Itaú BBA - Fundamentals improve, but politics pose risks

Scenario Review - Mexico

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Fundamentals improve, but politics pose risks

September 4, 2017

Given the solid performance of the economy in 1H17, we have revised our growth forecast for 2017 to 2.3%, from 2% previously.

Please see the attached file for all graphs.

• Andrés Manuel López Obrador (AMLO), the leader of Morena, is consolidating himself at the top of voter preferences for the presidential elections to be held in July 2018. With the ruling party (PRI) and the right-wing party PAN not having defined their candidates yet, there is uncertainty on whether the political establishment can find someone strong enough to beat AMLO in the ballots. A possible alliance between the PAN and the PRD, which proved successful in the 2016 regional elections, could be competitive. Alliances are expected to be defined in October-November 2017, which we believe will mark the beginning of the period when financial prices become more sensitive to political news. 

• Given the solid performance of the economy in 1H17, we have revised our growth forecast for 2017 to 2.3%, from 2% previously. The shocks battering the economy (uncertainty over trade relations, inflation spike and falling oil output) seem to be moderating, which, coupled with a solid U.S. economy, will likely sustain growth during the second half of the year. In 2018, we expect GDP growth at 2.1%, down from this year due to a less favorable carry-over.

• Given that disinflation for tradables is taking longer than we expected and non-core food inflation continues rising, we have increased our inflation forecast for 2017 to 5.7%, from 5.4%. Still, disinflation will likely materialize soon. The appreciation of the peso observed so far this year (around 14% in the first eight months of the year) will be the leading driver for disinflation. Moreover, non-core food inflation, which is running at an abnormally high level, 14% year-over-year, is expected to revert in the coming months.

• After an eighteen-month tightening cycle (400 bps since December 2015), Banxico left the policy rate unchanged in August. Although we do not expect further rate increases, we see cuts as unlikely. Our base-case scenario is that Banxico will take a cautious approach, amid Fed rate hikes, NAFTA negotiations and uncertainty over presidential elections next year, so the board will likely remain on-hold for a while. We see rate cuts (two 25bps) only in the second half of 2018, taking the policy rate to 6.5% by the end of the year. 

• Mexico’s current account deficit is narrowing significantly, on the back of a strong U.S. economy (benefiting manufacturing exports and remittances) and, to lesser extent, a moderation of internal demand growth. Given the results observed in 2Q17, we have revised our current-account deficit forecast for 2017 to 1.4% of GDP, from 1.6% of GDP.

AMLO cements lead in presidential polls

Throughout 2017, the anti-establishment candidate Andrés Manuel Lopez Obrador (AMLO) has consistently led the presidential polls surveying preferences for candidates. However, polls surveying preferences for parties in 2018’s presidential election actually painted a much tighter race (with the PAN, the right-conservative party, occasionally ranking at the top). Arguably, as a newly born party, Morena (founded by AMLO in 2014) is less well known than the traditional political parties. However, having run for president twice (in 2006 and 2012) and having been the mayor of Mexico City, AMLO is better known than the potential candidates of the establishment.  

Recently, however, the polls “by candidate” and “by party preference” are showing much more consistent readings; that is, AMLO (and Morena) are the clear front-runners for the presidential election. In late August, El Universal published a new poll for the presidential election, surveying preferences for parties, which shows that Morena is leading the presidential race. According to this poll, the first published in August, Morena ranks at the top of voter preferences (23%), 4 pp ahead of the PAN (19%). The ruling party (PRI) came in third (16%), followed by the center-left PRD (6%). Taking an average of three poll firms (El Universal, Mitofsky, and Excélsior) that carry out surveys of voter preferences for parties, we note that Morena improved by 5.3 pp with respect to the latest poll (June); vote intentions for the PAN increased slightly (0.4 pp), while the PRI (-0.6 pp) and the PRD (-0.7 pp) lost ground. The campaign in the State of Mexico (which holds the largest number of voters) likely increased Morena’s visibility, even though its candidate lost by a narrow margin to the PRI. Besides, running under the banner of anti-corruption and the need to reform Mexico’s economic model, Morena grows stronger with recent news of corruption scandals and low potential growth (in the  vicinity of 2%, in spite of the structural reforms implemented since 2012, which were marketed by the government as growth engines).

