Recent local elections suggest a rocky end of the term for President Pena Nieto. Low oil prices are acting as a headwind on growth, while price pressures are showing signs of picking up. All told, Mexico underperformance should continue.
President Pena Nieto is nearing the last third of his 6-year term. The next elections will be held in 2018, and his PRI party faces growing problems. Pena Nieto’s popularity is at an all-time low near 35%, and reflects widespread dissatisfaction. The recent clash between police and the teachers’ union at a protest didn’t help matters. Given these developments, he is likely to be a lame duck for the remainder of his term.
Local elections were held in 12 states on June 5. The ruling PRI lost a net five state governorships in the June elections, losing several where it had been ruling uninterrupted for decades. PRI leader Manlio Fabio Beltrones has just resigned as a result. The PAN won seven governorships, some in conjunction with the PRD.
The leftist vote is being split between the PRD and its splinter group Morena, led by former PRD presidential candidate Andres Manuel Lopez Obrador (AMLO). AMLO could be considered a frontrunner for the 2018 election. Other potential candidates are PRI’s Miguel Osorio Chong, PAN’s Margarita Zavala, and PRD’s Miguel Angel Mancera.
Relations with the US remain strong, as evidence by the recent visit to the US by President Pena Nieto. Going forward, much will depend on what happens in the US elections. A Clinton victory would see steady relations, while a Trump victory would probably usher in a decline in relations. We believe it’s too early to comment on the likely outcomes of the US elections.
The economy remains sluggish. GDP growth is forecast to remain virtually unchanged at around 2.4% in 2016 before picking up a bit to 2.7% in 2017. GDP rose 2.4% y/y in Q1. This was as expected, and was boosted by a low basis for comparison. Base effects for the rest of the year are higher and so less favorable for y/y comparisons. This latest leg down in oil prices will also be a headwind on growth.
Weakness seems to be carrying over into Q3. July manufacturing PMI fell to 48.9, the second straight sub-50 reading. What’s worse, the new orders component fell to 47.8 and was also the second straight sub-50 reading. Capital goods imports have contracted y/y for 4 straight months and for 6 of the past 7.
Price pressures are low, but are starting to accelerate. CPI rose 2.7% y/y in mid-July. While this is the highest rate since mid-February, it still remains in the lower half of the 2-4% target range. However, core CPI and PPI have been accelerating and so we see some upside risks to inflation. The central bank next meets August 11, and no change is expected. We think it will be hard for the central bank to hike rates again this year due to the soft economy. Much will depend on the peso.
Fiscal policy has remained prudent. Unlike many of the commodity exporters, Mexico was well-prepared for the downside of the commodity cycle. Pemex typically hedges proactively, whilst the Finance Ministry has announced several rounds of spending cuts in order to limit deterioration in the budget deficit. The deficit came in around-3.5% of GDP in 2015. It is expected to narrow slightly to around -3% this year and -2.8% in 2017. Lower oil prices will exert pressure on revenues.
The external accounts are in decent shape but bear watching. Lower oil prices have hurt exports, but sluggish growth has helped reduce imports. The current account gap was about -3% of GDP in 2015, and is expected to remain steady in 2016 and 2017. Still, the 12-month trade deficit is near the cycle highs and so we see risks of wider than expected current account deficits ahead.
Foreign reserves have risen modestly from the late 2015 lows. At $177.3 bln in June, they cover over 5 months of import and are about twice as large as short-term external debt. Mexico ranks pretty well in terms of vulnerability, as FDI covers a good chunk of the current account gap.
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%), and RUB (-20%). So far this year, MXN is -9% YTD and is lagging only the worst performer ARS (-14%). The next worst are TRY (-2.5%), CNY (-2.3%), and INR (-1%). Our EM FX model shows the peso to have WEAK fundamentals, so this year’s underperformance is to be expected.
USD/MXN has retraced over half of its post-Brexit drop. A break above the 19 area would set up a test of the June 24 high near 19.52. Banco de Mexico no longer has a regular FX intervention program, but instead acts with discretion as needed. It has hiked rates 50 bp twice this year, with the stated aim of preventing speculative activity. We note that net and gross peso shorts (as reported by the CFTC) remain well below the peaks in February.
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 -2.2% YTD, and compares to +10.4% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Mexico at an UNDERWEIGHT position.
Mexican bonds have performed alright this year. The yield on 10-year local currency government bonds is about -31 bp YTD. This compares to the best performers Brazil (-473 bp), Indonesia (-180 bp), Peru (-158 bp), Russia (-114 bp), and South Africa (-112 bp). With inflation likely to edge higher and the central bank in hawkish mode, we think Mexican bonds can start underperforming a bit more.
Our own sovereign ratings model shows Mexico to be correctly rated at BBB+ by both S&P and Fitch. However, we note that Moody’s decision to move the outlook on Mexico’s rating from stable to negative could presage an eventual cut from A3 to Baa1, as our model suggests.