Itaú BBA - After the earthquakes

Scenario Review - Mexico

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After the earthquakes

Outubro 5, 2017

Earthquakes pose meaningful risks on activity and fiscal accounts, but not on inflation

Please see the attached file for all graphs.

• Growth surprised to the upside in 1H17, but lingering risks have cast a shadow on the economic outlook. The recent earthquakes could be a (temporary) drag on GDP growth in 2H17, posing downside risk to our 2.3% growth forecast for 2017. Moreover, the fact that the anti-establishment candidate, Andrés Manuel Lopes Obrador (AMLO), is leading the presidential election polls could put investment decisions on hold, especially in 1H18. Additionally, tensions in the NAFTA renegotiation discussions seem to have increased in the last month. We expect growth this year at 2.3%, unchanged from 2016; for 2018, we forecast growth at 2.1%. 

• Inflation entered a downtrend in September. Annual inflation reached 6.5%, from 6.7% in the second half of August. We expect inflation to fall to 5.7% by the end of 2017 – driven by the lagged effects of the MXN appreciation and the normalization of non-core food prices – and decrease further in 2018, to 3.3%.      

• Macroeconomic policies are unlikely to support growth soon. The 2018 budget proposal submitted to Congress in early September confirmed the government’s plan to cut budget expenditures further (although by less than in the previous two budgets). On the monetary-policy front, the Central Bank is on hold – with no appetite for rate cuts, as suggested by the recent guidance – and we foresee rate cuts only in the second half of next year, after election-related uncertainty abates.

Resilient growth, but earthquakes pose a risk for 2H17

GDP growth was resilient in 2Q17 (2.3% QoQ/SAAR, from 2.7% in 1Q17), with a surprising pick-up in domestic demand (led by private consumption). Domestic demand rose by 3.3% QoQ/saar (from 1.9% in 1Q17), on the back of private consumption (5.2% QoQ/saar, from 2.8% in 1Q17). Public sector demand fell by 3.5% QoQ/saar (from a 3.4% contraction in 1Q17), as the growth of public consumption (0.5% QoQ/saar, -1.9% in 1Q17) was wiped out by the plunge of public investment (-17.1% QoQ/saar, -8.4% in 1Q17). Private investment (2.9% QoQ/saar, -2.5% in 1Q17) performed better than public investment. Exports of goods & services (-8.9% QoQ/saar, 18.3% in 1Q17) also performed poorly.   

Early data for 3Q17 points to a slowdown, which could be exacerbated by the fallout of the earthquakes. The monthly GDP proxy (IGAE) grew 1.4% QoQ/SAAR in July, with a significant deterioration in industrial production (-2.3% QoQ/SAAR, -1.3% in June) cushioned by resilient services sectors (3.2% QoQ/saar, 3.3% in June). Industrial production was dragged down by the decline in construction activity (-4.1% QoQ/SAAR, -4.3% in June). Construction is now the worst-performing sector of the economy (even worse than mining), reflecting the weak investment environment. Oil and gas production (the bulk of mining output) continues to fall, but at a slower pace (-1.5% QoQ/SAAR in July, after contracting at an average pace of 6.5% QoQ/saar in 1H17 and 9.3% in 2016). Manufacturing output weakened recently (-0.4% QoQ/SAAR in July, 0.2% previously), following a strong start to the year, but this weakness is likely temporary considering that manufacturing exports gained traction in August (8.7% QoQ/SAAR, 6.2% in July), probably boosted by the dynamic U.S. economy. On the services side, retail sales performed poorly in July (-2.9% QoQ/SAAR, 1.1% in June) but the more comprehensive monthly proxy for private consumption (3.4% QoQ/SAAR in June, 0.4% in May) – better correlated with GDP – continued to show positive dynamics.

The earthquakes that battered Mexico in September pose short-term risks to GDP growth, given that they have disrupted activity in six states that together account for one-third of the country’s economy. The first earthquake (8.2 magnitude on the Richter scale), on September 7, shocked Chiapas and Oaxaca – two of the country’s poorest states, which rely heavily on agriculture and tourism. Each one accounts for 1.6% of the nation’s GDP. The second earthquake (7.1 magnitude), on September 19, struck the urban areas of the two largest states in the country – Mexico City (16.8% of GDP, granted state-rank since 2017) and the State of Mexico (8.9% of GDP) – Puebla (3.2% of GDP), and Morelos (1.2% of GDP). Lesser damage, perhaps negligible, was also reported in the states of Guerrero and Tlaxcala. The death toll from the earthquakes is in the hundreds. There has been damage to public service infrastructure (mainly roads) and private property (which could imply negative wealth effects for the population). According to a recent survey by the statistics institute (INEGI), 40% of the surveyed businesses (in the affected states) closed their doors for at least one day. In fact, 16% of businesses in Mexico City shut down for more than three days.

