BOFAML: MEXICO IN FOCUS, ROUGH WATERS

By Carlos Capistran

Our calls: We expect GDP to decelerate to 1.6% in 2018 from 2.1% in 2017. Inflation will be above 4% for most of 2018. The central bank will cut rates to 6% by year-end 2018 from 7.25% in 2017. The presidential election will be a tight race that will keep uncertainty high and investment low in the first half of the year.

Main view: The domestic economy will decelerate following tight fiscal and monetary policies and high uncertainty from NAFTA renegotiation and elections in Mexico. But solid US growth will support the Mexican economy.

Main risks: The main outside risks are fiscal reform in the US (net positive for Mexico through higher growth in the US) and higher US interest rates (negative for Mexico through tighter global financial conditions). NAFTA breakdown is a downside risk. The main domestic risk for 2018 is that uncertainty regarding elections decelerates the economy even further.

Mexico did better than expected in 2017

Mexico will grow slightly above 2% in 2017 which is a positive surprise compared to our forecast of 1.3% growth a year ago. We thought uncertainty regarding policy changes in the US would decelerate investment and trade in Mexico. Investment did decelerate but not trade. We ended up in our bullish scenario where no US policies with meaningful negative impact on Mexico were enacted, leaving room for solid US growth to continue lifting Mexico’s growth through trade, investment and remittances (Chart 1) .

We correctly anticipated the peso would continue to be a buffer for the Mexican economy, but that inflation would accelerate forcing the central bank to continue its hiking cycle. A surprise increase to gasoline prices in January 2017, to align domestic prices with international ones as part of the liberalization of the retail gasoline market, accelerated inflation even more sending it above 6%. The central bank increased the overnight rate target all the way to 7%, tightening the monetary policy stance (Chart 2).

Mexico consolidated its public finances by moving the primary balance to a surplus, which helped prevent downgrades from rating agencies (Chart 3). Two rating agencies even removed the negative outlook from their ratings. Part of the fiscal consolidation was based on non-recurrent revenues provided by the central bank, but part was based on restraining public expenditure, mostly public investment.

Even though US policies with negative consequences for Mexico did not materialize, uncertainty remained high especially regarding a potential breakdown of the North America Free Trade Agreement (NAFTA). The US reportedly was close to invoking article 2205 to withdraw from the agreement in April. It has been a bumpy ride so far, with the three countries still trying to find common ground.

Deceleration knocking on the door

We expect GDP growth to decelerate to 1.6% in 2018 on the back of a deceleration of consumption and a continuation of weak investment. We expect consumption to decelerate because real wages have contracted as a result of high inflation, and credit growth has decelerated as a result of high interest rates. So far the deceleration of consumption has not been very noticeable because job creation and remittances remain solid mostly helped by above-potential grow in the US. But we are already seeing some deceleration in consumption. Domestic auto sales are down 2.1% ytd and department store sales decelerated to -1.2% yoy in real terms in 3Q 2017 from 2.9% in 3Q 2016.

Investment remains weak. Private investment has been negatively affected by high uncertainty from protectionism rhetoric in the US, the electoral process and higher interest rates. Public investment has been significantly affected by fiscal consolidation (Chart 4). Low investment will have a negative impact on Mexico’s potential.

We expect net exports to continue to have a net positive contribution to GDP growth in 2018 on the back of solid global and US growth and a depreciated real exchange rate, offsetting part of the deceleration in domestic expenditure. Although the trade balance is likely to continue putting pressure on the peso to depreciate through the oil trade deficit, as Mexico still needs to import most of the gasoline it consumes (Chart 5).

On the supply side the good news is that the drag from oil production is likely to abate as Pemex expects oil production to be flat in 2018. The energy reform is likely to continue as the highpoint in terms of investment and as source of good news.

Inflation falling towards the target

We expect inflation to decelerate to 3.6% by end 2018 from 6.8% by end 2017 (Chart 6). Inflation is likely to be below 5% in January 2018 once the impact of the adjustment to gasoline prices vanishes. As the economy decelerates and the output gap becomes more negative we expect core inflation to move below 4% by the end of 1Q 2018 and then to slowly fall to end the year below 3.5%. The risk is that further peso depreciation increases again the price of merchandises or that a large revision to the minimum wage in January, likely in an electoral year, further contaminates services inflation.

Banxico to cut rates towards year-end

We expect Banxico to hike one more time in 1H 2018 to put the overnight rate target at 7.5% but then to cut 150bp in the second half of 2018 to bring the rate to 6%. With the output gap in negative territory and inflation falling inside the target band in 2H 2018 we expect Banxico to cut the overnight rate target to bring the real rate closer to neutral in 2H 2018. It is unlikely that Banxico could cut rates before the uncertainty regarding the elections gets resolved. As risks to inflation are tilted to the upside, we see risks to our monetary policy call also tilted to the upside. Banxico could hike more ahead of the election if MXN depreciation puts inflation expectations at risk.

Two big risks are elections and NAFTA

Federal and local elections will take place on 1 July 2018. Investors will be watching the electoral process closely. Andres Manuel Lopez Obrador (AMLO) is leading the polls to be the next president of Mexico and he could enact policies that are less market friendly than the policies Mexico has followed since the 1990s. The presidential race is likely to be tight which would maintain uncertainty high, having a negative impact on investment and on asset prices. The main theme is likely to be corruption. Independently of who wins the election, it is unlikely that the president gets a majority in congress, reducing the probability of new structural reforms.

NAFTA renegotiation will continue in 2018 as the calendar of the negotiations was extended to 1Q 2018. Our baseline continues to be an update to NAFTA, although a new NAFTA is unlikely to be approved by the three countries even if common ground is found early in the year. We see the chance of the US withdrawing from NAFTA as one in four (25% probability). In the event of a NAFTA breakdown a mild recession in Mexico is possible through a deceleration in investment and trade to some extent, and the real exchange rate would need to depreciate. Banxico is unlikely to fight a real depreciation so that we would not expect much higher rates even under a NAFTA breakdown

Visintini, Daniela, daniela.visintini@bm.com