LatAm Macro Monthly - itau.com.br Policy Rate - eop - % 11,00 11,00 12,00 12,50 Monetary Policy Rate ... The European Central Bank (ECB) ... LatAm Macro Monthly – June 2014 since

LatAm Macro Monthly Scenario Review

June 2014

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.

Page Global Economy

Positive External Environment for Emerging Markets Continues 3

Interest rates in the U.S might remain low for longer and the ECB has eased policies again. Emerging markets benefit from this environment, but their weak growth might limit some of the gains.

Brazil

Consumers and Businesses Step on the Brakes: Activity Decelerates 7 The slowdown in demand is remarkable and we expect negative GDP growth in 2Q14, followed by a slight recovery in the second half. We expect economic growth of 1.0% in 2014 and 1.7% in 2015.

Mexico

An Unexpected Policy Rate Cut 14 The economy disappointed during 1Q14, but for the second quarter, available indicators suggest some improvement. The central bank took markets by surprise and reduced the policy rate in its June meeting.

Chile Private Consumption, Following in the Footsteps of Investment 17 Activity has been weak on many fronts. We have reduced our GDP growth forecast for 2014 to 2.8% (from 3.3%), while maintaining our 4.0% growth estimate for 2015.

Peru Private Demand Slows Further 20 Peru’s GDP growth slowed in 1Q14 as private domestic demand decelerated. Available indicators for 2Q14 also point to weaker activity. We reduced our GDP forecast for this year.

Colombia An Uncertain Presidential Election 23 Presidential run-off looms,momentum lies with Zuluaga. On the economy, growth remained robust in 1Q14, driven by the good performance of private consumption.

Argentina

Paris Is Well Worth a Mass 26 The agreement with the Paris Club marks an important step in normalizing the country’s financial relations with the international community and could open up access to international financing.

Commodities

Falling Prices for Agricultural Commodities and Metals 29

Favorable weather conditions dragged down prices for agricultural commodities. Iron ore prices continue to drop, given the outlook for larger supply from Australia and concerns involving the real estate sector in China.

Macro Research – Itaú

Ilan Goldfajn – Chief Economist Tel: +5511 3708-2696 – E-mail: [email protected]

http://bit.ly/Jun14_Video

Page 2

LatAm Macro Monthly – June 2014

Emerging Markets in Slow Motion

We have been warning that the favorable liquidity conditions for emerging economies would not be permanent. At some point, the global recovery will lead to a normalization of monetary policy, a process that could mean further volatility in financial markets. Over time, markets tend to stabilize as the beneficial impact of global growth on emerging economies compensates for less favorable financing conditions. The process, however, is inherently volatile.

We are now six months into 2014, and the process seems to have stabilized. The U.S. economy posted a weak first quarter and the Fed shows no hurry in normalizing monetary conditions beyond the tapering: U.S. treasury yields remain exceptionally low, and they are even dropping. For its part, the ECB assumed a more expansionary stance, reducing interest rates and adopting new measures to inject liquidity.

Is it possible that unusual policies in advanced economies (and low financing cost to emerging countries) are becoming more permanent? We do not believe so. Sooner or later, global liquidity will tighten again. We still forecast rising U.S. interest rates and more depreciated exchange rates for emerging economies in the future.

However, it is worth noting that the favorable effects of the current scenario seem to be wearing out. Commodity prices have reversed the upward trend seen in the first months of the year, and emerging market currencies are no longer appreciating, as growth disappoints.

In Latin America, we have reduced our GDP forecasts for Brazil, Chile, Mexico and Peru. In Mexico, the weak first quarter led to a drop in growth forecasts, and the central bank responded with an unexpected interest rate cut. Colombia alone continues to post good performance and has rising interest rates. The tight presidential race does not seem to be affecting the economy, as both candidates are market-friendly.

In Brazil, the dynamics of economic activity cause even more concern. The drop in business and consumer confidence in recent months is notable, raising doubts about the performance of consumption and investment in the second half. The central bank stopped raising interest rates, despite the fact that inflation remains close to the upper bound of the target range.

Good news in Argentina: the agreement with the Paris Club marks an important step towards the normalization of the country's financial relations with the international community. But the challenge of macroeconomic adjustment continues. Despite central bank's resistance, we continue to expect exchange-rate depreciation and rising interest rates this year.

While emerging economies advance at a sluggish pace, the coming month promises emotion and great drama as the globe turns its eyes to Brazil for football. We wish everyone good luck at the World Cup!

Hope you enjoy,

Ilan Goldfajn and Macro Team

Current Previous Current Previous Current Previous Current Previous

GDP - % 3,3 3,4 3,6 3,6 GDP - % 1,6 2,0 2,7 2,8


GDP - % 1,0 1,4 1,7 2,0 GDP - % 2,4 2,7 3,8 3,8

BRL / USD eop 2,45 2,45 2,55 2,55 MXN / USD eop 13,2 13,2 13,2 13,2

Monetary Policy Rate - eop - % 11,00 11,00 12,00 12,50 Monetary Policy Rate - eop - % 3,00 3,50 3,50 4,50

IPCA - % 6,5 6,5 6,5 6,5 CPI - % 3,7 3,7 3,2 3,2


GDP - % -2,0 -2,0 0,0 0,0 GDP - % 2,8 3,3 4,0 4,0

ARS / USD eop 10,0 10,0 13,0 13,0 CLP / USD eop 575 575 600 575

BADLAR - eop - % 35,0 35,0 30,0 30,0 Monetary Policy Rate - eop - % 3,50 3,50 3,50 4,00

CPI - % (Private Estimates) 37,0 37,0 27,0 27,0 CPI - % 3,6 3,6 2,9 2,9


GDP - % 4,5 4,5 4,5 4,5 GDP - % 5,0 5,3 5,9 5,9

COP / USD eop 1950 1950 2000 1980 PEN / USD eop 2,85 2,85 2,95 2,90

Monetary Policy Rate - eop - % 4,25 4,25 5,00 5,00 Monetary Policy Rate - eop - % 4,00 4,00 4,00 4,00

CPI - % 3,1 2,9 3,0 3,0 CPI - % 3,0 3,0 2,5 2,5

2015 2014 2015

Brazil

2014 2015 2014 2015

Mexico

Scenario Review

Latin America and Caribbean

2014 2015 2014 2015

Peru

Chile

Colombia

Argentina

2014 2015 2014 2015

World

2014

Page 3


Global Economy

Positive External Environment for Emerging Markets Continues

• After a weak start to the year, economic activity in major economies, particularly in the U.S., has improved in 2Q14.

• Meanwhile U.S. interest rates could remain low for longer. We have recently revised our 10-year Treasury forecast for

year-end 2014, to 2.90% from 3.45%.

• The ECB eased its policies again, increasing the perception of lower global interest rates for longer.

• Emerging-market assets benefit from this global environment, but weak growth performance could limit some of the gains.

Economic activity in most major economies is

improving. Admittedly, the U.S. economy was very

weak in 1Q14, but is now on track to post 3.8% growth

(seasonally-adjusted annual rate – saar) in 2Q14. The

recovery in the euro zone has been modest, but is

expected continue. Even the leading indicators in

China have shown a recent improvement. Only in

Japan do we see a temporary contraction due to a

VAT increase. The simple average growth rate for

these countries is likely to increase to 3.7% in 2Q14,

from 2.2% in 1Q14 (see graph).

Growth is accelerating

QoQ

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14

GDP Growth - G4 *

Forecast

*USA, Euro Zone, Japan, China Source: IMF, Itaú

Meanwhile interest rates in the U.S could remain

low for longer. Inflation rose, but remains moderate,

and the Central Bank’s rhetoric signals no rush to

increase rates. We recently changed our call on the

timeframe of the FOMC’s next hiking cycle, to 3Q15

from 2Q15. Moreover, we now expect the yield on the

10-year Treasury bond to reach 2.9% (vs. 3.45%

previously) by the end of 2014.

The European Central Bank (ECB) carried out

another round of easing. We believe that the ECB’s

actions (see details below) were necessary to

counterbalance the increasing risk of deflation.

Could the global environment get any better for

emerging markets? So far, so good. Of course some

future risks remain, such as the chance of an earlier

rise in U.S. interest rates and the downside risks to

activity in China, but they appear to be under control

for the time being.

The only (and major) caveat for emerging markets

is that their growth continues to disappoint. Some

countries experience domestic restrictions such as

high inflation and/or a necessary slowdown in fiscal,

credit or investment expansion after years of increase.

Structural reforms are, for the most part, absent. Weak

growth could limit the gains from the current global

environment.

Importantly, with little external pressure and a

slowdown in growth, policymakers in emerging

markets are beginning to increasingly focus on the

latter. In the past month, the central banks of Turkey

and Mexico surprised the markets with interest-rate

cuts triggered by signs of weak activity.

A Strong U.S. Economy and Low Interest

Rates

The U.S. economy was weaker than initially

expected at the beginning of 2014. The 1Q14 GDP

growth was revised 1.0% down (saar), from an initial

estimate of 0.1%. The revision was largely due to less

inventory accumulation. A sharp inventory correction

and harsh winter were clearly the main culprits behind

the slowdown in the first quarter.

Activity improved in 2Q14 and, according to our

models, GDP is on track to expand 3.8% (saar). The

May indicators have been slightly above consensus,

confirming the economy’s more solid footing. Non-farm

payrolls added another 217 thousand jobs and vehicle

sales reached 16.7 million (saar) – the highest level

Page 4


since 2006. Finally, the number of aggregate hours

worked has grown at a robust 4.2% annualized pace in

the last three months.

We continue to expect the economy to growth at a

3% pace in 2H14. The good performance of the

economic indicators in May underpin this positive

outlook.

Although comfortable with the outlook, we

reduced our 2014 GDP forecast, to 2.3% from 2.5%,

due to the negative 1Q14 surprise, but maintained

our 3.1% estimate for 2015.

Inflation has been firmer in the last two months,

but remains at fairly comfortable levels. The core

PCE deflator accelerated from 1.1% year over year in

February to 1.4% in April, but remains comfortably

below the Central Bank’s 2.0% inflation mandate.

Meanwhile, FOMC members hint that the hiking

cycle ought to begin in 2H15 or later. Although they

acknowledge that the decision depends on the inflation

evolution and labor-market conditions, the

communication suggests a later and slower hike pace

for Fed fund rates.

The disappointing 1Q14 growth, modest inflation

and Fed rhetoric have led us to postpone our

forecast of interest-rate increases in the U.S. We

have recently revised the start of the monetary policy

tightening cycle to 3Q14, from the second quarter of

2015. We still expect the FOMC to raise rates by 25

bps per meeting, outpacing the current market pricing

and itself, but the current Fed rhetoric is likely to

anchor rates for longer. We therefore reduced our 10-

year U.S Treasury yield forecast, to 2.9% in December

2014 (from 3.45%) and 3.5% in December 2015 (from

3.7%).

The ECB Carries out a New, Aggressive

Round of Easing to Counterbalance the

Increasing Risks of an Overly-prolonged

Period of Low Inflation.

The ECB lowered the interest rate on overnight

bank deposits to an unprecedented negative value

of 0.10% (from 0%) and reduced its main bank-

lending rate by 0.10%, to 0.15%.

Furthermore, the Central Bank will lend funds

(known as TLTRO – target long-term refinancing

operation) to banks for up to four years at a fixed

cost of 0.25%. Banks will be able to initially borrow up

to 7% of their outstanding loans to nonfinancial

corporations and households (excluding mortgages).

The combined initial entitlement totals approximately

EUR 400 billion (USD 550 billion). The actual

placement will depend on banks’ demand for ECB

funding. Banks will be able to place their orders in

September and December 2014. The TLTROs will

continue from March 2015 to June 2016 but will be

limited to the banks’ net lending performance. Note

that if banks do not increase their net lending to the

non-financial private sector (relative to specific

benchmarks), they will be required to pay back the

borrowed amount in September 2016. These

measures are intended to improve bank lending to the

private sector.

