Special Encore: Will US Tariffs Drive Mexico Closer to China?

Summary

Thoughts on the Market: Special Encore – Will US Tariffs Drive Mexico Closer to China?

Hosted by Morgan Stanley | Release Date: December 31, 2024

Morgan Stanley’s podcast, Thoughts on the Market, presents a comprehensive analysis of the evolving trade dynamics between the United States, Mexico, and China in their special encore episode titled “Will US Tariffs Drive Mexico Closer to China?” Hosted by Ariana Salvatore, Morgan Stanley's U.S. Public Policy Strategist, and Nick Lippmann, Morgan Stanley's Chief Latin American Equity Strategist, the episode delves deep into the repercussions of the 2024 U.S. election on Mexico’s economy, its trade relationships, and the broader geopolitical landscape.

1. US Election Outcomes and Immediate Market Reactions

The episode opens with Ariana Salvatore setting the stage by highlighting the significance of the 2024 U.S. election and its potential impact on Mexico:

“The U.S. election has generated a lot of debate around global trade and now that Trump has won, all eyes are on tariffs.”
— Ariana Salvatore [00:50]

Nick Lippmann responds by discussing the mixed sentiments among investors regarding Trump's re-election:

“International and US Investors are generally rather apprehensive about getting in front of the Trump risk in Mexico.”
— Nick Lippmann [01:14]

Despite investor apprehension, it’s noted that many Mexico-based and Latin American investors view Trump’s victory positively, even more so than alternatives like Biden or Harris. This sentiment is reflected in the Mexican peso’s performance, which has depreciated by 25% against the dollar year-to-date, a significant shift from its previous stability.

2. Trump’s Trade Policy and Potential Tariff Implications

Ariana explores the possible trajectories of Trump’s trade policies with Mexico, emphasizing the ambiguity and range of potential outcomes:

“We think a wide range of outcomes is possible here, especially because the President can do so much without congressional approval.”
— Ariana Salvatore [01:54]

She references past instances where Trump leveraged tariffs for policy concessions, such as the 2019 threat to impose a 5% tariff contingent on Mexico addressing border immigration issues. The discussion underscores the delicate balance required, given that the U.S. remains Mexico’s primary trading partner, making any policy shifts highly impactful.

Nick adds depth by analyzing the integration of North American manufacturing ecosystems and the challenges in disentangling U.S.-Mexico economic ties from China:

“The North American model is really very integrated. US Companies are by a mile the biggest investor in Mexico.”
— Nick Lippmann [02:52]

He emphasizes that Mexico’s transition from a mere assembly hub to a value-added manufacturing ecosystem is crucial for maintaining competitiveness, regardless of U.S. tariff policies.

3. Mexico’s Trade Relations with China: Current Dynamics and Future Prospects

The conversation shifts to Mexico’s trade policies with China, revealing a complex interplay between political rhetoric and actual implementation:

“There is growing evidence that China is trying to use Mexico as a China bridge.”
— Nick Lippmann [04:01]

A critical analysis is provided on Mexico’s imposition of 25% and subsequently 35% tariffs on Chinese imports. Despite these high tariffs, imports from China have not significantly declined, partly due to multiple discounts and exemptions resulting in effective tariffs of only 2.5% to 3%. This discrepancy suggests a superficial alignment between Mexico's policy stance and its actual trade practices.

Ariana summarizes the gap between rhetoric and reality:

“There is a political or rhetorical, at least alignment between the US And Mexico when it comes to China, but the reality is that the policy implementation is not yet there.”
— Ariana Salvatore [05:23]

4. The Future of the USMCA Agreement Under Trump’s Administration

Looking ahead, Ariana discusses the pivotal role of the upcoming USMCA (United States-Mexico-Canada Agreement) review in 2026:

“The USMCA review that's coming up in 2026 is going to be a really critical litmus test of the US Mexico relationship.”
— Ariana Salvatore [05:50]

She outlines the structure of the agreement, noting its longevity until at least 2036 but highlighting the 2026 review as an opportunity for significant evaluations and potential amendments. Key areas of focus include digital trade, AI, labor protections, Mexico’s energy sector, auto and EV disputes, and notably, Chinese investment in Mexico.

Nick elaborates on the potential outcomes of this review, suggesting that the Trump administration may confront specific trade disputes and integrate immigration policy considerations:

“Trump's approach likely will involve confronting the auto EV disputes and could possibly introduce an element of immigration policy within the revision.”
— Nick Lippmann [07:04]

5. Impact of Nearshoring and Future Manufacturing Ecosystems

The discussion transitions to the nearshoring trend, which has benefited Mexico by attracting manufacturing investments closer to the U.S.:

“Mexico has been a beneficiary of the nearshoring trend. Do you think this is going to change as we look ahead?”
— Ariana Salvatore [08:34]

Nick acknowledges Mexico's current underweight status but remains optimistic about its future:

“We're still underweight in Mexico, but I think risks are ultimately biased to the upside over time with regards to trade.”
— Nick Lippmann [08:34]

He distinguishes between the initial wave of nearshoring, focused on brownfield projects with existing infrastructure, and the next phase, which may involve greenfield projects in sectors like IT hardware and EV batteries. This evolution will hinge on policymaker incentives and strategic investments.

