Mexico, US: Is a Mexican Standoff Inevitable?
Bonds & Loans
Published: 2 February 2017 03:18
The notion that no party can walk away from the current Mexico-US confrontation unscathed is quickly gaining prominence among investors, issuers and observers. While investors are starting to move out of their short Mexican positions, analysts are split on what effect a Trump presidency, impending 2018 elections, and a new Central Bank governor will have on the country’s medium term prospects.
Since his election victory in November last year, US President Donald Trump has seemingly refused to back down from a number of campaign promises – which had, in the immediate aftermath of the election, rocked Mexican markets.
The Bolsa Mexicana de Valores, the country’s main stock exchange, dropped 10% in the days following the election announcement. In the spot markets, the Mexican peso dropped nearly 12% to MXN20.8492 against the US dollar the day after the election result was announced, one of the biggest daily declines since the ‘Tequila Crisis’ of 1994. In the run-up to the election investors ploughed in to short the peso in record volumes, with net positions jumping nearly 37% at the end of September according to data from Bloomberg.
Markets Overreact But Central Bank Keeps its Cool
In the weeks following the election the peso continued its decline against the US dollar, something Mexico’s Central Bank Governor Agustin Carstens puts down to market overreaction. In mid-January, the Central Bank was nevertheless forced to intervene in the spot market by selling up to US$1bn in foreign exchange reserves, propping up the peso and – at least so far – stemming its decline.
There is nothing overtly peculiar about how markets reacted. Over the past several months, rhetoric and ‘trade-negative’ policy positions have come hard and fast: building a wall along the US-Mexico border, cracking down on illegal immigration, renegotiating NAFTA, and more recently, and imposing steep trade tariffs on Mexican imports are just a handful of the policies that could damage Mexico’s – and the American – economy.
“The ‘Trump Trade’ – betting on a stronger dollar, a US treasuries selloff, and countries like Mexico taking a hard hit – hasn’t really worked out to a great extent,” said John Peta, Head of EM Fixed Income at Old Mutual Global Investors. “The market got a bit ahead of itself; US initiatives like tax reform and a fiscal overhaul are not likely to materialise for a while, and with the economy performing ‘so-so’, those will be the biggest drivers of dollar and peso action in the medium to long term.”
Andrew Stanners, a portfolio analyst on the emerging market debt desk at Aberdeen Asset Management said its surprising the peso is doing as well as it is given the volume of Trump’s rhetoric.
Until the inauguration the Mexican peso was one of the worst performers in the basket, but it has since rallied, benefitting from a weaker dollar, partly because many who shorted the peso as a way of hedging against ‘Trump risk’ are starting to unwind those trades, he explained.
“We’ve seen a liberalisation of gasoline prices but some of the benefits of the energy reforms are already starting to dissipate, so we’re seeing rising inflation, and some pass-through into the currency. It is leading to an expectation of a rising inflation environment at a time when growth expectations are being revised downwards. How many flows are actually going to be diverted? How many US companies are going to choose to forgo investing in Mexico because of this uncertainty? That remains unclear.”
The relationship between the two nations soured acutely and publicly when in January Mexican President Enrique Peña Nieto cancelled a trip to meet with Trump in the US, after being goaded by Trump into cancelling the trip if Peña Nieto refused to pay for the proposed border wall. Trump, like a spurned adolescent following a breakup, insisted the decision was mutual.
The US President has since signed an executive order auctioning the construction of the border wall, while tempering his insistence that Mexico will pay for it. He has flirted with the possibility of taxing remittances, which currently sit around US$28bn according to data from BBVA, to pay for the wall’s construction, and slapping a 20% tariff on imports from strategic sectors, but like many of the President’s policy positions with deeper implications for Mexico, nothing has yet been set in stone – pardon the pun.
“There is no question that trade negotiations are going to play a big part of the upcoming discussions, but much of the negativity has already been priced in to Mexican assets,” Peta added.
Trading on Trade
The real concern is around a revamp of the trade relationship between the US and Mexico, with the former arguing that existing rules – including the wide-reaching NAFTA in particular – make the latter unfairly competitive in certain sectors and depress American wages.
A wholesale renegotiation of the 25-year-old accord seems to be in the offing, but details of any forthcoming agreement or trade dynamic are scarce, let alone how markets will be affected. The nearly US$480bn crossing between the two borders each year is at stake, with key sectors in Mexico like auto, agriculture, and oil under threat; so are about 5 million US jobs directly linked with the trade agreement.
Wilbur Matthews, CIO of Vaquero Global Investment said Mexico has a lot more to lose in this fight than the US.
“[Walking out on the meeting] was pretty stupid. For Peña Nieto to act like a hot head and cancel a meeting is in a sense what people claim to want, but it’s not going to boost his popularity,” which is already at a dismal 12%. “NAFTA won’t be the be-all end-all, but being a rational negotiator is going to be what gets him and the country to where they need to go.”