The ECB also ended the weekly sterilization of its

periphery sovereign-bond portfolio, which was

acquired during the euro crisis and is likely to imply the

immediate addition of around EUR 120 billion in

liquidity.

Finally, the Central Bank reinforced its forward

guidance of low interest rates It has done so by

extending its full allotment procedure, by which it

allows banks to borrow unlimited funds per one week,

to the end of 2016 from mid-2015. The ECB President

Mario Draghi has pointed out this extension and the

fixed rate until 2018 on the TLTRO suggests that

interest rates will remain low for long.

Will these actions work or should we expect

further easing?

To some extent, the measures are off to a good

start in terms of the impact on inflation

expectations. Implied long-term inflation expectations

rose from 1.45% at the beginning of May to 1.57%

(see chart). It remains to be seen, however, whether

this will translate into a broader rise in inflation

expectations.

Inflation expectations up after the ECB

%

1.25

1.3

1.35

1.4

1.45

1.5

1.55

1.6

1.65

1.7

1.75

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14

Long Term* Inflation Implied on Market Prices

* 3 Year inflation 2 years ahead calculated from swaps

Source: Bloomberg, Itaú

Page 5


Despite a disappointing 1Q14, we expect the

modest economic recovery to continue. The 1Q14

GDP figure was weaker than expected, at 0.2% qoq,

showing a slightly decline from the 0.3% reported in

4Q13. Although we see a slight growth improvement

going forward, the negative 1Q14 surprise led to a

downward revision of our forecasts for 2014 to 1.1%

(from 1.3%). Our forecast for 2015 remains unchanged

at 1.5%.

We expect this recovery to contribute to a

reduction in disinflationary pressures ahead and

avoid the need for further monetary policy easing

by the ECB.

But the risks are tilted toward further action.

Inflation has been persistently weaker than expected

and there is a lot of uncertainty about the actual

demand for the TLTRO. The ECB has already signaled

that it could carry out asset-backed securities

purchases, which might reach sovereign bonds if

inflation continues to fall. We believe that, if necessary,

a new easing cycle could occur in December or early

2015.

China – Signs of Improvement in 2Q14;

Downside Risks from the Property Sector

Manufacturing PMI rose to 50.8 in May (from 50.4

in April), mainly driven by new domestic orders.

The improvement in domestic demand suggests that

the small, targeted measures are beginning to add up

and helping to stabilize the economy, thereby

offsetting the drag caused by the weakness in the

Property sector.

The risks, however, remain tilted toward the

downside, with the spotlight now on the Property

sector. Several indicators show weakness in the

sector during the first four months of the year and

extending into May. An additional slowdown in housing

might take China’s GDP growth to below 7.0% this

year.

The challenge continues to be balancing short-

and medium-term growth. The government is, in our

view, seeking to stabilize growth and advance reforms.

This is a fine balance, given that some of the reforms,

such as pushing for some deleveraging, will harm

short-term growth. Despite the risks, we believe that

the combination of targeted stimuli (not a repeat of the

broad measures of the past) and an emphasis on

reforms improves the medium-term outlook.

With the recent gain in the country’s PMIs, we are

confident that activity is stabilizing. We maintain

our GDP forecast at 7.2% for 2014 and 7.0% for

2015.

Japan – With better activity, the BoJ is

unlikely to increase its (already-

aggressive) easing policies.

Japan’s GDP grew 5.9% (qoq, saar) in 1Q14,

significantly above consensus. Private investment

rose an impressive 20.1%, notably above expectation.

Moreover, current economic indicators suggest a

modest decline in activity due to a VAT increase in

April, from 5% to 8%, but in line with expectations.

We revised our 2014 GDP growth forecast up to

1.7%, from 1.1%.

Given the improvements in activity and inflation,

which are so far in line with the BoJ’s forecasts,

we no longer expect further monetary easing (we

previously expected an announcement in October).

Emerging Markets – Favorable External

Liquidity Conditions Amid Weak Growth

External liquidity conditions remain supportive for

emerging markets assets. Interest rates in major

developed countries remain low, with little pressure to

rise, but we believe that the situation will change at

some point. For now, however, the environment

supports financial inflows to emerging economies.

Notwithstanding the supportive environment,

growth in developing economies continues to

disappoint. In Latin America, we have reduced our

GDP forecasts for Brazil, Chile, Mexico and Peru.

Importantly, the weak growth performance could

limit some of the gains from the favorable global

environment. For example, following the strong

appreciation trend until April, several emerging-market

currencies have remained mostly flat or even

depreciated (see graph).

Smaller gains in EM exchange rates Exchange rates of selected emerging markets. Index (Jan/14=100, + = appreciation)

92

94

96

98

100

102

104

106

108

110


BrazilMexicoTurkeyIndonesia

Smaller gains for EM exchange rates

Source: Bloomberg, Itaú

Page 6


Commodities - Falling Prices for

Agricultural Commodities and Metals

The Itaú Commodity Index (ICI) has fallen 3.7%

since the end of April, driven by lower agricultural,

iron ore and natural gas prices. Favorable weather

conditions, particularly in the U.S., have improved the

supply prospects for corn, wheat, soybean and cotton,

leading the ICI-Agricultural index to fall 10.0% in the

period. Easing concerns surrounding Ukraine are

somewhat responsible for the drop in grain and natural

gas prices.

The ICI-energy sub-index rose 0.6%. apart from

lower natural gas prices, there was no clear driver for

other energy-related commodities. Brent and WTI

crude prices rose 1.5% and 4.5%, respectively, with no

relevant changes in fundamentals. We continue to

expect the Brent price to drop to USD 105/bbl by year-

end (from 108.5 in early June) as a result of the better

expected supply in Iran, Iraq and Libya going forward.

We forecast a WTI price of USD 101/bbl, close to the

current levels.

Iron ore extended the losses in May, leading the

ICI-metals sub-index to fall 3.7%. The slowdown at

the beginning of the year, tighter regulation, and now

concerns about the Real Estate sector in China

continue to weigh on the sector. Moreover, the

stronger supply from Australia also encouraged prices

to drop below USD 95/t. We believe there is some

undershooting at play, as the current prices are below

some producers’ operational costs. However, the

supply-demand balance suggests that these

procedures are still necessary in order to reach

equilibrium. We therefore maintain our year-end

forecast at USD 101/t (6% above the current levels).

Improved supply conditions dampen agricultural

prices. Our index has fallen 10.0% since the end of

April, partially reversing the year-to-date gains. All of

the main commodities we track registered declines:

corn (-12.3%), wheat (-14.1%), soybeans (-4.8%),

cotton (-10.2%), coffee (-18.6%) and sugar (-1.5%).

The first four were affected by better supply prospects,

particularly in the U.S., while the last two oscillated

amid uncertainties regarding the fundamentals, given

that estimates range from a small surplus to a sizable

deficit.

Our year-end ICI forecasts remain unchanged at -

1.4% for 2014 and 1.6% for 2015, but not without a

couple of downside risks: i) iron ore prices could

reach equilibrium below USD 95/t and ii) above-

average weather conditions ahead could lead to

further declines in agricultural prices.

Forecasts: World Economy

GDP Growth

World GDP growth - % -0.4 5.2 3.9 3.2 3.0 3.3 3.6

USA - % -2.8 2.5 1.8 2.8 1.9 2.3 3.1

Euro Area - % -4.3 2.0 1.5 -0.6 -0.4 1.1 1.5

Japan - % -5.5 4.7 -0.4 1.4 1.6 1.7 1.3

China - % 9.2 10.4 9.3 7.8 7.7 7.2 7.0

Interest rates and currencies

Fed Funds - % 0.1 0.2 0.1 0.2 0.1 0.1 1.3

USD/EUR - eop 1.43 1.34 1.30 1.32 1.37 1.35 1.35

YEN/USD - eop 92.1 81.5 77.6 86.3 103.6 110.0 110.0

DXY Index* - eop 76.8 80.0 79.6 79.8 80.3 81.7 81.7

2015F2013 2014F2009 2010 2011 2012

Source: Central Banks, IMF, Haver and Itaú. * 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.


Page 7

Brazil

Consumers and Businesses Step on the Brakes: Activity

Decelerates

• In the light of the release of 1Q14 GDP numbers and the economic slowdown in April and May, we reduced our GDP

growth forecast for 2014 to 1.0%. The demand deceleration has been notable, and we expect negative GDP growth in

2Q14, followed by a slight recovery in the second half. We expect economic growth of 1.0% in 2014 and 1.7% in 2015.

• We forecast an exchange rate of 2.45 reais per U.S. dollar by year-end, pressured by a weaker-than-expected trade

balance (our call is USD 1.5 billion), election-related uncertainties and our scenario of a moderate rise in U.S. interest rates.

We see the exchange rate at 2.55 reais per dollar by the end of 2015. In the short term, we expect the exchange rate to

remain within a range that is consistent with the monetary authority’s comfort zone – as implied by the announcement of the

future renewal of the FX swap program.

• We reduced our forecast for the IGP-M general price index, to 6.0% from 6.8%, but maintain our estimate for the IPCA

consumer price index at 6.5%. Our forecast for 2015 stands at 6.5%, with sharper increases in regulated prices and some

deceleration in market-set prices.

• In this low-growth scenario, it will be difficult for the fiscal policy to achieve the primary budget surplus target of 1.9%. We

maintain our primary surplus estimates of 1.3% for 2014 and 1.7% for 2015.

• The Central Bank’s Monetary Policy Committee (COPOM) kept the benchmark interest rate at 11%, but the meeting’s

minutes indicate that concerns are equally balanced between inflation being uncomfortably close to the upper limit of the

target range and the declining economic growth rate. We see the SELIC rate at 11% by the end of this year and 12% in

2015.

• Polls show a drop in the government’s approval ratings and a narrowing of the gap between President Dilma Rousseff and

the other candidates.

Outlining a Lower-Growth Scenario

We revised our GDP forecast for 2014 to 1.0%. The

1Q14 GDP outturn and coincident indicators for April

and May suggest a slowdown in domestic demand,

and we expect negative growth in 2Q14. Depending on

the intensity of this contraction, growth in 1Q14 could

be revised downward to a negative reading as the

seasonal adjustment to that series is updated. In that

case, there would be two consecutive quarters with

negative GDP growth. However, we expect a

moderate economic recovery in 2H14 that will drive

growth to 1.0% in 2014.

The 1Q14 GDP report showed a deceleration in

domestic demand. Economic activity slowed in 1Q14,

with GDP growing 0.2% qoq/sa (1.9% yoy). The

deceleration reached investment, household and

government spending, with the first two actually falling

in the period. (For further details, please refer to the

link). The 1Q14 GDP outturn and the revision of the

2013 GDP figure triggered a deterioration in the

statistical carryover for 2014.

According to the available 2Q14 data, there was a

retreat in industrial activity and a moderation in

retail sales. Industrial activity declined and retail

growth has been moderate. Industrial production fell

0.3% mom/sa in April, showing a sharper decrease in

sectors in which demand is more dependent on

business/consumer confidence and credit availability,

such as capital and durable consumer goods. The

positive highlight was semi-durable and non-durable

consumer goods production, which rose 0.4%. Serasa

Experian’s retail activity index showed a growth

deceleration in May. The same occurred with vehicle

sales, according to FENABRAVE, the auto dealers

association.

Business confidence indices fell to exceedingly

low levels. There was a decline in business

confidence in the four largest economic-activity sectors

in both April and May. Moreover, these indices remain

low, indicating a cool-down in activity in the coming

months. We believe, however, that part of the retreat is

temporary due to the expectation of cuts in working

days during the Soccer World Cup event.

