Economy Trends Update July 2017
AT A GLANCE
Energy and commodity price correction weakens growth outlook
Heightened expectations of a meaningful boost to U.S. economic growth for the current year from higher fiscal spending, lower taxes, and lighter regulations have mostly dissipated. Widening political divisions over most of the policy proposals have made it difficult for any changes to gain wider acceptance, and be implemented. It is now considered unlikely that any of the major promises of the current administration would be achieved before the end of this year. This delay is likely to moderate U.S. growth expectations for the current year.
Negotiations to restructure the current NAFTA trade agreement between the U.S., Canada and Mexico are expected to start later this year. While there was increased political rhetoric in the U.S. about scaling back the trade agreement, more recent statements from the administration suggest a more conciliatory approach. The negotiations are expected to focus more on reducing the trade surpluses that Canada and Mexico have with the U.S.
The moderate correction in energy and commodity prices from the beginning of this year could reduce the pace of expansion in several countries in the region. However, the producers are likely to offset part of the price decline with higher volumes and higher cost efficiencies. Most regional currencies have stabilized, or have recovered as in the case of the Mexican Peso. The major exception is the Brazilian Real that declined after new corruption allegations emerged against the country’s president.
United States: Policy expectations reset as political gridlock limits possibilities
Expectations of meaningful fiscal stimulus measures and regulatory easing from the Trump administration have declined steadily in recent months. The administration’s efforts to overhaul the healthcare system have failed so far, despite repeated attempts. There has been no progress on tax reforms after the government released the broad outline of a plan, and it is now considered unlikely that tax cuts will occur before next year. Similarly, the proposed increase in infrastructure spending remains hampered by the lack of consensus on other budget proposals. Financial markets have so far discounted these delays as healthy corporate earnings growth has supported investor optimism.
U.S. economic growth during the first half of this year likely fell short of earlier expectations, despite the stable trends in domestic spending and the improvement in external trade. First quarter growth was revised higher to 1.4% annualized, as consumer spending exceeded initial estimates and exports accelerated. However, inventories declined during the period, which suggests that businesses were less confident of future demand.
The labor market has continued to see strong gains so far this year, as job additions increased to over 220,000 for the month of June. New jobs for the previous months were also revised higher while the unemployment rate has remained at near historic lows. Though wage growth has started improving recently, the gains are considered moderate at 2.5% annualized. If the current rate of monthly job additions is sustained, it is likely that wages will increase faster.
Housing market data has become more uneven as higher average home prices and low inventories have made monthly home sales data more volatile. After an unexpected decline in April, existing home sales recovered in May to an annualized growth of 2.7%. Inventories at the end of May were down more than 8% compared to same month of last year, while average home prices were nearly 6% higher. Mortgage rates have also moved higher, compared to last year, and could probably reduce home affordability at the lower end of the market.
The U.S. Federal Reserve could start reducing the size of its balance sheet before the end of this year, while continuing the current policy of moderate interest rate increases. The central bank’s investment portfolio increased substantially following the quantitative easing program initiated after the 2008 financial crisis. Now that the economy is believed to have stabilized, with lower systemic risks, the Fed believes it has the flexibility to unwind the bond purchases. This process is likely to last several years and, if managed well, should not cause higher financial market volatility.
Canada: Mining and domestic consumers help economic growth
The Canadian economy has expanded at a steady pace recently and the growth accelerated to over 3% annualized at the beginning of the second quarter. Gains in mining and business services have offset weakness in manufacturing. Domestic demand has also been healthy, pushing up retail sales by 0.5% in April from the previous month. At over 300,000 new jobs over a year through June, the economy continues to see strong job additions. The economy is currently forecast to grow over 2.5%, which would make it one of the fastest growing developed countries this year.
Faster economic growth has raised expectations of an interest rate hike by the Bank of Canada during the second half of this year. The unemployment rate is at the lowest in nearly a decade though inflation remains below the central bank’s target. If wages increase at a faster pace, along with higher job additions, in the coming months, the probability of a rate hike should also rise.
Home prices increased in Canada during the first half, even after a correction in select cities at the end of the second quarter, as the positive economic trends and low borrowing costs continued to support the housing market. The government and the central bank have been trying to reduce the risk of a price bubble in the housing market, with tighter mortgage conditions and a higher tax on purchases by foreigners.
Brazil: Reform prospects diminish as political risks escalate
Renewed political uncertainties have once again clouded Brazil’s economic outlook, as the country is slowly recovering from a deep recession. New corruption allegations against the current president could potentially stall the expected reform measures. There appears to be no immediate threat to the government, unless the president decides to step down, but declining popularity could make it more difficult to gather political consensus on major reform measures, such as the pension system overhaul.
The IMF now expects the Brazilian economy to expand 0.2% this year, after two years of sharp declines in economic activity. Growth is expected to accelerate to 1.7% in 2018, when the country is due to elect the next government. The Brazilian government remains far more optimistic and expects growth of 2% this year, though an index tracking economic activity declined in May. Meanwhile, the government is planning reductions in fiscal spending even after recent tax hikes that are expected to increase revenues by $3.5 billion.
Substantially lower inflation levels are likely to allow Brazil’s central bank to reduce interest rates further. Consumer inflation dropped below 3% in July, the lowest level in nearly two decades. The central bank has reduced interest rates aggressively over the last year, and another 250 bps reduction is expected by the end of this year.
