Mexican Bonds Rally Initially, Despite NAFTA Concerns and Dubious Budget Funding Plan

July 01, 2018 saw a historic shift in the centre of gravity in Mexican politics with the left-wing MORENA[1] party candidate, Andres Manuel Lopez Obrador (AMLO), winning the country’s presidential elections and Mexican bonds and the peso have rallied in its wake. ALMO received a strong mandate, winning close to 53% of the votes. The MORENA party and AMLO’s political coalition will now  be the  largest group in the Mexican Congress, providing a solid base for the president-elect to implement his legislative agenda. The markets appears to be embracing this shift in the political landscape thus far, as the average price on Mexican corporate bonds have been rising steadily while the Mexican Peso has appreciated 6.64% since the election.  However, there still some uncertainty in the market related to the on-going NAFTA negotiations and how the government intends to fund its spending plans which is expected to translate into continued volatility for Mexican bonds.  

Although AMLO’s administration will be inheriting an economy characterized by deeply entrenched fiscal discipline, favourable macroeconomic fundamentals, and a respectable (BBB+) credit profile, it will face headwinds from on-going NAFTA negotiations and the incoming administration’s spending plans.  The administration has committed to boosting social and infrastructure investments and implementing policies to improve the lives of the poor and marginalized; which for the budget, appears to place and increased emphasis on spending. It will also have to contend with Trump’s protectionist policies and negotiating a favourable NAFTA agreement.  We expect these two issues to continue to dominate the Mexican narrative and will be the key drivers of volatility within the Mexican Markets over the next 6 to 12 months. However, the expectation is that that there will be continuity in observing prudent fiscal policy, at least over the short to medium term, given the  new administration’s commitment to maintaining fiscal discipline- not increasing the public debt.   Additionally, despite the President Trump’s protectionist rhetoric and the seemingly interminable squabbles around NAFTA, the expectation is that the three parties will come to an agreement, which for the most part, preserves the trade bloc.

 

AMLO Pledges Fiscal Prudence

While the new administration has pledged to maintain the course of fiscal discipline over the short term by sticking to the guidelines already presented to Congress back in April., a key challenge it will face is financing a budget which is heavily skewed towards spending.   In his victory speech the president-elect vowed that he has no intentions to raise taxes, rack up debts, or interfere with central-bank’s independence. He also pledged to increase public investment, aiming to lift this amount to 5% of GDP over the medium to long-term, placing greater emphasis on social spending. ALMO has plans to create friendly environment for investors and has indicated he has no intentions of reversing policies which allowed for the privatization Mexico’s oil sector. The newly elected president had said the budget can be funded through savings by prioritizing a few important projects and streamlining the government’s procurement process, thereby reducing costs and corruption levels. However, analysts are wary of this proposition as it seems more like a panacea than a solid economic plan.   Further, the concern is that the new administration’s proclivity towards spending could put Mexico on the same path as Argentina and Brazil, both of which ran sizeable deficits causing deterioration in their fiscal position and credit profile.

 

NAFTA critical

The NAFTA renegotiation process and President Trump’s protectionist policies will continue to transfuse much uncertainty into the Mexican economy.  NAFTA plays an integral role in the Mexican economy, having a profound impact on the flow of trade and investments to Mexico and has contributed significantly to the country’s growth[2]  since the partnership was formed back in the early 1990’s. The agreement is also a key pillar in the country’s modernization efforts. Arguably, Mexico has the biggest stake in ensuring an amicable conclusion to the on-going NAFTA discussions given that the country has the largest exposure to trade of the three NAFTA countries[3]. However, unfortunately for Mexico, its vested interest in the agreement is not commensurate with its position at the table as the terms of current discussions are more less dictated by the  US and Canada .

The Manufacturing sector, which accounts for over 80% of the country’s exports^[4] to the US, is expected to be most heavily impacted by any retreat in from NAFTA.  This would no doubt have a significant impact on the country’s GDP as domestic demand would not be sufficient to replace the reduction in US demand.   Additionally, since the industries are supported by the tertiary/service sector,  a retreat from NAFTA would also have an adverse second order effect on support sectors such as the financial services. However, despite the current impasse, observers such as Fitch and Standard and Poor’s (S&P) are expecting a favourable conclusion to the talks that does not materially disrupt Mexico's trade with the US. An amicable conclusion of the NAFTA discussions will go a far way in providing clarity and easing some of the angst about Mexico’s economic future.   This would also be good news for Mexican corporates such as Pemex (Oil and Gas) and Unifin Financiera (Financial).

Sovereign Rating Outlook

In its March 2, 2018 report, S&P maintained its BBB+ rating and  stable rating outlook   on Mexico based on expectations of continuity in economic policies in the coming two years, along with observation of fiscal prudence. The rating agency also expects the three governments involved to conclude the NAFTA renegotiation, to come to a new arrangement which largely preserves the cross-border trade and critical links that underpin the North American economy. Mexico’s current BBB+ rating could be at risk of a downgrade if GDP growth along with larger-than-expected fiscal deficits which could make it difficult for the administration to stabilize its debt as a share of GDP over the next two years. Likewise, radical shifts in energy policies which could threaten the financial health of Petroleos Mexicanos (Pemex) and Comision Federal de Electricidad (CFE) could inadvertently increase the sovereign’s debt. This would affect the country’s credit profile and make the sovereign more susceptible to external shock, thereby increasing its downgrade risk. 

 

Conclusion

 

The average price on Mexican corporate bonds fell as much 7.85% since the start of the year, reaching its lowest point in mid-June, fuelled by uncertainties related to NAFTA and concerns regarding the outcome of the elections. Consequent on AMLO’s victory at the start of July bond prices have rallied initially, with prices increases ranging from 0.65%- to 4.33% amid an orderly transition, AMLO softening of his tone around his policy agenda and greater certainty around the new administration ability to achieve its policy agenda due to its absolute majority in Congress,  One credit for which we currently have a buy recommendation, Unifin Financiera 2023 has shown persistent price improvements since the election, growing 4.33% over the period. On the other hand, despite rallying initially on the news of the election results, the price on Pemex 2028 is down 4.05% since the start of this week, reacting negatively to the President-elect’s recently announced appointment of a new head for the company. As the NAFTA talks evolve and the new administration transitions into office, we continue to anticipate this volatility in Mexican bond prices.  In light of this, we continue to encourage investors in Mexican corporates to seek out entities with strong fundamentals.

 

[1] Movimiento Regeneración Nacional

[2] Economically, politically and institutionally

[3] Approximately 81% of Mexican exports went to the United States in 2017.

[4] Primarily capital and consumer goods such as machinery and transportation.