We see negative GDP growth in 2Q14. The statistical

carryover from 1Q14 and coincident indicators for April

and May suggest a 2Q14 retreat in GDP (-0.2%

qoq/sa). Given the revision in seasonal adjustment,

growth in 1Q14 could be negative, thus setting the

http://cdn.itaubba-economia.com/download/20140530_MACRO_BRAZIL_GPD1Q14.pdf


Page 8

stage for a technical recession. However, we expect

the economy to stabilize in 2H14, expanding by 0.5%

in 3Q14 and 0.4% in 4Q14.

Confidence in low levels index, sa Jul/10=100

60

65

70

75

80

85

90

95

100

105

110

May-08 May-09 May-10 May-11 May-12 May-13 May-14

ConstructionIndustryServicesRetail

Source: FGV, Itaú

We revised our growth forecast for 2015 to 1.7%.

Low growth in 2014 will provide a statistical carryover

that is likely to be less favorable than we anticipated

(our previous forecast for 2015 was 2.0%). We expect

a moderate recovery, fueled by an improvement in

domestic demand as election-related uncertainties are

resolved and business and consumer confidence

levels stabilize.

Industrial Production fall in April Industrial production index, as 2012=100

80

84

88

92

96

100

104

108

Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13 Apr-14

Level3mma

Source: IBGE, Itaú

Despite the slowdown in economic activity,

unemployment remains low. The unemployment rate

stood at 4.9% (seasonally-adjusted) in April (vs. 4.8%

in March), missing both our and market estimates. The

recent decoupling of unemployment and economic

growth has been partly due to successive year-over-

year drops in labor force. We understand that the

retreat is largely driven by young people who have left

the labor market to return to school (please see our

report titled “Macro Vision – Unemployment, Declining

Participation Rate and FIES”).

Looking ahead, we forecast a moderate rise in

unemployment. While our forecast is based on the

slowing economy, we also believe that the recent

dynamics of the declining labor force will eventually be

exhausted. We expect the seasonally-adjusted

unemployment rate to be at 5.3% by year-end and

5.6% by the end of 2015.

Dependence on thermal power plants and rationing

risks persist. The rainfall levels in key regions for

hydropower generation and storage were below

average in May, but have been in line with the

historical average since February 15. Power usage is

showing some signs of cooling down, possibly due to

the still-high prices in the free market. Reservoir levels

started to recede in May, following the seasonal

patterns, and should continue to drop slowly until

November. In a nutshell, recent developments

reinforce a scenario of intense thermal-power-plant

usage and a continued risk of rationing going forward.

Although precipitation levels that surpass the seasonal

average during the dry season (until October) provide

relief, they are not a definitive solution.

QoQ S.A.

2014 Q1

Old Series New Series New Series

GDP 2.3 2.5 0.2

Demand

Household Expenditure 2.3 2.6 -0.1

Government Expenditure 1.9 2.0 0.7

Investment 6.3 5.2 -2.1

Exports 2.5 2.5 -3.3

Imports 8.4 8.3 1.4

Supply

Agriculture 7.0 7.3 3.6

Industry 1.3 1.7 -0.8

Services 2.0 2.2 0.4

%Annual change 2013

Source: IBGE, Itaú

Poor credit performance in April. The daily average

of non-earmarked loans fell 2.5% mom/sa, in real

terms. Moreover, the expansion pace of the credit

stock has slowed. The year-over-year real growth in

total outstanding loans slid to 6.7% in April, from 7.1%

in March. The deceleration in lending was widespread,

reaching both earmarked credit (which slipped to


Page 9

15.9% from 16.6%) and non-earmarked loans (down to

0.0% from 0.3%), as well as credit granted by state-

owned banks (down to 13.3% from 14.2%) and private

banks (down to 0.3% from 0.4%). Overall delinquency

remained at 3% for a fifth consecutive month. The

average interest rate was also unchanged, at 21.1%.

While Exports Huff and Puff, the Current

Account Deficit Stands Firm

We revised our 2014 trade-balance forecast

downward. We expect the falling prices for exported

commodities and resilient imports (which continue to

advance despite the economic activity deceleration(

partly due to the fact that fuel prices are being held

back) to have a negative impact on the Brazilian trade

balance this year. We therefore revised our trade-

balance estimate for 2014 to USD 1.5 billion, from

USD 3 billion. A smaller trade balance widens the

current account gap, which is likely to end 2014 at

USD 82 billion (vs. USD 80 billion previously). For

2015, we maintain our expectation of a USD 16 billion

trade surplus.

Current account deficit likely to remain stable in

2014 USD Billions

-100

-80

-60

-40

-20

0

20

40

2009 2011 2013 2015(E)

IncomeTrade balanceServicesCurrent unilateral transfersCurrent account deficit

Source: BCB, Itaú

The current account deficit widened to USD 8.3

billion in April. Profit and dividend remittances were a

positive surprise, in what seems to be a one-off event

related to the recent exchange-rate appreciation. From

a financing standpoint, foreign direct investment (FDI)

remains robust, totaling USD 5.2 billion in the month.

The FDI inflows stand at USD 19.4 billion year to date,

2.3% higher than in the previous year. We revised our

FDI forecasts to USD 60 billion in 2014 (vs. USD 51

billion previously) and USD 57 billion in 2015 (vs. USD

49 billion previously).

The exchange rate has been fluctuating within the

2.20-2.30 range, which seems to be a comfort-zone

for monetary authorities. A weaker level would

increase the risk of breaching the upper-limit of the

inflation target’s margin of error, while a stronger level,

albeit positive for the inflation target, is perceived as

costly to exporters and those holding dollar-

denominated assets (such as the Central Bank itself).

The FX intervention program via swap contracts

will be extended beyond June. As the end of June

approaches, doubts regarding the continuity or

interruption of the Central Bank’s daily intervention

program in the foreign exchange market put pressure

on the Brazilian real last week. Facing this movement,

the monetary authority increased the rollover lot for

contracts expiring in July, to 10,000 daily contracts,

even after announcing the rollover of only 5,000 daily

contracts in the first day of June. Moreover, the

government reduced the IOF tax charges on foreign

borrowing to 180 days, from 360 days. This set of

measures signals that the government is

uncomfortable with a weaker exchange rate because a

weaker real makes the battle against inflationary

pressures more difficult in the short-term. Thus the

government will reach into its toolbox to maintain the

exchange rate stable.

Our year-end exchange-rate forecasts are at 2.45

reais per dollar for 2014 and 2.55 for 2015. We

regard the 2.25 vicinity as temporary, although it may

last a little longer. The recent deterioration in external

accounts, our expectation of a moderate increase in

U.S. yields (2.90% for the 10-year Treasury by year-

end) and electoral-related uncertainties in the second

half of the year are likely to weigh on the real, which is

set to weaken again during the year.

We Reduced Our 2014 IGP-M Forecast, but

Expect the IPCA to Advance 6.5%

The IPCA slowed in May, but topped market

estimates. The IPCA consumer price index rose

0.46% in May, beating our forecast (0.40%) and

median market expectations (0.38%). The inflation

slowdown from April (0.67%) was driven by smaller

changes in the food and transportation groups; the

year-over-year change in the IPCA advanced to 6.37%

in May, from 6.28% in April. Our preliminary forecast

for June indicates a 0.30% gain in the IPCA, with

expected declines in food consumed at home and fuel

costs.


Page 10

Inflation: IPCA versus IGP-M YoY

6.5%

6.0%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14

Forecast

IPCAIGP-MIPCAIGP-M

Source: IBGE, FGV, Itaú

We maintain our full-year IPCA forecast at 6.5%,

despite a slight reduction in our regulated price

estimate (to 5.4% from 5.6%) after incorporating tariff

reductions for landline phones (basic subscription with

Telefônica) and water and sewage (related to

discounts granted by Sabesp to consumers who cut

their water usage). We maintain our estimate for

market-set prices at 6.8%. An exchange rate that

remains at the current levels for a longer period of time

may help ease inflation throughout the second half of

the year.

We also maintained our 2015 IPCA forecast, at

6.5%, but the balance of risks may be a little more

favorable. We expect increases of 7.3% for regulated

prices and 6.3% for market-set prices. In our scenario

for regulated-prices, we include material price

increases in important sub-items such as electricity

tariffs (15%), water and sewage tariffs (12%), urban

bus fares (10%) and gasoline (6%), but the correction

of some of these prices may be more gradual. For

market-set prices, the slowdown relative to 2014 is due

to smaller increases in food and service prices. This

scenario assumes no new supply shocks in the

Agriculture sector and a slight slowdown in the labor

market, which would help reduce the upward pressure

on service costs. In a broader context, the weaker

economic activity may translate into a slightly more

favorable balance of risks for inflation on market-set

prices later this year and early next year.

The IGP-M general price index decreased 0.13% in

May. The IPA producer price index fell 0.65%, after

rising 0.8% in April, with agricultural prices dropping

0.7% (vs. +2.0% in April) and industrial prices sliding

0.6% (+0.3% in April). Iron ore prices fell 6.1%,

marking the largest downward contribution to the

general index (-0.22 pp). IGP-M inflation dropped to

7.8% year over year. According to the current data, the

IGP-M is also likely to remain subdued in June,

probably with another monthly deflation as the year-

over-year change sustains the recent downtrend.

We reduced our full-year IGP-M forecast to 6.0%

from 6.8%, due to a revision of our agricultural

items and iron ore forecasts. The IPA-M producer

price index, which carries the greatest weight in the

IGP-M, is expected to gain 5.6% this year, driven by a

4.6% increase in industrial prices and 8.2% increase in

agriculture goods prices. In the Mining Sectors, iron

ore prices are expected to post a substantial negative

contribution, due to an estimated 25% decline that is

likely to reverse most of last year’s 34.6% gain. For the

other index components, we anticipate a 6.5%

increase in the IPC-M consumer price index and a

7.5% gain in the INCC-M construction cost index.

Fiscal Balance: Postponement of

Expenditures Influences Short-Term

Result

The public sector’s consolidated primary fiscal

budget surplus reached BRL 16.9 billion in April, or

4.0% of the monthly GDP. The result is higher than in

April 2013 (2.6% of GDP) but below the average of the

post-Lehman period (4.7% of GDP). April is usually a

positive fiscal month, mainly due to income tax

payments. The primary surplus from January to April

stands at 2.6% of GDP, compared with 2.7% of GDP in

2013 and a 3.6% average for the post-Lehman period.

The year over year growth in the six-month moving

average real federal spending slowed to 3.8% in

April, from 7.3% in March. Although these numbers

seem to indicate an adjustment in expenditures, we

note that the slowdown was largely due to the

postponement of mandatory expenses to the end of

this year. Indeed, payroll expenses decreased 13.2%

year over year and social security disbursements fell

10.6% year over year. These lines were affected by

the government's decision to defer the payment of

precatórios bonds, which usually occur in April, to the

end of the year. We therefore expect these lines to

rebound at the end of 2014. Moreover, for the first time

this year, there were no transfers to the energy

development account (CDE). Transfers to the CDE

averaged BRL 900 million per month in 1Q14 and the

government’s budget includes BRL 13 billion in

payments to the CDE, which implies an average of

almost BRL 1.1 billion per month.


Page 11

Non-tax Revenues Remain High Collection of Dividends Jan-Apr (BRL bn)

3.8

7.2

5.45.0

1.0

8.2

0

1

2

3

4

5

6

7

8

9

2009 2010 2011 2012 2013 2014

Source: National Treasury, Itaú

Discretionary spending (such as investment

spending and government cost) also slowed, but at

a milder pace. The year over year growth in the six-

month moving real investment expenditure slid to 8.1%

in May, from 12.4% in April. In the same metric,

government cost growth dropped to 7.2% from 12.2%.

Although the growth rates remain high, these lines

have the greatest short-term flexibility for adjustments.

