Mexico Fundamentals Are Solid
By Win Thin and Ilan Solot
We do not expect any rate cuts by the Mexican central bank (Banxico) this year, but we could see some of the easing priced in (about 15 bp cut for the year) being taken out of the local swaps curve after Banxico meets on Friday. This could have implications for the back end of the curve, which has seen rates fall some 90 bp since the end of May and taking the 10-year TIIE swap rate to 5.56%.
Food and fuel inflation was to blame for the larger than expected increase in June CPI, offsetting the more subdued trend in service price inflation. June CPI inflation at 4.3% y/y was the highest since March 2010 and importantly, it precedes the sharp increase in agricultural commodity prices seen in July. This will certainly be a concern for Banxico and it could lead to a change in the tone of the next meeting’s statement towards a more hawkish posture. Still, we doubt it will be enough for the bank to consider rate hikes anytime soon. The stronger peso, along with weaker US and Chinese data, should help offset increases in Banxico’s inflation forecast stemming from commodity prices and the June CPI data.
The economy remains in solid shape, with exports, IP, retail sales all holding up well despite the sharper US slowdown. GDP rose 4.6% y/y in Q1, and is tracking at a similar rate for Q2. Manufacturing PMI rose to 55.7 in June from 54.3 in May, the highest since 2006. New orders component surged to 62.9, the highest level since 2004. Clearly, there is some strong momentum in the Mexican economy, and is likely to keep the central bank in wait and see mode for now.
All seems to be going well on the political front – well, almost. Presidential hopeful Obrador from the PRD is still disputing the victory of elected President Nieto from the PRI by claiming that some 5 million votes were bought with gift cards redeemable at supermarkets. The electoral tribunal is due settle the issue by September 6 and we don’t expect any surprises.
Beyond this, Nieto is on track to start his presidency with what we hope will be a strong mandate for reform. Even though the PRI failed to secure a majority in congress, outgoing president Calderon from PAN has stated that he is willing back the reform proposals put forward by the Nieto administration. These should include reforms in tax, labor, and even the energy sector. Nieto’s commitment and ability to gain support from the opposition must still be proven, but for now, the incoming president is saying and doing the right things. We hope that PRI’s newfound reformist rhetoric does indeed translate into a "results-oriented democracy” and that policymakers seize the opportunity at hand.
Drug violence is likely to simmer on, but here too Nieto is taking some unprecedented measures. Foremost was his naming of Oscar Naranjo as his top security advisor. General Naranjo was the head of Colombia’s national policy and had a significant role in reducing drug-related violence in his native Colombia. The scale of Mexico’s problems is much bigger, but Naranjo has very good relations with the US due to Plano Colombia, and we think this is an important development for Mexico.
MXN has gained 5% YTD against the dollar, making it the third best performing in the EM space. It has also performed well since the start of July. We still look favourably towards the peso, especially against other high-beta currencies such as ZAR and KRW. Against the dollar, however, the currency will continue to command one of the highest betas in the FX space, and so this pair is still very vulnerable to global market moods. The 13.25 level has posed strong support for USD/MXN so far in July, and a break below would open the pair for a test of the 13 level and early May lows just below the figure. On the top side, the key level to watch is 13.50 as a break above would target a test of the 14.0 area.
-Ilan Solot and Win Thin