Itaú BBA - Monetary tightening ends, but easing is distant

Scenario Review - Mexico

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Monetary tightening ends, but easing is distant

June 30, 2017

Board members have contrasting views on the future course of monetary policy

Please see the attached file for all graphs.

• The Mexican central bank (Banxico) has changed its forward guidance to indicate that, unless inflation and/or economic conditions deviate significantly from its baseline scenario, the tightening cycle (400 bps since December 2015) is over, even if the Fed continues hiking rates. Therefore, we have revised our monetary policy rate forecasts for 2017 and 2018 to 7% (from 7.25%) and 6.50% (from 6.75%), respectively. Although annual inflation will likely fall substantially in early 2018, we expect rate cuts to start only in the second half of 2018.

• We have revised our exchange rate forecast for 2017 to 18.5 pesos to the dollar (from 19.5 pesos to the dollar), largely based on the moderation of the uncertainty surrounding trade relations with the U.S. but also to reflect other factors that are now exerting appreciation pressure on the peso, such as Banxico’s foreign exchange intervention program, the narrowing of the twin deficits (fiscal and external), the more attractive carry and the pro-establishment outcome of the regional elections.

• With our updated expectation of a stronger currency and lower oil prices, we have kept our inflation forecast for 2017 at 5.4%. Although non-core inflation has surprised to the upside (agricultural inflation is unexpectedly running at 8% year-over-year, up from negative levels in 1Q17) and diffusion indexes remain on the rise, currency appreciation, weaker activity and lower oil prices will lead to disinflation ahead. We expect inflation at 3.3% by the end of 2018.

• Our GDP growth forecasts for 2017 and 2018 remain unchanged at 2% and 2.1%, respectively. The headwinds resulting from still-uncertain trade policies in the U.S. (which is holding back investment), higher inflation and tighter macro policies (both fiscal and monetary) will become more visible in coming quarters, likely reducing growth relative to last year (2.3% in 2016).

Banxico signals the end of the tightening cycle

Mexico’s central bank decided to hike the reference rate by 25 bps (to 7%) in June, but it also – and more importantly – signaled that the monetary tightening cycle is likely over. The minutes of the previous meeting had already revealed that “some” board members believed that the end of the tightening cycle was near. Nevertheless, the June statement was much more assertive. In fact, the forward guidance paragraph featured a new sentence that clearly signaled their intention to stop: “the Board considers that given today’s increase […] the reference rate has reached a level that is consistent with the convergence of inflation to the 3% target”. Put simply, Banxico’s baseline scenario is of no more hikes. Further dispelling any doubts on this score, in a recent interview, Governor Carstens confirmed this view by saying that Banxico could keep rates unchanged even if the Fed continues hiking.

The June decision was split, with one board member already voting to leave the policy rate unchanged. Usually, split votes are revealed only in the minutes, so it seems to us that the central bank was also sending a message about future decisions by noting the dissenting vote in the statement. Governor Carstens’ presentation of the inflation report and Deputy Governor Díaz de León’s recent remarks to the press make it clear that they were the two board members who were advocating the end of the tightening cycle in May.

Granted, the June statement also spells out that the board is “vigilant to ensure a prudent monetary policy”, so the door is not completely shut on hikes. However, in our view, the bar for more rate increases has been set significantly higher, meaning that only large upside surprises on inflation could prompt the board to hike again.

Against this backdrop, we have revised our monetary policy rate forecast for 2017 to 7% (from 7.25%). Mexico’s policy rate will likely remain unchanged for the rest of this year (previously we had foreseen one additional 25-bp rate increase in August). But considering the contrasting views among the board members (revealed in the minutes), with two other board members believing that the tightening cycle cannot end until inflation starts trending down, the likelihood of split decisions in coming months is high.

We anticipate two 25-bp rate cuts in 2018, but we do not expect lower rates before the second half of the year. Although a substantial decrease of annual inflation is likely in 1Q18, potential volatility ahead of the presidential elections (to be held in June 2018) and U.S. Fed rate hikes will likely reduce the board’s appetite for rate cuts. Also, the fact that board members do not see the current real interest rate as tight, and the likelihood that the economy will be exhibiting decent growth rates in 2018 (as long as the U.S. economic recovery continues and uncertainty over trade relations with the U.S. fades), further reduce the urgency to cut interest rates. On the other hand, we acknowledge that the new composition of the board in 2018 (with Governor Carstens departing, there will be a new governor and a new board member) introduces an element of uncertainty over the timing of potential rate cuts.

The MXN rallies

We have revised our exchange rate forecast for 2017 to 18.5 pesos to the dollar (from 19.5 pesos to the dollar) and left our 2018 forecast unchanged at 18.5 pesos to the dollar. After depreciating by 19% in 2016, the Mexican peso has appreciated by 13% year-to-date. The main factor driving this appreciation has been the more constructive dialogue between U.S. and Mexico policymakers in trade negotiations (in contrast with the diplomatic row observed in late 2016 and early 2017, when the MXN weakened to a historical low). Of course, there are also other factors that have been exerting appreciation pressure, such as: Banxico’s new exchange rate intervention tool (which uses FX swaps), announced in February; the moderation of the twin deficits, which lowers the odds of a sovereign downgrade; the widening of the interest rate differential with the U.S. (Banxico has hiked rates by 400 bps since December 2015, compared with 100 bps of hikes by the Fed); and the recent market-friendly outcome of the regional elections, which saw a victory of the traditional parties (PRI and PAN) over the left-wing, anti-establishment Morena.

