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Scenario Review - Mexico

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Politics in the spotlight

June 8, 2017

Political establishment wins regional elections

Please see the attached file for all graphs.

The regional and municipal elections were a victory for the political establishment, with the ruling party retaining control over the State of Mexico – the country’s most populated state – and Coahuila. In Nayarit and Veracruz, the remaining states at stake, the right-wing party (PAN) emerged as the winner. However, this is not to say that Andrés Manuel López Obrador’s (AMLO) chances to become President in 2018 have decreased. The performance of his party, Morena (founded only three years ago), has surpassed all expectations, almost defeating the PRI in its historical Mexico stronghold. 

Growth surprised to the upside in 1Q17, but we see signs of weakening at the margin. Investment is already deteriorating, amid the uncertainty surrounding bilateral relations with the US and fiscal consolidation, which will likely have negative second-round effects in the labor market. If this happens, consumption is also bound to slow down. Stronger exports, in contrast, due to higher growth in the U.S., will act as a buffer. We expect GDP growth to slow down to 2% in 2017 (from 2.3% in 2016), while a modest pick-up (to 2.1%) is likely in the next year. 

There is disagreement in the Banxico board on the timing to end the tightening cycle. Two board members embrace the view that Banxico is getting close to the end and that there is space to decouple from the U.S. Fed. Conversely, two other members argue that inflation must actually start to trend down before evaluating the possibility of ending the tightening cycle. In fact, inflation has consistently surprised to the upside in the first five months of 2017. We expect Banxico to deliver two more 25-bp hikes in 2017 (the next one in June, in lockstep with the Fed).

Political establishment wins regional elections

The political establishment, meaning the dominant center and right wing political parties, PRI and PAN, won the regional and municipal elections of 2017. To provide some background, elections in the 31 states (+ Mexico City) and thousands of municipalities of Mexico are scheduled in different years. Last Sunday (June 4), the constituencies of four states went to the ballots to elect a new regional governor (State of Mexico); regional governor, mayors, and regional parliament (Coahuila and Nayarit); and mayors (Veracruz). The ruling party’s (PRI) candidate, Alfredo del Mazo (33.7%), won in the State of Mexico, followed by AMLO’s protégée, Delfina Gomez (30.8%). Standing third was Juan Zepeda (17.8%), from the PRD (center-left party), and Josefina Vázquez (11.3%), from the PAN (right-wing party), was in fourth position. Coahuila was retained by the ruling PRI party. Nayarit and Veracruz, however, were clear victories for the PAN. 

The markets’ eyes were clearly on the State of Mexico. The importance of this gubernatorial election stems from the fact that the State of Mexico is the country’s most populated state (accounting for 14% of voters) and the ruling party’s historical stronghold, where it has ruled for 90 years. It is Enrique Peña Nieto’s home state, in which he ruled as Governor before taking office as President of Mexico in 2012. However, as the popularity of the federal government has reached historical lows amid growing anti-establishment sentiment (embodied by the left-wing leader AMLO), market participants were focusing on this election as a rehearsal for the presidential elections to be held next year. In fact, AMLO campaigned aggressively in favor of Delfina Gómez. 

Despite the defeat, the results of the regional and municipal elections do not weaken AMLO’s prospects to become president in 2018. Granted, winning the State of Mexico would have strengthened AMLO by giving Morena the opportunity to use this regional government as a platform to boost the presidential campaign. However, our main takeaway from the results is that Morena – a party created only three years ago – stood up to the mighty political machinery of the PRI and almost defeated them in the core of their supporting base. Looking ahead, López Obrador’s candidacy will likely continue benefitting from corruption scandals involving the PRI and the low GDP growth in spite of the reforms approved during Peña Nieto’s term. But he will face tough competition in next year’s presidential election. According to the average of the latest polls (April), AMLO only has a 1 pp lead over Margarita Zavala (the PAN’s likely presidential candidate, although this still needs to be decided in the party’s primaries). As there is no run-off in Mexico, and historically AMLO has faced a high rejection rate, a significant number of PRI supporters might end up voting for the PAN.

