Itaú BBA - A NAFTA deal within reach?

Scenario Review - Mexico

< Back

A NAFTA deal within reach?

April 12, 2018

We continue to expect that a successful renegotiation of NAFTA will be announced in 2Q18.

Please see the attached file for all graphs.
 

We continue to expect that a successful renegotiation of NAFTA will be announced in 2Q18. Notably, the renegotiation talks seem to have gained significant momentum recently.

On the election front, the campaign season officially began on March 30 and the anti-establishment candidate Andrés Manuel López Obrador (AMLO) still leads the race by a solid margin. His recent open letter to investors indicates he is willing to moderate his rhetoric in the run-up to Election Day (July 1).

Even though activity is surprising to the upside in 1Q18, we expect GDP to slow down to 1.8% in 2018, from 2% in 2017, mainly dragged down by weak investment (given the uncertainties that have put investment decisions on hold). 

Inflation is falling more consistently, which together with the recent appreciation of the Mexican peso and the central bank’s de-emphasis of the Fed indicates additional rate hikes are unlikely. In fact, the central bank left the policy rate unchanged in April, at 7.5%. In our view, the next policy rate move in Mexico will be a cut, likely in 4Q18.

NAFTA 2.0. within reach

NAFTA renegotiation has gained significant momentum over the past month, as the U.S. seems to be pushing for a deal in the short term. The media has reported that President Trump is applying pressure to conclude the renegotiations. Moreover, Mexico’s Minister of Industry & Trade, Ildefonso Guajardo (who leads the Mexican team in the NAFTA rounds) said there is an 80% probability of reaching an agreement by the first week of May. In all, it seems the U.S. government is taking into account that closing a deal before the Mexican elections can prevent negotiations from derailing. 

In fact, there has been major progress on rules of origin, one of the most critical issues. The U.S. dropped its toughest demand on rules of origin (50% U.S. content requirement for automobiles) and would be asking in return to include a USD 15 per hour wage (or higher) requirement for 30% of the value content of vehicles exported to North American countries under NAFTA’s zero tariffs. 

Our base case remains unchanged: NAFTA partners will reach a “successful” compromise in 2Q18, which will imply Mexico and Canada making concessions to the U.S. (but concessions that do not imply transformational changes for their economies). We note that the Mexican Senate could ratify the renegotiated deal by the last day of August (Senate enters into recess in May, but special commissions will remain operating). In the short term, the 8th NAFTA round – originally scheduled for early April – was postponed, but instead the heads of negotiating teams met last week in Washington. There is a possibility that no more rounds will be held, but rather that the renegotiation will be conducted more privately from now on. 

Presidential election campaign season kicks off

The campaign season officially began on March 30, with the anti-establishment candidate Andrés Manuel López Obrador (AMLO) leading the race by a solid margin and the traditional parties fighting over the second position (in order to have a chance at winning by attracting tactical votes). According to the latest surveys, comparing the average results of high-credibility pollsters (Reforma, Mitofsky, El Financiero), polls for AMLO stood at 29.5% in March (from 29.7% in February), followed by a weakened Ricardo Anaya (18.7%, from 22.6%), the ruling party’s José Antonio Meade (16.6%, from 16.2%), and the independent candidate – former First Lady – Margarita Zavala (4.9%, from 4.7%). 

Tellingly, the last polls indicate that voter preference for the presidential candidate of the PAN/PRD right/center-left alliance, Ricardo Anaya, are being eroded by its confrontation with the ruling party (PRI), which is accusing Anaya of corruption. Anaya has fired back by claiming that the PRI is using government institutions (such as the anti-corruption agency, the PGR) to discredit its political adversaries – a claim that was echoed by a large group of local academics (who sent an open letter of complaint to President Peña Nieto) – but it is clear by now that the confrontation between the two largest forces of the political establishment is causing more damage to Anaya than to Meade (the candidate of the PRI). AMLO, in contrast, is sitting back to watch how his competitors fight each other, and his poll numbers are increasing. 

In addition, we note that on April 4, less than three months away from Election Day (July 1), AMLO sent an open letter to a local newspaper asking investors and the private sector to trust him. In the letter, AMLO argued that Mexico’s main problem is corruption and his government would be focused on eliminating it. Moreover, he pledged to build an honest and austere government which will strengthen fiscal discipline, respect the central bank’s independence and promote an authentic rule of law within the framework of democracy. Regarding the contracts awarded by the Mexican government – such as those of the energy reform and the airport of Mexico City – AMLO stated that they will be scrutinized to prevent corruption. Finally, AMLO expressed an opinion about NAFTA renegotiation and claimed that the deal should be signed after the elections. In his view, the government must protect Mexican productive sectors, guarantee fair wages for the working class and include migration rules (which were not covered in the original NAFTA).           

In spite of NAFTA and elections, activity is surprising to the upside

Mexico’s GDP growth slowed to 2% in 2017 (from 2.9%), but activity has been surprising to the upside in 1Q18. The GDP proxy (IGAE) expanded 2.2% year over year in January. According to calendar-adjusted data reported by the statistics institute (INEGI), growth was lower (1.2%) but the three-month moving average growth rate picked up to 1.7% year over year (from 1.6% in December). 