Nevertheless, we expect the peso to depreciate somewhat against the dollar from its current level, mainly because the interest rate differential with the U.S. will likely narrow as Banxico stands pat and the Fed continues tightening its monetary policy. Also, we note that the risks related to NAFTA and domestic politics are far from having been put to rest. The kick-off of official NAFTA renegotiation rounds in August (possibly featuring a more aggressive U.S. stance, at least at the beginning of the negotiations, so they can have room to offer concessions) could trigger another bout of volatility in the currency. In addition, even though the outcome of the regional elections favored the political establishment, we do not believe that they irretrievably weakened the odds of the leftist leader, Andrés Manuel López Obrador (AMLO), being elected president in 2018. AMLO is still at the top of presidential polls, and if this lead widens the MXN might depreciate. Moreover, announcements of party alliances in advance of the presidential election (for which the registration deadline is November 2017) could introduce volatility in either direction. All eyes are on the center-left party, the PRD, which currently commands around 8% of vote intentions. The PRD has left the door open for an alliance with the right (the PAN, in a reprise of their successful alliance in the 2016 regional elections) or the left (Morena, which is more compatible ideologically but poses an existential threat to the PRD). Our base-case scenario is that the PRD will ally with neither the PAN nor Morena, which would be market-neutral.

Inflation remains a concern

The year-over-year inflation rate climbed to 6.3% in the first half of June, the highest level in more than eight years. The pressure seems more broad-based, suggesting the presence of second-round effects from the previous shocks (e.g., the MXN’s sharp depreciation in 2016 and the gasoline price spike in early 2017). In fact, the diffusion index, which tracks the percentage of items in the CPI basket with annual inflation rates higher or equal to 4% (the upper bound of the tolerance range around the central bank’s 3% target), has increased to 75.9% (from 52% in December 2016). Core inflation, however, was essentially stable at 4.8% from the second half of May to the first half of June. So was core goods inflation (at 6.3%), suggesting that the upward pressure on tradable prices might start to revert soon. Core services inflation increased slightly, to 3.6% from 3.5%, but a cleaner indicator for domestic driven prices (core services excluding telecom and FX-sensitive services) was stable. On the non-core side (11.1%, up from 10.5% previously), the acceleration was driven by agricultural inflation (8%, up from 6.3% previously).

With a stronger currency and lower oil prices (relative to our previous scenario), we have kept our 2017 inflation forecast at 5.4%. Although non-core inflation has surprised to the upside (agricultural inflation is unexpectedly running at 8% year over year, up from negative levels in 1Q17) and diffusion indexes remain on the rise, we believe that disinflation will resume in the coming months on the back of the lagging effects of MXN appreciation, weaker activity and lower international oil (and gasoline) prices. We expect inflation to fall to 3.3% by the end of 2018.

Activity will likely weaken in 2Q17

After surprising to the upside in 1Q17, Mexican GDP growth began 2Q17 on softer footing. In April, Mexico’s GDP proxy (IGAE) posted a year-over-year decline for the first time in almost four years due to adverse calendar effects. The IGAE index fell by 0.7% year-over-year, pulling down the three-month moving average growth rate to 1.5% year over year (from 2.7% in March). At the margin, the index gained a modest 0.1% from the previous month, with quarter-over-quarter annualized growth falling to only 0.1% (from 1.7% qoq/saar in March).

Growth was supported by the service sector, while the performance of industrial sectors was poor (with the exception of manufacturing). Service-sector activity rose by 0.5% from the previous month, although its momentum has slowed (2% qoq/saar, from 2.2% in March). Industrial production, in contrast, fell by 0.3% month over month and by 1.1% qoq/saar (vs. -0.4% previously). Notably, the strength of manufacturing output, which increased by 0.6% from March, was not enough to offset a contraction of mining activity (-0.9%, largely explained by falling oil output) and the deterioration of construction activity (-1.7%).

Domestic demand is weakening. Gross fixed investment fell by 2.8% qoq/saar in 1Q17, dragged down by the fiscal consolidation and the uncertainty surrounding bilateral relations with the U.S. (which has put investment decisions on hold). Private consumption growth was solid in 1Q17 (2.7% qoq/saar), but the seasonally-adjusted monthly proxy for private consumption fell by 0.4% month over month in March. Retail sales momentum has also weakened substantially, with sales growing by only 2.3% qoq/saar in April (which is less than one-third of the average growth rate observed in 2016).

Our GDP growth forecasts for 2017 and 2018 remain unchanged at 2% and 2.1%, respectively. In the short term, uncertainty surrounding trade relations with the U.S. (discouraging investment), higher inflation (affecting real wages) and tighter macro policies (higher rates and fiscal consolidation) will pose headwinds, likely reducing quarter-over-quarter growth rates meaningfully (although the growth rate for the full year might not be significantly below last year’s 2.3%). Conversely, stronger manufacturing exports will likely act as a buffer, boosted by faster industrial growth in the United States. In 2018, an expected positive outcome of the NAFTA renegotiation, with U.S. likely continuing to exhibit solid growth, would support the economy. At the same time, disinflation could lead to a recovery in real wages.


João Pedro Bumachar

Alexander Andre Muller

Please see the attached file for all graphs. 

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