For the next few months (May to December), we

forecast a 4.4% year-over-year real growth in total

spending, which would imply a growth rate of 3.9% for

2014.

Non-tax revenue (especially dividends) remains

high, while tax revenue is growing in line with

GDP. Dividends from state-owned enterprises totaled

BRL 2.3 billion in April. Year to date, dividends total

BRL 8.2 billion, versus BRL 1.0 billion in the same

period of 2013.

As a result, the gap between the conventional and

recurring primary surpluses remains wide and the

fiscal stance remains expansionary. In the last 12

months through April, the public sector’s conventional

(non-adjusted) primary balance reached 1.9% of GDP

(vs. 1.7% in March). The recurring primary surplus

(excluding atypical revenues and expenses) rose to

0.8% of GDP (vs. 0.6% in March). According to our

calculations, the primary surplus needed to stabilize

the public debt in the long run stands at 2.0%-2.5% of

GDP. Hence, a recurring surplus below this level

reflects a still-expansive fiscal policy.

Our 2014 primary-surplus estimate remains at 1.3%

of GDP (below the target of 1.9% of GDP). A

slowdown in discretionary spending is required in order

to come closer to reaching the primary surplus target

this year, particularly given the weak economic activity

and the consequent impact on tax revenue. Given the

slowdown in tax collection, efforts are being made to

increase non-tax revenue, which include the reopening

of the Refis fiscal amnesty program. This reinforces

our view that the recurring primary fiscal surplus will

remain below 1% of GDP this year (our forecast is

0.7% of GDP by year-end). The conventional primary

surplus should continue to hover at around 1.7%-1.8%

of GDP until the last two months of the year. By year-

end, we expect a drop in the 12-month cumulative

primary surplus to 1.3% of GDP, due to a tough

comparison base – a large primary surplus at the end

of 2013 caused by extraordinary revenue.

Primary Fiscal Surplus to Decline by Year-end

% PIB Public Sector Primary Fiscal Surplus

(acm. 12 months)

Source: Central Bank, Itaú

For the coming years, we anticipate a fiscal

adjustment particularly driven by an increased tax

burden (i.e., reversal of tax breaks and increases in

other taxes). We see the conventional primary surplus

rising gradually to 2.0% of GDP in 2016, from 1.3% in

2014. According to our calculations, this implies an

increase in the structural primary balance, to 1.8% of

GDP in 2016 from 0.5% in 2014 (i.e., zero momentum

this year). The average fiscal contraction in 2015-16

would be 0.6% of GDP. A less-favorable economic

cycle requires a greater fiscal effort to boost the

conventional primary surplus, increasing the downside

risk to our fiscal forecasts for 2015-16.


Page 12

Brazil: The End of the Rate Hikes, at This

Moment

The Monetary Policy Committee (COPOM)

maintained the SELIC benchmark interest rate at

11.00% pa at the May meeting. The decision was

unanimous and in line with our call and most market

estimates. The post-meeting statement included the

phrase “at this moment”, leaving the door open for

future monetary policy actions.

In the meeting’s minutes, the COPOM expressed

heightened concerns about the drop in economic

growth and greater ease with the stability of the

exchange rate. The minutes offered insight into the

elements that supported the decision to interrupt the

hiking cycle. The COPOM argued that growth is likely

to be “less intense” this year than in 2013, and did not

include the paragraph that cited currency depreciation

and volatility as a source of short-term inflationary

pressure in the minutes for the April meeting.

We expect stable interest rates until year-end. The

COPOM will probably wait to assess the effects of the

monetary policy adjustments implemented through

April. The Central Bank continued to indicate that

some of the effects of monetary policy on inflation

“have yet to materialize” and that such effects “tend to

be leveraged” in light of the low confidence levels.

Still, the COPOM acknowledges the importance of

remaining vigilant. There are specific concerns about

the secondary effects of two relative price changes:

the realignment of regulated and market-set prices

(driven by the need to adjust gasoline, electricity tariffs

and transportation fares) and international and

domestic prices (due to a weaker exchange rate).

We maintain our year-end SELIC rate forecast at

11.0%, and revised our projection for 2015 to

12.00% from 12.50%. The COPOM’s May decision

and the minutes that followed reinforce our call of a

stable SELIC rate until the end of 2014. In 2015, we

continue to expect the COPOM to create a new

tightening cycle to ensure stable inflation. However,

weakening activity has led us to reduce the size of the

cycle expected for next year. We revised our SELIC

rate forecast to 12.00%, from 12.50% pa, by the end of

2015.

Falling Approval Ratings and Worsening

Perceptions About the Economy Make for

a More Competitive Electoral Race

An Ibope poll ahead of the presidential elections

showed a drop in voting intentions for President

Rousseff. The President’s voting intentions dropped to

38% from 40%, while Aecio Neves rose to 22% (from

20%) and Eduardo Campos to 13% (from 11%). The

sum of the other candidates rose to 7% (from 5%) and

the percentage of blank/null/undecided fell to 20%

(from 24%). Since Dilma has less votes than all the

other candidates combined, the election, if held today,

would go to a runoff.

In runoff simulations, the gap between Rousseff

and her main opponents shrank. In the simulation

between the President and Neves, the difference

narrowed to 9 pp from 19 pp; against Campos, the gap

narrowed to 11 pp from 20 pp.

The approval ratings for the administration and

confidence in the economy decreased. Approval for

the Rousseff administration (share of participants who

regard her administration as "excellent/good") fell to

31% from 35%, the lowest reading since the wave of

popular protests last June. A poll by Datafolha shows

that perceptions about the economy deteriorated. The

share of people expecting higher unemployment rose

to 48%, from 42%, while 64% of the participants

expect higher inflation, from 58% previously.

Party conventions scheduled for June. From June

10 to 30, political parties will gather to formally decide

on their candidates and party alliances. The TV air

time granted to each party alliance, starting in August,

will be allotted according to the number of seats held

by the alliance parties in the House of

Representatives. The next step is the formal

registration of the candidates and alliances in the

Supreme Electoral Court until July 5, when the official

campaign season kicks off.

Page 13


Forecasts: Brazil

Economic Activity

Real GDP growth - % -0,3 7,5 2,7 1,0 2,5 1,0 1,7

Nominal GDP - BRL bn 3.239 3.770 4.143 4.392 4.845 5.201 5.639

Nominal GDP - USD bn 1.620 2.142 2.473 2.247 2.243 2.229 2.252

Population (millions) 193,5 195,5 197,4 199,2 201,0 202,8 203,8

Per Capita GDP - USD 8.371 10.956 12.529 11.277 11.157 10.992 11.050

Unemployment Rate - year avg 8,1 6,7 6,0 5,5 5,4 4,9 5,5

Inflation

IPCA - % 4,3 5,9 6,5 5,8 5,9 6,5 6,5

IGP–M - % -1,7 11,3 5,1 7,8 5,5 6,0 6,0

Interest Rate

Selic - eop - % 8,75 10,75 11,00 7,25 10,00 11,00 12,00

Balance of Payments

BRL / USD - Dec 1,75 1,69 1,84 2,08 2,36 2,45 2,55

Trade Balance - USD bn 25,3 20,1 29,8 19,4 2,6 1,5 16,0

Current Account - % GDP -1,5 -2,2 -2,1 -2,4 -3,6 -3,7 -2,9

Foreign Direct Investment - % GDP 1,6 2,3 2,7 2,9 2,9 2,7 2,5

International Reserves - USD bn 239 289 352 379 376 370 374

Public Finances

Primary Balance - % GDP 2,0 2,7 3,1 2,4 1,9 1,3 1,7

Nominal Balance - % GDP -3,3 -3,3 -2,6 -2,5 -3,3 -4,8 -4,7

Net Public Debt - % GDP 42,1 39,1 36,4 35,3 33,6 35,5 36,9

2015F2009 2010 2011 2012 2013 2014F

Source: FMI, IBGE, BCB, Haver and Itaú.

Page 14


Mexico

An Unexpected Policy Rate Cut

• Mexico’s economy disappointed during 1Q14, but for the second quarter, available indicators related to manufacturing

suggest improved economic activity. We see growth at 2.4% this year and at 3.8% in 2015.

• Inflation remained within the target range in May and core inflation is once again at the target center. We expect inflation to

end this year at 3.7% and at 3.2% in 2015.

• Mexico’s central bank took markets by surprise and reduced the policy rate by 50 bps in its June meeting. In our baseline

scenario, the next policy rate move will be a hike and it will come through 4Q15. However, if the economy fails to rebound,

additional rate cuts are possible.

• In spite of lower domestic interest rates and future increase in the U.S. treasury yields, we forecast only a small

depreciation of the peso. Larger capital flows associated with the reform agenda will likely curb the weakening of the

currency. We see the peso at 13.2 to the dollar both by the end of this year and by the end of 2015.

• The secondary laws of the energy and telecommunication reforms will likely be debated and voted in Congress this month.

A Weak First Quarter

Mexico’s economy disappointed during 1Q14. The

IGAE (monthly proxy for Mexico’s GDP) increased by

3.0% year over year in March, surprising market

expectations on the downside. Calendar effects were

very favorable, so the working-day-adjusted IGAE

expanded by a weak 0.5% year over year. As a result,

GDP increased by 1.8% year over year in 1Q14, while

the working-day-adjusted series expanded by only

0.6%.

A disappointing start of the year and increased

hopes for 2Q QoQ, saar QoQ, saar

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-2%

-1%

0%

1%

2%

3%

4%

5%

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14

IGAEManufacturing Exports (RHS)

Source: INEGI, Itaú

Indicators available for 2Q14 related to

manufacturing activity are rebounding.

Manufacturing exports increased by 2.1% from March

to April, lifting quarter-over-quarter growth to a strong

17.4% (annualized). Meanwhile, the Manufacturing

PMI (produced by IMEF) and most of its

subcomponents improved from April to May, and the

ISM-Manufacturing PMI of the U.S. remains at a level

consistent with strong growth.

After the release of the 1Q14 GDP, we reduced our

growth forecast to 2.4% (from 2.7%). We note that

this growth rate implies an annualized quarter-over-

quarter growth pace of 4.5% from the 2Q14 to 4Q14.

In fact, Mexico’s economy during 1Q14 was likely hurt

by the transitory contraction in the U.S. economy in the

same period and the introduction of tax hikes, so a

rebound is likely. The manufacturing data mentioned

above is consistent with this view. For 2015, our 3.8%

growth forecast is unchanged.

Inflation Remains Tame

Mexico’s inflation remained within the target range

in May and core inflation fell to the target center.

Headline inflation stood at 3.5%. Core inflation fell to

3.0%, from 3.1% in April. Inflation for core services

declined to 2.9% from 3.2%. Finally, inflation for non-

core items increased to 5.2% (from 4.7%), as the

volatile prices for non-processed food were up by 0.7%

(-1.1% previously), offsetting the decrease in inflation

for regulated items (8.1% vs. 8.5% in April).

We expect inflation to end this year at 3.7%. Low

global inflation, a stable exchange rate and a negative

output gap are all contributing to the comfortable

inflation readings in Mexico. For 2015, we see inflation

evolving close to the target center, as the impact of tax

hikes fades. Our year-end forecast for next year is

3.2%.

Page 15


An Unexpected Policy Rate Cut

Mexico’s central bank decided to reduce the policy

rate by 50 bps to 3.0%, in a very surprising move.

No market analyst was expecting a cut in this meeting

or in the upcoming ones. The decision to cut was due

to the disappointing 1Q14 GDP, amid well-behaved

inflation and looser external financial conditions (that

is, lower U.S. Treasury yields). While market

participants (including us) were well aware of these

factors, we read them as conducive to delaying the

start of a hiking cycle, rather than to reducing rates. In

the concluding remarks of the statement announcing

the decision, the board limits the expectation for further

cuts, by saying that it “estimates that additional rate

reductions are not recommended in the foreseeable

future, considering the expected recovery of the

economy and the relative monetary policy stance of

Mexico vis-à-vis the U.S.”

