Itaú BBA - Curbing rate cut expectations

Scenario Review - Mexico

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Curbing rate cut expectations

agosto 7, 2017

Board members agree that rate cuts will not be implemented anytime soon

Please see the attached file for all graphs.

The economic slowdown in Mexico is likely to be short-lived, given that the shocks that battered activity are subsiding. The official announcement by the Trump administration regarding the NAFTA renegotiation objectives – featuring a few contentious issues, but no game-changers – has reduced the uncertainty surrounding the process and lowered the risk of U.S. protectionist policies. Inflation, which eroded real wages in 1H17, has begun to stabilize. Moreover, the improvement in fiscal accounts recently led Standard & Poor’s and Fitch to revise Mexico’s credit rating outlook to stable from negative. We therefore expect only a moderate slowdown in GDP, to 2% in 2017 (from 2.3% in 2016), and a pick-up to 2.1% in 2018.

The Central Bank has indicated it is currently in no mood for rate cuts. While there are contrasting views among Banxico board members, mainly regarding the inflation outlook and the timing for the conclusion of the tightening cycle, board members seem to agree that there will be no rate cuts anytime soon. Our base-case scenario is that Banxico will take a cautious approach in light of the Fed rate hikes and the uncertainty surrounding the presidential election next year. We expect rate cuts to begin no earlier than 2H18, in the context of significantly lower inflation.

Activity loses momentum, but shocks moderate

Mexico’s 2Q17 activity indicators have been weak. The IGAE (monthly GDP proxy) fell by 0.6% qoq/saar in May. Momentum has been weakening in both the Industrial (-0.9% qoq/saar in May vs. -0.7% in April) and Service (2% qoq/saar vs. 2.1% previously) sectors. In the Industrial sector, the decline in mining output (-5.6% qoq/saar vs. -6.6% previously) and construction (-4.1% qoq/saar, unchanged) has offset the growth in manufacturing production (0.5% qoq/saar vs. 2% previously), which weakened in May. 

Internal demand is slowing down, with weakening investment and consumption. Gross fixed investment fell by 0.9% qoq/saar in May, dragged by fiscal consolidation and uncertainty over trade relations with the U.S. (which puts investment decisions on hold). The monthly private-consumption proxy posted growth of 0% qoq/saar in May, from 1.2% in April. The evolution of retail sales (2.5% qoq/saar in May – less than one-third of the average growth rate registered in 2016) also indicates that consumption is losing steam. Weakening consumption can be mainly attributed to falling real wages (down 1.4% YoY in June), although somewhat offset by the robust growth in formal employment. In fact, the real wage bill has only slowed down moderately so far in 2017, to 3% YoY in June (from 3.2% in May and 4.8% in 2016). 

However, economic deceleration is likely to be short-lived. In fact, the real wage bill is already recovering at the margin (3.5% qoq/saar in 2Q17 vs. 0.4% in 1Q17), given that sequential inflation peaked in 1Q17. Moreover, we see manufacturing exports as an important buffer for the Mexican economy. While there is still much uncertainty on the future of NAFTA, the fact remains that the U.S. manufacturing PMI hovering at strong levels provides a significant boost to Mexico’s manufacturing exports (8.7% qoq/saar in 2Q17). Finally, the reduced uncertainty – mainly due to the declining likelihood of protectionist policies in the U.S. and the improvement of fiscal accounts (lowering the odds of a sovereign downgrade) – will probably mitigate the drop in investment, which will continue to be dragged by tight macro policies (particularly fiscal consolidation). In sum, we expect GDP growth to decrease to 2% in 2017 (from 2.3% in 2016) and increase slightly in 2018, to 2.1%.

Stabilizing inflation

Annual inflation decreased slightly in the first half of July, to 6.28% YoY (from 6.33% in the second half of June), as inflation for regulated items fell to 10.8% (from 12.6%). Non-core inflation consequently reached 10.7% (from 11.1%), despite the price hike on non-core food components, to 10.5% (from 8.9%). Core inflation continued to climb, to 4.9% (from 4.8% previously), running above the 3% target. Among core items, inflation on goods is still on the rise, as inflation on processed foods rose to 7.2%, while goods’ price inflation excluding food dropped to 5.7% (from 5.9%), likely reflecting the effects of exchange-rate appreciation. Inflation on core services was 3.6% during the second half of June and 3.7% during the first half of July, although a cleaner domestic-driven core-service price index – excluding FX-sensitive services (such as tourism and airfares) and telecom (driven by supply-side factors of the telecom reform) – recorded stable inflation of 3.8%. 