Facing popular backlash, the PRI is struggling to define its candidate. In early August, the PRI’s national assembly reformed the party’s statutes to allow for more flexibility in the nomination of the presidential candidate. Specifically, the national assembly removed the bylaw article requiring that a presidential candidate must be an active party member for at least ten years, which ensured the eligibility of the Finance Minister, José Antonio Meade. Also, the party agreed that the methodology for appointing the candidate for the 2018 election will be a voting process in the 100-member leaders’ committee, as opposed to an open-party primary (which in the past has led to the selection of weak candidates, as was the case in the 2000 and 2012 presidential elections). Probably, voting in the 100-member leaders’ committee means that President Peña Nieto will hold more sway on the decision. Lately, the media has noted that four possible candidates – these are Miguel Osorio, the Interior Minister (who actually appears in most polls as the PRI’s candidate); the abovementioned José Antonio Meade; Aurelio Nuño, the Education Minister; and José Narro, the Health Minister – have been accompanying President Peña Nieto to strictly political events outside their normal duties (such as the assembly of the Green Party – the PRI’s ally – and the plenary of PRI Senators). We also would not rule out Enrique de la Madrid, the Tourism Minister, as a potential candidate, considering his low rejection rate, the positive public opinion toward his father (former President Miguel de la Madrid, 1982-1988), and solid academic credentials.          

In the PAN’s camp, there is also uncertainty about who will be the presidential candidate. Margarita Zavala is performing much better than her main rival, Ricardo Anaya (president of the PAN), in the polls that survey voter preferences for candidates (4 pp below AMLO, while Anaya lags by 15 pp, according to Reforma’s July poll). Nevertheless, this issue is far from settled, as the PAN’s primaries are expected to take place in 4Q17 (no specific date has been set yet).

An alliance between the PAN and the PRD, which seems the most potentially competitive platform to compete against AMLO, cannot be ruled out. The decline of the PRD’s vote intentions came in spite of the high media exposure of its President, Alejandra Barrales, over the past months and his campaign to form a “broad political front.” Barrales has not rejected the possibility of forming an alliance with Morena, probably to avoid alienating the most leftist factions of the PRD, but an alliance with the PAN (if any alliance is to materialize at all) seems more likely (reminiscent of the successful alliance for the regional elections in 2016). Importantly, alliances are expected to be defined in October-November 2017, and candidates in February-March 2018. We believe that this will intensify the sensitivity of Mexico’s financial assets to the presidential race – the election is scheduled for July 1, 2018.

Activity overcomes the headwinds

Growth has shown remarkable resilience to the headwinds in the first half of 2017, maintaining its pace in spite of the uncertainty surrounding bilateral relations with the U.S., the spike of inflation, the decreasing oil output and tighter fiscal and monetary policies. GDP growth came in at 1.8% year over year in 2Q17, down from 2.8% in 1Q17, but this is largely due to the negative calendar effect from the Easter holidays. According to calendar-adjusted data reported by the statistics institute (INEGI), year-over-year growth was higher in 2Q17 than in the previous quarter (2.9% year over year, from 2.6% in 1Q17).

At the margin, the quarterly GDP figures show 0.6% expansion between 1Q17 and 2Q17, although the IGAE (monthly proxy for GDP) expanded by a more modest 0.3%. We note that the sequential evolution of IGAE seems more consistent with that of other monthly activity indicators (such as private consumption, retail sales and gross fixed investment) than with the national accounts’ GDP. As a result, the GDP carry-over for this year is 2.2%, while the IGAE carry-over is 2.0% (that is, assuming zero seasonally adjusted month-over-month growth from July until December 2017).   