In our baseline scenario, additional rate cuts would

not take place and a hiking cycle by the end of

2015 is likely. However, the “commitment” to not

reduce rates further is conditional on the economic

recovery (we note that when the central bank last

reduced rates, the board also introduced a sentence in

the press statement closing the doors to additional rate

cuts). Economic indicators available for the second

quarter (in Mexico and in the U.S.) suggest that the

long-awaited recovery of Mexico’s economy is coming.

If they prove to be a false alarm and the monetary-

policy stance of the U.S. continues loose, a further

easing of monetary policy would be possible.

The Current-Account Deficit Narrows

The current-account deficit accumulated in four

quarters stood at 1.8% of GDP in 1Q14, from 2.1%

in 2013. In the capital account, net direct investment

was USD 3.2 billion in 1Q14, bringing it to a total of

USD 22.6 billion over the last four quarters. Foreign

portfolio investment remained robust at USD 12.6

billion, but was lower than in the previous quarter

(USD 18.7 billion), and reached USD 49.8 billion over

the last four quarters. Once again, portfolio investment

flew mainly to the fixed-income market and continues

to be low in the equity market.

Thus, Mexico’s external accounts continue to be

solid. The current-account deficit is significantly lower

than in the other core countries of LatAm. Meanwhile,

foreign interest in Mexico’s fixed-income market

continues strong. While FDI continues to be low, we

believe that the reform agenda will change this

significantly starting next year. In fact, due to reforms,

external savings to Mexico will probably be higher than

in the recent past, even with higher interest rates in the

U.S. We see the current-account deficit at 2.4% of

GDP in 2015, from an estimated 2.2% in 2014.

Our exchange-rate forecasts are unchanged, at

13.2 pesos to the dollar by the end of this year and

by the end of the next. In spite of lower domestic

interest rates and our expectation of a faster increase

in the U.S. treasury yields than the market is pricing in,

we see room for only a small depreciation of the peso.

In our view, capital flows associated with the reform

agenda will curb the weakening of the currency.

Secondary Laws of Energy and

Telecommunication Reforms Under

Debate

Gustavo Madero won the domestic elections of the

PAN, providing a positive outlook for the approval

of the energy and telecommunication secondary

laws. Madero was a supporter of the Pacto por

Mexico, an agreement between the main political

parties that pushed the proposal and approval of the

main structural reform agenda of the current

administration. This result should consolidate further

support for the approval of the pending secondary laws

of the proposed reforms.

PRI and its allied parties agreed with the PAN to

discuss the secondary legislation of the energy

and telecommunication reforms in June,

bypassing a proposal from the left-leaning PRD to

delay the discussions until after the World Cup.

The discussions will be transmitted live through the

congress’s television channel. The approval of both

legislations by the end of June or mid-July is likely.

Page 16


Forecasts: Mexico

Economic Activity

Real GDP growth - % -4.7 5.1 4.0 4.0 1.1 2.4 3.8

Nominal GDP - USD bn 897 1,052 1,172 1,186 1,261 1,302 1,388

Population (millions) 112.6 114.3 115.7 117.1 118.4 119.6 120.8

Per Capita GDP - USD 7,964 9,202 10,133 10,134 10,650 10,885 11,491

Unemployment Rate - year avg 5.5 5.4 5.2 5.0 4.9 5.0 5.0

Inflation

CPI - % 3.6 4.4 3.8 3.6 4.0 3.7 3.2

Interest Rate

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

Balance of Payments

MXN / USD - eop 13.06 12.36 13.99 13.01 13.08 13.20 13.20

Trade Balance - USD bn -4.7 -3.0 -1.5 0.0 -1.0 -8.0 -10.0

Current Account - % GDP -0.9 -0.4 -1.1 -1.3 -2.1 -2.2 -2.4

Foreign Direct Investment - % GDP 1.9 2.2 2.0 1.5 3.0 2.5 2.9

International Reserves - USD bn 90.8 113.6 142.5 163.5 176.5 196.0 210.0

Public Finances

Nominal Balance - % GDP -2.3 -2.8 -2.4 -2.6 -2.3 -3.4 -3.0

Net Public Debt - % GDP 29.7 30.1 31.1 33.1 35.6 36.0 36.4

2015F2013 2014F2009 2010 2011 2012

Source: Central Banks, IMF, Haver and Itaú,

Page 17


Chile

Consumption Following the Footsteps of Investment

• The IMACEC (monthly proxy for GDP) was flat from March to April, after a weak 1Q14. We have reduced our GDP growth

forecast for 2014 to 2.8% (from 3.3%), while maintaining our 4.0% growth estimate for 2015.

• Inflation moderated on a sequential basis in May, but base effects drove it higher on a year-over-year basis (to 4.7%). Core

measures are close to the upper bound of the target, while annual wage inflation continued to rise. We see inflation at 3.6%

by the end of this year and at 2.9% by the end of 2015.

• Chile’s central bank left the interest rate unchanged at 4.0% in May. Although the easing bias was maintained by the

committee, the minutes of the meeting emphasized its greater concern over inflation. We still expect the central bank to

resume the easing cycle, but given the recent inflation dynamics, rate cuts are likely to come only in 4Q14. We expect the

policy rate to end this year at 3.5%, but no moves in 2015 (previously, we saw the policy rate at 4.0% by the end of next

year), amid a wider output gap.

• Loose monetary policy at home and higher U.S. Treasury yields will likely weaken the peso further. Although our forecast

for the exchange rate is unchanged at 575 pesos to the dollar by the end of this year, we now expect the rate to reach 600

pesos to the dollar by the end of 2015.

• In the annual May 21 presidential speech, President Michelle Bachelet shed more light on her government’s reform

program. The tax reform bill, which will be used to finance the majority of her initiatives, is currently being debated in the

Senate. No change is expected to the revenue target, but the government is now more open to changing some of its

proposals to increase collection.

Activity: Poor on Many Fronts

The economy once again grew at a below-trend

pace in 1Q14. Chile’s GDP increased by 2.6% year

over year in 1Q14 (vs.+2.7% in 4Q13). Adjusting for

calendar effects, GDP expanded by even less (2.0%).

The demand-side breakdown showed that gross fixed

investment continues to be the main drag on the

economy, declining by 5.0% from one year before (-

12.3% in 4Q13), while domestic demand components

came in mixed: private consumption weakened to

3.7% year over year (from 4.9% in the previous

quarter), while public sector consumption increased by

9.6% (vs. +3.1% in 4Q13). On a sequential basis, GDP

growth was better but remained below-trend at 3.0%

qoq/saar.

The IMACEC (monthly proxy for GDP) for April

showed that Chile’s economy is still not

recovering. On a seasonally adjusted basis, activity

was flat from March after a 0.4% drop in the previous

month. In April, retail sales declined by 1.0% month

over month and by 1.2% qoq/saar, hinting that

consumption contributed for the weak IMACEC.

Meanwhile, imports of capital goods - a proxy for

investment in machines and equipment - fell by 30%

year over year in the same month.

Private Consumption Less Supportive of Growth

-10%

-5%

0%

5%

10%

15%

20%

25%

Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 Mar-14

YoYqoq/saar

Source: INE, Itaú.

We have lowered our 2014 GDP estimate to 2.8%

(from 3.3%). Chile’s economy has been slowing more

sharply than we previously expected as higher inflation

and lower employment growth weigh on private

consumption; while higher mining costs, lower copper

prices and uncertainty over tax measures reduce

investment. Meanwhile, exports are rising on the back

of stronger mining output, which is a consequence of

the massive investment made in the sector over the

past few years. Still, we expect a recovery ahead,

supported by looser monetary policy. For 2015, we

maintain our 4.0% GDP growth estimate.

Page 18


Wages Picked up, in Spite of the Weak

Economy

Although inflation fell sequentially in May, base

effects drove it higher on an annual basis. The

consumer price index increased by 0.3% between April

and May, after a 0.6% increase. Inflation rose to 4.7%

year over year (4.3% in April), further away from the

target range. Excluding food and energy, inflation was

0.2% month over month and 3.8% year over year

(0.8% and 3.5% previously).

Tradable inflation was once again strong in May.

Tradable prices rose 0.5% from April and by 4.5% year

over year (3.8% previously).

However price indexes less exposed to the

exchange rate and to commodity prices also

continue at an uncomfortable level. While inflation

for wages and non-tradable items fell sequentially, it

continues very high on a year-over-year basis,

especially considering the weakness of the economy.

Nominal wages rose 6.3% year over year (6.2%

previously) in April while non-tradable inflation was

5.1%.

We see inflation at 3.6% this year and 2.9% in

2015. The evolution of the output gap will likely

contribute to reduce inflationary pressures.

Rates on Hold Amid Greater Concern over

Inflation

As expected by us and most market participants,

Chile’s central bank left its policy rate unchanged

at 4.0% for the second consecutive month in May.

It is important to note that we and the market were

expecting the central bank to resume the easing cycle

at this meeting until the much higher-than-expected

April CPI was released. Importantly, the board

maintained its easing bias in the press statement

announcing the decision, stating that it “will evaluate

the possibility of introducing additional policy rate cuts

according to the evolution of the domestic and external

macroeconomic conditions”. However, the central bank

also made it clear in the statement that it remains

vigilant regarding the recent inflation spike, thereby

hinting that it might be a while before additional cuts

are made.

The minutes of the meeting indicated that the

likelihood of additional cuts will depend on

inflation data. The committee members sounded

concerned not only with the level of inflation, but also

with how broad-based it is. Considering the increase in

service and wage inflation, the committee doesn’t think

that the inflationary pressures are coming only from

the exchange rate. On activity, the committee has

been seeing (at least until this latest decision) a

slowdown in line with the forecasts in its most recent

monetary policy report, which highlights the fact that it

is more concerned about inflation than about economic

growth. Although the economy is growing at a below-

potential rate, the committee members acknowledged

that the size of the output gap is uncertain, especially

considering that the unemployment rate remains very

low.

As Chile’s economy continues to be sluggish, we

expect the central bank to further ease the policy

rate ahead. We continue to expect the interest rate to

end this year at 3.5%. However, considering the recent

inflation dynamics, we don’t expect rate cuts soon. In

our view, the central bank will resume the easing cycle

only in 4Q14, once the board has seen clear evidence

that the inflation outlook is no longer a major risk.

Based on our reduced growth forecast, we now expect

the central bank to maintain the reference rate at 3.5%

throughout 2015 (previously, we expected rate hikes

by the end of 2015).

Weak Domestic Demand Helps Narrow

Current Account Deficit

Improved trade balance numbers led to a decline in

Chile’s current account deficit, to USD 0.8 billion in

1Q14 from USD 1.9 billion one year before.

Consequently, the four-quarter rolling deficit declined

to 3.1% of GDP from 3.4% in 4Q13. Although foreign

capital flows to Chile continued to be strong, rolling

four-quarter foreign direct investment (FDI) fell to USD

17.4 billion in 1Q14 (from USD 20.3 billion in 2013 and

USD 28.5 billion in 2012). Net direct investment (FDI

excluding Chilean direct investment abroad) for the

last four quarters was USD 9.0 billion (down from USD

9.3 billion in 2013), still sufficient to fully finance the

current account deficit. Foreign portfolio investment

weakened in the first quarter of 2014, bringing total

portfolio flows for the last four quarters down to USD

10.3 billion (USD 15.7 billion in 2013), although this is

still higher than Chilean portfolio investment abroad

(USD 5.3 billion).

The trade balance continued to strengthen in 2Q14.

The 12-month rolling trade surplus increased to USD

5.3 billion in May (from USD 2.1 billion in 2013), its

highest value since August 2012.