There are still too many unknowns on the trade front, with negotiations on NAFTA likely to begin in May at the earliest. A complete withdrawal means a fall back to WTO rules, where average tariffs are below 3%. Levying tariffs on Mexico means tariffs for all WTO members, which is not a likely scenario.
There is good reason to think a wholesale renegotiation of the trade agreement won’t be as impactful as some anticipate. Mexico has slowly moved to reduce its dependency on the US in recent years, and exports to the US have started to shrink. According to data from the US census, Mexico sent about US$296bn worth of goods and services north of the border in 2015, which dropped to about US$270bn in 2016, and could continue to shrink.
Part of the drop is linked to declining US auto sales, and with some of the country’s largest carmakers claiming the industry has peaked, it is in Mexico’s best interests to secure access to alternative export markets for its lucrative parts manufacturing sector.
It is also a reflection of Mexican companies looking for these new markets. Pemex, the Mexican state-owned oil giant, exported about 20% less oil to the US in 2016 than the year before, shifting those crude exports to other markets with comparable refining capabilities.
At the same time, some of the country’s allies are lining up to expedite existing trade talks in the hopes of inking new and potentially lucrative deals Mexico. The European Union is the latest to suggest it will double down on a trade pact, which could be very beneficial for Mexico’s auto industry, and will likely be followed closely by the UK once it finalises its divorce from the EU.
“We’ve already seen a decent uptick in the current accounts, both in the non-oil manufacturing sector and the oil sector, which is bound to improve with higher oil prices. It’s not all doom and gloom – there has been some adjustment due to the currency weakness, but nothing significant,” Stanners added.
It’s Not Just About Trade
Trade aside, Matthews outlined three major threats facing the Mexican economy in the coming years.
The first is currency volatility. To some extent, Mexico has become a victim of its own success; its assets are very liquid and foreign investors hold a lot of them, making them prone to being oversold in the event volatility ramps up. If the peso moves almost a full figure every time President Trump makes an announcement or Tweets something even peripherally related to Mexico, finding a floor for the currency could be tricky – some analysts suggest the low 22s, but Matthews is more bearish.
The second is politics. Despite Peña Nieto’s low approval ratings, he is rightfully given credit for sticking with fairly austere policies, continuing the country’s reform-centric legacy, and avoiding populist clichés that have become the hallmark of some of the country’s neighbours to the south (and more recently, north).
Although the July 2018 elections seem too distant to be an immediate threat, some are concerned that some of the same socioeconomic pressures that gave rise to Trump could produce a similar outcome in Mexico, which would be damaging. Some Mexicans believe that the Morena movement and its leader Andres Manuel Lopez Obrador (AMLO), who narrowly lost to Peña Nieto in 2012, and has adopted some nationalist rhetoric while promising to fast-track reforms, may be Mexico’s answer to Trump.
Others, like Matthews, believe the next 18 months could produce an even more fringe candidate who transcends the dominance of the Institutional Revolutionary Party (PRI) and the Institutional Revolutionary Party (PRI), particularly if Peña Nieto continues to be a lame duck, succumbs to populist urges to curry favour with a disenchanted electorate, or aggravates tensions with the US. That could be very damaging for credit markets.
“Redemptions in local investment funds have been high, and portfolio managers have sold most of their US dollar positions in order to generate liquidity. This means that the next batch of assets to be sold will be local currency assets. Unfortunately, demand will be less and prices will probably gap down. This could lead to the bloodbath that never materialized in the aftermath of Donald Trump’s victory,” explained Walter Molano, Chief Economist at BCP Securities in a recent research note.
With foreign investors holding close to 60% of the Mbono market, spreads have already widened to levels not seen in nearly a decade.
The third threat is corruption. While Mexico has made tackling corruption at every level of government a priority, Matthews underscores the very real possibility of a corruption scandal on par with LaVa jato in Brazil erupting in Mexico.
“It would be totally foolish to think Brazil is in some way a market leader when it comes to corruption. Anyone who knows Pemex knows that when it comes to corruption, it is probably on the worse end of what we see at Petrobras. The possibility of a huge corruption scandal is very real.”
Despite the very real challenges confronting Mexico, investors and analysts seem bullish on the country’s medium and long term prospects, particularly if it continues its path to reform, sticks to monetary orthodoxy and fiscal restraint. Javier Elizalde, CFO and Treasurer of Fibra Uno, a Mexican real estate developer that counts manufacturers among its tenants, is also fairly optimistic, and cautioned that business leaders were equally concerned about the impact of NAFTA coming into force.
“It ended up benefitting both parties significantly.”
“Maybe the Trump administration is a blessing in disguise and it is the shot in the arm we needed as a country to move beyond trading only with the US,” he said. “I think the Trump administration has actually united Mexicans.”
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