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Latam Macro Monthly Scenario Review

September 16

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

External environment still favorable for emerging markets 3 With global interest rates set to remain at a very low levels and China activity risks under control, the external environment

remains supportive for emerging markets.

LatAm

Monetary policy (partially) decouples from the Fed 7 We expect most LatAm currencies to weaken slightly from their current levels. The Mexican peso is an exception.

Brazil

Recovery in sight, but sustained growth demands reforms 9

We have revised our GDP growth forecast to -3.2% (from -3.5%) this year and to 2.0% in 2017 (1.0%, previously). However,

this scenario depends fundamentally of the fiscal reforms.

Argentina

Driving on a bumpy road 16

The Supreme Court suspended the gas tariff hikes decreed in April, an important setback for the government.

Mexico

Fiscal adjustment in the spotlight 19

Amid a challenging outlook for public sector finances, Luis Videgaray stepped down as Finance Minister.

Chile

Officially neutral 22

The central bank finally dropped the tightening bias for monetary policy and will probably keep rates on hold until at least the

end of 2017.

Peru

A slower fiscal deficit reduction 26

We maintain our forecasts of the fiscal deficit for 2016 and 2017 at 3.1% of GDP and 2.6% of GDP, respectively, but the risks

are for a higher deficit.

Colombia

Tightening cycle comes to an end, peace seems at hand 29

The central bank left the policy rate unchanged, likely ending the tightening cycle. The government announced a peace

agreement with the Farc, shifting the focus to the tax reform debate.

Commodities

Sustaining the recovery 33

We expect oil price at USD 50/bbl by yearend. We have revised downward our grain and soybean forecasts, but increased our

sugar prices forecasts.

Macro Research – Itaú

Tel: +5511 3708-2696 – E-mail: [email protected]

http://bit.ly/ING_0916

Latam Macro Monthly – September 9, 2016

Weak activity in LatAm, despite an improving Brazil

The U.S. Fed is moving toward another rate hike. We think December is the most likely timing, but the risk

of a September move seems underpriced. In any event, the Fed will likely maintain its gradual and cautious

approach. At the same time, the other G7 central banks are likely to maintain their very loose monetary

stances.

With global interest rates set to remain at very low levels and China activity risks under control, the external

environment remains supportive for emerging markets.

Despite the favorable global liquidity conditions, however, economic activity remains weak in most countries

in Latin America. In Brazil and Argentina – both of which are enduring recessions and going through

reforms – GDP is expected to resume growing next year, but from low levels. In a context of weaker

inflationary pressure, monetary policy is becoming more expansionary, which will help the region to recover

in 2017. With the Fed policy becoming tighter, we expect LatAm currencies to weaken slightly from their

current levels between now and the end of 2017.

In Brazil, recent indicators suggest a stronger rebound than we had previously predicted. We have revised

our GDP growth forecasts to -3.2% for this year (up from -3.5% previously) and to 2.0% for 2017 (up from

1.0%). We expect inflation to continue to decline over the coming quarters. The central bank has changed

its communication, indicating that future monetary policy decisions will be more data-dependent, which is

consistent with our scenario of an easing cycle starting in October.

However, this scenario depends fundamentally on progress in fiscal reform. Without fiscal rebalancing,

economic predictability and stability will be compromised, leading to financial market volatility and limiting

the room for monetary easing. In such a scenario, Brazil’s economic recovery would be compromised.

Hope you enjoy,

Macro Team

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

GDP - % 3.1 3.0 3.4 3.4 GDP - % -0.3 -0.4 2.2 1.9


GDP - % -3.2 -3.5 2.0 1.0 GDP - % 2.1 2.1 2.4 2.4

BRL / USD eop 3.25 3.25 3.50 3.50 MXN / USD eop 17.50 17.50 17.50 17.50

Monetary Policy Rate - eop - % 13.50 13.50 10.00 10.00 Monetary Policy Rate - eop - % 4.50 4.50 5.00 5.00

IPCA - % 7.2 7.2 4.8 4.8 CPI - % 3.0 3.0 3.0 3.0


GDP - % -1.6 -1.6 3.0 3.0 GDP - % 1.5 1.5 2.0 2.0

ARS / USD eop 16.20 16.20 19.50 19.50 CLP / USD eop 685 685 695 695

BADLAR - eop - % 22.5 24.5 20.0 20.0 Monetary Policy Rate - eop - % 3.50 3.50 3.50 3.50

Lebac 35 days - eop - % 25.0 27.0 22.0 22.0 CPI - % 3.5 3.5 3.0 3.0

CPI - % (City of Buenos Aires) 42.8 44.2 23.0 23.0


GDP - % 2.0 2.3 2.7 2.7 GDP - % 3.8 3.8 4.0 4.0

COP / USD eop 3050 3050 3150 3150 PEN / USD eop 3.35 3.35 3.40 3.40

Monetary Policy Rate - eop - % 7.75 8.00 6.50 6.50 Monetary Policy Rate - eop - % 4.25 4.25 4.25 4.25

CPI - % 6.9 6.9 4.0 4.0 CPI - % 2.8 2.8 2.5 2.5

Latin America and Caribbean

Mexico

2016 2017

Scenario Review

World

Brazil

Argentina

2016 2017

2016 2017 2016 2017

2016 2017 2016 2017

Colombia Peru

Chile

2016 2017 2016 2017


Global Economy

External environment still favorable for emerging markets

• The U.S. Fed is moving towards another rate hike. We think December is more likely, but the risk of a September

move seems underpriced.

• Importantly, the Fed will likely hold to a gradual and cautious approach as it balances job gains and financial stability

on the one hand with below-target inflation, global risk and the asymmetric possibilities of monetary policy, in a world

of low interest rates, on the other hand.

• The European Central Bank (ECB) is in a wait-and-see mode, as activity shows some resilience after the UK Brexit

vote, but with an easing bias, given that inflation remains substantially below the target.

• The Bank of Japan (BoJ) is struggling to find the right policy mix, but it will probably still add stimulus within its

current negative-rate quantitative easing framework.

• China’s data remains consistent with a muddling-through scenario.

• With global interest rates set to continue at very low levels and China activity risk under control, the external

environment remains supportive for emerging markets.

U.S. – Fed holds to a very gradual and

cautious approach

The case for a rate hike in 2H16 has strengthened in

recent months with further improvement in the labor

market and looser financial conditions.

The labor market is improving at a good pace,

supporting the central bank’s outlook for growth.

Payroll has grown at a solid 175k per month over the

last six months. While payroll growth slowed down to

151k last month, from 275k in July, job gains in August

usually surprise to downside in the first data report, only

to be revised up afterwards. A strong job market

supports consumption and hence keeps the U.S.

economy expanding at pace close to 2%.

The tightening labor market should exert some

upward pressure on inflation. The current trend of job

gains is well above the estimated labor force breakeven

point (75k per month). As consequence, the

unemployment rate should drop from 4.9%, which is

already close to the FOMC’s estimate of full employment

(4.7%-5.0%).

Financial conditions have continued to settle and

support above-potential GDP growth. In fact, we

expect GDP to expand 3% qoq/saar in 3Q16, after a

slow 1H16, when it grew only 1%. Consumption remains

at a healthy 3% annual pace. Business investment may

be stabilizing, with tentative signs that the negative

effects from the USD and oil price shocks are fading.

Nonetheless, the tightening path for interest rates in

the U.S. should remain gradual and conservative,

given the balance of risks to the economic outlook

and still quiescent inflation.

Despite a gradually improving economic outlook,

the balance of risks remains asymmetric, with

limited scope to respond to a negative shock. In her

speech at Jackson Hole, Fed Chair Yellen showed

simulations that suggest the Fed’s current toolkit

(interest rates, forward guidance and QE) may be

enough to fight the next recession. But the worst-case

simulation assumed the 10-year Treasury would be at

3% when the economy is next hit by a recession,

whereas the current 10-year Treasury yield is only 1.6%.

So, if the next recession starts soon, the Fed’s toolkit

may not be enough.

In addition, the short-term neutral real rate in the

U.S. seems to be quite low, in the current context of

slow productivity growth and low global interest

rates. In short, there seems to be no need for a large

increase in Fed Funds rates in the next couple of years,

unless inflation rises much faster than expected.

Finally, we think inflation risks remain relatively low,

providing further scope for the Fed to remain on a

very cautious and gradual path. Our estimates

suggest that with well-anchored inflation expectations,

even if the unemployment rate undershoots significantly

and plummets to around 3.5%, measures of core

inflation would reach 2.25% by 2018, only 25 bps above

the 2% inflation target (see graph).


Low risk of inflation overshooting (two scenarios for the PCE deflator)

Source: Survey of Professional Forecasters, Itaú

Summing up, we continue to expect one rate hike in

2016, more likely in December than September, and

two hikes in 2017. We maintained our GDP growth

forecast at 1.5% for 2016 but adjusted it slightly, to 2.2%

from 2.1%, for 2017.

Europe – ECB on hold but with an easing

bias

Activity has shown some resilience in Europe. In the

Eurozone, the August Manufacturing Purchasing

Managers Index (PMI) was down to 51.7, but it remains

at levels consistent with moderate growth. In the UK, the

PMI recovered from July’s sharp fall and rose to 53.3,

above pre-Brexit levels (see graph). The depreciation of

the British pound and the realization that the EU exit

process will be a protracted affair have provided support

to the rebound.

The ECB is in wait-and-see mode but with an easing

bias, as weak inflation points to the need for future

action. Euro area CPI stayed at 0.2% yoy in August,

with core inflation falling to 0.8% from 0.9% in July. Both

measures are still far from the ECB’s target of “close to

but below 2%.”

We maintain our GDP forecast for the euro area at

1.5% and 1.3%, respectively, for 2016 and 2017.

Manufacturing PMIs recovered in the UK. Spillover to the Eurozone still low

Source: Haver, Itaú

Japan – September assessment will likely

signal future BoJ action.

Despite its efforts, the BoJ is struggling to achieve

its 2% inflation target. CPI inflation is negative,

currently at -0.4% yoy, while core inflation has fallen

from 0.7% to 0.5%. Meanwhile, consumer inflation

expectations fell from 1.8% to 1.6%. The challenge for

the BoJ to anchor inflation at its 2% target is huge, and

credibility may be an issue.

The central bank will release a comprehensive

assessment of its policy in September. BoJ officials

have clarified that their comprehensive review aims to

study the transmission of the current monetary policy

instruments to find the best way to reach the 2% inflation

goal as soon as possible. Based on statements from

board members, particularly Governor Kuroda at the

Jackson Hole Forum, we believe the BoJ is leaning

towards the conclusion that negative interest rates have

been the most efficient tool to bring down long-term

rates. This indicates that the BoJ will not abandon

negative rates and could still lower rates further, while

maintaining its QE.

We raised our GDP forecast slightly, to 0.5% from

0.4% in 2016, but we kept it at 0.7% in 2017.

0.4%

0.7%

0.9%

1.2%

1.4%

1.7%

1.9%

2.2%

2.4%

2.7%

1Q04 2Q06 3Q08 4Q10 1Q13 2Q15 3Q17 4Q19

Baseline (Unemp. Rate = 4.5%, Inflation Expectations (*) = 1.7%)Alternative (Unemp. Rate = 3.8%, Inflation Expectations (*) = 2.0%)

% yoy

(*) Survey of Professional Forecasters, 5-10 year CPI forecast (adjusted for CPI-PCE difference)

40

45

50

55

60

Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16

UKEurozone

Index


China – Risks remain contained

The latest economic data is in line with a muddling-

through scenario. This can be described as a gradual

slowdown in activity, benign inflation and capital flows

under control. This scenario limits spillovers from China

to the global economy, as it doesn’t apply too much

downward pressure on commodities and keeps the RMB

depreciation risk under control.

We have been highlighting, though, that currently

the main risk to this scenario has been the constant

slowdown in fixed investment. Nominal fixed-asset

investment slowed to 3.9% y/y in July from 7.3% in the

previous month. This rather sharp slowdown, particularly

in the private sector, might drag down industrial

production and metal prices.

