevertheless, after 14 consecutive quarters of

contraction, private investment grew in both quarters

of 2H17, in line with the 13.1% rise in export prices in

2017 – following five years of decline, mainly due to

higher copper and zinc prices. Nominal mining

investment rebounded by 15.7% in 2017, following three

10

20

30

40

50

60

70

t

t+1

t+2

t+3

t+4

t+5

t+6

t+7

t+8

t+9

t+1

0

t+1

1

t+1

2

t+1

3

t+1

4

t +

15

t+1

6

t +

17

t+1

8

Fe

b 2

01

8

Toledo (2001-2006)García (2006-2011)Humala (2011-2016)PPK (2016-present)

%, t = first month in office


years of sharp contraction. At its peak (USD 10 billion in

2013), mining investment accounted for almost one-fourth

of total private investment; however, the share decreased

by half in 2017, to 13%. According to the Ministry of

Finance (MEF), six big projects (Quellaveco, Michiquillay,

Pampas del Pongo, Mina Justa, Toromocho expansion

and Corani), with a total combined investment

commitment of USD 11.6 billion (5.4% of GDP), are likely

to initiate the construction phase in 2018.

We expect an acceleration in GDP growth in 2018, to

4% – in contrast with median GDP growth

expectations of 3.5% (down from 4% in November),

according to the latest BCRP survey. Although the

political crisis is likely to linger, possibly curtailing

investment decisions, it will be more than offset by the

positive effects of higher terms of trade (largely

determined by metal prices) and expansionary

macroeconomic policies (mostly fiscal, but also

monetary). According to our estimates, based on a

regression which controls for business confidence and

other external variables (U.S. GDP, foreign interest rates

and risk appetite), the increase of export prices (13.1%

in 2017, 15.6% YoY in 4Q17) would add around 0.7

extra percentage point to GDP growth in 2018 and 2019

(only as a result of this positive shock). We also note

that the government budget pencils in a 17.5% increase

in public investment in 2018 – massive fiscal stimulus,

including the El-Niño-related reconstruction work. Even

if there is significant under-execution – which is likely

due to administrative bottlenecks – the fiscal impulse will

probably be a relevant growth driver this year.

BCRP pulled the trigger in March

We expect annual headline inflation to fall to 0.4% in

March – due to a base effect associated with El

Niño, which caused food prices to spike in the same

month of last year – and then firm up to 2.2% by

YE18. The considerable base effect can be attributed to

food prices, which account for almost 40% of the CPI

and increased by 2.1% MoM in March 2017 due to El

Niño. We nevertheless expect annual inflation to

increase gradually throughout the rest of the year, when

base effects will play in the opposite direction. Moreover,

the pick-up in activity is expected to also help remove

the downward pressure from core prices. For 2019, we

see inflation climbing to 2.6%.

The Central Bank of Peru (BCRP) decided to cut the

reference rate by 25-bps, to 2.75%, in line with our

forecast and median market expectations (only 4 out

of 18 firms expected no action, as per Bloomberg).

The rate cut came in the context of low inflation,

disappointing activity in 4Q17, and heightened political

uncertainty. Annual headline inflation fell to 1.2% in

February (from 1.3% in January) – approaching the

lower bound of the 1 pp tolerance range around the 2%

target – and incoming activity data points to modest

growth of the GDP proxy in January (including a

deterioration of business confidence indicators, as per

the BCRP’s last expectations survey).

We believe the easing cycle concluded in March. By

cutting 25-bps in March, the BCRP accumulated 100

bps of cuts over the past 11 months. The monetary

policy stance is expansionary, considering that the ex-

ante real interest rate is now standing at 0.6% (below

the 1.8% neutral level estimated by the BCRP). Granted,

low inflation provides the board with the freedom to cut

rates further – should the economic outlook worsen –

but this is not our base case. For 2019, we foresee a

modest tightening of monetary policy (two 25-bp hikes)

to avoid choking the recovery (amid well-behaved

inflation).


