Latin America Manufacturing Outlook: Mexican Factories to Lead Growth While Brazil’s Manufacturers Falter

Wednesday, July 9, 2014

Latin America Manufacturing Outlook: Mexican Factories to Lead Growth While Brazil’s Manufacturers Falter

Need to Know . . .

  • Latin America's factories are forecast to expand output by 2% in 2014 and a still shy 2.1% in 2015
  • In 2014, the fastest-growing industries are motor vehicles (courtesy of Mexico's automakers), computing and electronic equipment, basic metals, and other transport equipment
  • Most of the factors that negatively affected the Mexican economy last year seem to have been resolved

Introduction
This biannual report examines the latest trends in selected manufacturing industries in Latin America and provides related forecasts. The focus is on Latin America’s three largest economies—Brazil, Mexico, and Argentina—as these countries account for more than 80% of the region’s manufacturing output. Annual production indexes for each manufacturing industry are weighted-average indexes, with the weights determined by each country’s value-added in U.S. dollar terms in each of the 14 sectors under analysis.1 All data come from national statistical agencies: the Mexican Institute of Statistics, Geography, and Informatics (INEGI); the Brazilian Institute of Geography and Statistics (IBGE); and Argentina’s Institute of Statistics and Census (INDEC).

The first section of the report offers a general overview of the region’s current manufacturing activity and MAPI’s forecast for 2014 and 2015. Significant developments affecting our forecasts are also examined. The second section sketches the positions of selected manufacturing industries along a cyclical path divided between phases of growth and decline. The final section details MAPI’s production forecasts for the subsectors by country.

The State of Latin America Manufacturing and Its Outlook

Regional Summary
MAPI predicts that manufacturing production in Latin America will expand 2% in 2014, courtesy of the outstanding performance of the motor vehicles sector in Mexico. Mexico’s factory growth is being dragged down by ongoing recessions in Brazil’s and Argentina’s manufacturing industries, however.

While Mexico’s industry growth is centered so far on just a few sectors—auto and basic metals—we are already seeing signs of broader-based manufacturing growth. I estimate that this broad-based growth across Mexico’s industrial supply chain will become more evident in the next few quarters and will continue in 2015. In Brazil, demand incentives for durable goods were partially lifted, leading to a sizable contraction in the auto sector that has induced other intermediate industries to scale back production. Similarly, Argentina’s manufacturing weakness is explained by a sharp retreat in car production as domestic sales and exports to Brazil plunged.

Conditions are set for broader manufacturing growth in 2015, although the expansion remains modest at 2.1%. Activity across Brazil’s factories will pick up in pace, Mexico’s manufacturing growth will moderate slightly as carmakers reduce expansion rates to more sustainable levels, and Argentina’s industry will remain a drag on overall growth.

Brazil
After posting a decent 2.5% growth rate in 2013, Brazil’s economy is slowing down and struggling to generate sustainable growth, particularly in manufacturing. The World Cup is not providing the boost I expected to the economy in general and manufacturing in particular. Although I anticipated a solid expansion of the food and beverages sector (the largest industrial sector in the region), the most recent statistics are revealing a vastly different outcome. The latest high-frequency data and most leading indicators are showing a manufacturing contraction in the second quarter of 2014 and a third quarter that is weak at best. This comes on top of a weak first quarter, in which manufacturing posted virtually no growth compared with the same period last year. In April alone, manufacturing contracted 7% over the previous year. The weak start to the year and this recent data led us to revise down our Brazilian manufacturing forecasts for 2014 and 2015.

Brazil’s manufacturing industry (48.7% weight in our index) struggled over the past four years and still faces barriers to sustainable growth. During the first four months of 2014, Brazil’s manufacturers saw their output decline 1.8% compared with the same period in 2013. Contrary to expectations, the automotive industry has been a drag on growth, with output declining 10.2% in this time frame, as demand incentives were trimmed. The weak carmaking industry is taking its toll on most intermediate industries. In addition, fixed investment has been a drag on the economy and explains weakness in machinery and equipment businesses. Only the computing and electronic equipment industry showed a sizable expansion in the January-April 2014 framework, as television sets sold like hot bread in light of the World Cup.

Brazil’s economy and manufacturing need a productivity boost to keep up with the gains on the currency front. The country’s competitiveness has suffered greatly from currency strength and it is clear that the overall economic model—in which demand is artificially generated via tax incentives but supply does not react—is compromised and is starting to generate inflation. While manufacturing production (a supply proxy) stopped growing almost four years ago, retail sales (demand proxy) went up 26% in the same time frame. Inflation is picking up as a tight labor market increases wage levels—and despite government-controlled prices on gas and other important consumer items.

Structural reforms are needed if the country wishes to experience another cycle of strong growth and rising incomes. Tackling infrastructure problems, the country’s poor education, and the onerous tax code for corporations is paramount, but all depend on the political willingness of the authorities. The bad news is that most experts do not see a major policy turn from the current administration in the event they are reelected in October 2014. I suspect that the government’s unwillingness to adjust the country’s compromised economic model signifies slow growth for a longer period in Brazil.

