Itaú BBA - The dust is far from settled

Scenario Review - Mexico

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The dust is far from settled

February 9, 2017

Uncertainty over bilateral relations with the US is the main risk

Please see the attached file for all graphs.

 Mexico’s GDP growth rate likely reached 2.3% in 2016, but we expect a slowdown to 1.6% this year. Among the headwinds impeding growth are an erosion of real wages, tighter macro policies and, most importantly, the uncertainty over U.S. trade policies.

 We now see inflation at 5% at the end of 2017 (up from our previous estimate of 4.6%), and we still expect the central bank to hike the reference rate to 7.0% (through one 50-bp rate increase this month and three 25-bp hikes following each of the Fed moves we expect this year). Lower inflationary pressures in 2018 will likely allow for some monetary easing.

 Given the mounting risks related to Mexico’s trade relations with the U.S., it is positive that external accounts are improving (on the back of a weaker currency and rising manufacturing exports). Meanwhile, the 2016 fiscal deficit came in slightly below the government’s own target.

Economic growth was solid in 4Q16, but it is likely to slow down this year

Mexico’s economic activity was solid in 4Q16. The flash estimate of GDP growth for the quarter came in at 2.2% year over year. Growth was also 2.2% year-over-year after adjusting for calendar effects – up from an adjusted rate of 2.0% in 3Q16. At the margin (seasonally adjusted), GDP grew by 2.6% (annualized) from the previous quarter (below the 4% qoq/saar observed in 3Q16, when growth rebounded from a trough in the previous quarter).

Growth continues to be led by the service sector, while industrial production is weak. Calendar-adjusted figures show that the services activity grew by 3.2% year-over-year in 4Q16 (only slightly below the 3.3% recorded in 3Q16), while industrial production growth remained in negative territory (-0.2% year over year, up from -0.9% previously).

Services activity is underpinned by solid consumption. A robust consumer credit market (up 13% year over year in December) and strong remittances inflows (up 33% year over year in 4Q16 in pesos) are supporting the service sector. Formal employment is also growing at a robust pace (4% year over year).

Industrial production, by contrast, is being dragged down by falling oil output and low infrastructure spending by the public sector. Oil and gas output fell by 1.3% in November compared with the previous month, weighing down quarterly growth, which remained deep in negative territory (-13.7% qoq/saar, vs. -13% in October). Meanwhile, non-residential construction investment fell by 1.7% qoq/saar in November.

Nevertheless, manufacturing has been stronger, which is preventing a further deterioration of industrial activity. At the margin, manufacturing production climbed by 2.2% qoq/saar, while manufacturing exports were up 11.2% qoq/saar (in current dollars) in 4Q16. The numbers are consistent with a strong U.S. industry (the U.S. ISM manufacturing index averaged 53.3 in 4Q16).

This preliminary/flash result for 4Q16 implies an annual GDP growth rate of 2.3% – that is, only a moderate slowdown from the 2.6% growth posted in 2015. While the flash result (as well as the time series) might be revised, it is likely that annual growth in 2016 was a bit above our previous forecast and market expectations (both 2.1%, per Bloomberg).

However, uncertainty over bilateral relations with the U.S. will be a key drag on growth this year, especially on manufacturing investment. In fact, there is a non-negligible risk that the U.S. government could end up implementing policies that are disruptive to the Mexican economy, such as a withdrawal from NAFTA, border-tax adjustments and/or restrictions on remittances. Our baseline scenario is that some trade protectionism will materialize in the U.S., but not of a magnitude that would have transformational implications for the Mexican economy.

Higher inflation and tighter macro policies (both fiscal and monetary) will likely also contribute to a slowdown in growth from its 2016 level. Manufacturing exports are expected to continue serving as a buffer, as long as the U.S. does not adopt protectionist policies. For 2018, we expect a recovery of 2.1%, assuming that the risks related to external trade will gradually dissipate.

Inflation spikes

Mexico’s consumer price index increased by 1.51% between the second half of December and the first half of January, significantly exceeding market expectations. Given that the government is moving to liberalize the fuel market, the bulk of the increase was due to higher gasoline prices (which accounted for 93 bps) and higher liquefied petroleum gas prices (28 bps). Still, the increase in core prices (0.37%) was also above market expectations (0.27%), with the tradable component rising by 0.58%, influenced by the further weakening of the exchange rate.

As a result, inflation reached 4.8% in mid-January, above the upper bound of the target range for the first time since December 2014 and up from 3.2% in the second half of December 2016. Non-core inflation jumped from 2.7% to 8% over the same period due to a 16.5% increase in energy prices. Core inflation also increased, reaching 3.7% (from 3.4% at the end of December), with goods inflation at 4.5% (from 4.1%). Core services inflation remained tame (at 3%, up from 2.8%).