Growth slowdown ahead

Growth surprised to the upside in 1Q17. After a robust flash estimate, which surprised market expectations, Mexico’s GDP growth for 1Q17 was revised up (to 2.8% year over year). Adjusting for calendar effects, GDP growth was 2.6% year over year, up from 2.3% in 4Q16. Growth rested on the shoulders of the service sectors (3.8% year over year, 3.4% in 4Q16), while industrial sectors contributed negatively. Looking at the breakdown of industrial sectors, manufacturing was the bright spot (4.4% year over year in 1Q17, from 2% in 4Q16), which is consistent with the acceleration of manufacturing exports observed in the trade balance data. In contrast, construction activity fell for the first time in over a year (-0.2% year over year in 1Q17, 3% previously), hit by the ongoing fiscal consolidation. Moreover, mining contracted at a sharper pace (-10.5% year over year, from -9.9% in 4Q16), dragged by falling oil output.

At the margin, however, the monthly GDP proxy (IGAE) has posted two consecutive monthly contractions, and gross fixed investment is weakening considerably. Adjusting for calendar effects, gross fixed investment fell 1.8% year over year in 1Q17, after expanding 1.3% in the previous quarter, and posted a quarter-over-quarter annualized contraction of 6.2% (from a 2.4% qoq/saar expansion in 4Q16). This weakness, in our view, is attributable to both the fiscal consolidation and the uncertainty surrounding bilateral relations with the U.S. (which puts investment decisions on hold). We believe that formal employment creation will eventually deteriorate as investment slows down, which together with rising inflation, will reduce consumption growth. Moreover, other fundamentals of private consumption (credit, remittances expressed in pesos and consumer confidence) have turned less supportive. 

We expect GDP growth of 2% in 2017, down from 2.3% in 2016, and a modest pick-up to 2.1% in 2018. In the short term, uncertainty surrounding bilateral relations with the U.S. (discouraging investments), higher inflation (affecting real wages), tighter macro policies (rising rates and fiscal consolidation), and falling oil output will weigh on growth. Stronger manufacturing exports, conversely, boosted by higher industrial growth in the U.S. and a competitive real exchange rate, will act as a buffer.

Tightening cycle coming to an end?

The Central Bank of Mexico published the minutes of May’s monetary policy meeting, in which the Board decided to increase the policy rate by 25 bps (to 6.75%). The minutes are clear-cut about the reasons that led Banxico to hike rates in May; the document explicitly reads that all board members decided to vote for tightening monetary policy with the purpose of “preventing contagion in the price-formation process and anchoring inflation expectations” (in other words, avoiding second-round effects). Likewise, all board members agreed that the balance of risks on inflation has deteriorated. So, bottom line, May’s hike was largely about deteriorated inflation conditions.

In fact, the latest readings on inflation show that price increases are becoming more generalized across the consumer basket. Mexico’s CPI fell between April and May, as it normally does during this time of the year (because of the seasonality of electricity prices). But it fell much less than in the previous year, thereby pushing annual inflation to 6.2% (from 5.8% in April). Overall, we see more generalized pressure. In fact, a diffusion index that tracks the percentage of items in the CPI basket with annual inflation higher or equal to 4% (the upper bound of the tolerance range around the Central Bank’s 3% target) increased to 75% in May (from 51% in December 2016). Looking ahead, we nevertheless expect inflation to decrease to 5.4% by the end of 2017. Inflation would move down because of the lagged effects of peso appreciation (12% year to date, compared to the 19% depreciation observed in 2016) and, to a lesser extent, weaker activity.  

