A special message from Joyce Chang, Global Head of Research
In this edition of Geopolitical Flashpoints, which can also be found on J.P. Morgan Markets, the Global Research teams examine the current status of the renegotiation of NAFTA 2.0 and the economic and market implications as well as the outlook for the July 1stgeneral elections in Mexico. The reports highlighted below summarize the latest developments and include recommendations and views across asset classes.
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Plans for reaching an ‘agreement in principle’ on the renegotiation of the North American Free Trade Agreement (NAFTA) are very unlikely to materialize as the Trump administration has turned its focus on trade issues with China, imposing US$50bn in tariffs, and has moved forward with steel and aluminum tariffs including its NAFTA partners. There is limited time remaining to advance negotiations before the July 1stMexican general elections and the November 6th U.S. mid-term elections. Left-wing Morena candidate, Andres Manuel Lopez Obrador (AMLO), who is making his third run for the Mexican presidency, remains the clear front-runner, benefiting from his long-standing campaign against corruption, public concerns about security issues, and frustration with the low economic growth rate of Mexico, which has averaged only 2.4% annually during current President Enrique Peña’s six-year administration—only marginally above the U.S. average of 2.2% in the same period. We recommend a neutral stance for sovereign, corporate and local bonds and MXN, and remain underweight Mexican equities.
Economic and Political View
The U.S. decision to impose tariffs on aluminum and steel for both Canada and Mexico and the fresh Section 232 investigation on autos on the basis of national security concerns, as well as rising tensions between the U.S. and Canada, diminish the prospects for a quick resolution or fast-tracking for NAFTA 2.0. After the 7th round of negotiations in March, optimism prevailed on reaching an “agreement in principle” as the negotiators shifted to “permanent negotiating sessions,” meeting daily with the goal to meet the May 31st informal deadline that would have provided the necessary space to notify the U.S. Congress six months in advance of the president’s intention to send the bill to legislators. However, negotiations reached an impasse over rules of origin for autos. The Mexican proposal to increase U.S. content from 62% to 70% was rejected by the U.S. administration, which reduced its demands for U.S. content from 80% to 75%, but the 5% gap was rejected by Mexico as it would have impacted as much as 30% of their auto trade with the United States. Even though there are nine chapters and technical annexes now completed after permanent sessions took place in DC last month, and ten chapters with 95% progress, contentious issues remain unresolved, including dispute resolution chapters. In fact, we believe withdrawal risk on the part of the U.S. has materially increased given retaliation by Mexico and Canada on the U.S. steel and aluminum tariffs. Mexico and Canada remain committed to the trilateral NAFTA framework, but U.S. negotiators have hinted at bilateral negotiations. Formal negotiations may not resume in earnest until 4Q18 or even 1Q19 given the political calendars in Mexico and the U.S.
With Mexico’s elections less than a month away, the gap has widened to more than 20 percentage points between the left-wing Morena party candidate, Andres Manuel Lopez Obrador (AMLO), and Ricardo Anaya from the right-left PAN-PRD coalition. The incumbent PRI candidate, Jose-Antonio Meade, is running in third place. AMLO’s lead has widened with the narrowing pool of candidates as support for the independent right-wing candidate, Margarita Zavala, who dropped out of the race in mid-May, has splintered amongst the field of candidates. With AMLO having survived all three debates unscathed, barring a major surprise in the final weeks, the race appears to be his to lose. AMLO’s strong lead has raised the question of whether the Morena party will be able to reach a simple majority in either or both chambers of congress, reducing the degree to which the legislative branch may act as a check on any less-market-friendly policy initiatives. Given the mechanics in electing legislators in Mexico, it appears more likely that Morena will be able to reach a simple majority in the Lower House but not in the Upper House. A constitutional majority in either chamber (two-thirds) looks particularly difficult. Such a backdrop could give Morena free rein to move forward on some spending initiatives that only require Lower House approval, but would require AMLO negotiate for key appointments or major reforms.
