The U.S. political rhetoric surrounding renegotiation of the North American Free Trade Agreement (Nafta) - called for in a January executive order signed by President Donald Trump - is toned down a bit. Secretary of Commerce Wilbur Ross stated in March that a “sensible agreement” would be beneficial to both sides, citing the Mexican peso in particular.
The peso rose after Ross' comment, reflecting sentiment that any policy change would not adversely affect Mexico's growth outlook. But even if Nafta turns out to be a non-event, and even if U.S. interest rates in 2017 rise by less than market expectations, the Mexican economy faces “substantial headwinds from other quarters that pose downside risks to its currency,” William Adams, senior international economist with PNC Financial Services Group, explains.
It is still not entirely clear what the Trump administration can gain from renegotiating Nafta, and market analysts say there may be some marginal tweaks to the agreement that could be helpful.
“Even if Nafta should be changed in favor of the U.S., it is very unlikely that this will mean that the jobs the U.S. lost to Mexico in the decade after Nafta was passed will ever come back to the U.S.,” Moody's Analytics chief economist Mark Zandi said in an interview. “Those apparel, textile and light manufacturing jobs will simply go to other lower-cost producers in other parts of the world.”
In an April 27 investment note, Gary Greenberg, head of emerging markets at Hermes Investment Management, and Yasmin Chowdhury, senior investment analyst, wrote that “most Mexican businesses have already priced in the worst-case scenario for the U.S. trade deal in their forecasts and business plans. Their growth forecasts are significantly lower than the consensus views in the global market. Meanwhile, record-low unemployment and record-high remittances have lifted consumer sentiment from its late 2016 doldrums.”
Inflation and Oil
Mexico's inflation report on April 7 was what PNC's Adams calls a “reminder that Mexico faces other challenges besides its relationship with the U.S., and maybe bigger ones.” Inflation has jumped this year and is ultimately a symptom of the state-owned oil company Pemex's declining output, which has fallen from its peak of more than a decade ago.
The Mexican government's decision to liberalize consumer energy prices in 2017 had very little to do with the U.S. This was because Pemex revenue has been insufficient to keep the Mexican state fiscally sound while also supplying Mexican consumers with subsidized energy.
The government had hoped to revive energy-sector revenue by auctioning exploration rights, but shale oil production in the U.S. and Canada has been a factor in keeping global oil prices low, in turn limiting Mexico's revenue. Mexico may have no choice but to continue to raise taxes over the next few years to compensate for the energy industry's decline.
“If financial markets get tired of thinking about trade policy as it relates to the peso, they may discover that the economic fundamentals underlying the currency have weakened in the last 12 months as U.S. fundamentals strengthened,” said Adams. “Mexico's economic fundamentals pose downside risks to the peso,” he added.
More Globally Integrated
There is, however, light at the end of the tunnel, as Mexico has reasons to draw favorable attention from investors. Despite the various headwinds, the Mexican economy “has arguably been the best performing Latin American economy in recent years,” Zandi said. “It has become less dependent on the ups and downs in oil prices, and more integrated into the global supply chain. Given its young population, Mexico has a bright economic future, particularly if it is able to address its problem with crime and corruption.”
On April 27, Moody's Investors Service reaffirmed Mexico's government issuer rating of Aaa.mx on the Government of Mexico's National Scale Rating. Moody's also affirmed its A3 issuer rating on its global scale for the Government of Mexico. The outlook on the country remains negative.
Hermes' Greenberg and Chowdhury titled their investment note, “Mexico - Not in Crisis but Hold the Tequila.” On a recent visit that came after Secretary Ross' moderate statement on the treaty, they did not observe “a country nervously anticipating the actions of the new U.S. president.” It was further buoyed by National Trade Council Director Peter Navarro's comments about creating a North American manufacturing powerhouse to reduce imports from the rest of the world. Since its trough in mid-January, the peso has appreciated 15%.”
State Election
The Hermes analysts pointed to a political risk: the June election in the State of Mexico, where the Morena party, led by leftist Andres Manuel Lopez Obrador, is gaining popularity against the long-entrenched Institutional Revolutionary Party (PRI).
A Morena win was viewed as unlikely - though in the anti-establishment mold of the 2016 Brexit and Trump votes - and “a very real tail risk in our investment case for Mexico,” Greenberg and Chowdhury wrote.
“Despite this risk,” they added, “we believe there is limited downside for the Mexican economy” and “a reasonable chance that U.S. trade policy will be more benign than expected, and that growth in the U.S. will ultimately aid Mexico, its largest trading partner.”
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