Itaú BBA - Exports and Private Internal Demand Take Off; Public Sector Lags Behind

Scenario Review - Mexico

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Exports and Private Internal Demand Take Off; Public Sector Lags Behind

septiembre 30, 2014

The demand-side breakdown of the GDP indicated that the external sector was the main engine of growth in 2Q14.

• The economy continues to recover in the third quarter of 2014.

• Exports remain performing well, supported by strong U.S. industrial activity. Private domestic spending is also recovering, but public sector demand is not contributing yet to the economic recovery. We maintain our growth projection of 2.4% in 2014 and 3.8% for 2015.

• Annual headline inflation stayed above the upper bound of the central bank´s target range, led by higher non-core food prices. We now expect headline inflation to end this year at 3.9% (previously: 3.7%). For 2015, we expect inflation to fall to 3.2%, helped by a negative output gap, more favorable telecom tariffs, lower gasoline price hikes and the fading impact of the tax increases introduced this year.

• The exchange rate depreciated recently, as the dollar strengthened globally. However, Mexico is closely linked with the U.S. economy, and reforms will likely attract meaningful capital inflows, so the Mexican peso will probably perform better than most emerging market floating currencies. We see the exchange rate at 13.2 pesos per dollar by the end of this year and the next.

• The minutes of the latest monetary policy decision revealed that the board was more upbeat on growth, but rate hikes are unlikely in the near term because the economy still has substantial slack. We see the policy rate at 3.0% by the end of this year and at 3.50% by the end of 2015, with rates hikes starting only by the end of 2Q15.

• Eleven of twenty two service contracts that Pemex currently has with private oil companies are in the process of migrating to risk-sharing agreements, from now until the end of the year. This means that the first capital flows associated with the energy reform may come as soon as 1Q15.

The Economic Recovery Continues in 3Q14

The demand-side breakdown of the GDP indicated that the external sector was the main engine of growth in 2Q14. Exports increased by an impressive 16.5% qoq/saar, leading to 4.2% GDP growth. There were also solid growth rates in private consumption (5.5%) and private investment (6.8%).

On the other hand, although government expenditures have grown rapidly this year (public expenditures in fixed capital assets, for example, grew 34% year over year in nominal terms during the first seven months of 2014), they haven’t yet impacted internal demand. Public sector fixed investments actually contracted in the second quarter (-4.8% qoq/saar), according to national account statistics, after a 22.4% drop in 1Q14. Anecdotal evidence suggests that the decoupling between fiscal capital expenditures and public sector investment as recorded in the national accounts is mostly due to delays in the execution of projects already approved. This means that public demand, in particular infrastructure investment, will likely add to growth ahead. 

The first indicators available for 3Q14 hint that the recovery continues. Mexico´s IGAE (monthly proxy for GDP) came in at 2.5% year over year in July. Sequentially, the IGAE increased 0.4% from June as the Industrial and Service sectors both expanded by 0.3%, and the volatile Agricultural sector grew by a strong 3.98%. On a quarter-over-quarter (annualized) basis, the IGAE grew by a robust 4.0%. Retail sales increased by 6.3% qoq/saar in July, lifted by a stronger labor market: formal employment increased by 4.4% year over year in July, while temporary employment (a leading indicator of permanent employment) expanded by 6.2%. Meanwhile, manufacturing exports retreated in August, but they still expanded at a solid 10% qoq/saar pace, while imports of consumer goods ex-fuel were up by 14.7% qoq/saar. On the other hand, imports of capital goods – which closely track investment in machinery and equipment – fell 0.1% qoq/saar in August.

We maintain our growth forecasts at 2.4% for 2014 and 3.8% for 2015.  This implies a similar sequential growth pace in the second half of this year to the second quarter of 2014. For 2015, the first impacts of the structural reforms and the sustained fiscal stimulus (the public deficit planned for next year implies a sound fiscal impulse) and monetary stimulus alongside the U.S. recovery will all contribute to the economic expansion.

Inflation Temporarily High

Inflation is still above the upper bound of the target range. On a year-over-year basis, headline inflation stood at 4.21% in the first two weeks of September, from 4.23% in the second half of August. Non-core inflation came in at 7.09%, led by higher agricultural and livestock prices, which rose by 7.51% (from 6.81% previously). Meanwhile, core inflation reached 3.34% (from 3.41%), somewhat above the center of the target range.

We have increased our inflation forecast for 2014 to 3.9% from 3.7%, as non-core food inflation has been more persistent than we previously thought. However, our inflation estimate for 2015 remains at 3.2%. Next year, inflation will likely approach the center of the target, helped by a negative output gap, more favorable telecom tariffs, lower gasoline price hikes (next year, gasoline price will increase one-off in January, according to expected inflation, contrasting with an average yearly increase of around 10% over the recent years) and the fading impact of tax increases introduced this year. On the other hand, it is important to highlight as an upside risk to inflation that the mayor of Mexico City, from the left-leaning PRD party, recently sent to congress a proposal to increase the minimum wage by 26%. As a response, the federal government announced the creation of a committee that will evaluate mechanisms to adjust the minimum wage. The committee will be formalized on October 24 and will have six months to divulge its findings. The discussions on this matter will likely take place during the first half of 2015.

Outperformance of the Peso to Continue

Although the Mexican peso depreciated in September, it performed better than most of its peers. Because Mexico is closely linked with the U.S. economy and the reforms will likely attract meaningful capital inflows, the outperformance of the peso is set to continue amid higher U.S. treasury yields.

We kept our exchange-rate forecasts at 13.2 pesos per dollar for the end of this year and the next. 

No Rate Hikes in the Near Term

The minutes of the latest monetary policy decision hinted that interest rates will likely stay on hold for a while, even though the board is much more optimistic on growth. The document revealed a unanimous decision to leave the policy rate unchanged, at 3.0%. Most of the members see an improved balance of risks for activity. Still, in the board’s view, the output gap remains negative, which means that demand-side inflationary pressures are unlikely in the near future. So, the central bank remains comfortable with the inflation outlook for the medium term. However, due to transitory factors (higher livestock prices), there is a worse balance of risks for inflation in the short term, according to the minutes.

Our year-end forecasts for the policy rate are unchanged, at 3.0% in 2014 and 3.5% in 2015. In our scenario, activity will probably grow above potential over the next quarters, but we also think that there is enough spare capacity to keep inflation under control. The central bank will probably preemptively remove the monetary stimulus, but it is unlikely to start doing so before the Fed. Therefore we see rate hikes starting only by the end of 2Q15. 

Energy Reform Underway

The migration to risk-sharing contracts of 11 (of the 22) service contracts that Pemex has with private oil companies will be finalized by December. The first capital inflows of this process could come as soon as 1Q15. The migration of the remaining contracts will be done in 2015. The total investment associated with the renewal of these 22 contracts is estimated at USD 44 billion.

The energy reform regulations are expected to be announced in October, and the final guidelines of the bidding rounds will likely be announced in February next year (Round 1 and farm-out agreements). For example, the Ministry of the Economy is in the process of determining how to measure the national content, which was established at 25% and will increase to 35% over 10 years. This initial 25% will be an average for oil exploration and production activities, so some of the oil activities will require lower domestic-content requirements (such as deep-water drilling) than others.

João Pedro Bumachar

Jesus Gustavo Garza-Garcia



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