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Scenario Review - Mexico

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Rate hikes on the horizon

December 7, 2017

Central Bank will likely make hawkish turn, amid looming risks

Please see the attached file for all graphs.

• We expect a 25-bp interest rate hike in the last policy meeting of 2017 (to 7.25%), matching the likely Fed rate hike. Moreover, given the risks related to NAFTA and the presidential elections, we think the central bank of Mexico will not want to decouple from the Fed in the short term, so one additional interest rate hike in the first half of the year is likely.

In our view, NAFTA renegotiations advanced in November, as the U.S. moderated its demands somewhat, Mexico showed more willingness to compromise and progress was made in several areas, dispelling the perception of deadlock. 

On the election front, however, the anti-establishment candidate, Andrés Manuel López Obrador (AMLO), continues to lead in the polls, and his recently published government plan did not present surprises. Also important is the fact that José Antonio Meade left the Finance Ministry and is well-positioned to become PRI’s candidate for the presidency.

Tightening cycle will likely resume

President Enrique Peña Nieto appointed Alejandro Díaz de León as the new Governor of the Central Bank of Mexico, who will replace Agustín Carstens, an announcement that was welcomed by markets. This appointment did not require confirmation from the Senate, as Alejandro Díaz de León had already gone through that process before assuming the job of Deputy Governor in January 2017. His mandate as governor began on December 1 and will last until December 31, 2021. Before joining Banxico’s board, Alejandro Díaz de León served as CEO of Mexico’s foreign trade bank (Bancomext), Head of Public Credit at the Ministry of Finance and Chief Economist at Banxico.

We expect Mexico’s central bank to increase the policy rate by 25 bps in December (to 7.25%), matching the U.S. Fed’s move. Both in the statement announcing the most recent monetary policy decision and in its latest quarterly report, the central bank mentioned first the relative monetary policy stance between Mexico and the U.S. when listing the factors that the board will monitor for its upcoming decisions. 

The minutes of the most recent policy decision revealed that concerns over monetary policy in the U.S. are disseminated within the board. In fact, two board members seemed already convinced of the need to react to the likely Fed rate hike in December. One of them said it is important not to modify the relative monetary policy stance between Mexico and the U.S. The other said Banxico should be very inclined to respond to the Fed. Although the three-member majority saw the current policy stance as consistent with meeting the 3% inflation target, they were also cautious. Within the majority camp, one board member mentioned that new interest rate hikes could be necessary, depending on the impact on inflation of the NAFTA renegotiation, elections in 2018 and monetary policy normalization in the U.S. Another member also said that the board should be vigilant and ready to respond quickly to changes in monetary policy north of the border. And a third member of the majority argued that the hikes implemented so far have given “room of maneuver” to monetary policy in Mexico, but that member also acknowledged the uncertainties surrounding the scenario.

Alejandro Díaz de León´s early statements have been consistent with further monetary policy tightening. Speaking to the press, he emphasized monetary policy in the U.S. as an important risk for the central bank’s inflation forecast, even though the Mexican peso has strengthened since the most recent policy meeting. Furthermore, the new governor saw (rightly in our view) the recent slowdown in activity as a result of transitory factors, amid tight labor market conditions. In all, the probability of a rate hike implied in market prices has been increasing, and Alejandro Díaz de León did not take the opportunity, in his first remarks to the press, to discourage the market movement. 

Given risks related to NAFTA and the presidential elections, the central bank is also unlikely to decouple from the Fed in the short-term. Although we expect year-over-year inflation to fall substantially during the next seven months, the central bank will likely deliver one additional 25-bp rate hike (to 7.5%) before the end of 1H18. Nevertheless – assuming that the uncertainty/volatility associated with NAFTA, the elections, and U.S. monetary policy subsides – we expect Banxico to cut rates twice in 2H18, taking the reference to 7% by the end of 2018. 

