Itaú BBA - Another victim of cheap oil

Scenario Review - Mexico

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Another victim of cheap oil

February 3, 2016

the decline in oil prices is negatively affecting activity, fiscal revenues, exports and the exchange rate.

Please see the attached file for all graphs. 

• Despite the country’s decreased dependence on oil, the decline in oil prices is negatively affecting activity, fiscal revenues, exports and the exchange rate. At the same time, consumers are not benefiting much, as the government prevents domestic gasoline prices from falling significantly. We expect a recovery of oil prices in the second half of this year, which would bring some relief to the economy.  

• The economy picked up in 2015 (to 2.5%), but falling oil production, weak demand for Mexico’s manufacturing exports and the ongoing fiscal tightening (induced by lower oil revenues) are slowing the recovery. We expect growth of 2.8% this year, but there are downside risks.

• Inflation increased somewhat in the beginning of 2016. Even so, inflation continues low (below the target center), supporting real wages and, consequently, consumption. We expect inflation to end this year at 3.0%.

• The Mexican peso depreciated strongly in December and January, underperforming most currencies. The fact that oil fell by more than other commodities partly explains the evolution of the currency. But in our view, “softening” of the exchange-rate intervention also had a role. Our year-end forecast for the exchange rate stands at 17.5 pesos to the dollar, a small appreciation from the current level, as we expect oil prices to recover later this year.

• The central bank of Mexico is unlikely to react to the depreciation of the Mexican peso through monetary tightening, unless the driver of the weakening is the narrowing of the interest-rate differential between Mexico and the U.S. Furthermore, as we now expect the Fed to be somewhat more cautious when removing monetary stimulus, we expect fewer rate hikes in Mexico. Our year-end forecast for the interest rate is 3.75% (from 4.0% previously).

• The government managed to keep a moderate fiscal deficit in 2015, in spite of lower oil prices and lower oil production. However, challenges remain for this year. The oil price was hedged at USD 49 per barrel (36% lower than the price hedged in 2015). At the same time, oil production is failing to recover and could even fall further, so there are headwinds for the government’s deficit-reduction targets. 

A gradual and unbalanced recovery

The economy picked up in 2015. The GDP increased by 0.6% between 3Q15 and 4Q15, according to preliminary figures released by INEGI (the official statistics institute). As a result, the economy expanded by 2.5% in 4Q15 from a year earlier, down slightly from the 2.6% gain in 3Q15, bringing full-year growth to 2.5%, up from 2.3% in 2014 and 1.3% in 2013.

In 4Q15, economic growth was led by a solid 3.5% expansion in the services sector, consistent with the strong positive evolution of private consumption. In fact, retail sales in Mexico grew by a strong 5.7% year over year in November, following a 4.8% gain the previous month. The working-day adjusted series also picked up (to 5.4% from 5.0%). Solid credit expansion (10% in December), strong growth in remittances (when converted to pesos, they grew by 29% year over year in the quarter ended in November), low inflation and strong formal employment growth (the two factors led to a real wage-bill growth of 6%) are all driving consumption growth higher.

However, industrial production remained weak in 4Q15 (at 0.6% year over year) as oil production contracted, the ongoing fiscal tightening hit the construction sector and manufacturing growth was dragged down by the sluggish U.S. manufacturing sector (in spite of the weaker Mexican peso). Mining production fell by 4.3% year over year in the quarter ended in November. In the same period, construction slowed to 1.5% (from 3.3% in 3Q15), as the strong expansion in housing investment was more than offset by the contraction in public capital spending. Meanwhile, manufacturing exports (in nominal dollar terms) fell by 3.6% qoq/saar in 4Q15, erasing much of the 6.9% gain seen in 3Q15 (the only quarter of positive growth in the year).

In all, Mexico’s economy is recovering gradually, but its growth is relying too much on rising consumption, which is unlikely to be sustainable without a recovery of the exporting sector.

We expect a growth rate of 2.8% for Mexico in 2016. Our base-case scenario is that the U.S. industrial sector will pick up, lifting Mexico’s exports. We also expect a stabilization of oil output. Some investments associated with the energy reform would also contribute to higher economic growth this year.

However, there are downside risks: the most recent U.S. ISM manufacturing data hint that a rebound of Mexico’s exports in the very near term is unlikely. In addition, low oil prices may limit the success of the energy reform while at the same time reducing fiscal revenues, which would lead to more fiscal tightening, less activity in the construction sector and potentially lower oil production (as a significant portion of the adjustment in public capital expenditures is being made by Pemex).

Annual inflation rises, but remains low

In spite of lower gasoline prices, annual inflation rose in the first half of January. Mexico’s consumer price index increased by 0.03% during the first half of January. Inflation was low, mostly due to the decline in gasoline prices, as the government introduced a new mechanism governing domestic prices linking their evolution to international prices (though price changes are constrained by a +/- 3% band centered on the year-end 2015 price). In this context, gasoline subtracted 10.5 bps from headline inflation.

