Mexico’s Outlook Remains Cloudy

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While markets are no longer panicking about Mexico, the outlook for the nation remains cloudy.  The economy is slowing even as price pressures rise, while oil prices are sinking due to supply concerns.  Political risks will likely pick up as the 2018 elections approach.POLITICAL OUTLOOK

The next national elections will be held in June 2018.  At this point, polls suggest Morena candidate Andres Manuel Lopez Obrador (AMLO) is currently leading the field.  Former First Lady Margarita Zavala is the likely PAN candidate, but she could be challenged by PAN leader Ricardo Anaya.  The ruling PRI’s likely candidate is Interior Minister Angel Osorio Chong, while the leading PRD candidate is Miguel Mancera.

While it is way too early to get nervous, an AMLO victory would not be taken well by the markets.  He is a breakaway from the leftist PRD, which has never held the presidency.  However, AMLO came close to winning in 2006, losing by a slim margin in controversial results as PAN’s Calderon won by only 244k votes (or 0.58 percentage points).

AMLO has come to represent a more nationalist brand of politics and this would very likely stoke tensions with the US.  Indeed, part of his popularity stems from perceptions that he would stand up better against Trump than Pena Nieto has.

Elections in the state of Mexico will be held on June 4.  It is the most populous state in the country, and home of current PRI President Pena Nieto.  The PRI has held the governorship of Mexico state for more than 80 years, and last won in 2011 with over 61% of the vote.  PRI candidate Alfredo del Mazo Maza is not only the son and grandson of previous governors, he is also the cousin of Pena Nieto, facts that are not lost on his opponents.

That polls suggest a close race between the Morena and PRI candidates show just how badly things have been going for the ruling party.  While a lot can happen between now and June 2018, the results of this state election should provide some important clues for the national elections.  Formed in 2014, Morena has yet to win any gubernatorial races.  A win in Mexico state would surely give AMLO and Morena a national boost.

Structural reforms have basically stalled after the oil sector was opened up back in 2013.  While Mexico scores fairly well in the World Bank’s Ease of Doing Business rankings (47 out of 190 but down from 45 last year), it does very poorly in Transparency International’s Corruption Perceptions Index (123 out of 176).

Relations with the US remain in flux.  The status of the border wall is in doubt after the most recent budget compromise contained no funding for it.  Likewise, the so-called Border Adjustment Tax was left out of the budget compromise.  Elsewhere, President Trump was reportedly ready to withdraw unilaterally from Nafta before reconsidering in favor of renegotiations.  Members of his economic team (Mnuchin, Ross) have been more constructive (and less confrontational) on US-Mexico relations.

ECONOMIC OUTLOOK

The economy is still sluggish as several rounds of monetary and fiscal tightening bite.  GDP growth is forecast by the IMF to decelerate modestly to 1.7% in 2017 from 2.3% in 2016, before picking up to 2% in 2018.  GDP rose 2.4% y/y in Q4, while monthly data so far in Q1 suggest some acceleration.  However, this latest leg down in oil suggests some downside risks to the growth forecasts.

Price pressures bear watching, with CPI accelerating to 5.82% y/y in April from 5.35% in March.  This is the highest rate since June 2009, and moves inflation further above the 2-4% target range.  Food prices are climbing quickly (due in part to spiking avocado prices from a poor harvest), but we note that core inflation of 4.7% y/y is the highest since August 2009.

While this supports the case for higher rates, we believe Banco de Mexico will remain on hold at its May 18 meeting.  It has already hiked a total of 350 bp since December 2015, and probably would like to pause a bit and assess the situation.  If the Fed hikes June 14, then we believe Banco de Mexico will likely follow up with a 25 bp hike to 6.75% at its June 22 meeting.

Fiscal policy has remained prudent despite low oil prices.  Oil revenues account for around a third of government revenue.  As such, the drop in oil prices necessitated several rounds of fiscal tightening.  The budget surplus came in at an estimated -2.6% of GDP in 2016, down from -3.5% 2015.  It is expected to remain around -2.5% of GDP in both 2017 and 2018.

The external accounts should improve.  Low oil prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was about -3.5% of GDP in 2016, and is expected to narrow to -2.5% in 2017 before widening to -2.7% in 2018.  However, the gap will likely be covered entirely by FDI inflows.  Foreign remittances remain strong, rising 15% y/y in March.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $175 bln in April, they cover nearly 4 ½ months of import and are nearly 3 times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The peso has done much better after an awful 2016.  In 2016, MXN fell -16% vs. USD and was ahead of only the worst performers ARS (-18%) and TRY (-17%).  So far in 2017, MXN is up 8% YTD and is the top EM performer.  The next best are TWD (+7%) and KRW (+7%).  Our EM FX model shows the peso to have WEAK fundamentals, so this year’s outperformance is likely to ebb.

USD/MXN has been unable to reach pre-election lows, with strong support seen around 18.50.  Retracement objectives from the January-April drop come in near 19.8250 (38%), 20.2475 (50%), and 20.6700 (62%), while the 200-day moving average comes in near 19.64 currently.  With oil prices softening and political risks rising, we see more upside ahead for USD/MXN.

Mexican equities are performing like the rest of EM after an awful 2016.  In 2016, MSCI Mexico sank -12% vs. +7% for MSCI EM.  So far this year, MSCI Mexico is up 16% YTD and compares to 15% YTD for MSCI EM.  This modest outperformance should ebb, as our EM Equity model has Mexico at a VERY UNDERWEIGHT position.

Mexican bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -16 bp YTD.  This is in the middle of the EM pack.  The worst performers are China (+60 bp), India (+43 bp), and Romania (+39 bp), while the best are Argentina (-220 bp), Brazil (-123 bp), and Colombia (-89 bp).  With inflation likely to continue rising and the central bank forced to tighten further, we think Mexican bonds will start underperforming more.

Our own sovereign ratings model showed Mexico’s implied rating fell a notch to BBB/Baa2/BBB this quarter.  As such, actual ratings of BBB+/A3/BBB+ are facing growing downgrade risks.  However, the agencies may wait to see how US-Mexico economic relations actually develop under President Trump before making any moves.