 | Horacio Coutino, multi-asset strategist |
If you were to walk on Reforma avenue, one of Mexico City’s busiest streets in what some consider to be Mexico’s financial district, you’d think it’s business as usual. However, just as we’ve been bewildered by rain recently (a sacrilege for us fans of Mexican weather this time of the year) – there’s a general sense of unease due to the extraordinary uncertainty for the country’s outlook, and how forcefully and swiftly changes may take place.
Although it seems that the primary tariff target for President Trump’s ire is China, within the Emerging Markets universe it is actually Mexico that is poised to bear the brunt of it, given the economic gravitational force of the US in its economy.
Mexico’s business cycle and value chains are highly integrated with the US. As a result, Mexico is experiencing a period of heightened multi-asset volatility and higher risk premia. This integration into each other’s supply chains and labour markets has proven to be essential as it benefits Mexican and US companies.
Despite these benefits, a smooth future for Mexico is not guaranteed as President Trump appears to be wanting to use tariffs and other economic policies not just for financial reasons, but to meet specific foreign policy objectives. This is not the first time the US tariff threat has been used as leverage. On 15th August 1971, a period of time perhaps beyond the comprehension of the TikTok generation, then President Richard Nixon imposed a 10% ad valorem supplemental duty on all dutiable articles imported into the US by issuing proclamation 4074. Nixon was using the surcharge as leverage to compel Japan and West Germany to revalue their currencies. Less than six months later, on 18th December, President Nixon announced the conclusion of the Smithsonian Agreement.
Nixon, in a strikingly familiar tone to 2025, called it ‘the most significant monetary agreement in the history of the world.’ Two days later, President Nixon removed the supplemental duties. Tariffs, it turns out, can be a point of maximum pressure in some economies. President Trump’s conception of tariffs is best crystallised by his statement in a meeting with Senators on 8th January, “My goal is not to tax people, my goal is to change their behaviour.” Days after this meeting, the now US Treasury Secretary Scott Bessent said at his Congressional confirmation hearing that tariffs would be used for three purposes: 1. To address “unfair trade practices” by foreign nations, such as tariffs Trump imposed on China and the duties he levied on steel from various nations in his first term. 2. To raise revenue for the federal budget, particularly with across-the-board duties. And finally, 3. As a negotiation tool to achieve foreign policy objectives.
Tariffs: someone, somewhere, is going to pay for them
If recent history is any guide, tariffs’ incidence has affected the US. A Harvard Business School article by Cavallo, Gopinath, Neiman, and Tang found that when assessing the tariff pass-through effect of tariffs imposed on Chinese imports since 2018, tariffs passed through almost fully to US import prices. Analysis of the data revealed significantly lower rates of exchange rate pass-through to import prices. This suggests that the depreciation of the Chinese renminbi against the US dollar in the summer of 2019 failed to substantially mitigate the impact of the tariffs. Furthermore, despite the considerable increase in the total cost of importing goods, evidence regarding corresponding retail price increases remains inconclusive. This indicates that many US retailers may have absorbed the increased costs by reducing profit margins on sales of the affected goods.
Another factor that is frequently mentioned as a mitigating factor in using tariffs is the potential for currency depreciation. One might assume that a 25% depreciation in the peso would effectively neutralise the impact of a 25% import tariff. However, in reality, it is not. Enrique Martínez and Braden Strackman from the Dallas Fed offer a nuanced perspective on the accounting drivers behind import price dynamics in the US. Although exchange rate pass-through is statistically significant, it appears less economically important than previously thought, and this holds true in both the long- and short-run.
Regarding short run exchange rate pass-throughs, Canada stands out with a significantly higher short-run exchange rate pass-through of 0.36, nearly twice that of Mexico at 0.20 and the UK’s 0.16. This difference suggests that factors like geographical proximity and the institutional frameworks of trade agreements, such as the USMCA, may amplify the impact of exchange rate fluctuations on import prices. One possible explanation is that a larger proportion of firms in these countries may engage in producer-currency pricing. By setting prices in their local currency instead of US dollars, these firms become more sensitive to dollar fluctuations.
Further complicating matters, untangling global value chains is a complex task, if not an impossible one.
Alonso de Gortari, from Princeton University and Dartmouth College, found in 2019 that the high level of integration in global value chains in Mexico and US trade has increased the level of estimated share of value in US imported Mexican manufacturers from 18% to 30%. This consequently increases the cost of a trade war. This is because import tariffs are more costly when imports have domestic content because they ripple back and hurt domestic suppliers.
