Banco de Mexico meets Thursday and is expected to hike rates 25 bp to 8.25%. Yet there are risks of a dovish surprise. AMLO inherits an economy that is struggling under the weight of tight fiscal and monetary policies under his predecessor. Low oil prices aren’t helping matters.
President Andres Manuel Lopez Obrador (AMLO) took office on December 1 and began serving a single 6-year term. He is the first leftist president in modern Mexican history and so markets are very sensitive to his policy agenda. So far, AMLO has been sending the wrong signals.
Even before taking office, AMLO roiled markets with several controversial moves. One was the so-called “referendum” on the Mexico City airport project, while the second was the controversial move to eliminate some bank fees. AMLO has sought to minimize the damage but we think investor confidence will be hard to win back. This is especially so considering AMLO is planning to hold two more “referendums” in other areas of the economy.
The incoming US House may reopen USMCA (NAFTA 2.0). This injects a bit of uncertainty into the trade outlook. While we do not expect any wholesale changes, the uncertainty may delay some investment decisions and other critical business planning.
Congressional, provincial, and municipal elections will be held in 2021. AMLO’s Morena party and its allies currently hold 314 seats in the 500-seat lower house, and 70 seats in the 128-seat Senate. The congressional results from the July election show that voters overwhelmingly supported AMLO, at the expense of the traditional PAN and PRI.
A BRIEF HISTORY LESSON
The National Revolutionary Party (NRP) was founded in 1929 and unified all the military and political factions that came out of the so-called Mexican Revolution. It was later renamed the Mexican Revolutionary Party and then the Institutional Revolutionary Party (PRI). Single-party rule was the name of the game, though electoral reforms in the 1970s planted the seeds for eventual democracy. The National Action Party (PAN) was founded in 1939 but did not become relevant until the 1980s.
The 1988 elections presented the first serious threat to the PRI. Cuauhtémoc Cardenas, son of President Lazaro Cardenas (1934-1940) had defected from the PRI to run as the candidate of a leftist coalition of parties. The official count had Cardenas winning 31.1% of the vote vs. 50.4% for PRI candidate Carlos Salinas. However, some believe Cardenas actually won and that the results were altered. The PRI came within 11 seats of losing its majority in the Chamber of Deputies, which supports the case for possible fraud in the presidential count.
Further electoral reforms led to what many consider to be the first free and fair election in 1994. PRI candidate Ernesto Zedillo won 50.2% of the vote vs. 26.7% for PAN candidate Diego Fernandez. After the 1988 elections, Cardenas formed the Party of the Democratic Revolution (PRD) and he won 17.1% of the vote as its candidate in 1994.
Note that Zedillo was the replacement candidate for Luis Donaldo Colosio, who was assassinated in March 1994. Zedillo and the PRI were thought to have benefitted from a sympathy vote and desire for stability, as Colosio’s death came just as the Zapatista uprising in the state of Chiapas was spreading.
Nevertheless, Zedillo’s share of the vote was the lowest for the PRI since its inception and foreshadowed the 2000 elections. That year, Vicente Fox of PAN became the first opposition leader of Mexico since the PRI was created, winning 43% of the vote vs. 36% for PRI candidate Labastida and 17% for PRD candidate Cardenas. The PAN alliance became the largest bloc in the lower house, while PRI continued to dominate the Senate.
PAN continued its streak in the controversial 2006 election, with Felipe Calderon winning with 35.9% of the vote. AMLO won 35.3% of the vote as the PRD candidate, while PRI candidate Roberto Madrazo came in a distant third with 22% of the vote. The Federal Electoral Institute declared the race too close to call in its preliminary (PREP) count on July 2.
Both Calderon and AMLO claimed victory, but the official count on July 6 showed Calderon was the winner. The final difference between the two candidates was 243,934 votes (or 0.58 percentage points). PAN once again dominated in the lower house and won the Senate as well.
AMLO refused to accept the result, alleging irregularities at over 30% of the polling stations. He called on his supporters for nationwide protests but was unable to reverse the decision. After numerous and largely peaceful protests, the Federal Electoral Court upheld Calderon as the winner on September 5.
AMLO ran again in 2012 under the PRD banner, losing by a somewhat larger margin (38%-32%) to PRI candidate Pena Nieto. AMLO left the PRD after the 2012 elections and founded the National Regeneration Movement (Morena) in 2014. This year was the first time that Morena fielded any candidates for national elections.
Once upon a time, AMLO followed a more orthodox path. He began his career with the PRI in the state of Tabasco. He eventually defected to the PRD and was the 1994 candidate for Governor of Tabasco. AMLO then became the mayor of Mexico City in 2000, where he developed a solid reputation that put him on the national stage in 2006. AMLO left that post with an approval rating above 80%.
The economy remains sluggish. The IMF expects GDP growth of 2.2% this year and 2.5% next year vs. 2.0% in 2017. GDP rose 2.5% y/y in Q3, down from the cycle peak of 2.6% y/y in Q2. Data so far in Q4 suggest the slowdown has intensified. Both manufacturing and non-manufacturing PMIs fell below 50 in November, suggesting downside risks to these growth forecasts.