Although our forecast for the exchange rate is

unchanged at 575 pesos to the dollar by the end of

this year, we now expect the rate to reach 600

pesos to the dollar by the end of 2015. Loose

monetary policy at home and higher U.S. Treasury

yields will likely weaken the peso further.

Page 19


We have reduced our expected current account

deficit for 2014 to 2.5% of GDP (from 2.7%), as

domestic demand is more sluggish than we

previously thought. In 2015, a weaker peso, higher

mining output and moderate domestic demand growth

will likely help to reduce the deficit further (to 1.7% of

GDP).

A Wider Budget Deficit

Amid slower growth, the government now foresees

a 2014 nominal deficit of between 1.7% and 1.8% of

GDP (up from its original forecast of 0.9% and the

0.6% posted in 2013). The Ministry of Finance

reduced its economic growth forecast for 2014 to 3.4%

from 4.9%. Finance minister Alberto Arenas said that

the government’s forecast for the deficit also takes into

account an average copper price of USD 3.05 per

pound (down from USD 3.25) as demand in China has

continued to slow. In order to make up for the shortfall

in revenues, the minister has spoken about using

resources from sovereign wealth funds, issuing new

debt or to utilize money collected from Codelco that is

being held for military spending.

President Bachelet Spells out Her Political

Plans

In the annual May 21 presidential speech, Michelle

Bachelet spelled out what her government is

planning to achieve in its term in office. Apart from

the widely discussed tax reform (which has started to

be debated in the Senate), the president’s speech also

touched on a USD 650 million energy program that

would focus on strengthening the State´s role in the

planning and regulation of the industry, while

increasing private competition; the commitment to form

a state pension fund (to compete with private pension

funds); and the education reform (an initial reform bill

proposing an end to state subsidies for for-profit

schools has already been submitted to Congress). She

also discussed a proposal to nationalize water rights.

This proposal, which had already been raised in

Bachelet’s first government, would seek to establish

priority uses for water and limit the use of water rights

acquired under certain circumstances. The president

also indicated that a capitalization proposal for the

state-owned copper company Codelco would be

submitted to Congress in the second half of the year.

Codelco’s former CEO, Thomas Keller, has previously

said that the company’s investment program will

require more than USD 20 billion to increase output by

about 10% over this decade, adding that without these

investments, output is likely to fall by more than half as

open-pit ore-bodies start to become commercially

exhausted and are replaced by underground mines.

Forecasts: Chile

Economic Activity

Real GDP growth - % -1.0 5.8 5.8 5.4 4.1 2.8 4.0

Nominal GDP - USD bn 172 218 251 266 277 265 266




Inflation

CPI - % -1.5 3.0 4.4 1.5 3.0 3.6 2.9

Interest Rate


Balance of Payments

CLP / USD - eop 507 468 520 479 526 575 600

Trade Balance - USD bn 15.4 15.7 11.0 2.5 2.1 3.0 2.5

Current Account - % GDP 2.0 1.5 -1.3 -3.5 -3.4 -2.5 -1.7



Public Finances

Nominal Balance - % GDP -4.1 -0.4 1.4 0.6 -0.6 -1.8 -1.0

Net Public Debt - % GDP -10.6 -7.0 -8.6 -6.8 -6.1 -3.9 -2.7

2015F2013 2014F2009 2010 2011 2012

Source: Central Bank, IMF, INE, Haver and Itaú.

Page 20


Peru

Private Demand Slows Further

• Peru’s GDP growth slowed in 1Q14 as private domestic demand decelerated. Available indicators for 2Q14 also point to weaker activity. In this context, we reduced our GDP forecast for this year to 5.0% (from 5.3%), while maintaining our 5.9% expected growth rate in 2015.

• The inflation rate increased to 3.6% in May, remaining above the upper limit of the central bank target (between 1.0% and 3.0%), but the core measure is still within range (2.8%). We expect inflation to be at 3.0% and 2.5% at year end of 2014 and 2015, respectively.

• The central bank left the interest rate and the easing bias unchanged in May, while Governor Velarde also indicated that the reserve-requirement rate will be unchanged for the second consecutive month in June. We expect the central bank to maintain the interest rate unchanged at least until the end of 2015. However, considering the looser external financial conditions and the weaker economy, we can’t rule out additional monetary stimulus, through reserve requirements or even lower policy rates.

• The central bank intervened again in the foreign-exchange market, this time as a buyer of dollars, as it continues its policy of limiting currency volatility. We expect the exchange rate to end 2014 at 2.85 soles per dollar, and through a sharper depreciation of the sol in 2015, to end the year at 2.95 per dollar.

• President Humala remains an unpopular figure, with approval ratings sitting in the first quartile, and the first lady, Nadine Heredia (a potential presidential candidate), continues to harm her husband’s image following open criticism of political opponents.

Weak Growth in 1Q14, in Spite of Strong

Public Sector Demand

Peru’s 1Q14 GDP increased by 4.8% year over

year, after a 6.9% expansion in 4Q13. This economic

growth rate is the slowest since the 4.6% recorded in

the same quarter of last year. The slowdown was led

by primary activities (they grew by 4.2%, after 12.4% in

4Q13), but non-primary sectors also grew at a slower

pace (4.9% in 1Q14 vs. 5.6% in 4Q13). On a

sequential basis, the economy also slowed

substantially, to 0.3% qoq/saar (according to the

seasonally-adjusted monthly GDP series published by

the central bank), after a 6.9% gain in 4Q13.

Activity was led by public sector demand while

growth in private demand showed further signs of

slowing. Public sector consumption increased by

9.5% (4.5% in 4Q13) and public sector investment

accelerated to 8.3% (2.1% last quarter). On the other

hand, private consumption grew by 5.1% year over

year, down from the 6.0% recorded last quarter, and

private gross fixed investment slowed further to 1.6%,

from 2.5% in 4Q13. Real exports also weakened, to

0.2% year over year from 3.1% in the previous quarter.

Preliminary indicators suggest that economic

activity slowed considerably in April, negatively

affected by calendar effects. Annual mining and

hydrocarbon output contracted by 6.1% (after

decelerating to 0.9% last month). Consumer goods

imports grew by 5.9% (vs. 13.6% last month), while

new-car sales contracted by 11.1%, after increasing by

a weak 0.9% last month.

Domestic Demand Growth YoY

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

Mar-06 Mar-08 Mar-10 Mar-12 Mar-14

Private Demand Public Demand

Source: BCRP, Itaú

Annual electricity generation declined to 4.9% (7.0% in

March), although consumer confidence still remains in

the optimistic zone at 60 points. We expect GDP

growth of less than 3% in April.

We have reduced our GDP estimate for 2014 to

5.0% (from 5.3%), but maintain our 5.9% growth

estimate for next year. All in all, Peru’s economy is

slowing from last year, mostly due to weaker private-

investment growth. At the same time, mining output is

Page 21


still not responding to the sizable investment made in

the sector over the past few years, so real exports are

also very weak. Public sector spending should

continue to help the economy in the short term, as the

government carries on with a number of infrastructure

projects. Next year, higher mining output will help the

recovery.

Inflation Slowing Sequentially, but

Remains Above the Target Range

Headline inflation increased to 3.6% in May (from

3.5% in the previous month), remaining above the

1.0%-3.0% target range for the fifth consecutive

month. The core inflation measure, which excludes

food and energy, declined slightly to 2.82% in May,

from 2.83% in the previous month. On a monthly basis,

prices increased by 0.2%, led by the 0.4% increase in

food prices (due to higher poultry prices), which

contributed 16 bps to the monthly CPI change.

We expect inflation to be above the upper bound of

the central bank target throughout our forecast

horizon. We foresee headline inflation converging

slowly towards the target range, ending this year at

3.0% and 2015 at 2.5%.

Unchanged Rates and Unchanged

Reserve Requirements

The Central Bank left the interest rate unchanged,

as expected, at 4.0%. The press statement said that

the decision to maintain the rate was consistent with

an inflation forecast of 2.0% within the next two years,

as inflation expectations remain in the target range and

supply-side pressures continue to moderate. In this

scenario, the central bank expects inflation to remain

near the upper limit of the target band, thereafter

converging to the 2.0% target. The board also

considered the current below-potential growth and the

mixed signals of a global recovery in its decision,

adding that the current indicators point to a dynamic

economy, albeit at a lower-than-expected rate. Finally,

the board repeated what it said in April’s statement

about tracking inflation’s evolution with respect to

additional monetary policy moves.

In addition, reserve requirements for June will be

left unchanged, for the second consecutive month.

After lowering the rate in each of the first four months

of this year, credit growth in local currency increased

by a strong 22.4% year over year in the quarter ending

in April (20.8% in 4Q13), possibly achieving, for the

time being, the desired impact.

We don’t expect the central bank to alter the

interest rate in our forecast horizon. However,

considering the looser external financial conditions and

the weaker economy, we can’t rule out additional

monetary stimulus, through reserve requirements or

even lower policy rates.

The Central Bank intervenes in the

Foreign-Exchange Market…as a Buyer of

Dollars

As a reaction to the recent appreciation of the sol,

the central bank bought dollars in the spot market

for the first time in 13 months. Although the

intervention amount was small, USD 10 million, the

action itself reaffirms the central bank’s policy of

reducing foreign-exchange volatility. The central bank

bought USD 5.2 billion in the first half of 2013 to ease

a currency rally before selling almost the same amount

in the second half of the year as the sol weakened

(last sale was on February 5 of this year.)

We have maintained our 2014 year-end exchange-

rate forecast of 2.85 soles per dollar, but we now

expect a sharper depreciation of the sol in 2015, to

2.95 per dollar (from 2.9) by the end of 2015. This

adjustment has been influenced by the higher U.S.

Treasury yields expected for next year and a local

monetary-policy environment that remains

expansionary.

Peru’s current-account deficit widened further in

1Q14, amid lower foreign-direct-investment flows.

The four-quarter rolling deficit increased to 4.8% of

GDP from 4.5% in 4Q13. The rolling four-quarter

foreign direct investment (FDI) fell to USD 7.6 billion in

1Q14 (from USD 9.3 billion in 2013 and USD 11.9

billion in 2012), so net direct investment (FDI excluding

Peruvian direct investment abroad) for the last four

quarters did not fully cover the current-account deficit.

Foreign portfolio investment weakened slightly in the

first quarter of 2014, bringing total portfolio flows for

the last four quarters down to USD 5.2 billion (USD 5.9

billion in 2013), but remaining well above portfolio

investment abroad (USD 1.6 billion).

We now expect a current-account deficit of 4.8% of

GDP for this year (previously 4.5%). In spite of

weaker domestic demand, Peru’s current-account

deficit is unlikely to improve in the near term due to

poor prospects for the mining sector in the short term.

For 2015, we see the deficit improving to 4.0% as

mining production starts to react to the strong

investments made in the sector over the past few

years and as the exchange rate weakens.

President Humala Remains Unpopular

The May Ipsos poll showed that approval for

President Humala fell to 22% (24% in April), while

in the GFK survey it sits at a low 21%. Respondents

Page 22


continue to lament the failure to adequately address

crime and corruption. The first lady, Nadine Heredia,

remains a divisive figure after polls followed up on a

controversial interview in which she accused former

president and potential political opponent, Alan Garcia,

of attempting to manipulate institutions including the

Judiciary to clear him of alleged corruption. Ms.

Heredia also said that the prime minister’s job was too

big for Cesar Villanueva (the previous prime minister of

Peru). In this context, 20% of Ipsos respondents said

that they were not proud of their first lady, while 66%

disapprove of her conduct.

