Banco de Mexico Preview

Mexico (7)

Banco de Mexico meets tomorrow. Consensus sees a 50 bp hike to 5.25%, but it’s a tough call and some look for more aggressive action.

POLICY OUTLOOK

The markets are split on the decision. Of the 20 analysts polled by Bloomberg, 12 look for a 50 bp hike to 5.25%. However, 1 sees no hike, 3 see a 75 bp hike, and 4 see a 100 bp hike. The swaps curve is pricing in a 50 bp hike, while the 1-month Cetes rate is pricing in 75 bp. We think 50 bp seems most likely, but acknowledge significant risks of a bigger hike. We also do not think this will be the last hike of the cycle.

Since the tightening cycle started last December with a 25 bp hike, the central bank has hiked three more times this year in 50 bp increments. One reason to stick with 50 bp and not go bigger now is that a lot of uncertainty remains globally. Keeping more rate hikes in reserve for later is not a bad strategy in this environment. After tomorrow, the next meeting is December 15. The central bank prefers not to move intra-meeting, but will do so under extraordinary conditions as it did in February.

ECONOMIC OUTLOOK

The Mexican economy is already sluggish. Past tightening is in the pipeline, both fiscal and monetary. Back in September, the official 2017 growth forecast was cut to 2-3% from 2.6-3.6% forecast back in April. The IMF sees 2016 and 2017 growth of 2.1% and 2.3%, respectively. GDP rose 2.0% y/y in Q3, the slowest since Q2 2014 and underscores downside risks to the forecasts.

Price pressures are rising, with CPI rising 3.1% y/y in October. This is the highest rate since April 2015, though still within the 2-4% target range. Core inflation is also rising, while PPI rose 7.3% y/y in October. This is the highest since January 2012. Along with the weak peso, all signs point to higher inflation ahead.   We note that this is not even addressing the potential inflationary impact if tariffs were to rise due to a NAFTA renegotiation.

Fiscal policy has remained tight. Yet downside risks to growth remain in play, and will likely lead to further pressure to tighten fiscal policy. Such pro-cyclical moves are not desirable, and will further weigh on the growth outlook. The budget deficit came in around -3.5% of GDP in 2015. It is expected to narrow slightly to around -3% this year and -2.5% in 2017, but this may be too optimistic in light of the growth trajectory.

The external accounts bear watching. Lower oil prices have hurt exports, but slow growth has helped reduce imports. The current account gap was around -3% of GDP in 2015, and is expected to remain around there in 2016 and 2017. Foreign reserves have fallen modestly, but at $175 bln in October, they cover more than five months of import and are about two times larger than short-term external debt.

INVESTMENT OUTLOOK

The peso has generally underperformed in EM. In 2015, MXN lost -14% vs. USD. This compares to the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), RUB (-20%), and TRY (-20%). So far this year, MXN is -15% YTD and is ahead of only the worst performer ARS (-17%). Our EM FX model shows the peso to have WEAK fundamentals, so this year’s underperformance is expected to continue.

USD/MXN traded at a new all-time high near 21.40 last Friday before falling back to near 20.30 currently. Volatility is likely to remain elevated, while further weakness appears likely as uncertainty over what a Trump presidency really entails will continue well into next year.

Mexican equities have underperformed this year after a weak 2015. Last year, MSCI Mexico was -15% while MSCI EM was -17%. So far in 2016, MSCI Mexico is -13% YTD, and compares to +6% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Mexico at an UNDERWEIGHT position.

Mexican bonds have underperformed this year. The yield on 10-year local currency government bonds is +78 bp YTD. This is ahead of only the Philippines (+92 bp). With inflation likely to continue rising and the central bank likely to continue tightening, we think Mexican bonds will continue underperforming.

Our own sovereign ratings model shows Mexico to be correctly rated at BBB+ by both S&P and Fitch. Moody’s seems to have been a bit premature in upgrading it to A3 back in February 2014. Indeed, it warned last week that Trump’s victory would be credit negative for Mexico if it were to hurt trade and financial flows. Moody’s moved the outlook on its A3 rating from stable to negative back in March, and could be setting the table for a downgrade.