Itaú BBA - Facing the Trump fallout

Scenario Review - Mexico

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Facing the Trump fallout

November 16, 2016

The outcome of the U.S. presidential election has weakened Mexico’s economic prospects.

Please see the attached file for all graphs. 

The outcome of the U.S. presidential election has weakened Mexico’s economic prospects. We continue to expect a GDP growth rate of 2.1% in 2016, down from 2.5% in 2015, but have trimmed our forecast for 2017 by 0.6 p.p. (to 1.8% from 2.4%), due to higher U.S. treasury yields and uncertainty over protectionism (which will be particularly harmful for investment in Mexico’s manufacturing sector). Higher growth in the U.S. (due to the likely fiscal stimulus) is a buffer. 

The Mexican peso has weakened sharply after Trump’s victory was announced. We now expect the central bank to raise interest rates by 100-bps in November and by 25-bps in December (the second move in tandem with the Fed). While the price action of the Mexican peso indicates the central bank will be aggressive, the recent rhetoric of Governor Agustín Carstens suggests the board is at least questioning to what extent it has tools to deal with the “Trump shock” (an extraordinary policy meeting was ruled-out, right after the victory of Donald Trump was announced), so there is a probability the central bank opts for a smaller move (50-bps). 

We have revised our exchange rate forecasts for 2016 (to 20.5 from 17.5) and 2017 (19.5 from 17.5). In our view, an appreciation from the current levels is still likely, as higher domestic interest rates, a recovery of oil prices and a narrower current account deficit would contribute to improve the currency’s dynamics. However, a prolonged period of uncertainty about U.S.-Mexico trade relations would exert similarly protracted pressure on the MXN, keeping the currency far away from fundamentals.

As a consequence of the developments in the exchange rate market, we have increased our 2017 inflation forecast by 70-bps, to 3.7% from 3.0%. For this year we expect 3.2% (3.0% in our previous scenario).

Activity improved in 3Q16, but it faces new headwinds

Activity in Mexico took a turn for the better in 3Q16, although the economy still looks fragile and uneven across sectors. The flash estimate of GDP growth for 3Q16 came in at 2% year over year. Adjusted for calendar effects, GDP growth was 1.9% year over year – up from 1.5% in 2Q16, thereby marking acceleration. At the margin, GDP grew by 4.1% qoq/saar (compared with -0.7% qoq/saar in 2Q16).

Growth continues to be led by the service sector, while industrial production is weak. Recent data show that year-over-year growth in the service sector picked up from 2.4% in 2Q16 to 3.3% in 3Q16, while year-over-year industrial production growth slipped to -1% in 3Q16 from -0.3% in 2Q16. Service-sector activity is being sustained by solid consumption. Industrial production, in contrast, is being dragged down by falling oil output (-5.6% year over year in 3Q16) and anemic infrastructure spending by the public sector, that are more than offsetting a recovery in manufacturing exports (+13% qoq/saar, in U.S. dollars).

We continue to expect GDP growth rate of 2.1% in 2016, down from 2.5% in 2015, but have trimmed our forecast for 2017 by 0.6p.p. (to 1.8% from 2.4%). As we do not expect protectionism to materialize, at least not in the short-term, manufacturing exports in Mexico will benefit from a weaker exchange rate and higher growth in the U.S. (induced by fiscal stimulus). However, because the uncertainty over protectionism is expected to diminish only gradually, investment in the manufacturing sector will be a major drag for growth.  

Prices adjust to Trump

The Mexican peso has weakened sharply after Trump’s victory was announced, trading weaker than 20 to the dollar for the first time in history. Central Bank Governor Carstens and Finance Minister Meade held a press conference on the day after the U.S. elections, but there was no concrete policy announcement. In particular, Central Bank Governor Agustín Carstens said they would take the necessary measures on the next scheduled meeting (due on November 17), therefore ruling out an extraordinary meeting – something that was speculated in the market should Trump win.