Forecast: Peru

Economic Activity

Real GDP growth - % 6.0 5.8 2.4 3.3 4.0 2.5 4.0 4.0





Inflation

CPI - % 2.6 2.9 3.2 4.4 3.2 1.4 2.2 2.6

Interest Rate


Balance of Payments

PEN / USD - eop 2.57 2.79 2.98 3.41 3.36 3.25 3.25 3.30

Trade Balance - USD bn 6.4 0.5 -1.5 -2.9 1.9 6.3 7.5 7.0




Public Finances

NFPS Nominal Balance - % GDP 2.3 0.9 -0.3 -2.1 -2.6 -3.2 -3.2 -3.0

NFPS Debt - % GDP 20.8 20.0 20.1 23.3 23.8 24.8 25.9 26.90.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: IMF, INEI, BCRP, Itaú

2012 2013 2019F2018F2017201620152014


Colombia

Uncertain recovery

• Activity ended 2017 on a weak note, suggesting that the expected recovery this year is not exempt from risks, including

those stemming from a weak labor market and from political uncertainty ahead of the presidential election.

• Despite the central bank’s indication of the end of the easing cycle under current conditions, we expect the still weak

internal demand, faster current account deficit correction and ongoing disinflation will allow the board to venture into a more

expansionary position. We expect two further 25-bp rate cuts, to 4.0%, in the coming months.

• On March 11, Colombia will hold congressional elections. The results will likely lead to some consolidation in the pool of

presidential candidates as coalitions are reshaped. While Gustavo Petro (left) edges out Sergio Fajardo (center) in recent

polls, Uribe-backed Iván Duque has made up ground.

Activity still weak

Activity in the final quarter of 2017 was characterized

by weak private consumption, deteriorating imports

and only a moderate rise in investment, hinting that

the growth recovery path is not exempt from risks.

The activity slowdown from 2.3% YoY in 3Q17 to 1.6%

can mainly be attributed to private domestic consumption

decelerating to 0.6% year over year (2.3% in 3Q17).

Public consumption growth stayed elevated, at 4.2%,

while net exports remained positive for the second

consecutive quarter (mainly due to a further weakening of

imports). Meanwhile, gross fixed investment increased for

the third consecutive quarter, following a seven-quarter

spell of contraction, but retained only a modest growth

rate of 0.3%. On the supply-side, activity related to

natural resources grew 0.8% in the quarter, moderating

from the 2.6% increase in 3Q17, while non-tradable

sectors slowed to 1.9% (from 2.4% previously), explained

mainly by construction. In 2017, activity grew 1.8%,

down from the 2.0% in 2016 and the weakest since

the global financial crisis.

Activity posted the third consecutive quarter of

growth at the margin, but it slowed down at the

close of the year. GDP decelerated to 1.1% qoq/saar in

4Q17 (3.1% in 3Q17; 2.6% in 2Q17), pulled down by

private consumption. Investment once again slipped

sequentially.

We expect some recovery this year. Growth of 2.5%

would come amid an improvement in real wage growth

(with the advancement of disinflation), expansionary

monetary policy and favorable external conditions

(supporting oil prices). Risks to our scenario include a

weak labor market and uncertainty over the political

cycle, which could limit a recovery of investment.

Flat investment

Source: Dane, Itaú

However, recent data show that the expected

recovery is not exempt from risks. The labor market

started the year on the back foot. In the quarter ending in

January, urban employment fell 1.0% year over year

(+0.2% in 3Q17), but the 1.4 percentage points fall in the

participation rate over twelve months managed to offset

the effects of job destruction - hence, the unemployment

rate increase was contained to 10.9% (10.6% one year

before). Besides the labor market, the uncertainty over

the political scenario is also a risk for activity.

Current account deficit correction continues

Recovering commodity prices and weaker internal

demand have led to a notable correction of the

external imbalance. A USD 1.9 billion current account

deficit was recorded in 4Q17, smaller than the USD 2.6

billion recorded one year earlier. Rising exports offset

-5

0

5

10

15

20

25

-2

0

2

4

6

8

10

08 09 10 11 12 13 14 15 16 17

GDPGross Fixed Investment (rhs)

Private Consumption

%, yoy


the increasing income deficit as commodity prices

recovered. As a result, the current account in 2017

narrowed to USD 10.4 billion (3.3% of GDP; smaller

than our 3.5% forecast), from a USD 12.1 billion deficit

in 2016 (4.3% of GDP), reaching the smallest deficit

since the 3.3% recorded in 2013. At the margin, our own

seasonal adjustment shows that the deficit edged further

down, to 2.8% of GDP, in 4Q17.

Narrower current account deficit

Source: Banrep, Dane, Itaú.

