Itaú BBA - Slower Growth, Weaker Peso and Steady Rates

Scenario Review - Mexico

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Slower Growth, Weaker Peso and Steady Rates

julio 1, 2013

We revised our growth forecast down for this year, to 2.5% (3.2%, previously).

•           Mexico’s economy weakened during 1Q13, and the first activity indicators available for 2Q13 hint that the economy is taking a long time to rebound. We now expect growth at 2.5% this year, but our 3.6% forecast for 2014 is unchanged.

•           The Mexican peso depreciated sharply against the dollar, like the currencies of most emerging markets. In our view, positive developments in the reform agenda and a stronger U.S. economy will support the currency ahead. However, we revised our forecasts for the exchange rate to 12.2 to the dollar by the end of this year and to 12.0 by the end of 2014. 

•           Although the economy is surprising on the downside, the prospect of the withdrawal of monetary stimulus in the U.S. (and its impact on the pace of exchange-rate appreciation), the positive surprises in the U.S. economy and the already low interest rate in Mexico will prevent the board from engaging in additional monetary easing. 

Slow Growth This Year, Good Prospects Ahead

Following a weak 1Q13, Mexico’s economy is failing to rebound. The first indicators available for 2Q13 suggest that both external and internal demand remain sluggish, so the weakness in the economy goes beyond the calendar effects that negatively affected activity in the first quarter of the year. In April, the IGAE (monthly proxy for GDP) contracted by 0.8% from March, dragged down by a 1.7% decrease in industrial activity. The service sector also performed poorly (-0.6%), which is consistent with a 0.8% fall in retail sales. On a quarter-over-quarter basis, the IGAE was down by 0.5%. Meanwhile, activity data available for May are so far mixed: the Manufacturing PMI (both in the U.S. and in Mexico) came in weak, while both manufacturing exports (4.0% month over month) and formal employment recovered.     

We revised our growth forecast down for this year, to 2.5% (3.2%, previously). For 2014, we continue to expect a 3.6% expansion. In our forecasts, Mexico’s economy picks up from the second half of this year on. External demand would be lifted by higher growth rates in the U.S. In fact, a key reason for Mexico’s recent slowdown has to do with lower growth rates in industrial activity in the U.S. Meanwhile, the labor market continues robust (even though employment is not growing as fast as it was until recently) and consumer confidence is at a good level. These two factors should also support consumption ahead. We note that part of the slowdown in Mexico’s activity is related to a harsh contraction in primary public expenditures during the first quarter of the year. While it is true that Mexico’s government plans a tighter fiscal policy for this year than in 2012, the sharp fall in expenditures is inconsistent with the budget set for 2013. In fact, public expenditures picked up already in April and in May. Finally, in 2014 we expect Mexico’s economy to start benefiting from higher productivity and investment growth related to economic reforms.

The Peso Spikes

Like most floating currencies, the Mexican peso has experienced a sharp depreciation against the U.S. dollar since early May. The Mexican peso was one of the region’s currencies hit hardest by the sell-off in emerging-market assets that accompanied the higher Treasury yields. Because the U.S. economy is surprising positively (especially relatively to China – the key trade partner of LatAm’s commodity exporters), one would expect Mexican assets to suffer less than their LatAm peers. In our view, the sharp deterioration in Mexican assets is linked to the heavy investor positioning in Mexican assets over the last few years. Accumulated foreign portfolio flows since 2010 amounted to USD 159 billion, of which USD 101 billion went to the local government-bond markets.

We now expect the Mexican peso to end this year at 12.2 to the dollar and at 12.0 to the dollar by the end of 2014. Although we still expect the Mexican peso to appreciate after the strains in financial markets decrease, we now expect a weaker exchange rate than we were previously forecasting. As Mexico advances with reforms, allowing higher foreign investment in some key sectors (like Telecom and Energy), equity-capital flows will pour into Mexico, offsetting lower debt flows.       

Weaker Exchange Rate Will Add To Inflation This Year

Headline inflation started its downward trend in the first half of June, reaching 4.24% year over year (from 4.54% in the second half of May). Inflation is therefore approaching the target range, helped by favorable base effects, but also because of a sequential drop in non-core food inflation. Meanwhile, annual core inflation fell to its lowest level on record (2.83%), below the mid-point of the target range, underscoring the temporary nature of the high headline-inflation readings. Within the core, goods inflation came in at 3.22% (3.45% previously). Core goods inflation excluding food is running at 2.56% year over year, helped by (lagged) exchange-rate appreciation, while inflation for core food items continues above the target-range (at 4.05%). Inflation for services increased to 2.50%, but remained below the target’s midpoint.

We now expect inflation to end this year at 3.6% (from 3.5% in our previous forecast). Inflation will continue falling in the months ahead due to favorable base effects and the fact that the expiration of the electricity discounts will add less to inflation than it did in 2012. However, the devaluation of the Mexican peso has been more intense and more lasting than we previously thought. For 2014, our inflation forecast is unchanged.

No Rate Moves Ahead

As widely expected, Mexico’s central bank left the policy rate unchanged at 4.0% in its most recent monetary policy meeting. Both in the minutes and in the press release that accompanied the decision, board members displayed a more concerned tone over economic growth. As in the previous decision, the board downplayed the recent high inflation readings as temporary. Core inflation remains stable while non-core inflation is increased by: i) base effects, ii) transitory impacts from the CPI’s weighting changes, and iii) weather-related and regulated-price pressures. The board expects that inflation will return to the target range during the second half of the year. On the other hand, the central bank is now concerned about the change in the monetary policy stance in the U.S. The board pledged to monitor the monetary stance of Mexico vis-à-vis other countries, in particular the U.S. So, while the monetary policy in the core economies was a factor supporting lower rates in the previous decision (which took place in the aftermath of the quantitative easing program of the Bank of Japan), now this factor plays in the opposite direction.

We continue to expect rates to remain unchanged throughout this year and the next. In our view, in spite of the downside surprises in Mexico’s economy, the prospect of the withdrawal of monetary stimulus in the U.S. (and its impact on the exchange-rate appreciation pace), the positive surprises in the U.S. economy and the already-low interest rate in Mexico will prevent the board from engaging in additional monetary easing. 

João Pedro Bumachar

Forecasts: Mexico

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