Banxico’s latest expectations survey showed a significant increase in inflation forecasts. Median Inflation expectations were raised for both 2017 (to 5.2% from 4.1%) and 2018 (to 3.8% from 3.6%). Long-term tenors were more stable, but still showed an increase. For example, the average inflation rate expected for the next five to eight years went up to 3.5% from 3.4%.

We have revised our 2017 inflation forecast to 5% (from 4.6%), given the higher-than-expected inflation in early January and the deterioration in inflation expectations.

Inflation will likely moderate in 2018. Both exchange-rate depreciation and the increase in gasoline prices are temporary shocks that will fade as the year goes on, provided that there is no substantial change in Mexico’s trade relationship with the U.S. and assuming higher interest rates in Mexico.

Central bank in damage-control mode

While during 2016 the central bank was raising rates to shield the Mexican peso, now its focus is on avoiding second-round effects from the currency depreciation and gasoline price increases. The reference rate is currently at 5.75%, above the upper bound of Banxico’s neutral rate estimates (4.3%-5.2%, according to the analysis presented in the last inflation report). Still, given the recent increase in inflation expectations we think that further rate hikes are likely. Additionally, the interest rate differential with the U.S. (and its potential impact on the exchange rate) remains a key variable that is cited in the central bank’s official statements. So, hikes by the Fed this year will probably lead Banxico to raise interest rates too.

We expect the central bank to take the reference rate to 7.0% before the end of this year (through one 50-bp rate increase this month and three 25-bp hikes following each of the Fed moves we expect this year). Lower inflationary pressures next year will likely allow for some monetary easing. We see two 25-bp rate cuts later in 2018.

Progress on the fiscal and balance-of-payment accounts

Given the mounting risks related to Mexico’s trade relations with the U.S., we would highlight the narrowing of the trade deficit and the government’s compliance with fiscal targets set for 2016 as positive developments.

The trade deficit has narrowed on the back of a weak currency and rising manufacturing exports. The trade deficit reached USD 6.8 billion in 4Q16 (seasonally adjusted and annualized), down from USD 13.5 billion in 3Q16 thanks to a marked improvement in the non-energy balance (which reached a USD 8.1 billion surplus, up from USD 1.0 billion). The improvement in the non-energy balance, in turn, was due to a sharp increase in manufacturing exports (the third consecutive quarterly increase), while non-oil imports increased by a modest 2.9%. Among non-oil imports, the intermediate goods component was the only one with a positive growth rate in 4Q16 – which is probably linked to the imported content of Mexico’s exports.

In all, the latest trade balance figures confirm that Mexico’s external accounts are improving as a result of higher U.S. industry growth, a weaker exchange rate and, to a lesser extent, a gradual deceleration of internal demand. For 2017, we expect further improvement, as the U.S. economy will likely continue to strengthen and the Mexican peso will probably depreciate relative to its 2016 value. A slowdown in internal demand due to lower real wages and uncertainty over U.S. trade policies could also help to reduce the external imbalance. On the other hand, a further drop in oil production is likely in 2017, offsetting higher oil prices and keeping the energy deficit wide.

The fiscal deficit was narrower than the government target. The rolling four-quarter fiscal deficit indicators widened somewhat in 4Q16, reflecting smaller oil hedge revenues (compared with 2015) and the backloading of public debt interest payments, but on the bright side the annual results were better than had been expected by the market and the government. The primary balance, the fiscal balance and public-sector borrowing requirements – expressed as a percentage of GDP – ended the year at -0.1%, -2.6% and -2.9%, respectively, below both the government targets (-0.6%, -3%, -3.5%) and Hacienda’s last estimates (-0.3%, -2.8%, -3%), presented in September.

Still, public debt is still on a rising trend. The net debt of the public sector increased from 47.6% of GDP in 3Q16 to 50% of GDP at the end of 2016, as the sharp depreciation of the peso in November (after the U.S. election) increased the local currency value of foreign debt and the government purchased the pension liabilities of the national electricity company (CFE) for MXN 160 billion (0.8% of GDP) in December. The government’s fiscal consolidation plan is aiming to stabilize net public debt (as a percentage of GDP) in 2017, after 10 consecutive years of increases.

In our view, it is likely that the Mexican government will meet its fiscal targets for 2017, preventing a rating downgrade. Nonetheless, the risks to the sovereign rating are still high, especially considering that all the rating agencies have a negative outlook for Mexico. The government is targeting a primary surplus of 0.4% of GDP and public-sector borrowing requirements of 2.9% of GDP for 2017. Considering that the peso depreciated by around 20% in 2016, the government will likely receive another meaningful dividend from the central bank (in 2015, the depreciation was 17%). Oil revenues will likely also be higher, in spite of lower oil production. Nevertheless, the implications for Mexico of the election of Donald Trump may lead to a deterioration in public debt dynamics at a time when the level of public debt is already high.


João Pedro Bumachar
Alexander Andre Muller

Please see the attached file for all graphs. 


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