The main force behind the improvement in the last

quarter of 2017 came from the trade balance, which

recorded a USD 1.5 billion deficit, narrower than the

USD 2.8 billion deficit in 4Q16. Exports of goods

increased 15.0% year over year in 4Q17, as higher

energy prices and improved volumes boosted coal and

fuel exports, while imports of goods declined 2.4% year

over year in the quarter (+1.1% in 3Q17).

Meanwhile, foreign direct investment posted some

improvement from last year, fully funding the current

account deficit. Direct investment into Colombia (mainly

directed to mining and oil) came in at USD 3.8 billion in

4Q17 (USD 3.3 billion in 4Q16), and totaled USD 14.5

billion in 2017 (4.7% of GDP, broadly stable from 2016,

when the sale of ISAGEN boosted FDI). Net direct

investment improved to USD 10.8 billion in the year, from

USD 9.3 billion in 2016. Meanwhile, foreign portfolio

investment was USD 7.8 billion for the year, lower than

the USD 8.9 billion recorded in 2016.

Still weak internal demand, improved terms of trade

and higher quantum of exports will aid some

additional deficit narrowing this year. We now expect

a current account deficit of 3.1% of GDP (3.3%

previously).

With oil prices staying elevated, the Colombian peso

continues to perform well. We still see the exchange

rate ending the year at 3,000 pesos per dollar, with

some weakening to 3,030 next year. The expected

weakening from current spot levels is warranted by the

diverging monetary policies between the U.S. and

Colombia and some moderation in oil prices.

Inflation edging down

The disinflation process is advancing. Inflation

slowed to 3.37% (from 3.68% in January), nearing the

central bank’s 3% target, led by lower food and tradable

prices. Food price inflation decelerated to 0.94% (1.49%

in January), however, inflation excluding food prices also

retreated to 4.40% (4.61% one month before), the

lowest reading since August 2015. Meanwhile, tradable

goods prices (excluding food and regulated items)

dropped below the 3% target to 2.5% (from 3.16% in

January) as the pass-through from the strengthened

Colombian peso becomes more evident. This is the

lowest tradable inflation recording since January 2015.

Meanwhile, stickier non-tradable prices (excluding food

and regulated prices) are moderating too, falling below

5% for the first time in more than a year (reaching

4.95%, from 5.37%). Our diffusion index continues to

drop sharply, with more products now posting annual

inflation below 3% than above it, the first such instance

since March 2015.

At the margin, inflation is diminishing from the end

of last year. The three-month accumulated inflation

came in at 2.3% (seasonally adjusted and annualized)

versus the 4.0% recorded in 4Q17 as food inflation

decelerated (from 2.5% to -1.8%) and tradable inflation

slowed to 1.7% (from 3.1% in 4Q17). Meanwhile, non-

tradable inflation moderated to 4.9% (5.2% in 4Q17).

We expect inflation to end the year at 3.3% (4.09% in

2017), after nearing the 3% target in the second and

third quarter of the year. A strong currency, the

negative output gap and less inertia will support an

inflation slowdown and aid further disinflation to the 3%

target next year.

-8

-6

-4

-2

0

2

Jun-01 Mar-04 Dec-06 Sep-09 Jun-12 Mar-15 Dec-17

Rolling-4QSeasonally Adjusted annualized

% of GDP


Moderation at the margin

Source: Dane, Itaú

Data-dependent mode

Presenting the central bank’s quarterly Inflation

Report, General Manager Juan José Echavarría

reaffirmed the end of the easing cycle under current

conditions, but he continued to emphasize that if the

disinflation process unfolds at a faster-than-

expected pace, more easing is likely. Therefore, the

messaging from the central bank suggests it is in data-

dependent mode. According to the central bank,

improved external demand and recovering terms of

trade are expected to boost activity to 2.7% this year.

Regarding inflation, there is overall satisfaction with the

disinflation process, although some concern with sticky

non-tradable inflation remains. The technical staff see

inflation close to 3% by year-end (Itaú: 3.3%), from 4.1%

at the close of last year. Risks to the central bank’s

baseline scenario include faster disinflation unfolding if

the strengthened exchange rate persists and if the

internal demand recovery is below expectations. Upside

risks to inflation come from food prices, while the

minimum wage increase of 5.9% for this year was also

flagged.

We continue to expect a continuation of the easing

cycle with two additional 25-bp rate cuts (to 4%),

with the next cut likely in April, after probably

staying put in March. A negative output gap and a

stronger currency will likely contribute to disinflation

towards the target. Furthermore, the current account

deficit (previously a source of concern) is narrowing at a

faster than expected pace. However, if volatility in asset

prices rises amid the election period, or if the improved

external scenario leads to a swifter activity recovery, the

central bank may opt to adhere to the end-of-cycle

approach.