There is no evidence yet that manufacturing or the economy will recover soon, with leading indicators showing weak figures in recent months. Confidence levels among consumers and the country’s captains of industry are trending lower. Clearly, the upcoming presidential elections are bringing a high degree of uncertainty to the overall picture. Risks of electricity rationing are mounting, a situation that is dependent on the weather since most of Brazil’s electricity is generated in hydroelectric dams. Below-average rain levels in the summer led to worrisome water levels in key dams.

I expect manufacturing growth to remain modest this year and next. Our model forecasts Brazil’s factory output will expand 1.6% in 2014 and 2.2% in 2015. Next year’s improvement is partially explained by a recovery in key manufacturing sectors that drive growth across multiple intermediate industries. I suspect that the automotive industry will recover some of this year’s losses and will generate positive spillover effects across basic metals, fabricated metals, machinery and equipment, and electrical machinery industries. Our model suggests that in 2015, aircraft production will regain some of the strength lost this year.

Mexico
Mexico’s economy and its manufacturing industry disappointed in 2013: GDP grew a mere 1.1% and manufacturing just 1.4%. While the overall economy has not yet shown signs of a sustained recovery (it was up 1.8% in the first quarter of 2014), the latest manufacturing data came in relatively strong, as I anticipated in my last report.

Mexico’s manufacturing output (38.7% of our index) increased by a relatively strong 3.2% during January-April 2014. In line with our previous forecast, most of the growth can be attributed to the strong performance of the automotive sector, which increased output 11.5% during that period. Stimulated by ongoing momentum in the auto industry, basic metals manufacturers expanded production 11.8% in the first four months of 2014. Rubber and plastic makers are starting to benefit from the automotive expansion and I anticipate that other intermediate industries will pick up the pace in the second quarter and beyond. Although strong manufacturing growth remains limited to a few sectors, our model points to broader gains ahead along Mexico’s industrial supply chain.

A positive outlook for manufacturing in the United States is driving up confidence among Mexico’s manufacturing leaders. MAPI’s U.S. Industrial Outlook—a key input for our forecast for Mexican factories—predicts solid 3.2% and 4% manufacturing output growth in 2014 and 2015, respectively. Similarly, recent leading indicators in Mexico suggest improved manufacturing in upcoming quarters. In the May 2014 Purchasing Managers Index published by INEGI, almost all subcomponents were above the 50-point mark, calling for output growth over the next few months. New orders, production levels, employment, and inventory levels remain supportive, and the supplier deliveries index is the only subcomponent below 50. The latest INEGI Producer Confidence Index indicates that Mexico’s captains of industry are confident about prospects for the near future, although most remain cautious about current conditions.

During January-April 2014, manufacturing exports increased a sizable 5.5%, pushed by 10.2% growth in auto exports. Similarly, imports of intermediate manufacturing goods (components and subassemblies for production purposes) were up 3.4%, suggesting continued output gains across factories.

Our econometric modeling indicates that Mexico’s manufacturing industry will expand output by 3.2% in 2014 and 2.8% in 2015. This year’s growth leaders include the auto sector, basic metals, and electrical machinery and apparatus. In 2015, I expect gains to be broad based, as auto production remains resilient and as construction activity picks up.

In my view, there is a strong case for acceleration in the overall economy, pushed by stronger manufacturing activity. It seems that most of the factors that negatively affected the Mexican economy last year are behind us. First, the initial impact of tax reform, which lowered consumer confidence and brought uncertainty to business leaders, has run its course. Second, the harsh winter in the United States that led to weak Mexican manufacturing activity late last year and early in 2014 has ended. And third, public spending—which was a drag on last year’s overall economic growth—is now soaring and will remain strong considering next year’s mid-term elections. In short, the Mexican economy’s long-elusive recovery is already taking place.

In the medium to longer term, energy reform should lead to a boom of foreign direct investment, in turn increasing incomes and promoting a stronger pace of overall economic activity. The expected gains from these investments are not automatic, however; the situation requires that Mexico tackle the well-known structural problems that put a damper on economic growth, notably poor human capital and underdeveloped infrastructure.

Argentina
Argentina’s manufacturing industry (12.6% of our index) contracted 3.7% during January-May 2014, a consequence of the 20.8% output decline seen in motor vehicle factories. After record-high production in 2013, carmakers are suffering from weak demand from Brazil and plunging domestic sales. The elimination of demand incentives in Brazil hurt Argentine car exports and a government-imposed excise tax on mid-tier and high-end cars (imported and locally made) provoked a sudden rise in inventories and consequent plunge in factory output. When automakers started laying off workers, the government organized a series of meetings with companies to find a creative solution to the sector’s ongoing recession. The result was the recent implementation of a public-funded soft credit scheme to purchase some locally made cars, a tactic that may mitigate the auto output contraction but one that is not likely to bring about sizable changes in the current downward trend.

