The reaction of Mexican markets to this month’s election of firebrand Andrés Manuel López Obrador has defied the expectations of many investors and analysts. The Mexican peso has rallied 5 per cent against the US dollar, reversing a 12-month decline, while the Mexican Bolsa is up 9 per cent. That’s far from the crashes some foresaw. Investors seem to have taken comfort from the incoming president’s post-election promises to respect central bank autonomy, the free-floating peso and business freedoms.
But have investors been lulled into a false sense of security? The incoming president – the first to be elected from outside of Mexico’s two main parties – faces high expectations if he is to meet pledges to balance boosts to infrastructure spending, agricultural subsidies and old age and disability pensions with fiscal prudence. He’s also vowed to suspend energy market reforms, including banning foreign fuel imports and reviewing contracts awarded to private investors. What’s more, Donald Trump’s threats to impose tariffs on the Mexican auto sector and potentially derail the North American Free Trade Agreement (Nafta) could disrupt Mexico’s relationship with its largest export market.
Forwards or backwards?
Mr López Obrador, or ‘Amlo’ as he is also known, is not the first Mexican president to be elected on an ambitious reform agenda. Enrique Peña Nieto, who leaves office in December, also promised big. On his electoral victory in 2012, he promised to treble annual gross domestic product (GDP) growth to around 6 per cent by closing corporate tax loopholes, as well as opening the country’s energy sector to private investment, loosening the grip of state oil company Pemex in the process. Under the Pacto Por México, the country’s three main political parties backed reforms including deregulation of the telecoms industry, an increase in the top personal tax rate to 35 per cent and raising education standards by evaluating teachers every three years. The latter was particularly important in getting more workers into formal employment, and helping to boost productivity, which has lagged other emerging market countries.
Those reforms have borne fruit, to an extent. Total tax revenue increased by 3 percentage points during the two years to 2016, to 17.2 per cent of GDP, according to data from the Organisation for Economic Coordination and Development (OECD). That’s compared with an increase of just 1.1 percentage points during the prior 14 years, but still leaves it well behind the OECD average of 34.3 per cent. The proportion of workers in informal jobs had also declined to 56.5 per cent of the country’s workforce by the first-half of last year, according to the OECD, from59.6 per cent at the start of Mr Peña Nieto’s presidency.
Yet frustration with the pace of reform, disillusionment with public sector corruption and security, as well as opposition to education policies have all paved the way for Amlo’s victory.
Outside effects
External events have had a big hand in shaping Mexico’s economy, too. On a five-year view, the US Federal Reserve’s 2013 signal that it would end quantitative easing (coupled with the 2016 US presidential election, which stoked fears of inflation) exacerbated sluggish domestic growth and weighed on the peso. The expansionary fiscal and monetary policy envisioned by Mr Peña Nieto’s administration soon turned to austerity and interest rate increases, says Oxford Economics senior economist Fernando Murillo. “Instead of being in planning mode, they entered reactionary mode, emergency mode,” he says.
The 2014-15 collapse in the oil price has also hampered the initial success of the energy industry’s liberalisation, which had been under the monopoly of Pemex since 1938. International oil majors shied away from investing in the Gulf of Mexico, and just two of the 14 oil and gas blocks were sold in the first annual auction in 2015. At that time, the government hoped to have sold a third of the country’s prospective oil assets by 2018, attracting $50bn in private investment. And while later auctions have been more successful, the country’s dependence on oil and gas – traditionally funding around one-third of the federal budget – has left public coffers damaged by lower prices.
Given its importance to the economy, the new administration was always going to look to put its stamp on the oil and gas industry. Plans to suspend energy reforms pending a review of contract-linked corruption have proved a contentious part of Amlo’s campaign. Earlier this month, the country’s oil and gas regulator announced the delay of two scheduled oil auctions and a tender to find a joint-venture partner for Pemex, to give the new administration time to revise the contracts to be tendered and the tender process. However, Mr Murillo believes it is positive that a new date has even been set and that this is part of an orderly transition process. He also points to the fact that 85 per cent of investment in Mexico originates from the private sector. Amlo will need to be pragmatic in his engagement with industry.
That doesn’t mean combating corruption – one of the central tenets of Amlo’s campaign – will get short shrift. The new president hopes anti-graft and government-downsizing measures will lead to savings equivalent to 2 per cent of GDP. In turn, this will be used to fund higher pensions for the elderly, guaranteed food prices for small farmers and subsidised gasoline prices, as well as a series of heavy-duty infrastructure projects such as a rail link between the Pacific and Atlantic coasts. The cost of the reforms is expected to come in at 2.5 per cent of GDP. Given there is little detail on how savings from combating corruption would be achieved, the scepticism of some economists is understandable.
However, it’s worth noting that Mexico’s balance sheet is in robust shape, certainly compared with Latin American peers such as Brazil. Mexico’s government debt stood at 53.5 per cent of GDP at the end of 2017, according to the International Monetary Fund (IMF), in line with the emerging market average of 51 per cent and below the 64.7 per cent average for the Latin American and Caribbean category. Inflation has also kept steady at around the 4 per cent mark during the past 15 years. And while a 1.9 per cent budget deficit is above the emerging market average of 0.1 per cent of GDP, it looks more manageable than the Central and South American averages of 2 per cent and 2.9 per cent, respectively.
Nafta uncertainties
Given the threats to build a wall along the US-Mexico border and the protectionist policies floated on the US presidential election campaign trail, the peso unsurprisingly hit a record low against the dollar the day after Mr Trump’s election. In May, Mexico retaliated against Mr Trump’s imposition of a 25 per cent tariff on steel and aluminium imports by slapping levies of between 20 and 25 per cent on imports of US goods including cheeses, bourbon and some steel products.