Encouragingly, this risk might moderate, as we see

factors that could stabilize investment growth in the

short term. First, other data for the real estate sector

reveal a much brighter picture than nominal investment

in the sector. Second, the narrowing of PPI deflation is

helping to improve industrial profits, which in turn will

probably sustain a better pace of investment ahead (see

graph). In fact, our models suggest that industrial profits

help to explain fixed investment both in the same month

and with a three-quarters lag. Finally, policymakers

seem to be leaning toward providing additional fiscal

stimuli (via tax cuts).

Stronger industrial profits may improve investment growth ahead

Source: Haver, Itaú

We continue to expect GDP to expand 6.5% in 2016

and 6.0% in 2017.

Commodities – Sustaining the recovery

The Itaú Commodity Index (ICI) was 2.4% above the

level seen at end of July, with a mixed performance

among its components over the period. Energy

prices were up 10.2% due to a partial recovery in oil

prices from recent lows. Agricultural prices fell as field

surveys reinforced the scenario of above-average yield

for corn and soybean. Finally, the ICI-metals index fell

2.8% with falling aluminum, copper and iron ore

outweighing gains in lead, zinc and tin prices.

Fine-tuning our metal price forecasts. The 6.3%

decline in copper prices in August – despite rising oil,

still-strong Chinese imports and disappointing output in

Chile – is a strong signal that the market is structurally

oversupplied. Hence we lowered our year-end copper

forecasts. Meanwhile, other base metals are well above

our year-end forecasts, so we adjusted our scenario for

lead, tin, zinc and nickel slightly upward. The net effect

on ICI-metals is negligible.

We expect oil prices to recover by year-end 2016.

Advancing beyond the recent ups and downs caused by

talk of a deal among major producers, we believe

additional supply from the U.S. shale industry will be

needed to balance the market in 4Q16. We are

confident that equilibrium prices are close to USD 50/bbl

and the risk of oil prices dipping below USD 40 is low.

Lower grain and soybean prices; higher sugar

forecasts ahead. We lowered our forecasts for corn,

soybeans and wheat, recognizing recent surveys

pointing to abnormally high crop yields in the U.S.

Conversely, we revised our sugar scenario upward in

accordance with prices in the futures curve, as there are

no clear factors to drive prices lower in the short term.

Despite the revision, our sugar scenario remains tilted to

the upside.

Our estimates imply that the ICI will be stable by the

end of 2016 from its current levels, and then rise by

4% in 2017.

-15%

0%

15%

30%

0%

10%

20%

30%

Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

Fixed Investment (FAI)Industrial Profits (rhs)

yoy yoy


Forecasts: World Economy

GDP Growth

World GDP growth - % 5.4 4.2 3.5 3.3 3.4 3.2 3.1 3.4

USA - % 2.5 1.6 2.2 1.5 2.4 2.7 1.5 2.2

Euro Area - % 2.0 1.6 -0.8 -0.3 0.9 1.6 1.5 1.3

Japan - % 4.7 -0.4 1.7 1.4 0.0 0.6 0.5 0.7

China - % 10.6 9.5 7.9 7.8 7.3 6.9 6.5 6.0

Interest rates and currencies

Fed Funds - % 0.2 0.1 0.2 0.1 0.1 0.2 0.6 1.1

USD/EUR - eop 1.34 1.30 1.32 1.37 1.21 1.09 1.10 1.07

YEN/USD - eop 81.5 77.6 86.3 105.4 119.8 120.4 105.0 110.0

DXY Index* - eop 79.0 80.2 79.8 80.0 90.3 98.7 96.8 99.5Source: IMF, Bloomberg and Itaú

2017F2010 2011 2012 2013 2014 2016F2015

* 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

Monetary policy (partially) decouples from the Fed

• Consistent with some strengthening of the U.S. dollar globally, we expect most LatAm currencies to weaken slightly

from their current levels between now and the end of 2017.

• Activity remains weak across the region, with varying levels of momentum at the margin. We have raised our growth

forecasts for Brazil but left unchanged our forecasts for most of the other countries. Brazil and Argentina will likely

drive the region’s recovery next year, helped in both cases by a low comparison base.

• In a context of lower inflationary pressure, monetary policy stances in the region are becoming more expansionary,

with most LatAm central banks – the exception being Banxico – decoupling from Fed policy.

LatAm currencies are unlikely to weaken

much in response to the Fed’s upcoming

rate hikes

The probability of a new interest rate hike by the Fed

before the end of this year has increased, but so far

this has had only a limited impact on emerging

market assets. In a world of low interest rates, the Fed

will likely maintain its gradual and cautious approach.

We continue to expect one Fed hike in 2016 (more likely

in December than in September) and two hikes in 2017.

In this context, the performance of LatAm currencies in

August was mixed. The Colombian peso recorded

strong gains, influenced by rising oil prices and the

historic peace deal reached between the government

and the FARC. But the Chilean peso and the Peruvian

sol both weakened as copper prices fell.

Consistent with some strengthening of the U.S.

dollar globally, we expect most LatAm currencies to

weaken slightly from the current levels between now

and the end of 2017. The exception is the Mexican

peso, which we continue to see as undervalued.

Although Mexico’s fundamentals have weakened (as

highlighted by the recent decision of Standard and

Poor’s to change the outlook on its sovereign rating from

Stable to Negative), we see the peso’s depreciation as

excessive, and we expect a correction ahead. A Clinton

win in the U.S. presidential elections, a narrowing of the

current account deficit, more progress in the fiscal

consolidation effort and additional rate hikes (we expect

Mexico’s central bank to hike rates in tandem with the

Fed at least until the end of 2017) are all potential

triggers for markets to reassess the valuation of the

Mexican peso.

Brazil and Argentina likely to drive the

region’s recovery

Economic activity remains weak across the region,

with varying levels of momentum at the margin.

Brazil’s economy is not yet out of recession, but recent

indicators suggest that activity is at last rebounding. For

the time being, the recovery is being driven by a cycle of

inventory replacement. In Argentina, the other country

under our coverage that is enduring a recession, activity

is not yet clearly stabilizing. In Chile, Colombia and

Mexico activity has recently weakened further. The

Peruvian economy continues to stand out, showing solid

growth relative to the rest of the region (but not relative

to its own past), largely due to higher mining production.

We have raised our growth forecasts for Brazil,

reduced our 2016 growth forecast for Colombia and

left unchanged our growth forecasts for the other

countries. Argentina and Brazil will, in our view, come

out of their recessions. We expect a growth rate of 3.0%

in Argentina next year, supported by higher real wages

and strengthened business confidence. In Brazil, we

now expect 2.0% growth in 2017 (up from 1.0% in our

previous scenario), following a 3.2% contraction this

year (up from -3.5% previously). We also see somewhat

higher growth in 2017, relative to 2016, for Mexico,

Chile, Colombia and Peru.

Looser monetary policy stances

As exchange rates in LatAm are evolving in a more

favorable direction and activity remains weak,

inflation continues to fall in most countries in the

region. In Argentina, although annual inflation – in the

city of Buenos Aires – has yet to peak, it has been

moderating substantially on a month-over-month basis,


with preliminary indicators pointing at a further slowdown

in August. In Brazil and Colombia, the most recent data

show annual inflation falling but still far above the upper

bounds of the respective target ranges. In Chile and

Peru, inflation is back within the ranges targeted by the

central banks. In Mexico inflation remains below the

midpoint of the target range, although it is gradually

rising with the sharp weakening of the peso.

In this context, the region’s monetary policy stances

are becoming more expansionary. The central bank of

Chile officially removed the tightening bias from its

communication, and one board member even wanted to

discuss the possibility of rate cuts. We expect Chile’s

policy rate to be left unchanged at least until the end of

2017; still, the likelihood of rate cuts is clearly increasing

(and in our view is higher than the risk of further rate

hikes). The faster-than-expected drop in inflation in

Argentina led that country’s central bank to continue

reducing its policy rate (by 200 bps in August), and we

now foresee more rate cuts than we did in our previous

scenario. Meanwhile, the central bank of Colombia has

left its policy rate unchanged, likely putting an end to a

325-bp hiking cycle. An easing cycle next year in

Colombia is likely as inflation falls towards the target

range. Rate cuts are also likely in Brazil: the central

bank changed its post-meeting statement to indicate that

future steps would be more data-dependent, dropping

the expression “there is no room for monetary policy

easing” while listing potential drivers of rate cuts. In our

view, the change in communication is consistent with

our call that an easing cycle will start in October, with a

25-bp rate cut. Mexico is the one country going in the

opposite direction: although its central bank continues to

forecast subdued growth and at-target inflation, its focus

remains on the evolution of the currency and on the

Fed’s decisions, so more rate hikes are likely as the Fed

raises interest rates. We expect the next interest rate

increase in Mexico in December (25 bps), but if the Fed

moves in September, the central bank of Mexico would

probably also move to raise rates in its September

meeting.


Brazil

Recovery in sight, but sustained growth demands reforms

• Economic activity is stabilizing and we will probably see positive growth in 4Q16. Recent indicators suggest a slightly

shallower recession than we had previously predicted. We have revised our GDP growth forecast to -3.2% this year

(previously -3.5%) and 2.0% in 2017 (from 1.0%). Despite this recovery in activity, the labor market is likely to continue

weakening until the first half of next year.

• Fiscal accounts continue to deteriorate, a trend that is only likely to be reversed with structural reforms. We have adjusted

our primary-result forecast to -2.6% from -2.5% of GDP in 2016 based on lower-than-expected extraordinary revenues, but

we are maintaining our 2017 forecast at -2.2% of GDP.

• We kept our 2016 IPCA inflation forecast at 7.2%. We expect inflation to fall over the second half of the year as the food-

price shock wanes, in a trend that should consolidate next year. We continue to see IPCA inflation slowing to 4.8% in 2017,

with market prices rising 4.7% and regulated prices inflation at 5.2%.

• We forecast the exchange rate at 3.25 reais per dollar at the end of 2016 and 3.50 reais per dollar at the end of 2017. The

still-high interest-rate differential and government efforts to approve reforms, especially on the fiscal side, should sustain the

currency at its current levels, even with a U.S. interest-rate hike. This scenario is consistent with a low, albeit slowly

increasing, current-account deficit over the coming years.

• The central bank has changed its communication, indicating that future monetary policy decisions will be more data-

dependent. We believe that this change, combined with our expectations for the economy in the coming weeks, is consistent

with our call of an easing cycle starting in October. We see the benchmark Selic rate at 13.50% by the end of 2016 and

10.00% at the end of 2017.

A stronger recovery. But is it sustainable?

Recent indicators suggest that the recession will

be shallower and the recovery stronger than

expected. Industrial output has seen resumed growth

and business surveys indicate a stronger-than-

expected recovery. For the time being, the recovery is

being driven by a cycle of inventory replacement.

However, demand remains weak, contained by

contractionary monetary policy and a labor market that

continues to deteriorate.

Demand must rebound to sustain the recovery. The

economic recession and recent exchange-rate

appreciation have improved the inflation outlook, which

should create room for a long and gradual monetary

easing cycle. Monetary stimulus, along with less

uncertainty domestically and abroad, will probably

boost aggregate demand, making the recovery more

sustainable.

However, this scenario depends fundamentally of

the fiscal reforms. As the political transition reaches

its conclusion, attention turns to approval of the

reforms. Without fiscal rebalancing, economic

predictability and stability will be compromised, leading

to instability in financial markets and limiting the room

for monetary easing. In this scenario, the economic

recovery would be compromised.

The government has shown consistent signs of its

commitment to reforms. Our base scenario assumes

that the bulk of the proposed fiscal reforms will be

approved by Congress over the next several months

and in 2017.