Price pressures are easing but remain high. CPI rose 4.7% y/y in November, the lowest since June but still above the 2-4% target range. However, the 3-month annualized rate accelerated to 7.2% in November, the highest since January. With the peso still vulnerable, there are risks that the inflation readings move higher in the coming months. PPI rose 7.2% y/y in November. While down from the 9.2% y/y peak in June, PPI still suggests potential for further acceleration in CPI inflation.
Banco de Mexico meets Thursday and is expected to hike rates 25 bp to 8.25%. Yet the market is split and there are risks of a dovish surprise. Of the 23 analysts polled by Bloomberg, 7 see steady rates and 16 see a 25 bp hike. We lean towards a hike. While the peso has firmed this week, it remains vulnerable to a multitude of factors and we think a preemptive hike would be a good signal.
The central bank sees inflation remaining above the 2-4% target range until H2 2019, longer than previously forecast. In its November quarterly inflation report, end-2018 inflation is now seen at 4.7% y/y vs. 4.2% previously but the bank kept its end-2019 forecast near 3%. The bank also cut its 2019 growth forecast slightly to 1.7-2.7% from 1.8-2.8% previously.
The bank warned that “Public policy decisions could generate greater concern in the market and a sustained loss of confidence in Mexico as a destination for investment.” While correct, this is a highly unusual comment for a central bank, in our view. However, the bank has made a strong link between the weak peso and stubbornly high inflation and so perhaps feels compelled to sound this warning.
AMLO inherits a solid fiscal position. The Finance Ministry forecasts a budget deficit equal to -2.5% of GDP in 2018 vs. -1.1% in 2017. Market consensus sees the deficit remaining steady at -2.5% of GDP in 2019.
AMLO appears to have delivered a sensible budget for 2019. He proposed more spending on social programs but still preserved a primary surplus equal to 1% of GDP. This translates into an overall deficit equal to -2.5% of GDP. The budget assumes 2% growth, 3.4% inflation, an exchange rate of 20 pesos per USD, and oil prices of $55 per barrel for its crude exports.
The oil outlook is very important for the budget. Revenues and royalties from the oil sector account for nearly a third of total budgetary revenue. Mexican crude has averaged $62.60 in 2018, but currently is trading near $50.75, well below the $55 assumed in next year’s budget.
Despite the planned OPEC+ output cuts, oil is making new lows for the year. WTI oil is leading this move down, with a new low seen just below $47 today. Break of the $45.45 area would set up a test of the February 2016 low near $26.05. Brent is holding up relatively better, but it is also sliding alongside WTI.
AMLO raised Pemex’s budget for 2019 to MXN464.6 bln in the hopes of reversing the secular drop in oil production. Within that plan, Pemex would spend MXN211 bln for exploration and production, a 25% increase from 2018. AMLO has said that the goal is for Pemex to boost crude output to 2.4 mln bbl/day from 1.65 mln currently. We note that increased funding for the labor and energy ministries came at the expense of the agriculture, communications and transportation, and environmental ministries.
The external accounts are improving. The IMF sees the current account deficit narrowing to -1.3% of GDP both this year and next from -1.6% in 2017. The 12-month total trade deficit has started to widen again after narrowing in September. With oil prices sliding again, we see risks that the external deficits will come in worse than forecast.
Foreign reserves have stabilized. At $173.8 bln in November, reserves cover more than 4 months of imports and are equivalent to nearly 3.5 times the stock of short-term external debt. This suggests relatively low external vulnerabilities. Mexico’s Net International Investment Position is -46% of GDP, however.
The peso is outperforming after a horrible 2017. Last year, MXN rose 5% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR, PHP, COP, PEN, and RUB. So far in 2018, MXN is -2% and is behind only the best performer THB (-0.5%). Our EM FX model shows the peso to have WEAK fundamentals, and so we expect this outperformance to ebb.
USD/MXN is testing support near the 20 level. However, with oil prices slumping and EM FX vulnerable to further selling, we believe the pair will eventually reverse to test the June high near 20.9605.
Mexican equities continue to underperform. In 2017, MSCI Mexico was up 11% vs. 34% for MSCI EM. So far this year, MSCI Mexico is -18.5% YTD and compares to -16.5% YTD for MSCI EM. With growing risks of an economic slowdown, we expect Mexican equities to continue underperforming. This supports the UNDERWEIGHT in our EM Equity Allocation model.
Mexican bonds have underperformed. The yield on 10-year local currency government bonds is +113 bp YTD and is behind only the worst EM performers Argentina (+665 bp), Turkey (+552 bp), Indonesia (+179 bp), Hungary (+124), and Russia (+120 bp). With inflation likely to remain high and Banxico remaining in a tightening cycle, we think Mexican bonds will continue to underperform.
Our own sovereign ratings model showed Mexico’s implied rating remained steady at BBB/Baa2/BBB. Actual ratings of BBB+/A3/BBB+ are still facing downgrade risks, but much will depend on the policies of AMLO. Lower oil prices are also likely to weigh on many of the macro ratios of the economy, which could trigger downgrades.