We forecast GDP growth of 2.3% in 2017 – although with a downward bias as a result of the earthquakes – and 2.1% in 2018. Some of the headwinds affecting activity – such as higher inflation (affecting real wages) and the fiscal drag – are likely to diminish in the coming quarters. Moreover, the acceleration of economic growth in the U.S. will continue to boost Mexico’s manufacturing exports. On the negative side, the mains risks are the fallout of the earthquakes, the proximity of the presidential elections (which could affect business confidence, given the lead of the non-establishment candidate in the polls, causing a decline in private investment) and uncertainty about the fate of NAFTA. It should be noted that, while a temporary hit on activity, the earthquakes will necessarily entail reconstruction work, thereby supporting activity in some sectors, such as construction, going forward. 

Inflation outlook unaffected by earthquakes

Mexico’s CPI is showing more benign price dynamics across core and non-core components, with annual CPI inflation decreasing from the second half of August to the first half of September. Headline inflation fell to 6.53% YoY (from 6.74%), while core inflation decreased to 4.90% (from 4.98%) in the same period. The decline in core goods inflation (to 6.26% from 6.44%) is, in our view, due to the lagged effect of the MXN appreciation. Core services inflation was broadly unchanged at 3.73% (from 3.74% previously), although core services excluding telecom and FX-sensitive services (which include airfares and tourism-related services) – a cleaner indicator of prices driven by domestic demand – increased to 3.97% from 3.93%. In fact, the labor market remains tight, with low unemployment and robust formal employment growth. Turning to non-core inflation, the decrease (to 11.73% from 12.37%) can be attributed to lower inflation on non-core foods (11.03% from 13.36%), partly offset by energy (14.96% from 14.22%) – pressured by Hurricane Harvey (i.e., an increase in Mexico’s fuel import prices from the U.S.) – and regulated items (7.51% from 7.49%). We note that the diffusion index, which tracks the percentage of items in the CPI basket with inflation higher or equal to 4% (upper bound of the tolerance range for the Central Bank’s 3% target), decreased to 76.5% (from 78.8% in the second half of August), indicating that inflation has become less generalized across goods and services. 

We expect inflation to slow further over the next few months, falling to 5.7% by the end of 2017. Appreciation of the MXN so far this year will be the leading driver for disinflation, with a benign impact on core tradable prices. Moreover, agricultural inflation (which is volatile and still running abnormally high) will likely continue to show a reversal in the coming months (as in the first half of September). We note that we do not expect a material impact from the earthquakes on inflation. In our view, transportation infrastructure (roads, highways, ports, etc.) has not been damaged to the point that it might trigger a shortage of goods in the main local markets, far from it. Mexico City has multiple access points, and the capital cities of the other affected states are also very well connected to the national highway network. Agricultural output is also unlikely to be significantly affected, considering that the main agricultural powerhouse states are located elsewhere (in the north and Bajío regions). Granted, construction material prices could be pressured by the reconstruction works that will likely follow, but these are not part of the consumer price index.

The MXN depreciated a bit recently, approaching our 18.5 (end-of-period) forecast for 2017. The currency is now trading around 18.2 MXN/USD, from 17.8 in late August. The main driver of the depreciation has been the increase in U.S. treasury yields, a response to the U.S. Fed’s guidance on balance sheet normalization (set to begin in October) and the announcement of President Trump’s tax reform (which aims to cut the corporate income tax rate to 20% from 35%). Moreover, with the Fed probably hiking rates in December and Banxico on hold, the narrowing of the interest differential between Mexico and the U.S. will continue to exert depreciation pressure on the MXN. Looking further, our forecast for the MXN in 2018 is also 18.5, although this assumes that the renegotiation of NAFTA and the presidential elections will not hurt Mexico’s economic prospects. 

