Reality Check for Mexico

Despite initial optimism over the renegotiated trade deal with the US, the Mexican peso has come under renewed pressure. Clearly, Mexico cannot decouple from the ongoing stresses on the wider EM. The weak peso is feeding into higher inflation and supports our view that Banco de Mexico may be forced to tighten again.

POLITICAL OUTLOOK

President Trump announced last month that the US and Mexico had reached a preliminary trade agreement. The two countries were able to resolve some major differences in the auto sector. Under the new deal, auto companies must produce at least 75% of the car’s value in North America vs. 62.5% previously. In addition, at least 40-45% of the car must be made by workers earning $16/hour or more.

Trump wants to get a new trade deal signed before current Mexican President Enrique Peña Nieto’s term ends December 1. The White House notified Congress that it planned to sign a deal with Mexico in 90 days and that Canada can “join if it is willing.”   By informing Congress on August 31, it allows outgoing President Peña Nieto to sign the agreement before incoming President Andrés Manuel López Obrador (AMLO) takes office. Many fear AMLO could add new demands that potentially derail it.

Furthermore, President Trump must deal with the US electoral calendar. Under congressional rules for trade agreements, the Trump administration must publicly release text of an agreement 60 days before any signing. The next US Congress will be inaugurated on January 3, 2019. If Trump wants the current Republican-led Congress to vote on it, then he must get Canada on board quickly to meet this 60-day requirement. Polls suggest that the Democrats will likely win the House in this November’s vote.

Canada and the US are scheduled to resume talks today. The previous round ended with no agreement last week. Here, the sticking points center around the dairy industry and the role of dispute panels. Most US businesses and farm groups are opposed to any deal that does not include Canada. Indeed, the head of the AFL-CIO just came out in favor of including Canada.

Total US trade with Canada was $535.6 bln in 2017. Exports totaled $235.6 bln and imports totaled $300 bln, resulting in a trade deficit of -$64.3 bln. On the other hand, total US trade with Mexico was $520.3 bln in 2017. Exports totaled $206.2 bln and imports totaled $314 bln, resulting in a trade deficit of -$107.8 bln.

President Trump said that he plans to terminate NAFTA when the new US-Mexico deal is approved. Indeed, he calls it the “United States-Mexico Trade Agreement.” Trump has favored bilateral deals over multilateral ones. Can the US proceed without Canada? President Trump has threatened as much and warned Congress not to interfere. Senator Ron Wyden, however, warned that the President cannot pull the US out of NAFTA without Congressional approval, echoing a widely held belief (more on this below).

 

A BRIEF HISTORY LESSON

The birth of NAFTA can be traced to President Ronald Reagan, who proposed a North American common market in his campaign for the 1980 election. Canadian Prime Minister Mulroney of the Progressive Conservatives and Reagan kicked off negotiations. In the US, Congress gave the President authority to negotiate this deal subject to Congressional review. The Canada-US Free Trade Agreement was eventually signed in 1988 and went into effect in 1989.

Mexican President Carlos Salinas de Gortari approached President George H.W. Bush to propose a similar bilateral agreement. However, Canada was reportedly worried that this would undermine its bilateral agreement and so requested in 1991 that Mexico be included in a trilateral agreement.

All three legislatures approved NAFTA in 1993. In the US, Congress voted on the so-called North American Free Trade Implementation Act. On November 17, the House vote was 234-200, with 132 Republicans and 102 Democrats in favor. Three days later, the Senate vote was 61-38, with 34 Republicans and 27 Democrats in favor. The Democrats held majorities in both houses and so it’s worth noting that more Democrats voted against NAFTA than for it.

NAFTA was also controversial in Canada. The pro-free trade Progressive Conservatives were nearly eliminated in the October 1993 elections, winning only 2 seats vs. 156 previously. The Liberals led by Jean Chretien won 177 seats, up from 81 previously. Chretien had campaigned on a pledge to renegotiate or kill NAFTA. Subsequent negotiations added two supplemental agreements, but Chretien was criticized for breaking his campaign promise.

President Bill Clinton signed NAFTA into law on December 8, 1993. While he had little to do with its conception, Clinton did push his fellow Democrats to pass NAFTA. However, it must be noted that it was conceived by a Republican President and passed by mostly Republican Senators and Congressmen. None other than House Majority Leader Richard Gephardt (D-MO) opposed NAFTA.

NAFTA went into effect on January 1, 1994. It established a free trade zone for goods and services between the US, Mexico, and Canada. Some tariffs were eliminated immediately, whilst others were phased out over 10-15 years. NAFTA also made cross-border investment easier, leading to a surge in Foreign Direct Investment (FDI).

