Mexico’s Central Bank Hikes Key Rate In Hawkish Turn

 

December 18, 2017 [Emerging Markets, Mexico, Central Bank]


Mexican asset prices reflect current and potential economic and political risks. But a likely turn in the country’s economic cycle makes for a potentially attractive entry point for longer-term investors, and the financial sector may soon benefit.

Mexican Peso Coin

The Central Bank of Mexico has raised the policy rate a quarter point to 7.25%, its highest level in nearly nine years. Banxico, as the Mexican monetary authority is known, had been widely expected to hold it steady throughout the second half of 2017 after hiking it from 5.75% to 7% in the first half of the year.

But November inflation numbers came in worse than expected, with CPI at 6.67%, more than double the 3% inflation target. And a weakening peso over the last three weeks didn’t help. Another noteworthy factor: this was the first meeting under new central bank governor Alejandro Diaz de Leon, and the communique from Banxico, struck a fairly hawkish tone, noting the December inflation read is expected to be "higher than that of November," and added that the convergence toward the 3% target will be "slower than expected…reaching levels nearing the objective by the end of next year." That has prompted the market to anticipate another quarter-point rate hike in January 2018.

Long-term investors, though, might consider the degree to which risks are reflected in Mexican asset prices, not to mention the country’s economic fundamentals and the current state of its economic cycle.

The inflation numbers this year are being impacted by the "Gasolinazo," the 20% hike in gasoline prices in January 2017. There were also some concerning recent data points. In November, for example, the inflation diffusion index showed some of the inflationary pressures are widening.

Yet it couldn’t have been an easy call for Banxico, as the economy contracted at an annualized 1.2% in the third quarter, following declines in gross fixed capital formation in the previous two quarters. And retail sales has been in a declining trend since November 2016. Then there’s impact from rate key hikes north of Mexico’s border, as well as the uncertainty over the status of the North American Free Trade Agreement (NAFTA). Domestic political risk also looms in the prelude to Mexico’s general election in June.

Yet much of the bad news has been priced into Mexican stocks. In the year to mid-December, the MSCI Mexico Index has advanced 13.5%, a far cry from the 30% gain in the broad MSCI Emerging Markets Index. Moreover, while another Banxico hike appears likely in early 2018, any hikes thereafter may be fewer and far between as the "Gasolinazo" and the impact from two major earthquakes in southern Mexico in September fade. Faster U.S. growth also tends to benefit Mexico, which is the U.S.’s second-largest trading partner after China.

The economic contraction in Mexico, which enjoys low debt to gross domestic product and fiscal deficit ratios, is expected to bottom in the current quarter, and begin rebounding in early 2018, notwithstanding the NAFTA and electoral risk factors, or the potential for another Banxico hike or two.

One sector particularly well-poised to benefit from any further rate hikes is financials. Higher rates are a positive for net interest income (NII). Mexican bank Banorte, for example, has provided guidance in the past suggesting that 100 basis points of benchmark rate hikes impact NII by MXN1.2 billion. So another 50 basis points in rate hikes would likely have an impact of MXN600 million on NII. This would roughly generate a 2% positive impact on earnings per share, thought that would likely be felt in 2020, given the six-month lag effect.

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