After posting sharp increases in 1H17, the diffusion index also decreased slightly during the first half of July. This index, defined as the percentage of items in the CPI with annual inflation above or equal to 4% (upper bound of the tolerance range for the central bank’s 3% target), decreased to 78.5% from 78.8%, indicating that second-round effects have not spread further. Granted that the abovementioned decrease was small (-30 bps), but it is a considerable departure from the twelve preceding bi-weekly periods (which showed an average increase of 209 bps).

We expect inflation to decrease to 5.4% by YE17 and 3.3% by YE18. The 14% appreciation of the MXN year to date, which has nearly offset the 19% depreciation in 2016, will be the leading driver for disinflation, which will also benefit from a reduction in regulated price inflation, such as gasoline price cuts.

Trade balance improvement helped by exports

Despite the widening energy deficit, Mexico’s trade balance continued to improve in 2Q17, on strong manufacturing exports. The 12-month rolling trade deficit narrowed to USD 9 billion at the end of 2Q17 (vs. USD 11.9 billion in March), as a widening energy deficit of USD 15.6 billion (vs. USD 14.6 billion in March) was more than offset by a larger non-energy surplus of USD 6.6 billion (vs. USD 2.7 billion in March). In fact, the 12-month non-energy balance, which posted a deficit in 2016, is now at an all-time high.

There was also a significant improvement in the trade balance at the margin. The seasonally-adjusted, annualized deficit narrowed to USD 5.8 billion in 2Q17 (from USD 10.3 billion in 1Q17). Manufacturing exports gained traction in 2Q17 (8.7% qoq/saar vs. 8.2% in 1Q17), while non-oil imports slowed down during the period (5.2% qoq/saar vs. 8.2% in 1Q17), mostly due to weaker intermediate goods imports (probably temporary given that manufacturing export growth usually pressures demand for imported components). 

We expect the 12-month trade deficit to narrow to USD 7 billion by YE17 (from USD 9 billion in 1H17), driven by solid export growth (due to a dynamic U.S. economy) and weaker domestic demand. We note, however, that Mexican manufacturers’ cost advantage narrowed substantially in 2017 due to the stronger MXN. Another factor curbing the improvement of external accounts is PEMEX’s falling oil output, which will continue to pressure the energy deficit.

Our exchange rate forecasts for 2017 and 2018 remain unchanged at 18.5 MXN/USD. Depreciation from the current level (17.8) is likely as Banxico decouples from the Fed – which, in our baseline scenario, will carry out an additional 25-bp hike in 2017 and three more in 2018. The heating up of the NAFTA renegotiation, with the first official round scheduled to begin on August 16, could also introduce some volatility, although we believe that the objectives laid out by the U.S. government do not imply transformational changes for the Mexican economy and therefore leave room for a compromise that will preserve NAFTA (and remove the risk of severe protectionism). Next year’s elections represent an important risk for the currency.

No appetite for rate cuts

The minutes of the latest policy rate decision in Mexico confirmed the message in the statement: the bar for additional rate hikes is high, but new rate increases are not completely off the table given the still-challenging environment for inflation. As expected, two board members continued to call for additional rate increases because they believe that the balance of risks is still tilted to the upside.

When discussing future policy decisions, the majority of the five-member board – who opted to include in the statement that the 7% policy rate level is consistent with bringing inflation to the target (signaling that the cycle is likely over) – believe that there is room for “pause”. Of course, “pause” is much more subtle wording than “end”, suggesting that most board members would be open to new rate increases depending on the deviation of inflation from the path projected in the latest inflation report. 

