Our recent visit to Mexico—during which we met a host of government officials, policymakers and credit analysts—has largely confirmed the economic and investment views we had expressed during the first half of the year.
As a reminder, back then we stated that:
- we believe Mexico's greatest challenge lies in its 2018 elections—not in its relations with the United States;
- Mexico's institutional framework should provide political and economic stability even in an unfavorable election outcome; and
- markets do not seem to be pricing in the possibility of such an outcome.
Yet we also emerged from our trip with two modified views.
- We are less constructive on the short end of the yield curve for the rest of 2017.
We believe the majority of market participants (including ourselves) had become too excited about Mexico’s ability to deliver lower short-term interest rates for the remainder of this year. And though it still could happen, we believe the probability is remote on the basis of the meetings we’ve had with various policymakers.
- We are more bullish on the medium- and long-term economic outlook for Mexico.
We were impressed with the strength of Mexico’s governing institutions and its highly qualified technocrats. In talking to political consultants and constitutional lawyers, we grew comfortable with the resilience of its constitution and the continued progress on its economic-reform agenda. These foundations, in our view, will make it hard for any new president to undo the progress made.
The political uncertainty presented by the 2018 election makes us more concerned about potential
investment opportunities than it does about some untoward political event that would create longer-term havoc in an investor’s portfolio.
Over the last few months, we’ve been building out our position in Mexican interest rates as we were expecting the end of the rate-hiking cycle would be reached over the summer or fall of this year. This expectation materialized with the “dovish hike” by Mexico’s central bank (Banco de Mexico) on June 22, and resulted in a significant market rally over the subsequent few days. The market even started to price in rate cuts for later in the year. (The bank decided to keep rates unchanged at its periodical policy meeting on August 10.)
Yet, on the basis of the views we’ve gained during our trip, we took the following actions in our portfolio:
- we unwound our front-end receiver positions (i.e., we trimmed our long positions on the front end of the yield curve);
- we unwound our curve-steepener positions (i.e., we trimmed our positions that stood to benefit from a lower yield curve on the short end and a higher one on the long end);
- we added to our long position in 5-year government bonds versus 5-year U.S. Treasuries (also known as a spread trade); and
- we bought long-end Mexican peso-denominated government bonds (MBONOs).
Moving forward, we will continue to build out our position in Mexico by:
- shifting our risk allocations and actively managing our positions along the yield curve;
- looking for the best way to express our views through various instruments—from bonds to derivatives; and
- continuing to explore relative value positions between Mexico and its trading partners.
Our Current Economic and Political Perspectives
Mexico has developed a strong macroeconomic framework, and during times of weakness it has sought to reinforce it. Its economy, in our view, is resilient and able to deliver solid, albeit low, growth. As mentioned earlier, its governing institutions appear strong and technically staffed.
1. The political environment
Our note of caution, however, is on Mexico’s political uncertainty: There is widespread dissatisfaction among Mexicans with the ruling class and general social conditions. Barring any change in the political and economic direction of the country, we think Mexico has a promising future: It has just started to reap the benefits of the energy reforms it continues to embrace—and we expect productivity gains to allow the country to enjoy a higher, more sustainable growth rate.
2. The general economy
Mexico’s fiscal and current-account balances are narrowing. In fact, on the fiscal side—arguably the most vulnerable one that has led to market pessimism until not very long ago—there are no expectations of a shortfall in oil revenues this year, unlike in previous years. It is possible that 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.
Mexico’s national oil company is also being revamped through changes in its administration and the country’s energy reforms. We think these are lasting improvements. Rating agencies—most recently Standard and Poor’s, on July 18—are acknowledging Mexico’s progress by moving their outlook from negative to stable.
Similarly to other emerging markets, Mexico had to absorb a series of shocks. Consumer prices increased nationwide, largely because of the cumulative effects of the peso’s depreciation late-2014, and because of the increase in gasoline prices in the beginning of the year.
The latter comes on the back of a lasting change to Mexico’s fuel-pricing regime, which needed to be liberalized. Despite upward pressure on consumer prices, the central bank has been acting preemptively in the face of expectations of tightening global financial conditions. The bank has been acting on its mandate of controlling inflation, so that: (a) it does not show second-order effects (meaning that prices across the board do not rise); and (b) long-term inflation expectations do not rise.
4. Business sentiment
The majority of Mexican companies last surveyed by the central bank1 expect a higher increase in the demand for goods and services across the country in the next 12 months in comparison to what they expected in the previous quarter of the year. Additionally, companies expect a slower pace of growth in inflation and wage costs in the next 12 months. Accordingly, currency pressures have eased, as the fiscal and monetary response of Mexico’s government has been firm, and as its relationship with the United States has improved since last year’s U.S. elections.
5. The external environment
Finally, renegotiations of the North American Free Trade Agreement (NAFTA)—which involves Canada, Mexico and the United States—have been pushed out to the second half of the year. The United States is aware that Mexico’s presidential elections of 2018 may bring a different party to power, and that Mexico may therefore seek to resolve key NAFTA-related disputes before then. Early indications suggest that such renegotiation on Mexico’s part would likely be benign—rather than major—and focus on:
- labor and environmental standards;
- tighter “rules of origin” (which provide the basis for customs officials to make determinations about which goods are entitled preferential tariff treatment under the agreement); and
- changes to the agreement’s dispute-settlement mechanism.
In closing, we are “sombrero bullish” about Mexico—more bullish today about Mexico’s economic prospects in the medium and long term, with a cautious view on the yield curve. Politically speaking, we believe Mexico's greatest challenge lies ahead in its 2018 elections. And we continue to build out our portfolio positions in Mexican fixed income, while modifying our positions along its yield curve with the expectation that Mexico may not be able to deliver lower interest rates through the remainder of the year.
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- ^Source: Banco de Mexico, Reporte sobre las Economias Regionales, January ̶ March 2017.
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