Itaú BBA - Rate hikes only after the Fed

Scenario Review - Mexico

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Rate hikes only after the Fed

July 13, 2015

We believe that the central bank will start its tightening cycle in 1Q16, once the board has more assurance that the economic recovery is solid enough.

• The recovery of external demand remains bumpy and the persistent decline of oil production remains a drag to growth. But there are positive signs for internal demand. We maintained our GDP-growth forecast at 2.4% for this year. For 2016, we continue to expect a 3.3% growth rate underscored by higher U.S. growth, the stabilization of oil output and investments related to the structural reforms (especially the energy reform).    

• We expect the exchange rate to end this year at 15.5 pesos to the dollar, despite the recent depreciation induced by the uncertainty over the Greek and the Chinese economies and by the stronger U.S. data. We also see the currency at 15.5 pesos to the dollar in 2016, as the FDI inflows linked to the energy reform offset the impact of the further strengthening of the U.S. dollar globally.

• We see inflation ending this year and the next at 3%, as the negative output gap curbs demand-side pressures on prices.

• Mexico’s central bank announced a change to the calendar of its monetary policy meetings scheduled for the second half of the year, so the board will now announce its decisions right after the Fed’s. Despite the calendar synchronization, we believe that the central bank will start its tightening cycle in 1Q16, once the board has more assurance that the economic recovery is solid enough to justify the withdrawal of monetary stimulus.   

• The winners of the first phase of Round One will be announced on July 15, which includes 14 shallow-water fields. The outcome of the auctions is key, as it will indicate how interested private companies are in Mexico’s Oil sector.

Weaker external demand, encouraging signs on internal demand

Economic growth continues to disappoint. The IGAE (monthly proxy for GDP) increased 0.7% from March to April, after a 0.5% drop previously, but its trend slowed to 1.2% qoq/saar (from 1.4% in 1Q15). Manufacturing production contracted 0.9% month-over-month in May, while manufacturing exports fell sharply in the same month (-6.6% MoM). From the supply side, mining output (which includes oil production) keeps dragging growth downwards, contracting 11.6% qoq/saar in May.

On the positive side, indicators linked to internal demand are doing better. Although retail sales contracted by 0.3% from March to April, the decline came after a very strong 1Q15 (9.7% qoq/saar). On a working-day adjusted basis, retail sales gained 4.4% year over year. Furthermore, the same-store sales by Antad increased 7.4% year over year in May and 5.0% in June. In fact, fundamentals for consumption are solid: consumer confidence is improving (by 2.0% from May to June), inflation has been low and formal employment is growing at a robust pace (4.4% year over year in June). Investment is also gaining ground after a weak 1Q15 (0.2% qoq/saar).Gross fixed investment grew by 0.4% from March to April, after a 4.1% expansion, led by a 2.5% gain in investment in machines and equipment (construction was up by 0.3%). On a year-over-year basis, investment increased by 5.3% in April, after a 6.5% gain the previous month. Construction investment grew 4.1% year over year, lifted by a 7.8% gain in the residential component. Non-residential construction investment grew by a weak 1.4%. Investment in machinery and equipment increased 7.2% from the previous year. We note that the recovery of investment came despite the negative impact of the tighter fiscal policy on non-residential construction investment.

We maintained our GDP growth forecast for this year at 2.4%, and we continue to expect the economy to grow by 3.3% in 2016. Above-potential growth in the U.S. and the positive impact of the energy reform on investment and on oil output next year are the main factors behind the recovery expectation.

Inflation remains low

Both headline inflation and core inflation are below the center of the target. Headline annual inflation stood at 2.87% in June, as core inflation came in at 2.33% (flat from May). Prices for core goods increased by 2.48% (compared with an increase of 2.44% in May), showing a small pass-through from the weakening of the currency, and inflation for core services stood at 2.2% (down from 2.23%). Non-core prices rose by 4.63% (versus an increase of 4.64%).

We are keeping our inflation forecast at 3% both for this year and next, as the slow pace of narrowing in the output gap works to contain demand-side pressure on prices.  

Trade deficit widens

The trade balance of Mexico deteriorated in May, in spite of a recovery in the energy balance. The sharp deterioration of manufacturing exports widened the non-energy deficit substantially. On a seasonally adjusted and annualized basis, the trade balance posted a USD 21.6 billion deficit in May (USD 15.2 billion deficit in April). The three-month deficit stood at USD 14.8 billion (annualized), worsening from the USD 8.0 billion deficit in April, with the energy balance registering a deficit of USD 5.5 billion (from USD 6.9 billion in April) and the non-energy deficit at USD 9.3 billion (significantly higher than the USD 1.1 billion deficit in April). As a result, the 12-month rolling balance stood at a deficit of USD 5.5 billion (from USD 4.3 billion in April and USD 2.8 billion in 2014), as the energy balance keeps breaking historical records, posting a deficit of USD 3.4 billion, and the non-energy deficit worsened to USD 2.1 billion (from USD 1.6 billion in April).

We still expect the current account deficit at 2.5% of GDP in 2015.The trade balance figures remain consistent with a low current account deficit.

The peso has continued to depreciate, affected mostly by uncertainty over the Greek and Chinese economies and stronger U.S. data.We still see the exchange rate at 15.5 pesos to the dollar by the end of this year. Next year, the tightening cycle in Mexico and the capital inflows associated with the structural reforms will likely contain the depreciation pressure exerted by the strengthening U.S. dollar globally, so we also expect the peso next year at 15.5 to the dollar.

Central Bank changes calendar for monetary policy meetings

The minutes of the most recent monetary policy decision revealed a unanimous decision to leave the policy rate unchanged, at 3.0%.The document showed that most of the committee members see both the balance of risks to inflation and activity unchanged from the previous meeting. As in the previous minutes, the majority of the board members consider that a hike before the Fed’s liftoff would do more harm than good, as weak cyclical conditions persist. 

On July 1, the central bank announced that it changed the calendar for the monetary policy meetings scheduled for the second half of the year. According to the statement announcing the change, the new calendar will allow the board of the central bank to react in a more timely fashion to the Fed’s decisions. In fact, except for September – when the Fed board meets during an important holiday in Mexico – all the decisions of Mexico’s central bank will be announced on the day after the Fed announces its own decisions.  

Although the new calendar could be read as a sign that Mexico’s board members are considering raising rates right after the Fed moves, we think a tightening cycle in Mexico will start only in 1Q16 - after the Fed (we now expect the Fed’s liftoff in December) - once it becomes clear that the economic recovery in Mexico is solid enough to justify the withdrawal of monetary stimulus.After all, weak growth in Mexico, low inflation, the stable inflation expectations and the fact that the exchange rate is not depreciating excessively (in spite of a high probability that the Fed’s liftoff will come this year) mean that the central bank of Mexico can act independently from the Fed.   

Our year-end forecasts for the policy rate stand at 3.0% and 4.0% for 2015 and 2016, respectively.

Round 1 auctions to start very soon

The winners of the first phase of Round One will be announced on July 15, which includes 14 shallow-water fields. This is the first risk-sharing contracts awarded to the private sector. A total of 26 firms pre-qualified for this stage. The outcome of the auctions is key, as it will indicate how interested private companies are in Mexico’s Oil sector, given the terms offered by the government.

Meanwhile, the Ministry of Energy is defining the requirements of the fourth phase of Round One, which includes deep-water fields. The final details of this phase will be released in August. The Ministry is also advancing on the fifth phase. Given that the government has to generate economic growth and, more specifically, reverse the declining trend in oil output, we expect the government to continue adjusting the contractual terms, as needed, to attract private oil companies.



João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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