Itaú BBA - Resilient to shocks, but inflation prone

Scenario Review - Mexico

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Resilient to shocks, but inflation prone

May 11, 2017

Growth surprised to the upside, while inflation conditions deteriorated.

Please see the attached file for all graphs.

 Headline inflation continues to increase. While this is mainly due to the lagged effects of last year’s peso depreciation, core services inflation has increased (even if items directly affected by the currency are excluded) and diffusion indexes show more broad-based inflationary pressures.

• Although the more recent appreciation of the peso will likely bring relief to consumer prices, we have revised our inflation forecast for 2017 to 5.4% (from 5% previously).

• In this context, it will be hard for the central bank to pause the tightening cycle. So we now believe that the next 25-bp hike will come in May (rather than waiting for the Fed’s move, which we expect to come in June). Due to this extra hike in May 2017, we have revised our monetary-policy rate forecasts for 2017 (to 7.25%, from 7%) and 2018 (to 6.75%, from 6.5%). 

• Activity surprised to the upside in 1Q17, with the flash estimate at 2.7% year over year (above expectations), and consumption remains strong. Given the recent activity figures, we have revised our growth forecast for 2017 (to 2%, from 1.8%). Nevertheless, we expect a slowdown in coming quarters, even though manufacturing exports will continue to act as a buffer.

• Meanwhile, fiscal accounts improved in 1Q17, beyond the effects of a whopping central bank dividend. Stronger fiscal numbers, together with the more constructive stance of U.S. policymakers on NAFTA, has reduced the odds of a sovereign rating downgrade.

Inflation accelerates

Inflation is on the rise, driven by the lagged effects of last year’s peso depreciation. Mexico’s CPI  came in higher-than-expected in April. The seasonal decrease of electricity tariffs was more than offset by the increase of core goods (tradables), a rebound of agricultural prices, and the seasonality of the Easter holidays (which exerted upward pressure on core services). Thus, annual headline inflation increased to 5.8% year over year (from 5.4% in March).  Core inflation also increased, to 4.7% (from 4.5%), during the same period. Both core goods (6.0%, up from 5.8%) and core services (3.6%, up from 3.3%) showed an increase. The former is running high, reflecting the sharp exchange-rate depreciation observed until mid-January, and the latter is more moderate but showing an upward trend.

The increase of services inflation, coupled with higher diffusion indexes, suggests that second-round effects are showing up. In fact, 73% of the items in the CPI basket are featuring annual inflation rates higher than or equal to 4% (the upper bound of the tolerance range around the central bank’s 3% target), up from 51% in December 2016. Regarding services, while it is true that part of the increase seen in the past few months is related to base effects of telecom prices (which have been driven by supply-side factors, rather than demand) and to FX-sensitive services (airfares, tourism, hotels), services inflation has increased even if those items are excluded (though by far less than the full core services index). Excluding telecom and the abovementioned FX-sensitive items, core services inflation rose from 3.3% year over year in  December 2016 to 3.7% in April (while the core services measure increased from 2.9% to 3.6% during the same period).

We have increased our inflation forecast for 2017 to 5.4% (from 5%). In our baseline scenario, inflation would peak in August (at 6.1% year over year), and then move down because of the lagged effects of peso appreciation (9% year-to-date, compared to the 19% depreciation observed in 2016) and, to a lesser extent, weaker activity. We believe that inflation will moderate to 3.3% in 2018, as the shocks affecting the CPI (gasoline spike and peso depreciation) dissipate. In fact, according to Banxico’s latest survey (April), median inflation expectations for 2017 increased to 5.7% (5.6% previously), which marked the seventh consecutive increase, but inflation expectations for longer-term measures – such as 2018 (3.7% down from 3.8%) and next 5-8 years (3.4%, down from 3.5%) – decreased slightly. 

No room to pause

With the recent exchange-rate appreciation, the central bank found room to reduce the pace of rate hikes. The quarterly Inflation Report marked a turning point in the central bank’s guidance, stating that tightening aggressively could be “inefficient and costly for economic activity.” In the week after the report, Banxico’s board unanimously decided to reduce the pace of monetary tightening by hiking 25 bps (to 6.50%), departing from the last six policy moves (50 bps). Moreover, in April, Governor Carstens told the press that Banxico “might not necessarily follow the Fed in the medium term.”

The latest inflation numbers, combined with the expectation of new hikes by the Fed, mean that additional rate increases are likely. Headline inflation has yet to peak, and the behavior of diffusion indexes (73% of items in the CPI basket showing inflation higher or equal than 4%) and service inflation suggests second-round effects are materializing. In this context, the central bank still sees the balance of risks for inflation as tilted to the upside. Furthermore, the central bank continues to highlight the interest-rate differential with the U.S. as a key variable to monitor.

We have revised our monetary-policy rate forecast for 2017 to 7.25% (from 7%), and now believe that the next rate hike will come in May (rather than June). To be sure, it will be hard for Banxico’s board to pause in May given the latest inflation data. Afterward, the next hike will probably come in June, following the Fed. In 2018, we expect Banxico to ease monetary policy a bit, bringing the reference rate to 6.75% (6.5% expected previously), as the inflation shocks dissipate and the economy expands at a moderate pace. 

