Itaú BBA - Hello recovery, goodbye disappointment

Scenario Review - Mexico

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Hello recovery, goodbye disappointment

septiembre 9, 2014

The GDP figures for 2Q14 confirmed the recovery of the economy.

• The GDP figures for 2Q14 confirmed the recovery of the economy, and the first activity indicators available for 3Q14 suggest that the positive momentum continues. We expect Mexico’s economy to grow by 2.4% this year and by 3.8% in 2015. 

• Inflation has been temporarily high, breaching the upper limit of the target range, while core inflation continues to be tamed. We see inflation at 3.7% by the end of this year and at 3.2% by the end of 2015. 

• Capital flows associated with reforms will likely lead the Mexican peso to perform better than most emerging market currencies once U.S. treasury yields rise. We see the currency trading at 13.2 to the dollar both by the end of this year and by the end of the next.   

• While our year-end forecasts for the policy rate are unchanged, at 3.0% in 2014 and 3.5% in 2015, we now expect the central bank to start to withdraw the monetary stimulus earlier (by the end of 2Q14, instead of 4Q14 in our previous scenario).  

• On September 5, the Ministry of Finance sent to congress its 2015 budget proposal for its discussion and approval. The proposal requests a similar budget deficit to 2014 and no changes to the tax regime. It also assumes a medium-term fiscal consolidation and is optimistic on medium-term growth.

A Promising 3Q14

The GDP figures for 2Q14 confirmed the recovery of the economy.  Mexico’s IGAE (monthly proxy for GDP) came in at 2.7% year over year in June. As a result, the GDP expanded by 1.6% during the second quarter of the year and, adjusting for working days, there was a 2.7% year-over-year increase. Sequentially, the GDP expanded by 4.2% qoq/saar, with solid gains in primary, secondary and tertiary activities.  

Activity has been led by external demand, but positive developments in consumption and investment suggest that internal demand is also recovering. The demand-side breakdown of the GDP is not available yet, but the evolution of the Manufacturing sector indicates that exports are the main engine of growth. During 2Q14, manufacturing exports gained an impressive 19.7% qoq/saar. The monthly private consumption indicator published by INEGI (the official statistics institute) was up by 3.2% qoq/saar in May, after a 3.4% gain in 1Q14. Also in May, gross fixed investment increased by 6.7% qoq/saar.

The first activity indicators available for 3Q14 suggest that the export-led recovery continues. Manufacturing exports increased by 3.8% from June to July, led by a 6.3% increase in auto exports. Non-auto exports also performed well (2.6% month-over-month). Importantly, in August the ISM manufacturing in the U.S. – which is a good tracker of manufacturing activity in Mexico – reached its highest level since March 2011. At the same time, employment in the formal sector is picking-up: in July, it increased by 3.7% year over year, and temporary employment (a leading indicator of total employment) was up by 6.2%. We expect that the recovery of employment will sustain consumption growth. Finally, the strong increase in fixed-capital expenditures by the public sector (16.4% year over year in July and 28.9% year to date) will probably lift construction investment growth (in fact, construction activity was already improving substantially in 2Q14).

We expect Mexico’s economy to grow by 2.4% this year, which implies a sequential growth pace in the second half of the year, similar to 2Q14. In 2015, apart from the cyclical recovery of the U.S., Mexico’s economy will start to feel some of the benefits of the structural reforms, leading to a 3.8% growth rate.

Headline Inflation Above the Target Range (for Now)

Inflation is temporarily high. On a year-over-year basis, headline inflation stood at 4.07% in the first half of August. However, core inflation remains tame (especially considering the upward effect of tax hikes) at 3.34% (from 3.3% in the second half of July), and core service inflation is at 3.14%, very close to the center of the target range.

As base effects become favorable in the last quarter of the year, and some non-core food prices start to decrease, we see inflation at 3.7% by year-end. Furthermore, as the impact of tax hikes fade in the beginning of 2015, inflation will likely hover close to the center of the target, ending the year at 3.2%.  

