US-Mexico End Tariff Meeting Without Breakthough; Peso, US Futures Plunge
Update (1845ET): President Trump has tweeted that “not nearly enough progress is being made” in the talks with Mexico, which will resume tomorrow:
Immigration discussions at the White House with representatives of Mexico have ended for the day. Progress is being made, but not nearly enough! Border arrests for May are at 133,000 because of Mexico & the Democrats in Congress refusing to budge on immigration reform. Further…
— Donald J. Trump (@realDonaldTrump) June 5, 2019
….talks with Mexico will resume tomorrow with the understanding that, if no agreement is reached, Tariffs at the 5% level will begin on Monday, with monthly increases as per schedule. The higher the Tariffs go, the higher the number of companies that will move back to the USA!
— Donald J. Trump (@realDonaldTrump) June 5, 2019
The market rebounded on this news…
Mexico’s foreign minister Ebrard told reporters as he left the meeting that it was cordial.
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Update (1815ET): Trump administration officials have now confirmed that President Mike Pence met for two hours with Mexican foreign minister Marcelo Ebrard at the White House, and the meeting ended without reaching a resolution.
Bloomberg reminds readers that Pence has previously failed to thread the needle when acting as the president’s surrogate in important negotiations. The vice president led talks with congressional Democrats earlier this year to end a government shutdown, only for Trump to tweet later that there was “not much headway made.” The government remained shuttered until Trump relented on his demand that Congress provide more money to build a border wall.
Additional news reports suggested that the US Secretary of State, Mike Pompeo, will meet Mexican Foreign Minister Marcelo Ebrard to discuss the way forward.
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In an oddly-timed double-whammy, both Fitch and Moody’s have taken a negative ax to Mexico’s credit rating as the country’s officials are in Washington DC negotiating with the Trump administration over immigration and tariffs.
Moody’s Investors Service lowered Mexico’s outlook to negative from stable, and minutes later Fitch downgraded the country to BBB (from BBB+).
As a reminder, Trump’s threatened penalties are set to begin Monday if Mexico doesn’t take unspecified actions to stem the flow of migrants and illegal drugs to the US.
The result is clear – the peso is plunging…
And US futures just opened notably lower…
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Fitch explains why it downgraded Mexico.
The downgrade of Mexico’s IDRs reflects a combination of the increased risk to the sovereign’s public finances from Pemex’s deteriorating credit profile together with ongoing weakness in the macroeconomic outlook, which is exacerbated by external threats from trade tensions, some domestic policy uncertainty and ongoing fiscal constraints.
The impact of the contingent liability represented by Pemex weighs increasingly heavily on the sovereign credit profile, as evidenced by Fitch’s two-notch downgrade of Pemex to ‘BBB-‘ from ‘BBB+’ in January 2019 and the latter’s stand-alone credit profile of ‘CCC’. Spreads on Pemex’s debt over sovereign debt rose materially in 1Q19, leading the government to step up support. The fiscal cost of that support to date represents 0.2% of GDP to the budget in capital injections and lower effective taxes, but in Fitch’s view, are not sufficient to provide a long-term solution or prevent continued deterioration in Pemex’s credit profile.
Pemex’s tax bill (oil accounted for 2.3% of GDP in federal government revenue in 2018) exceeds its FCF, preventing it from investing sufficiently to maintain production and reserves. Fitch expects oil output to contract by 5% in 2019 and 2020. The company’s debts, which are largely external, reached USD106.7 billion (8.7% of GDP) in 2018 and are not included in the general government debt metric used by Fitch in its sovereign rating model. However, as our base case expectation is that ongoing sovereign support will be extended to Pemex over the medium term through a combination of a lower tax burden and/or further capital injections, our assessment of the sovereign’s public finances is weaker than indicated by the headline gross general government debt to GDP ratio of 42% at YE 2018.
Growth continues to underperform, and downside risks are magnified by threats by U.S. President Trump to impose tariffs on Mexico from June 10 (starting at 5% and rising by a further 5% per month up to a potential 25%) to compel it to stop the flow of migrants across its territory into the U.S., amid a pattern of trade uncertainty. Mexico’s five-year GDP growth averages 2.6%, below the ‘BBB’ median of 3.6%. Excluding the drag from oil production narrows the gap to the median by around half (i.e. 0.5pp). Although full-year GDP growth reached 2% in 2018, the pace of growth decelerated during the year and the economy only narrowly avoided recession, as growth was flat in 4Q18 before contracting 0.2% qoq (1.25% yoy) in 1Q19.