Navigating a calmer NAFTA storm

After an impasse in the 4th round (October) of NAFTA negotiations, the 5th round (November) ended on a more positive note, improving sentiment in the markets. In our view, the U.S. moderated its demands somewhat; Mexico showed more willingness to compromise; and progress was made on certain areas (digital trade, technical barriers to trade, anti-corruption, telecom, regulatory practices, sanitation & phytosanitation, trade facilitation and energy), dispelling the perception of deadlock.

On November 18, in the midst of the 5th round, the office of USTR (United States Trade Representative) updated the “Summary of U.S. negotiation objectives” (earlier version July 17), from which we draw three positive signs of moderation. First, the demand for the “sunset clause” is now worded as “assess the benefits of NAFTA on a periodic basis,” rather than “renegotiate or terminate every 5 years,” as it was presented in the 4th round in October. In November, Mexico actually presented a counter-proposal along these lines (i.e.: revise without threat of termination), and we believe the negotiating positions have gotten at least a little closer on this thorny issue. Second, the demand for increasing local content requirement in the auto sector is stated loosely (not as a specific increase to 85% from 62.5% in regional content, and the creation of a 50% U.S. content provision). This, coupled with the complaint from Robert Lighthizer (the U.S. head negotiator) about the lack of Mexican and Canadian counter-proposals for rules of origin, in or view, is indicative that the U.S. is waiting to receive an offer and willing to settle for middle-ground. Third, there is no mention whatsoever of measures to artificially increase wages in Mexico, something that was rumored in the press and viewed as an impossible concession. 

We see a glass half full for rules of origin, which is a crucial aspect in the renegotiation. The U.S. head negotiator and many analysts in the market were disappointed about the lack of concrete Mexican and Canadian counter-proposals in the 5th round. However, we highlight that on November 21, after the closing of the 5th round, Mexico’s head negotiator, Ildefonso Guajardo, confirmed that Mexico would present a counter-proposal on automobile rules of origin. He explained the Mexican position in the 5th round as an attempt to listen to the technical arguments behind the 85%/50% U.S. proposal, before crafting a reasonable counter-proposal. Moreover, on November 27, Guajardo told the press he “expects more progress in the intermediate meetings.” Intermediate meetings will take place on December 11-15 in Washington, before the 6th round (January 23-28 in Montreal). 

Our call on NAFTA is unchanged. We expect the three countries to strike a deal by 1Q18, with the U.S. getting concessions that do not imply transformational changes for the Mexican economy. We believe such concessions are feasible. The U.S. has a surplus versus Mexico in services trade, and a possible way to narrow the overall deficit would be the liberalization of the service sectors on which Mexico still imposes significant non-tariff barriers (digital trade, cross-border data flows, telecom). In the same spirit, the strengthening of intellectual property rights, something that Mexico already agreed to in the now-defunct Trans-Pacific Partnership (TPP) agreement, could boost the sales of U.S. IP-intensive goods in the Mexican market. However, it is unlikely that these concessions will be enough to satisfy the U.S. We believe something groundbreaking needs to happen in more critical areas, such as rules of origin or Chapter 19 (which regulates trade remedies; namely: safeguards, anti-dumping, and countervailing duties). Currently, NAFTA prohibits safeguards (i.e., a temporary increase in tariffs imposed on imports that hurt a specific local industry) but allows anti-dumping duties (imposed when a foreign firm exports at below-cost) and countervailing duties (imposed when foreign exports are subsidized). A powerful way to compromise, in our view, would be to legitimize safeguards. Since the 4th renegotiation round, Mexico has been complaining that some of the U.S. demands are illegal under international trade legislation. However, safeguards are a legitimate trade policy instrument. In fact, eliminating the prohibition on safeguards (“global safeguard exclusion”) would not only be compliant with WTO law but also provide the U.S. judiciary with more discretion to protect its local industry (which is precisely what Trump wants) and preserve other crucial benefits of Chapter 19 for Mexico.