In addition to the major retreat in car production—an engine of industrial growth in this part of the world—a rise in uncertainty levels regarding the overall macroeconomic outlook is not helping. The recent decision by the U.S. Supreme Court to rule in favor of the 7% of bondholders who did not accept Argentina’s debt restructuring in 2005 and 2010 (holdouts) has complicated the authorities’ intentions to gain access to international credit markets after a decade of isolation. Bear in mind that the government recently turned more pragmatic by: (1) reaching an agreement with Spain’s Repsol after the nationalization of the energy giant YPF; (2) negotiating a long-awaited payment schedule with the Paris Club; and (3) fulfilling the payment of the agreements achieved with companies that had rulings before the ICSID tribunals.

The last obstacle to regaining access to international credit—something badly needed given the country’s fiscal and foreign exchange situation—is the holdouts case. The U.S. Supreme Court’s decision means that Argentina has to pay holdouts in full, an amount estimated at around USD $15 billion (half of the country’s foreign exchange reserves) if all holdouts claim immediate payment. A negotiation between Argentine authorities and the holdouts is being undertaken; the government’s intention is to reach a deal on a long-term payment schedule to avoid suffocating the country’s already precarious foreign exchange reserves.

Considering the weak start to the year and the uncertainty affecting consumer and business decisions, I believe that economic growth in general and manufacturing in particular will remain stagnant this year and next. Our model points to manufacturing contractions of 0.7% and 0.5% in 2014 and 2015, respectively. I believe that the import substitution export-oriented model that had its foundations in a weak currency ran out of steam three years ago and needs an adjustment. In order to avoid a balance of payments crisis, the government will continue to limit everything that generates dollar outflows, particularly imports, in turn affecting manufacturing production.

Next year’s elections will become a major event in Argentina, a country with huge untapped potential. Although it is clear that the road to the October 2015 elections will be bumpy, I remain confident that more pragmatic policies will generate the country’s needed foreign direct investment to unleash the enormous potential hidden in this resource-endowed and diversified economy, which comes with a homogeneous and highly educated labor force.

MAPI’s Latin America Manufacturing Forecasts
MAPI’s manufacturing forecast for Latin America has been revised downward from our December 2013 report; I expect the region’s factories to expand output by 2% in 2014 (the December growth estimate was 3.1%) and a still shy 2.1% in 2015. Most of the manufacturing growth predicted for this year and next is supported by Mexican factories, since industrial activity in Brazil and Argentina remains weak.

Thirteen out of the 14 manufacturing industries tracked by MAPI will expand output in 2014. The fastest-growing industries are motor vehicles (courtesy of Mexico’s automakers), computing and electronic equipment, basic metals, and other transport equipment. Machinery and equipment production and intermediate industries such as rubber and plastics, nonmetallic minerals, and fabricated metals will show modest growth. The food and beverages sector—the largest industry in the region—will post modest gains.

The slightly stronger manufacturing growth in 2015 is clearly a consequence of the improved backdrop among intermediate industries, which will have to expand production to satisfy the projected solid demand from Mexican auto plants and the shy rebound expected among Brazil carmakers. In addition, the large food and beverages industry, machinery and equipment, electrical machinery and apparatus, and other transport equipment are expected to gain some traction. All 14 industries are expected to expand output in 2015.

Table 1 – Manufacturing Production Forecast, 2014-2015 (Annual Percent Change)

F=Forecast
Source(s): MAPI

Manufacturing Subsectors in the Current Business Cycle
Figure 1 illustrates a model business cycle that summarizes the current economic performance of the 14 subsectors under study. Specifically, it shows the approximate cyclical positions of these industries as of March 2014 based on our rate-of-change analysis. (The smaller inset figure shows these industries’ positions in September 2013.) The cyclical position of a particular industry may signal a point within a growth subcycle (up and down variations of production that are not technically a recession) as opposed to the conventional business cycle. It should be emphasized that the three countries being examined may be at dissimilar stages of the cycle or in different growth subcycles.

The manufacturing picture in Latin America as of March 2014 remains somewhat similar to what was depicted in our last report, which used September 2013 data. Some large industries moved from the accelerating growth phase to the decelerating growth phase, explaining our downward revision. In March 2014, six industries were in the accelerating growth phase, the same as in September 2013. The six sectors were: paper and paper products; nonmetallic minerals; basic metals; computing machinery, communications, and electronic equipment; electrical machinery and apparatus; and other transport equipment.

As of March 2014, seven industries were in the decelerating growth phase of the cycle, again the same as in September. The seven industries were: food and beverages; wood products; coke, refined petroleum products, and nuclear fuel; chemicals and chemical products; rubber and plastics; machinery and equipment; and motor vehicles. Only fabricated metals was below water (in one of the two decline phases of the cycle).

Figure 1 – Manufacturing Sector by Phase of Cycle: March 2014

Source(s): MAPI

Country Forecasts

Table 2 – Brazil: Manufacturing Production Forecast, 2014-2015 (Annual Percent Change)

F=Forecast
Source(s): MAPI

Table 3 – Mexico: Manufacturing Production Forecast, 2014-2015 (Annual Percent Change)

F=Forecast
Source(s): MAPI

Table 4 – Argentina: Manufacturing Production Forecast, 2014-2015 (Annual Percent Change)

F=Forecast
Source(s): MAPI

 

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  • 1. Local currency value-added is translated to dollar terms using the period's average nominal exchange rate.