Mexico: Robust labor markets support domestic demand
Domestic demand continues to drive Mexico’s economic growth outlook even as external trade faces the uncertainties of the ongoing NAFTA negotiations. Retail sales have expanded at a healthy 4% so far this year, helped by the sustained fall in unemployment levels to just over 3% in March. Reforms implemented in 2012 have made the labor market more flexible and additional workers have shifted to the formal or organized sectors. Consumer credit demand has also been expanding at a fast pace, over 10% in May, further supporting domestic demand.
The economy is expected to grow 1.7% this year and 2% in 2018, according to the most recent forecasts from the IMF. The Mexican central bank increased its benchmark rate in June, but indicated that the rate is likely to be on hold for the rest of this year. The sharp currency decline during the second half of last year had forced the series of interest rate hikes, totaling 375 basis points. The Mexican Peso has recovered and is one of the top performing emerging market currencies so far this year. Inflation remains well above the central bank’s upper target of 4%, but is expected to moderate by the end of the year.
The Mexican government’s success in reducing public debt levels encouraged rating agency S&P to upgrade the country’s credit outlook to positive. Debt levels are expected to remain below 50% of GDP for the next two years, though weaker growth could add to the government’s fiscal challenges.
Chile: Subdued domestic demand restricts growth forecasts
Despite the recovery in the price of copper, Chile’s major export, the country’s economic growth outlook remains subdued. Domestic demand has been softer than expected as the moderate recovery in export revenues has yet to reflect in higher wages and investments. The Chilean government has lowered its growth forecast for the current year to 1.5%, from 2.25% earlier. The government expects higher average copper prices for the current year, but domestic spending by households and businesses is likely to moderate. Chile is due to elect a new president in November this year.
Inflation has cooled off appreciably this year, allowing the central bank to reduce benchmark rates. At its most recent meeting in July, the bank left the rate unchanged at 2.5% as expected. Inflation is expected to remain below the central bank’s 3% target, and could allow further rate cuts if growth slows again.
Rating agency S&P has downgraded Chile’s sovereign rating, citing weaker than expected growth trends. S&P anticipates economic growth of 2% and 2.4% in 2018 and 2019, respectively, as business confidence in the country remains weak.
Peru: Severe floods limits current year growth expectations
Floods and landslides that caused extensive damage in June may have reduced the pace of economic growth in Peru during the second quarter of the year. However, construction activity should expand strongly during the coming months on reconstruction efforts. This should allow the economy to expand at a faster pace of 3.5% during the second half of the year, according to the central bank. The bank expects growth to accelerate further to 4.2% in 2018.
Softer than expected economic trends during the first half of the year encouraged the central bank to reduce its benchmark rate by 25 basis points each in May and July. The central bank said the country needs more fiscal stimulus measures to revive credit demand, which expanded 3.3% in May from a year ago. Inflation has also been trending lower in recent months on muted domestic demand growth.
The government is delaying a proposed cut in value-added taxes, to prevent further decline in government revenues from slower economic growth. The tax rate will remain at the current 18% for the next few years, until government finances improve. The government is also planning to increase its fiscal deficit target to 3% this year, and 3.5% in 2018, to pay for the reconstruction projects.
Colombia: Weaker oil prices restrict growth outlook
Increased public investments following the implementation of a new peace deal with rebels could boost the Colombian economy during the second half of this year. However, the moderation in oil prices in recent months may limit government revenues and the expected gains in private investments. The economy expanded 1.1% during the first three months of this year, compared to 1.6% for the last quarter of 2016. Growth estimates by the IMF are 2.3% for the current year and 3% for 2018.
However, the Colombian central bank is less optimistic about growth and has lowered its benchmark rates recently. The central bank expects the economy to expand less than 2% this year, as the recently implemented tax reforms could restrict economic activity. Falling inflation levels, which declined to 4% in June from 4.4 the previous month, have also helped the central bank to reduce rates.
Meanwhile, the Colombian government is planning to reduce spending by more than $1.6 billion to lower the revenue deficit in 2018. Among the measures being planned are include a freeze on hiring of public employees and limited pay increases. As revenues from oil exports are expected to moderate, spending cuts are essential to maintain the health of government finances and retain the country’s credit rating.
Argentina: Economy recovering from recession
Argentina’s economy is gradually emerging out of recession and is expected to see healthy growth this year, helped by the fiscal policy reforms implemented by the government. During the first quarter of this year, growth was supported by 3% gains in investments and higher consumer spending. The IMF expects the country’s economy to expand 2.2% this year, compared to a decline of 2.3% in 2016.
The fiscal deficit during the first half of this year was 1.5% of GDP, a substantial improvement from recent years, and below the government’s target. The government’s efforts to reduce public spending appear to be succeeding while revenues were higher by over 30% during the first six months. Better fiscal discipline was among the factors that helped Argentina’s successful $2.75 billion issue of 100 year bonds recently.
The Argentinean government is now trying to increase the country’s energy production by encouraging higher investments in shale oil fields. The country has one of the largest shale energy deposits outside North America, and potentially offers a significant export revenue stream for the next few decades. However, high costs and lack of infrastructure has limited investments in developing the reserves. That could be changing as the success of U.S. shale oil producers, and their declining costs, have encouraged Argentinean producers to commit more nearly $3 billion in new investments over the next few years.
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