Mexico’s Contradictory Outlook

We expect Mexican assets to continue underperforming in the short term, along with the bearish EM environment and downside risks to oil prices. However, we remain positive on Mexico’s medium-term prospects.

INTRODUCTION

Mexico is a case of many contradictions and oddities. The effective policy management is counterbalanced by high asset price volatility, while the relatively good economic backdrop is often overshadowed by drug-related violence and corruption scandals. Overall, we expect Mexican assets to continue underperforming in the short term, along with the bearish EM environment and downside risks to oil prices. However, we remain positive on Mexico’s medium-term prospects.

ECONOMIC OUTLOOK

The economy is holding up OK. GDP is expected to accelerate to 2.6% this year and then to 3.2% next year, while the unemployment rate mostly stayed sub-5% for the last few years. Moreover, we see Mexico as being in a better position than many other oil exporters are with regards to rebalancing its economy from energy to industrialized exports. Its proximity to the US, along with the potential positive impact of lower energy prices on US consumption, could help make up for some of its challenges. The weaker peso will also help.

Moreover, Mexico continues to push ahead with the modernization of its oil industry. Today, Mexico holds its first oil field auction since 1938. This is another major step towards regaining its position as an important player in the global energy market after a decade of steady decline. Last year, Brazil’s production rose above Mexico’s for the first time in history, but the gap is already closing again (see graph below).

Interestingly, Pemex will not participate in today’s auction. The decision seems to be less political/procedural and more practical. Instead of entering into a new venture, the company will focus on conserving cash and creating partnerships to streamline existing projects. Other companies have also pulled out after the government announced a requirement that bidders have one partner to act as guarantor for at least $6 billion of shareholder equity. Still, there still seems to be plenty of interest for today’s historical event.

At the same time, the government has been very proactive in dealing with the changing environment. For example, it announced cuts of $8.3 bln for the 2015 budget to counteract the shortfall from lower oil prices, which account for around 1/3 of its budget. Meanwhile, the central bank has explicitly anchored its rate cycle around the Fed’s, giving at least some degree of predictability to its reaction function. It has also kept inflation under control, falling slightly below the 3% inflation target despite the upside risks from the weaker peso.

POLITICAL OUTLOOK

Yet despite this relatively positive economic backdrop, the government is under a lot of pressure. The recent prison escape by drug kingpin Guzman is the latest black eye for the government of President Pena Nieto. Guzman’s second (yes, second) escape from a maximum security prison simply confirms the worst suspicions about corruption in the nation. Halfway through his six-year term that ends in 2018, Pena Nieto will have to work hard to get past this latest setback. He was already under fire for the student kidnappings and growing corruption scandals.

These political problems have not yet been expressed in polls, but they surely will be at some point. In that regard, Pena Nieto should be happy with the results of the recent midterm elections. Despite his growing unpopularity, the PRI did well in taking the largest share of the votes with 29%. PAN won 21% of the vote, while a split in the leftist opposition PRD could continue to help the PRI. With Andres Manuel Lopez Obrador splitting off to form the Morena party, the PRD only got 11% of the vote and lost a dozen seats in the lower house. Morena won around 8% of the vote.

Interestingly, independent candidate Jaime Rodriguez (El Bronco) won the governorship of Nuevo Leon, reflecting perhaps growing discontent with the traditional parties. There is no clear frontrunner yet for the 2018 presidential race. Perhaps this is a sign of things to come.

INVESTMENT OUTLOOK

At the same time, the peso remains well within the high-beta camp despite the good macroeconomic management. The peso has fallen nearly 18% over the last 12 months, ranking amongst the worst performers. Curiously, we suspect that part of this volatility comes from Mexico’s own success. With rates at 3.0%, it doesn’t have the interest rate buffer that Brazil, Turkey, India, or South Africa has. Moreover, the typical daily volume is somewhere around $10-15 bln in spot and, $5-10 bln in forward markets. This is about the same of Brazil, even though Mexico’s economy is about 35% smaller.

But probably the most important factor is that the peso is freely tradable, in contrast to the other currencies in the region. We note that the CFTC reports that for the latest week ended July 7, the non-commercial (speculative) community has built up a record high net short MXN position of -72415 contracts. Long contracts have remained fairly steady around 30000 after the April plunge, but short contracts have risen to a record high -96482. While it may be tempting to say this is purely a bearish MXN call, we do think part of this is that MXN is being used as a proxy for the wider EM class.

Mexico’s equity market has lagged this year, with MSCI Mexico -2.8% YTD vs. -2.2% for MSCI EM. We expect this to continue, and note that our EM equity model has tapped Mexico to underperform within EM over the next three months.