By Jorge Amato
Investment Strategist – Latin America
October 30, 2017
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NAFTA talks have stalled but we still believe that a successful renegotiation can occur
After four rounds of talks, the NAFTA negotiations have hit an impasse.
Mexico and Canada have strongly suggested that they will not accept the latest US proposals as they stand. A cool down period has been announced and the parties have agreed to allow for negotiations to extend into 2018 with the fifth round of talks now set for 17 November in Mexico City.
Market angst had also increased as President Trump has publicly spoken about the possibility of the US walking away and terminating the agreement. He recently threatened to give six months’ notice to leave the agreement but not necessarily then pull out, believing this will give the US more leverage.
Moreover, the Mexican and Canadian governments have indicated that they would not continue negotiating under a six-month notice window.
While the long-term economic impact for Mexico is unlikely to be fatal, the short-term consequences of the uncertainty in case of termination are likely to be felt through the exchange rate, consumer and investment confidence, and consequently throughout the economy.
Eventually, an even more competitive exchange rate and reallocation of specific sector resources should pave the way for a strong recovery, but this could take some time.
Our base case (70%) is that NAFTA will ultimately be successfully renegotiated, with the second most likely scenario (20%) is new bilateral agreements. Terminating NAFTA is a lose-lose for all involved, but accepting a bad NAFTA is also a poor option for Mexico and Canada.
It is worth highlighting, however, that NAFTA was not entirely a boon for Mexico. Its impact on the Mexican economy was more crucial via the direct investment poured into Mexico by US companies and the integration of supply chains, particularly in the auto sector and in the northern region of the country. A very broad segment of the Mexican economy would actually see little direct impact if NAFTA was terminated.
Moreover, while the broad economic impact of withdrawing from NAFTA on the US would be limited, it could be most felt in those states such as Texas, Illinois, and Michigan and industries like automotives where the supply chain integration and investment is the largest. Potential negative impacts are likely to play a significant role in our view that a political solution could be reached.
A divide and conquer strategy could also be a real possibility. President Trump has suggested several times that he prefers bilateral over multilateral deals. If NAFTA talks fail completely we would not be surprised to see Canada and Mexico begin bilateral talks in the immediate aftermath. This strategy, however, might not be the preferred route for Canada and Mexico as they would lose some of the leverage they currently have by presenting a united front in current talks, but they might not have a choice
We expect further volatility and potential weakness in the Mexican peso during the negotiation period. But sharp market sell-offs can present tactical opportunities.
We have held a broadly market weight recommendation for tactical exposure to Mexico throughout the year, balancing a constructive macroeconomic and valuation view with the potential risks of NAFTA talks. We maintain our 12-18 month neutral tactical recommendation for equities and external debt and our overweight in local bond markets despite our expectations of additional spot FX volatility and potential weakness. We would consider sharp market sell offs as tactical opportunities to add to equities and external debt.