Economic activity: recent data suggest

stronger growth

The economy is not yet out of recession, but it is

starting to stabilize. GDP shrank 0.6% in 2Q16

compared with the previous quarter, in line with our

estimates. However, the improving trend is clearer

looking forward. Growth is likely to be driven by

industry (on the supply side) and investment (on the

demand side). Both have risen after a long sequence

of quarterly drops. This view is reinforced by industrial

production, which posted the fifth consecutive monthly

increase in July. Private consumption, on the other

hand, is likely to take longer to recover, as the labor

market remains weak.


Still declining GDP

Source: IBGE

Leading indicators suggest positive growth in the

fourth quarter. Our diffusion index – which is based

on a wide set of indicators – is set to end July at

around 55% (3-month moving average), above what

we consider to be the neutral level (44%). Diffusion

has shown a clear upward trend in recent months

(Graph). The indicator suggests a fourth-quarter rise

for GDP, which should also increase next year’s

statistical carry over.

Diffusion index suggests that the economy will pick up soon

Source: Itaú

Widespread rise in confidence indicators. Business

and consumer confidence indicators continued to

improve in August. On average, indicators are up

approximately 15% year to date, in almost all sectors

surveyed. Additionally, inventories are falling in the

industrial sector. Generally, confidence surveys

indicate that activity is improving faster than we

expected.

“U-turn” in the industrial sector

Source: IBGE, Itaú

We now forecast a smaller drop in GDP this year,

and a stronger recovery in 2017. We still expect

GDP to shrink further in the third quarter. However,

leading indicators suggest that GDP will resume

growing in the fourth quarter, bringing the recession to

an end. If these forecasts are confirmed, the carry-over

for 2017 will be zero, compared with -0.5% in our

previous scenario. Thus, the short-term revision alone

would add 0.5 pp to 2017 growth on top of our

previous forecast (1.0%). The outlook for 2017 is also

looking more positive. In addition to rising confidence,

our calculations suggest that the unit cost of labor

continues to fall, which should contribute to a cyclical

return to profitability for companies. Moreover, the

cycle of monetary-policy easing that we expect to start

this year should boost demand, even if the impact on

activity only starts to become apparent from the middle

of next year.

We now forecast GDP to decline 3.2% this year

(-3.5% previously), and to grow 2.0% in 2017 (1.0%

before).

120

130

140

150

160

170

180

2004.II 2006.II 2008.II 2010.II 2012.II 2014.II 2016.II

index, sa1995=100

GDP

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

16%

24%

32%

40%

48%

56%

64%

72%

80%

Ma

r-0

3

Ma

r-0

5

Ma

r-0

7

Ma

r-0

9

Ma

r-1

1

Ma

r-1

3

Ma

r-1

5

Ma

r-1

7

Diffusion index (12m, t-2)Diffusion index (3m, t-2)GDP Growth (12m) (rhs)

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-50%

-30%

-10%

10%

30%

50%

Aug-06 Aug-08 Aug-10 Aug-12 Aug-14 Aug-16

yoy

Industrial productionIndustrial confidence(T-1, rhs)


GDP to resume growing in 4Q16

Source: IBGE, Itaú

Despite signs of improvement in the economy, the

labor market continues to weaken. In July, payroll

declined by 94 thousand. Job contraction was

widespread, affecting 6 out of 7 sectors of economic

activity. This is a natural outcome, given that

employment normally lags behind in the economic

cycle.

Job creation remains negative…

Source: Caged, Itaú

Unemployment rate remains high. According to the

PNAD Contínua survey, the nationwide unemployment

rate rose to 11.6% in July. Over the last 12 months,

unemployment has risen an average of 0.25 pp every

month. We believe that job losses will continue into the

first half of next year. We forecast the unemployment

rate to reach 12.5% at the end of this year. The faster

economic recovery should cause unemployment to

stabilize next year. We have revised our

unemployment forecast to 12.2% at the end of 2017

(previously 13.0%).

… pushing unemployment rate up

Source: IBGE, FGV, Itaú

The fiscal reform debate heats up. Will

reforms be approved?

Fiscal results continue to fall. In July, the 12-month

cumulative primary deficit reached 2.5% of GDP. Over

the same period, the nominal deficit was 9.6% of GDP.

As a result, gross debt remained high: it reached

69.5% of GDP in July, compared to 66% of GDP at the

end of 2015 and 57% of GDP in 2014 (see graph).

We have reduced our primary-result forecast for

2016 ) to -2.6% of GDP (BRL 162 billion) from -2.5%

(BRL 155 billion, matching the fiscal target. Our

revision includes a BRL 9 billion (0.1% of GDP)

reduction in extraordinary revenues from sovereign

wealth fund withdrawals and IPOs for Caixa

Seguridade and IRB (the reinsurance company), which

are only likely to occur in 2017. This reduction more

than offsets the BRL 2 billion increase in tax revenues

related to the improvement of our GDP forecast for

2016.

As expected, the 2017 budget submitted to

congress by the government’s economic team

does not contemplate tax increases. To fulfill the

-1.0%

-2.3%

-1.3%

-0.4%

-0.6%-0.5%

0.2%

0.7%0.9%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

20

13.I

20

13.I

I

20

13.I

II

20

13.I

V

20

14.I

20

14.I

I

20

14.I

II

20

14.I

V

20

15.I

20

15.I

I

20

15.I

II

20

15.I

V

20

16.I

20

16.I

I

20

16.I

II

20

16.I

V

20

17.I

20

17.I

I

20

17.I

II

20

17.I

V

ActualForecast

qoq/sa

-200

-150

-100

-50

0

50

100

150

200

250

Jul-02 Nov-04 Mar-07 Jul-09 Nov-11 Mar-14 Jul-16

thousandssa3MMA

6

7

8

9

10

11

12

13

30

40

50

60

70

80

90

100

Jul-09 Jul-11 Jul-13 Jul-15 Jul-17

Jobs hard to get Index* (T-12)Unemployment rate (rhs)

%

*Based on Consumer Confidence Survey


0.9% of GDP (BRL 55 billion) effort required to achieve

the primary result target of 2.2% of GDP (BRL -143

billion), the budget assumes that 0.2% of GDP (BRL

14 billion) will come from the upward revision in its

2017 GDP forecast (from 1.2% to 1.6%), 0.6% of GDP

(BRL 36 billion) from extraordinary revenues linked to

asset sales and concessions, and 0.1% of GDP (BRL

5 billion) from cuts in discretionary spending.

Adverse debt dynamics reinforces the importance of fiscal reforms

Source: Banco Central, Itaú.

We have maintained our forecast for a primary

result of -2.2% of GDP in 2017 (BRL 143 billion), in

line with the government target.

The constitutional amendment proposing a cap on

public-spending increases is in Congress. The

proposed 2017 budget is already consistent with the

bill, as the increase in total primary spending is lower

than past inflation. If approved, the reform will

represent a structural change for the Brazilian

economy, as public spending has risen in real terms

almost continuously over the past 20 years. Under the

cap, if any expenditure (for example, on Social

Security) rises in real terms, it will have to be offset by

a reduction of other expenditures.

The social security reform is critical to ensure that

the spending cap remains feasible in the years

ahead and to improve the medium-term fiscal

outlook. Social security expenditure represents 45%

of the federal government’s total spending (8.5% of

GDP) and will increase in real terms over the next

several years. A social security reform that increases

the minimum retirement age to 65 and delinks benefits

from the minimum wage would mitigate the need to

make significant cuts in other areas.

We believe that, if approved, these measures will

improve debt dynamics over the medium term.

However, even with these reforms, primary results will

remain in negative territory for several years and

public-debt stabilization will result from higher

economic growth and lower interest rates.

Short-term pressure does not change

disinflation outlook

We have maintained our IPCA inflation projection

for 2016 at 7.2%, with 7.6% increase in market

prices (compared with 8.5% in 2015). Looking at the

components in the market prices group, we estimate

an increase of 11.9% for food at home (12.9% in

2015), 5.6% for industrial prices (6.2% in 2015) and

7.0% for services (8.1% in 2015). We forecast a 6.0%

increase in regulated prices (compared with 18.1% in

2015). Two factors are upside risks for our IPCA

forecast: i) more persistent food-price increases; ii)

change in the electricity “flag” to yellow from green (a

“yellow flag” would have an impact of around 0.10 pp

on inflation).

We expect short-term pressure from food inflation

to fade during the second half. We estimate a 2.8%

increase in household food prices in the second half of

the year, after rising 5.4% over the same period last

year and 8.8% in the first half of this year. During this

period, we expect to see a drop in prices of fresh fruit

and vegetables, as well as beans and milk, which

would give back a significant proportion of the

increases seen in recent months (0.60 pp impact on

the IPCA between June and July). In any event, we

believe that a large part of these products’ price

accommodation will only be seen next year, after

supply conditions have fully normalized.

The fiscal policy also represents a risk for the

inflation scenario. Future attempts to increase

government revenues could lead to fresh tax increases

and/or larger increases in regulated prices. However,

favorable fiscal developments could improve the

outlook for inflation, either through exchange rates and

inflation expectations, or through a switch from the

current expansionary to a neutral or even

contractionary stance on fiscal policy.

The high level of idle capacity in the economy is

also likely to help drive inflation down even further

as we move ahead. The negative output-gap

45%

50%

55%

60%

65%

70%

75%

Jul-07 Jan-09 Jul-10 Jan-12 Jul-13 Jan-15 Jul-16

General government gross debt

% of GDP


measurement could lead to faster market price

disinflation in the second half of the year, particularly

for industrial products and services.

In this scenario, we have maintained our forecast

that IPCA inflation will fall to 4.8% next year. Next

year’s drop in inflation will reflect the end of relative

price adjustment (regulated prices and exchange

rates), less inflationary inertia, lower inflation

expectations, more favorable weather conditions and

the impact from the high level of idle capacity. A more

intense reversal of this year’s food-price shock is a

downside risk for inflation next year.

Declining inflation expectations reinforce the

scenario of falling inflation. According to the Focus

survey, inflation expectations fell further last month.

Median expectations for 2018 and further ahead are at

the central bank’s target (4.5%), reflecting economic

agents’ increasing conviction that the BCB will act to

ensure that the IPCA will indeed converge to the target

over time. Expectations for 2017 remain slightly above

5%, due to inflation inertia and fiscal uncertainty, but

this figure could still fall as we move ahead.

On a disaggregated basis, we forecast a 4.7% rise

in market prices and a 5.2% increase in regulated

prices for 2017. Among market prices, we are

forecasting a 4.0% increase for food at home as the

exchange rate is expected to stabilize and weather

conditions are likely to be more favorable. In this

scenario, a considerable proportion of the price

increases from certain products (such as milk and

beans) are likely to be reversed over the coming year.

We forecast a 5.5% increase in service prices and

4.0% increase in industrial prices.

Disinflation in the horizon

Source: IBGE, Itaú

Foodstuff to contribute to 2017 disinflation

Source: IBGE, FGV, Itaú

The real remained stable as external and

domestic factors offset each other

The exchange rate held steady at around 3.20 reais

per dollar in August, with foreign and domestic

factors offsetting one another.

Currencies were driven by the Fed. Members of the

Federal Open Market Committee (FOMC) indicated

that U.S. interest rates could rise this year,

following a recovery in activity and more favorable

financial conditions. This signaling led the dollar to

appreciate against emerging currencies, including the

Brazilian real.

In Brazil, government efforts to push through

reforms and adjustments continue to sustain the

currency

We have maintained our exchange-rate forecast of

reais 3.25 per dollar at the end of 2016 and reais

3.50 per dollar at the end of 2017. Even if U.S.

interest rates rise this year, the differential between

Brazilian and foreign interest rates will remain

substantial. Domestically, greater consensus on fiscal

reforms should also help keep the real at current

levels.

Despite their significant improvement throughout

2015, external accounts are stabilizing. The current-

account deficit is stabilizing at around USD 20 billion.

Improved activity and, to a lesser extent, the recent

8.5%

18.1%

10.7%

7.2%

4.8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17

yoy

IPCAMarket-set prices (76%)Regulated prices (24%)

forecast

-5%

0%

5%

10%

15%

20%

25%

30%

35%


yoy

Food at homeAgricultural products

forecast


currency appreciation have contributed to more

modest current-account results in recent months. On

the financing side, net foreign direct investment inflows

were somewhat lower in July (compared with other

months), resulting from one specific banking-sector

transaction that is unlikely to be repeated in the

coming months. Portfolio (fixed income and equities)

flows reveal an inflow over the past two months, but

remain negative for the year.

