Itaú BBA - Less linked to the Fed?

Scenario Review - Mexico

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Less linked to the Fed?

November 10, 2015

We expect the central bank to raise the policy rate only in 1Q16, and after the Fed (in December).

Please see the attached file for all graphs.  

• The GDP accelerated modestly between the 2Q15 and 3Q15. Private consumption is increasing sharply. Supply-side factors, namely the stabilization of oil output and strong agricultural production, also helped. On the other hand, manufacturing exports are still sluggish. We still see growth at 2.2% this year and 2.8% in 2016.

• The exchange rate has stabilized in October, helped by intervention. The two intervention mechanisms currently in place expire by the end of this month. Market conditions by then will likely determine whether the programs will be fully extended or not. We still see the currency ending this year at 17.0 pesos to the dollar and ending 2016 at 17.5 pesos to the dollar.

• Inflation reached a new record low in October, even though inflation for core goods ex-food is rising due to the exchange-rate weakening. We now see inflation reaching 2.7% at the end of the year (from 2.8% in our previous scenario) and at 3.0% in 2016.

• Weak growth, low inflation and the financial-market stabilization will likely lead the central bank to raise interest rates after the Fed does. The central bank left the policy rate unchanged, at 3% in October, as widely expected. The tone of the statement was unchanged from the previous decision, so no new hawkish elements were added in spite of the changes introduced in the Fed’s statement. Also Governor Carstens recently stated that Mexico’s central bank response to the Fed shouldn’t be automatic, also hinting that the bank may raise the policy rate after the Fed’s liftoff. We expect the central bank to raise the policy rate only in 1Q16, and after the Fed (in December), once there is more evidence that the economy is benefiting from the U.S. recovery.

GDP improved modestly in 3Q15

According to preliminary figures by INEGI (official statistics institute), the GDP grew 2.4% qoq/saar in 3Q15, up from 2% in 2Q15. The data is consistent with a gradual recovery of activity.

Private consumption is contributing to a recovery. The dynamism of consumption is highlighted by the 9.8% qoq/saar expansion of retail sales in August. All drivers of consumption are supportive. Job creation in the formal market remains solid. Low inflation continues to boost real wages. Meanwhile, the growth of remittances in 3Q15, especially if converted to pesos, has been robust, and consumer credit is improving.

Supply-side factors are also helping growth. The small and volatile Agricultural sector grew by an impressive 11.2% qoq/saar after a contraction in 2Q15. Additionally, oil output, which contracted in each of the past six quarters, stabilized in 3Q15.

Exports improved in 3Q15 but remain at odds with the solid expansion of internal demand in the U.S. and the weaker Mexican peso. Manufacturing exports increased by 7.5% qoq/saar in 3Q15 but after a 2.0% contraction in 2Q15. On a year-over-year basis, they are down by 0.3%. The fact that U.S. industry is performing poorly could be limiting the expansion of external sales of Mexico’s intermediate goods, but auto exports are sluggish too, more recently dragged down by sales of Volkswagen.

Fiscal tightening is also curbing the recovery. In fact, non-residential construction investment (which is largely driven by infrastructure spending) fell by 4.4% qoq/saar in August.

We still see growth at 2.2% this year and accelerating to 2.8% in 2016. In our forecasts, the recovery of internal demand in the U.S. and the weaker exchange rate will likely contribute to a stronger expansion of manufacturing exports, which – considering the openness of the economy – would keep the growth of private consumption at a solid pace. Also, investments related to the energy reform will likely push growth up next year.

A relief for the exchange-rate market

The perception that there is now lower risk in the global economy brought some relief to the Mexican peso recently. Intervention has also helped. The two intervention mechanisms in place expire by the end of this month: reserves are currently at USD 176 billion, down from a USD 196 billion peak in January 2015. If current market conditions are sustained until the end of this month, it is likely that the amount of dollars offered in the auctions will be reduced.

We still see the exchange rate ending this year at 17.0 pesos to the dollar and at 17.5 pesos to the dollar at year-end 2016. The further strengthening of the U.S. dollar globally, as the Fed raises rates by more than the market is pricing in, will likely lead to an additional weakening of the Mexican peso.

The trade balance was almost flat from 2Q15 through 3Q15, as the deficit of non-energy products fell and the energy balance deteriorated further. Looking ahead, the stabilization of oil output and oil prices will likely provide a floor for the energy balance, while the weak exchange-rate and the recovery of the U.S. economy will probably contribute to a further recovery of manufacturing exports. In this context, we expect that the current account deficit in Mexico will remain low.  

Inflation reaches a new low

Inflation remains very well behaved in spite of the exchange-rate weakening. Although the exchange-rate depreciation is pushing prices up for tradable goods (inflation for core goods ex-food continues on an upward trend), headline inflation stood at 2.48% in October (from 2.52% in September). 

We now expect inflation to end the year at 2.7% (from 2.8% in our previous scenario). For 2016, we still see inflation at 3.0%. Although on a sequential basis inflation was already running at around 3.0% in 3Q15 (according to our own seasonal adjustment), the stabilization of the exchange rate and the still-negative output gap will likely help to put inflation at the target-center next year.

A softer tone

Mexico’s central bank left the policy rate unchanged, at 3.0%, as widely expected. The tone of the press statement was broadly unchanged from the previous decision. The board continues to highlight the weak cyclical conditions of the economy, the low inflation and well-behaved inflation expectations, while at the same time it is pledging to monitor the relative monetary policy stance of Mexico vis-à-vis that of the U.S. Considering that the Fed’s statement one day before signaled clearly that the December liftoff is on the table, the fact that Mexico’s central bank did not introduce new hawkish elements in the statement suggests that the board is open to the alternative of hiking after the Fed does, especially if the exchange-rate market remains well-behaved. More recently, when presenting the 3Q15 inflation report, Governor Carstens stated that Mexico’s central bank response to the Fed shouldn’t be automatic.

We continue to expect rate hikes in Mexico to start only in 1Q16, after a hike by the Fed in December and once it becomes clearer that Mexico is benefiting from the U.S. recovery. The modest recovery, the low inflation rate and the recent market stabilization will likely convince the board to postpone rate hikes. By the end of 2016, we see the policy rate at 4.0%.


 

João Pedro Bumachar

Jesus Gustavo Garza-Garcia


 

Please see the attached file for all graphs.  


 



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