Some Thoughts on Mexico

Mexico flag waving

Trump’s surprise win will have an impact on Mexico, but the extent is still unknown. Like Brexit, the actual event has yet to happen but markets will have to be prepared for a significant negative impact. Until the uncertainty clears, Mexican assets are likely to continue underperforming.

Donald Trump will be inaugurated on January 20, 2017. He ran on a platform that had anti-trade and anti-immigration planks. While we suspect that Trump the president will behave differently from Trump the candidate, markets will be watching for clues to the likely policies of his administration.

It will be very important to see how his cabinet shapes up in the coming weeks. Trump will also have the benefit of having the Republican Party holding both houses of Congress. It remains to be seen how 1) the establishment wing of the Republicans and 2) the Democrats in opposition act. Will these blocs work with Trump or work against him?

US POLICY OUTLOOK

The US could (theoretically) withdraw unilaterally from NAFTA. From the NAFTA Secretariat, Article 2205 on withdrawal states that “A Party may withdraw from this Agreement six months after it provides written notice of withdrawal to the other Parties. If a Party withdraws, the Agreement shall remain in force for the remaining Parties.”

However, it’s still unclear whether US laws will require some sort of congressional approval. NAFTA needed to be passed by both houses of Congress. Legal scholars are split as to what’s needed to withdraw from or amend NAFTA. The Republican establishment wing typically favors free trade. Will this wing support Trump if he pushes an anti-trade agenda? If Trump tries to unilaterally exit NAFTA, we would expect legal challenges to such a move. Surely, US businesses that are currently involved in trade with Mexico will lobby to remain in NAFTA.

Rather than exit NAFTA, Trump could simply try to renegotiate the terms. However, it’s unclear to us what new terms he would push for. Here too, it’s unclear whether Congressional support is needed. Either way, the risk of tariffs going up in both countries would be significant.

Immigration was an important issue in Trump’s platform. Here, the potential impact of immigration curbs may be limited since the size of the Mexican immigrant population in the US has stabilized in recent years. Indeed, a recent study by the Pew Research Center showed that more Mexican immigrants have returned to Mexico than have migrated to the US since the end of the financial crisis.

On the other hand, deportation of illegal immigrants could have an impact on the US labor force. The Migration Policy Institute believes that Mexico accounts for more than half of the estimated 11 mln illegal immigrants residing in the US, or about 3.5% of the population. It’s worth noting that Mexico’s share has been declining while the share from Central America, Asia, and sub-Saharan Africa has been rising.

Pew estimates that the US civilian workforce included 8 mln illegal immigrants in 2014. This accounts for 5% of those working or looking for work in the US. With the US approaching full employment, any shrinkage of the labor force stemming from deportation would likely put upward pressure on wages. This would have a pass-through effect on prices.

MEXICAN POLICY OUTLOOK

The last coordinated policy response to peso weakness back in February was a combination of rate hikes, spending cuts, and discretionary FX intervention. The Finance Ministry and central bank held a press conference today in an effort to reassure investors and markets, but no new measures were announced.

Banxico holds a regular policy meeting on November 17. We think it’s likely to hike rates 50 bp to help limit inflation pass-through. Earlier today, October CPI came in at 3.1%, above the 3% target but within the 2-4% target range. This is the highest since April 2015, and is likely to move higher due to the weak peso. Core inflation was 3.1% y/y in October, while PPI ex-oil rose 6.7% y/y. All these measures are expected to accelerate.

After the 50 bp intra-meeting hike in February, Banxico followed up with 50 bp hikes in June and September. Another 50 bp next week would take the policy rate up to 5.25%, the highest since May 2009. The pre-crisis high for this rate was 8.25%, before Banxico embarked on an aggressive easing cycle starting January 2009.

The Mexican economy is already sluggish. Further measures to support the peso are likely in the coming days or weeks, which would act as further headwinds on the economy. After the February fiscal measures, incoming Finance Minister Meade added another package of spending cuts upon taking his post back in September.

Then, the official 2017 growth forecast was cut to 2-3% from 2.6-3.6% forecast back in April. We think the forecast will have to be cut again significantly, and that will lead to further pressure to tighten fiscal policy. Such pro-cyclical moves are not desirable, and will further weigh on the growth outlook.

ECONOMIC IMPACT

If the US were to exit NAFTA, the negative impact on the Mexican economy would be large. Exports account for almost a third of Mexico’s GDP, with most of those going to the US. In 1990, this ratio was less than half that, at around 15%. NAFTA was a major factor behind the growth of Mexico’s external sector, and so less trade would harm the Mexican export sector and overall growth in general.

A US exit from NAFTA or renegotiated terms would most likely lead to higher tariffs and inflation in both countries. Freer trade typically benefits the smaller, more open economy more than the larger, less open one. The negative impact of less free trade would thus be greater on the smaller, more open economy, Mexico. Banco de Mexico is facing increased price pressures from the weak peso, and may have to grapple with an added boost to inflation from higher tariffs.

INVESTMENT OUTLOOK

The peso has become the worst EM performer in 2016. So far this year, MXN is -13.4% YTD and is tied with ARS as the worst. TRY is -9.4% YTD, followed by CNY at -4.4% YTD. Our EM FX model shows the peso to have WEAK fundamentals, so this year’s underperformance should continue.

USD/MXN traded at a new all-time high near 20.78 in overnight trading before falling back to below 20 currently. Volatility is likely to remain elevated, while further weakness appears likely as uncertainty over what a Trump presidency really entails will continue well into next year.

Mexican equities have underperformed this year after a decent 2015. Last year, MSCI Mexico was -15% while MSCI EM was -16.6%. So far in 2016, MSCI Mexico is -5.5% YTD, and compares to +10% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Mexico at an UNDERWEIGHT position.

Mexican bonds have underperformed this year. The yield on 10-year local currency government bonds is +27 bp YTD. This is ahead of only the Philippines (+58 bp), the worst EM performer overall. With inflation likely to continue rising and the central bank forced to hike rates further, we think Mexican bonds will continue underperforming.

Our own sovereign ratings model gives Mexico an implied rating of BBB+/Baa1/BBB+.   As such, both S&P and Fitch both appear to have it correctly rated. Moody’s seems to have been a bit premature in upgrading it to A3 back in February 2014. Indeed, it warned today that Trump’s victory would be credit negative if it were to hurt trade and financial flows. Moody’s moved the outlook on its A3 rating from stable to negative back in March.