The share of foreign inputs in Mexican manufacturing exports varies across manufacturing industries. However, it’s interesting to note US inputs account for 74% of foreign inputs in Motor Vehicles exports to the US. Other manufacturing industries that have a significant share of inputs sourced from the US as percentage of total foreign inputs are Other Transport at 80%, Wood and Paper at 71% and Textiles at 70%.
Looking beyond the aforementioned factors, it is highly probable that the USMCA will undergo significant changes in the future, given the dynamic challenges posed by China to North American industrial integration. According to Sam Lowe, Partner at Fint Global, China will be a central focus of the USMCA review by July 2026, potentially leading to the implementation of more stringent rules of origin to mitigate concerns regarding Chinese inputs within North American value chains. He states:
In this context, the presidential memorandum on trade signed on 20th January directs the USTR to commence public consultations and submit recommendations regarding US membership in the USMCA by 1st April, 2025.
Scenarios: What could really happen and why?
Ten days following the President’s inauguration address, there has been relentless speculation regarding the timeline and scope of US tariffs. The severity of potential tariff outcomes remains uncertain.
On Thursday, 30th January, the President reaffirmed his intention to announce tariffs on USMCA partners on 1st February. However, since 20th January, market sentiment suggests that these threatened tariff increases may be less severe than initially anticipated. The prevailing expectation is that any implemented tariffs will be strategic rather than universally applied, phased in gradually rather than imposed immediately, and ultimately lower than the originally proposed rates (60% on China, 25% on USMCA partners, and 10% to 20% on the rest of the world). Furthermore, these tariffs are being viewed as a one-time adjustment to price levels, implying a more transitory rather than persistent inflationary effect.
Investors should, nevertheless, prepare for a tariff announcement on 1st February. Context, particularly concerning potential exceptions, is crucial.
A plausible scenario involves the announcement of 25% tariffs, with enforcement postponed to 1st April, to allow for negotiations on migration and security matters, potentially placing significant pressure on Mexico. This delay would also afford time for the US Senate to confirm the President's economic cabinet nominees that will oversee the implementation of trade policy. Currently, only the Treasury Secretary has been confirmed, while the nominees for Commerce Secretary and USTR remain pending.
Moreover, the Wall Street Journal reported on 30th January that White House officials are considering more targeted measures. The use of derogations and exemptions is consistent with previous tariff implementations (as exemplified by the Section 301 tariff exclusions on US imports from China). While the executive branch can define the scope of tariffs through industry-specific derogations, an exclusion mechanism could also be established following the USTR's investigation, mandated by the trade memorandum signed on 20th January.
Another plausible scenario introduces additional complexity. In this case, tariffs would be announced on 1st February, with enforcement delayed to a later date but accompanied by gradual, monthly increases in tariff rates. This strategy could be used to pressure USMCA partners into aligning with US foreign policy objectives. According to the Financial Times, US Treasury Secretary Scott Bessent has advocated for a similar approach, albeit with a lower initial tariff rate.
Should the enforcement of tariffs on imports from Mexico and Canada take place on 1st February, sectors and industries that are more exposed would be those with a high degree of substitution in the US, finished goods with low to no US inputs, and those with a high degree of Chinese inputs.
The least probable scenario would involve renegotiating the USMCA without the threat of tariffs or postponing the announcement of tariffs to USMCA partners. This outcome appears unlikely due to the President’s consistent public statements since his inauguration, and the testimonies of his nominees for Treasury and Commerce during their respective Senate confirmation hearings. Furthermore, their remarks align with the President’s broader economic agenda, in which tariffs are considered a fundamental policy tool.
The reactions of both Canada and Mexico to any announced tariffs will be critical in determining the direction and tone of the North American trade relationship. If historical precedent is any indication, targeted retaliatory measures implemented by both nations with expediency can be expected. These reciprocal actions are often strategically designed to maximise the economic and political impact of the response. The nature and scope of these retaliatory measures will, in turn, influence the subsequent dynamics of the trade relationship and the potential for future cooperation or escalation.
Can complacency be lethal in investing in EM?
Paradoxically, Trump’s surprising victory in 2016 gave way to heightened uncertainty coupled with a sense of urgency. It prompted a high degree of coordination between the Mexican government and the private sector to counter Trump’s protectionist impulses ahead of the NAFTA negotiations.
