Latin America in a Global Context - Economic Briefing November 2006

Outlook for Latin America Improves Again

The outlook for the global economy remains positive for this year but is showing signs of a slowdown in 2007. While oil prices have declined amid abating tensions in the Middle East, the end of the housing boom in the United States could weaken private consumption, one of the key pillars of global consumption during the past years. In fact, the U.S. economy is slowing for the second consecutive quarter. However, consumer confidence is picking up again and could provide for a recovery of consumption in the months ahead. Meanwhile, the Japanese economy is on track to mark its longest expansion since the end of World War II and the economic outlook remains robust. Moreover, non-Japan Asia will continue to grow at a resilient rate, driven by the two leading economies of the region, China and India. Finally, prospects for Latin America improve again, as the region profits from a drawn out upward cycle in commodity prices.

U.S. economy grows less than expected on housing slump

According to advance estimates released on 27 October, gross domestic product (GDP) increased at an annual rate of 1.6% in the third quarter, which was below expectations, of 2.0% growth.  Moreover, the third quarter reading represents a significant slowdown from the resilient 5.6% growth registered in the first quarter and the already reduced 2.6% pace in the second quarter.  Unlike the slowdown observed in the second quarter, the third quarter deceleration was not broad-based.  In fact, key gauges of economic activity, namely private consumption and business investment, accelerated over the preceding quarter.  Private consumption picked up from the 2.6% expansion registered in the second quarter and expanded 3.1% annually in seasonally adjusted terms.  In particular, durable goods rebounded, as the 0.1% contraction of the second quarter gave way to a healthy 8.4% expansion in the third.  Simultaneously, non-residential fixed investment added 8.6% over the third quarter last year, almost double the pace registered in the second quarter.  The key reasons for the slowdown were the external and the housing sectors.  Exports accelerated a notch (Q2: +6.2% seasonally adjusted annual rate; Q3: +6.5% saar), however, imports jumped from a 1.4% expansion in the second quarter to 7.8% in the third, prompting a negative contribution from the external sector.  The recession in the housing market had an even stronger impact on third quarter growth.  Residential investment dropped a staggering 17.4% over the same quarter last year, well below the 11.1% contraction in the second quarter and shaving off more than a full percentage point from economic growth.  Hence, without considering housing, the economy would have expanded at a much more resilient 2.7% pace in the third quarter.   

Fed likely to keep interest rates stable as decline in housing dampens domestic demand

Given the pivotal role of residential construction in the third quarter GDP reading, the development of the housing market is likely to be the key determinant of the economy in the coming quarters.  While the third quarter slump probably constituted the bottom of the housing market, most observes consider that the sector is in for another double-digit contraction in the final quarter this year before contracting at a more moderate rhythm throughout next year.  The latest data support the notion of an ongoing decline in housing in the months ahead.  In September, U.S. home re-sales fell 14.2% over the same month last year and prices dropped 2.2% from the levels observed a year ago.  House prices declined for a second consecutive month, the first uninterrupted two-month drop since 1990.  If the downturn in the housing sector turns out to be more severe than currently anticipated, monetary authorities would probably have to ease policy to prevent a slump of the entire economy.  However, for the time being, the Fed is unlikely to loosen policy strains, as inflation remains persistently above the comfort zone.  Nevertheless, recent development in the housing market renders further interest rate increases unlikely and after an unbroken two-year stretch of raising interest rates, the Fed may now be entering a prolonged period where it keeps rates unchanged.  On 25 October, the Federal Open Market Committee decided to keep its target for the federal funds rate at 5.25%, leaving the rate unchanged for the third consecutive time.  The last time monetary authorities moved the rate was on 29 June 2006, concluding the tightening with the 17^th consecutive rate hike to the current level.  In principle, the Fed maintained its tightening bias but ceased describing energy prices as a source of inflation danger.  In addition, the statement claims that inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations and the cumulative effects of monetary policy actions.