External adjustment loses steam

Source: BCB, Itaú

We have marginally reduced our trade balance

forecast. We forecast a US$ 47 billion trade surplus in

2016 (previously US$ 50 billion) and US$ 42 billion

surplus in 2017 (previously US$ 46 billion). We are

forecasting a US$ 21 billion current account deficit in

2016 (previously US$ 18 billion) and US$ 33 billion

deficit in 2017 (previously US$ 28 billion).

We believe that the current-account deficit will

remain low over the coming years.

Monetary Policy: Copom in data-

dependent mode, we expect easing cycle

to begin in October

The balance of inflation risks continues to

improve. The weak labor market, stronger exchange

rate, deflation in wholesale food inflation and

conservative approach to monetary policy have

reinforced the outlook for disinflation ahead. In this

scenario, inflation expectations are converging to the

target for 2017, and are already at the target for 2018

and beyond.

Focus on bringing inflation to the target in 2017

has prevented the central bank from cutting

interest rates so far. At its August meeting, the

Central Bank Monetary Policy Committee (Copom)

once again held interest rates at 14.25%, the same

level they have been since September 2015.

However, the Copom changed its communication

in order to make future steps more data-

dependent. Both in the post-meeting statement and in

the minutes, the committee dropped the expression

stating that “there is no room for monetary policy

easing.” Instead, it listed several conditions that

monetary easing would depend on: limited persistence

of food-price shocks, an appropriate speed of

disinflation in the IPCA components most sensitive to

monetary policy and activity (i.e. services) and less

uncertainty surrounding fiscal adjustment

implementation and composition.

We believe the central bank’s change in its

communication and our expectations for the

economy in the short term are consistent with our

scenario of an easing cycle starting in October. We

forecast an initial 0.25 pp cut followed by a 0.50 pp cut

in November, with the Selic benchmark rate ending the

year at 13.50% p.a.

We expect the easing cycle to continue in 2017,

bringing the Selic rate to 10.00%.

-120

-100

-80

-60

-40

-20

0

Jul-08 Jul-10 Jul-12 Jul-14 Jul-16

Current account (3MMA SAAR)Current account (over 12 months)

Billion dollars


Forecast: Brazil

Economic Activity

Real GDP growth - % 7.5 3.9 1.9 3.0 0.1 -3.8 -3.2 2.0

Nominal GDP - BRL bn 3,886 4,374 4,806 5,316 5,687 5,904 6,208 6,602

Nominal GDP - USD bn 2,208 2,611 2,459 2,461 2,416 1,773 1,789 1,950

Population (millions) 195.5 197.4 199.2 201.0 202.8 204.5 206.1 207.7

Per Capita GDP - USD 11,292 13,226 12,339 12,243 11,914 8,670 8,680 9,391

Nation-wide Unemployment Rate - year avg (*) - - - 7.2 6.8 8.3 11.2 12.4

Nation-wide Unemployment Rate - year end (*) - - 7.5 6.7 7.1 9.8 12.5 12.2

Inflation

IPCA - % 5.9 6.5 5.8 5.9 6.4 10.7 7.2 4.8

IGP–M - % 11.3 5.1 7.8 5.5 3.7 10.5 7.5 4.2

Interest Rate

Selic - eop - % 10.75 11.00 7.25 10.00 11.75 14.25 13.50 10.00

Balance of Payments

BRL / USD - eop 1.66 1.87 2.05 2.36 2.66 3.96 3.25 3.50

Trade Balance - USD bn 18.5 27.6 17.4 0.4 -6.6 18 47.0 42.0

Current Account - % GDP -3.4 -3.0 -3.0 -3.0 -4.3 -3.3 -1.2 -1.7

Direct Investment (liabilities) - % GDP 4.0 3.9 3.5 2.8 4.0 4.2 4.1 3.8

International Reserves - USD bn 288.6 352.0 378.6 375.8 374.1 369 369.0 369.0

Public Finances

Primary Balance - % GDP 2.6 2.9 2.2 1.7 -0.6 -1.9 -2.6 -2.2

Nominal Balance - % GDP -2.4 -2.5 -2.3 -3.0 -6.0 -10.3 -9.8 -9.3

Gross Public Debt - % GDP 51.8 51.3 53.8 51.7 57.2 66.2 71.6 76.4

Net Public Debt - % GDP 38.0 34.5 32.3 30.6 33.1 36.0 47.6 52.90.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

(*) Nation-wide Unemployment Rate measured by PNADC

2010 2011 2012 2013 2014 2017F2015 2016F

Source: IBGE, FGV, BCB and Itaú


Argentina

Driving on a bumpy road

• The Supreme Court suspended the gas tariff hikes decreed by the Macri administration in April. The decision is an

important setback for the current government as efforts to reduce the energy subsidy bill, and adjust the fiscal accounts, are

hampered. The government will send the budget bill in September. We have reviewed our expected headline deficit for 2017

to 5.4% of GDP (-4.4% for the primary result) from 4.9% previously.

• The latest inflation readings surprised positively nearing the 1.5% month-over-month inflation goal for 4Q16 set by the

central bank. We adjusted our forecast of annual inflation to 42.8% in 2016, from 44.2% in our previous scenario. For next

year, we maintain our forecast of 23%. In this context, the central bank will probably ease the monetary policy by more than

we were previously expecting. We see now the Lebac rate hitting 25% before the end of this year (27% previously). Our

forecast for the Lebac rate by the end of 2017 remains unchanged at 22%.

• Lower domestic rates will likely contribute to the depreciation of the peso. We expect an exchange-rate of 16.2 pesos to

the dollar by December. For 2017, we expect a stable real bilateral exchange-rate (meaning 19.5 pesos to the dollar by the

end of the year).

• Recession continues in the beginning of the second half of the year. With a recovery in real wages, higher public

expenditures, a better environment for investments ahead, and stronger growth in trading partners, GDP will probably grow

3% in 2017, after a 1.6% contraction this year.

Stones in the path towards consolidation of

the fiscal accounts

The Argentine Supreme Court nullified the gas tariff

hikes implemented by the government in April. While

the court upheld the rights of the national government to

set tariffs, it objected to the way in which they were set

and established that the government must call for public

hearings before adjusting them. At first, the decision

affected only the gas bills paid by households (30% of

total gas demand). But as the ruling may be extended to

other gas consumers as well as to electricity tariffs, the

government quickly called for hearings in September.

The opinions on the hearings are not binding, so the

government can reinstate the hikes afterwards.

However, given the political noise (the government

approval fell 4 percentage points in August, to a still-high

56%, according to Poliarquía Consulting firm) it is

unlikely that the government will bring tariffs to the same

level as of April. The treasury initially planned to save

0.72% of GDP this year (0.6% for electricity and 0.13%

for gas). While it is likely that most of the savings will be

preserved after the hearings, the episode shows the

difficulties of adjusting the fiscal accounts and preserve

political capital/governability at the same time.

Adjusting inflation expectations

Source: Inflation expectations survey, Central Bank, Itaú

We now expect a wider deficit in 2017 relatively to

our previous scenario. We still think the government

will meet its fiscal target for this year (a primary deficit of

4.8% of GDP) implying a nominal deficit of 5% of GDP,

but for 2017 we now expect a primary deficit of 4.4% of

GDP (nominal deficit of 5.4%, versus 4.9% in our

previous scenario). The government will submit the

budget bill in September, which is supposed to show

some fiscal consolidation compared to 2016. However,

meeting the original target of a primary deficit of 3.3% of

GDP next year seems a tall order, as the government is

10

15

20

25

30

35

40

45

2016 Next 12-month

2017 Next 24-month

July surveyAugust survey

%


indicating it will undertake a series of expansionary

measures - the treasury will probably introduce new

changes in the income tax (with a cost of approximately

0.8% of GDP). On top of that, there is the increase in

pensions (0.8% of GDP) and higher transfers to

provinces (0.2%). The mid-term election poses another

challenge as it will be an important test for the popularity

of the administration. There are potential one-off

revenues such as the sale of stocks in the social

security agency’s investment portfolio. Also the tax

amnesty program has started and will finish by March

next year – we expect revenue equivalent to 0.5% of

GDP from this program.

Positive news on inflation makes room to

further ease monetary policy

Inflation in July came lower than expected, while a

further deceleration is expected for August.

Consumer prices increased 2.2% month over month in

July in the city of Buenos Aires (3.2% in June) and 2%

according to the index published by INDEC, the

statistics office (down from 3.1% in the previous month).

Core inflation also retreated to 2.3% and 1.9%,

respectively, from 3.6% and 3.1% in June. According to

private estimates, inflation continued to decline in

August. Elypsis, a private consulting firm that collect

prices online, estimates core inflation at 1.6% in August.

The headline inflation will likely register lower figures,

but that will be a transitory effect from the Supreme

Court decision to suspend the gas tariff hikes.

All in all, inflation is now approaching the target of

1.5% month over month inflation set by the central

bank for 4Q16. We adjusted our forecast for inflation

this year to 42.8% (from 44.2% in our previous

scenario). Besides the recent inflation surprises, our

expectation of a lower increase in gas tariffs (than that

tried in April) is behind the revision. For 2017 we keep

our forecast of 23%, as inertia from this year (through

wage negotiations) and probable new tariff hikes would

continue to pressurize consumer prices.

The central bank continued to ease monetary policy.

The reference rate (35-day lebac) is now at 27.75%,

which is more than 10% below the peak reached earlier

in the year. The rate cuts followed the progress in the

reduction of inflation. We think there is room to

implement further cuts as inflation expectations for 2017

start to decline. The latest survey of the central bank

showed analysts expecting 19% inflation for next year.

We now see the Lebac rate hitting 25% by December

(from 27% in our previous scenario), but maintain

unchanged our forecast for 2017 at 22%.

The nominal exchange rate has been floating around 15

pesos to the dollar, keeping the real effective exchange

rate 10% stronger than the level it reached right after the

exchange rate controls were removed in December. The

stronger Brazilian real prevented a further inflation-

adjusted multilateral appreciation. We currently expect

the exchange rate to end this year at 16.2 pesos to

the dollar, as domestic interest rates fall (although

we acknowledge that the risks are tilted for a

stronger peso).

No recovery yet

The IGA (a private-estimated proxy for GDP) fell 5%

year over year and 0.4% month over month in July.

Activity, measured by the revamped official index EMAE,

registered a 2.8% yoy contraction in 2Q16 (-0.7%

QoQ/sa). The EMAE matches the evolution of the GDP,

which grew 0.5% in 1Q16. The new official statistics

showed that unemployment hit 9.3% in 2Q16. However,

there are signs that some sectors reached a bottom.

Different estimations of industrial production showed a

marginal recovery in July. Likewise, construction activity

has been improving at the margin.

As real wages recover and investment picks up, and

benefiting from stronger activity in trading partners,

we see the economy expanding by 3.0% next year (-

1.6% this year). Real wages will recover relatively to the

first half of the year as nominal wages were already

adjusted amidst falling inflation. At the same time, the

more business-friendly environment combined with

higher access to external financing are likely to improve

investment.