Activity surprises positively in 1Q17

The flash estimate of GDP growth was stronger than expected in 1Q17. Growth for 1Q17 came in at 2.7% year over year, above market expectations (2.5%, per Bloomberg). Adjusting for calendar effects, growth was a bit lower (2.5% year over year), about the same as in 4Q16. At the margin, GDP expanded 0.6% from the previous quarter.

The breakdown by sectors shows that industrial growth is anemic and that services activity remains robust. Industrial growth was nil at the margin. Stronger manufacturing, as shown in February’s industrial production data and March’s trade balance figures (manufacturing exports gained 8% qoq/saar in 1Q17), is not enough to offset the sharp contraction of oil & gas output and weaker construction. Non-residential construction, in particular, is being dragged by the fiscal consolidation process. The uncertainty surrounding bilateral relations with the U.S. is also a drag on investment. Services, in contrast, advanced 4.1% qoq/saar from the previous quarter, as consumption remains solid. The monthly private consumption indicator remains strong (6.4% qoq/saar), in spite of weaker real wage-bill growth and low consumer confidence.

Given stronger-than-expected activity figures, we have revised our growth forecast for 2017 (to 2%, from 1.8%). The flash estimate of 1Q17 GDP shows that activity has been resilient to shocks affecting the economy (uncertainty over trade relations with the U.S., fiscal consolidation, falling oil production and lower real wages). We note that our new growth forecast for the year is still consistent with low quarter-over-quarter growth rates from the second quarter until the end of 2017, as we continue to expect internal demand to slow down in response to the shocks. In fact, gross fixed investment is already performing poorly (-4.1% qoq/saar, after weak 0.7% growth in 4Q16). However, stronger manufacturing exports – boosted by firmer U.S. activity and a competitive real exchange rate – will continue to act as a buffer.

Fiscal picture improves

Nominal fiscal indicators improved in 1Q17, even if the effect of the central bank’s dividend is excluded. Over the past couple of years, MXN depreciation has created gains on international reserves, leading to strong dividends to the treasury – MXN 31 billion in 2015 (0.2% of GDP) and MXN 239 billion in 2016 (1.2% of GDP) – reaching a record high of MXN 322 billion this year (1.6% of GDP). This year the dividend was recorded in March, unlike in 2016 (when it was recorded in April), so the 12-month rolling results have posted a massive improvement in 1Q17. Still, the improvement of the fiscal accounts goes beyond the abovementioned windfall effects. In fact, excluding 70% of the dividends from the time series (as the balance is directed to stabilization/sovereign funds, and therefore recorded as both revenues and expenditures), the 12-month rolling result of all fiscal-deficit indicators narrowed significantly in 1Q17.

The developments on the fiscal front, together with the softer stance of U.S. policy makers on NAFTA, reduce the odds of a sovereign rating downgrade. In fact, Moody’s recently re-affirmed Mexico’s credit rating, also highlighting the progress on the fiscal consolidation, although it still maintains a negative outlook. The market and rating agencies will keep a close eye on whether the proceeds of the dividend are used to accommodate more spending (and reduce the pace of fiscal consolidation). We forecast that the nominal public-sector deficit will narrow to 2.1% of GDP in 2017 (from 2.6% in 2016), larger than the government’s updated forecast (after the dividend) of 1.3% of GDP. Importantly, it is likely that the Mexican government will be able to reduce the public-debt-to-GDP ratio in 2017, for the first time in ten years.

MXN stabilizing around stronger levels

We have maintained our exchange-rate forecasts for 2017 and 2018 at 19.5 and 18.5, respectively. A more constructive dialogue between U.S. and Mexico trade negotiators (which reduces the risk of an escalation of protectionism), central bank FX intervention, and higher interest rates have anchored the currency. We believe that the peso will depreciate a bit from current levels as long as the U.S. tightens monetary policy further in 2017 (we expect two 25-bp hikes, in June and September). In 2018, once the U.S. and Mexico are done with the NAFTA renegotiation (assuming the agreement lives on), we believe the MXN will appreciate in response to fading uncertainty.  

However, politics may bring volatility. The left-wing Morena party (of the likely presidential candidate López Obrador, AMLO) is ranking at the top of presidential polls (based on an average of the main pollsters: Reforma, El Universal, El Financiero, and Mitofsky) and second in the polls for elections in the State of Mexico (using a similar average), very close to the ruling party’s candidate, who is the front-runner. Importantly, the regional elections in the State of Mexico (June 4), the country’s most populous state, are a thermometer for next year’s presidential election. At the beginning of the year, many analysts argued that Morena lacked the political machinery to perform well in the State of Mexico’s regional elections. In fact, the PRI has never lost an election in this state. So Morena’s performance in the polls has already been a surprise, boosting AMLO´s chances in 2018.



João Pedro Bumachar

Alexander Andre Muller

Please see the attached file for all graphs. 

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