We expect the central bank to raise the policy rate by 100-bps in November and 25-bps December (in tandem with a hike by the Fed), bringing it to 6.0% by yearend. While the price action of the Mexican peso indicates the central bank will be aggressive, the recent rhetoric of Governor Agustín Carstens suggests the board is at least questioning to what extent it has the tools to deal with the “Trump shock” (an extraordinary policy meeting was ruled-out, right after the victory of Donald Trump was announced), so there is a probability the central bank opts for a smaller move (50-bps).

We have revised our exchange rate forecasts for 2016 (to 20.5 from 17.5) and 2017 (19.5 from 17.5). In our view, an appreciation from the current levels is still likely, as higher domestic interest rates, a recovery of oil prices, and a narrower current account deficit would contribute to improve the currency’s dynamics. However, prolonged uncertainty on U.S. policies may keep the MXN far away from fundamentals, at least temporarily.

Inflation accelerated a bit further in October on the back of a weaker exchange rate and higher non-core inflation. The year-over-year measure is now at 3.06%, slightly above the target for the first time in 18 months. Core inflation has stayed virtually unchanged (3.10% in October, vs. 3.07% in September), but there is a sharp contrast between the level of core goods inflation (3.97% in October) and core services inflation (at 2.36%), which remains low reflecting the benefits of the telecom reform and the absence of demand-side pressures.

We have increased our inflation forecast for both 2016 (to 3.2% from 3.0%) and 2017 (to 3.7% from 3.0%). In the short term, unfavorable base effects (related to the telecom reform) will likely contribute to drive inflation up from its current level. In 2017, the weaker currency (relatively to our previous scenario) should lead to higher inflation.   

Fiscal accounts deteriorated in 3Q16

Mexico’s fiscal accounts deteriorated in 3Q16, but the numbers are still consistent with the fiscal consolidation plan. The net debt of the public sector (gross debt minus federal government’s financial assets) as a percentage of GDP increased from 45.7% in 2Q16 to 47.6% in 3Q16, below the 48.5% estimate for 2016 that was presented in the 2017 budget bill. According to the Treasury’s plan, net debt would stabilize in 2017 at 48.4% of GDP. Showing a similar pattern, the 12-month public deficit widened from MXN 402.9 billion (2.1% of GDP) in 2Q16 to MXN 450.1 billion (2.4% of GDP) in 3Q16. As stressed by the Treasury’s Chief Economist Luis Madrazo in a recent interview, these results show that the fiscal accounts are still on track to meet the fiscal targets set for 2016 – specifically, a public sector deficit of 2.9% of GDP and public sector borrowing requirements of 3.0% of GDP.

In late October, the Lower House of Congress approved a modification to the revenue bill that implies an extra 51.4 billion pesos (0.3 pp of GDP) in government revenues for the 2017 budget plan presented by the Treasury (SHCP) in September. Specifically, two important parameters of the budget were changed: the average exchange rate (to 18.62 Mexican pesos to the dollar, from 18.20) and oil output (to 1.947 million barrels per day, from 1.928). As we expected, given the more optimistic revenue assumptions, Congress used this room to stipulate higher spending in the spending bill (approved on November 11) by an equal amount (51.4 billion pesos) without changing the fiscal targets. So for 2017, the government is still aiming at a primary surplus and public sector borrowing requirements of 0.4% of GDP and 2.9% of GDP, respectively.  

We have revised our forecasts of Mexico’s net public debt for 2016 (to 49.2% of GDP, from 48%) and 2017 (to 48.7% of GDP, from 48.1%) as a result of the exchange rate impact on foreign currency debt. Our forecast of the public deficit for 2016, however, remains unchanged at 3% of GDP. We believe that, next year, lower GDP growth and higher domestic interest rates (affecting tax revenues and the interest burden, respectively) will exert negative pressure on the fiscal balance, but this will be partly offset by the positive effect of the weaker exchange rate on oil revenues (expressed in pesos). Therefore, we have widened our public deficit forecast for 2017 by 0.1p.p. (to 2.4% of GDP, from 2.3%). A positive risk (for the fiscal accounts) is that the Mexican government could receive another large dividend from the Central Bank (1.2% of GDP in 2016), due to exchange rate gains on international reserves.


 

João Pedro Bumachar
Alexander Andre Muller


Please see the attached file for all graphs.  


 



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