Forecast: Argentina

Economic Activity

Real GDP growth - % 10.4 6.1 -1.1 2.3 -2.6 2.4 -1.6 3.0

Nominal GDP - USD bn 427 531 583 613 568 630 562 582



Unemployment Rate - year avg 7.8 7.2 7.2 7.1 7.3 6.5 9.0 8.5

Inflation

CPI (City of Buenos Aires) - % 26.4 22.8 25.6 26.6 38.0 26.9 42.8 23.0

Interest Rate

BADLAR - eop - % 11.3 17.2 15.4 21.6 20.4 27.3 22.5 20.0

Lebac 35 days - eop - % - - - - - 33.0 25.0 22.0

Balance of Payments

ARS / USD - eop 3.98 4.30 4.92 6.52 8.55 13.01 16.20 19.50

Trade Balance - USD bn 11.4 9.0 12.0 1.5 3.1 -3.0 -0.5 -3.5


Foreign Direct Investment - % GDP 2.6 1.9 2.4 1.4 0.8 1.6 2.3 2.6

International Reserves - USD bn 52.2 46.4 43.3 30.6 31.4 25.6 32.3 35.3

Public Finances

Nominal Balance - % GDP 0.2 -1.4 -2.1 -2.0 -2.7 -4.8 -5.0 -5.4

Gross Public Debt - % GDP 38.5 33.7 33.9 33.0 39.1 35.4 47.4 49.83848.3% 3372.4% 3388.2% 3301.1% 3907.1% 3535.4% 4742.6% 4982.0%

2017F

Source: IMF, Bloomberg, BCRA, Haver and Itaú

2010 2011 2012 2016F2013 2014 2015


Mexico

Fiscal adjustment in the spotlight

• In spite of the large dividend received from the central bank (1.2% of GDP), stemming from the 2.5% of GDP exchange-

rate gains on international reserves, the government cut its target for the Public Sector Borrowing Requirements (PSBR,

which is the broadest measure of the public-sector deficit) by only 0.5% of GDP. Shortly thereafter, Standard and Poor’s

revised the outlook for Mexico’s sovereign credit rating to negative. While the government is promising to deliver more

fiscal consolidation ahead (including a primary surplus next year), the recent episodes highlight the difficulties in adjusting

the fiscal accounts amid lower oil prices, weak oil production and a challenging political environment.

• The loss of oil revenues is also having a negative impact on the balance of payments, with the current-account deficit

reaching 2.9% of GDP in the year ended in 2Q16. On a better note, recent trade data shows an improvement at the margin,

as manufacturing exports recover and the energy balance stabilizes. We expect current-account deficits of 2.6% and 2.3%

of GDP in 2016 and 2017, respectively.

• The performance of the Mexican peso disappoints, and we see the currency as undervalued. We expect the Mexican peso

to appreciate somewhat, ending this year and the next at 17.5 to the dollar.

• In spite of low inflation and subdued growth, we expect Mexico’s central bank to raise interest rates in December (by 25

bps) together with the Fed. In 2017, our baseline scenario considers two further hikes, also in lockstep with the Fed. An

earlier hike by the Fed (say, in this month's policy meeting) would bring an earlier response from Banxico.

Fiscal consolidation disappoints, while the

current-account deficit peaks

In late August, rating agency Standard and Poor’s

revised its outlook for Mexico’s sovereign credit

rating (BBB+) from stable to negative, based on

rising debt-to-GDP and low economic growth. This

decision came just one day after the Ministry of Finance

lowered its estimate of the broadest fiscal-deficit

measure (public-sector borrowing requirements) for

2016 by only 0.5% of GDP (to 3.0% of GDP), in spite of

the whopping dividend that the government received

from the central bank this year (MXN 239.1 billion or

1.2% of GDP). In fact, the budget cuts trumpeted in

February and June – amounting to 0.9% of GDP – are

being watered down by a variety of expenditure

increases (including clearing the arrears with Pemex

suppliers). Although Moody’s also has a negative

outlook for Mexico, its rating (A3) is one notch above

those of S&P (BBB+) and of Fitch (which has a stable

outlook), so the S&P decision is certainly harsh.

The rating outlook revision highlights the difficulties

of adjusting the fiscal accounts amid low oil prices.

As oil accounts for a significant share of the

government’s revenues, lower oil prices have widened

the fiscal deficit and contributed to pushing the public

debt upward (to above 45% of GDP, from around 35%

of GDP two years ago). And the government's apparent

lack of political support does not help to expand its

capacity to adjust.

Fiscal consolidation aims at stabilizing net debt

Source: SHCP, INEGI, Itaú

To preserve fiscal sustainability and the sovereign

rating, the government will likely need to step-up its

fiscal-consolidation efforts. Although the oil-price

recovery seen recently could bring relief to public

finances, oil production is failing to stabilize (it fell 5.1%

year over year in July, after 13 consecutive quarters of

negative growth). In this context, the government’s

current target for next year’s PSBR (3.0% of GDP,

unchanged from the revised number for 2016) will

require a significant effort by the government,

25

30

35

40

45

50

-4

-3

-2

-1

0

Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16

Fiscal balanceNet debt (rhs)

4-quarter rolling, % of GDP % of GDP


considering that it will not be able to count on the sizable

dividend from the central bank of Mexico next year.

President Peña Nieto announced that Luis

Videgaray stepped down as Finance Minister and

appointed José Antonio Meade (former Finance

Minister of the Calderón administration, 2006-2012)

to replace him. Both Videgaray and Meade boast

strong market credibility, which explains why the

reaction of financial prices was fairly muted. We believe

the appointment of Meade implies policy continuity, and

expect the transition to be smooth. The Ministry of

Finance would remain focused on the implementation of

the fiscal consolidation program.

The current-account deficit has widened, reaching

2.9% of GDP (USD 31 billion) in the four quarters

ended in 2Q16 (vs. 2.0% of GDP one year earlier).

Deterioration of the current-account balance is largely

due to weaker net energy exports (-1.1% of GDP vs. -

0.4% in 2Q15), which brought the trade balance near to

its lowest levels since the Lehman crisis. On the other

hand, remittances climbed 0.5% of GDP in the period.

The remaining components of the current account have

been more stable over the past year, in spite of the

sharp weakening of the Mexican peso.

Trade balance has improved at the margin

Source: INEGI, Itaú

On the funding side, portfolio flows into the

domestic bond market (a key source of financing)

are scarcer, while direct investment is not enough to

fully fund the deficit. In the four quarters ended in

2Q16, adding the current account deficit (2.9%) to net

FDI (2.1%) leaves a gap of 0.8% of GDP. More

concerning is the fact that net portfolio investment

recorded outflows of USD 4.8 billion in 2Q16 (with the

four-quarter rolling measure decreasing from net inflows

of USD 31.7 billion in 1Q16 to 16.3 billion in 2Q16).

Importantly, there were meaningful outflows from the

domestic government bonds (USD 7 billion in 2Q16),

and over four quarters, foreign investment in these

securities was negative by USD 11 billion (a sharp

contrast with the record USD 46.6 billion inflows in

2012).

We expect the current-account deficit to narrow to

2.6% and 2.3% in 2016 and 2017, respectively, as a

recovery of U.S. manufacturing supports Mexico’s

industrial goods exports and the weak real

exchange rate weighs negatively on import growth.

In fact, in July the trade balance already recorded a

significant improvement at the margin, with the three-

month average deficit narrowing to USD 12.1 billion

(annualized), the lowest level since April 2015, and the

non-energy balance reaching one of the highest values

on record (helped by a pick-up in manufacturing

exports).

In all, we see Mexico’s fiscal and external accounts

as manageable. Still, the worsening of macro

fundamentals seen recently is partly behind the

poor performance of the Mexican peso. We hold to

our view that the exchange rate is substantially

undervalued and that it will appreciate going forward (we

see the peso at 17.5 to the dollar by the end of 2016 and

2017). Amid supportive external conditions for emerging

markets, the improvement of external accounts, a more

credible commitment to fiscal consolidation, Mr. Trump’s

(still) likely defeat in the elections and a further recovery

of oil prices are the many potential triggers for the

appreciation.

The central bank waits for the Fed

We expect Mexico’s GDP growth to slow from 2.5%

in 2015 to 2.1% in 2016. However, for 2017, we see a

modest recovery, to 2.4%. As U.S. industry performs

better, Mexico’s manufacturing exports will continue to

recover, with significant spillovers to the rest of the

economy (given its openness) more than offsetting the

negative impact of fiscal consolidation.

Inflation is trending up, but we expect it to stabilize

around the 3% target in 2016 and 2017. The Mexican

peso’s sharp depreciation and firmer oil prices have put

upward pressure on consumer prices, with CPI running

at 2.80% year over year in the first half of August. The

lagged effects of the exchange-rate depreciation,

-25

-20

-15

-10

-5

0

5

10

15

20

25

Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16

TotalEnergy

Non-energy

3-month moving average, annualized, USD Billion


coupled with unfavorable base effects related to the

telecom reform, would drive inflation up slightly from

current levels.

Consistent with our forecasts, the Central Bank of

Mexico (Banxico) published the third quarterly

inflation report of 2016, with a reduction in GDP

growth forecasts (down to ranges of 1.7%-2.5% in

2016 and 2%-3% in 2017). Previously, Banxico’s official

GDP growth forecasts for 2016 and 2017 stood at 2%-

3% and 2.3-3.3%, respectively. Moreover, the report

tweaked the inflation outlook, by stating that end-of-

period and average CPI inflation would come in “close

to” and “below” 3% in 2016, respectively, rather than

“above” and “close to” (as they expected previously).

The inflation forecast for 2017 remains unchanged at

3%.

Still, the stance of Mexico’s monetary policy

remains unchanged: it will continue closely

monitoring the evolution of the exchange rate and

the Fed’s decisions, focusing less on the short-term

dynamics of growth and inflation. Our view is that

Mexico’s central bank will likely raise interest rates in

December (by 25 bps) together with the Fed, and then

tighten monetary policy again in 2017 in lockstep with

the U.S. Depending on the evolution of the currency, the

central bank may raise interest rates more than the Fed

does, as has been the case so far this year. If the Fed

decides to bring forward its rate hike, Banxico probably

will as well.

Forecast: Mexico

Economic Activity

Real GDP growth - % 5.1 4.0 4.0 1.4 2.2 2.5 2.1 2.4

Nominal GDP - USD bn 1,106 1,119 1,223 1,264 1,270 1,103 1,087 1,169




Inflation

CPI - % 4.4 3.8 3.6 4.0 4.1 2.1 3.0 3.0

Interest Rate

Monetary Policy Rate - eop - % 4.50 4.50 4.50 3.50 3.00 3.25 4.50 5.00

Balance of Payments

MXN / USD - eop 12.3 13.9 13.0 13.1 14.7 17.4 17.5 17.5

Trade Balance - USD bn -3.0 -1.4 0.0 -1.2 -3.1 -14.6 -15.0 -11.0




Public Finances

Nominal Balance - % GDP -2.8 -2.4 -2.6 -2.3 -3.1 -3.5 -3.0 -2.3

Net Public Debt - % GDP 31.7 33.3 34.3 36.9 40.3 45.0 48.0 48.10.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

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

2017F2010 2011 2012 2016F20152013 2014


Chile

Officially neutral

• We expect 1.5% GDP growth this year, slowing from 2.3% in 2015, with a modest recovery to 2.0% next year. Activity is

being hindered by low commodity prices and weak confidence.

• As the Fed resumes rate hikes, we see the peso weakening somewhat, to 685 to the dollar by the end of this year and 695

by the end of 2017.

• Still, as the evolution of the currency is now far more favorable than over the past few years, we expect inflation to continue

on a downward trend, reaching 3.5% by the end of this year and the 3% target in 2017. Weak activity amid well-anchored

inflation expectations also helps to reduce inflationary pressures.

• The central bank finally dropped the tightening bias for monetary policy and will probably keep rates on hold until at least

the end of 2017, in line with our scenario. But as inflation approaches the target center and the economy remains sluggish,

we cannot rule out interest-rate cuts next year.

• Ahead of the upcoming 2017 presidential election, as yet no potential candidate has amassed convincing support,

reinforcing the perception of popular unease with the political class. The pension-reform discussion will play a key role in the

election.

The economy slows further in 2Q16

GDP expanded 1.5% year over year in 2Q16, below

the 2.2% recorded in 1Q16. The annual expansion of

the seasonally adjusted series (which also corrects for

calendar effects) was even lower, at 1.3%. At the

margin, the GDP fell from 1Q16 (-1.4% saar).

