Itaú BBA - No further rate hikes this year

Scenario Review - Mexico

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No further rate hikes this year

marzo 31, 2016

The board would not react automatically to higher interest rates in the U.S.

Please see the attached file for all graphs. 

• Many activity indicators rebounded recently, easing concerns that the economy could be decelerating rapidly. We expect GDP growth of 2.5% this year, the same as recorded in 2015, and 2.7% in 2017.

• The announcements on monetary, fiscal and exchange-rate policies in mid-February, together with the more supportive external environment for emerging-market currencies, made the Mexican peso one of the best performing emerging-market currencies recently. We expect the Mexican peso at 17.5 to the dollar by the end of this year as well as in 2017.

• The slack in the economy continues to contain both the demand-side pressures on domestic prices and the pass-through from past depreciation. Our forecasts for inflation in 2016 and 2017 stand at 3.0%.

• The focus of Mexico’s central bank on the exchange rate means that the board would not react automatically to higher interest rates in the U.S. We do not expect further rate hikes this year.

Activity holding up

Activity indicators in January eased concerns raised by previous data releases that the economy could be decelerating rapidly. Mexico’s IGAE (monthly proxy for GDP) came in at 3.0% year over year in January (adjusted for working days), picking up from the 2.5% registered in December, mostly due to a recovery in the Industrial sector (1.9% versus -0.1% in December). Sequentially, the IGAE improved markedly (0.6% between December and January, after three consecutive months of weak readings), also led by Industry (1.2%), which had been performing poorly over the past few months (negative month-over-month rates throughout 4Q15). A sharp improvement in construction activity and, to a lesser extent, an uptick in oil output drove the good results. Retail sales gained 2.7% from December, more than offsetting the 1.3% contraction seen one month before, as consumption continues to benefit from strong remittances (when converted to pesos), low inflation, solid employment growth (3.8% year over year in February) and more credit.      

However, economic growth is still missing help from the north. Manufacturing activity contracted by 0.1% between December and January, after a weak 0.4% quarter-over-quarter gain in 4Q15. Manufacturing exports (in current dollars) fell by 1.5% month over month in February, following a 0.6% drop the previous month and a 1.2% quarter-over-quarter contraction in 4Q15.

We expect the economy to grow by 2.5% this year, the same rate recorded in 2015. Fiscal expenditure cuts, delays in the implementation of the energy reform due to lower oil prices, and a still-sluggish U.S. manufacturing sector (which demands a lot of Mexico’s intermediate goods) limit a more meaningful recovery. However, a more competitive exchange rate, combined with our expectation of a recovery in the U.S. industry ahead as the negative impacts of lower oil prices and a strong U.S. dollar fade, will likely prevent the economy from slowing. For 2017, we expect a 2.7% expansion.

Relief in the exchange-rate market   

The Mexican peso has appreciated strongly recently. The announcements on monetary, fiscal and exchange-rate policies in mid-February, together with the more supportive external environment for emerging-market currencies, made the Mexican peso one of the main outperformers.

We continue to expect the exchange-rate at 17.5 pesos to the dollar by the end of this year and in 2017. An expected recovery in oil prices later this year will likely help to sustain the currency around the current levels.  

Inflation remains well-behaved

Both headline and core inflation are running below the center of the target. In the first half of March, inflation came in at 2.71% year over year, down from 2.8% in the second half of February. While inflation continues to be led by the volatile non-core food prices (6.74% year over year), they were also the prices that contributed the most to bringing inflation down from the second half of February (when these prices increased by 7.69%). Non-core inflation was also benefited by low oil prices, so energy saw deflation of 2.24% year over year. Core inflation increased slightly, to a still-low 2.86%. The slack in the economy continues to contain both the demand-side pressures on domestic prices and the pass-through from past depreciation. In fact, even the component of the CPI most sensitive to the exchange rate (core goods ex-food) is tamed (at 3.26%), while service inflation is at 2.57%, benefited by the telecom reform.   

We continue to expect inflation at 3.0% by the end of this year and in 2017. A recovery of oil prices later this year and the fading impact of the benefits from the telecom reform will mean some increase of year-over-year inflation from the current levels.

No further hikes this year

Mexico’s central bank left the policy rate unchanged in March. The move was widely expected, given that the board explicitly said the hike in the extraordinary meeting held in February was not the beginning of a cycle and the Mexican peso – the variable responsible for the hike - reversed its weakening trend.

Still, the board continues to highlight the evolution of the exchange rate as the main variable that it will monitor in the upcoming decisions. The interest-rate differential and the evolution of the output gap are also listed as variables that the board will watch closely.   

Considering our expectation of a stable exchange rate ahead, we do not expect further rate hikes this year, even though we see two rate hikes in the U.S. In our view, the Fed is unlikely to raise rates if it perceives that international markets would not react in an orderly fashion. Also, the focus of Mexico’s central bank on the exchange rate means that the board would not react automatically to higher interest rates in the U.S.


 

João Pedro Bumachar


 

Please see the attached file for all graphs.  


 

 



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