Itaú BBA - A Rally Coming?

Scenario Review - Mexico

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A Rally Coming?

octubre 11, 2016

A potential defeat of Trump would help the peso.

Please see the attached file for all graphs. 

Amid growing uncertainty over the potential impact of the U.S. presidential election on Mexico, policy makers have continued to tighten macro policies. The government raised the primary surplus target for 2017 from 0.2% of GDP to 0.4% of GDP, while the central bank delivered another 50-bp hike in September.

We expect the central bank to raise the policy rate by 25 bps in December, in tandem with a rate hike by the Fed. Our monetary policy rate forecasts for 2016 and 2017 are 5% and 5.5%, respectively (assuming the Fed delivers two 25-bp hikes in 2017). But new episodes of sharp currency depreciation could lead to further hikes in addition to those necessary to keep the interest rate differential with the U.S. unchanged.

We expect the Mexican peso to strengthen to 17.5 to the dollar before the end of this year, assuming that Donald Trump loses the U.S. presidential election. The ongoing improvement of the external accounts, a more benign environment for oil prices, loose monetary policies in the core economies and higher interest rates in Mexico would support such a rally. On the other hand, a victory by Trump would likely mean an even weaker Mexican peso, at least until the direction of U.S. foreign policy under his administration becomes clear.

The composition of growth will likely start to change over the next few quarters, with more balanced contributions from services and industry. We continue to expect a GDP growth rate of 2.1% in 2016 and a recovery to 2.4% growth next year.

Ambitious new fiscal targets, but the market will continue to focus on implementation

The government presented its budget proposal for 2017, calling for an increase of 0.2% of GDP in the primary surplus target (now 0.4% of GDP). Despite the recent replacement of the finance minister, the ministry reaffirmed the fiscal consolidation path that was approved in 2013, which dictates annual reductions of 0.5% of GDP in public sector borrowing requirements (the PSBR, the broadest measure of the fiscal deficit), with the goal of reaching 2.5% in 2018. Nevertheless, the PSBR deficit target for 2017 was lowered from 3% of GDP to 2.9% of GDP (consistent with a higher targeted primary balance).

It will not be easy to meet these fiscal targets. Mexico last ran a primary surplus in 2008 and the primary deficit this year will likely be 0.4% of GDP. Although the PSBR target for 2017 is only 0.1% of GDP narrower than the value expected for 2016, we note that Mexico received a sizable dividend of 1.2% of GDP from the central bank this year due to exchange-rate gains on international reserves. Furthermore, the government reaffirmed its commitment to not raising taxes, and oil revenues are expected to fall by 6.8% in real terms in 2017 (oil production will fall by 9.5%, according to the government’s forecasts). On the expenditure side, the government aims to reduce programmable expenditures (a proxy for primary expenditures) by 0.3% of GDP in 2017, adding to the 0.9% of GDP reduction expected to result from the budget cuts announced for this year. As a significant portion of these budget cuts will be executed by Pemex, the risk is that oil production will fail to stabilize, worsening oil revenues further.

If Mexico’s government is successful in delivering on the announced fiscal adjustment targets, the markets and the rating agencies will probably react positively. However, given previous disappointments in fiscal consolidation, analysts will continue to focus on implementation rather than announcements.

Central bank tightens monetary policy

Mexico’s central bank raised the policy rate by 50-bp (from 4.25% to 4.75%) in September. In the statement, the board explicitly mentioned the U.S. election and its potentially negative consequences for Mexico.

The central bank continues to list the evolution of the exchange rate as the key variable in its upcoming decisions. The interest-rate differential with the U.S. and the output gap are also listed as significant variables. However, September’s statement specified that the latest hike is not the beginning of a tightening cycle; in contrast with June’s statement, when the Central Bank also hiked rates by 50bps but refrained from making this qualification (indirectly suggesting that further rate action was more likely). Interestingly, the central bank included the disclaimer that it does not have a target for the currency.

Rate hikes – conditional on the Fed’s actions and on the evolution of the exchange rate – are still likely, but the board seems less happy with its current reaction function. In fact, what began as a one-off move to support the peso became the new baseline this year, and there is a limit to how much monetary tightening the central bank can deliver to support the currency without significantly damaging economic activity and deviating from textbook inflation targeting. 

We expect the central bank to raise the policy rate by 25-bp in December, in tandem with a hike by the Fed. Our monetary policy rate forecasts for 2016 and 2017 are 5% and 5.5%, respectively (assuming the Fed delivers two 25-bp hikes in 2017). But new episodes of sharp currency depreciation could lead to further hikes in addition to those necessary to keep the interest rate differential with the U.S. unchanged. In fact, the day after the latest rate decision announcement, Governor Carstens said in an interview that a Trump victory could lead to more monetary policy tightening.

A stronger currency ahead?

We currently see a significant undervaluation of the Mexican peso, which we expect to vanish by the end of the year, assuming that Donald Trump loses the U.S. presidential election. We expect the peso to strengthen to 17.5 pesos to the dollar before the end of 2016. The ongoing improvement of the external accounts, a more benign environment for oil prices, loose monetary policies in the core economies and higher interest rates in Mexico would support such a rally. A Trump win would likely mean an even weaker Mexican peso, at least until the new direction of U.S. foreign policy under his administration becomes clear.

Activity heading toward a firmer 3Q16

Economic activity remained subdued in 1H16, with falling oil production and weak manufacturing exports offsetting solid consumption growth. At the margin, the economy shrank between 1Q16 and 2Q16 (-0.7% qoq/saar), but the carryover from IGAE to 3Q16 indicates a rebound. In fact, the July GDP proxy (IGAE) showed an expansion of 2.7% qoq/saar. 

We expect Mexico’s economy to grow by 2.1% this year (after 2.5% growth in 2015). For 2017, we forecast a 2.4% expansion. In our view, the growth breakdown will likely change, with more balanced contributions from services and manufacturing. A moderation of private consumption is likely, as inflation is not as low as before.

A smaller impulse from remittances (once converted into pesos) and tighter fiscal and monetary policies will also negatively affect consumers. Exports, by contrast, will likely accelerate together with U.S. industrial activity, although the continuing decline in oil output is a risk.


 

João Pedro Bumachar
Alexander Andre Muller


 

Please see the attached file for all graphs.  


 

 



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