Some Thoughts on Mexico

The US has suspended the tariff threat on Mexico after reaching a deal. Yet the agreement has no specific targets and leaves open the possibility of other punitive measures by the US. Mexican assets thus remain vulnerable to ongoing political risk.

POLITICAL OUTLOOK

According to the US-Mexico Joint Declaration released late Friday, Mexico agreed to “take unprecedented steps to increase enforcement to curb irregular migration.” These steps include deploying its national guard at its borders to curb the flow of migrants to the US, as well as expanding a program that keeps migrants in Mexico while their asylum claims are heard and processed in the US. In return, President Trump suspended the threatened US tariffs on Mexican imports.

Yet we probably have not heard the last of this issue. The Joint Declaration contains the clause that other measures may be taken if Mexico’s efforts “do not have the expected results.” No numerical targets were set but Mexico said it could not agree to the zero migrants demanded by the US. Mexican officials said that if its efforts do not yield results (however they are measured) in 45 days, they will look for a broader regional initiative.

President Trump’s claim that Mexico agreed to “large” agricultural purchases from the US have so far unsubstantiated. Mexican officials said that agricultural trade wasn’t even discussed during the negotiations, while the Joint Declaration contained no language on the matter. Mexico reportedly refused to agree to US demands that it change its asylum rules to make it easier for the US to reject asylum seekers from Guatemala, Honduras, and El Salvador.

Press reports suggest that some aspects of the deal had already been agreed to before the tariff threats. If so, this suggests that both Trump and AMLO simply hoped to get a quick face-saving solution that avoided a potentially devastating trade war in this hemisphere. President Trump was facing unprecedented pushback from the Republic Senate, while AMLO is facing an already weak economic outlook even before the tariff threats.

Total US trade with Mexico was $611.5 bln in 2018, up from $520.3 bln in 2017. Exports to Mexico totaled $265 bln last year, up from $243.3 bln in 2017, while imports from Mexico totaled $346.5 bln, up from $314.3 bln last year. The US trade deficit with Mexico was -$81.5 bln last year vs. -$71 bln in 2017.

 

A BRIEF HISTORY LESSON

The three countries with the highest number of migrants are Guatemala, Honduras, and El Salvador. The so-called Northern Triangle of Central America (NTCA) is widely considered to be amongst the most corrupt and violent regions of the world. Mexico just happens to be located between NTCA and the US and thus became the flashpoint with the Trump administration.

The NTCA countries all suffered under the weight of civil war. Guatemala’s lasted from 1960-1996 and El Salvador’s from 1979-1992. While Honduras avoided a civil war during the 1980s, it was nevertheless affected by the regional conflicts. For instance, it was used as a staging area for the US-backed Nicaraguan contras that fought the leftist Sandinista government during the 1980s.

These wars left legacies of violence and corruption that remains endemic in the region. Along with organized crime and drug trafficking, there is widespread corruption and a weak rule of law. Transparency International’s Corruption Perceptions Index ranks 180 countries and has Guatemala at 144, Honduras at 132, and El Salvador at 105. According to the World Economic Forum, El Salvador was the world’s most dangerous country not at war last year while Honduras came in fifth and Guatemala sixth.

 

ECONOMIC OUTLOOK

The Mexican economy is slowing down. GDP growth is forecast by the IMF at 1.6% in 2019 and 1.9% in 2020 vs. 2.0% in 2018. GDP rose only 1.2% y/y in Q1, matching the cycle low from Q1 2018. As such, we see downside risks to the growth forecasts. Indeed, Banco de Mexico recently cut its growth forecast this year to 0.8-1.8% from 1.1-2.1% previously.

Price pressures may be easing but it’s too early to sound the all clear. CPI rose 4.3% y/y in May vs. 4.4% in April. This is still above the top of the 2-4% target range. PPI rose 2.9% y/y in May, down from 4.8% in April and the lowest since April 2016. This suggests low pipeline pressures. Much will depend on the peso going forward.

Banco de Mexico has been on hold since its last 25 bp hike to 8.25% back in December. The next policy meeting is June 27 and no changed is expected then. Bloomberg consensus sees an easing cycle starting in Q4 2019 and continuing into 2020, but much will depend on external conditions and the peso.

The fiscal outlook bears watching. While higher oil prices will help boost revenues, AMLO came into office pledging increased spending on social programs. He has delivered many of them, but at a cost. Bloomberg consensus sees the budget deficit widening to -2.5% of GDP in 2019 and 2020 from -2.1% in 2018.

The external accounts are worsening. The current account deficit was -1.3% of GDP in 2018, and the IMF expects the deficit to widen to -1.7% this year and -1.9% in 2020. Export growth has been slowing this past year, but imports have been slowing even more, leading the 12-month trade deficit to narrow since November. The outlook for oil prices remains unclear right now.

Foreign reserves have recovered. At $177.9 bln in May, reserves are the highest since April 2016. They cover nearly 4 months of imports and are over three times greater than its the stock of short-term external debt. Still, Mexico’s Net International Investment Position (NIIP) is -50% of GDP, which makes it very vulnerable to shifts in sentiment and so-called hot money.

 

INVESTMENT OUTLOOK

The peso continues to outperform. In 2018, MXN rose 0.1% vs. USD and was the best EM performer. The next best performers last year were THB (flat), SGD (-2%), MYR (-2%), and TWD (-3%). So far in 2019, MXN is up 2% and is behind only the best EM performers RUB (+8%) and THB (+4%). Our EM FX model shows the peso to have STRONG fundamentals, and so we expect this outperformance to continue.

In the aftermath of the tariff announcement last month, USD/MXN traded at its highest level since December 27 near 19.88. After those tariffs were rescinded this past week, USD/MXN has retraced nearly that entire move higher. Looking at the bigger picture, USD/MXN has now retraced about a quarter of the December-March drop. Major retracement objectives of that drop come in near 19.43 (38%), 19.64 (50%) and 19.85 (62%). The 200-day MA comes in near 19.3640.

Mexican equities are underperforming slightly this year after outperforming slightly last year. In 2018, MSCI Mexico was -16.2% vs. -17.4% for MSCI EM. So far this year, MSCI Mexico is up 7.1% YTD and compares to 7.4% YTD for MSCI EM. Our EM Equity Allocation Model puts Mexico at UNDERWEIGHT, and so we expect Mexican equities to underperform more in the coming weeks.

Mexican bonds have outperformed. The yield on 10-year local currency government bonds is -93 bp YTD. This is behind only the best performers Philippines (-166 bp), Brazil (-111 bp), and Russia (-100 bp). With inflation likely to remain high and the central bank forced to maintain its hawkish stance as a result, we think Mexican bonds will start underperforming more.

The ratings agencies are punishing Mexico. Fitch recently cut Mexico one notch to BBB with stable outlook while Moody’s cut the outlook on its A3 rating from stable to negative. Our own sovereign ratings model has Mexico’s implied rating at BBB/Baa2/BBB and so we are not at all surprised by Fitch’s move. What we are surprised at is that Moody’s still has Mexico at A3.