Growth soft-patch endures

Source: BCCh, Itaú

The weak GDP happened despite an improvement in

gross fixed investment and strong public-

consumption expansion (7.0% year over year). Total

consumption expanded 2.6% (2.9% in 1Q16), even

though private consumption grew by 1.7%. Meanwhile,

gross fixed investment posted a second consecutive

quarter of expansion (+2.7%, after +1.1% in 1Q16),

following a 1.5% contraction in 2015.

We expect 1.5% GDP growth this year, down from

2.3% recorded in 2015, with a modest recovery to

2.0% next year. With low copper prices and weak

business confidence, a further improvement of

investment is unlikely. Moreover, the labor market will

probably provide less support for private

consumption. The national unemployment rate

reached 7.1% in the quarter ending in July, the

highest unemployment rate for this period of the year

since 2011. Meanwhile, employment growth was

sustained by low-quality jobs, evidencing the weakness

of the labor market. However, we note that the central

bank recently revised GDP growth up to 2.3% (from

2.1%) for 2015 as well as for the first half of 2016, which

helps limit downside risks to our growth forecast for this

year.

-5

0

5

10

15

20

2009 2010 2011 2012 2013 2014 2015 2016

YoYQoQ/Saar

%


Above 7% for the first time in 5 year

Source: INE, Itaú

Current-account deficit remains moderate

The current-account deficit remains moderate, in

spite of lower copper exports. The trade deficit

reached USD 5.1 billion (-2.1% of GDP) in 2Q16

(accumulated in four quarters), slightly above the USD

4.8 billion (-2.0% of GDP) in 2015. Mining exports (due

to both lower prices and lower volumes) continue to be a

drag on trade balance. Meanwhile, the income deficit

inched up, but is still well below the deficits earlier in the

decade, as the low copper prices weigh down on the

profits of foreign mining companies operating in Chile.

Weak growth and a weaker peso, compared with figures

seen in the recent past, also acted to narrow the income

deficit.

Despite weak growth prospects and low copper

prices, foreign direct investment in Chile remains

robust. Foreign direct investment was USD 19.7 billion

in the rolling four-quarter period (8.4% of GDP), from

USD 21.3 billion previously (USD 20.5 billion in 2015).

As of the second quarter, net direct investment shrank to

3.0% of GDP, but still fully funds the current-account

deficit.

We expect a current-account deficit of 1.7% of GDP

this year. Weak internal demand will probably narrow

the deficit from current levels. For 2017 we expect a

larger deficit, of 2.2% of GDP, consistent with our

expectation of a modest economic recovery.

FDI fully funds wider current account deficit

Source: BCCh, Itaú.

As the Fed resumes rate hikes, we see the peso

weakening somewhat, to 685 to the dollar by the end

of this year and 695 by the end of 2017.

Inflation in the target range

In August, inflation convincingly returned to the

central bank’s 2%-4% target range. Consumer prices

were flat from July to August as falling energy prices

offset the seasonal fruit and vegetable gains. As a

result, annual inflation moderated to 3.4%, from 4.0%

previously. Core inflation – which excludes food and

energy prices – was 3.9% (4.2% previously), the lowest

reading since July 2014. Tradable inflation slowed to

2.6% (3.7% in July), as the supply-side shocks from the

previous weakening of the exchange rate dissipate,

while non-tradable inflation is still high at 4.3%, from

4.5% the previous month. Our diffusion index showed a

notable decline, with pressures from the tradable

component becoming less widespread, while the non-

tradable component was broadly stable.

We expect the negative output gap, a more favorable

evolution of the exchange rate (compared with the

previous two years) and well-anchored inflation

expectations to support year-end inflation of 3.5%

(4.4% in 2015). For next year, we expect inflation to

stabilize at the 3% target.

3

4

5

6

7

8

-8

-4

0

4

8

12

2011 2012 2013 2014 2015 2016

Unemployment rate (rhs)Rest of employment Waged employment

%, yoy %

-6

-4

-2

0

2

4

6

8

10

12

2004 2006 2008 2010 2012 2014 2016

Current AccountCurrent Account +

Net FDI

Rolling-4Q, % of GDP


Back in the target range

Source: INE, Itaú

A looser monetary-policy stance

The central bank removed the tightening bias from

its communication. The minutes of the August

monetary-policy meeting show that the board is

anticipating faster convergence of inflation than that

envisioned in the 2Q16 Inflation Report (IPoM), largely

due to the behavior of the exchange rate. In this context,

the board of the central bank unanimously voted for the

eighth consecutive month to leave the policy rate at

3.50%. The scenario also convinced most board

members to drop the tightening bias in the

communication, adopting a neutral stance.

Moreover, one board member deemed it necessary

to include a rate cut as a valid alternative. This

member disagreed with the staff’s recommendation to

consider only the option to keep the rate unchanged, as

he saw the need for additional monetary stimulus. The

other board members were more cautious, with two of

them preferring to wait until the publication of the 3Q16

IPoM before dropping the bias. One member believed

that a more-detailed explanation of the bias-change

could minimize the risk that the market incorporated rate

cuts into the baseline scenario, something he believed

would be incorrect in the current circumstances.

The 3Q16 IPoM confirmed that its baseline scenario

now considers the policy rate to remain at current

levels (3.5%) throughout the 2-year policy horizon.

The previous baseline scenario had seen some gradual

tightening ahead. The central bank lowered the medium-

term GDP growth outlook to 3.2% (3.5% as of 3Q15)

given lower capital investment expenditure. This is in

line with a lower neutral real rate, of around 1.0% -

1.5%, and a nominal neutral rate of 4.0% - 4.5%

We expect the central bank to remain on hold for at

least the remainder of this year and the next. With

inflation returning to the range around the target, weak

growth and well-anchored inflation expectations, rate

hikes are unlikely. Actually, in our view, rate cuts in 2017

are more likely than hikes, considering that the real

policy rate is not far below its historical average.

However, given the long period of above-target inflation,

the board is unlikely to consider this option before

inflation has stabilized around the 3% target.

Dissatisfaction with the political class is

rising

Public opinion surveys provide no respite to

President Bachelet and her government. Meanwhile,

the opposition is failing to take advantage of the

downturn, showing that discontent with the political class

is widespread. Survey results from CEP, a local think

tank, show the government’s approval rating dropped to

15% from 24% in the previous survey (November 2015).

This is the lowest presidential approval rating recorded

by CEP since the return to democracy (the Piñera

administration had the previous record, with a minimum

approval rating of 23%). The disapproval rating rose to

66% (from 58%), higher than Piñera’s 62% record. The

survey results were echoed by other higher-frequency

polls.

There is no frontrunner with substantial support for

the 2017 presidential election. A vast majority of

respondents (62%) did not have a preferred candidate,

while former President Sebastián Piñera led the rest of

the candidate pack with only 14%. Recently, former

President Ricardo Lagos confirmed his candidacy for the

presidency, but will face a notable challenge, as he

currently has single-digit support. The lack of clear

frontrunner from either political coalition is unusual with

just over a year to go until the election.

Pension reform can play an important role in the

outcome of next year’s election. Recent protests have

drawn attention to the shortcomings of the private

pension system. In response, Michelle Bachelet has

pledged to enhance the public role in pensions, aiming

at increasing competition and reducing financial fees.

However, some protesters have demanded a complete

-40

-20

0

20

40

0

2

4

6

2011 2012 2013 2014 2015 2016

CPICPI ex food & energy

* Diffusion Index (rhs)

%, yoy %

*Diffusion Index (Price changes above 3% minus price changes below 3%)


overhaul of the pension model, eliminating the private

system. Such a drastic change is not in the

government’s plans. Rather, President Bachelet

proposed including an additional 5% contribution to be

paid by employers, which would go into a solidarity fund

used to prop up the lowest pensions.

Forecast: Chile

Economic Activity

Real GDP growth - % 5.8 5.8 5.5 4.0 1.9 2.3 1.5 2.0





Inflation

CPI - % 3.0 4.4 1.5 3.0 4.6 4.4 3.5 3.0

Interest Rate


Balance of Payments

CLP / USD - eop 468 520 479 525 606 709 685 695

Trade Balance - USD bn 15.9 11.0 2.3 1.7 6.3 3.5 3.0 1.3

Current Account - % GDP 1.7 -1.2 -3.5 -3.7 -1.3 -2.0 -1.7 -2.2



Public Finances

Nominal Balance - % GDP -0.5 1.3 0.6 -0.6 -1.6 -2.2 -3.3 -3.2

Net Public Debt - % GDP -7.0 -8.6 -6.8 -5.7 -4.4 -3.5 1.1 4.10.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

2017F

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

2010 2011 2012 2016F20152013 2014


Peru

A slower fiscal deficit reduction

• We expect GDP growth to accelerate from 3.3% in 2015 to 3.8% in 2016 and 4% in 2017. A recovery of private investment

is crucial, as there will be less impetus from mining production and public investment ahead, even though mining production

will continue to lead growth.

• The strong increase in mining exports will help to narrow the current-account deficit to 3.8% of GDP this year, from 4.8% in

2015. The exchange rate performed poorly in August, but this was influenced by transitory factors (maturing of exchange-

rate intervention instruments). Our exchange-rate forecasts for 2016 and 2017 remain unchanged at 3.35 soles to the dollar

and 3.40, respectively.

• We expect inflation to remain on a downward trend, ending 2016 at 2.8% and 2017 at 2.5%. The reversal of the El Niño

weather phenomenon and the more favorable contribution of the exchange rate will continue to exert downward pressure on

consumer prices.

• With inflation and inflation expectations moderating, it is unlikely that the Central Bank will hike rates again. In fact, the

monetary-policy stance is gradually softening, although a tightening bias remains.

• We maintain our forecasts of the fiscal deficit for 2016 and 2017 at 3.1% of GDP and 2.6% of GDP, respectively, but the

risks are for a higher deficit. In coming months, we could revise the fiscal deficit forecast for 2017 downward, depending on

the approval by Congress of a VAT cut (as proposed by the new government) and the postponement of a reduction of the

corporate income tax rate.

Export-led growth is strong, but

sustainability of acceleration depends on

private investment

As we begin 2H16, Peru’s GDP growth remained on

a solid footing, driven by a strong increase in metal

mining exports that is more than offsetting the drag

of falling private investment (now down, in year-

over-year terms, for 10 consecutive quarters).

Private consumption, which accounts for the lion’s share

of GDP, recently lost some traction, in lockstep with

softer labor-market conditions. We believe that the

softening of the labor market is mainly explained by the

fact that the most labor-intensive sectors of the economy

(i.e., non-natural-resource sectors) are growing at a

subdued pace, in contrast with the strong pickup of

natural-resource output. Public-sector demand also

remains supportive for activity, yet far less than in 1Q16,

when it recorded a major statistical rebound that is

typically observed every four years (following the

seasonality of regional and local elections).

GDP growth came in at 3.7% year over year in 1Q16,

lower than the 4.5% recorded in 1Q16. The slowdown

is due to the “normalization” of public-sector demand

(3.6% in 2Q16 vs. 15.3% in 1Q16). Exports of goods

and services expanded by 7.8% year over year in 2Q16

(8.9% in 1Q16), a result of the strong growth of metal

mining output (28.7% year over year). Private

consumption slowed mildly, from 3.6% in 1Q16 to 3.4%

in 2Q16, while private investment remained the main

drag, contracting 4% (-5.1% in the previous quarter). All

in all, final domestic demand grew 2% (down from 3.5%

in 2Q16).

Non-mining investment is already showing some recovery

Source: BCRP, MINEM, Itaú

-50

-40

-30

-20

-10

0

10

1Q15 2Q15 3Q15 4Q15 1Q16 2Q16

Total private investmentMining investmentPrivate investment ex-mining

%, yoy


We expect GDP growth of 3.8% this year, up from

3.3% in 2015. In fact, based on coincident indicators for

economic activity, we believe that the monthly GDP

proxy grew 4.1% year over year in July – a good start for

3Q16 – again led by natural resource sectors. Looking

ahead, the boost from mining exports will likely be

smaller (though still significant), but we expect private

investment to improve. Both business and consumer

confidence indicators – the former strongly correlated

with private investment – have improved significantly

over the past few months.