Mexico’s growth continues to lag that of the more developed U.S. economy, to which it is closely linked. Fitch expects growth to accelerate from 2Q but despite this it will reach only 1% in 2019; this would be consistent with a pattern of slower growth in the first year of a new administration. Lower inflation and higher wages (stemming from rises in the minimum wage) should support consumption, but the energy sector, characterized by a trend of falling production at Pemex, and weaker investment levels, reflecting lower business confidence, will continue to weigh on growth. The suspension of private sector bidding rounds that had been scheduled as part of the energy sector reforms is unlikely to help investment sentiment.
The 2019 budget presented in December, followed by the “pre-criterios” or 2020 fiscal policy guidelines released in April 2019, maintain a disciplined fiscal stance. Estimated oil revenue for 2019 has been revised down by 0.5% of GDP, and spending cuts were announced for an equivalent amount. Resources for the government’s priority programs were scaled back in the budget relative to pre-budget announcements, and other expenses have been cut. The government targets a primary surplus at the non-financial public sector level of 1% of GDP in 2019 (2018: 0.6% of GDP). The president has also stressed that public debt “will not grow in real terms.” General government debt ended 2018 at 42% of GDP, slightly above the current ‘BBB’ median of 37.5% of GDP, and Fitch expects it to stay around that level in 2019-2020. The general government deficit was 1.9% of GDP, lower than the non-financial public sector deficit of 2.3% of GDP.
In Fitch’s view, meeting fiscal targets will become more difficult heading into 2020 and could result in tighter policy that creates a further headwind to growth. The president has pledged not to raise taxes before 2021. In 2020, the fiscal rule demands a further tightening of the public sector primary balance to 1.3% of GDP. The government plans a change to the fiscal rules framework that would increase counter-cyclical space and, by reducing potential over-spending, the credibility of fiscal targets.
Government revenues should benefit from efforts to curb tax evasion and the scrapping of “universal compensation”, a provision which allowed corporate tax payers to write off tax due (most frequently corporate tax) against VAT or other tax claims. Meanwhile, spending on new social programs for pensioners and the youth population (which were allotted 0.6% of GDP in the 2019 budget) is likely to undershoot as these get off the ground. Data YTD show revenue and spending were below budget at the public sector level, the former largely owing to lower revenues from Pemex.
It remains to be seen whether the new administration, which has pledged action against crime and corruption, can reverse the trend of deteriorating governance, which began under its predecessors. The president has a stronger mandate than prior administrations, and his coalition has a majority in the lower House of Congress, and close to a majority in the Senate, giving him the ability to effect change. The average of the six World Bank governance indicators used by Fitch is weighing on Mexico’s score in Fitch’s Sovereign Rating Model and is currently the lowest in the ‘BBB’ category. Progress in combatting fuel theft, which had become a major problem for Pemex, is a positive achievement. The government has created a National Guard to fight crime and is encouraging the judiciary to pursue corruption cases.
Mexico’s ratings are supported by the country’s diversified economic structure and a track record of disciplined economic policies that has anchored macroeconomic stability and contained imbalances. While some of the Lopez Obrador administration’s microeconomic policy decisions have proved contentious, macro policy choices have been orthodox to date. These strengths counterbalance Mexico’s rating constraints, which include economic growth below the ‘BBB’ median, structural weaknesses in its public finances (a low revenue base compared with peers), shallow credit penetration, and governance scores among the lowest in the ‘BBB’ category.
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Moody’s explains why it shifted Mexico to a negative outlook.
Moody’s decision to change the outlook to negative on Mexico’s A3 ratings reflects the rating agency’s concern that the policy framework is weakening in two key respects, with potential negative implications for growth and debt.
First, unpredictable policymaking is undermining investor confidence and medium-term economic prospects.
Second, lower growth, together with changes to energy policy and the role of PEMEX, introduce risks to Mexico’s medium-term fiscal outlook, notwithstanding the government’s near-term commitment to prudent fiscal policy.
The A3 rating affirmation balances the country’s large and diversified economy, its high fiscal strength and low susceptibility to event risk, against ongoing challenges related to weak growth rates, weaker-than-peers institutional strength and a large informal sector.