Macro policies unlikely to be eased soon

As was widely expected, Mexico’s central bank left the policy rate unchanged (at 7.0%) at the September monetary policy meeting, maintaining its neutral stance. The statement accompanying the decision suggests that rate cuts are unlikely, at least anytime soon. In the concluding remarks of the statement, the central bank continues to cite the relative monetary policy between Mexico and the U.S. as a relevant variable for the upcoming decisions, which – given the high likelihood of further monetary policy tightening in the U.S. – poses an obstacle to interest rate reductions in Mexico. The board also pledged to monitor the impact of the recent earthquakes on prices, although as stated at the beginning of the statement, it is expected to be small and temporary. As in previous statements, the central bank noted that, given the present risks, it will be “vigilant to maintain prudent monetary policy in order to strengthen the anchorage of inflation expectations”, hinting at a cautious stance.

Our base case is that the policy rate will be kept at 7%, at least until the beginning of 2H18. We reaffirm our view that Banxico has no appetite for cuts, considering the risks associated to NAFTA, the upcoming elections and monetary policy in the U.S. in a context of solid growth and an interest rate within a range consistent with neutrality. In fact, a number of board members have already expressed this, both in policy documents (minutes) and public remarks. The latest was outgoing Central Bank Governor Agustín Carstens, who during a speech in Monterrey in late August said that “Banxico is prepared to be an element of certainty, this and next year, when Mexico might suffer from an increase in uncertainty, both because of external and internal causes.” Although Carstens will leave Banxico in December, our take on his comments is that the board will be reluctant to cut rates, at least until most of this risk has dissipated (we expect the NAFTA renegotiation to be concluded in 1Q18, the elections will take place in July 2018, and the Fed tightening pace will become more evident as throughout 2018).

On the fiscal front, the Ministry of Finance submitted the 2018 budget proposal to Congress in early September, laying out the details of the final year of the fiscal consolidation plan (announced in 2013) that aims to decrease the public sector’s borrowing requirements (PSBR, broadest measure of the fiscal deficit) to 2.5% of GDP – a level that allows for a sustained reduction in the public-debt-to-GDP ratio. The PSBR swelled to 4.6% of GDP back in 2014 (from 3.7% in 2013), as the fiscal consolidation plan submitted to Congress in September 2013 also included a waiver request for 2014 (to accommodate a temporary fiscal stimulus amid the implementation of the structural reforms). Since then, however, the Mexican government has made progress in its fiscal consolidation objectives. Granted, the massive central bank dividends provided to the government in 2016 (1.2% of GDP) and 2017 (1.5% of GDP) – the outcome of exchange rate gains on international reserves – have helped a lot. But the improvement in the fiscal accounts is evident, especially in 2017, even after netting out the effects of the dividends. In fact, the latest data show that the fiscal deficit indicators continued to narrow in August. The 12-month (ex-dividends) rolling primary balance reached a surplus of MXN 91 billion (0.4% of GDP) in August, from a surplus of MXN 52 billion in July. Using the same metric (ex-dividend), the 12-month nominal fiscal deficit also narrowed, to MXN 421 billion (2% of GDP) from MXN 452 billion in July, and the public sector borrowing requirements (broadest deficit indicator) narrowed to MXN 501 billion (2.4% of GDP) from MXN 534 billion previously.

We see a substantial improvement of fiscal accounts in 2017, and expect fiscal consolidation to carry on into 2018 (albeit with smaller budget cuts in the midst of an electoral year). Given the better-than-expected performance in the first eight months of 2017, we have lowered our public deficit forecast for 2017 (to 1.5% of GDP, from 2.2% previously), but continue to expect a deficit of 2.4% of GDP in 2018. We underscore that excluding dividends from the central bank implies a narrower fiscal deficit in 2018 than this year. In our view, however, there are two main risks that could derail the fiscal consolidation. In the short-term, the earthquakes could hurt GDP growth (denting revenues) and put pressure on spending (in the form of reconstruction works and financial aid). The second risk is related to politics. The anti-establishment presidential candidate, AMLO, has pledged to be fiscally responsible if he assumes the presidency, but we find it hard to reconcile some of his actual policy proposals (doubling of pensions, free tertiary/superior education, subsidies for unemployed youth, increase in minimum wage) with the notion of fiscal conservatism. 


João Pedro Bumachar
Alexander Andre Muller

Please see the attached file for all graphs. 

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