PRI has a likely candidate, and AMLO presents his plan

President Peña Nieto announced the resignation of José Antonio Meade as Finance Minister, who later said publicly that he will compete to become the presidential candidate for the ruling party, the PRI. The PRI has recently postponed the official announcement of its candidate to February 11 (deadline for primary elections). The catch is that Mexican electoral law forbids parties to carry out advertisements in mass media (until primary elections are over), unless it has two or more pre-candidates. In any case, we already see Meade as the PRI’s de-facto candidate, even though – on paper – he will still face one or more competitors in the run-up to the PRI’s primary elections. Additionally, we note that Meade was replaced by José Antonio González Anaya, previously the CEO of PEMEX, as the new Finance Minister. 

The latest polls for the presidential election (to be held on July 1, 2018) show anti-establishment Andrés Manuel López Obrador (AMLO) at the top, with Meade in third place.  The average results of four pollsters (Reforma, El Financiero, El Universal, and Mitofsky) that conducted surveys in October and November are: AMLO (30.7% in November, from 27.3% in October), Anaya (19.3%, 20.3 previously), Meade (17%, compared with a 20% average score for Osorio in October) and Zavala (10.3%, 11.5% previously). Going back further in the polls raises comparability issues because the structure of the surveys changed fundamentally in October, when Zavala decided to run as an independent candidate (she had been consistently the runner-up until then, as a stand-alone PAN candidate). 

Finally, a third eventful development on the political front was the publication of AMLO’s government plan, mainly proposing higher spending in some areas (besides quasi-fiscal expansion, through the development bank balance sheet) and, at the same time, ensuring fiscal responsibility and avoiding tax hikes. In our view, a few positive aspects are outweighed by several proposals that raise the odds of economic policy discontinuity beyond 2018. Among the positive aspects, we highlight: a commitment not to increase the public debt-to-GDP ratio, a pledge of central bank independence, a war on corruption and absolute respect for private property and rule of law. On the negative side, the elephant in the room is a cluster of big spending promises (doubling of pensions across the country to level them with those in Mexico City; free higher education; and 15.6% + inflation annual hikes of the minimum wage to almost triple it – in real terms – between 2017 and 2024), which are hard to reconcile with the notion of fiscal responsibility. The government plan also mentions the objective of increasing the government’s presence in the energy sector, mainly through larger investments in PEMEX and CFE (with private pension funds being forced to finance PEMEX and CFE). Another issue featured in the plan is AMLO’s intention to carry out “public consultations” on the structural reforms implemented by the Peña Nieto administration since 2012. However, public consultations cannot produce a binding outcome, unless the Constitution is reformed (which is probably why the government plan also proposes a constitutional reform). Furthermore, the government plan proposes trade policies seeking import substitution (such as price floors for agriculture and increases in national content, among others) – in contrast with the status quo of liberalized trade – features tougher language on NAFTA (emphasis on protecting agriculture). The next key date for AMLO’s camp will be December 14, when it plans to announce the names that would make up the ministerial cabinet. 

Downward trend in inflation was interrupted in November

Mexico’s CPI came in high in November, pressured by volatile items such as energy prices (electricity, gasoline and LPG), FX-sensitive services (airline tickets and tourism) and non-core food prices. Headline inflation increased to 6.63% year over year (from 6.37%) between November and October, while core inflation increased to 4.90% (from 4.77%) during the same period. Core goods (tradables) inflation came in higher (6.19%, from 5.97%), while the core services component rose slightly (to 3.79%, 3.75% previously). In fact, a cleaner indicator of prices driven by domestic demand – that is, core services excluding telecom and FX-sensitive services (which includes airfares and tourism-related services) – was broadly unchanged (3.96%, from 3.95%). Turning to non-core inflation (11.97%, 11.40% previously), the increase was explained by higher inflation for food (8.84%, from 8.37%), energy (17.03%, from 16.34%), and regulated items (8.15%, from 8.09%). 

