Monday, July 18, 2011

Viva Mexico! Mexican Growth Outlook - 19 July 2011

The Mexican growth outlook has deteriorated on expectations for slower US growth this year. Owing to their high correlation via the export sector, decelerating US growth will feed into Mexico’s economic expansion, which we expect to firm 0.3% below our previous forecast at 4.2% in 2011. The main culprit is the deceleration in IP due to supply-chain disruptions in Japan. The car sector has been the worst hit among manufacturing industries, although this is likely to be just a temporary correction. According to our math, Mexico is currently growing above potential, but private consumption (still the weak link) is not providing enough support to GDP.

The export sector continues to perform despite the strong MXN. Eighty percent of Mexican exports still go to the US market. Hence, a medium-term deterioration of America’s largest economy (we expect a deceleration to 2.5% in 2011 from 2.9% in 2010, and a rebound to 3.0% in 2012) is likely to translate into weaker growth for Mexico’s industrial sector. However, in spite of less favourable external conditions and MXN strengthening over the last year, exports continued to grow at 19.6% y/y in May, recovering the April drop to 14.9%. Oil exports were the main driver. On a 12-month rolling basis, total exports increased to $322bn in May from $304bn in January, of which oil exports increased to $42bn (13.1% of total) from $37bn (12.3% of total).
Strong MXN and dropping food prices continue to keep inflation at low levels. As we had forecast, headline inflation bottomed out at 3.0% y/y in March, but failed to rebound significantly higher. Sequential CPI continued to fall until May, translating into soft annual figures hovering just below 3.3% in May and June. Current inflation levels continue to reflect the declining trend in unit labour costs, the fading impact of tax changes last year, stronger peso and a significant reduction in agricultural prices. Likewise, stable core inflation around 3.2% testifies that the underlying trend is still weak for now. As the recovery remains export led, domestic demand is still not exerting inflationary pressures.

We lower our 2011, CPI forecast to 3.6% but leave it unchanged at 3.5% for 2012. We think price dynamics justify a ‘moderate’ downward revision of our 2011, CPI forecast to 3.6% from 3.7% previously. In a similar vein, the last survey of expectations pointed at slower CPI at 3.6% in 2011 (0.3% less than in March) and 3.7% in 2012 (-0.1%), while the 2011-2014 average (the measure Banxico is most sensitive to) remained stable at 3.6%. Risks to the inflation outlook are posed by potentially resurging prices of agricultural staples, MXN weakness and upside adjustments to fuel price caps. However, as we think risks remain tilted to the downside and the Fed is unlikely to move until late 2Q 2012, Banxico should not feel pressures to hike until 2Q 2012.

C/A deficit correction continues but coverage remains adequate. The 12-month C/A deficit widened to $7.4bn (0.7% of GDP) in Q1 from $5.6bn (0.5% of GDP) in Q4’10. CAD widening mostly owes to the deterioration of the income and services deficits, while exports of goods continued to expand robustly and offset import growth. In 2011, as we expect the economy to recover further, the annual CAD is set to widen to 1.2% of GDP. Yet, coverage remained abundant in Q1, with FDI ($6.1bn) covering 82% of the gap, while still exceptionally high portfolio flows ($37bn) added extra coverage. However, a few concerns remain on the still low FDI buffer against volatility of portfolio inflows and the non-negligible $7bn (0.7% of GDP) of net errors & omissions.

Ahead of next year’s vote, the gubernatorial race in 3 states, including the state of Mexico, saw the PRI secure a significant victory. Though they have ruled the state for 70 years, the magnitude of this victory (62.5% of votes, while PRD’s 21.5% pushed Calderon’s PAN in the third place with a sour 12.5%) dramatically increases PRI’s chances to win presidential elections in 2012. State of Mexico’s outgoing governor Peña Nieto is likely to be PRI’s candidate. The greatest risk here is PRI softening some of the tough laws against drug cartels introduced by PAN over the years. Violence remains a significant drag on Mexico’s GDP, estimated to trim no less than 1.0% of potential growth each year.

While we still forecast a first Fed hike in 2Q 2012, the softer patch in US growth poses a significant downside risk to the rate outlook. This is likely to reflect on Mexico’s fundamentals and should determine a delayed start of tightening from Banxico. Consequently, we are now pencilling in a first 25 bps hike in 2Q 2012 rather than 1Q 2012, and one additional hike in every successive quarter of next year. While Banxico is not striving to hike rates, risks that earlier tightening takes place depend on suddenly rising commodity prices, a sustained MXN depreciation, and upside adjustments of administered prices – especially fuel – which is unlikely in the run-up to the elections.

Well-capitalized Mexican banks are supporting growth through the expansion of both corporate and mortgage lending, which will eventually translate into job creation. The balance sheet cleanup of the banking sector is now complete and credit institutes can afford pushing consumer lending higher as well. However, the banking system is dominated by a few banks and remains exposed to European troubles, with the two largest commercial banks subsidiaries of Spanish banks and accounting for more than a third of the asset and loans in the industry. Compared to 3-6 months ago, lower yields on long maturities are justified by the benign inflation trend. However, as inflation is likely to accelerate at moderate pace going forward, we do not see scope for additional downward moves at the back- end of the curve. Instead, as the market will commence pricing in later hikes than currently implied, the 1yr sector could nudge somewhat lower. TIIE futures are currently pricing in a full 25 bps hike in Mar’12 and cumulatively little more than 50 bps in June’12. As we believe monetary tightening will be delayed, we continue to like 6m-12m TIIE and IRS receivers.

Investors’ interest in the Mexican MBono curve remains supportive for yields as high spreads to UST and a steep curve continue to attract investment. In the short term, we see the risk of minor steepening which suggests holding onto short maturities. However, as both the Fed and Banxico will get closer to rate hikes by the end of this year, the market is likely to anticipate the move with a flattening bond curve. At this point we suggest to start switching to longer maturities. The swap curve also offers opportunities with 2s5s spreads still very high. We expect these spreads to start flattening again towards year end.

Year to date the USD/MXN appreciated 8.0% in total return terms against the dollar. This performance makes it the ninth strongest appreciating currency in a basket of 24 EM crosses. This is the result of both the MXN being a laggard (USD/MXN still trades 17% above pre-crisis levels) and, until May, market expectations of stronger economic performance in the country. Going forward, the former item will continue to play in favour of MXN, while the latter one is likely to reduce its positive contribution. Hence, appreciation will only be moderate in coming quarters and new risk-off episodes are likely to bring in extra volatility. When these episodes materialize, in particular if linked to negative US data surprises, we prefer market neutral BRL/MXN longs a on tactical basis.

Stronger US deceleration, the EU debt crisis and a blurred political outlook are major risks. Major risk factors are mostly exogenous and are likely to play against the MXN at points in time. Risks that Banxico intervenes to weaken the MXN are limited in the current environment. Meanwhile, we expect the Bank to continue building FX reserves. While still a background for now, political uncertainty has soared after the ruling PAN suffered defeats in gubernatorial elections. However, we expect this factor to come in the spotlight not before next year. We have revised our USD/MXN forecast to 11.48 by the end of Q4 and 11.56 in 2Q12.

Published: 19 July, 2011
written by: Bill Hubard , Chief Economist at