Itaú BBA - The Future in the Spotlight: Oil and Security

Scenario Review - Mexico

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The Future in the Spotlight: Oil and Security

Novembro 7, 2014

Mexico’s IGAE (monthly proxy for GDP) came in at 1.3% year over year in August

• Mexico’s IGAE (monthly proxy for GDP) in August surprised to the downside. Sequentially, it fell 0.2% from July, after four months of consecutive growth rates. In our view, this slowdown is temporary as the U.S. economy remains strong. We maintain our growth forecasts of 2.4% for this year and 3.8% in 2015. 

• Annual inflation remained above the upper bound of the central bank’s target in October due to high non-core inflation. On the other hand, core inflation remains tame. We see inflation at 3.9% by the end of this year, but we expect it to reach 3.2% in 2015. Disinflation will be supported by lower inflation for gasoline and telecom services and the fading impact of the tax hikes introduced this year. 

• As the dollar strengthened globally, the Mexican peso weakened but by less than its peers. We now see the exchange rate at 13.6 pesos per dollar, both at the end of this year and by the end of 2015.

• The central bank left the policy rate unchanged in October and did not signal any move in the short term. We maintain our policy-rate estimates unchanged at 3.0% at the end of 2014 and 3.5% at the end of 2015, and expect the tightening cycle to begin only by the end of 2Q15, in tandem with the Fed’s.  

• While Mexico is not vulnerable to oil prices in the short term, low oil prices reduce the upside that the economy can gain from the energy reform.

• The disappearance of 43 students who are presumed dead in the State of Guerrero has reignited the feeling of insecurity in the country.

Activity Slows, but Growth Becomes More Balanced

Mexico’s IGAE (monthly proxy for GDP) came in at 1.3% year over year in August, surprising to the downside. Sequentially, the IGAE declined 0.2% from July after four months of consecutive growth, as both the primary and the tertiary sectors contracted. Although the trend in economic activity slowed, it is still robust (at 3.4% qoq/saar).

Manufacturing exports lost momentum in 3Q14, but expanded at a solid pace. They grew by 9.4% qoq/saar, after an 18.8% jump in 2Q14. The carry-over for 4Q14 is unfavorable (on a month-over-month basis, manufacturing exports declined, by 1.1% in August and by 0.6% in September), but the positive momentum of U.S. industry (the ISM manufacturing index is hovering at very high levels) leaves us optimistic about external demand for Mexico’s manufactured goods.

Private consumption has also performed well. In July, the monthly private-consumption indicator expanded 3.8% qoq/saar after a 5.2% gain in 2Q14, and retail sales grew an impressive 9.3% qoq/saar. Consumption has been supported by the labor market. Formal employment grew 4.1% year over year in September (the largest annual growth rate since February 2013). So, in spite of high inflation, the real wage bill (in the formal labor market) remains supportive, up by 4.5% in September. Furthermore, the expected drop in inflation, combined with good prospects for employment growth (temporary employment, a leading indicator to total employment, accelerated to 8.3% in September), creates a positive outlook for labor income.

Investment is also gaining ground. In July, gross fixed investment expanded by 0.6% from the previous month, leading to a 7.1% qoq/saar gain. Adjusting for calendar effects, it grew 3.1% year over year (from -3.2%, -1.9% and 1.0% in 4Q13, 1Q14 and 2Q14, respectively). The recovery of investment is driving a strong performance in the construction sector (up 1.2% month over month and 7.7% qoq/saar in August), but it is interesting to note that, at least until July, construction investment demand was mostly related to housing (non-residential construction investment fell by 1.7% year over year in the quarter ended in July). Considering the expansionary fiscal policy run by the government (which contains an aggressive infrastructure plan), it is only a matter of time until investment gets an extra push from public capital spending.

We maintain our growth forecast of 2.4% this year and 3.8% for 2015. The solid evolution of the U.S. economy, alongside domestic expansionary monetary and fiscal policies, will support growth. The structural reforms will also likely start to help economic growth next year.

Inflation Rises Further 

Annual inflation remained above the upper bound of the central bank’s target due to persistently high non-core inflation. On a year-over-year basis, headline inflation reached 4.3% in October, from 4.22% in September. Core inflation stood at 3.32%, somewhat above the center of the target. Non-core inflation rose to 7.5% (from 7.1%) due to higher agricultural and livestock prices, 8.5% (from 7.6%), and regulated tariffs, 6.9% (from 6.8%).

Inflation is likely to fall towards the end of the year due to more favorable base effects. We expect inflation to end this year at 3.9% and to fall sharply next year (to 3.2% by year-end), supported by more favorable telecom tariffs, lower gasoline price hikes and the fading impact of the tax hikes introduced this year.

