A Seaworthy Mexico into the Maelstrom

 

January 25, 2017 [Mexico, Economy, Oil, Trade]
Pablo Echavarria, CFA


Mexican markets have been buffeted by successive political and economic shocks. But against its economic fundamentals, valuation of Mexican assets has become attractive, to the benefit of patient, longer-term investors.

Zocalo Sqaure, Mexico City

In the tumultuous twelve months ended January 20, 2017, the MSCI Mexico Index has declined 0.3%, badly underperforming the broad MSCI Emerging Market Index’s 32% return, while the Mexican peso has depreciated by 13.2% versus the U.S. dollar, the third-worst performing emerging markets currency behind the Turkish lira and the Argentine peso. A confluence of internal and external blows have taken a heavy toll. In our view, the toll has been too heavy. Mexican asset prices may be oversold.

Internal Dynamics

Over the year, three factors have impacted the internal dynamics of the Mexican economy. Those include decelerating economic growth; increasing inflation; and higher borrowing costs. Following a period of strong economic recovery post the Global Financial Crisis, Mexican growth has stagnated over the last four years. Real GDP growth has ranged from 1.4% to 2.5% over that period and Mexico, much like many other countries in the world, has experienced what many refer to as a “growthless recovery.” Most economists don’t expect a meaningful improvement in economic growth over the coming years due to a deceleration in consumption and lower government expenditures. Moreover, due to the recent depreciation of the Mexican peso, the country is experiencing higher inflation, with CPI expected to increase from 2.7% in 2016 to 4.1% in 2017. This has resulted in higher borrowing costs, with Banco De Mexico having nearly doubled overnight borrowing costs over the last two years.

The External Picture

The peso has depreciated 16.7% since the November 8, 2016 surprise election of Donald Trump to the U.S. presidency. Trump’s “America First” agenda has forced investors to reconsider the future of foreign trade. A more protectionist stance by the U.S. has clear negative consequences for Mexico considering that the U.S. absorbs approximately 80% of Mexican exports. Changes in the North American Free Trade Agreement (NAFTA), which Trump has vowed to renegotiate, could fundamentally change the U.S.-Mexico economic relationship. It is not surprising that investors have cut their exposure to Mexico, where asset prices and the peso continue to react to news flow around trade, including a nearly 4% depreciation after Ford announced it would no longer go through with its plans to build an auto production facility in San Luis Potosi.

Despite challenging internal and external backdrops, we remain constructive on Mexico and continue to like the long-term opportunity there.

Mexico’s Well-Run Economy

Mexico has seen a significant decline in oil-related revenues over the last four years. In 2013, oil revenues totaled $861 billion and constituted approximately 32% of the government’s total revenues. The contribution in the first 11 months of 2016 totaled $288 billion, or a mere 9% of government revenues. Oil revenues have been impacted by production declines at state-owned PEMEX: output fell from 2.5 million barrels of oil per day (b/d) in 2011 to 2.1 million b/d in the first 11 months of 2016. Combined with lower oil prices, the government coffers have taken a big hit. Yet, while many developing countries would have failed to adjust expenditures and chosen instead to run a wider fiscal deficit, the Mexican government has taken a proactive approach. It has cut spending, limiting the deterioration in the fiscal deficit to roughly 3% of GDP. Economists expect the pace of fiscal consolidation to continue, with the fiscal deficit falling to around 2.3% of GDP in 2018.

More importantly, Mexico is in the process of opening up its oil and gas sector to foreign investors for the first time since the industry’s nationalization in the 1930s, a courageous effort given the country’s deep-seated political sensitivity around the oil industry, not to mention its powerful oil workers union. But the opening, one of several structural reforms, should ultimately reverse the decline in oil production over the medium to long-term and bring additional revenue to the government. Meantime, the government has also reduced domestic gasoline subsidies in a country that has to import nearly half the gasoline, one-third of the natural gas and two-thirds of the petrochemicals that it consumes. An up to 20% increase in gasoline prices this year has been politically explosive for President Enrique Pena Nieto’s administration, sparking widespread protests. So far, though, the government hasn’t back-tracked. We view Mexico’s willingness to undertake painful but necessary adjustments as evidence of its pragmatism and strong institutional framework.

