Itaú BBA - Growth picking up but challenges remain

Scenario Review - Mexico

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Growth picking up but challenges remain

enero 15, 2016

The slow recovery of U.S. industrial production, the ongoing fiscal consolidation and low oil prices pose important challenges.

Please see the attached file for all graphs. 

• The economy continues to improve, mainly led by private consumption. Investment ex-infrastructure is also helping. However, recent indicators suggest that the manufacturing sector (which is linked to exports) has yet to pick up. We expect growth at 2.8% in 2016 (up from an estimated 2.5% in 2015) and at 3.0% in 2017. However, the slow recovery of U.S. industrial production, the ongoing fiscal consolidation and low oil prices pose important challenges. 

• Inflation ended 2015 at its lowest level on record (2.13%) and core inflation remained subdued (2.41%). We see inflation reaching 3.0% in 2016 (up from 2.13% in 2015) as the weaker currency lifts tradable prices, the telecom reform contributes less to disinflation and agricultural prices pick up. For 2017, we also see inflation at the center of the target.

• The Central Bank raised the policy rate in December (in tandem with the Fed) in spite of historically low inflation and a still-incipient economic recovery. The potential impact of the Fed’s tightening cycle on the exchange rate was the determining factor for the hike. We still see the policy rate ending at 4% in 2016, with three 25-bp rate hikes this year (we see the Fed hiking four times by 25 bps). In our view, the central bank will not synchronize its actions with the Fed’s moves ahead, giving more weight to domestic variables. We see the policy rate ending 2017 at 4.5%. 

• In spite of the rate hike in December, the Mexican peso has recently underperformed most currencies, likely due to the further decline in oil prices. We see the exchange rate ending this year at 17.5 pesos to the dollar, slightly weaker than at the end of 2015. The expected oil-price recovery and rate hikes will likely shield the Mexican peso.   

• The budget deficit will likely end the year below the 3.5% of GDP approved by congress, but the evolution of oil output remains a risk for revenues in 2016. In addition, the oil price in 2016 was hedged at a lower level than last year. In this context of more challenging revenues, the government will have to continue cutting expenditures to meet its deficit-reduction goal.

Gradual recovery is led by internal demand

The IGAE (monthly proxy for GDP) expanded 3.9% qoq/saar (up from 3.3% in 3Q15) led by the solid growth of private consumption (fueled by the growth of formal employment, low inflation, a steady flow of remittances and the acceleration of consumer credit). As a result, the Service sector kept expanding robustly in October, at 4.1% qoq/saar (from +3.5% in 3Q15). Investment ex-infrastructure has also been supportive of higher growth. Housing investment grew 2.3% qoq/saar in 3Q15, while investment in machinery and equipment expanded 13.8%. However, the manufacturing sector has slowed and the most recent indicators hint at a further loss of momentum: the manufacturing PMI declined in December (in tandem with the U.S. manufacturing ISM), while manufacturing exports fell 3.5% between October and November.

We see growth ending this year at 2.8% (up from 2.5% in 2015) and at 3.0% in 2017. Although we believe that the economy will likely grow stronger this year, there are important risks. First, U.S. industrial production has yet to recover. Second, the fiscal consolidation process in Mexico will likely keep public capital spending depressed (specifically at Pemex). Finally, the lower investment by Pemex could harm the stabilization of oil output (which was a drag on growth in 2015), while low oil prices cast doubt on the implementation of the energy reform.

Inflation to start increasing

Inflation ended the year at its lowest level on record (2.13%) as core inflation remained well below the center of the target (2.41%). Non-core inflation kept evolving favorably, standing at 1.28% in December (down from +1.84% in November), led by the lower increases of energy and government tariffs, at 1.0% (down from +1.33%). Meanwhile, agricultural and livestock prices grew far below their historical average in 2015.

But inflation is unlikely to stay so low. Less contribution of the telecom reform to disinflation, stronger effects on domestic prices from the weakening of the peso, and higher inflation of agricultural items are factors that will push inflation up. Gasoline prices are falling early this year, but will likely rise during the second half as international prices recover. Still, we expect inflation to end both this year and the next at the center of the target (3%), which is lower than in Mexico’s past.     

Exchange-rate evolution is key for the timing of the next hikes

The board of the central bank decided unanimously to raise the policy rate by 25 basis points, in spite of the incipient recovery and the low inflation. The minutes and the statement of the decision highlighted that this was a direct response to the Federal Reserve’s hike, arguing that not adjusting the policy rate accordingly could cause additional (and disorderly) depreciation of the currency and affect inflation expectations.

In our view, Mexico’s central bank will try to desynchronize from the Fed in 2016. However, the willingness to detach from the Fed will depend on how the Mexican peso behaves as interest rates in the U.S. rise.

We are keeping the 4.0% policy-rate forecast for year-end 2016 (three 25-bp rate hikes this year, vs. our expectation of four 25-bp rate hikes in the U.S.). For 2017, we expect the policy rate at 4.5%. 

A stable peso this year?

In spite of the Mexico’s central-bank rate hike in December, the Mexican peso has depreciated recently, underperforming most emerging-market currencies. The decline of oil prices is likely behind the poor performance. We expect that policy makers will keep in place the current intervention mechanisms (which are set to expire by the end of January). Although the ongoing tightening cycle in the U.S. will likely lead to a further appreciation of the U.S. dollar, we expect the exchange rate to end this year at 17.5 pesos to the dollar (from 17.2 by the end of 2015). Rate hikes in Mexico and an expected recovery of oil prices will likely shield the peso. In 2017, we also see the peso at 17.5.

The trade balance improved somewhat, but the recent decline in oil prices will likely lead to a deterioration in the upcoming readings. The three-month seasonally adjusted deficit stood at USD 14.2 billion (annualized) in November, better than the USD 16.3 billion deficit in October. The three-month rolling energy balance (annualized) recorded a deficit of USD 9.4 billion in November improving from the USD 13.4 billion deficit in October. On the other hand, the non-energy balance reached a USD 4.8 billion deficit over the past three months (also annualized), from a deficit of USD 2.9 billion in October.

Fiscal consolidation on track, in spite of a challenging scenario for revenues

The budget deficit from January through November stood at 2.8% of GDP, as tax collection compensated the decline in oil revenues. Tax collection expanded 7.1% in real annual terms in the period, highlighting the impressive growth of excise taxes (+229.9% YoY), due to domestic gasoline prices that were higher than international prices. In contrast, oil-related revenues fell by 36.7%. As a result of the expenditure cuts announced earlier in 2015, expenditures in fixed capital assets declined 9.9%, also in real terms. The budget deficit will likely end the year below the 3.5% of GDP approved by congress, but the evolution of oil output remains a risk for revenues in 2016. In addition, the oil price in 2016 was hedged at a lower level than last year. Further budget tightening will be required.


 

João Pedro Bumachar


 

Please see the attached file for all graphs.  


 

 



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