6. Conclusion and Forward Look

In wrapping up, Ariana anticipates further insights as the Trump administration makes key personnel appointments, which could influence Mexico’s trade policies and its relationship with China. The hosts express gratitude to listeners, encouraging them to share the podcast and look forward to future episodes.

Key Takeaways

• Investor Sentiment: Mixed reactions to Trump’s re-election, with apprehension among international investors contrasted by optimism among Mexico-based investors.

• Trade Policy Uncertainty: Trump’s potential to influence Mexico’s trade policies significantly, especially regarding tariffs and immigration, without needing congressional approval.

• China-Mexico Trade Dynamics: Despite high nominal tariffs, effective rates remain low due to exemptions, indicating challenges in shifting Mexico’s trade orientation away from China.

• USMCA Review Importance: The 2026 review stands as a critical juncture for redefining US-Mexico trade relations, with potential impacts on various sectors including digital trade and energy.

• Nearshoring Evolution: Mexico’s role as a nearshoring beneficiary is poised to evolve, potentially expanding into new manufacturing sectors contingent on strategic policy and investment decisions.

This episode of Thoughts on the Market offers a nuanced exploration of the intricate trade relationships shaping North American economies, providing listeners with valuable insights into the potential shifts in Mexico’s economic landscape amidst changing U.S. policies and global geopolitical tensions.

Transcript

[Narrator]

2024 was a year of transition for economies and global markets. Central banks began easing interest rates, US Elections signaled significant policy change, and generative AI made a quantum leap in adoption and development. Thank you for listening throughout 2024 as we navigated the issues and events that shape financial markets and society. We hope you'll join us next year as we continue to bring you the most up to date information on the financial world this week. Please enjoy some encores of episodes over the last few months and we'll be back with all new episodes in January from all of us at Thoughts on the Market Happy Holidays and a very happy New Year.

[Ariana Salvatore]

Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's U.S. public policy strategist.

[Nick Lippmann]

And I'm Nick Lippmann, Morgan Stanley's chief Latin American Equity Strategist.

[Ariana Salvatore]

Today we're talking about the impact of the U.S. election on Mexico's economy, financial markets and its trade relationships with both the U.S. and China. It's Friday, November 22nd at 10am in New York. The U.S. election has generated a lot of debate around global trade and now that Trump has won, all eyes are on tariffs. Nick, how much is this weighing on Mexico investors?

[Nick Lippmann]

It's interesting because there's kind of no real consensus here. I'd say international and US Investors are generally rather apprehensive about getting in front of the Trump risk in Mexico. While interestingly enough, most Mexico based investors and many Latin American investors think Trump is kind of good news for Mexico and in many cases even better news than Biden or Harris net net the Mexican peso has sold off. Mexico is now down 25% in dollar terms year to date, while it was flat to up 3, 4, 5% around May. So we have already seen a lot being priced in. Arianna, what are your expectations for Trump's trade policy with regards to Mexico?

[Ariana Salvatore]

So Mexico has been a big part of the trade debate, especially as we consider this question of whether or not Mexico represents a bridge or a buffer between the US And China. On the tariff front, we've been clear about our expectations that a wide range of outcomes is possible here, especially because the President can do so much without congressional approval. Specifically, on Mexico, Trump has in the past threatened an increase in exchange for certain policy concessions. For example, back in 2019 he threatened a 5% tariff if the Mexican government didn't send emergency authorities to the southern border. We think given the salience of immigration as a topic this election cycle, we can easily envision a scenario again in which those tariff threats re emerge. However, there's really a balance to strike here because the US is Mexico's main trading partner. The that means any changes to current policy will have a substantial impact. So Nick, how are you thinking about these changes? Are all tariff plans necessarily a negative or do you see any potential opportunities for Mexico here?

[Nick Lippmann]

Look, I think there are clear risks, but here are my thoughts. It would be very hard for the United States to de risk from China and de risk from Mexico simultaneously. Here it becomes really important to double click on the differences in the manufacturing ecosystems in North America. The versus Southeast Asia and China. The North American model is really very integrated. US Companies are by a mile the biggest investor in Mexico. And Mexican exports to the US Kind of match the Mexican import categories. The products go back and forth. Mexico has evolved from a place of assembly to a manufacturing ecosystem. 25 years ago it was more about sending products down, paint them blue, put a lid on it. Now there's much more value add. The link, however, is still alive. It's a play on enhancing U.S. competitiveness. You can kind of, as you did, call it a China buffer, a fender that helps protect U.S. competitiveness. But by the end of the day, I think integration and alignment is going to be the key here.