Twin deficits unlikely to trigger credit-rating

outlook revision

With the strong growth of net exports, Peru’s

current-account deficit is narrowing. The four-quarter

rolling current-account deficit narrowed from 4.5% of

GDP in 1Q16 to 4.3% of GDP in 2Q16. According to our

calculations, the seasonally adjusted deficit was smaller,

at 3.1% of GDP in the second quarter. Stabilization of

the terms of trade (after recording the longest decline in

Peru’s history, between 2013 and 1Q16), rising mining

export volumes and a weaker exchange rate are

bringing about the improvement in the trade balance.

We expect the current-account deficit to be 3.8% of

GDP in the full-year 2016.

Meanwhile, the low public debt levels allow for a

wider fiscal deficit for now. Gross public debt stands

at 22.2% of GDP in 2Q16 and net public debt is

currently 5.6% of GDP. The government is using this

fiscal space. The four-quarter rolling public-sector deficit

increased from 2.9% of GDP in 1Q16 to 3.1% in 2Q16.

Preliminary data published by the central bank shows

that the deficit widened to 3.3% of GDP in July.

Furthermore, the recently elected government approved

in congress an amendment of the Fiscal Transparency &

Responsibility Law, which had been drafted with the aim

of loosening the constraints of the fiscal rule. Previously,

the law dictated that the convergence path of the

structural fiscal deficit (in % of GDP) would be 2% in

2016, 1.5% in 2017 and 1% thereafter. But now, the

path has been modified to 2.4% this year and 2.2% next

year, with the 1% target reached only in 2021. The new

path allows the proposed expansionary fiscal policies

(such as the VAT cut, from 18% to 17%). While fiscal

expansion seems to go against trends seen in most

other countries in the region, Peru's low public-sector

debt suggests that, for the moment, the economy can

afford it.

Monetary policy gradually shifting toward a

neutral stance

The central bank of Peru (BCRP) decided to leave its

reference rate at 4.25% in August, as inflation

continues to fall. Indeed, inflation is being influenced

by the fading of temporary shocks such as El Niño

(crucial for food prices) and exchange-rate depreciation

(the sol has been broadly stable this year, in contrast

with the 15% depreciation recorded in 2015). We expect

inflation to decrease further, to 2.8% and 2.5% by the

end of 2016 and 2017, respectively (from 2.9%

currently).

Central bank reduces its short-dollar position

Source: BCRP, Itaú

Although monetary policy retains a tightening bias,

we expect the central bank to move soon to an

entirely neutral stance, and to maintain the

reference rate at 4.25% throughout 2016 and 2017.

Besides falling inflation, the central bank seems much

less worried about exchange-rate depreciation than

before. For instance, in July the BCRP launched a new

exchange-rate intervention instrument (i.e., USD-settled

certificates of deposit) that allows pension funds to sell

dollars directly to the Central Bank without going through

the spot market (thus removing most of the appreciation

pressure that is stemming from the new regulations for

the pension system, which is inducing pension funds to

sell U.S. dollars). The central bank is also letting a

significant portion of its short-dollar position in FX swaps

and dollar-linked certificates of deposit mature (from a

peak of USD 17 billion in February 2016 to USD 3 billion

in August 2016). The expiration of these securities

0

5

10

15

20

25

30

35

Apr-13 Dec-13 Aug-14 Apr-15 Dec-15 Aug-16

Spot salesFX swapsCDRsSubstitution reposCDR repos

USD billion


pressured the exchange rate in August, so the sol

weakened by more than most LatAm currencies.

Beyond transitory effects, we still expect the exchange

rate at 3.35 soles per dollar by the end of this year and

at 3.4 by the end of 2017.

Forecast: Peru

Economic Activity

Real GDP growth - % 8.5 6.5 6.0 5.8 2.4 3.3 3.8 4.0





Inflation

CPI - % 2.1 4.7 2.6 2.9 3.2 4.4 2.8 2.5

Interest Rate


Balance of Payments

PEN / USD - eop 2.82 2.70 2.57 2.79 2.98 3.41 3.35 3.40

Trade Balance - USD bn 7.0 9.2 6.4 0.5 -1.5 -3.1 -2.7 -3.4




Public Finances

NFPS Nominal Balance - % GDP -0.2 2.0 2.3 0.9 -0.3 -2.1 -3.1 -2.6

NFPS Debt - % GDP 24.3 22.1 20.4 19.6 20.1 23.3 24.9 25.90.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Source: IMF, Bloomberg, INEI, BCP, Haver and Itaú

2010 2011 2012 2017F2016F20152013 2014


Colombia

Tightening cycle comes to an end, peace seems at hand

• The Colombian government and the rebel Revolutionary Armed Forces of Colombia (FARC) announced a final peace

agreement, signaling the end of the last major armed conflict in the Americas. The deal needs to be ratified in a yes-no

plebiscite. Once the institutional part of the peace process is completed, the government will turn to the approval of a

structural tax reform, which is necessary before the end of this year so the government can avoid a rating downgrade.

• With tighter macro policies, lower capital expenditures in the oil sector and falling real wages, Colombia’s economy is now

more visibly hit by the terms-of-trade deterioration. In this context, activity surprised to the downside in 2Q16, leading us to

revise our growth forecast to 2.0% for this year, down from 2.3% in our previous scenario.

• Inflation moderated in August, which is likely the beginning of a downward trend. The fading impact of El Niño and of the

weaker currency on consumer prices is the key factor behind the expected disinflation. Our forecast for inflation this year

stands at 6.9%. For 2017, we see inflation at 4%, but we note that the tax reform is an upside risk.

• The central bank left the policy rate unchanged in August, likely ending the tightening cycle. We expect rate cuts next year,

taking the policy rate to 6.5% before the end of 2017 (from 7.75% currently).

• Amid a weaker currency, waning internal demand and some improvement in oil prices, the trade-balance deficit is

gradually narrowing, although it remains wide. We expect a current-account deficit of 5.5% of GDP (6.4% in 2015). In 2017,

we see a further narrowing to 3.9% of GDP.

• We see the Colombian peso at 3,050 to the dollar by the end of this year and at 3,150 by the end of 2017. Depreciation

from the current level is expected as the interest-rate differential with the U.S. narrows, amid a wide current account-deficit.

Peace agreement reached

The Colombian government and the Revolutionary

Armed Forces of Colombia (FARC) announced a

final peace agreement, which could mean the end of

the last major armed conflict in the Americas. The

announcement, concluding negotiations that began in

2012, considers a definite bilateral ceasefire, the

protection of victims and a special (transitional) justice

system, a structural agrarian reform, the gradual political

participation of the FARC and an effective combat of

illegal drug trafficking.

The final deal will have to be ratified in a yes-no

plebiscite planned for October 2. Most surveys

indicate that the deal will receive sufficient support.

President Juan Manuel Santos revealed the precise

question voters will answer in the plebiscite: “Do you

support the final accord to end the conflict and build a

stable and lasting peace?” The peace deal will only be

ratified if the “yes” option wins and exceeds the 4.4

million vote threshold (13% of the electorate).

Over the long term, the benefits of the peace

agreement would probably come from productivity

gains associated with resources freed from security

activities and reintegration of former FARC

operatives into civilian life. Increased investment in

areas affected by the conflict and in infrastructure, as

well as exploration in oil and mining, can provide a

cyclical boost to growth in the near term. However, to

implement the peace deal, more resources will be

needed at a time the fiscal situation is already

challenging, due to weaker growth and lower oil

revenues.

Thus, a tax reform that raises fresh resources is key.

Once the plebiscite hurdle is passed, the government

will have to concentrate its efforts on tax reform, to

ensure that the law is approved before the end of this

year (allowing tax revenues to rise in 2017). Even if the

peace deal is approved by the population, it will not be

easy to raise taxes, considering that a VAT hike will

likely be the core proposal in the bill, at a time when

inflation is already eroding the purchasing power of

Colombian households. Failure to approve the tax

reform, or a severely watered-down bill, would probably

trigger a rating downgrade (currently, two rating

agencies have a negative outlook for Colombia’s

sovereign rating).

The slowdown intensifies

The GDP slowed down to 2.0% year over year in

2Q16, after 2.5% growth in 1Q16, which is the

weakest growth recorded since 3Q09 (1.3%), when

the economy was hit by the global financial crisis. At


the margin, the economy is growing by even less (0.8

qoq/saar, following 1.0% in 1Q16).

Weakening activity

Source: DANE, Itaú.

If it wasn’t for a strong rise in oil-refining activity

(28.8% year over year), the economy would be even

weaker. Oil refining continues to benefit from higher

production at the expanded Cartagena refinery, so

manufacturing growth came in at 6.0% year over year in

2Q16. Financial services also continue to perform

robustly (4.6% versus 3.9% in 1Q16). On the other

hand, commerce posted a growth rate of 1.4% (2.7% in

1Q16). Construction also weakened to 1.0% (5.2%

previously), although it was disadvantaged by an

unusually high base of comparison. In all, the non-

natural-resource sectors expanded by 2.4%.

Natural-resource sectors continue to disappoint,

contracting 3.9% year over year (-2.3% in 1Q16). An

unfavorable environment for investment in the

hydrocarbon sector resulted in oil production falling by

11% year over year. Meanwhile, the El Niño weather

phenomenon continues to be reflected in the poor

performance of the Agriculture sector (-0.1% vs. +0.3%

in 1Q16).

All in all, after solid growth in 2015 (3.1%),

Colombia’s economy is now more visibly hit by the

deterioration of oil prices. Lower real wages, tighter

macro policies and lower capital expenditures in the oil

sector are channeling the lower terms of trade into

aggregate demand.

Considering the latest data, we now see GDP growth

of 2.0% this year (2.3% in our previous scenario),

but still expect a recovery to 2.7% in 2017. A higher

average oil price next year and the investments

associated with the 4G PPP program will likely lead to

some recovery. However, we acknowledge a downside

risk to our growth forecast for next year, as a tax reform

could mean another drag for Colombian consumers.

Inflation respite

Inflation showed some moderation in August as

food prices declined. Consumer prices fell 0.32% from

July to August. The monthly drop mainly resulted from

the unwinding of food price increases following the

conclusion of a truck-driver strike in July. However, as

the exchange rate stabilizes, tradable prices (excluding

food and regulated prices) are also moderating

sequentially, helping to reduce inflationary pressures. As

a result, annual inflation fell to 8.1% (from 8.97%), which

is still far above the range around the central bank’s 3%

target. The core measure that excludes food prices

decelerated to 6.1% from 6.26% in July. Tradable

inflation is still high at 7.53%, but moderated from

7.87%, while non-tradable inflation rose slightly, to

5.05% (5.01% in July), highlighting that inertia will

prevent a fast convergence of inflation to the target,

even after the full dissipation of the shocks lifting prices.

Some inflation relief

Source: Dane, Itaú

We expect year-end inflation at 6.9%. For next year,

we expect inflation to slow to 4%, the upper bound of the

band around the 3% target, as supply-side shocks wind

down and demand-side pressures remain mild. The tax

reform is an upside risk for inflation next year.

-15

0

15

30

-6

0

6

12

11 12 13 14 15 16

GDPNon-Natural resource activity, ex

oil refiningNatural Resource activity

Oil refining (rhs)

%, SA yoy

-50

0

50

100

150

200

0

3

6

9

12

15

2011 2012 2013 2014 2015 2016

HeadlineFoodCPI ex food Diffusion index (RHS)*

%, yoy %

*Diffusion Index (Price changes above 3% minus price changes below 3%).


Tightening cycle likely over

The central bank decided to keep the policy rate

stable at 7.75%, interrupting an eleven-month 325-bp

tightening cycle. Since the previous meeting, the

central bank has published its inflation report with a

hawkish tone, estimating that there was less than a 50%

chance that inflation would end 2017 in the 2%-4%

range around the target, while at the same time

reinforcing the commitment of the central bank to bring

inflation to this range next year. However, after the

inflation report was released, economic activity data

came in weak and inflation expectations stabilized,

probably convincing many board members that it was

time to stop the cycle. In fact, the board voted 6-to-1 in

favor of holding the policy rate, which compares with the

split 4-to-3 decision in favor of a rate hike in the previous

month.

