Itaú BBA - Better Days to Come

Scenario Review - Mexico

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Better Days to Come

enero 13, 2015

The labor market continues to evolve favorably.

• Indicators available for 4Q14 are mixed. The IGAE (monthly proxy for GDP) slowed to 1.4% qoq/saar, but industrial production in November and auto production in December hint that the industry is gaining momentum. We expect the economy to grow by 3.5% this year, after an estimated 2.2% in 2014, helped by the ongoing recovery of the U.S. economy, the expansionary fiscal and monetary policies and the implementation of the structural reforms.  

• The decline in oil prices weakened the peso to 14.7 to the dollar by the end of December 2014. Because we continue to expect oil prices to end this year at USD 70 per barrel (Brent), our year-end forecast for the peso is unchanged at 14.0 to the dollar. However, as we do not expect oil prices to converge to our year-end forecast immediately, the average exchange rate for this year will likely be weaker than our year-end expectation.    

• Annual inflation ended 2014 above the upper bound of the target. On the other hand, core inflation stood only slightly above the center of the target. For 2015, we expect Inflation to fall, due to lower fuel-price increases, a negative output gap, the elimination of long-distance tariffs and the dissipation of the effects of the tax package implemented in 2014. However, given our expected path for the exchange rate, we now see inflation at 3.5% this year (from 3.2% in our previous scenario).    

• The minutes of the last monetary-policy decision revealed another unanimous decision to leave the policy rate unchanged at 3.0%. Due to the evolution of the exchange rate, the board saw a worsening balance of risks for inflation, even though they also saw a deterioration in the balance of risks for activity. We currently see rate hikes starting by the end of 2Q15, in tandem with the Fed, but we acknowledge that global volatility, together with the ongoing recovery of the U.S., might lead to an earlier initial hike. 

• Oil prices are a risk for the investments related to the energy reform. In fact, the migration of 11 of 22 service contracts that Pemex currently has with private firms to risk-sharing contracts did not materialize. At the same time, the 169 fields originally announced to be auctioned in the Round 1 bidding process may be a lower number. The government will likely try to replace non-conventional and deep-water fields (which require higher oil prices) with shallow-water fields and on-shore fields in the upcoming auctions. 

• Still, in our baseline scenario, we expect the economy to grow by 3.8% in 2016, as the investments associated with the reforms offset the moderation of the U.S. economy. The peso would appreciate somewhat and the current account would widen, as capital inflows come and monetary stimulus is removed (we see the policy rate ending next year at 5.0%.) Inflation will likely end the year at the center of the target.

Mixed indicators for 4Q14

The IGAE (monthly proxy for GDP) came in at 2.5% year over year in October and, adjusting for working days, it grew 2.7%, from 2.0% in September. Sequentially, although the IGAE increased 0.6% from September, its trend slowed to 1.4% qoq/saar. During the same month, retail sales fell 0.1% month over month, following a 0.7% contraction.

However, industrial-production and auto-industry data for November and December, respectively, hint that industry is gaining momentum, in spite of declining oil production. On a quarter-over-quarter and annualized basis, industrial production grew 2.6% (from 2.0% in October) led by manufacturing production, which accelerated to 5.2% qoq/saar (from 2.8% previously). Construction grew a robust 4.1% qoq/saar (although it was down from 5.2% in October). On the other hand, mining output declined 6.4% qoq/saar. In December, auto production surged 27% year over year (partly due to base effects), bringing growth during 4Q14 to 16.8%. These data come along with high growth numbers for the U.S. industry.   

The labor market continues to evolve favorably. Formal employment grew 4.3% year over year in December, led by a 8.0% increase in temporary employment (which usually leads total employment growth). The solid employment gains coupled with the expected drop in inflation next year will probably boost real labor income and, consequently, consumption. Also, confidence is gradually recovering among consumers: its average value for the last quarter of the year was the highest since 3Q13.

Our growth forecast for this year is unchanged at 3.5%, from an estimated 2.2% expansion in 2014. Mexico will likely continue to benefit from the ongoing recovery of the U.S. economy and from expansionary fiscal (public capital spending is playing an important role in the recovery of construction) and monetary policies. Supply-side problems in the oil industry will probably continue to be a drag on the economy for a while.

Disinflation ahead

Annual headline inflation came in at 4.08% by the end of 2014, slightly down from 4.17% in November and above the upper bound of the target (3% +/-1 p.p.). This result was mainly explained by high non-core inflation (6.7%), as non-core food prices increased 8.61% (the highest rate since June 2013) and energy and government tariffs were up by 5.55%. Core inflation remained tame (3.24%), close to the center of the target, confirming that there were no demand-side pressures on inflation. Within the core, inflation for goods stood at 3.5% while prices for services slowed to 3%.