While AMLO’s team has emphasized respecting the prevailing 0.9% of GDP primary surplus target and continuing with prudent debt management, the campaign platform calls for spending increases for which funding is unclear. The AMLO team expects public-private partnerships (PPPs) and efficiency gains to finance much of the spending agenda, including an ambitious development plan (worth 2.5% of GDP) in Mexico’s poorer center-south (including construction of refineries), a universal pension system, and social programs aimed at the youth. Markets will be watchful to see the final composition of the economic team and how much influence is wielded by the more moderate, pro-business figures that have represented AMLO in the campaign. For example, Jesus Seade, the trade negotiator proposed by AMLO, is a highly qualified professional, but as AMLO seems set to inherit the NAFTA negotiations, some AMLO advisors have emphasized that NoFTA is better than a bad NAFTA. Overall, the level of engagement the transition team will have with the ongoing talks remains uncertain. Markets may also be concerned over an evolving stance toward Mexico’s energy sector as AMLO has said he will review (though not attempt to fully reverse) the liberalization of the sector undertaken by the outgoing administration. Gabriel Lozano
Rates and FX Strategy Views
High levels of uncertainty and minimal international appetite warrant a neutral stance in Latin American local bonds; we stopped out of our Latin America FX overweight stance in mid-May as market volatility increased across the region. GBI-EM yields sold off 55bp since early May while Latin yields rose by 75bp. Over this same period, ARS has declined by 25% despite a larger-than-expected 3-year $50bn IMF agreement. In addition, the recent changes to the central bank leadership (a new governor and monetary policy board) and cabinet (unifying the Ministry of Finance and Treasury) had added to policy uncertainty. Brazil local bonds sold off by 230bp over the same period and BRL weakened around 7.5% amid heavy BCB intervention with markets not yet convinced that the worst is over. Likewise, the MXN has weakened and international investors’ demand for Mbonos is running at 10-year lows relative to supply. Foreigners have added only MXN52 billion from January to May, which is just 24% of the total net supply—the lowest since 2009. Volatility in the region as well as the upcoming presidential elections and the NAFTA impasse are likely to keep international investors wary of local assets, warranting a neutral stance. Continued USD strength should add further pressure on regional markets. Carlos Carranza
We maintain our cautious approach to MXN, holding a small UW in our GBI-EM Model Portfolio. Since USD/MXN hit our 20.0 target, we have maintained that further MXN weakness could still play out from the lack of progress on NAFTA 2.0 and market expectations of a more left-leaning AMLO presidency, with the possibility that the Morena party wins more seats in the Upper and Lower chambers than anticipated. With less than a month remaining before the July 1st elections, AMLO’s rhetoric could take a harder line. We await better entry levels and see the potential for opportunities on the back of Banxico’s prudent stance, 3%+ ex-ante real rates and cheaper valuations. Robert Habib
For the Canadian dollar, we have revised forecasts as we expect recent weakness to persist through the U.S. mid-term elections, but the baseline still reflects mean reversion into 2019 as we still assume that NAFTA 2.0 eventually passes next year and BoC continues its steady hikes in parallel with the Fed.The unusual acrimony over trade on display at this past weekend’s G7 meetings and the breakdown of NAFTA discussions are a sharp reversal from just a few weeks ago. Combined with the outsized $11/bbl fall in Canadian crude prices in the past month due to local and regional transportation bottlenecks, we recently revisited our near-term target for USD/CAD to show persistent weakness at 1.30 through the fall ahead of U.S. mid-term elections. The baseline still reflects USD/CAD to remain bounded in this year’s range as BOC quarterly hikes keep rate spreads stable, and for the currency to mean-revert back to the middle of this range in 1H19 as the NAFTA overhang is resolved, although the negative tail risk of a NoFTA scenario has fattened. Daniel Hui
Emerging Markets Credit Views
We remain marketweight Mexican sovereign credit and recently took profits on our long Colombia versus Mexico relative value trade. UMS bonds have been trading wider than other IG sovereigns, and investors had been steadily reducing UMS exposures, moving from an OW positioning to an UW exposure over the past two years. As such, we see marketweight as the appropriate stance, and also recently took profits on our long Colombia versus Mexico trade in 5y CDS. We put on the RV trade in early April, citing that NAFTA optimism was already priced in, leaving Mexico vulnerable to any disappointments, at the same time that election uncertainties still loom with an AMLO win largely expected, but with lack of clarity on the policy direction. While lingering NAFTA noise could point to further challenges for Mexico going forward, Mexico-Colombia differentials around 30bp had surpassed that of November 2016 in the immediate aftermath of the U.S. elections. Using post-elections as a barometer for very bearish Mexico valuations, we viewed risk-reward as appropriate for taking profits on the RV trade. Rising tensions in Mexico have been accompanied by greater demand for hedges, which has resulted in the rise in bond-CDS basis, and CDS continuing to trade wider than comparable cash bonds. Basis recently has widened but remains below the peaks seen in the past two years; bond-CDS basis for UMS 4% 23 is currently 52bp compared to a 2-year range of 7-57bp. As such, we believe it is too early to enter trades selling bonds and selling CDS in Mexico, as uncertainties around trade and the Mexican election will likely exert more pressure on CDS as portfolio hedges remain sought after. Trang Nguyen