Can the US unilaterally withdraw from NAFTA? Some believe that under Section 125 of the Trade Act of 1974, the President has the authority to unilaterally withdraw from trade agreements, including NAFTA. Others believe that because Congressional approval was needed to pass NAFTA, this means the President does not have the power to withdraw from NAFTA unilaterally. Either way, most expect a protracted legal and legislative battle if Trump attempts to do end it.

What about that “giant sucking sound?” Despite Ross Perot’s dire warnings during his 1992 presidential campaign, most economists believe that fears of massive job losses in the US have been overstated. Indeed, many studies suggest more jobs have been lost to automation than to Mexico.

 

ECONOMIC OUTLOOK

The economy is picking up. GDP growth is forecast by the IMF at 2.3% in 2018 and 2.7% in 2019 vs. 2.0% in 2017. GDP rose 2.6% y/y in Q2, the strongest since Q1 2017. As such, we see some modest upside risks to the growth forecasts.

Price pressures are rising again. CPI rose 4.81% y/y in mid-August, continuing the march higher from the trough of 4.5% in May and further above the top of the 2-4% target range. PPI rose 8.5% y/y in July, down from the 9.2% y/y peak in June but still quite high. August inflation data will be reported Thursday, with CPI expected to accelerate modestly to 4.85% y/y. We see upside risks.

Banco de Mexico paused its tightening cycle after the last 25 bp hike to 7.75% in June. The next policy meeting is October 4, and we expect a hawkish hold due to rising inflation risks as well as the still-vulnerable peso. After that, the next meetings are November 15 and December 20. Bloomberg consensus sees an easing cycle starting in Q1 2019, but we do not think the tightening cycle is over yet.

The fiscal outlook bears watching. While high oil prices will help boost revenues, AMLO comes into office pledging increased spending on social programs. Whether he implements these plans will be crucial. Bloomberg consensus sees the budget deficit widening to -2.2% of GDP in 2018 and -2.5% in 2019 from -1.1% in 2017.

The external accounts are worsening. The current account deficit was -1.7% of GDP in 2017, and the IMF expects the deficit to widen modestly to -1.9% this year and -2.2% in 2019. However, export growth has been slowing this year even as import growth picks up, leading the 12-month trade deficit to widen since March. This points to upside risks to the current account deficit.

Foreign reserves have stabilized. At $173.6 bln in August, reserves cover over 4 months of imports and are three times greater than its the stock of short-term external debt. On the other hand, Mexico’s Net International Investment Position (NIIP) is nearly -50% of GDP, which makes it more vulnerable to shifts in sentiment and so-called hot money. Banco de Mexico data show that as of the end of July, foreigners held 63% of the total outstanding government bonds. This is down slightly from the record high 66% held in 2017.

 

INVESTMENT OUTLOOK

The peso is outperforming after lagging in 2017. In 2017, MXN rose 5.5% 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 (+5%). So far in 2018, MXN is up 1% and is the best EM performer. Indeed, it’s the only EM currency that is up YTD against the dollar. Our EM FX model shows the peso to have WEAK fundamentals, and so we expect this outperformance to ebb.

USD/MXN was trading at its lowest levels since April on August 7 but has since reversed higher as EM weakness is finally catching up to the peso. USD/MXN retraced half of the June-August drop but ran out of steam today near the 50% retracement of 19.6830. Break of the 62% objective near 19.9845 is needed to set up a test of the June high near 20.96. Note that was the highest level since January 2017, and a break above that would set up a test of the January 2017 all-time high near 22.0385.

Mexican equities are outperforming after underperforming last year. In 2017, MSCI Mexico was up 11% vs. 34% for MSCI EM. So far this year, MSCI Mexico is -0.5% YTD and compares to -11.5% YTD for MSCI EM. Our EM Equity Allocation Model puts Mexico at VERY UNDERWEIGHT, and so we expect Mexican equities to underperform ahead.

Mexican bonds have held up well. The yield on 10-year local currency government bonds is +40 bp YTD. This is in the middle of the pack and compares to the best performers China (-28 bp), Korea (-20 bp), and Taiwan (-10 bp) as well as the worst performers Turkey (+843 bp), Argentina (+773 bp), and Indonesia (+229 bp). With inflation likely to move higher and the central bank taking a more hawkish stance as a result, we think Mexican bonds will start underperforming more.

Our own sovereign ratings model shows 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 incoming President Andres Manuel Lopez Obrador.