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Mexico faces a host of external challenges, which include strained relations with the United States—its economically superior neighbor—and the Trump administration’s intention to renegotiate the North American Free Trade Agreement (NAFTA). Yet these problems are secondary to the 2018 election in Mexico, which may mark the demise of one of the remaining powerful political machines in Latin America—the incumbent Institutional Revolutionary Party (PRI) under the leadership of President Enrique Peña Nieto.

The Decline of the Political Party System Has Reached Developed Markets

Ever since the industrial revolution, political parties as we know them started making headway in aggregating and representing the views of economic groups and their constituents. However, they have also served as platforms to promote the individual ambitions of party elites and led to nepotism and corruption. The political party system has been declining with the advent of social media, which is taking its place by aggregating the interests of the public and democratizing the political conversation.

Interestingly, the decline of political parties began in emerging markets—especially Latin America. Gone are the Peronists in Argentina, the Liberals in Colombia, the Concertación in Chile, the American Popular Revolutionary Alliance (APRA) in Peru, and the Acción Democrática (AD) in Venezuela. Developed markets then followed, with the unexpected results of the U.S. presidential election and the UK’s European Union membership referendum. Most recently, French voters rejected their two big political parties, the Republicans and the Socialists, which have been governing for decades. Now the two biggest Latin American economies, Brazil and Mexico, are hosts to elections next year.

How will Mexico vote?

The Political Dynamic in Mexico

President Trump’s verbal attacks on the character of Mexicans seemed to have galvanized a nation that witnesses the ineffectual response of its traditional political parties, or perhaps their lack of interest in defending its honor. In our view, a national sense of humiliation and disenfranchisement might be carving out a political niche for an outsider to assume leadership—in a similar phenomenon to what has brought Mr. Trump to power in the United States.

Some Mexicans believe that oppositionist Andres Manuel Lopez Obrador (a.k.a. AMLO), leader of the MORENA party, who has adopted strong nationalist rhetoric, will enlist populist support as president in 2018 to mount a strike against corporate interests (more on AMLO and next year’s election below). The first preview will come soon, with the important June 4 election in the State of Mexico. The incumbent PRI party, which has never lost this election, is in a tight race with MORENA that is currently too close to call. Mexico faces not only the prospect of an incumbent party losing the most populous state after losing the second and third most populous ones to traditional parties, but the loss this time would be to MORENA.

Would such a development create a period of instability?

The Curse and the Blessing of Mexico’s Political Gridlock

Over the tenure of Mexico’s current administration, Mexicans and investors took notice of the steady stream of deal-making after years of gridlock. With the Pact for Mexico signed by the three major parties in a remarkable legislative coalition, gone were the obstructionist policies, and important reforms were passed. (Those reforms were wide-ranging: They included telecom and energy reforms, new rules to rein in state debts, reduced control of teachers’ unions, the creation of a national electoral body, tax reform—even the barring of “junk food” in schools.)

However, in contrast with other emerging markets that have majorities in their state congresses, under virtually no conditions can we anticipate Mexico to have one party represent a dominant majority given the structure of its legislative branch. This means that it would be very hard for AMLO, should he be elected, to significantly change the structural reforms of late. (It’s worth noting that current polls showing AMLO’s popularity fail to reflect the popularity of other parties that have not spent as much resources on promoting candidates.)

Thus, crucially, there is an institutional framework constraint that grants Mexico an important degree of stability to the hard-won gains of past reforms. Further, a “fiscal responsibility” law was enacted to constrain fiscal spending to its target budget. The president cannot spend more than the target budget dictated by this constraint. In addition, the president cannot remove the governor of the central bank—an independent institution—in order to shape monetary policy in his own view.

Of course, this institutional constraint could also bring back the gridlock of past years.

Mexico’s Economic Story—and Investment Implications

In 1997, Mexico became a full democracy and the PRI, which had governed since 1929, lost control of Congress for the first time. From 1997 until 2013, the country’s key hurdle was to pass structural reforms for promoting economic growth, since no single party dominated Congress and it was hard to obtain the necessary majority.

During that time, Mexico was out of favor with investors. It didn’t have the investment appeal of a country that would enact structural reforms to unlock its potential, neither did it enjoy the benefits of the commodity cycle. It didn’t really fit into the emerging market narrative mainly because it was a story of manufacturing—not commodities. Mexico’s commodities—about two-thirds of which are oil—have constituted less than 15% of exports, and most of its trade is with the United States. (Linkages are strong, and the backlash from the U.S. financial crisis led to lower Mexican economic growth compared to its South American neighbors.) Additionally, Mexico has had very little interaction with China, whereas many other emerging markets in South America were benefiting from the rise of commodity prices and the Chinese economy.

It’s true that during those years, Mexico languished behind other emerging market economies. At the same time, and despite the political gridlock of those years, it managed to build a robust and resilient economy. Meanwhile, it avoided much of the consumer credit binge of the broader region, increased exports, and even reduced the gap with Brazil’s fast-growing economy.