The GDP breakdown shows that service sectors remain robust. Service sectors expanded 3.3% qoq/saar (from 3.9% in 1Q17), although again we highlight that coincident indicators for private consumption would be consistent with weaker activity readings. The monthly proxy for private consumption posted nil quarter-over-quarter annualized growth in May (from 1.2% qoq/saar in April), and retail sales expanded at a modest 1.4% qoq/saar (less than one sixth of the average growth rate observed in 2016, 9.4% qoq/saar).

Industrial sectors are a mixed bag. The national accounts showed that Industrial growth posted a soft 0.1% qoq/saar in 2Q17 (from 0.6% qoq/saar in 1Q17). Looking at the components, we note that manufacturing lost traction in 2Q17 (-1% qoq/saar, from 7%) after a very strong start in the beginning of the year. Mining activity (largely oil) moderated its contraction (-2.6% qoq/saar in 2Q17, -8.2% in 1Q17) and construction growth (dragged by the fiscal consolidation and the uncertainty surrounding trade relations with the U.S.) deteriorated to -1% qoq/saar (0.1% previously). The fall of gross fixed investment (-0.9% qoq/saar in May) is closely linked to the poor performance of construction.

Given the solid performance of the economy in 1H17, we have revised our growth forecast for 2017 to 2.3%, from 2% previously. Thus, GDP would grow at the same pace as in 2016. The shocks battering the economy (uncertainty over trade relations, inflation spike, and falling oil output) seem to be moderating, which together with solid exports will likely sustain growth in the second half of the year. In fact, the real wage bill is already recovering at the margin and the U.S. manufacturing PMI is hovering at strong levels, supporting Mexico’s manufacturing exports. In 2018, we expect GDP growth to slow down a bit to 2.1%, from 2.3%, amid a less favorable carry-over. However, we note that there are downside risks: protectionism in the U.S. remains a threat (although this is a lower risk than it seemed right after the election of Donald Trump) and presidential elections next year could also hold back investment.

Disinflation is taking longer than expected

Mexico’s CPI surprised to the upside in the first half of August. Bi-weekly CPI inflation was 0.31%, above median market expectations, while core inflation advanced 0.20%, with an unexpectedly high variation for tradables (0.41%) in spite of MXN appreciation. Non-core prices increased 0.64%, because of persistently high agricultural inflation (0.87%). As a result, annual inflation and core inflation were stable (and high) between the second half of July and the first half of August, running at 6.6% and 5%, respectively.

Given that disinflation for tradables is taking longer than we expected and that non-core food inflation keeps rising, we have increased our inflation forecast for 2017 to 5.7%, from 5.4%. Still, disinflation will likely materialize soon. The appreciation of the peso observed so far this year (14% year-to-date, almost matching last year’s 19% depreciation) will be the leading driver for disinflation, with a mild impact on core tradable prices and energy prices (especially gasoline). Moreover, agricultural inflation (which is volatile and currently running at an abnormally high level, 14% year-over-year) will likely show a reversion in the coming months. Early next year, favorable base effects will lead to further disinflation. Our forecast for inflation at year-end 2018 is unchanged at 3.3%.

Rate cuts not yet imminent

After an eighteen-month tightening cycle (400 bps since December 2015), the Central Bank of Mexico left the monetary policy rate unchanged in August. The minutes of the latest monetary-policy meeting, however, show that there are contrasting views within the board, particularly on the inflation outlook and the room to decouple from the Fed.

Two deputy governors (out of five) are more cautious, with one of them still mentioning the possibility of further interest-rate hikes. One board member said that given the risks in 2018 (presidential elections, Fed hikes, NAFTA), the future monetary policy response is “uncertain,” and that market expectations of rate cuts are based on risky assumptions. Moreover, he added that further rate hikes cannot be ruled out. Also with a hawkish tone (but without referring to rate hikes), another board member said that cutting rates prematurely could turn out “very costly.”

