Itaú BBA - Energy Reform Advances; the Economy, Not So Much

Scenario Review - Mexico

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Energy Reform Advances; the Economy, Not So Much

May 7, 2014

Enrique Peña Nieto sent to congress on April 30 the secondary legislation related to the constitutional reform approved in late 2013.

• The Mexican government has sent to congress the secondary legislation for the energy reform. We read the proposed bill as positive, as it doesn’t water down the advances made in the constitutional reform. Apart from boosting oil production, the reform will also contribute to making fiscal policy in Mexico more counter-cyclical.

• The GDP gained momentum in the beginning of 2014, but it continued to grow below trend. More recently, indicators related to exports weakened, while there were mixed results for internal demand data. We now see growth in 2013 at 2.7% (3.0% previously). For 2015, we maintain our growth expectation at 3.8%. 

• The U.S. treasury yields will likely rise faster than the market is expecting, strengthening the dollar globally. However, because of the advances on reforms in Mexico (and their expected impact on capital flows and productivity) together with the benefit of higher U.S. growth on Mexico’s exports, we expect only a modest depreciation of the peso against the dollar. We see the peso at 13.2 to the dollar by the end of both this year and next.

• As widely expected, the central bank left the policy rate unchanged in its April monetary policy meeting. The tone of the press statement announcing the decision was similar to the previous one. We don’t expect policy-rate moves in Mexico this year. However, we expect a tightening cycle in 2015, once the Fed starts to raise rates.

Energy Reform Takes Another Step Forward 

Enrique Peña Nieto sent to congress on April 30 the secondary legislation related to the constitutional reform approved in late 2013. Six laws will be first discussed in the senate, while three laws were sent first to the lower house. The proposed legislation confirms the government’s intentions of transforming PEMEX into a “productive state enterprise,” which means that the company will have its tax burden lowered gradually (from around 80% to around 65% one decade from now), and it will have budgetary autonomy from the federal government (although the government will be able to impose a cap on its debt). Regarding national content, the law proposes that firms source at least 25% of goods and services locally (which is not high, according to our Oil and Gas team), but it gives companies a decade to comply. According to the bill, competition in gas stations will be introduced only gradually, so private firms will not be able to compete with PEMEX in retail right away. Finally, a sovereign fund (named Mexican Oil Fund) will be responsible for channeling revenues related to the Energy sector to the government. The fund should provide the federal government with the equivalent of 4.7% of GDP per year and save excess revenues (the government targets savings in the fund of around 3% of GDP). 

We read the secondary legislation as positive because it doesn’t water down the advances made in the constitutional reform. Apart from boosting oil production, the reform will also contribute to making fiscal policy in Mexico more counter-cyclical. Given that only a simple majority is required for the secondary legislation to pass in congress, its approval is very likely. The congress is expected to vote on the bill in June in an extraordinary session.

A Bumpy Recovery

Mexico’s GDP gained momentum in the beginning of 2014 but continued to grow below trend. The IGAE (monthly proxy for GDP) came in at 1.74% year over year in February, after a 1.0% expansion in January and a 0.8% gain in 4Q13. While growth in February was influenced by a sharp 11.8% increase in the small and volatile Agricultural sector, growth in Services also improved, to 1.9% (from 1.1% in January and 1.5% in 4Q13), while the Industry (0.7% in February) performed slightly poorer than in January (0.8%) but better than in 4Q13 (-0.4%). On a sequential basis, the IGAE gained 0.54% from January, after a 0.2% rise the previous month. As a result, activity accelerated to 2.0% qoq/saar, from 1.7% in January and 1.2% in 4Q13. The Service sector increased by 0.5% month over month and 1.3% qoq/saar, while the Industrial sector was up by 0.3% from January and 1.8% qoq/saar. 

Recent data related to exports were weak, while internal demand indicators had a mixed performance.

Manufacturing exports were weak in 1Q14 and the manufacturing PMI and its key subcomponents worsened in April. Manufacturing exports gained a modest 0.1% from February, after a 5.0% increase the previous month. Auto exports increased 1.5% month over month, while non-auto manufacturing exports contracted 0.6%. So in 1Q14, manufacturing exports were flat with the previous quarter, with a 14.1% annualized increase in auto exports and a 5.8% qoq/saar contraction in the non-auto component. Meanwhile, in April, the seasonally-adjusted manufacturing PMI (calculated by IMEF) fell to 51.1, from 52.4 in March. The main subcomponents all saw significant decreases from the previous month: new orders fell to 50.1 (previously 54.3), production came down to 51.3 (from 54.7) and employment retreated to 51.3 (previously 53.2).