Moving forward, we should consider the possibility of continued political gridlock, assuming the market-unfriendly outcome of the election of AMLO, though such gridlock could actually help preserve past legislative achievements.

Today, our view is that Mexico’s economy is on moderately good footing despite being below potential and growing less than it did last year. We find the following encouraging:

  • Mexico’s economy is doing better than expected at the start of 2017 thanks to the country’s industrial sector. In fact, recent meetings we’ve held with Mexican companies that we follow confirm that their business performance has so far been better than what market observers were expecting.
  • Its consumer sector is more resilient than expected despite rising inflation.
  • Job creation reached record highs in the first quarter.
  • The steady liberalization of the fuel-pricing regime should set a bottom for the fundamentals of Pemex, the Mexican state-owned petroleum company. Pemex reported first-quarter earnings that showed some improvements in its business trajectory, and its new management team is committed to improving the company’s fundamentals.
  • The peso has been appreciating, and its strong rebound has helped strengthen the balance sheets of local corporations.
  • Renegotiations of NAFTA are reportedly pushed out to the second half of 2017. The United States is aware that the Mexican elections of 2018 may bring a market-unfriendly party to power, and may therefore seek to resolve key NAFTA-related disputes before then.
  • If the United States were to impose a border-adjustment tax (BAT) on Mexican imports, Mexico could remain fiscally sound by tapping concrete sources of alternative revenue, such as property taxes, value-added taxes, and social security contributions.
  • Unlike in previous years, there are no expectations of a shortfall in oil revenues, and it is possible Mexico will reach a higher primary surplus than its target (i.e., 0.5% of gross domestic product, or GDP, in contrast with the deficits of the last eight years) and a reduction in the debt-to-GDP ratio.
  • Alongside its finance ministry, Mexico’s central bank has also contributed to reinforce the macroeconomic framework alongside its finance ministry. To date, it has pre-emptively hiked interest rates by 350 basis points since December 2015. (Most of the hikes were in response to the policy of the U.S. Federal Reserve, or “Fed.”) Now its monetary policy is reasonably tight. Given that inflation expectations are relatively tame, a flatter yield curve and inverted spread curve give Mexico’s central bank the latitude to respond to the Fed’s rate-hiking cycle of 2017-2018. In other words, Mexico may afford to not hike interest rates, even if the Fed does.

Despite Mexico’s Strengths, We Are Cautious for the Near Term

Over the years, and despite past political gridlock, Mexico has developed a strong macroeconomic framework. And though its economy has lagged that of other emerging markets, it has managed to build a robust and resilient economy based on manufacturing.

However, Mexico’s biggest challenge today is not external (i.e., its strained relations with the United States, or the outcome of future NAFTA negotiations) but internal. The 2018 elections could bring to power a new party that is less market-friendly and devoted to sweeping change. And though that party would be curbed by the country’s checks and balances, which should preserve the positive reforms enacted to strengthen Mexico’s economy and institutions, we do not feel the markets are pricing in the country’s political risk.

We thus maintain a cautious stance on Mexico for the near term and continue to monitor the developments ahead.

More About Andres Manuel Lopez Obrador (AMLO)

AMLO is a longstanding left-wing Mexican politician. He began his political campaign with the incumbent Institutional Revolutionary Party (PRI), and broke with it in 1988 when he was denied the party’s candidacy for governor of Tabasco. From then on, he was a major presence in the Party of the Democratic Revolution, or PRD.

AMLO was elected mayor of Mexico City in 2000 and served until 2005. As mayor, he implemented several infrastructure works and social programs. He left one year prior to the end of this term to run for the Mexican presidency in 2006, which he lost. He is known for closing down one of Mexico City’s landmark avenues for about three months to rally his supporters while claiming to be “Mexico’s legitimate president.” He broke with the PRD in 2011 and founded the left-of-center MORENA party (short for Movimiento de Regeneración Nacional, or the National Regeneration Movement). AMLO later ran for president in 2012 and lost again.

His name is one of the most highly recognized (among close to 95% of Mexico’s population) of the country’s potential candidates for president in 2018. Only Mrs. Margarita Zavala (the wife of former President Felipe Calderón of the right-of-center PAN party, between 2006 and 2012) has earned similar recognition.

AMLO is an advocate for ending corruption, reallocating expenditures, and using the savings generated from Mexico’s surplus to invest in public programs and social subsidies. He is a strong critic of concessions and the “strategic outsourcing” activities of the state, such as for refining or distributing gasoline. An AMLO administration may backtrack on some of the country’s structural reforms, but with the realization that such a move would have to be done through its existing legal framework. As mayor of Mexico City, he delivered mixed results but generally welcomed public-private partnerships. The fiscal outcome of his mayoral tenure did not raise alarms.

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