Risks to Beneficial, U.S.-Mexico Bilateral Trade

Mexican asset prices have felt the brunt of protectionist rhetoric by the new U.S. administration. But global trade data show that both countries have benefited from the North America Free Trade Agreement (NAFTA). The U.S. has a roughly $60 billion trade deficit with Mexico, compared to a $366 billion (as of 2015, source Factset) deficit with China; a $130 billion deficit with the Eurozone; and a $69 billion deficit with Japan. More importantly, Mexico is the U.S.’s second-largest export destination behind Canada, with $211 billion in goods traded, representing about 16% of total U.S. exports. Nomura recently calculated the imports/exports ratio for several U.S. trading partners (a measure of balance in bilateral trade relations.) Mexico’s ratio is 1.27x (that is, for every $1.27 of goods imported into the U.S. from Mexico, the U.S. exports $1 of goods to Mexico). That compares favorably to the ratios of the U.S.’s other main trade partners: China at 4x; Korea at 1.7x; and the Eurozone at 1.5x. Moreover, one U.S. Class 1 railroad company running between the U.S. and Mexico recently reported that approximately 60% U.S./Mexico traffic is southbound, and added that it’s actually growing faster than northbound traffic.

 

U.S. Imports and Exports by Region

Source: Nomura

Potential changes in NAFTA could also have negative consequences for the U.S. labor market. According to research by the Mexico Institute at the Wilson Center, a nonpartisan think tank based in Washington D.C., trade with Mexico creates approximately 4.9 million jobs in the U.S. We are by no means suggesting that changes to NAFTA are unlikely to occur, but are suggesting that both countries have much to lose if negotiations are not handled carefully.

Mexico’s Healthy Long-Term Demographic Profile

With a population of nearly 120 million people, Mexico is the second-most populous country in Latin America. Mexico’s population is also growing at a healthy clip, with a fertility rate of 2.3 births/women and a life expectancy of 77 years, just two years lower than that of the U.S., according to the World Bank. Unlike several countries in Latin America that went through a levering phase in the early 2000s, the Mexican consumer remains under-levered, with Mexico’s household debt to GDP at 16.3%, compared to Brazil’s 24.7%. We think this provides a healthy base for consumption growth to remain strong over the medium-to-long run, even if near-term consumption decelerates as a result of higher inflation and slower growth.

Mexican Assets Attractively Valued

The MSCI Mexico Index trades at 2.2x price-to-book, which is below its seven-year average of 2.75x and close to its seven-year low of 2.11x in 2011. As for the currency, Santander estimates that the Mexican peso’s real effective exchange rate is at levels similar to those during Mexico’s 1994 “Tequila crisis,” when its over-valued peso had the rug whipped out from under it after a collapse in the Banco de Mexico’s foreign reserves. Back then, the peso traded in a narrow band under a “crawling peg” exchange rate system. Today, it floats against the dollar, facilitating adjustments to changing economic conditions. Moreover, Mexico’s economic fundamentals are far stronger today than they were back then. Against those fundamentals, the well-documented Economist Big Mac index shows the Mexican peso as one of the most under-valued currencies in the world, alongside the Egyptian pound, the Malaysian ringgit, the Russian ruble and the South African rand.

 

Mexico's Real Effective Exchange Rate (1970-2016)

Source: Bloomberg, Santander, fivethirtyeight

 

Micro Views and Long-Term Perspective

While it is difficult to predict when sentiment toward Mexican stocks will improve, we remain constructive on the country’s long-term fundamentals. We believe that our investments there will strengthen their competitive positions during the current period of economic uncertainty, to the ultimate benefit of shareholders. Understanding their individual fundamentals and the broader context in which they are operating can give longer-term investors the confidence and patience that, we believe, successful investing requires.

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