Itaú BBA - Before, with or after the Fed?

Scenario Review - Mexico

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Before, with or after the Fed?

March 10, 2015

We currently expect Mexico’s central bank to deliver an interest rate hike in June, but there are balanced risks to this forecast.

• Although the Mexican economy performed well in 4Q14, the most recent indicators from the first quarter of 2015 suggest a loss of momentum. We have reduced our growth forecasts to 2.9% (from 3.2%) and to 3.3% (from 3.5%) for 2015 and 2016, respectively.

• The Mexican peso has continued to weaken recently, in line with the global strengthening of the U.S. dollar. While we still expect the peso to appreciate from its current levels as a result of a further recovery of oil prices (which we expect to take place during the second half of this year), we now see an exchange rate of 14.7 pesos to the dollar by the end of this year (from 14.0 pesos to the dollar in our previous scenario). For 2016, we now expect a year-end exchange rate of 15.0 pesos to the dollar (from 13.6 pesos to the dollar in our previous scenario), as we now foresee the dollar continuing to strengthen globally next year as well. 

• Our year-end inflation forecast for both this year and the next is 3.0%. Our new growth forecasts neutralize the impact of the weaker currency on consumer prices.

• The minutes from the most recent monetary policy meeting confirmed that the debate is over when to hike. Soon after the minutes were published, the Central Bank Governor Agustin Carstens stated that rate increases in Mexico could come before the Fed starts to raise rates. We currently expect Mexico’s central bank to deliver an interest rate hike in June, together with the start of a tightening cycle by the Fed. There are balanced risks: while exchange-rate volatility may lead the central bank to hike earlier, the disappointing growth figures and the benign inflation outlook allow the central bank to increase rates after the Fed’s liftoff.

• The National Hydrocarbons Commission announced the details of the second phase of the Round One auction. The terms offered to oil companies seem more attractive than those in the first phase of Round One. Lower oil prices and disappointing oil production are hurting the prospects of Mexico’s public finances and, together with weaker-than-expected growth, are increasing the pressure on the government to make progress in the energy reform implementation.

A bumpy recovery

The Mexican economy performed well in 4Q14. Mexico’s GDP came in at 2.6% year over year, up from 2.2% in 3Q14 and bringing the full-year growth to 2.1%. Sequentially, GDP increased by 2.7% qoq/saar, after a 2.1% expansion the previous quarter. Supply-side shocks – namely the drop in oil production – negatively affected activity in the period. In fact, GDP excluding natural resource sectors (mostly agriculture, oil and gas), which in the short term are driven by supply rather than demand, rose by 4.1% qoq/saar. Manufacturing exports continued to drive growth (up 10% qoq/saar). Gross fixed investment gained 5.6% qoq/saar, supported both by a recovery in housing investment (8.5%) and purchases of machines and equipment (12.9%). On the other hand, private consumption continues to perform poorly (2.2%).

However, indicators for the first quarter of this year suggest a loss of momentum. First, the carry-over will be unfavorable, as the IGAE (a monthly proxy for GDP) contracted by 0.3% from November to December. On top of that, manufacturing PMI (in both Mexico and the U.S.) and manufacturing exports (-3.3% month-over-month in January) have deteriorated. On the positive side, imports of capital goods improved, hinting that the investment recovery is on track.

We have reduced our growth forecast for this year to 2.9%. For 2016, we now expect a 3.3% expansion. In our previous scenario, we were forecasting GDP growth rates of 3.2% and 3.5% for 2015 and 2016, respectively. However, the export sector is not as strong as we were expecting, and the spillover to domestic consumption from the recovery in exports is taking longer to materialize. In any case, activity is still likely to improve meaningfully compared with 2014, driven by the U.S. economic recovery and by the implementation of Mexico’s economic reforms, though the latter will not be of much help to growth this year. The recovery of the real wage bill (due to both falling inflation and solid formal employment growth), the gradual improvement in consumer confidence and the expected acceleration in credit will also contribute to raise growth.

A weaker exchange rate

Mexico’s current account deficit was low in 2014, supported by manufacturing exports and moderate internal demand growth – factors that more than offset the sharp deterioration in net energy exports (to USD 1.6 billion from USD 8.7 billion in 2013). The deficit stood at USD 5.3 billion in 4Q14, down from USD 8.8 billion in 4Q13, bringing the total yearly deficit to USD 26.5 billion (or 2.1% of GDP), lower than the 2013 deficit of USD 29.7 billion (or 2.3% of GDP). Foreign direct investment (FDI) came in at USD 5.6 billion for the fourth quarter of the year, bringing the cumulative inflow in 2014 to USD 22.6 billion (1.7% of GDP), down from USD 44.2 billion in 2013 (3.4% of GDP), when flows were boosted by a large M&A transaction. Foreign portfolio flows were again the highlight of the capital account, at USD 10.1 billion in 4Q14, mainly due to investments in local government bonds (USD 9.9 billion), which largely offset the USD 1.1 billion in outflows from the equity market. As a result, foreign portfolio flows in 2014 totaled USD 47.2 billion (only marginally down from USD 50.3 billion in 2013).

On the other hand, the trade balance weakened considerably in January on a sequential basis. The three-month deficit stood at USD 11.9 billion (annualized and seasonally adjusted), deteriorating from the USD 2.1 billion deficit posted in 4Q14 due to inferior balances for both energy and non-energy products. In fact, the three-month rolling energy balance recorded its lowest value ever, a deficit of USD 9.9 billion (also annualized). Besides the sharp drop in oil prices, net energy exports are being hit by the contraction of oil output. The non-energy balance reached a USD 2 billion deficit (annualized) over the past three months after showing a surplus of USD 4.2 billion in 4Q14.