The performance of Mexican corporates and financial bonds should remain tightly linked to NAFTA headlines and the outcome of the July elections. CEMBI Broad Mexico has been one of the weaker performing country segments with returns at -5.18% YTD after spreads widened +70bp to 277bp. We keep select overweights, notably in the belly of the although we are comfortable with Mexico's banking system and believe there could be opportunities to extend maturities if volatility subsides. Despite the volatility in the peso, a large majority of the Mexican corporates have proactively hedged the revenue exposure in Mexico to soften the impact on earnings and leverage metrics. The macro outlook points to lower investment, slower growth, and a less favorable consumer backdrop should impact domestic operations and profitability. Large corporates with hard currency bonds tend to be well insulated from direct impacts, and shielded from the full effects of related macroeconomic pressure due to geographically diverse earnings streams, hedging policies, and conservative balance sheets. In the quasi-sovereign space, we expect an increase in spread volatility in the event of an AMLO victory, particularly for credits such as Mexcat and CFE due to the possibility that AMLO would probably seek to delay ongoing processes related to the construction of the airport and the energy reform events scheduled for 2H18 (energy rounds, open season auctions and Fibra E transactions). Natalia Corfield and YM Hong
U.S. Autos View
NAFTA uncertainty is likely to remain an overhang on U.S. automotive credit. Uncertainty around the renegotiation of NAFTA has been an overhang on U.S. automotive credit YTD given the integrated nature of the supply chain throughout the region. Ongoing negotiations appear to have reached a standstill over automotive content requirements (with dialogue between the U.S. and Canada turning incrementally acrimonious in the wake of the recent G7 summit), and an upcoming change in Mexican leadership may likely introduce more uncertainty. A U.S. withdrawal from the agreement could potentially expose significant Mexican and Canadian auto imports to recently threatened tariffs, while the renegotiation of the treaty is likely to raise costs for automakers and ultimately consumers. While a withdrawal of the agreement is certainly not our base case, in such a scenario we view Ford as relatively better positioned versus GM given its fully domestic pickup truck production footprint compared to GM’s substantial light truck production platform in Mexico. As it relates to the ongoing trade talks, we think a NAFTA negotiated solution is likely to either call for more U.S. content (effectively repurposing content to higher-cost U.S. production facilities) or perhaps raise labor costs in Mexico (effectively also raising costs for the U.S. manufacturers and suppliers as it makes Mexico less cost competitive); costs are likely to rise regardless of the ultimate outcome. Jon Rau and Avi Steiner
European Autos View
Despite some obvious production and sales imbalances across U.S., Mexico and Canada, we are seeing key car makers already taking measures to improve the trade balance across regions, committing to additional production in the U.S. such as VW and FCA, or even suggesting, if absolutely necessary, the roll out of sedan production in the U.S. at SUV-dedicated production plants, such as BMW. Daimler, however, is more flexible having already introduced sedan production at its SUV-dedicated U.S. plant some years ago. VW has the largest imbalance between sales and production across Mexico and the U.S. Since President Trump started indicating the need to renegotiate the NAFTA agreement, VW has committed additional production in the US, including the new Atlas, derivatives of the Atlas, as well as potentially a new pickup truck which could go on stream over the coming year. BMW has recently mentioned in the press (Reuters) that if needed they could start producing sedans in the U.S. at its existing facility, which currently is BMW's largest global dedicated SUV production hub. In addition, BMW is also expanding additional sedan production in Mexico from FY19 onwards. Daimler has the largest export SUV production hub in the U.S., selling SUVs not only in the U.S. but exporting on a global basis. Daimler has recently expanded compact class production in Mexico. FCA recently committed to relocating some pickup truck production from Mexico to the U.S. in FY20. Jose M Asumendi
Mexico Equity Strategy View
Remain UW as uncertainty will weigh on the MXN. The outlook for Mexican equities will mostly be a call on the currency, in our view, as MXN could still suffer from pre-electoral jitters. Nonetheless, our FX team is constructive on the MXN after the event, which also builds on a more benign outlook for equities given attractive valuations in some sectors. This de-rating has created a “barbell”-type opportunity for investors, with interesting entry points on names with stable earnings/cash flow, dollar defensiveness and exposure to the domestic consumer, which should be short-term insulated from investment uncertainty generated by a delay in NAFTA renegotiations. In any case, our base case scenario still remains for a NAFTA deal at some point in 2019, which should remove – if at least partially – the cloud over the investment case for Mexico. The pending risk will remain economic policy under a new regime, assuming a left-leaning government as polls consistently indicate. For the equity market, this is likely to be reflected in a higher cost of equity for Mexican assets, which should lead to a lower “structural” or “neutral” valuation in the long term. In the meantime, we favor financials, industrials, materials and select opportunities on staples. Nur Cristiani
Please find below links to recently published reports from the J.P. Morgan Research team.
ECONOMIC RESEARCH
NAFTA
Mexican Politics
FX STRATEGY RESEARCH
EMERGING MARKETS STRATEGY RESEARCH
Argentina: Main takeaways from the IMF "Bazooka" (Diego Pereira and Lucila Barbeito, 8 June 2018)
EMERGING MARKET CORPORATE CREDIT RESEARCH
US CREDIT RESEARCH
MEXICO EQUITY STRATEGY RESEARCH
EQUITY RESEARCH
VIDEOS AND PODCASTS
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