Mexican Market’s Reprieve from Political Ferment to Be Short-lived

 

May 11, 2017 [Mexico, Border trade, politics]
Pablo Echavarria, CFA


Politics north of Mexico’s border shook the country’s asset prices, which have recovered nicely in recent months thanks to sound economic prospects and solid monetary and fiscal policies. Yet politics—this time on the home front—are likely to swing Mexico’s capital market once again, and create nice entry points for long-term investors.

The political squalls blowing from north of Mexico’s border took a heavy toll on the Aztec nation’s asset prices at the beginning of the year, but as we noted a few days after Donald Trump, whose rhetoric on trade and immigration drove much of the selloff, moved into the Oval Office, Mexico’s improving economic fundamentals would ultimately prevail over fears that growth would stall. Since then, asset prices have rebounded and first quarter economic performance came in much stronger than expected at the time.

We continue to think Mexico enjoys long-term tailwinds thanks to its favorable demographics, greater formalization of employment, low level of banking penetration and large and relatively inexpensive work force. But over the next year, we also expect the political turbulence to continue swaying investor sentiment. The source of volatility ahead, though, will likely come less from Washington D.C. than Mexico itself due to a key state election in June and especially the general election in July 2018. Keep your seatbelts fastened.

Recall that the peso blew out to MXN21.70 a dollar on January 20, 2017 the day Trump was inaugurated, from MXN18.56 on November 8, 2016 the day of his election. But as the first quarter of this year progressed, the economy stabilized. Annual growth ran at 2.7% in January through March, much better than the roughly 1% many economists had projected following the U.S. election. The peso has now recovered to MXN18.95. That’s also reflected in the dollar-denominated MSCI Mexico Index, which since January 20 has produced a total return of 22%, doubling that of the broad MSCI Emerging Markets Index. Mexico’s 10-year sovereign bond yield has also dropped nearly half a point. Having just met with a score of corporate executives in Mexico, it’s also apparent that the economic rebound continued in April, with many of the companies we saw citing strong demand.

One key driver behind Mexico’s resilient growth is the peso, which is still trading about MXN5 weaker than its 10-year average exchange rate against the dollar, boosting the price competitiveness of the country’s exports. Another is the increasing formalization of Mexico’s economy. Since the end of 2010, the number of formal jobs has increased some 35%, with an acceleration in formalization following the passage of labor reforms in 2012.

Mexico’s deft fiscal and monetary policies have also helped. The government’s revenue composition has changed sharply over the last five years. In 2012, oil revenues constituted 39% of total government income. The contribution has declined to 16% of government revenues. But taxes have increased from 8.4% of GDP in 2012 to 14% of GDP by 2016. And Mexico’s finance ministry expects the government to deliver a primary surplus in 2017 for the first time in eight years.

Concerns about the U.S. withdrawing from the North American Free Trade Agreement (NAFTA) have also eased, though the peso, which is now trading roughly in line with its level days before the U.S. election, still embeds some trade concerns. Mexico’s finance ministry believes that any potential renegotiation of NAFTA would be a positive for Mexico. Why? Because the two economies are intricately interconnected. Mexico imports four times more American goods than Brazil, South Korea and Russia combined. Mexico is the most important trade partner for most Southern U.S. states and Mexico is the largest emerging market investor in the U.S. Mexican companies such as Bimbo, Alfa, Coke Femsa and Cemex which have important U.S. operations.

On the monetary front, inflation is expected to increase throughout 2017 on the back of a liberalization in gasoline prices, which should add about 160 basis points to the inflation forecast for 2017, and the pass-through of the inflation spike early in the year, which would add around 100 basis points. Mexico’s central bank believes inflation is well anchored and should converge toward the 3% target range by end of 2018. However, Credit Suisse figures inflation could be sticky, and sees risk to that 3% target. Most observers think Banxico, as the county’s monetary authority is known, will follow the U.S. Federal Reserve (Fed) this year, lifting its benchmark rate 25 basis points two more times. In 2018, though, an easing in its monetary policy may prove challenging. While some hope Banxico can decouple from Fed policy action, the most likely outcome is that Banxico will continue to follow the Fed next year. But at least this should continue to act as a driver for bank stocks.

Political noise will still likely move Mexican markets. The upcoming Mexico State elections will certainly be perceived as an important litmus test for next year’s presidential ballot. The latest polls show that Alfredo del Mazo, the candidate of the Partido Revolucionario Institucional (PRI), is slightly ahead of Delfina Gomez, of Andres Manuel Lopez Obrador’s Movimiento de Regeneración Nacional (Morena). Morena winning the Mexico State election would be a strong indication that AMLO, as Lopez Obrador is known, could emerge as a leading candidate for next year’s presidential election, and Gomez’ momentum in the polls suggest the race is tightening. Most people we spoke to believe the governing PRI, which has been dogged by corruption allegations, is headed for a fall in the presidential contest, even though it hasn’t yet fielded a candidate.

A unified Partido de Acción Nacional (PAN) would pose the biggest challenge to AMLO. At this point, it seems a bit early to tell how the political environment shapes up next year. But we think politics will become an area of concern for investors later this year and into 2018, especially considering how strong AMLO’s initial momentum is. Interestingly, perceptions of what AMLO would do were he to win the election vary. One political analyst believes AMLO could lead to a “Venezualisation” of Mexico, but others who have met with AMLO’s economic team believe he would respect the country’s institutional framework, while potentially looking to roll-back some of the market-friendly reforms of recent times.

As the political noise impacts asset prices, good opportunities to increase exposure to Mexican firms benefitting from the country’s long-term economic tailwinds should open for long-term investors.

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