The proposal to aggressively increase the minimum wage is a key upside risk for inflation from 2015 on. Congress is currently analyzing the proposal made by the mayor of Mexico City, Miguel Angel Mancera of the left-wing PRD, to increase the minimum wage by 23% next year and to double it over the subsequent three years. In response, the government formalized a committee on October 24 that will be in charge of evaluating the mechanisms to adjust the minimum wage in 2015. This committee will have six months to publish its recommendations. The government is also trying to eliminate indexations to minimum wages, so it limits the “damage” from potential increases. 

The Mexican Peso Weakens

The trade balance in 3Q14 continues to be consistent with a low and easily financed current-account deficit. On a seasonally adjusted and annualized basis, the trade balance posted a strong USD 11.5 billion surplus in September, after a USD 5.3 billion deficit in August, so the surplus stood at USD 4.0 billion (annualized) in 3Q14, an improvement from the USD 4.6 billion deficit in 2Q14, due to a better non-energy trade balance. The 12-month rolling balance remains slightly positive (and significantly higher than the historical average).  

We now see the exchange rate at 13.6 pesos per dollar both at the end of this year and by the end of 2015. Amid a strong U.S. dollar globally, the Mexican peso depreciated recently, although it continues to perform well against its peers. As we expect that the dollar will continue to strengthen next year, our new forecasts imply that the Mexican peso will continue to overperform.

No Change in Rates or in the Balance of Risks

The central bank decided to keep its policy rate at 3% in October, in line with our expectations and those of the market consensus.

In the press statement, the board said that the balance of risks is unchanged from the previous meeting. The board noted that domestic activity appears to have shown a moderate recovery during the third quarter of the year, lifted by external demand and improved internal demand. The balance of risks to activity remains the same as it was at the time of the previous monetary policy decision, according to the board, with the positive outlook for U.S. economic growth and the domestic structural reforms approved by Mexico’s congress offsetting the downside risks to the global economy. In the board’s view, although inflation has remained above the upper bound of the target range, this has been a consequence of transitory factors. The bank foresees inflation at 4.0% by year-end and at around 3% from mid-2015 on. The balance of risks for this inflation forecast is also unchanged from the previous decision. On the one hand, there are upside risks, like the possibility of more significant exchange-rate depreciation and increases in the minimum wage, but there are also clear downside risks, such as the prospect of additional reductions in the price of telecom services and the possibility of less-dynamic economic activity if the recent domestic social conflicts affect economic agents’ decisions.

In the concluding remarks of the statement, the board reiterated that for upcoming decisions, members will pay special attention to the evolution of the output gap and to Mexico’s monetary policy stance vis-à-vis that of the United States. 

Thus, the central bank’s view for the economy seems unchanged, which suggests that policy-rate moves are unlikely in the short term. In our view, the central bank will stay on hold until the Fed starts to raise rates. We see a tightening cycle starting by the end of 2Q15, with the policy rate reaching 3.5% before the end of next year.

Oil Prices Matter a Lot for Mexico’s Future

Oil prices fell sharply over the past month. While our baseline scenario is that the drop is transitory and prices will recover in the short term (though not to their pre-October levels), it is worthwhile to assess the vulnerability of Mexico’s economy to oil prices.

Mexico is shielded from oil-price shocks in the short term. Although Mexico is a net energy exporter, the energy surplus has shrunk considerably over the past few years due to lower oil production. In the 12-month period through September, the energy balance was only USD 6 billion (or 0.5% of GDP). Regarding the fiscal accounts, while oil revenues account for about one-third of Mexico’s public-sector revenue, the sensitivity to prices is low in the short term, because domestic gasoline prices do not float according to international prices and net energy exports (which vary according to international prices) are low. According to Mexico’s Ministry of Finance, a one-dollar change in the price of oil has a revenue impact of 0.02% of GDP. Finally, the government has some savings available from the Revenue Stabilization Fund and part of the revenue exposure to oil in 2015 has been hedged.

In the medium to long term, lower oil prices represent a significant risk. Lower oil prices, if sustained, remove at least part of the upside from the aggressive energy reform recently approved by the government. Investment (and overall activity), capital inflows and fiscal revenues would be all at risk.

Insecurity Rises Again

The disappearance of 43 students who are presumed dead in the State of Guerrero has reignited the feeling of insecurity in the country and prompted strong international reactions. The initial investigations of the events point to the participation of the local mayor of Iguala (where the students disappeared) and a Guerrero-led criminal gang. Subsequent investigations have uncovered the existence of numerous mass graves. The mayor of Iguala and his wife were detained and the governor of the state, Angel Aguirre from the left leaning PRD, has resigned. In his place, the state Congress appointed Rogelio Ortega, an academic and former student leader. These events have raised questions on the rule of law, corruption and impunity in some regions of the country. Business leaders, the international community and government officials have stated that rising insecurity could dampen foreign investments to the country and hurt domestic confidence.   


João Pedro Bumachar

Jesus Gustavo Garza-Garcia

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