A Low Current Account Deficit

The current account deficit in Mexico remains lower than in most countries of the region, reflecting a solid performance from the export sector amid moderate internal demand growth. The four-quarter rolling deficit stood at 1.9% of GDP in 2Q14, down from 2.1% in 2013.

Foreign Direct Investment (FDI) continues to disappoint, while portfolio flows continue to be strong. The FDI came in at USD 2.3 billion for the second quarter of the year, down from USD 7.4 billion in 1Q14, bringing the total to USD 20.1 billion over the last four quarters. Foreign portfolio investment increased to USD 23.5 billion from USD 9.8 billion in the first quarter of the year and reached USD 70.6 billion over the last four quarters. While portfolio investment went mainly to the fixed income market, it increased notably in the equity market (to USD 6.3 billion in 2Q14 from USD 0.3 billion in the first quarter of the year).

While capital flows continue to be dependent on portfolio investment, we think that the reform agenda will likely increase foreign direct investment in Mexico in the years to come, while higher U.S. treasury yields are likely to curb portfolio flows. The current account deficit will probably increase to finance energy investments.

Our forecasts for the Mexican peso are unchanged. We see the currency trading at 13.2 to the dollar both by the end of this year and by the end of next, which is slightly weaker than the current level. Capital flows associated with reforms will likely lead the Mexican peso to perform better than most emerging market currencies once U.S. treasury yields rise.

The Central Bank Is More Upbeat on Activity

As widely expected, Mexico’s central bank left the policy rate unchanged, at 3.0%, but in the press statement announcing the decision, the board sounded more upbeat on the economy (highlighting that the balance of risks for activity improved). Still the board continues to see significant slack in the economy, meaning that demand-side inflationary pressures are not an issue. On the other hand, because of higher livestock prices, the board sees a small deterioration in the balance of risks for inflation in the short term. Inflation by the end of this year is now projected to be about 4% (from “below 4%” in the most recent inflation report). However, the expectation that inflation ends next year around the 3% target center (as the impact of tax hikes and non-core inflation eases) was left unchanged. 

In its concluding remarks, the board held to its neutral tone that has marked its past few decisions: for the coming meetings, it will pay special attention to the evolution of the output gap and to the policy stance of Mexico relative to the U.S.

We expect the central bank to leave the policy rate unchanged this year. In 2015, a hiking cycle is likely, as the Fed starts its own hiking cycle. While our year-end forecasts for the policy rate are unchanged, at 3.0% in 2014 and 3.5% in 2015, we now expect the central bank to start to withdraw the monetary stimulus earlier (by the end of 2Q14, instead of 4Q14 in our previous scenario).  

2015 Budget Proposal Sent to Congress

On September 5th, the Ministry of Finance sent to congress the 2015 budget proposal requesting a 1% budget deficit (3.5% including investments of state companies – such as Pemex and CFE). The total deficit would reach 3.5% in 2015 from 3.6% in 2014, which implies a small reduction in Public Sector Borrowing Requirements (a broader measure of the public deficit), to 4.0% of GDP from 4.2% in 2014 – a fiscal consolidation lower than the one indicated one year ago.

The government expects a growth rate of 3.7% in 2015 (2.7% in 2014) supported by the recovery in domestic consumption, positive dynamism of external demand and capital inflows, all of which should contribute to reducing the output gap throughout the year. It’s important to note that the expected growth rate in 2015 is slightly lower than the most recent Banxico and Banamex surveys (3.8%). 

The budget proposal does not include any tax modifications. Gasoline prices next year will increase according to expected inflation (they have increased by 10 to 12% in recent years) until their liberalization in 2018. The government expects revenues to grow by 1.0% in real terms, as oil revenues are expected to contract 7.1% (due to a lower oil production and a lower Mexican oil mix price), but it expects tax revenues to expand by 7.2%. Public sector expenditures are projected to grow 1.2% over 2014.

Finally, the budget proposal indicates a fiscal consolidation path ahead (the budget deficit excluding state enterprise investments would reach zero in 2017). This, however, assumes a strong increase in growth over the medium term. From 2017 on, the economy would expand above 5%.


 

João Pedro Bumachar

Jesus Gustavo Garza-Garcia



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