[Ariana Salvatore]

But of course it's not just the direct trade relationship between the US and Mexico. We need to also consider the global geopolitical landscape and specifically this question of the role of China. What's Mexico's current trade policy like with China?

[Nick Lippmann]

Another great question, Arian. And I think this is the key. There is growing evidence that China is trying to use Mexico as a China bridge. And I think this is an area where we will see the biggest adjustments or need for realignment. This is a debate we've been following. We saw with interest that Mexico introduced first a 25% tariff and then a 35% tariff on Chinese imports and saw this as the initial signs of growing alignment between the two countries. However, Mexican import from China never really dropped. So we started looking at the complicated math, saying 35% times $115 billion of import. Best case scenario, Mexico should be collecting $40 billion from tariffs. A huge and almost unrealistic number of Mexico. Even half of that would go a long way to solve fiscal challenges in that country. However, when we started looking at the actual tax collection from Chinese imports, it was closer to $3 billion. As we highlighted in a note with our Mexico economist just recently. There's just multiple discounts and exemptions. The effective tariffs at neither 25% nor 35% but actually closer to 2.5%, 3%. I think there's a problem with Chinese content in Mexican exports, and I think it's likely to be an area that policymakers will examine more closely. Why not drive up US Or North American content?

[Ariana Salvatore]

So it sounds like what you're saying is that there is a political or rhetorical, at least alignment between the US And Mexico when it comes to China, but the reality is that the policy implementation is not yet there. We know that there's currently nothing in the USMCA treaty that prevents Mexico from importing goods from China. But a lot has changed over the past four years, even since the pandemic. So looking forward, do you expect Mexico's policy vis a vis China to change after Trump takes office?

[Nick Lippmann]

Well, I certainly think so. And I think again, this is going to be the key. As you mentioned, there's nothing in the USMCA treaty that prevents Mexico from buying the stuff from China. And it's not a customs union. Mexican consumers, much like American consumers, like to buy cheap stuff. However, the geopolitics that you refer to is important. And when I reflect frankly on the bilateral relationship between the two countries, I think Mexican policymakers need to perhaps pause and think a little bit about things like the spirit of the treaty and not just the letter of the treaty, and also about how to maintain public opinion support in the United States by the end of the day. When we see what has happened with regards to China after the pandemic, it has been a significant change in political consensus and public opinion when I think Americans are not necessarily interested in just using Mexico as a China bridge for Chinese products. During the first Trump administration, the NAFTA agreement was renegotiated at the US Mexico Canada Agreement, the USMCA that took effect or took force in mid-2020. This agreement will come under review in 2026. Ariana, what are your expectations for the future of this agreement under the Trump administration?

[Ariana Salvatore]

So I think this USMCA review that's coming up in 2026 is going to be a really critical litmus test of the US Mexico relationship. And we're going to learn a lot about this China bridge or buffer question that you mentioned. Just for some very brief context, that agreement, as you mentioned, was signed in 2020, but it includes a clause that lets all parties evaluate the agreement six years into a 16 year time horizon. So at that point they can decide to extend the agreement for another 16 years or to conduct a joint review on an annual basis until that original 16 years lapses. So Although the agreement will stay in force until at least 2036, the review period, which is around June of 26, provides an opportunity for the signing parties to provide recommendations or propose changes to the agreement. Short of a full scale renegotiation, we do see some overlapping objectives between the two parties, for example, things like updating the foundation for digital trade and AI, ensuring the endurance of labor protections, and addressing Mexico's energy sector. But Trump's approach likely will involve confronting the auto EV disputes and could possibly introduce an element of immigration policy within the revision. We also definitely expect this theme of Chinese investment in Mexico to feature heavily in the USMCA review discussions. Finally, Nick, keeping in mind everything that we've discussed today with global supply chains getting rewired post the pandemic, Mexico has been a beneficiary of the nearshoring trend. Do you think this is going to change as we look ahead?

[Nick Lippmann]

So look, we're still underweight in Mexico, but I think risks ultimately biased to the upside over time with regards to trade, we need evidence to be able to lay out these scenarios. Mexico could end up doing quite well with Trump, but much work needs to be done south of the border with regards to all the areas you just mentioned there. Rihanna when we reflect on this over the next couple of years, there's a couple of things that really stand out. Number one is that first wave of near shoring which was really focused on brownfield. It was bringing over manufacturing ecosystems where we already had existing infrastructure. What is potentially next and what we're going to be watching in terms of policymaker incentives and so on, will be some of the greenfield manufacturing ecosystems that could involve things like IT hardware, maybe EV batteries and a couple of other really important sectors.

[Ariana Salvatore]

And that's something we might get some insight into when we hear personnel appointments from President Elect Trump over the coming months. Nick, thanks so much for taking the time to talk. Thank you very much, Arianna, and thank you for listening. If you enjoy thoughts on the market, please leave us a review Wherever you listen and share the podcast with a friend or colleague today. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.