Mexico Likely to Remain Under Pressure From Heightened Political Risks

mexico

Leftist candidate Andres Manuel Lopez Obrador (AMLO) holds a commanding lead in the polls.  Elsewhere, various developments suggest that a completing NAFTA deal is now unlikely.

POLITICAL OUTLOOK

Elections will be held July 1 and the most recent polls show AMLO’s support holding above 50%.  The latest Reforma poll comes after the second presidential debate and shows AMLO with 52%.  PAN candidate Ricardo Anaya remains a distant second at around 26% and PRI candidate Antonio Meade third with 19% support.  The margin of error is 3.8 percentage points.

It’s worth noting that this Reforma poll excludes undecided voters, which remain significant.  According to an El Financiero poll last month, undecided voters make up nearly 30% of the electorate.  Some believe these voters will not show up on July 1.  Others believe they will vote for whoever is polling second to prevent AMLO from winning.  We won’t know until July 1.

A separate Mitofsky poll suggests that AMLO’s coalition has a shot at winning a congressional majority.  A leftist alliance headed by his Morena party could win between 236-298 seats in the 500-seat lower house.  It could also win between 51-73 seats in the 128-seat Senate.

President Pena Nieto and his PRI are hobbling into the July elections.  Even though Pena Nieto can only hold one 6-year term, the PRI has been hurt by his ongoing corruption allegations, as well as a perceived failure to respond more forcefully to President Trump’s rhetoric.  As a result, polls suggest PRI will fall to third place in congress.

Mexico just announced retaliatory tariffs on US pork, steel, and whisky.  This was in response to US tariffs on Mexican steel and aluminum on national security grounds.  Mexico has also said it will go to the WTO over the US measures, and we expect other countries to follow suit.  Recent reports also suggest the US wants separate NAFTA talks with Canada and Mexico.  We do not believe either country will play into this US strategy of “divide and conquer.”

Under these deteriorating conditions, our base case is that there is no NAFTA deal this year.  What’s worse, tensions are likely to worsen if AMLO wins, as his approach to President Trump is likely to be more confrontational.  Indeed, all the candidates took a tough line against Trump in the most recent debate.

We continue to believe that if AMLO wins, he will be more like Lula than Chavez.  Whilst some of his rhetoric concerning the petroleum sector have raised eyebrows, AMLO has often walked back these comments.  Reports suggest AMLO could tap veteran policymaker (Banxico Governor and Minister of Finance) Guillermo Ortiz to join his cabinet.  Furthermore, we believe Mexico’s institutional framework is strong enough to withstand any efforts to install Chavismo.

Mexico scores very 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 registering property and paying taxes.  However, Mexico does much worse in Transparency International’s Corruption Perceptions Index (135 out of 180) and tied with Dominican Republic, Honduras, Kyrgyzstan, Laos, Papua New Guinea, Paraguay, and Russia. 

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.  Cuauhtemoc 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 was also 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 to 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 will be the first time that Morena has 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.  He 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%.

ECONOMIC OUTLOOK

The economy remains sluggish.  GDP growth is forecast by the IMF at 2.3% in 2018 and 3.0% in 2019 vs. 2.0% in 2017.  GDP rose only 1.3% y/y in Q1, down from 1.5% peak in Q4 and the weakest since Q4 2013.  As such, we see downside risks to the growth forecasts.  Trade tensions are also likely to be a headwind on the economy.

Price pressures are falling.  CPI rose 4.55% y/y in April, the lowest since December 2016 but still above the 2-4% target range.  May CPI data will be reported Thursday, with inflation seen easing still to 4.47% y/y.  Banxico acted quickly and aggressively over the past year, but we think it would prefer not to hike any more.  It may not have a choice, however.

After a six-month pause, the central bank restarted the tightening cycle with a 25 bp hike to 7.25% in December.  It followed up with another 25 bp hike in February but has since been on hold at 7.5%.  Next policy meeting will be held June 21, and much will depend on how the peso is trading then.  If this current bout of weakness persists, then we think another rate hike ahead of the election is likely.

The fiscal outlook has improved.  With oil accounting for around 20% of government revenues, there are clear upside risks to the budget forecasts.  The budget deficit was equal to -3% of GDP in 2017, and the IMF expects it narrow to -2.8% in 2018 and -2.5% in 2019.

The external accounts remain solid. The current account deficit was -1.7% of GDP in 2017, and the IMF expects the deficit to widen modestly to -1.9% in 2018 and -2.2% in 2018.  It is not clear yet what the overall impact of tariffs will be on Mexico’s trade balance.  Foreign remittances remain solid, if not spectacular.  So too does FDI.

Foreign reserves have remained fairly steady, near $173 bln in May.  They cover over 4 months of imports and are equivalent to 3 times the stock of short-term external debt.  Overall, Mexico’s external vulnerabilities are relatively low.  The notable exception is the nation’s Net International Investment Position (NIIP) that’s equal to -50% of GDP.

Banco de Mexico started a new $20 bln FX hedging facility back in February 2017.  It is very much like the swaps program used by Brazil, and should allow Banxico to influence the FX market without impacting its foreign reserves.  The central bank takes on FX risk but pays out in local currency so there is no drain on its FX reserves.

INVESTMENT OUTLOOK

The peso continues to underperform.  In 2017, MXN rose 5% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), PHP (-0.5%), COP (+0.5%), PEN (+4%), and RUB RON (+5%).  So far in 2018, MXN is -3% and is ahead of only the worst performers ARS (-25%), TRY (-17%), BRL (-13%), RUB (-7%), PHP (-5%), and INR (-4.5%).  Our EM FX model shows the peso to have WEAK fundamentals, and so we expect this underperformance to continue.

USD/MXN has broken above the key level of 20.2860.  Break above that 62% retracement objective sets up a test of the January 2017 high near 22.0385.  We expect the central bank to issue more FX swaps in the coming weeks to help support the peso.  However, within a context of a broad-based EM bear market, the peso is still likely to weaken.

The net long speculative position in the Mexican peso futures fell to a multi-year low of 18.3k contracts for the week ending May 29.  This was a decrease of 13.2k contracts from the previous week and continues a seven-week decline to the lowest since May 2017.  It reflected the bulls liquidating 5.5k contracts, bringing the gross long position down to 73.2k contracts, the lowest since March 2017.  The bears added another 8k to their gross short position, lifting it to a new high for the year of 55k.

Mexican equities continue to underperform.  In 2017, MSCI Mexico was up 11% vs. 34% for MSCI EM.  So far this year, MSCI Mexico is -10% YTD and compares to -0.2% YTD for MSCI EM.  Our EM Equity Allocation Model puts Mexico at VERY UNDERWEIGHT, and so we expect Mexican equities to continue their underperformance.

Mexican bonds are around the middle of the EM pack.  The yield on 10-year local currency government bonds is +17 bp YTD.  This compares to the worst EM performers Turkey (+345 bp) and Brazil (+210 bp), as well as the best performers China (-21 bp) and Russia (-11 bp).  With the weak peso likely to feed into higher inflation and the central bank possibly hiking rates again, we think Mexican bonds will underperform near-term.

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