Forecasts: Peru

Economic Activity

Real GDP growth - % 1.0 8.5 6.5 6.0 5.6 5.0 5.9





Inflation

CPI - % 0.2 2.1 4.7 2.6 2.9 3.0 2.5

Interest Rate


Balance of Payments

PEN / USD - eop 2.88 2.82 2.70 2.57 2.80 2.85 2.95

Trade Balance - USD bn 6.1 7.0 9.2 5.2 0.0 -0.5 0.3



International Reserves - USD bn 33 44 49 64 66 64 66

Public Finances

Nominal Central Govt Balance - % GDP -1.3 -0.2 2.0 2.1 0.8 0.4 0.5

Gross Central Govt. Debt - % GDP 26.0 23.5 21.4 19.7 19.2 17.3 15.2

2015F2013 2014F2009 2010 2011 2012


Page 23


Colombia

An Uncertain Presidential Election

• The presidential election became a two-horse race after both the incumbent Juan Manuel Santos and the challenger Óscar

Iván Zuluaga failed to obtain an absolute majority on May 25. Óscar Iván Zuluaga won the first round by approximately 3.5

percentage points. The run-off between the two candidates is set for June 15.

• According to a number of activity indicators, the Colombian economy remained robust in 1Q14, driven by the strong

performance of private consumption. Industrial. production (although still weak) is showing small signs of improvement. We

expect activity growth of 4.5% in both 2014 and 2015.

• Inflation was once again led by volatile food prices in May, pushing the annual headline rate to 2.9%. Core measures, on

average, are also on the rise but remain comfortably below the center of the target range. We see inflation at 3.1% by the

end of this year (2.9% in our previous scenario) and at 3.0% by the end of 2015.

• The Central Bank Board unanimously decided to raise the reference rate by 25bps for the second consecutive month, to

3.75%. The board continued to emphasize that a gradual increase in the monetary policy rate now will prevent the need for a

sharper interest-rate adjustment in the future. We expect the interest rate to end the year at 4.25% and 2015 at 5.0%, but do

not foresee a rate increase this month.

• Increased global liquidity, higher domestic interest rates and the greater weight of Colombian bonds in the benchmark

index for local-currency sovereign debt have led to a strengthening of the peso. However, the appreciation of the peso is

likely to reverse once U.S. treasury yields start to rise. We expect the currency to weaken to 1,950 to the dollar by the end of

this year and to 2,000 by the end of the next.

1Q14 Activity Ends on a Strong Note

Available indicators suggest a robust end to 1Q14.

Retail sales grew 8.3% year over year in March (after

posting a 6.7% expansion in the previous month) and

sales increased 5.9% (excluding vehicles).

Manufacturing production recorded a stronger-than-

expected annual growth of 9.8% in March, after a gain

of 2.8% in February; however, we note that this figure

was heavily influenced by calendar effects. We

estimate that, on a seasonally- and calendar-adjusted

basis, manufacturing continues to underperform most

sectors of the economy, up by a modest 1.6% year

over year and 1.8% qoq/saar. According to the

Finance Ministry’s recently developed ISAAC+ activity

index,the economy grew at a similar rate to the 4.9%

recorded in 4Q13.

Employment and domestic credit continue to be

strong economic drivers. The national

unemployment rate fell to 9.0% in April (well below the

10.2% recorded one year ago), led by a strong 3.4%

growth in total employment (2.1% increase in the labor

force). This is the first time in 14 years in which a

single-digit unemployment rate has been recorded in

April. According to our calculations, consumer credit

registered a strong 19.1% year-over-year expansion in

the quarter ending in April (up from 11.2% in 4Q13),

while housing loans rose 32% in the same period (27%

in 4Q13).

Leading indicators remain positive overall.

Consumer confidence in April, as reported by local

think-tank Fedesarrollo, continued to recover to 17.9

points, following a surprise drop to 15.7 points in

February, but remained below the 23.7 points recorded

in the corresponding period of last year; the

breakdown showed an improvement in the economic

sentiment. Industrial confidence rose to 4.1 points (vs.

2.8 in March), likely driven by an improvement in order

expectations. Meanwhile, retail confidence fell to 26.2

points (vs. 28.8 points in March), due to a slight

decline in economic-condition expectations; these

leading indicators surpass the levels registered in April

2013.

We continue to expect the economy to grow 4.5%

in both 2014 and 2015.

Inflation Led by Volatile Food Prices

Headline inflation rose to 2.9% in May mostly due

to higher food prices. The volatile food component of

inflation has climbed sharply from 0.9% in December

of 2013 to 3.4% in May. Core measures that exclude

food have shown a far more measured rise, increasing

from 2.4% to 2.8% in the same period. When both food

and fuel prices are removed, prices rose by 2.6% in

May from 2.5% in April.

We expect that the shrinking output gap and the

low base of yearend 2013 will push inflation to

3.1% by the end of 2014 (previously 2.9%). We

Page 24


continue to foresee inflation at the center of the target

range in 2015.

The Tightening Cycle Continues

In a unanimous decision, the Central Bank raised

the policy rate by 25bps, to 3.75%. This was the

second consecutive 25-bp rate hike and, unlike last

month, was expected by us and most market

participants. The press statement was very similar to

the previous one, once again emphasizing that a

gradual increase of the monetary policy rate now will

prevent the need for a sharper interest-rate adjustment

in the future, under the assumption that the output gap

will close this year.

We expect the policy rate to end the year at 4.25%

and see the tightening cycle continuing in 2015,

until the rate reaches 5.0%.We foresee a pause in

the hiking cycle in June based on the Central Bank’s

clear communication that it will maintain a “gradual

approach” to removing monetary stimulus.

Reactions to a Stronger Peso

Increased global liquidity, higher domestic interest

rates and the greater weight of Colombian bonds

in a benchmark index for local-currency sovereign

debt have led to a strengthening of the peso. As a

result, the Central Bank has decided to use the full

dollar intervention program established in March for

2Q14 (USD 1.0 billion). Finance Minister Mauricio

Cardenas stated that the Ministry will use its “excess

liquidity” to purchase dollars. We expect the Central

Bank to announce a renewal of its dollar purchase

program at the next monetary policy decision, possibly

increasing the size of the potential purchases.

Intervention in the FX market Picks Up USD Million USD Million

20.000

25.000

30.000

35.000

40.000

45.000

50.000

0

100

200

300

400

500

600

700

800

900

jan-11 jul-11 jan-12 jul-12 jan-13 jul-13 jan-14

Gross International reservesDollar purchases (LHS)

Source: Banco de La República.

The expected rise in U.S. treasury yields is likely to

reverse the peso’s appreciation trend. Our

exchange-rate forecast for the end of the year remains

at 1,950 pesos to the dollar. For next year, we see the

peso weakening further, to 2,000 to the dollar.

Presidential Run-Off Looms, Momentum

Lies with Zuluaga

The result of the May 25 presidential election was

somewhat surprising in terms of Óscar Iván

Zuluaga’s margin of victory over current President

Juan Manuel Santos. Mr. Zuluaga (a member of

former President Uribe’s party) received 29.3% of the

first-round vote, while Mr. Santos secured 25.7%. The

failure of the candidates to acquire an absolute

majority will lead to a run-off on June 15. In a

campaign trail fraught with scandals, Mr. Santos’ early

advantage has been whittled away despite the

progress in the peace negotiations with the FARC

rebel group and the country’s strong economic

performance. Mr. Zuluaga, also a business-friendly

candidate, has momentum in his favor.

The latest polls provide mixed results. According to

the Gallup poll, the two candidates are neck and neck

with Mr. Zuluaga receiving 48.5% and Mr. Santos

47.7%. However, the latest Ipsos poll gives Mr.

Zuluaga a clear advantage with 49% of the intended

vote, while Mr. Santos only received 41%.

Mr. Zuluaga has moved away from the threat to

end the peace talks with the FARC rebels if

elected, softening his stance on the election's

most pivotal issue. Mr. Zuluaga maintains that, if

elected, he will demand that the FARC cease conflicts

and criminal activity in order to continue the talks

initiated by Mr. Santos in late 2012, but will no longer

immediately suspend these talks as he had previously

stipulated. This change in stance comes, in part, at the

request of conservative party leader, Marta Lucia

Ramirez (15.5% in the first-round vote), who is now

backing Mr. Zuluaga’s candidacy.

Meanwhile, the peace process between the FARC

rebel group and the Colombian government has

added another notch to its belt by reaching an

agreement last month on the third point (drug

trafficking) of the five-point agenda. The remaining

issues involve victim reparations and transitional

justice.

Page 25


Forecasts: Colombia

Economic Activity

Real GDP growth - % 1.7 4.0 6.6 4.0 4.3 4.5 4.5





Inflation

CPI - % 2.0 3.2 3.7 2.4 1.9 3.1 3.0

Interest Rate


Balance of Payments

COP / USD - eop 2044 1908 1939 1767 1930 1950 2000





Public Finances

Nominal Balance - % GDP -4.1 -3.9 -2.8 -2.3 -2.4 -2.1 -1.9

Gross Public Debt - % GDP 37.7 38.6 36.5 34.5 37.3 36.8 36.0

2015F2009 2010 2011 2012 2013 2014F


Page 26


Argentina

Paris is Well Worth a Mass

• Argentina signed an agreement with the Paris Club to regularize a USD 9.7 billion debt in arrears. The agreement marks an important step in normalizing the country’s financial relations with the international community and could open up access to international financing.

• The U.S. Supreme Court may render a decision in the holdout case in June. If the case is rejected, Argentina will have to pay the holdouts the full USD 1.4 billion amount owed. If the decision is postponed until 2015, the country could negotiate with the holdouts without affecting the restructured bondholders’ right to request a similar deal.

• The Central Bank is resisting depreciating the exchange rate further. Access to capital flows seems to be the only viable strategy to prevent international reserves from falling during the second half of the year and ease the adjustment of financial variables. Our exchange-rate and interest-rate forecasts for the end of 2014 stand at 10 pesos to the dollar and 35%, respectively.

Facing Up to Debts and Creditors

Argentina took an important step toward

regularizing its financial relations with the

international community. The country will pay off its

USD 9.7 billion debt to the Paris Club over a five-year

period, according to the following scheme: an initial

USD 650 million payment in July 2014 and another

USD 500 million to be paid in May 2015 (plus 3%

interest), with the following payment scheduled for May

2016. The agreement sets a minimum annual payment

thereafter, which may be raised if there is new

financing from the Paris Club members. Argentina is

allowed to extend the payments for two additional

years if the new financing is not enough to meet its

commitment. The agreement with the Paris Club

extends the list of the country’s solved disputes with

creditors, which include Repsol and private-sector

claims under World-Bank arbitrage rules.

The U.S. Supreme Court could announce a

decision in the holdout case on June 16. Argentina

appealed the Supreme Court ruling that ordered the

country to pay holdouts in-full and prohibits

intermediary banks from processing payments to

restructured bondholders until the country’s debt to the

plaintiffs is cleared. The court will convene on June 12

to decide whether or not it will hear the case. If the

case is rejected, Argentina will have to pay the

holdouts the full USD 1.4 billion amount owed. If the

court requests the opinion of the U.S. Solicitor

General, the decision will be de facto postponed until

2015. In this case, Argentina will be allowed to

negotiate with the holdouts without affecting the

restructured bondholders’ right to request the same

financial conditions – a scenario that could pave the

way for Argentina to access international financing this

year. However, Argentina recently signaled to the

Supreme Court that it is willing to obey a negative

ruling (which represents a significant change in the

government’s rhetoric on the case), while some

holdouts have said that they are open to negotiation

(which may include a partial payment in bonds).

Is There Room to Ease the Adjustment?

The peso is strengthening and the Central Bank is

finding it difficult to depreciate the currency in an

orderly manner. The Central Bank attempted to set

up some kind of crawling peg in May, but only raised

depreciation expectations, while the gap with the

informal exchange rate widened to 50% (from 30%).

The initiative was soon aborted, the peso remained

slightly above 8 to the dollar and the gap fell to 43%.

