Mexico State Election Not Very Reassuring

(from my colleague Dr. Win Thin)

INTRODUCTION

The ruling PRI narrowly won the state of Mexico.  Yet the margin was hardly assuring to those looking ahead to the 2018 national elections.  We think today’s bounce in the peso is overdone. 
 
POLITICAL OUTLOOK

The so-called quick count showed the PRI ahead by a narrow margin, which triggered a big rally in the peso overnight.  The official running tally is also pointing to a narrow PRI win (34% vs. 31%) with 98% of the votes tallied.  This is hardly good news for the PRI, which has held the governorship of Mexico state for more than 80 years, and last won in 2011 with over 61% of the vote. 
Yet Moreno is not going quietly.  Party head Andres Manuel Lopez Obrador (AMLO) said he did not accept the results yet, while his candidate Delfina Gomez claimed victory.  If the final vote count is very close, it’s very possible that Morena takes the matter to the courts.  

While a lot can happen between now and June 2018, the results of this state election provide some important clues for the national elections.  That the race was so close between the Morena and PRI candidates show just how badly things have been going for the ruling party.  We believe that even a narrow loss in Mexico state gives AMLO and Morena a national boost.  

There were two other state elections Sunday.  In the state of Nayarit, it appears that the PRI lost decisively to a PAN-led opposition coalition.  In the state of Coahuila, the vote remains too close to call.  With the loss of Nayarit, the PRI would have six fewer governors than when current President Pena Nieto took office in 2012.  Again, not a good sign for 2018.

The next national elections will be held in June 2018.  Polls have Morena candidate Andres Manuel Lopez Obrador (AMLO) currently leading the field.  Former First Lady Margarita Zavala is the likely PAN candidate and is polling second, but she could be challenged by PAN leader Ricardo Anaya.  The ruling PRI’s likely candidate is Interior Minister Angel Osorio Chong, who is polling third.  The leading PRD candidate is Miguel Mancera, who is polling fourth.

While it is way too early to get nervous, an AMLO victory in 2018 would not be taken well by the markets.  He is a breakaway from the leftist PRD, which has never held the presidency.  AMLO came close to winning in 2006, losing by a slim margin in controversial results as PAN’s Felipe Calderon won by only 244k votes (or 0.58 percentage points).

AMLO has come to represent a more nationalist brand of politics and this would very likely stoke tensions with the US.  Ironically, part of AMLO’s popularity stems from perceptions that he would stand up better against President Trump than Pena Nieto has so far. 

ECONOMIC OUTLOOK

The economy is still sluggish as several rounds of monetary and fiscal tightening bite.  GDP growth is forecast by the IMF to decelerate modestly to 1.7% in 2017 from 2.3% in 2016, before picking up to 2% in 2018.  GDP rose 2.8% y/y in Q1, the strongest rate since Q3 2015.  While monthly data so far in Q2 suggest some modest improvement, this latest leg down in oil should highlight downside risks to the growth forecasts.  

Price pressures bear watching, with CPI accelerating to 5.82% y/y in April from 5.35% in March.  May CPI data is due out Thursday and is expected to rise 6.16% y/y.  If so, this would be the highest rate since April 2009, and would move inflation further above the 2-4% target range.  

This supports the case for higher rates, and we believe Banco de Mexico will hike 25 bp again when it meets June 22.  This is especially true if the Fed hikes June 14, as widely expected.  Note that Banco de Mexico delivered a hawkish surprise 25 bp hike to 6.75% at its May meeting.  

Fiscal policy has remained prudent despite low oil prices.  Oil revenues account for around a third of government revenue.  As such, the drop in oil prices necessitated several rounds of fiscal tightening.  The budget deficit came in at an estimated -2.6% of GDP in 2016, down from -3.5% 2015.  It is expected to remain around -2.5% of GDP in both 2017 and 2018, but much will depend on oil prices. 

The external accounts should improve.  Low oil prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was about -3.5% of GDP in 2016, and is expected to narrow to -2.5% in 2017 before widening to -2.7% in 2018.  However, the gap will likely be covered entirely by FDI inflows.  Foreign remittances remain strong, with the 12-month total of $27.5 bln in April at record highs.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $175 bln in May, they cover nearly 4 ½ months of import and are nearly 3 times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The peso has done much better after an awful 2016.  In 2016, MXN fell -16% vs. USD and was ahead of only the worst performers ARS (-18%) and TRY (-17%).  So far in 2017, MXN is up 13% YTD and is the top EM performer.  The next best are RUB (8%), KRW (+8%) and ZAR (+8%).  Our EM FX model shows the peso to have WEAK fundamentals, so this year’s outperformance is likely to ebb.

Before today’s drop, USD/MXN had traded largely in the 18.50-19.50 range since mid-March.  Now, the pair is poised to test the November 9 low near 18.1635.  After that, the August low near 17.90 and the April 2016 low near 17.05 come into focus.  We think MXN gains will get a bit tougher ahead as positioning becomes a bigger part of the story.  CFTC just reported that net MXN longs were at 75k for the week ended May 30, which is the highest since 2014.

Mexican equities are outperforming EM after an awful 2016.  In 2016, MSCI Mexico sank -12% vs. +7% for MSCI EM.  So far this year, MSCI Mexico is up 20% YTD and compares to 18.5% YTD for MSCI EM.  This modest outperformance should ebb, as our EM Equity model has Mexico at a VERY UNDERWEIGHT position.  

Mexican bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -21 bp YTD.  This is in the middle of the EM pack.  The worst performers are China (+60 bp), Czech Republic (+38 bp), and India (+14 bp), while the best are Indonesia (-96 bp), Turkey (-96 bp), and Colombia (-93 bp).  With inflation likely to continue rising and the central bank forced to tighten further, we think Mexican bonds will start underperforming more.  

Our own sovereign ratings model showed Mexico’s implied rating fell a notch to BBB/Baa2/BBB this quarter.  As such, actual ratings of BBB+/A3/BBB+ are facing growing downgrade risks.  However, the agencies may wait to see how US-Mexico economic relations actually develop under President Trump before making any moves.      

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