Japan's economy to mark its longest expansion since the end of World War II

One month after Shinzo Abe took over the reins from Junichiro Koizumi as prime minister, the Japanese economy is on track to mark its longest expansion since the end of World War II.  The current expansion phase began in February 2002 and given the conditions in place, it is almost certain that the economic expansion cycle next month will surpass the 57-month-long Izanagi boom that lasted from November 1965 to July 1970.  Moreover, the economic outlook remains robust and the country seems well positioned to withstand external shocks, such as a slowdown in the United States that seems to be unfolding or a potential hard landing in China.  In its monthly report of recent economic and financial developments from 17 October, the Central Bank reiterated that the economy is expanding moderately while deflationary pressures are easing.  The Bank of Japan states that exports have continued to expand and business investment has continued to increase against the background of high corporate profits and favorable business sentiment.  Moreover, household income has continued rising, fuelling a pick up in private consumption.  Monetary authorities expect the underlying trends to remain intact and see both domestic and external demand to continue boosting production.  The latest data support the cautiously optimistic outlook of the Central Bank.  While industrial production in September declined 0.7% over the previous month on sagging production of cars and tools to produce semiconductors, the reading slightly exceeded market expectations of a 0.9% month-on-month decline.  Moreover, compared to September last year, industrial production added 5.1%.  However, consumer and business sentiment point in diverging directions.  While the Central Bank’s September Tankan report showed that profits and investments are likely to rise, the latest consumer confidence survey, uncovered yet another decline in confidence.  In the third quarter, the consumer confidence index dropped to 45.6 points from 46.2 points in the second quarter.  The reading marks the second consecutive decline after the index scored the highest level since 1991 in the first quarter.  However, notwithstanding the strong increase earlier this year, consumer confidence still marks the highest level in the past decade.  Consequently, Consensus Forecast panellists remain upbeat that the current recovery will continue and expect the economy to grow 2.6% this year, which is unchanged from last month’s forecast.  Moreover, the panel is optimistic that the recovery will continue into next year, with the economy expanding at a more moderate but still positive pace of 2.1%.  On the price front, the Central Bank expects the year-on-year change in consumer prices to continue to follow a positive trend.  Consensus Forecast panellists mainly share the Central Bank’s assessment and see inflation reaching 0.3% in 2006 and 0.5% in 2007.

Outlook for Asia improves amid growing optimism for China and India

Asian growth prospects continue to improve.  Following on eight upward revisions during the past nine months, Consensus Forecast panellists beefed up this year’s economic growth forecast for the region including Japan another 0.1 percentage points this month to 5.5%.  The regional average growth forecast for 2006 increased in spite of increasing risks that U.S. consumption, one of the key growth drivers in the export-dependent Asian economies, might slow in the months ahead.  In particular, a less dynamic U.S. housing sector causes concerns, as a diminished wealth level could prompt American consumers to act more cautiously.  This month, upward revisions to economic growth in five of the twelve economies surveyed are mitigated by only one downward revision (Korea) and unchanged outlooks in the remaining six countries.  Once more, China is the key reason for the more optimistic prospects for the entire region.  Since China accounts for almost one quarter of total regional output, any shift in the economic assessment has a notable impact. Consequently, even this month’s small 0.1 percentage point upward revision to the 2006 GDP forecast to 10.3% was more than sufficient to compensate for weaker projections for Korea.  However, in China, the government’s measures to slow the resilient economic expansion are beginning to show some effect and in the third quarter, GDP grew at a strong but less dynamic pace than in the second quarter.  Consensus Forecast panellists are also more upbeat about India and revised their projections from 7.8% last month to the current 8.0%, as better than expected economic growth data suggest a more vigorous growth this year.  Next to China and India, Indonesia, Singapore and Vietnam experienced notable upward revisions to their GDP forecast.  On the downside, Consensus Forecast panellists pared the outlook for Korea from 5.1% expected last month to 5.0%, as domestic demand is faltering.

Outlook for Latin America remains unchanged

The outlook for Latin American output growth this year remained unchanged over the past month, as upward revisions to five major economies were insufficient to compensate for a downward revision to two countries.  As a result, the Consensus Forecast for GDP growth in 2006 for Latin America remained at the 4.6% expected last month.  Thus, the Latin American region will experience yet another year of above average growth, following on last year’s 4.0% expansion.  In fact, apart from 2004, this year’s expansion would represent the highest rate since 1997.  This month, Argentina, Colombia, Mexico, Peru and Venezuela are seen more optimistically.  Argentina experienced a 0.5 percentage point upward revision to the 2006 GDP forecast.  Consensus Forecast panellists raised their forecast eleven times during the past twelve months, culminating in the current 8.2% forecast, which makes Argentina the fastest growing economy in the region.  Mexico, Latin America’s second largest economy, also experienced a 0.1 percentage point upward revision to the 2006 GDP forecast.  Consensus Forecast panellists continuously raised their forecast since April to the current 4.4% forecast, as the country’s manufacturing sector has profited from strengthening U.S. demand.  However, the Mexican economy is likely to loose dynamism in the months ahead, as the long anticipated slowdown in the United States is materializing.  Peru profits from strong commodity prices and reduced political uncertainty, as the incoming García administration shows little inclination to fundamentally change the course of economic policy.  As a result, Consensus Forecast panellists lifted last month’s 2006 growth projection by 0.4 percentage points to 6.4%.  Finally, even though oil prices dropped markedly in October, Venezuela’s oil sector continues to generate huge windfall profits that spread into the non-oil economy.  On the downside, panelists pared their outlook for Brazil and Chile.  In Brazil, economic data continue to surprise to the downside in spite of the ongoing monetary loosing that has reduced nominal interest rate to the lowest level in 20 years.  Panellists applied yet another 0.1 percentage point downward revision to the GDP growth forecast for this year to 3.2%.  Chile also experienced a 0.1 percentage point downward revision this month, following signs that the economy is loosing some of the momentum that has been fuelling the current business cycle.  Nevertheless, with 5.0% output growth expected for this year, Chile will experience yet another year of solid growth.