Investment is gradually improving, while retail sales surprised negatively in February. Although it is at a depressed level, construction activity gained 4.5% qoq/saar in February, while imports of capital goods increased 7.1% in 1Q14, after a 6.0% gain the previous quarter. Public capital expenditures increased 46% year over year in 1Q14. On the other hand, retail sales were down by 1.7% year over year in March and contracted by 3.7% qoq/saar.  The breakdown of retail data reveals that the weakness was broad-based within the main product categories. Although consumption is disappointing, the labor market and consumer confidence are gradually recovering, which together with the lower inflation readings will likely support consumption ahead.  Formal employment growth came in at 3.1% year over year in March, up from 2.7% from February, and the temporary component of formal employment – a leading to permanent employment growth – picked up to 4.4%, from 3.3% in February.  

We reduced our growth forecast for this year to 2.7% (from 3.0%). For 2015, we still expect a 3.8% expansion. In our forecast, there is a strong recovery from the 2Q14 on. The economy will likely benefit from higher growth in the U.S. and expansionary fiscal and monetary policies at home. In 2015, the economy will get an extra push from the first impacts of structural reform on growth.    

Exchange Rate to Depreciate Slightly         

The trade balance for March suggests that the current account deficit continues to be very comfortable. In March, the trade balance posted a USD 1.0 billion surplus, bringing the 12-month rolling deficit to USD 1.2 billion, from USD 0.5 billion in February. The seasonally-adjusted trade deficit was USD 8.8 billion (annualized) in 1Q14, down from a USD 10.2 billion surplus in 4Q13. The deterioration of the trade balance between the last quarter of 2013 and the first quarter of this year was mostly due to a higher non-energy deficit (USD 13.8 billion in 1Q14 versus USD 0.8 billion in 4Q13). However, we note that in December 2013 the seasonally-adjusted trade surplus was unusually high, which was reversed through a large deficit in January 2014. So the average of the trade balances in 4Q13 and 1Q14 (a USD 700 million annualized surplus) shows a more accurate picture of current external trade activity in Mexico.

We see the peso at 13.2 to the dollar by the end of both this year and next. In our view, the U.S. treasury yields will rise faster than the market is expecting, strengthening the dollar globally. However, because of the advances on reforms in Mexico (and their expected impact on capital flows and productivity) together with the benefit of higher U.S. growth on Mexico’s exports, we expect only a modest depreciation of the peso against the dollar. The recovery of exports and the stable exchange rate will likely keep the current account deficit in Mexico below that of other LatAm countries.

Inflation Falls Deeper Into the Target Range          

Inflation in Mexico fell further in the first half of April, standing firmly within the target range in spite of the upward pressure on prices from tax increases. Headline inflation stood at 3.53% year over year, down from 3.62% in the second half of March and 4.63% in the first half of January (when the tax hikes were introduced). Non-core inflation reached 4.7% (from 5.79%), as both inflation for regulated items and inflation for non-processed food retreated (to -1.2%). Meanwhile, core inflation rose (to 3.17%, from 2.95%) but continued to hover around the center of the target. Furthermore, the increase in core inflation was concentrated in services related to the Holy Week holidays. So inflation for core goods stood at 2.94% (2.93% previously), while core services inflation rose from 2.96% to 3.36%. In all, excluding the impact of higher taxes, headline inflation is likely close to the target center, while core inflation is below 3%.

We see inflation at 3.7% by the end of this year and at 3.2% by the end of 2015. In our view, a well-behaved exchange rate with no demand-side inflationary pressure will likely keep inflation within the target range this year. Next year, inflation will likely fall – in spite of our expectation for a stronger economy – as the effect of tax increases fades. Considering the recent behavior of core inflation – which is far less volatile than the headline number – we think that the central bank will likely stabilize inflation at the center of the target starting in 2016.

Monetary Policy: Rate and Bias Remain Unchanged          

As widely expected, the central bank left the policy rate unchanged in its April monetary policy meeting. The tone of the press statement announcing the decision was similar to the previous one. In the concluding remarks, the board once again highlighted the evolution of the output gap as one of the factors that it will monitor in upcoming meetings. Still, the board continues to say that it will also monitor the monetary policy stance relative to the U.S. So in our view, a neutral bias remains.

The central bank sees unchanged balance of risks for inflation and marginally better balance of risks for activity. Board members stated that Mexico’s economy has grown below expectations in 1Q14, but they sounded more optimistic regarding activity ahead, due to the recent performance of some activity indicators. Regarding inflation, the board remains upbeat, noting that there were no second-round effects from the new taxes introduced in January, as inflation has continued to decline. The central bank also highlighted the lower non-core inflation, as a consequence of the fading supply shocks that affected food prices in previous months.

In our view, the statement reaffirms that the central bank will not change its policy rate soon. We don’t expect policy rate moves in Mexico this year. However, we expect a tightening cycle in 2015, once the Fed starts to raise rates.

João Pedro Bumachar
Economist



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