Mexico Risks Should Keep Investors Cautious

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President Peña Nieto will reportedly send his nominee for Banco de Mexico governor to the Senate for confirmation next week.  Next month, the ruling PRI will officially name its presidential candidate.  While neither event carries much risk, we note that uncertainties facing Mexico should keep investors cautious.    

POLITICAL OUTLOOK

Banco de Mexico Governor Augustin Carstens steps down November 30 to lead the Bank for International Settlements (BIS).  Finance Minister Meade is now considered a leading contender to replace Carstens, but this will also hinge on his possible candidacy for President (see below).

One of the four Deputy Governors could also be named to replace Carstens.  One that’s often mentioned is Alejandro Diaz de Leon, who was the head of the Finance Ministry’s public debt office before becoming Deputy Governor last December.

Whomever is chosen, however, we expect continuity in monetary policy.  While having someone from the government move to the central bank might raise eyebrows, it was done successfully by Guillermo Ortiz back in 1998.  After serving as Finance Minister, Ortiz went on to serve two successful terms as Governor.

The next national elections will be held on July 1, 2018.  Morena (PRD breakaway party) candidate is Andres Manuel Lopez Obrador (AMLO).  Former First Lady Margarita Zavala left the PAN and is running as an independent.  PAN and PRD are trying to form a coalition (Citizen Front for Mexico), but this will be very difficult given where the two parties stand on the political spectrum.  Zavala’s exit adds to the difficulties of fielding a joint candidate, but the likely contender is thought to be PAN leader Anaya.

The ruling PRI will name its presidential candidate in December.  Pena Nieto cannot run again due to term limits.  The likely PRI candidates are either Finance Minister Meade or Interior Minister Angel Osorio Chong.  Some believe Education Minister Aurelio Nuno is in the running.  All are cut from the same cloth as Pena Nieto, and therein lies the problem.  Why?

The latest poll from El Universal shows AMLO still leading the field with 29-31% support.  It seems voters in Mexico are tired of the status quo and perhaps willing to bring in an unknown quantity in AMLO.  Zavala is running second with 26-27% support, followed by Anaya with 18%.  Nevertheless, PRI is likely to remain the biggest party in Congress, followed by PAN.  Morena is likely to overtake PRD to become the third largest party in Congress.

A victory for AMLO would be taken negatively by markets.  Mexico has never been led by a leftist president.  Indeed, PRI has ruled the country throughout its modern history, except for the two terms won by center-right PAN (2000-2012).  A strong showing for Morena in Congress would add to the political uncertainty.

Mexico scores well in the World Bank’s Ease of Doing Business rankings (49 out of 190).  The best components are getting credit and resolving insolvency, while the worst are paying taxes and registering property.  Mexico does less well in Transparency International’s Corruption Perceptions Index (123 out of 176 and tied with Azerbaijan, Djibouti, Honduras, Laos, Moldova, Paraguay, and Sierra Leone).

ECONOMIC OUTLOOK

The economy is still sluggish as several rounds of monetary and fiscal tightening continue to bite.  GDP growth is forecast by the IMF to decelerate modestly to 2.1% in 2017 and 1.9% in 2018 vs. 2.3% in 2016.  GDP rose 1.9% y/y in Q2, the weakest rate since Q4 2013.  Monthly data so far in Q3 suggest some further slowing, and so we see some downside risks to the growth forecasts.

Price pressures bear watching, with CPI accelerating again to 6.4% y/y in October from 6.3% in September.  This comes after inflation decelerated in September for the first time since June 2016.  Inflation has been above the 2-4% target range since January.  Carstens’ successor will inherit a difficult backdrop for monetary policy, and will have to balance high inflation and slow growth.

The inflation risks support the case for keeping rates high, and we believe Banco de Mexico will keep rates at the current 7% until well into 2018.  This will come at a cost of slower growth, and we cannot rule out another hike if the peso comes under greater pressure.  Next policy meeting is December 14, and no change is expected.  It could get a bit tricky if the Fed hikes December 13, as widely expected.  Note that Banco de Mexico has been on hold since a 25 bp hike to 7.0% at its June 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 overall fiscal deficit came in at an estimated -2.8% of GDP in 2016, down from -4.1% in 2015.  The IMF expects it to narrow to -1.4% of GDP in 2017 before widening to -2.5% in 2018, but we think much will depend on oil prices.

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 -2.2% of GDP in 2016, and the IMF expects it to narrow to -1.8% in 2017 before widening to -2.4% in 2018.  Still, the gap will likely be covered almost entirely by FDI inflows.  Foreign remittances remain strong, with the 12-month total of $28.2 bln in September at record highs.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $172.8 bln in October, they cover nearly 4 ½ months of import and are over 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 7.6% YTD and is behind only KRW (+8.6%) and THB (8.4%).  Our EM FX model shows the peso to have VERY WEAK fundamentals, so this year’s outperformance is likely to ebb.

USD/MXN has traded largely in the 18.50-19.50 range since October.  Since November began, that range narrowed to roughly 19.00-19.25 before today’s breakout to the upside.  To put things in perspective, the pair has only retraced a third of its drop this year.  Major retracement objectives of the January-July drop in USD/MXN come in near 19.7445 and 20.2860.

Mexican equities are still underperforming EM after an awful 2016.  In 2016, MSCI Mexico sank -12% vs. +7% for MSCI EM.  So far this year, MSCI Mexico is up 11.5% YTD and compares to 30% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Mexico at a VERY UNDERWEIGHT position.

Mexican bonds have performed OK this year.  The yield on 10-year local currency government bonds is about -9 bp YTD.  This is in the middle of the EM pack.  The worst performers are Czech Republic (+138 bp), Turkey (+96 bp), and China (+94 bp), while the best are Indonesia (-124 bp), Peru (-108 bp), and Hungary (-93 bp).  With inflation likely to continue rising and the central bank forced to remain hold or even tighten further, we think Mexican bonds will start underperforming more.

Our own sovereign ratings model shows Mexico’s implied rating remaining steady at BBB/Baa2/BBB.  Actual ratings of BBB+/A3/BBB+ are still facing downgrade risks, and we disagree with Fitch recently moving the outlook from negative to stable.