Inflation is likely to fall sharply in 2015 due to a more favorable comparison base (fading effects of the tax hikes), a negative output gap, the elimination of long-distance tariffs and a lower increase in gasoline prices. In fact, the government recently increased gasoline prices by a lower-than-expected 1.9% and confirmed no further increases for the year (gasoline inflation was 6.63% in 2014). However, considering the exchange-rate path that we now expect, we have increased our inflation forecast for 2015 to 3.5%, from 3.2% in our previous scenario. 

The recently created Minimum Wage Commission approved an increase of 4.2% in the minimum wage for 2015. This comes after the Senate did not vote the decoupling of the minimum wage as a reference to other prices last December, which had been approved by the lower house. So the Congress failed to meet a condition imposed by the Committee to raise the minimum wage above inflation. The discussions are likely to evolve during the year, but we now believe that it is unlikely that a further increase will be announced before the end of 2015. Thus a significant upside risk for inflation seems lower now. 

Peso weakens even further

The peso has depreciated since the beginning of December as the dollar strengthened globally and oil prices collapsed. In 2015, we expect the peso to appreciate and end the year at 14.0 pesos per dollar, supported by the positive outlook of the U.S. economy, the FDI inflows from the structural reforms and a recovery of oil prices in the second half of the year. While our year-end forecast for the peso is unchanged, we now believe that the peso will probably trade weaker than 14.0 to the dollar for most of the year.    

Net energy exports slightly deteriorated the trade balance. Mexico’s trade balance posted a USD 1.1 billion deficit in November, down from a USD 0.3 billion surplus a year before. As a result, the 12-month-rolling balance stood at a deficit of USD 1.1 billion (from a USD 0.3 billion surplus in October), as the energy surplus shrank to USD 3.8 billion (USD 5.0 billion surplus in October), its lowest level since August 1999. The non-energy trade deficit widened slightly to USD 4.9 billion (from USD 4.6 billion in October), but remained at a very low level historically. 

Although we now expect lower oil prices for 2015 on average, the energy balance now represents only 0.3% of GDP (12 months running through November) and hence we are leaving the current-account-deficit forecasts unchanged. We still expect a current-account deficit of 2.2% of GDP in 2015.

More concern over the exchange rate 

The minutes of the most recent monetary policy meeting revealed that all board members agreed to keep the policy rate unchanged, at 3.0%. As in the statement announcing the decision, the minutes showed that most of the committee members see a worsening balance of risks for inflation, even though they also see a deterioration in the balance of risks for activity and recognize that there are no demand-side inflationary pressures in the economy, given the negative output gap.

Committee members talked extensively about the evolution of the exchange rate. While only one member mentioned that the current global scenario might prompt the central bank to raise rates, other members saw less room for domestic macro policies to help the economy under tighter external financial conditions. Governor Carstens recently said that interest rates will likely rise in Mexico this year, which is a clear departure from the neutral message that the central bank uses in the concluding remarks of the statement and minutes of the recent policy decisions. So the debate is now on when to hike.

We still see rate hikes starting by the end of 2Q15, in tandem with Fed rate hikes, but we acknowledge that global volatility together with the ongoing recovery in the U.S. economy (and its impact on Mexico’s economy) might lead to an earlier initial hike by Mexico’s central bank.

Energy reform delays

The migration of 11 of 22 service contracts (that Pemex currently has with private oil firms) to risk-sharing contracts, which was expected to occur by the end of 2014, did not materialize, likely reflecting the impact of lower oil prices on the valuation of the contracts. At the same time, the 169 original fields announced to be auctioned in the Round 1 bidding process may now be fewer. The replacement of non-conventional and deep-water fields (which requires higher oil prices) with fields that have lower production costs is an increasingly likely possibility.

The economy will likely gain traction in 2016 

Although we expect the U.S. economy to moderate in 2016, we see Mexico’s economy growing at 3.8% next year. In this forecast, we are assuming that in 2016 there will be a meaningful impact from the implementation of structural reforms, especially the energy reform. Thus, oil prices are a key risk to our forecast. The central bank, we believe, will continue to remove monetary stimulus, and we see the interest rate at 5.0% by the end of 2015. Tighter monetary policy and capital inflows associated with the reforms would benefit the peso – we expect the exchange rate to appreciate to 13.6 pesos to the dollar – and widen the current account deficit (to 2.7% of GDP). Inflation would moderate to the 3.0% target.       


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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