Fiscal concerns persist

Moody’s retained Colombia’s sovereign debt rating

at ‘Baa2,’ one notch above the minimum investment

grade level, but it downgraded its outlook to

Negative from Stable. The agency highlighted

economic and institutional strength and relatively low

external vulnerability as key points supporting the

current rating. However, the outlook downgrade

responds to the expectation of a slower pace of fiscal

consolidation and the risk that the new government

arising from this year's elections will not have an

effective mandate to pass additional fiscal measures to

preserve Colombia's fiscal strength. We expect the

nominal deficit to narrow to 3.1% of GDP this year (3.6%

in 2017) and gross debt to stabilize. However, with no

additional fiscal measures, further narrowing towards

Colombia’s 1% of GDP long-term fiscal deficit target

would be challenging.

Fiscal challenges

Source: Finance Ministry, Itaú

Presidential campaign becomes a sensitive

issue

Prior to the May presidential election, the country

will hold parliamentary elections this month, a result

that could reshape political coalitions ahead of the

presidential vote. During the March 11 congressional

-10

-5

0

5

10

15

20

25

2014 2015 2016 2017 2018

Non-tradable*Tradable*CPIFood

Seasonally adjusted, quarterly accumulated and annualized, %

* Excluding food & regulated prices

-6

-5

-4

-3

-2

-1

020

30

40

50

Gross Debt- - - Itaú ForecastNominal Deficit (rhs, inversed)- - - Itaú Forecast

% of GDP


vote, the right coalition will hold a consultation to choose

its candidate. They include Iván Duque (Uribista), Marta

Lucía Ramírez (former president Pastrana’s candidate)

and Alejandro Ordóñez. In recent polls, Duque and

Ramírez have started to gain traction. Duque remains

the least known of the front-running candidates

nationwide (recall rate under 70%), so there is still room

for further polling progress. Currently, Gustavo Petro

(left, former mayor of Bogotá) is the frontrunner, with an

average in February near 20%. One factor against Petro

is his rejection rate, which will limit his ability to raise his

vote ceiling as the campaign advances. Sergio Fajardo

(center, former mayor of Medellin and governor of

Antioquia) is one of the competitive contenders to Petro,

with a polling average in February of around 15%.

Meanwhile, more mainstream political figures including

former Vice-President German Vargas-Lleras and chief

peace negotiator Humberto de la Calle, have failed to

captivate the electorate, in line with the anti-

establishment wave prevailing in global politics.

Right-leaning candidates (Duque; Vargas Lleras)

favor reduction in corporate tax rates, but these

suggestions will likely be restrained by poor fiscal

accounts. The centrist movement (Fajardo) would likely

support broad continuity of the macroeconomic and

investment policies. Meanwhile, the left (Petro) would

likely push for higher taxes to fund social spending.

Average polling

Source: Invamer, CNC & Celag, Datexco, Opinometro, Guarumo

Forecast: Colombia

0 5 10 15 20 25

Gustavo Petro

Iván Duque

Sergio Fajardo

Marta Lucía Ramirez

Germán Vargas Lleras

Humberto de la Calle

FebJanDecSep

%

Economic Activity

Real GDP growth - % 4.0 4.9 4.4 3.1 2.0 1.8 2.5 3.2





Inflation

CPI - % 2.4 1.9 3.7 6.8 5.8 4.1 3.3 3.0

Interest Rate


Balance of Payments

COP / USD - eop 1,767 1,930 2,377 3,175 3002 2,932 3,000 3,030

Trade Balance - USD bn 4.0 2.2 -6.2 -15.6 -11.1 -6.2 -6.1 -5.5




Public Finances

Nominal Central Govt Balance - % GDP -2.3 -2.3 -2.4 -3.0 -4.1 -3.6 -3.1 -2.7

Central Govt Gross Public Debt - % GDP 34.6 37.1 40.5 45.1 46.4 47.5 47.7 47.40.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: IMF, Bloomberg, Dane, Banrep, Haver and Itaú

2019F2018F2017F201620152013 20142012


Macro Research – Itaú

Mario Mesquita – Chief Economist

Tel: +5511 3708-2696 Click here to visit our digital research library.

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