The country’s monetary policy and fiscal policy are not

helping. Public sector expenditures continue to grow

(40.6% YoY in 1Q14) due to the heavy burden of

subsidies, and the fiscal deficit is almost entirely

financed by the Central Bank.

Meanwhile, the domestic disputes between the

Ministry of Economy and the Central Bank

regarding the tightening of the monetary policy

have risen. The treasury pressed for a more

aggressive interest-rate reduction due to activity-

related concerns. The Central Bank has already

reduced the interest rate on its sterilization bills

(LEBACS) by 200 bps. According to CB President

Juan Carlos Fábrega, future rates cuts are likely if

inflation falls below 2% (on a monthly basis). The

Badlar rate ended May at 24% (vs. 25.75% in April),

after reaching a peak of 27%.

The second half of the year is usually poor in

terms of dollar inflows to Argentina, and reserves

should fall. The soy harvest ends in late-July and, in

the absence of significant capital inflows, international

reserves are likely to fall to USD 24 billion by the end

of the year. Gross international reserves currently

stand at USD 28.5 billion, following a mild increase of

USD 0.3 billion in May.

Page 27


Keeping an eye on international reserves USD Billion USD Billion

20

25

30

35

40

45

50

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14

MoM changeStock (RHS)

Source: BCRA

In our view, a downward trend in reserves will

trigger both a further devaluation of the peso and

interest-rate hikes. We expect the peso to end the

year at 10 to the dollar. Higher interest rates will be

required to prevent inflation from rising much further

and encourage dollar inflows. We expect a year-end

Badlar rate of 35%. The recent appreciation of the real

exchange rate raises concerns about the need for a

sharp devaluation of the currency.

However, we note that a positive outcome in U.S.

courts may lead to higher capital inflows that

would help the government ease the adjustment in

the exchange and interest rates. A deferral of the

Supreme Court’s decision, or even the acceptance of a

negative ruling, may foster issuances by YPF and

provincial governments as well as Central Bank

borrowing.

Activity: Revising the Past, Living the

Present

The official statistics agency (INDEC) reported a

new national account series (2004 prices) after

introducing methodological changes. According to

INDEC, GDP grew 2.95% in 2013. The new GDP

figure matches private growth estimates and is

significantly below the 5.7% official estimate for the

first three quarters of 2013, under the old methodology

(1993 prices). The previous growth figures were

revised downward, the most significant of which were

for 2008, 2009 and 2012. The average revised growth

rate for the period of 2007-12 was 4.9%, compared

with the previously reported 6.0%. However, according

to private consultants, growth during the same period

averaged 3.1%. Meanwhile, the nominal GDP level in

2013 was revised 20% upward. On June 6, the IMF

conducted the first revision of Argentina’s new set of

national accounts and consumer price index. The IMF

recognized that Argentina met the specified actions

requested at this stage to remedy the inaccurate

provision of official data provided for the CPI and GDP.

Argentina must continue implementing actions for end-

September and end-February 2015.

We expect GDP to contract 2% in 2014. The IGA

(GDP proxy produced by consulting firm OJF) fell 1.7%

YoY in April, following a revised 3.7% drop in March.

According the Universidad Di Tella’s leading indicator,

the probability of a recession in Argentina over the

next six months is now 50%.

Inflation continues to decelerate on a sequential

basis, as the depreciation pass-through effects

fade and recession limits the price pressure.

According to estimates produced by Elypsis consulting

firm, inflation likely fell to 2% month over month in May.

The April inflation (2.8%) reported by a congressional

commission again exceeded the mark (1.8%)

published by the official national statistics agency,

giving rise to doubts about the reliability of the new

official CPI. We expect inflation to end the year at

37%, but note that annual inflation is likely to reach

40% soon due to unfavorable base effects. Potential

increases in electricity and transport tariffs add

significant upside potential to this forecast.

Corruption Scandal Involving High

Government Official Goes to Court

Vice President Amado Boudou testified as a

suspect in a criminal investigation. The next step

would be a formal indictment. Amado Boudou is

accused of using his power to get a contract for a

money printing company he controlled (Ciccone

Calcográfica) to provide services to the government.

Page 28


Forecasts: Argentina

Economic Activity

Real GDP growth (Private Estimates) - % -4.2 7.9 4.9 -0.2 3.2 -2.0 0.0

Nominal GDP - USD bn 378.5 462.7 557.7 603.1 611.3 544.6 496.7




Inflation

CPI (Private Estimates) - % 14.9 26.4 22.8 25.6 28.4 37.0 27.0

Interest Rate

BADLAR - eop - % 10.00 11.25 17.19 15.44 21.63 35.00 30.00

Balance of Payments

ARS / USD - eop 3.80 3.98 4.30 4.92 6.52 10.00 13.00


Current Account - % GDP 2.9 -0.2 -0.4 0.0 -0.8 -0.7 0.2



Public Finances

Nominal Balance - % GDP -0.5 0.2 -1.3 -2.0 -1.9 -1.7 -1.7

Gross Public Debt - % GDP 38.9 35.5 32.1 32.7 30.7 30.2 29.2

2013F 2014F 2015F2009 2010 2011 2012


Page 29


Commodities

Falling Prices for Agricultural Commodities and Metals • Favorable weather conditions in May dragged down prices for agricultural commodities.

• Iron ore prices continue to drop, given the outlook for larger supply from Australia and concerns over the real estate sector

in China. We expect a slight recovery in prices.

The Itaú Commodity Index (ICI) has fallen 3.7%

since the end of April, driven by lower prices for

agricultural items, iron ore and natural gas.

Favorable weather conditions, particularly in the U.S.,

have increased supply expectations for corn, wheat,

soybeans and cotton. A lower risk perception over the

conflict in Ukraine is also behind price declines for

grains and natural gas. We maintain our ICI forecast

for a decline of 1.4% in 2014 and an uptick of 1.6% in

2015. Our forecast for 2014 assumes an advance of

0.6% from current levels, driven by iron ore and

agricultural commodities (excluding soybeans). The

two main downside risks to our scenario are: i) the iron

ore balance reaching equilibrium with prices below

USD 95.0/ton (our call: USD 101.0/ton); and ii) better-

than-average weather conditions for supply ahead,

leading to further drops in agricultural commodity

prices.

Partial Reversal in Agricultural Commoditites

80

90

100

110

120


ICI AgricultureICI EnergyICI Metals

Source: Itaú.

Better weather conditions for agriculture in May.

International prices for agricultural commodities have

declined since the end of April (-10.0%, according to

the ICI-Agricultural), partly reversing the gain year to

date. The recent slide included all the main

commodities: corn (-12.3%), wheat (-14.1%), soybeans

(-4.8%), cotton (-10.2%), coffee (-18.6%) and sugar (-

1.5%). The first four items were directly affected by the

outlook for better supply, particularly from the U.S. In

turn, sugar and coffee prices are influenced by

uncertainty over fundamentals, as estimates for the

balance between supply and demand for both

commodities range from small surpluses to wide

deficits.

Earlier Decline Itaú Commodity Index* (2010=100)

100

105

110

115

120

125

Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

Previous

Current

Source: Itaú.

Iron ore prices continue to retreat, driving the ICI-

Metals Index down by 3.7% since the end of April.

In addition to the reasons cited in our latest report

(slowing growth and tighter regulations in China),

concerns over the Real Estate sector in China

combined with higher supply from Australia pushed

prices to below USD 95.0/ton (2013 average: USD

131.8/ton), in a move that we believe is exaggerated.

Current prices are below operational costs for

producers, who must keep working to meet current

demand on a global level. We thus maintain our

forecast at USD 101.0/ton by year-end, 6% above

current levels. Prices for other non-precious metals

marched in the opposite direction, with some gains

during the month.

The ICI-Energy Index has risen 0.6% since the end

of April. Except for lower natural gas prices, there

were no major events involving energy-related

commodities. Brent crude prices rose 1.5%, to USD

109.15/bbl, while WTI crude climbed 4.5%, to USD

103.59/bbl in the same period, without any major

changes in fundamentals. We maintain our year-end

Page 30


estimates at USD 105.0/bbl for Brent and USD

101.0/bbl for WTI. Our scenario of lower Brent prices

assumes some increase in the combined supply from

Iran, Iraq and Libya in coming months.

Agricultural Commodities: Favorable

Weather in May

May was marked by favorable weather conditions.

In the U.S., corn planting recovered, while soybean

planting is evolving in line with seasonal patterns.

In Brazil, the winter corn crop benefited from adequate

rainfall. The weather has also been favorable in other

producing regions, prompting price drops for corn (-

12.3%), wheat (-14.1%), soybeans (-4.8%) and cotton

(-10.2%).

Favorable Weather Conditions in U.S. Affect

Prices Prices correspond to CBOT first future

1200

1300

1400

1500

1600

1700

400

500

600

700

800

Jan-13 May-13 Sep-13 Jan-14 May-14

CornWheatSoybean (RHS)

Source: Itaú.

Downside for grain and soybean forecasts. We

maintain our year-end price forecasts for corn, wheat

and soybeans at USD 5.0, USD 6.8 and USD 12.2 per

bushel, respectively. But if favorable weather

conditions are sustained, prices should fall further,

particularly for corn and wheat.

Sugar and coffee prices are expected to rebound.

Weather conditions have been normal in producing

regions in Brazil. There is, however, still a lot of

uncertainty over the 2014-15 crops. Estimates for

these two commodities range widely, from small global

surpluses to large deficits. In our view, the recent

normalization will not be enough to offset losses

caused by the drought in January. Hence, production

in Brazil should be smaller than what is priced in by the

market and will likely lead to deficits in the global

balance for both commodities. We thus continue to

expect price increases for coffee and sugar, to USD

2.20/lb. and USD 0.195/lb., respectively.

El Niño is expected in the second half of the year,

but its intensity and impact are as yet unclear.

America’s National Oceanic and Atmospheric

Administration sees an increasing likelihood of the El

Niño weather pattern in the second half, now above

80%. Meanwhile, conditions in the Pacific Ocean are

evolving in a way that could create a milder and short-

lived phenomenon, with a smaller impact on conditions

for agricultural supply.

Page 31


Forecasts: Commodities

Commodities

yoy - % -25.7 35.4 21.9 -5.2 0.8 -5.2 4.5 2.5

avg growth - % 6.2 -14.6 25.1 19.5 -9.5 -3.1 2.8 0.2

yoy - % -34.2 36.8 33.3 -6.5 3.5 -6.1 -1.4 1.6

avg growth - % 25.7 -29.5 32.4 24.9 -7.9 -3.8 -3.3 0.5

a/a - % -26.5 22.2 41.5 -14.8 13.2 -22.4 9.5 3.5

avg growth - % 30.8 -20.3 15.7 35.1 -5.1 -11.5 -4.2 3.3

yoy - % -43.8 47.3 11.5 10.1 -0.7 5.4 -2.3 -0.4

avg growth - % 33.2 -39.2 22.0 25.6 -2.4 0.9 2.1 -1.6

yoy - % -23.4 40.9 63.4 -18.2 -1.0 -3.2 -11.8 3.0

avg growth - % 4.0 -18.9 78.5 13.7 -19.4 -1.2 -11.8 1.3

yoy - % -31.5 37.2 32.5 -6.8 5.0 -11.3 3.6 2.6

avg growth - % 22.9 -23.2 24.8 28.1 -5.7 -7.2 -1.9 2.4ICI - Inflation **

2013 2014F2010

CRB Index

Itaú Commodity Index (ICI)*

Agricultural

Energy

Metals

20122009 2015F2008 2011

* 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

Ilan Goldfajn – Chief Economist

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

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 Itaú Unibanco or Itaú Corretora de Valores S.A. and should not be construed as a research report (‘relatório de análise’) for the purposes of the article 1 of the CVM Instruction NR. 483, dated July 06, 2010.

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