Itaú BBA - An Unexpected Policy Rate Cut

Scenario Review - Mexico

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An Unexpected Policy Rate Cut

June 9, 2014

Mexico’s economy disappointed during 1Q14.

• 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 only in 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 1Q14

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, the GDP increased by 1.8% year over year in 1Q14, while the working-day-adjusted series expanded by only 0.6%. 

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 are 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%.

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 internal 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 before the end of this month is likely.


 

João Pedro Bumachar

Jesus Gustavo Garza-Garcia



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