The Mexican Peso, MXN, performance was very much reflective of this in the months following the election, as it declined 15.2% against the dollar from election night in November of 2016 to inauguration day in January of 2021. Contrary to expectations going into Trump’s first term, going long MXN through Trump’s first term, would have yielded a total return of 10.2%.
The angst that triggered the Mexican government’s strategy that culminated in the signing of the USMCA is not palpable in Mexico today. Local investors have adopted a wait-and-see approach, pretending our second rodeo with a Trump administration will be like the first one, mostly benign.
This time, it’s different. The US President’s appointments and escalating tariff rhetoric have signalled an inclination to replicate tactics and trade policy direction used in his first term. And, unlike in his first term, he is coming in with an experienced team of advisors, as well as swift nominations before inauguration day, a more comfortable legislative majority in the Senate, and a popular mandate. This is a more seasoned, and emboldened administration that will be able to carry out trade policy more effectively and in alignment with recent statements.
This complacency is not exclusive to Mexico. The market has been generally complacent about the implications of a second Trump to Emerging Markets. This is clear in terms of the 3-month implied FX volatility, as measured by JPM’s EM-VXY index. It averaged 8.74 in the 30 days following the election, compared to the 1-year average of 7.69 preceding the election. In 2016, it averaged 10.93 in the 30 days following the election.
In Mexico and Brazil, for instance, complacency is also reflected in the 3- and 6-month volatility of the MXN and the BRL. Volatility has actually subsided since the election. Furthermore, the spread of MXN’s 3-month volatility to JPM’s EM VXY Index, a way to capture risk perception driven by idiosyncratic dynamics, shows that, apart from shifts in sentiment towards emerging markets assets, there was a decline through the 30 days following the election in 2016 from 9.98 to 4.60. This time around it increased only slightly from 16.32 to 16.66 over the course of the same time frame.
So what can investors expect in the coming weeks?
Steve Bannon, a long standing ally of President Trump, in a wide ranging interview with Politico on 14th January labelled the first days of the incoming administration as ‘Days of Thunder’. This has thus far proven to be all too true.
Noel Maurer, an associate professor of International Affairs and International Business at George Washington University, predicts that the reaction of US markets can be relatively coy.
At this stage you might rightly ask, Qui bono? Robust academic evidence from the actions of the previous Trump administration and the implementation of tariffs on Chinese goods indicates that proximity to the governing regime tends to correlate with more favourable outcomes.
Fotak, Seung Lee, Megginson, and Salas in their article The Political Economy of Tariff Exemption Grants found that evidence on campaign contributions strongly suggests that politicians are effectively using exemptions to reward supporters and withholding exemptions to punish supporters of their opposition. From their conclusions:
On the Mexican side, it’s a strikingly different story. The interplay of idiosyncratic risks and the ongoing trade policy uncertainty from the US compound the risk premium in Mexican assets. The majority of the Mexican peso's depreciation in 2024 occurred in response to controversial judicial reform, which undermined the independence of the judiciary. The ramifications of imposing tariffs could cause major distress to Mexico’s financial markets and economy.
How would it play out? It would yield a sentiment shock that would hit the investment channel the most immediately in terms of contagion. The trade channel would be affected by even greater uncertainty given the potential impact of higher tariffs.
The economic shock of tariffs would be fractured and asymmetrical across different industries, contingent upon each sector’s reliance on US demand and supply, their level of integration in cross-border value chains, availability of substitutes in the US, and the capacity of importers and/or exporters to absorb the costs associated with tariffs.
Even in the absence of enacted tariffs, the uncertainty surrounding trade policy can negatively impact Mexican GDP, as firms may adopt more defensive investment and spending strategies in response to heightened perceived risk. Should tariffs ultimately be enacted, growth would likely be further constrained by reductions in real income and decreased exports to the US, effects that would only be partially offset by currency depreciation and the domestic monetary policy response.
The near-term outlook for Mexican monetary policy is clouded by this heightened trade policy risk, and a number of domestic factors that are likely to contribute to subpar growth in 2025. In the event of substantial tariffs imposed on US imports from Mexico, Banxico would likely initially adopt a conservative stance to preserve financial stability and anchor the currency. Furthermore, broad-based retaliation by Mexico against US import tariffs would have a more pronounced impact on domestic inflation, given the potential passthrough to Mexican consumers, presenting Banxico with more complex trade-offs to manage.
Given the asymmetry in the economic and financial consequences of a tit-for-tat trade war, the situation resembles a Mexican standoff with an uncertain outcome. However, Mexico’s position in this standoff is akin to bringing a knife to a gunfight.
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