At the margin, the momentum of activity improved. Even though the seasonally-adjusted GDP proxy fell 0.7% from December, quarter-over-quarter annualized growth jumped to 4.4% (from 3.7% qoq/saar in December). Although the qoq/saar print is being affected by a low base of comparison (due to natural hazards), over the past three months month-over-month growth averaged 4.0% annualized. Moreover, the firmer momentum is observed across the board: services (3.9% qoq/saar, from 3.7% in December), industrial activities (2.1% qoq/saar, from 0.5%) and primary sectors (12% qoq/saar, from 10.1%). 

Other coincident indicators – such as gross fixed investment and trade data – have also surprised to the upside. Seasonally adjusted gross fixed investment grew 1% month over month in January, on top of a 4.2% month-over-month print in December, which took quarter-over-quarter annualized growth to 2.6% in January (from -2.7% qoq/saar in December). On the trade side, the breakdown of exports and imports shows more positive news both for external and internal demand. Manufacturing exports expanded by 11.8% qoq/saar in February, while non-oil imports were up by 16.7% qoq/saar. Within non-oil imports, the acceleration was broad-based – consumer goods (23.1% qoq/saar, from 9.8%), intermediate goods (13.1% qoq/saar, from 12.6%) and capital goods (38.3% qoq/saar, from 18.1%).

Still, we expect GDP to slow down to 1.8% in 2018, from 2% in 2017, mainly dragged down by weak investment. The factors playing against activity are the uncertainties associated with NAFTA and elections (which put investment decisions on hold) and tight macro policies (both fiscal and monetary). On the plus side, however, the acceleration of the U.S. economy will likely boost Mexican manufacturing exports, falling inflation will support real wages (and probably prevent a further slowdown of consumption), and smaller budget cuts (relative to 2017) will imply a lower fiscal drag on the economy.  

Benign inflation conditions provide room to decouple from the Fed

Inflation continued decreasing in March, more than expected by the market, with stronger evidence that the disinflationary process is gaining traction. Headline inflation fell to 5.04% year over year in March (from 5.34% in February), and core inflation decreased to 4.02% (from 4.27%) during the same period. Core goods (tradables) inflation came in much lower than before (4.64%, from 5.18%), while core service (non-tradable) inflation was unchanged, at 3.49%. Turning to the non-core index (8.03%, from 8.49%), the decrease for food (to 7.74% from 9.69%) and regulated items (6.85%, from 7.08%) was partly offset by higher energy inflation (8.85%, from 8.16%). 

The diffusion index has fallen substantially, and measures of inflation at the margin (for both the CPI and the core index) have decreased to levels close to the central bank’s 3% target. The diffusion index, which tracks the percentage of items in the CPI basket with inflation higher or equal to four, went down to 56.7% (from 62.5% in February), reaching the lowest result in 15 months. Moreover, seasonally adjusted three-month annualized inflation has fallen across the board: headline (3.13%, from 3.26% in February), core (3.31%, from 3.64%), core goods (3.62%, from 4.21%) and core services (3.06%, from 3.24%).

We expect inflation to decrease to 3.7% by the end of 2018 (below median market expectations of 4.1%, according to the central bank’s last survey). The more benign evolution of the Mexican peso will be the key driver, as pass-through is now actually exerting downward pressure. Moreover, we see further room for the normalization of non-core inflation. 

Mexico’s monetary policy committee unanimously decided to leave its policy rate unchanged at 7.5% in April, following two 25-bp rate hikes. The decision was expected by us and market consensus. 

Importantly, in the press release announcing the decision, the board said that the current policy stance is consistent with anchoring inflation expectations and with a downward trend of headline inflation towards the central bank’s target. We note that a similar sentence was included in the press statement of June 2017 when the central bank wanted to indicate a pause in the tightening cycle.    

Still, the board maintains a cautious tone, so further rate hikes are possible. Specifically, the central bank continues to pledge that it will “if necessary, act timely and firmly to strengthen the anchorage of medium and long term inflation expectations and achieve inflation convergence to the 3% target”. Furthermore, the board continues to say that the balance of risks for inflation is tilted to the upside, even though it acknowledges that risks related to NAFTA have moderated. 

We read the statement as consistent with our baseline scenario. Additional rate hikes are unlikely unless risks related to NAFTA, monetary policy in the U.S. and elections intensify (that is, lead to a sharp weakening of the Mexican peso). But we also note that the central bank under the new governorship is clearly signaling that it doesn’t want to be as reactive to exchange rate and the Fed as in the past. In fact, in this latest statement the board once again highlighted it is conducting monetary policy based on inflation forecasting and it is tracking closely the evolution of inflation against the path predicted in the last inflation report. So, the bar (in terms of exchange rate weakening) for rate hikes seems higher than before.
 

João Pedro Bumachar
Alexander Muller

 

Please see the attached file for all graphs. 



< Back