Solid Fundamentals to Help Support Mexico

Low oil prices and sluggish growth have weighed on Mexican assets, along with generally negative EM sentiment.  We believe these conditions will continue in H2.  However, due to solid fundamentals, we look for Mexican assets to generally perform about the same as wider EM rather than underperforming like Brazil.

POLITICAL OUTLOOK

Political concerns have picked up with the well-publicized prison escape of El Chapo.  Rather than elaborate on this, suffice to say that the escape simply fits into the long-standing narrative of deep-seated corruption in the nation.  That is also how we would describe the ongoing investigation into President Pena Nieto’s connection to construction magnate, as well as for the tragic deaths of the college students last year.

The oil block auctions were historic, but proved to be a dud as only 2 of the 14 blocks were sold.  The timing was not good, with oil at multi-year lows.  However, we are hopeful that the authorities will learn from this and make adjustments to the terms that could make the next sale more attractive

Looking ahead, we are concerned that the growing scandals will turn Pena Nieto into a lame duck.  As it is, his term is half over and already entering a potential lame duck phase.  The midterm elections in June saw the PRI hold on to its majority in the lower house.  More importantly, the emergence of the new leftist offshoot Morena and independent candidates (such as El Bronco) could prove to be game-changers for the 2018 elections.  There are no clear PRI contenders for the presidency yet.

ECONOMIC OUTLOOK

Banco de Mexico kept rates steady this week at 3%, as expected.  More importantly it announced changes to its FX intervention program, which had been rumored since last week.  Extraordinary dollar auctions will now be triggered by a 1% depreciation from the previous day’s fix (vs. 1.5% previously).  Regular daily dollar auctions were increased from $52 mln to $200 mln.

While we were not surprised by the changes, the announcement was enough to start a short-covering rally for the peso, which earlier in the day had hit a new all-time low near 16.50.  Given the negative EM backdrop still in play, we think this short-covering bounce will soon run out of steam.  It’s important to stress that the measures are really meant to provide extra liquidity in disorderly markets, and are not meant not to protect a level or to reverse the trend.

Banco de Mexico was suitably dovish on the economy.  It noted continued cyclical weakness in the economy, particularly in non-auto manufacturing mining, and building; exports and investment have deteriorated compared to H2 2014.  Yet Governor Carstens resumed talking about a rate hike.  We do not think he can follow through on this.  Why?

Inflation remains low.  At 2.76% y/y in mid-July, headline CPI is at cycle lows.  It is also below the 3% target but still within the 2-4% target range.  More importantly, there has been no inflation pass-through from the weak peso.  Even the central bank acknowledges significant slack in the economy remains.

Indeed, the economy remains sluggish.  Q2 GDP growth is tracking around 1.8% y/y vs. 2.5% in Q1.  The IMF now sees growth this year of 2.4% (vs. 3% previously) vs. 2.1% in 2014.  There are clearly downside risks to this new forecast, however.  Slow growth will hurt the fiscal accounts.  The IMF sees the budget gap narrowing to -4.1% of GDP from -4.6% in 2014, but we think this is too optimistic and we see upside risks.

The external accounts have worsened a bit, though still manageable.  Exports had been contracting, but rose 1.2% y/y in June as strong manufactured exports offset a -41% y/y contraction in petroleum exports.  The IMF sees the current account gap widening to -2.2% of GDP, but we see upside risks given lower oil prices.  Still, this is almost fully covered by FDI.  Overall, Mexico’s macro backdrop is solid.

INVESTMENT OUTLOOK

Mexican bonds have held up well compared to the rest of EM, with 10-year local currency government bond yields up only 19 bp YTD.  This compares to the group of worst performers that includes Turkey (+151 bp), Peru (+136 bp), Indonesia (+76 bp), and Brazil (+61 bp).  The US 10-year yield is up 3 bp YTD.  With domestic inflation set to remain low, the long end of Mexico can continue to hold up.  However, rising borrowing needs (greater supply of bonds) due to the fiscal hole from lower oil prices are likely to offset this somewhat.

Lower oil prices and sluggish growth have helped drag Mexican stocks lower.  It’s performing about the same as the wider EM (MSCI Mexico at -6.0% YTD vs. MSCI EM at -5.9%).  We believe the weak growth outlook and low oil prices will keep Mexican equity markets under pressure.

Despite the recent change in the dollar auctions, we remain negative on MXN and expect USD/MXN to continue making new all-time highs in the coming weeks.  MXN is one of the worst performers in EM, -8% YTD and ahead of only ZAR (-8.5%), IDR (-8.5%), MYR (-9%), CLP (-10%), TRY (-16%). COP (-17% YTD) and BRL (-22% YTD).  Most of the worst performers are linked to commodities, and Mexico is no exception.  An upward sloping channel for USD/MXN dating back to the 1994 devaluation can be found on the monthly charts, and the top comes in above 18 currently.  Before that, the all-time high near 16.50 as well as the obvious round number target of 17 looms.