Itaú BBA - A brighter outlook

Scenario Review - Mexico

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A brighter outlook

April 12, 2017

Uncertainties over trade relations with the U.S. remain, but have diminished recently.

Please see the attached file for all graphs. 

The uncertainties over trade relations with the U.S. remain, but they have diminished recently. We have revised our GDP growth forecast for 2017 to 1.8% (from 1.6%). Still, higher inflation, tighter macro policies and remaining uncertainties over trade relations with the U.S. are consistent with a slowdown from 2016. 

The Mexican peso has strengthened substantially, and with that there is less upside risk for inflation this year. In this context, the central bank is finding room to reduce the pace of monetary policy tightening.

At the same time, the twin deficits are narrowing, adding to the more positive sentiment. The central bank announced that it will remit a dividend of MXN 321.7 billion (1.5 pp of GDP) to the Treasury in April, making it very likely that the government will meet its fiscal targets in 2017. This reduces the odds of a sovereign downgrade.

Headwinds on growth ease a bit

The uncertainty over bilateral relations with the U.S. is far from over, but the escalation of trade protectionism – a key risk for the Mexican economy – seems less likely than before. Besides, current activity seems more resilient to the shocks than we expected, creating a favorable carry-over for this year. In fact, the monthly GDP proxy (IGAE) gained 3.7% qoq/saar in January (from 3.5% in December).

However, there are signs that internal demand is weakening. Retail sales fell 1.1% from December, posting two consecutive declines, bringing quarter-over-quarter annualized growth down to 2.2% (from 7.0% qoq/saar in December). Formal employment remains robust, but real wages are falling, and consumer confidence is standing at very low levels (about the same as the average of 2009, when the economy was experiencing a deep recession), despite a recent rebound. Consumer credit is starting to slow down, amid higher interest rates, with rising NPLs. Also, the boost from remittances (converted into pesos) is waning, given a stronger currency. Gross fixed investment fell 1.6% in January with a deteriorating momentum (-1.5% qoq/saar, from 1.2% in December).

We have revised our GDP growth forecast for 2017 to 1.8% (from 1.6%). Still, higher inflation (affecting real wages), tighter macro policies (higher rates and fiscal consolidation) and remaining uncertainties over trade relations with the U.S. will weigh on aggregate demand. Manufacturing exports will continue as a buffer of the economy in 2017 (as long as protectionism does not materialize). The pick-up in U.S. industrial output and a competitive real exchange rate bode well for Mexico’s exports. We believe growth will recover to 2.1% in 2018, assuming that trade protectionism in the U.S. does not materialize and uncertainty fades. 

Stronger currency caps inflation risk

Financial markets have also priced in the moderation of protectionism, which is reflected in the substantial appreciation of the MXN. The peso has strengthened considerably from its weakest level reached in January, outperforming all other emerging market currencies. A more constructive dialogue between U.S. and Mexican trade negotiators and the exchange rate intervention program (through swaps) announced by the foreign exchange commission have brought the peso closer to its fundamentals. We have revised our exchange rate forecast for 2017 (to 19.5, from 20.5) and 2018 (to 18.5, from 19), assuming that the uncertainty will dissipate gradually, although we acknowledge that volatility is likely to return at some point between now and the presidential elections in Mexico in June 2018, considering the strong showing of the leftist candidate Andrés Manuel López Obrador in the polls.

A stronger exchange rate reduces upside risk for inflation this year. Headline inflation has increased (to 5.4% year over year in March), driven by the lagged effects of exchange rate depreciation and the liberalization of gasoline prices in early 2017. Gasoline prices, however, are decreasing sequentially because of a stronger peso, although variations are being smoothed out with adjustments in the excise tax (IEPS). Inflation expectations for 2017 continued increasing in the latest central bank survey, but longer-term expectations seem to be stabilizing.

We expect inflation to decrease from the current levels to 5% by the end of 2017. Although inflation surprised to the upside in 1Q17, our forecast is unchanged considering the exchange rate appreciation. Looking beyond 2017, we believe inflation will moderate to 3.3% in 2018, as the effect of temporary shocks (gasoline spike and peso depreciation) dissipate and domestic demand slows down.

Reducing the pace of monetary tightening

In this context, the central bank is finding room to reduce the pace of monetary policy tightening. Mexico’s Central Bank decided to hike the reference rate by 25 bps in March, to 6.50%. In the last six policy rate moves, between February 2016 and February 2017, Banxico opted for 50-bp hikes. So this marks a departure in the pace of tightening. Earlier in March, during the presentation of the inflation report, Governor Carstens stated that tightening too aggressively in the short term could be “inefficient and costly for economic activity.”

Banxico is following the Fed, for now. In the concluding remarks of its statement, the central bank explicitly mentioned the 25-bp rate increase of the Fed as one of the reasons for its decision to hike. Looking ahead, the central bank remains focused on the same factors as before: second-round effects from the shocks affecting domestic prices, the relative monetary policy stance between Mexico and the U.S., and the output gap. Still, the board clearly took some comfort from the behavior of the currency and said that there was no additional deterioration of the balance of risks for inflation since the previous meeting.

We read the recent actions and guidance as consistent with our scenario (only a couple more 25-bp rate hikes after each of the next two Fed moves expected for this year). We see the reference rate at 7% by the end of the year. For 2018, provided that inflation decreases and GDP growth remains sluggish, we believe rate cuts are likely (though volatility related to the presidential elections may stand in the way of monetary loosening). In fact, during a testimony at the Senate in early April, Governor Carstens stated that Banxico may not need to follow each Fed move in the medium term. The monetary policy rate is already above the upper bound of Banxico’s estimates for the neutral rate (4.3%-5.2%) and above the level predicted by our Taylor Rule.

Twin deficits narrow

The twin deficits are narrowing, adding to the more positive sentiment. Mexico’s trade deficit has narrowed substantially from the high levels of the previous year. The rolling 12-month non-energy balance is in surplus territory since January (the first time in 20 years). In contrast, the energy deficit remains wide. We expect the trade deficit to continue narrowing on the back of higher U.S. growth, a competitive real exchange rate (in spite of the recent appreciation) and a deceleration of internal demand.

On the fiscal front, a whopping dividend from the central bank will likely allow the government to surpass the fiscal targets set for 2017, reducing the odds of a sovereign rating downgrade. The dividend (MXN 321.7 billion, 1.5% of GDP), which is the outcome of exchange rate gains over international reserves, has reached a record-high in 2017, surpassing last year’s MXN 239.1 billion (1.2% of GDP). The government is currently targeting a primary surplus of 0.4% of GDP, a public sector nominal deficit of 2.4% of GDP and public-sector borrowing requirements (broadest measure) of 2.9% of GDP for 2017. Considering the announcement of the central bank dividend and our revised GDP and exchange rate forecasts, we now expect a narrower public sector nominal deficit in 2017 (2.1% of GDP, 2.4% previously) and lower public-debt-to-GDP ratios for both 2017 (49% of GDP, 49.5% previously) and 2018 (48.7% of GDP, 49.2% previously). The rating agencies are probably expecting the achievement of more ambitious fiscal results in 2017 (relative to the targets) and would react negatively if the windfall of the dividend is allocated toward further spending.


João Pedro Bumachar
Alexander Andre Muller

Please see the attached file for all graphs.  

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