With the dust starting to settle around Mexico’s new administration and challenges on multiple fronts, investors have much to consider. Antoon de Klerk sifts through the evidence following a recent trip to the country.
Since last summer’s elections in Mexico, moves by the new president, Andrés Manuel López Obrador (AMLO), have in turn spooked and charmed the market. As the dust starts to settle, bond investors must now assess Mexico’s prospects under the AMLO administration.
Weighing up the new president
A key question is how big a risk premium AMLO warrants over the longer term. The answer largely depends on where he falls on the ideological (bad for markets)/pragmatic (market-friendly) scale. Meetings in Mexico with political analysts, rating agencies, bankers and other investors, highlighted evidence in support of both views:
A presidential personality test
|AMLO the ideological leader||AMLO the pragmatic president|
|Is he a fan of the Cuban revolution?||✓|
|Has he appointed far-left staff in key roles (eg education)?||✓|
|Are most of his project proposals economically questionable?||✓|
|Did he cancel a large infrastructure project part-way through construction?||✓|
|Is he willing to rethink some of his ideas (eg placing the national guard under civilian authority?)||✓|
|Has he made a credible commitment to a 1% primary surplus?||✓|
|Has he stood up to a labour union?||✓|
|Has he taken a (generally) constructive approach with the US?||✓|
|Has he stated he will scrap social programmes if the finances don’t add up?||✓|
The balance seems to be in favour of AMLO the (predominantly) pragmatic president, albeit among an entourage that spans the ideological/pragmatic spectrum. This might suggest that the current ‘AMLO risk premium’ is rather high, yet there are many other factors for investors to consider. Furthermore, with public finances looking fairly stable for the year ahead we think monetary policy is a relatively higher-stakes concern for bond investors than factors that may affect fiscal policy direction.
What future for monetary policy-making?
Despite concerns raised following AMLO’s election win over the future of the central bank’s independence, the consensus now seems to be that the central bank will not see its mandate change, with recent market-friendly appointments allaying most fears.
There is also a general view that a loosening of the currently very tight monetary policy – which prices in approximately 200 basis points of risk premium – is on the horizon. Recent monetary policy committee meetings have highlighted a subtle but important shift, with even the traditionally more hawkish committee members citing the (currently weak) growth outlook as an important factor for future decision-making.
We believe rates will ultimately be cut to a greater extent than the market consensus view.
While we think it is reasonable to expect a rate cutting cycle over the medium-term, market participants who anticipate imminent rate cuts may be disappointed. We believe cuts will be gradual as the majority of the central bank’s monetary policy committee remains concerned over the government’s potential to stick to its prudent fiscal targets, but we believe rates will ultimately be cut to a greater extent than the market consensus view.
Grappling competing forces
A trio of challenges puts Mexico’s government between a rock and a hard place. AMLO’s administration has big expectations to meet given its election promises on social spending, self-inflicted pressure for fiscal prudence (budgeting for a 1% primary surplus) and a struggling utility giant – Pemex – to prop up. And the new administration’s energy policy stance to date, favouring a bigger role for the state at the expense of the private sector, has only added to Pemex’s woes.
But the Mexican administration may just be able to pull off a squaring of the circle. At least in the near term. The general view on the ground is that this year AMLO will be able to achieve the 1% surplus he forecast in his first budget. A backtrack or delay on election promises also seems a possibility, with AMLO suspected by some to be fiscally conservative at heart. And while we expect the government to provide further support to Pemex, this should initially come from stabilisation funds which would not impact the government budget.
A delicate balancing act
While the above seems encouraging in the short-term, it will be a trickier balance to maintain over a longer time frame.
The drip-feed approach to Pemex’s woes that the government has taken so far is a long way from a credible and sustainable plan. A reduction in the amount of taxes that the government takes may be necessary to truly stabilise the Pemex situation. But this prospect may not bear as heavy a weight as many fear. The credit market is already pricing in a negative outlook, trading at a spread consistent with a multiple notch debt downgrade; we think this is overly pessimistic as the impact on sovereign debt of reducing the tax burden on Pemex would be modest and manageable, by our estimates.
Weak growth can translate relatively quickly into fiscal challenges and then political unrest.
In line with others, we expect that hitting the 1% surplus target will be a lot tougher in 2020 than this year. Add to this lacklustre growth and a corporate investment pipeline that has all but dried up and the picture is further weakened. Poor economic growth rates can translate relatively quickly into fiscal challenges and then political unrest. It is an all-too-familiar pattern in emerging markets that can easily catch out investors.
Other factors for investors to consider include the conspicuous absence of moves by AMLO to pursue the previous regime over corruption allegations. This formed a big part of his election promise and could see his sky-high popularity rating diminish as time goes by. And his response to recent strike action will be an important factor to watch.
Pragmatist or not, AMLO faces a significant test in the months and years ahead.
We are positioned across some of our strategies as follows:
- Local bonds: we are overweight the 5-7-year segment of the yield curve as we ultimately expect interest rates to be cut to a greater extent than the market consensus view.
- We have a relative value trade in favour of Pemex credit versus Mexican sovereign bonds as we believe the state is very unlikely to allow Pemex to fail and we see value in Mexican credit as the market is pricing in multiple rating downgrades on sovereign debt, which we believe will not materialise.
- We have a modest underweight in the peso. We are concerned that high real rates have been the key supporter of the currency and that as the central bank starts to loosen monetary policy this effect may diminish. However, we are cautious about holding a sizeable underweight given our expectation that weak imports will help keep the current account under control.
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.