Monetary policy will continue to favor disinflation

Source: Banrep, Itaú

Considering our forecasts for inflation, it is unlikely that

the central bank will resume rate hikes. We expect the

central bank to remain on-hold this year, before

engaging in an easing cycle next year, taking the

policy rate to 6.5%. The ex-ante real policy rate is at a

high historical level, indicating that monetary conditions

are tight. As inflation falls, bringing down inflation

expectations, rate cuts will be necessary to at least

prevent the real interest rate from rising further. Still,

given the high level of inflation and the risks for the CPI

associated with the tax reform, it is unlikely that interest

rates fall faster than we are expecting.

Gradual adjustment of the external

accounts continues

The trade deficit narrowed in 2Q16. The 12-month

rolling trade deficit came in at USD 15.4 billion, below

the USD 15.9 billion deficit in 2015. The annualized

trade deficit (using our seasonal adjustment) reached

USD 13 billion in 2Q16, down from the USD 15.5 billion

deficit estimated for 1Q16: a larger energy trade surplus

explains most of the improvement, as oil prices

recovered during the period.

No further deterioration of the trade balance

Source: DANE, Itaú

We expect the current-account deficit to narrow to

5.5% of GDP, from 6.4% recorded in 2015. The lagged

effect of the previous exchange-rate depreciation, the

recovery of oil prices and a weakening internal demand

will support the improvement. In 2017, we expect a 3.9%

of GDP deficit.

We see the Colombian peso at 3,050 to the dollar by

the end of this year and at 3,150 by the end of 2017.

Depreciation from the current level is expected as the

interest-rate differential with the U.S. narrows, amid a

still-wide current account deficit.

-2

0

2

4

6

8

10

12

04 05 06 07 08 09 10 11 12 13 14 15 16 17

Policy RateItaú forecast

Real policy rate*Average real policy rate

(2004-present)

%

* policy rate deflated by the 12-month inflation expectations

-25

-20

-15

-10

-5

0

5

10

2008 2009 2010 2011 2012 2013 2014 2015 2016

Trade Balance SA (3mma annualized)Rolling 12-month Trade Balance

USD billion


Forecast: Colombia

Economic Activity

Real GDP growth - % 4.0 6.6 4.0 4.9 4.4 3.1 2.0 2.7





Inflation

CPI - % 3.2 3.7 2.4 1.9 3.7 6.8 6.9 4.0

Interest Rate


Balance of Payments

COP / USD - eop 1,908 1,939 1,767 1,930 2,377 3,175 3,050 3,150

Trade Balance - USD bn 1.6 5.4 4.0 2.2 -6.3 -15.9 -12.0 -8.0




Public Finances

Nominal Central Govt Balance - % GDP -3.9 -2.8 -2.3 -2.3 -2.4 -3.0 -3.9 -3.3

Central Govt Gross Public Debt - % GDP 38.6 36.5 34.5 37.1 40.6 45.1 45.4 45.70.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

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

2017F2016F20152010 2011 2012 2013 2014


Commodities

Sustaining the recovery

• We have revised downward our price forecasts for corn, soybeans and wheat after incorporating higher yields for the

summer crop in the United States. On the other hand, we have revised upward our price estimates for sugar (after a

reassessment of equilibrium prices) and coffee (on lower supply).

• Oil prices climbed in response to news of an agreement between the largest producers. In our view, even without an

agreement, the fundamentals are consistent with prices around USD 50/bbl by year-end.

• We have revised downward our price forecasts for copper (to current levels), given that prices fell even as favorable news came out. We continue to expect a drop in iron ore prices to USD 45 by year-end.

The Itaú Commodity Index (ICI) has risen by 2.4%

since late July, with a mixed performance by its

components. The ICI-Energy soared by 10.2% due to a

partial rebound in oil prices, which have recovered from

their recent lows as the market searches for equilibrium

between USD 42/bbl and USD 50/bbl. The ICI-

Agriculture has dropped as the current crop reinforces

the likelihood of above-average yields for corn and

soybeans. Finally, the ICI-Metals slid by 2.8% as drops

in aluminum, copper and iron ore prices more than offset

higher prices for lead, zinc and tin.

Lower agricultural and metal prices; energy on the rise

Source: Itaú.

Fine-tuning our metal prices forecasts. The 6.3%

drop in copper prices in August – notwithstanding rising

oil prices, still-resilient Chinese imports and lower-than-

expected output in Chile – is a convincing sign of

structural oversupply in the market. Hence, we have

lowered our YE16 price forecast. Meanwhile, other base

metals are trading substantially above our forecasts,

prompting us to marginally increase our price

expectations for lead, tin, zinc and nickel. The net effect

on the ICI-Metals is negligible.

Revised expectations for agricultural commodities leads to a lower forecast

Source: Itaú.

We expect oil prices to recover by year-end 2016.

Looking beyond the present ups and downs being

triggered by rumors of a deal among major producers,

we believe that the market will need additional oil

production from the U.S. shale industry to balance the

market in 4Q16. We are confident that equilibrium prices

are close to USD 50/bbl and that the risk of oil prices

dipping below USD 40/bbl is low.

Lower grain and soybean forecasts; higher sugar

prices ahead. We have lowered our price forecasts for

corn, soybeans and wheat, recognizing that recent

surveys are pointing to abnormally high crop yields in

the United States. Conversely, we have revised our

sugar scenario upward to match the prices in the futures

curve, as we see no clear factors that could drive prices

90

100

110

120

130

140

Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16

ICIICI AgriculturalICI EnergyICI Metals

Itaú Commodities Index* (2015YE = 100)

45

55

65

75

85

95

105

115

125


Previous

Current

Itaú Commodity Index* (2010=100)


lower in the short term. Despite this revision, the risks in

the sugar scenario remain skewed to the upside.

Our scenario implies that the ICI will be stable by the

end of 2016 from its current levels, and then rise by

4% in 2017.

Grains: Greater odds of a “super crop” in

the U.S.

Corn, soybean and wheat prices have been on an

extended decline since late July (-4%, -5% and -8%,

respectively).

Falling grain and soybean prices due to favorable weather

Source: Itaú and Bloomberg.

The price drop was driven by lower risks to the

current crop in the United States. A new round of

declines was caused by farm assessments that

corroborate the U.S. Department of Agriculture’s

forecast of above-average yields for the corn and

soybean crops. The U.S. harvest may still be hindered

by excessive rainfall and above-average soil humidity,

but the balance of indicators points to lower odds of crop

losses.

We expect international prices for these three

commodities to remain around current levels until

year-end. Here are our YE17 estimates (USD/bushel):

Corn: 3.6

Soybeans: 10

Wheat: 4.8

Excellent conditions for the U.S. crop

Source: USDA.

Our scenario assumes a transition to a La Niña

weather pattern toward the end of the year, affecting

the next crop in the Southern Hemisphere.

Sugar: Funds remain long, with good

reason

Since mid-June, international contracts for raw

sugar (#11, NY) have been trading near USD 0.2/lb,

consolidating a 30% hike year-to-date.

According to our calculations, the global sugar

deficit will narrow to 4 million tons in the 2016-17

crop year from 10 million tons in 2015-16. This

scenario assumes 1% growth in global demand (below

trend, due to higher prices) and production stability in

India and Thailand.

We have raised our forecasts for average sugar

prices in 2017 to USD 0.2/lb from USD 0.185/lb, after

adjusting the estimates for our revised expectations for

the global balance.

800

850

900

950

1000

1050

1100

1150

1200

300

350

400

450

500

550

600

Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16

Corn (Dec-16)Wheat (Dec-16)

Soybean (Nov-16) (rhs)

35

40

45

50

55

60

65

70

75

80

2012 2013 2014 2015 2016

Percentage of US crop considered good or excellent

by the end of August

CornSoybeans


Consolidated price increase


Additional upside risk for prices. The biggest risk in

the global balance between sugar supply and demand is

that production in India and Thailand decreases further

in the next crop. In that case, the global deficit in the

2016-17 crop year may become even wider and lead to

another round of price hikes.

We expect two consecutive years of global deficits in the sugar market

Source: USDA and Itaú.

This upward bias is the reason for the sustained

long positions being held by investment funds.

Funds have been net long by 250,000 futures contracts

for more than two months. The fact that these positions

have not been reduced signals that the risks remain

tilted to the upside.

Coffee: Prices climb in response to lower

supply and FX moves

Coffee futures contracts (Arabica) traded in New

York climbed to USD 1.50/lb from USD 1.30/lb in

early June. The contract for the first due date is up

18.5% year-to-date.

Coffee prices are at their recent highs


The recent gains were caused by short-term weather

conditions (excessive rainfall right before the harvest in

the Southern part of Minas Gerais State in Brazil, sparse

frosts in producing regions), the impact of a drought on

the next Robusta crop and the appreciation of the

currencies of major producers against the U.S. dollar.

We have increased our YE16 price forecast by 7%,

to USD 1.43/lb, assuming lower supply in the current

crop and the next.

12

14

16

18

20

22

Jan-16 Mar-16 May-16 Jul-16 Sep-16

Sugar

USD cents / lb

-15.0

-10.0

-5.0

0.0

5.0

10.0

4/5 6/7 8/9 10/11 12/13 14/15 16/17

Global Balance

million tons110

115

120

125

130

135

140

145

150

155

Jan-16 Mar-16 May-16 Jul-16 Sep-16

Coffe

USD cents / lb


Forecast: Commodities

Source: Bloomberg Itaú. * The Itaú Commodity Index is a proprietary index composed of commodity prices, measured in U.S. dollars and traded on international exchanges, which are relevant to global production. Its sub-indexes are Metals, Energy and Agriculture. ** The ICI-Inflation Index is a proprietary index composed of commodity prices, measured in U.S. dollars and traded on international exchanges, which are relevant to inflation in Brazil (IPCA). Its sub-indexes are Food, Industrials and Energy.

Macro Research – Itaú

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Relevant Information 1. This report has been prepared and issued by the Macro Research Department of Banco Itaú Unibanco S.A. (“Itaú Unibanco”). This report is not a product of the Equity Research Department of

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Commodities

yoy - % 21.9 -5.2 0.8 -5.2 -2.9 -15.1 6.9 3.7

avg growth - % 25.1 19.5 -9.5 -3.1 1.1 -14.0 -1.8 2.5

yoy - % 33.3 -6.5 3.5 -6.1 -27.5 -28.4 14.1 4.0

avg growth - % 32.4 24.9 -7.9 -3.8 -10.2 -32.7 -7.9 6.3

a/a - % 41.5 -14.8 13.2 -22.4 -8.7 -12.5 0.2 6.2

avg growth - % 15.7 35.1 -5.1 -11.5 -13.6 -16.0 -1.3 2.5

yoy - % 11.5 10.1 -0.7 5.4 -38.9 -39.1 33.7 4.3

avg growth - % 22.0 25.6 -2.4 0.9 -5.2 -44.7 -14.7 17.2

yoy - % 63.4 -18.2 -1.0 -3.2 -27.0 -33.6 11.0 -0.2

avg growth - % 78.5 13.7 -19.4 -1.2 -14.9 -29.7 -7.2 -3.6

yoy - % 32.5 -6.8 5.0 -11.3 -16.9 -22.2 7.5 2.9

avg growth - % 24.8 28.1 -5.7 -7.2 -8.0 -25.0 -5.8 3.8

Energy

2017F2010 2016F2011 2012 2013 2014 2015

CRB Index

Metals

Itaú Commodity Index (ICI)*

Agricultural

ICI - Inflation **

http://www.itau.com.br/itaubba-en/economic-analysis/publications/

latam macro monthly - itaú the one hand with below-target inflation, ... of low interest rates, on...

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