Itaú BBA - Weaker U.S., Weaker Mexico

Scenario Review - Mexico

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Weaker U.S., Weaker Mexico

May 7, 2015

The economy weakened in 1Q15, as exports fell from the previous quarter.

• The economy weakened in 1Q15, as exports fell from the previous quarter. Weaker activity in the U.S. is likely behind the momentum loss. We currently expect Mexico’s economy to grow by 2.6% this year and by 3.3% in 2016.    

• Inflation remains very well-behaved around the center of the target, and core inflation remains well below this threshold. The negative output gap is limiting both service inflation and the pass-through from the weaker peso to prices of tradable goods. We continue to expect inflation to end this year and the next at 3.0%. 

• The central bank decided to maintain the policy rate at 3.0%, as expected, in April. The minutes of the previous meeting show board members divided on when the central bank should hike. Two board members see appeal in a hike before the Fed moves, while two other members think that acting in anticipation of the Fed could be a mistake. More recently, Governor Carstens said that all options are on the table and hinted that higher volatility could trigger hikes before the Fed’s tightening cycle starts. We continue to expect the central bank of Mexico to raise rates in September, together with the Fed (our year-end call for the policy rate is 3.5%). 

• In April, the peso failed to benefit from the weakening of the U.S. dollar globally. The softer tone of the central bank (or at least of some of its board members) may have contributed to the underperformance. Still, we continue to see the peso at 15 to the dollar, both by the end of this year and by the end of the next. A further recovery in oil prices, Mexico’s tightening cycle and the capital flows associated with the energy reform will likely offset the Fed’s liftoff.   

• A recent survey from Parametria puts the PRI ahead in the electoral polls for the June 7 midterm elections, with 32%, followed by the PAN (24%) and PRD (13%). This is in line with our expectation that the PRI will remain the largest political force in congress.


Consolidating a Weak 1Q15

The IGAE (monthly proxy for GDP) slowed to 1.9% qoq/saar in February, from 3.5% in 4Q14. The available indicators hint that weaker exports are the key reason behind the slowdown. Manufacturing exports declined by 11.8% qoq/saar in 1Q15 (from +10.5% in 4Q14). In fact, manufacturing output in February grew by only 0.5% qoq/saar. The 1.0% (annualized) contraction of the U.S. industry during 1Q15 is in our view the reason for the deterioration of exports in Mexico.

On the positive side, private consumption is showing signs of a recovery. Retail sales accelerated to 5.6% qoq/saar in February (from 0.1% in 4Q14) as formal employment kept growing at a robust pace (4.5% year over year in April), which alongside low inflation is boosting the real wage bill (5.8% year over year in  March). Both consumer confidence and remittances are also evolving more favorably and are likely to add to private consumption growth.

Supply-side factors – namely weaker oil production – are also weighing negatively on growth. Oil and gas output contracted by 8.5% qoq/saar in February, following a 6.0% contraction in 4Q14.

We forecast growth this year at 2.6% and at 3.3% in 2016. Our forecasts imply that the slowdown in 1Q15 is temporary, just as in the U.S. economy. Besides the above-potential growth in the U.S., investments related to the implementation of the reform agenda will likely lift growth ahead. For 2016, we expect that the investment in energy will stabilize oil production.

Inflation remains very well-behaved

The negative output gap is containing both service inflation and the pass-through of the weaker peso to prices for tradable goods. Lower telecom prices and smaller increases in non-core prices are also contributing to lower inflation. Headline inflation stood at 3.06% in April, which was lower than the 3.14% recorded in March, while core inflation came in at 2.31% (down from 2.45%), lower than the target center. Prices for core goods increased by 2.65% (compared with an increase of 2.6% in March), and inflation for core services stood at 2.03% (down from 2.32%), near the target’s lower bound.

Our year-end inflation forecasts for both this year and the next remain at 3.0%. In our view, the negative output gap and its slow narrowing pace will likely continue to keep inflation tamed.

