In this note we provide analysis of the impact on Mexico’s economy and financial markets of the recent geopolitical shocks. From direct economic effects to the transmission of indirect factors. Financial markets are exposed through three channels, the one related to economic policy reactions, the liquidity effects, and the country risk premium. We also analyze the effect of this shock on public finance, describing the overall transmission mechanism, and its effect on the revenues and expenses of the federal government and Pemex.
Mexico has a small direct economic relationship with both Ukraine and Russia. While the direct impact should be mild, some indirect effects could be more relevant though. Any delay in the restoration of supply chains because of the conflict and the expected higher energy and food inflation, could materialize in lower growth in Mexico. On the inflation front, the shock will be more direct and should lead to higher-than-expected inflation by the end of the year. The local balance of risks together with a FOMC hiking the fed funds rate will favor a continuation of Banxico’s tightening cycle. In our view, the CB will keep a hawkish stance in the near term though we see a limited scope for a more aggressive CB into the 2H22. We would expect a reference rate around 7.5% by the year-end.
We provide a sensitivity analysis of the changes to the macroeconomic scenario on public finance, using the elasticities provided by the Finance Ministry. Higher oil prices are positive as they lead to higher oil revenues. This is positive for Pemex, but less favorable for the federal government as it is subsidizing gasoline prices to soften the increase in consumer prices.
Local markets have experienced high volatility since the beginning of geopolitical events. The curve has shifted to price in even higher rates. The swap curve is factoring in rates near 9.0% in the one-year term and above 7.7% for the next three years. We see room for a downward correction all across the nominal curve once volatility eases. In our view, slopes have room to fall further, particularly the short end vs. the belly. The reason for this is that in the near term the uncertainty towards inflation and the tightening cycle prevail while risks to growth in the medium and long term will remain elevated. Additionally, we expect the risk premium to remain stable. In the short term, however, volatility will continue, so we are currently staying out of nominal sovereign rates.
We can expect the dollar to strengthen further in the short term. LatAm countries are less exposed than other EMs. Rate spreads against the USD are widening and could continue to do so, and currency valuations in this region are more attractive. Once we see a relative stabilization in global market volatility, we would expect the MXN to outperform other EM currencies. In the meantime, however, volatility will remain the name of the game. In addition, we continue overweighting equities vs. Sovereign rates and we keep our 57,000 target for the IPC.
For Pemex, high oil prices benefit the oil company and could reduce the funding provided by Mexico. Despite a lower DUC rate, high oil prices would allow for an increase in the royalties that Pemex pays to Mexico of about USD6.8bn. It would also mean a substantial increase in Pemex’s FCF generation to a positive USD3.7bn in 2022 from a negative USD9.5bn in 2021.