Itaú BBA - Slowing down amid weaker fundamentals

Scenario Review - Mexico

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Slowing down amid weaker fundamentals

August 10, 2016

In coming quarters, a rebalancing of growth sources toward firmer manufacturing exports and softer consumption is likely.

Please see the attached file for all graphs.

 Mexico’s fundamentals are weakening due to lower oil prices. The Mexican peso has depreciated sharply, but we view the weakening as excessive, and to some extent influenced by concerns about the direction of future U.S. policies. We continue to expect the Mexican peso to strengthen, to 17.5 to the dollar by the end of this year and through the end of 2017.

 The economy lost momentum in 2Q16. We expect GDP growth to slow down from 2.5% in 2015 to 2.1% in 2016, and then to pick up to 2.4% in 2017. In coming quarters, a rebalancing of growth sources toward firmer manufacturing exports and softer consumption is likely. 

 We now expect Mexico’s central bank to raise interest rates in December, by 25 bps (together with the Fed). In fact, the interest-rate differential with the U.S. continues to play a central role in monetary-policy decisions in Mexico. We still see two additional rate hikes (of 25 bps each) in 2017, also in line with the Fed.

Weakening fundamentals

While Mexico is not a typical commodity exporter, it is not insensitive to trends in raw material prices. In fact, the deterioration of oil prices is worsening the country’s fiscal position. As oil accounts for 18% of the government’s revenues (down from a peak of 40% in 2012), lower oil prices are widening the fiscal deficit and pushing the public debt up (to above 45% of GDP), forcing the government to cut expenditures to preserve sovereign ratings. As many of the budget cuts are carried by Pemex, oil production keeps falling (-2.2% year over year in 2Q16, after a 3.1% contraction in 1Q15 and 6.7% fall in 2015), while the environment of low prices is an obstacle to attracting private oil companies into Mexico. As oil output falls, the outlook for related revenues weakens, which in turn can demand further fiscal consolidation in the future, thus creating a vicious cycle.

Besides fiscal accounts, the drop of oil prices and oil production is weakening the balance of payments. In fact, in 2015 Mexico saw an energy-balance deficit of 0.9% of GDP, contrasting with the 0.7% surplus two years before. Besides weak oil output, the price of Mexico’s energy exports (largely crude oil) has decreased by much more than the price of its oil imports (mostly refined oil products), thereby pulling down the terms of trade. In addition, without foreign direct investment in the oil sector (which was supposed to be massive due to the energy reform), Mexico loses (or foregoes) an important source of financing to replace the once abundant portfolio flows to the domestic bond market.  

Sharp underperformance

With worse fundamentals, the Mexican peso has depreciated sharply, underperforming most LatAm currencies. The rise of Trump could well be a factor behind the weakness, considering that the prospects of his election as the next U.S. president cast a shadow on the Mexican economy. Among the proposals with a likely negative impact on Mexico are: the elimination of the North American Free Trade Agreement (NAFTA), ramp-up of deportations and taxing of remittances. The high liquidity of the Mexican peso coupled with its low carry is also often cited as a reason for the underperformance.

In any case, we view the depreciation as excessive. First, oil prices are already rising. Also, U.S. manufacturing is recovering, which will likely boost Mexico’s exports soon. Although Mexico’s fiscal accounts have deteriorated, policymakers seem committed to reducing the fiscal deficit. The level of the current-account deficit is not excessive (now at 2.8% of GDP) and more recent data points to stabilization. In addition, Mexico’s reserves stand at slightly more than USD 170 billion, putting net external debt (foreign currency debt of the public and private sectors minus reserves) at a low 11% of GDP. Finally, Trump’s defeat in the U.S. elections is the base case of most political analysts, which combined with our expectation of further oil-price recovery, can trigger an appreciation. We continue to expect the Mexican peso to end this year and the next at 17.5 to the dollar.

GDP growth remains subdued

Mexico’s economy weakened in 2Q16. The flash GDP estimate came in at 2.4% year over year (below the 2.6% registered in 1Q16) and fell 0.3% sequentially. The service sector expanded 3.2% year over year, again reflecting solid consumption growth (which is induced by low inflation, still-healthy employment growth, remittances converted to pesos and credit). On the other hand, the recovery of U.S. industry has yet to benefit Mexico and manufacturing exports currently perform poorly (although they stopped contracting at the margin).

We still expect GDP growth to slow from 2.5% in 2015 to 2.1% in 2016, and then pick up to 2.4% in 2017. The growth drivers will probably start to change over the next few quarters, with more-balanced contributions between exports and consumption. We believe that a firmer pace of U.S. industrial activity and substantial real exchange-rate depreciation will lift Mexican manufacturing exports. Conversely, private consumption, and hence service sectors, looks set to lose steam. Temporary employment in Mexico – a leading indicator of overall employment – is growing at low levels, pointing to a less supportive labor market for Mexican consumers. Moreover, inflation will probably rise somewhat (to the target center), reducing real wage growth. As the exchange-rate stabilizes, the impetus from remittances will fall. Finally, ongoing fiscal tightening will hit consumers at some point. 

Following the Fed

In spite of low inflation and moderate growth, Mexico’s central bank started to raise interest rates in December 2015. It has raised the reference rate by 125 bps so far, from 3% to 4.25%. The key determinant of Mexico’s monetary policy is the evolution of the exchange rate, whose sharp depreciation – according to Banxico’s official statements – threatens the medium-term inflation expectations.

Although we expect better performance of the exchange rate ahead, we now expect Mexico’s central bank to raise interest rates again in December (by 25 bps), together with the Fed. Previously we saw no additional rate hikes in the U.S. or Mexico this year. The interest-rate differential with the U.S. (independent of the behavior of the exchange rate) remains an important factor in Mexico’s official policy communications. In 2017, we see two additional 25-bp rate increases, also together with the expected Fed moves.


João Pedro Bumachar
Alexander Andre Muller


Please see the attached file for all graphs. 



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