Divided on when to hike

Mexico’s central bank left the policy rate unchanged, at 3.0% in April, as expected. As in the previous meeting, the board explicitly said in the statement that the monetary policy tightening in the U.S. is the key variable that the central bank of Mexico is watching, even though it acknowledges that the “cyclical position” of the economy is weak.

But according to the minutes of the March meeting, board members seem divided on when to hike. One member (out of five) advised on hiking before the Fed in order to consolidate low inflation and protect financial stability. Another member mentioned that, given the probability of increased volatility in financial markets, the central bank needs to be prepared to react, including by raising rates before the Fed. Conversely, two board members said that raising interest rates before the Fed could be a mistake, given the cyclical position of the Mexican economy. More recently, Governor Carstens mentioned that the board is open to all options, including raising rates before the Fed should volatility becomes excessive.

We expect Mexico’s central bank to deliver a hike together with the Fed (in September). While we acknowledge that heightened volatility could prompt the central bank to act in anticipation of the Fed’s first hike, the negative output gap, the disappointing recovery and low inflation, increases the probability that Mexico’s central bank will raise rates months after the Fed.

Our year-end forecasts for the policy rate stand at 3.5% and 4.5% for 2015 and 2016, respectively.

The Mexican peso underperforms

In spite of the sharp deterioration of the energy balance, affected by both lower oil prices and declining oil output, the trade balance figures remain consistent with an easily-financed current account deficit. In March, the trade balance posted a USD 0.5 billion surplus, lower than the surplus one year ago (USD 0.9 billion). As a result, the 12-month rolling balance stood at a deficit of USD 3.3 billion, as the energy balance recorded a deficit of USD 1.6 billion, the highest ever, while the non-energy balance deficit fell further, to USD 1.7 billion (the lowest deficit in almost 20 years). On a seasonally adjusted and annualized basis, the trade deficit stood at USD 10.1 billion in 1Q15, deteriorating from the USD 1.3 billion deficit in 4Q14 due to a worse balance of both energy (USD 8.2 billion deficit versus USD 6.0 billion deficit in 4Q14) and non-energy goods (USD 1.9 billion deficit versus USD 4.7 billion surplus in 4Q14). We still expect a current account deficit of 2.5% of GDP in 2015 and 2.7% in 2016.

The peso has underperformed its Latam peers in April, probably due to the softer tone from the central bank (or at least from some of its board members). The Mexican peso has failed to follow the “weaker dollar movement” seen in April. Depreciation pressures will likely resume later in the year as the Fed’s liftoff approaches. Even so, we see the peso trading at the end of this year slightly stronger than the current levels, at 15 to the dollar. A further recovery in oil prices and higher interest rates in Mexico are the reasons behind our call.

PRI and PAN ahead in the midterm polls

The PRI will likely remain the largest political force in congress. The most recent poll by Parametria puts the ruling PRI and the center-right PAN parties ahead for the June 7 midterm elections. The PRI registered an effective preference of 32%, against 24% for the PAN (down from 27% in March). The left-wing PRD party continues in third place, with 13% (from 12% in March), and Morena (Andres Manuel Lopez Obrador’s party) has 10%. 

The central bank announced that a surplus of 31.4 billion pesos will be transferred to the federal government. This amount will be used for infrastructure spending next year in a context of low oil prices. This follows the recent announcement by the Finance Ministry of expected budget cuts worth 0.8% of GDP for 2016.

The third phase of Round One to be released soon. Round One’s third phase includes contracts for between 20 and 40 onshore fields that have a breakeven price of around 20 dollars per barrel. Terms are being designed to attract the interest of smaller firms by lowering the technical experience and capital requirements that firms need. These fields are expected to attract the participation of Mexican firms. In phase one, 14 exploration fields were included in the bidding process, and in phase two, five extraction fields were included in the tender. Overall, 34 firms have initiated the process to participate in phase one of Round One and 8 firms have registered for phase two  The winners of phase one will be announced by mid-July and for phase two in September 30.


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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