At the margin, seasonally adjusted 3-month annualized inflation increased in November for both the CPI (to 4.92%, from 4.42% in October) and the core index (to 3.81%, from 3.13% in October), although these levels are still much below the respective year-over-year figures. 

Given the upward inflation surprise, we have revised our inflation forecast for 2017 (to 6.2%, from 5.9%). Nevertheless, we still believe inflation has begun a downward trend, after peaking in August (at 6.7%), and will decrease to 3.3% by the end of 2018, consistent with the evolution of inflation at the margin. We note the stabilization of the Mexican peso around the current levels is a key input for our 2018 forecast. 

Growth weakened in 3Q17, pressured by temporary effects

The economy weakened in 3Q17, battered by natural hazards (hurricanes and earthquakes) whose effects were temporary but, nevertheless, widespread across sectors (particularly detrimental for oil output and services). GDP growth came in at 1.5% year over year in 3Q17, down from 1.9% in 2Q17. The result was a bit below the GDP flash estimate (1.6%) announced by the statistics institute (INEGI) in late October. At the margin, the quarterly GDP figures showed a 0.3% contraction between 2Q17 and 3Q17.

The GDP breakdown shows that, in spite of taking a big hit from the earthquakes, the service sector continues outperforming the industry. The service sector fell 0.4% qoq/saar (from a 2.5% qoq/saar expansion in 2Q17). Industrial growth, in contrast, fell 2.4% qoq/saar (from a 1.7% qoq/saar contraction in 2Q17). Looking at the components of industrial production, we note that mining (-17.9% qoq/saar, from 0.7% qoq/saar in 2Q17) bore the brunt of the natural hazards, as not only the hurricanes (August and September) but also the earthquakes (September) disrupted production areas. Other industrial sectors – such as manufacturing (0.5% qoq/saar in 3Q17, 1% qoq/saar in 2Q17) and construction (-1.8% qoq/saar, -7.6% qoq/saar) – were less affected. 

We expect GDP growth of 2.1% both for 2017 and 2018, down from 2.9% in 2016 (revised by INEGI, from 2.3% using the 2008 base year). A sequential rebound is highly likely in 4Q17, as the temporary effects of the natural hazards dissipate. In fact, seasonally adjusted oil output expanded 9.9% month over month in October. Looking at the growth story, we note that uncertainty is high, given the debate related to NAFTA and the presidential elections, which pose negative risks to investment decisions. However, we also believe that there will be significant buffers for activity in coming quarters. Manufacturing output will be boosted by the strength of U.S. industry. Furthermore, we believe that falling inflation coupled with robust employment (growing consistently above 4% year over year in the first ten months of 2017) will sustain consumption growth.

Low current account deficit

Mexico’s current account deficit (CAD) continues narrowing, on a strong U.S. economy (benefiting manufacturing exports and remittances) and a smaller net income deficit (reflecting lower profit remittances from foreign firms operating in Mexico). The four-quarter rolling deficit narrowed to USD 16.1 billion (1.4% of GDP) in 3Q17, from USD 16.8 billion (1.5% of GDP) in 2Q17. At the margin, according to our seasonal adjustment, the current account deficit came in at 1.8% of GDP in 3Q17, but following a low 0.2% deficit in the previous quarter. 

We have revised our current account deficit forecast for 2017 (to 1.6% of GDP, from 1.4%) because of deterioration in the trade balance in October (explained by a wider-than-expected energy deficit). Nevertheless, the CAD will likely remain at a low level (we expect the deficit to stay at 1.6% of GDP in 2018), as manufacturing exports grow strongly and internal demand expands at a moderate pace. Also, it is worth pointing out that the narrowing of the current account deficit also reflects a lower fiscal deficit, so Mexico’s fundamentals are strengthening.


João Pedro Bumachar
Alexander Muller


Please see the attached file for all graphs. 

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