We expect Mexican energy reform to pass, says Ashmore’s Dehn

Jan Dehn, head of Research at Ashmore, discusses Mexico’s reform effort and the elections which will dominate the outlook for Emerging Markets in 2014.

A review of market moves in Mexico over the past year or so shows that global events as much as Mexico-specific factors drove the price action. In the past week Mexico passed an important fiscal reform and is now moving onto the equally important energy reform. We expect this reform to pass and believe that the outlook for Mexico continues to brighten. Meanwhile in the United States the Fed is getting ready to have another go at tapering. This time they are likely to replace Bernanke’s ineffective verbal intervention (‘tapering is not the same as rate hikes!’) with a commitment to keeping rates low until unemployment gets really low. But even with enhanced forward guidance how exactly will the Fed prevent the market from selling the long end absent direct market intervention via QE? The mortgage market may be part of the answer, but on its own may not resist a speculative movement if fast money tries to push long-term yields higher again.

The run-up to and aftermath of Mexico’s 2012 election
This is a great example of the kind of price action we can expect in the election countries next year. In Mexico’s case the market began to rally early and strongly in anticipation of a benign election outcome (which subsequently materialised). The rally was interrupted briefly in May-June 2012 due to reasons entirely unrelated to Mexico, namely concerns about Spanish banks. This European risk triggered the usual mindless knee-jerk selling of EM assets, but subsequently turned out to be a wonderful buying opportunity, because Mexican bonds went on to rally a whopping 40% from the June lows.

When EM fixed income valuations adjusted sharply lower in late May 2013 on the back of Fed tapering talk Mexican fixed income did not escape the broader market correction. During the most intense phase of selling the market briefly appears to have lost sight of the fact that Mexico is now addressing its deeper fundamental structural constraints for the first time in many years.

It is important not to get too caught up in the short term volatility caused by the shifting sentiment about tapering and other non-EM matters: Mexico is making the most important strides forward on structural reform in more than a decade and investors who recognise this fact are likely to do better than those who only gamble on short-term market momentum.

Another important development in Emerging Markets
In the past week was the news that international oil companies Chevron and Shell committed to invest serious money to develop Ukraine’s nearly 3 trillion cubic meters of shale gas reserves. Why is this news so important? To see why, it is important to understand the complex and highly challenging domestic and external political landscape in Ukraine. On the external front, Ukraine is critically dependent on energy from Russia. Russia regularly uses its financial and energy might to put the squeeze on Ukraine in a bid to get Ukraine to cede its huge underground gas storage capacity to its Eastern neighbour. Control of Ukraine’s gas storage facilities would confer onto Russia the ability to manage daily gas supplies to Western Europe more effectively, a hugely valuable geopolitical power.

Tapering is coming back
The US stock market reacted negatively to the strong payroll number, illustrating precisely why the Fed has to scale back QE: The market pays more attention to the next QE sugar high than the economic data.

In slow growing, debt-burdened economies higher long rates can cause serious economic damage. This summer sell-off in US treasuries caused mortgage applications to drop 65% as mortgage rates rose. To avoid a repeat performance, the Fed now appears to be considering enhanced forward guidance in the shape of a materially lower unemployment threshold before it hikes rates. Will a lower unemployment threshold stabilise the long end of the treasury curve? Very possibly not. After all, what tools would the Fed employ to manage the long end if the market chose to sell? The Fed only has very little ‘twist’ capacity left – only 16% of the assets on its balance sheet are less than 5 years to maturity.

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