However, far higher stakes are involved in the renegotiation of Nafta – which Mr Trump has called the “worst deal in US history” – between the US, Canada and Mexico. The US is Mexico’s largest export market. A total of $340bn in goods and services headed north last year, according to the Office of the US Trade Representative, compared with $276bn in US exports to Mexico. Exports to the US have increased almost sevenfold since 1993, the year prior to Nafta being signed.
The uncertainty over the trade relationship between the neighbouring countries is set to linger. After requesting a renegotiation of the terms of the deal in April last year, a revised agreement is on hold until after the US mid-terms in November. However, both Mexican and US leaders have made some positive noises in recent months. That was part of the reason for Moody’s upgrading the country’s credit rating from negative to A3 in April, citing solid engagement between the nations. Most recently, the US president said he had “very good sessions with Mexico and the new president of Mexico” and that the government could potentially pursue a separate trade deal with its southern neighbour. Meanwhile, incoming finance minister Graciela Márquez has said she believes a ‘Nafta-lite’ deal would be possible.
Nevertheless, the cost of hedging against depreciation in the peso against the US dollar has increased since the election, and indicates the market expects a pick-up in volatility during the next 12 months. “If the US were to walk away from Nafta, the currency is not pricing that in yet,” says Claudia Calich, manager of M&G’s Emerging Markets Bond Fund. She reckons that event could result in depreciation in the peso of between 5 and 10 per cent. That could leave some local currency bondholders getting burnt if a deal is not agreed.
This month’s upward swing in Mexican asset prices is just the latest in what has been a rollercoaster series of fluctuations since the US election at the end of 2016. With Amlo not due to take office until December and sparse details on the practical implementation of his policies, uncertainty remains over the direction of domestic policy. However, the country’s relationship with the US has been the biggest mover of asset prices during the past two years. The Mexican Bolsa is trading at 15.9 times forward earnings, having retraced from a 12-month high of 17.9 times. Yet on a cyclically-adjusted price/earnings basis, Mexican equities are trading at a ratio of 21.3, according to Star Capital. That’s a sizeable premium to the emerging market average of 16.2. The extent to which the government can negotiate a favourable trade deal with the US looks likely to determine whether that reassurance has been misplaced.
The funds route into Mexico
Product providers seem to agree: there are only three passive exchange-traded funds (ETFs) investing in the MSCI Mexico index. None of these are large enough, cheap enough, or tradeable enough – in terms of the average spread available or daily volume traded – to be recommended.
Investors should therefore look to include Mexican stocks as part of a wider focus on Latin America, either via an open-ended fund, investment trust or ETF. There are 10 open-ended investment funds investing in Latin America that allocate over 20 per cent of assets to Mexico. To get similar exposure via investment trusts you are limited to two.
There are numerous ETFs following the MSCI Emerging Markets Latin America index, which has a 24 per cent weighting to Mexico, second behind Brazil’s 54 per cent. The index has fallen 2.4 per cent in the past 12 months, but risen 38 per cent and10.6 per cent over three and five years.
Weightings to Mexican stocks does vary among active funds, but they share a characteristic with the index in that Brazil is the highest regional allocation – often over 50 per cent. It is worth noting that while you are getting Mexican equity exposure, the majority of the fund or ETF’s performance will be driven by the Brazilian equity market.
The iShares MSCI EM Latin America UCITS ETF (LTAM) has been trading on the London Stock Exchange since 2007 and has amassed over £390m in assets under management, making it the largest ETF covering the region. It has a total ongoing charge of 0.74 per cent, making it cheaper than most active funds, but not as cheap as one would perhaps expect for a tracker fund, but the trading spread is low and daily share volume high so it is relatively easy to trade. It has a 27.4 per cent exposure to Mexican stocks.
Picking an active fund is difficult. Latin America has been volatile in the past decade, driven by sharp commodity and currency fluctuations as well as corporate scandals and economic pressures in the largest market, Brazil. So looking at historical performance does not necessarily give investors a view of how well a fund may do in future, as performance was likely to have been affected by one of the above factors rather than manager ability.
The JPM Latin American Equity Fund (LU0129491972) has the largest exposure of any active fund to Mexico at 28.3 per cent. The fund has vastly different portfolio composition than the MSCI EM Latin America index. With a tilt to mid-cap and small stocks, and consumer stocks and financials among the Mexican holdings, the $8.6bn average market cap of companies in the fund compares with $15.8bn for the index. Performance relative to its benchmark has not been positive, and the fund is down 10 per cent over one year. But on a three-year view, it has returned 19.7 per cent. It has an ongoing charge of 1.05 per cent.
The Threadneedle Latin America Fund (GB00B8BQ6V57) has around 27.4 per cent allocated to Mexico, but is more focused on the mega-cap space with an average stock market cap of $18.2bn. The fund also has a value tilt with the portfolio’s price to prospective earnings ratio of 10.5 times, against the index on 11. Since 2015, it has been run by Ilan Furman, who tends to focus on consumer stocks and financials, and remains bullish on the outlook for perhaps the key driver of the Mexican economy. “Regarding the future of US-Mexico trade relations, we hold a constructive outlook as it seems unlikely that decades of economic integration will come to a halt,” he said, prior to Amlo’s election.
The fund’s highest allocation is to Brazil, a 53 per cent weighting. Bank Grupo Financiero Banorte (GFNORTEO:MEX) and supermarket Wal-Mart de Mexico (WALMEX*:MEX) both feature in the fund’s top 10 holdings, as the fund runs a relatively concentrated portfolio of only 44 stocks. Taha Lokhandwala