Although there are contrasting views among Banxico board members, mainly on the inflation outlook and the timing for the conclusion of the tightening cycle, all seem to agree that there will be no rate cuts anytime soon. According to the minutes, even the one board member to vote to keep the policy rate on hold noted that it could be difficult to implement rate cuts in 2018, given the uncertainties associated with the presidential election. During an interview on July 7, Deputy Governor Ramos Francia called for a “very, very prudent conduction of monetary policy”, arguing that it is premature to state whether Banxico can decouple from the Fed. During an interview on July 14, Central Bank Governor Agustín Carstens noted that, given the proximity of the presidential elections, it is important to ensure that inflation is stopped (indirectly suggesting that the electoral dynamics could have an impact on inflation dynamics, and thus prevent rate cuts). 

Our base-case scenario is that Banxico will take a cautious approach in light of the Fed rate hikes and the uncertainty surrounding the presidential election next year, likely leading the board to remain on hold for some time. All in, it seems that there is no appetite for rate cuts in the near term, and we cannot completely rule out additional rate hikes (although they would require a more meaningful deviation of inflation from the path projected by the central bank). Overall, our take is that given that policymakers do not see the current real interest rate level as tight, and considering that we expect the economy to be growing at a decent pace in early 2018 (based on the expected evolution of the U.S. economy), there would be no urgency for monetary easing. We foresee rate cuts (specifically two 25-bp cuts) only during the second half of 2018.

Fiscal accounts contribute to improvement in sentiment

Mexico’s fiscal accounts improved in 2Q17, even after netting out the windfall effects of the central bank’s dividend. Following the exchange rate gains on international reserves in 2016, the central bank’s dividend reached a historical high of MXN 322 billion in 2017 (1.5% of GDP), helping the government in its efforts to strengthen public finances (considered a critical aspect of Mexico’s credit rating outlook by the three main rating agencies). Importantly, we note that all fiscal balance measures have been improving beyond the effects of the abovementioned dividend. In fact, excluding 70% of the dividends received in past years (30% is directed to stabilization/sovereign funds, and therefore recorded as both revenue and expenditure), the 12-month rolling primary balance reached a surplus of MXN 41 billion (0.2% of GDP) at the end of 2Q17, from a deficit of MXN 25 billion in 1Q17. Using the same metric (ex-dividends), the 12-month nominal fiscal deficit narrowed to MXN 471 billion (2.3% of GDP), from MXN 526 billion in 1Q17, and the public sector borrowing requirements (broadest deficit indicator) narrowed to MXN 576 billion (2.8% of GDP), from MXN 620 billion previously.

The public-debt-to-GDP ratio – for both the gross and net measures – was significantly lower in 2H17 than at the end of 2016, which means that 2017 could very well mark the first decline in this ratio in ten years. We note that the public sector’s gross and net debt decreased to MXN 9,701 billion (from MXN 9,934 billion) and MXN 9,300 billion (from MXN 9,693 billion), respectively, between the end of 2016 and 2Q17 – largely due to the stronger currency. 

Amid evidence of a narrower fiscal deficit and a falling public-debt-to-GDP ratio, rating agencies’ stance on Mexico is now moderating, which has played a key role in buttressing the improvement in sentiment regarding the Mexican economy. S&P and Fitch revised Mexico’s credit rating outlook to stable from negative (in July and August, respectively), while Moody’s stated that the recent oil discoveries (by firms awarded exploration contracts in the energy reform) are “credit-positive”. Of course, the better-than-expected performance of the economy and the improving growth outlook (mainly due to the reduced risk of U.S. protectionist policies) are also important to Mexico’s sovereign rating. However, fiscal accounts are critical. Between 2012 and 2016 – the first four years of the Peña Nieto’s administration – net debt rose by 15.3 pp of GDP, leading the three main rating agencies to change their outlook to negative, citing the uptrend in debt as a red flag. Now that the tide has started to turn, we believe that the Mexican government will have to remain committed to fiscal consolidation to rule out a future sovereign rating downgrade. 2018 will be particularly challenging, as the government will have to meet more ambitious fiscal targets (mainly a PSBR of 2.5% of GDP, vs. 2.9% of GDP in 2017), but without the windfall of a central bank dividend and, perhaps more importantly, in the midst of an electoral year that could bring spending pressures. Based on the past four electoral years (2012, 2006, 2000 and 1994), we note that expenditures always increased in these periods (by 0.5 pp of GDP, on average).


João Pedro Bumachar
Alexander Andre Muller


Please see the attached file for all graphs. 

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