NAFTA: Mexico At A Critical Point

It appears the gloves are now off as the North American Free Trade Agreement (NAFTA) enters Round 4 of the trade pacts re-negotiation.

There has been some progress–as has been reported in earlier rounds of talks– but there is a sense of foreboding about the upcoming round, which will discuss domestic content rules that will prove very controversial. Ironically, the US is pushing for a higher minimum wage in Mexico, and Canada wants better labor rights in the US.

Current reports suggest that the US is arguing that 85% of vehicles must be made in NAFTA countries to count and up to as much as 50% must originate in the US. Such a demand, explains Brown Brothers Harriman (BBH) coupled with the push for a “sunset” clause (which would end NAFTA at some future date unless explicitly endorsed by all three countries), is seen as part of the “poison pill” strategy, according to the US Chamber of Commerce.  “The idea is that although [President] Trump backed off from his threat to leave NAFTA, his Administration’s demands will not produce an agreement,” Marc Chandler, global head of currency strategy with BBH wrote in an October note to clients.

Ultimately, it is the members of US Congress that will have to ratify the final agreement. Just like the White House stance spurred a bipartisan response from Congress regarding sanctions against Russia, North Korea, and Iran, there seem to be bipartisan efforts to resist a disruption of supply chains and trade relations. This is part of the check and balances, writes Chandler.

Risks Rising

With the positive tailwinds that were supporting Mexico earlier this year no longer in place, Mexican assets have become more vulnerable to global headwinds, at a time when concerns surrounding NAFTA negotiations and the presidential election in Mexico next year are increasing.

“Given our expectation that risk premium will pick up heading into year-end, we move to a neutral view on Mexican fixed income and position for Mexican peso underperformance,” Gordian Kemen, a NY-based managing director and global head of emerging market and fixed income strategy with Morgan Stanley says.

This month, the largest business group in the US, the Chamber of Commerce, raised the red flag over the direction in which NAFTA discussions seem to be headed. Prior to the start of renegotiating the agreement, there had been hopes on all sides that minor adjustments and tweaks, rather than the dismantling of it altogether, would occur. The recent rise in rhetoric has many concerned, and Mexico’s top negotiator has publicly stated that Mexico would find a way forward, and NAFTA being terminated would not be the end of the world for them. The country would find a way forward, if not recover from NAFTA falling apart.

A Look At Mexico’s Domestic Affairs

While NAFTA talks have raised renewed concerns, some market observers see no need to entirely panic. Yes, former Mexican first lady Margarita Zavala has announced that she is abandoning the National Action Party (PAN) to prepare for an independent presidential run. This has increased fears that next year’s election could usher in a populist president. These fears are also compounded with recent concerns about progress on NAFTA negotiations and the impact that US Fed tightening [interest rates] will have in Mexico. These factors amount to a triad of negative influence on Mexican assets. “However, we believe the presidential election and NAFTA negotiations are likely to end better for Mexico than markets fear,” Pedro Tuesta, senior economist with 4CAST-RGE said.

First, Tuesta believes that the Bank of Mexico (Banxico) will maintain its hawkish policy stance until after the elections. And while Jose Meade is currently lagging in the polls, “we believe a strong centrist PRI campaign will likely be enough to prevent AMLO from winning the presidency. Although many Mexicans view the PRI negatively, AMLO faces similar disapproval,” he adds.

The prospect of an AMLO presidency is starting to send warning signals to investors, thus stoking the growing pessimism about investing in Mexico. This is already affecting having a negative impact on the peso, and will start to put some pressure on the back-end of Mexico’s yield curve as the country’s long-term risks are reassessed.

“Our baseline scenario is still optimistic, with USD/MXN closing at 18.00 in 2017 and at 17.50 in 2018. This is under the assumption that both the election and NAFTA negotiations will resolve favorably for Mexico.”

Any revision to their [4CAST-RGE] view on Mexico, according to Tuesta, could be triggered by a weak candidate field to oppose AMLO or an unfavorable outcome for Mexico from NAFTA negotiations. “However, we still see our baseline scenario as most likely.”

While the outlook remains positive, NAFTA negotiations seem to have slowed down as some of the more contentious issues need to be addressed. While all parties involved have an interest in preserving and improving NAFTA, the speed and success of the negotiations over the next few months is less certain now. “This means that the timeline could be more complicated than what the market was pricing in, especially given Mexican elections,” Kemen wrote.

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