Itaú BBA - Still not Rebounding

Scenario Review - Mexico

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Still not Rebounding

March 11, 2014

Recent activity indicators show that the economy has not rebounded yet.

• Recent activity indicators show that the economy has not rebounded yet.  We reduced our GDP forecast for this year to 3.0% (from 3.3%). For 2015, our 3.8% GDP growth forecast is unchanged.

• Inflation declined in February, and core inflation is back to the target center, even after the tax increases. We still see inflation at 3.7% by the end of this year and at 3.2% by the end of 2015.

• We no longer expect an appreciation of the Mexican peso in the near term. The peso will likely end both this year and next at around 13.2 to the dollar.

• The disappointing activity figures and the well-behaved inflation support our view that no policy rate moves will come this year. In 2015, a tightening cycle is likely, as the Fed starts to normalize its policy rate.

• The secondary legislation of the energy reform will likely be sent to congress within the next few days. Meanwhile, the law on public referendums was approved, but a public poll on the energy reform (which the PRD wants to see) seems unlikely.

More Disappointing Activity Figures

Mexico’s GDP expanded by a weak 0.7% qoq/saar during 4Q13, surprising expectations on the downside. The Service sector also grew by 0.7% during the last quarter of 2013, while Industrials contracted 0.1%. The small and volatile Primary Activity sector  increased by 0.9%. As a result, Mexico’s economy grew by a poor 0.7% year over year in 4Q13. The working-day adjusted GDP series also increased by 0.7%, so calendar effects were neutral. Growth for full-year 2013 was 1.1%.

Some activity indicators point to a weak 1Q14. The IGAE (monthly proxy for GDP) decreased by 0.3% from November to December, so the carry-over effect for the first quarter of the year is not favorable. In January, manufacturing exports fell by 1.8% month over month, as both auto (-2.3%) and non-auto (-1.5%) external sales contracted. Bad weather in the U.S. may have played a role in the weak export figure for January, but the trend is far from encouraging (in 4Q13, manufacturing exports contracted by 3.8% qoq/saar). While consumer confidence improved from January to February (it increased by 3.03%), the level of confidence remains low (down by 11.4% from February 2013), which is likely a result of the tax hikes introduced earlier this year. Languishing consumer confidence suggests that the recovery of consumption seen in 4Q13 (retail sales increased 6.6% qoq/saar in 4Q13) was not the beginning of a trend. On the investment side, we see nothing but a very incipient recovery. Construction activity increased by a modest 0.5% qoq/saar in 4Q13, after four consecutive quarters of negative growth, while imports of capital goods fell 0.9% from December to January, after a 5.1% gain in 4Q13.

We now expect Mexico’s economy to expand by 3.0% this year. In our previous scenario, we were expecting a 3.3% growth rate. In our view, growth during the first quarter of this year will likely be weak, but above-trend growth rates are likely in the subsequent quarters. Activity will benefit from higher U.S. growth and expansionary fiscal and monetary policies. In 2015, the economy will likely start to feel the first impacts of the energy reform, which together with continued strong growth in the U.S. will probably lead to GDP growth of 3.8%.

Inflation is Well Behaved, in Spite of Tax Hikes

Inflation in Mexico fell to 4.2% in February, down from 4.5% in January. Inflation is now closer to the target range. Importantly, core inflation fell to 3.0% (from 3.2% in January), so it is now at the center of the target, even after the tax increases. Inflation for core services is also at 3.0% (in January it was at 3.5%, mostly due to unfavorable base effects). Inflation for core goods was flat from January to February, at 2.9%. Meanwhile, inflation for non-core items also fell, but it continues very high (at 8.3%), due to higher prices for regulated items (10.1% in February). Inflation for non-processed food, which is very volatile, is falling after the increase in the last quarter of 2013.

We see inflation at 3.7% by the end of this year and at 3.2% in 2015. In our view, the output gap will continue to keep core prices under control, while inflation for non-core items is unlikely to stay as high as it is now. From January 2015 on, the tax increases will not affect year-over-year inflation figures, and we see inflation hovering closer to the center of the target.


