President Trump has added another chapter to the trade conflict. Last Thursday, he surprised markets with a 5% tariff on all imports from Mexico, starting June 10, with a monthly increase of 5 percentage points (to a maximum of 25%) if the Mexican authorities do not stop migrants passing through Mexico and entering the US. This bold move contravenes the still-existing NAFTA rules, but the US government is justifying it with arguments of national security.
The Mexican government has said it will not retaliate before starting discussions with the US. Delegations from both countries will meet for talks tomorrow in Washington, DC, but US officials have stated that Trump is likely to stand firm. For the government of Andrés Manuel López Obrador (AMLO), this is a major test. AMLO knows the country is very dependent on exports to the US - 85% of its exports go to its large neighbour, representing 30% of GDP - but he was elected on an assertive nationalist platform. The president is faced with a weak economy, mainly due to private-sector uncertainty about the economic policy course, which is generally expected to be more interventionist. Fixed investment growth has been weak because of this domestic uncertainty, and with trade uncertainty increasing again, the Mexican economy runs a risk of falling back into a recession.
The timing of the new tariffs is curious, with Trump's announcement coming on the same day that AMLO asked the Mexican Senate to hold an extraordinary session to ratify USMCA, the new trade agreement between the US, Mexico and Canada, which should replace NAFTA. Meanwhile, in the US, approval of USMCA had already become more uncertain. This new unilateral move by the US reduces the likelihood of the US Congress passing USMCA in the foreseeable future.
Investors will have to price growing headwinds to Mexican trade. The peso is one of the most liquid and freely tradable currencies in emerging markets, so much of the immediate market impact will come via the exchange rate. Also, Mexican equities are currently vulnerable to a correction. The market recently recovered a bit relative to global emerging markets as investors focused on the negative growth impact of the escalated US-China trade conflict on emerging Asia. Mexican bond markets appear less vulnerable, as more trade headwinds increase the likelihood that the central bank will cut interest rates.
We have had an underweight in Mexican equities since September 2017, partly due to a high risk of further US protectionism. We also fear the AMLO administration's interventionist policy course, with its negative impact on business confidence and corporate capital expenditure and a high risk of a widening government budget deficit. An additional reason for caution with Mexican assets in general is the poor operational and financial condition of PEMEX, the state oil company, and CFE, the national electricity company. Required investments to increase capacity are unlikely to be achieved, while the eventual costs of the necessary financial clean-up will cause a meaningful deterioration of the federal state budget and public debt ratios.
Maarten Jan Bakkum, senior emerging markets strategist, NN IP