Since being elected, AMLO has delivered on his campaign promise to be broadly consultative, conducting a “people’s poll” that resulted in the cancellation of one of the country’s largest infrastructure projects, the $13 billion construction of a new airport in Mexico City. The decision stunned investors and soured market sentiment, with equities selling off and bond yields reaching a 10-year high.
While this episode demonstrates the heightened political risk and policy uncertainty tainting Mexico’s economic outlook, we believe that such missteps are the result of attempts to deliver on specific campaign promises to improve the economic well-being of southern Mexico, possibly via private public partnerships. Coupled with what we see as an adherence to fiscal discipline and sound economic fundamentals, we remain constructive on Mexico, maintaining overweight sovereign debt positions in the middle part of the yield curve.
Moves to Ease Investor Concerns
The cancellation of the airport construction project raised concerns about the rule of law since a public consultation supporting the cancellation only included 1.2% of registered voters. Also, AMLO’s commitment to other long-term investment projects such as his intentions to build the Maya Train project and a new oil refinery have been questioned. These projects may be cost prohibitive but are important to correct the geographical and economic imbalances that exist between northern and southern Mexico.
We believe AMLO’s appointment of Alfonso Romo, a high-profile name from Mexico’s banking and financial services sector, as his Chief of Staff has helped assuage investor fears and improved the relationship between the private sector and policymakers. Romo’s appointment has created anticipation of more meetings between the two sides.
More importantly from an economic outlook perspective, the key positive development was the 2019 budget presentation in mid-December. Mexico’s new Finance Minister, Carlos Urzúa, announced a projected primary surplus budget of 1.0% of GDP, indicating the government’s commitment to fiscal responsibility. No new taxes are expected to be levied, and AMLO’s administration plans to fund its budget by reducing corruption and imposing austerity on the public sector.
Local investors and members of the Central Bank of Mexico (Banxico) view the new budget as ambitious but broadly credible, with growth and inflation assumptions in line with market expectations. While it remains to be seen if the administration can deliver on its budget plan, we believe AMLO is committed to fiscal discipline, which is a promising sign for investors.
The Pemex Challenge
Pemex, Mexico’s problematic state-owned oil company, remains a challenge for the new administration. AMLO has appointed a new Pemex CEO, who has been charged with trying to revitalize the company. The government recently stated it would provide a $1.25 billion capital infusion along with tax relief to boost production and increase domestic output. It is still unclear how this will impact Pemex’s debt trajectory and, possibly, sovereign credit ratings, as the assumptions on savings from reducing corruption are murky at best.
While Pemex’s fundamentals continue to deteriorate (diminishing production, margin pressures, high debt load), the expected new business plan may not alleviate the pressures on its medium- to long-term viability. In our view, it raises the probability that Pemex may need additional government support, which could have an adverse impact on Mexico’s credit ratings outlook. This, in turn, could have a negative impact on Pemex itself and trigger a potential downgrade, which would lead to higher borrowing costs.
Economic Resilience, Political Risk
For now, Mexico’s economic fundamentals are on solid ground, in our view, however, that could change. Higher political risk and lower investor confidence are expected to negatively affect investment. These risks have led Banxico to decrease its 2019 GDP growth forecasts by 0.1% to a range of 1.7% - 2.7%. With inflation trending downward – albeit at a slower pace than expected – and closer to the central bank’s 3% mandate, Banxico continues to run restrictive monetary policy with high real interest rates. Finally, fiscal balances have been improving and trending positive. In our opinion, the resilience of the underlying economy will provide some room for political maneuvering and is supportive of asset prices.
In this scenario, investors require a risk premium. While AMLO delivered on campaign promises that were unfriendly to markets and investors, Banxico had already increased interest rates in anticipation of higher market uncertainty. We believe, however, that AMLO will also adhere to his fiscal discipline campaign promise.
With economic fundamentals remaining resilient and the administration improving its communication with investors, we are constructive on Mexico’s short-term outlook and see it as one of the few countries in Latin America with room for monetary policy easing later this year.
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