The Balance of Payments Remains in Very Good Shape

The current account deficit for Mexico continues to be low. In 4Q13, the current account deficit reached USD 4.7 billion, down from USD 7.3 billion one year before. As a result, the deficit in 2013 reached USD 22.3 billion (1.8% of GDP), up from USD 14.8 billion (1.3% of GDP) in 2012.

In spite of higher U.S. yields, portfolio flows to Mexico are still very strong.  In 4Q13, foreign portfolio investment in Mexico came in at USD 18.7 billion. Once again, almost all the portfolio investment flew to fixed-income securities (investment in equities was only USD 300 million). In 2013, foreign portfolio investment was USD 50.4 billion, a very strong figure though down from USD 81.3 billion in 2012. On the other hand, foreign direct investment (FDI) came in at USD 5.4 billion in the last quarter of the year. During 2013 as a whole, FDI was strong (USD 35.2 billion), but this was due to a large M&A transaction that took place in the second quarter of the year (FDI in that quarter was USD 19.3 billion). Furthermore, Mexican direct investment has also been high, so net direct investment to Mexico was USD 25.2 billion in 2013.

We no longer expect an appreciation of the Mexican peso in the near term. We now see the peso at 13.2 to the dollar both by the end of this year and by the end of 2015. Previously we were expecting the exchange rate at 12.8 by year-end 2014 and 2015. As data confirms the U.S. recovery, pressure on U.S. treasury yields will return, which will put depreciation pressure on emerging market currencies. However, the prospects of higher FDI (due to the energy reform) together with the recovery of Mexico’s economy will likely prevent the peso from weakening. Relative to most LatAm currencies, the Mexican peso is expected to continue outperforming.

No Policy-Rate Changes This Year

The central bank is unlikely to move the policy rate soon. In its latest monetary policy meeting (held at the end of January), the central bank kept a neutral bias but expressed concern over inflation. According to the press statement announcing the decision, the board saw a worse balance of risks for inflation, due to the potential second-round effects from high headline inflation (the latest data on inflation available at the time of the meeting was 4.6% year over year) and to global market volatility. At the same time, the board said that the balance of risks for activity improved. Since the last meeting, a number of weak activity indicators were published and inflation retreated substantially, with the core measure back to the center of the target. So, data do not support rate hikes. On the other hand, the central bank has already signaled that it would be unwilling to bring the short-term (ex ante) real interest rate to negative. In our view, rate cuts will not return to the table unless the outlook for activity deteriorates much further.

However, a tightening cycle is likely in 2015, as the output gap narrows and the U.S. starts to raise interest rates. We expect the central bank to bring the policy rate to 4.5% before the end of 2015.

Two Minor Risks for Energy Reform: a Public Referendum and the Secondary Legislation     

The Mexican congress passed the Law on Public Referendums. The bill sets the terms under which a referendum can be called. The referendum mechanism is part of a broader political reform approved in 2012, but only now were the details on the referendum process approved in congress. Because the PRD is trying to block the energy reform with a public referendum, the bill becomes relevant for the macro outlook.

A public referendum on the energy reform seems unlikely, but a slight risk remains. The approved bill says clearly that fiscal issues can’t go to a public referendum. Because public sector revenues in Mexico are highly dependent on energy, the government will likely try to classify the energy reform as a fiscal matter. In addition, the law on public referendums establishes that only issues of “national significance” can be submitted to a public vote. If the president or one-third of any chamber of congress asks for a referendum, the majority of each chamber of congress must then vote on whether the issue is of national significance. Another possibility (which the PRD is trying to explore) is to request a referendum with signatures of 2% of the electorate. Then, however, it would be up to the Supreme Court to determine first whether the issue was of national significance before a public referendum was held. Political analysts think it very unlikely that the Supreme Court would agree with a referendum on the energy reform.

The government is expected to submit the secondary legislation on the energy reform to congress within the next few days. We believe it unlikely that the secondary legislation will water down the energy reform. After all, most of the political cost in approving the reform was already paid when congress changed the constitution.

João Pedro Bumachar

 Forecasts: Mexico


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