The majority of board members have a more sanguine view of the inflation outlook. In the statement, the central bank mentioned that some categories of the CPI – specifically, non-food core goods (tradables) and energy – are showing a “change of trend;” and that, excluding the price of tomatoes, annual inflation would have fallen to 6.17% in July (27 bps below the actual print). Consistent with this, the minutes show that the majority of board members think that many inflation measures have slowed down and some are falling. Moreover, one board member, possibly Governor Carstens, considering that he made a similar point in a recent TV interview, stressed that – excluding the prices of tomatoes and potatoes – CPI inflation would have fallen to 6.08% in July.

Still, based on recent communication, even the board members within the majority seem unwilling to deliver rate cuts, at least until the elections are over. In a recent interview, Governor Carstens indicated that the elections next year are an obstacle for rate cuts. In the same spirit, according to the previous meeting minutes, even the only board member who voted to leave the reference rate unchanged at that meeting argued that it will be difficult to deliver the rate cuts that the market is expecting in 2018 because of the volatility associated with the presidential elections.    

Our base-case scenario is that Banxico will take a cautious approach in light of the Fed rate hikes and the uncertainty surrounding the presidential election next year, maintaining the reference rate at 7% until 2H18. Rate cuts are unlikely to be implemented anytime soon, even though we expect inflation to come down. The heating-up of political campaigning by the end of the year, with the presidential elections coming closer (July 2018), pose risks to the exchange rate (and inflation). Plus, as we mentioned before, NAFTA negotiations remain a risk. Also, the central bank continues emphasizing the relative monetary policy stance between Mexico and the U.S. as an important variable to monitor for the upcoming decisions: while this doesn’t mean that the central bank will continue hiking in tandem with the Fed, it does mean that board members see Fed rate increases as an obstacle for monetary easing in Mexico. Finally, we highlight that the authorities do not see the current level of policy rate as excessively tight, and the growth outlook (around trend, with a low unemployment rate) means the economy is not calling for stimulus – a contrast with other LatAm economies, whose central banks are cutting interest rates.

We only see rate cuts kicking-in in 2H18 (two 25-bp cuts, taking the reference rate to 6.5%). This would bring the real policy rate (ex-ante measure currently at 3.1%) to levels more consistent with the neutral level (estimated by Banxico in the broad range of 1.7%-3.3% in the long term, according to the latest Inflation Report published in 2016).

External accounts improve

Mexico’s current-account deficit (CAD) is narrowing significantly, on the back of a strong U.S. economy (benefiting manufacturing exports and remittances) and, to lesser extent, a moderation of internal demand growth. In the second quarter of 2017, the four-quarter rolling CAD narrowed to USD 17.6 billion (1.7% of GDP), from USD 23.3 billion (2.2% of GDP) in 1Q17. At the margin, the seasonally adjusted CAD was 0.2% of GDP in 2Q17, according to our estimations. The trade deficit (four-quarter rolling) narrowed to 0.8% of GDP in 2Q17 from 1.1% of GDP in 1Q17, with a growing non-energy surplus (now at 0.6% of GDP, from 0.3% of GDP in 1Q17) partly offset by a deterioration of the energy deficit (1.5% of GDP, from 1.4% of GDP in 1Q17).

Given the results observed in 2Q17, we have revised our current-account deficit forecast for 2017 (to 1.4% of GDP, from 1.6% of GDP). The CAD (accumulated in four quarters) will likely narrow a bit more, as manufacturing exports grow strongly, while internal demand expands at a more moderate pace.

The narrowing of the current-account deficit also reflects a lower fiscal deficit, improving Mexico’s fundamentals. Importantly, the narrowing of the twin deficits supports a more constructive view on the Mexican economy. Recently, rating agencies – specifically, S&P (July) and Fitch (August) – revised Mexico’s credit-rating outlook to stable, from negative, as a result of these positive developments.


 

João Pedro Bumachar
Alexander Andre Muller


 


Please see the attached file for all graphs. 



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