Even so, year-over-year inflation rose to 2.48%, from 2.3%, during the second half of December. This was a result of an unfavorable base effect created by the sharp decline in telecom service prices the year before (-6.4% between the second half of December 2014 and the first half of January 2015). Core inflation stood at 2.6% (from 2.4% previously). Within core inflation, prices for core goods grew at an annual pace identical that in the second half of December 2015(2.8%), indicating that exchange-rate pressures on domestic prices are contained for now. Non-core inflation rose (in spite of lower gasoline prices) due to the volatile agricultural prices.

We expect inflation at 3.0% by the end of this year, which means that inflation will increase somewhat from the current levels, but will remain benign. We expect stronger effects on domestic prices from the exchange-rate depreciation earlier this year. In addition, more unfavorable base effects related to telecom prices will emerge by the end of 2016. For 2017, our forecast also stands at 3.0%.    

Trade balance is affected by oil

Low oil prices and lower oil production widened the trade deficit in 2015. Mexico’s trade balance deficit came in at USD 0.9 billion in December, bringing the deficit during the year to USD 14.4 billion, from USD 2.8 billion the previous year. In spite of the sharp weakening of the exchange rate during 2015, the non-energy deficit was slightly higher than in 2014, as manufacturing exports remained sluggish. Simultaneously, the energy balance deteriorated significantly last year (to a deficit of USD 9.9 billion, from surpluses of USD 1.1 billion in 2014 and USD 8.6 billion in 2013). Lower oil prices greatly reduced the value of Mexico’s exports, while declining oil production turned Mexico into a net energy importer last year.

Looking ahead, we expect oil prices to recover in the second half of 2016, but the weak oil production means that Mexico will not benefit in the short term. On the other hand, as we expect a recovery of U.S. production this year, manufacturing exports will likely recover and lift the non-energy trade balance. In this environment, Mexico’s current-account balance will likely remain manageable (in the four-quarter period ended in 3Q15, it reached 2.5% of GDP).  

The Mexican peso depreciated strongly in December and January, underperforming most currencies. The fact that oil fell more than other commodities partly explains the evolution of the currency. But currencies of countries with higher exposure to oil (like the Colombian peso and the Norway kroon) performed better during the period. In our view, exchange-rate policy has a role in explaining the behavior of the peso, as by the end of November 2015 the exchange-rate commission (formed by members of the central bank and the Ministry of Finance) “softened” intervention. Specifically, the USD 200 million daily auctions with no minimum price were suspended, while the volume offered in the auctions with minimum price (that is, those triggered when the exchange rate depreciates at least 1% from the previous day) was increased (to USD 400 million). The exchange-rate commission announced at the end of January that it will continue intervening at least until the end of March, but it did not change the parameters of intervention (volumes and required depreciation to trigger auctions) in spite of the recent evolution of the Mexican peso. Therefore, official dollar sales will continue with no floor and with a USD 400 million daily ceiling.  

Our year-end forecast for the exchange rate stands at 17.5 pesos to the dollar, meaning a small appreciation from the current levels. We expect oil prices to recover later this year, as supply adjusts to lower prices. In addition, interest-rate increases in Mexico will partly offset the impact of higher interest rates in the U.S.

Fewer hikes than we were previously expecting

We now expect Mexico’s central bank to hike the policy rate twice this year (instead of three 25-bp rate increases in our previous scenario), so our year-end forecast for the interest rate is 3.75% (from 4.0% previously). As we now expect the Fed to be somewhat more cautious when removing monetary stimulus, we expect fewer rate hikes in Mexico. In our view, the central bank of Mexico is unlikely to react to the depreciation of the Mexican peso through monetary tightening, unless the driver of the currency-weakening is the narrowing of the interest-rate differential between Mexico and the U.S. So, we do not think that the recent evolution of the currency will trigger rate movements. For 2017, our forecast for the policy rate now stands at 4.25% (from 4.5% in our previous scenario). 

A small deterioration of the public deficit, in spite of a large oil shock

The public sector nominal deficit widened slightly in 2015, to 3.5% of GDP (from 3.1% in 2014). During 2015, oil revenues fell by 32.9% in real terms. Besides lower oil prices (-49.3% in dollars), lower oil production (-6.9%) also contributed to the decline. However, a large portion of the decline in oil revenues was offset by keeping domestic gasoline prices above international levels. The oil-price hedge was another offsetting factor (returning around USD 6.0 billion to the government by December). Finally, there were other one-off factors related to the tax reform. On the expenditure side, the government implemented budget cuts last year (in particular, public spending in fixed assets fell by 5.8% in nominal terms during the year).

In sum, the government managed to keep a moderate fiscal deficit in 2015, but challenges remain for this year. The oil price was hedged at USD 49 per barrel (36% lower than the price hedged in 2015). At the same time, oil production is failing to recover and could even fall further this year. Thus, there are headwinds for the government’s deficit-reduction target.


 

João Pedro Bumachar


 

Please see the attached file for all graphs.  


 

 



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