Against this inflation backdrop, there are contrasting views about the future path of monetary policy. The minutes revealed that “some” board members consider that, provided the absence of new inflationary shocks, Banxico is getting close to the end of the tightening cycle. Moreover, one of these board members argued that, given the substantial monetary adjustment carried out so far (375 bps since December 2015), Banxico must not necessarily match future U.S. Fed rate hikes with similar moves. In fact, in a recent interview, Deputy Governor Díaz de León took this view one step further by arguing that monetary policy should be loosened if inflation converges to the target. On the other end of the table, “other” members believe that inflation must start to trend down before evaluating the possibility of ending the tightening cycle. One member, in fact, mentioned that given the high levels of inflation and impending Fed hikes, more rate hikes in Mexico are likely in the next months.

We expect Banxico to deliver two more 25-bp hikes in 2017 (the next one in June, in lockstep with the Fed). There are balanced risks for our call: while the fact that some board members see the cycle ending soon increase the probability of only one additional 25-bp rate hike, the behavior of inflation may end up forcing the central bank to raise interest rates by a bit more than we are currently expecting. 

External and fiscal accounts improve

Mexico’s current-account deficit has narrowed, on the back of an improving trade balance and solid remittances. The central bank revised the annual current-account deficit recorded in 2016, to USD 22.4 billion (2.1% of GDP) from USD 27.9 billion (2.7% of GDP). In the first quarter of 2017, the CAD came in at USD 6.9 billion, which brought the four-quarter rolling deficit to USD 22 billion (2.1% of GDP) – compared with USD 27.8 billion one year before. At the margin, the seasonally adjusted CAD was 2.2% of GDP in 1Q17. Higher growth in the U.S. and the more competitive exchange rate are more than offsetting the loss of oil exports.

We have revised our current-account deficit forecast for 2017 (to 1.7% of GDP, from 2.3%) and 2018 (to 1.6% of GDP, from 2.2%). The CAD will likely continue narrowing as the economy experiences a rebalancing in its sources of growth (with stronger exports and weaker domestic demand). From a funding perspective, the risk of NAFTA renegotiation escalating into protectionism is falling, but will likely affect FDI; while – given the current benign environment for emerging-market financial assets – portfolio investment is expected to remain solid. 

Mexico’s fiscal accounts are following a consolidation path, beyond the windfall effects of the Central Bank’s dividend. In March 2017, the government received a whopping MXN 322 billion (1.6% of GDP) dividend from the Central Bank – the outcome of exchange rate gains on international reserves during the previous year – which exceeded the MXN 239 billion (1.2% of GDP) dividend received in April 2016. But we note that fiscal accounts are improving even if the dividends are excluded. In fact, excluding 70% of the amount of the dividends (as the rest is directed to stabilization/sovereign funds, and therefore recorded as both revenues and expenditures), the 12-month rolling primary deficit narrowed to MXN 22 billion (0.1% of GDP) in April, from MXN 24.5 billion in March. Also importantly, the gross and net debt of the public sector has decreased to MXN 9,880 billion (from MXN 9,934 billion) and MXN 9,244 billion (from MXN 9,693 billion) in April and at the end of 2016, respectively.

Our take is that the developments on the fiscal front (and the perception of lower risks for NAFTA) reduce the odds of a sovereign-rating downgrade and, thus, provide support to the valuation of Mexican financial assets. Nevertheless, the three main rating agencies maintain a negative outlook on Mexico’s sovereign debt, and will be watchful if the proceeds of the dividend are fully used to accommodate more spending (and reduce the pace of fiscal consolidation), which is not farfetched considering the proximity of the presidential elections (to be held in mid-2018). We forecast the public-sector nominal deficit at 2.1% of GDP in 2017 (from 2.6% in 2016), lower than the fiscal target set for 2017 (2.4%) before the dividend announcement. It is also highly likely that the government will meet its other fiscal targets (0.4% of GDP primary surplus, and 2.9% public-sector borrowing requirements). 


João Pedro Bumachar

Alexander Andre Muller

Please see the attached file for all graphs. 

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