We now expect a current-account deficit of 2.5% of GDP for this year (up from 2.2% in our previous scenario). However, we note that in all likelihood this current-account deficit would still be low compared with most countries of the region, as external demand is expected to continue driving growth (that is, outpacing internal demand). Regarding capital flows, we expect FDI to accelerate due to the implementation of Mexico’s structural reforms, while portfolio investment will probably fall due to tighter external financial conditions.

The Mexican peso has continued to weaken recently, in line with the global strengthening of the U.S. dollar. While we still expect the peso to appreciate from its current levels, we now see an exchange rate of 14.7 pesos to the dollar by the end of this year (from 14.0 pesos to the dollar in our previous scenario). After all, some of the factors that might drive up the value of the peso (the start of Mexico’s tightening cycle, capital inflows associated with the energy reform and exports to the U.S.) seem to be already priced in. The likelihood of a further recovery in oil prices (which we expect to take place during the second half of this year) is the reason why we still expect some appreciation from the current levels. For 2016, we now expect a year-end exchange rate of 15.0 pesos to the dollar (from 13.6 pesos to the dollar in our previous scenario), as our scenario for the international economy assumes that the U.S. dollar’s strengthening trend will continue next year.

Inflation remains low in spite of a weaker currency

Headline inflation came in at 0.19% for February, led by a 0.34% gain in prices for goods. Annual inflation stood at 3.00%, down from 3.07% in January. Core inflation rose to 2.40% (from 2.34%) but remained below the 3% target. Prices for core goods increased by 2.64% (compared with an increase of 2.43% in January) – suggesting that the weakening of the peso is already having some effect on inflation – and inflation for core services was 2.20% (down from 2.26% in January). Non-core prices rose by 4.88% (vs. an increase of 5.34% in January) due to a smaller increase in energy and government tariffs of 2.90% (vs. 3.49% in January), while agricultural and livestock prices rose by 8.32% (compared with 8.50% in January). 

Our year-end inflation forecast for both this year and the next stand at 3.0%. Our new forecasts for growth would offset the impact of the weaker currency on prices. In all, we do not see the convergence of inflation to the target center as temporary. Our view contrasts with that of the market consensus. In fact, according to the most recent survey of expectations produced by Mexico’s central bank, the consensus expects year-end inflation to reach 3.46% by the end of 2016 (up from the 3.11% expected for 2015).

Following the Fed?

The minutes from the most recent monetary policy committee meeting revealed a unanimous decision to leave the policy rate unchanged, at 3.0%. As in the statement announcing the decision, the minutes show that most of the committee members see the balance of risks to inflation as unchanged, even though they also see a deterioration in the balance of risks for activity. Committee members again sounded concerned about the evolution of the exchange rate, in spite of making the usual disclaimer that the pass-through in Mexico has been historically low.

The document indicates that rate cuts are clearly off the table and the debate is over when to hike. In that sense, one committee member explicitly called for rate hikes before the Fed moves. Another member said that a monetary policy reaction in anticipation of “an external shock” can’t be ruled out. A third member did not hint at imminent moves, yet made it clear that the next step will be a hike. On the other hand, one committee member said that the central bank’s actions should be guided by the convergence of inflation to the target and by the goal of anchoring inflation expectations, rather than by the Fed’s actions.

Soon after the minutes were published, Banxico governor Carstens stated that rate increases in Mexico could come before the Fed starts to raise rates. 

We currently expect Mexico’s central bank to deliver an interest rate hike in June, together with the start of a tightening cycle by the Fed. However, considering the higher exchange-rate volatility and the committee members’ rhetoric (expressing concern over the path of the Mexican peso and openly acknowledging the possibility of hiking before the Fed), we cannot rule out an earlier move. On the other hand, the low inflation, the slower-than-expected recovery and the fact that the pass-through in Mexico has been low mean that there is also the risk that the central bank hikes after the Fed.

Our yearend interest rate forecasts are 3.5% and 4.5% for 2015 and 2016, respectively.

Progress in the implementation of the energy reform

The Mexican government indicated that additional budget cuts in 2016 are possible. This would follow the 0.7%-of-GDP cut announced for this year and a public deficit last year that was lower than approved by the Congress. The uncertain scenario for fiscal revenues (given low oil prices and disappointing oil production) are the reasons for this more conservative fiscal policy.

On February 27, the Mexican government (or more precisely, the National Hydrocarbons Commission) announced the details of the second phase of the Round One auction. Nine shallow water fields (which carry low-breakeven prices) will be divided into five (production-sharing) contracts. The government expects to attract close to USD 4.5 billion in investment by 2018 to explore these fields. The five contracts will be assigned at the end of September.

Importantly, according to experts, the terms seem to be better than those offered in the first phase of Round One. Lower oil prices and disappointing oil production are hurting the prospects of Mexico’s public finances and, together with weaker-than-expected growth, are increasing the pressure on the government to make progress in the energy reform implementation. While the government makes the contractual terms more attractive to private oil firms, it is also postponing the offering of the more risky non-conventional fields due to the uncertain outlook for oil prices.


 

João Pedro Bumachar

Jesus Gustavo Garza-Garcia



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