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Will Mexico suffer from a trade war with the US?

Article | 02 May 2017

An ‘America first’ trade policy is causing friction with its southern neighbour. Will the Mexican economy stall from US protectionist policies?

Dean Newman

Dean Newman

Head of Emerging Market Equities

President Trump’s aim of pursuing an ‘America first’ trade policy and possibly imposing a 20% tax on Mexican imports is cause for concern. A revamping of the bilateral relationship between the two countries could have an adverse impact on both economies and potentially lead to an escalation of protectionism in other regions.

Heavy two-way traffic

While Mexican exports to the US are important– accounting for nearly 80% of the total – it is important to highlight that Mexico is the second largest export destination for US goods. Indeed, the US sells more to Mexico than it does to all the 28 countries of the European Union combined. Furthermore, every dollar of Mexican export has 40% content of US inputs1 – think of the US car manufacturing plants, attracted by low tax rates and competitive real labour costs that are located in Mexico. A trade war will hurt the US consumer with higher prices for imported goods, but it could also hurt the domestic labour market. Analysis by UBS suggests that a tariff would result in cost inflation, lower sales and a net job loss in the US. And there is no guarantee that carmakers will abandon Mexico, given the huge wage differential between the two countries (see Figure 1). Mexican auto wages are only 15%- 20% of those in the US. Slap even a 35% tariff on car imports and it would still be cheaper to manufacture motor vehicles in Mexico.

Figure 1. Average hourly auto wages 2017 (US$)

Figure 1. Average hourly  auto wages 2017 (US$)

Source: UBS, as at 26 January 2017


Violation of the rules

The imposition of a border tax will require congressional approval and would be a clear violation of the North American Free Trade Agreement (NAFTA). Even if this agreement ultimately gets consigned to the history books, Mexico will still enjoy the benefits of a safety net from the World Trade Organization (WTO), assuming that the US remains a member. Mexico’s most relevant exports to the US – representing more than 60% of the total – are machinery and transportation equipment. Under NAFTA, the tariffs on these are zero. The average rate under WTO rules would be 2.2%. By contrast, exports from the US to Mexico would attract higher tariff rates, which would make their goods less attractive and subject to greater competition from suppliers elsewhere in the world.

Political hurdles

Given that the US economy is not immune from a protectionist war, it will be interesting to see what unfolds over coming months, especially since it seems that support for Trump’s trade stance is coming more from the Democrats than the Republicans. So far, the Mexican Government has stated that they will be open to a constructive and holistic negotiation on trade as well as migration and security.

Diversified economy

Although the export sector plays an important role, there are other drivers for the Mexican economy. Consumption has been the bright spot in Mexico’s growth story – the unemployment rate is low and real wages are rising. The country also has a significant number of blue-chip companies that have a good earnings profile and are likely to show resilience in any economic downturn. While some of these have exposure to the consumer sector, many are involved in other sectors of the economy, for example industrials and materials.

Concrete evidence

Increased investment in US infrastructure has been a key target for Trump. Whether the US goes ahead with the construction of a border wall on its southern boundary, we believe that Mexico’s Cemex, the largest concrete company in the world with large operations in the US, is in a good position to benefit from increased demand for building materials from both sides of the border.

Reforms

Mexico continues to make steady progress in modernising the economy through reforms. The energy sector has received plenty of attention in recent times. Although Mexico is a large oil producer with huge reserves, the country is still – due to lack of investment over several years – heavily reliant on imports to meet growing demand for gas. Insufficient infrastructure investments are being addressed: for example, 10 liquefied petroleum gas destination terminals are currently under development. With Mexico’s deep water and shale fields now open to foreign investment, we believe lower energy prices should eventually filter through to companies and consumers. Aimed at boosting national productivity and competiveness, the Government has also introduced reforms in education, telecommunications, financial and fiscal – the 2017 budget contains the first primary surplus since 2008. These structural reforms should help transform the Mexican economy and add to its long-term appeal, in our view.

1marketpulse.com, as at 26 January 2017.

Important information

Where Dean Newman has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.

Tags: Equity, Investment, Economic

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