IN FOCUS6-8 min read

Why investors are so bullish on Mexico

Cyclical and structural growth drivers underpin the outlook, and Mexico is a beneficiary of the 3D Reset. What are the risks?

27/02/2024
Photo of Guanajuato, Mexico

Authors

Robert Davy
Emerging Market Equities Fund Manager
Andrew Rymer, CFA
Senior Strategist, Strategic Research Unit

There is much to like at a macroeconomic level in Mexico, underlining why a consensus of EM (emerging market) fund managers are overweight to the market. Its key export market in the neighbouring US continues to hum, and there is significant optimism with regards to the potential for nearshoring as a long-term driver of economic growth. Demographics are also favourable, with over half of the population aged under 30 years old. These are two of the three trends in what Schroders refers to as the 3D Reset: deglobalisation, demographics, and decarbonisation.

The external accounts are solid, and the central bank has maintained a highly orthodox monetary policy approach. These factors led the Mexican peso to strengthen against the US dollar last year, even in the face of broader US dollar strength. This is despite some concern about fiscal slippage for this year’s budget.

However, the outlook is not without risk. Policy concerns have been an ongoing feature under the administration of President Andrés Manuel López Obrador (AMLO), as an unexpected change in regulation for airport operators recently emphasised. Meanwhile, presidential, congressional and gubernatorial elections are scheduled for June. The US election will also be important to watch for Mexico, not least because the US-Mexico-Canada (USMCA) trade agreement is up for review in 2026.

What is the macroeconomic outlook?

GDP growth in Mexico has remained relatively strong, with full year 2023 seeing an expansion of 3.3%. A deceleration in activity to 2.4% is anticipated this year, largely driven by the expected slowdown in the US economy; which at this point may not be as significant as previously estimated and could be offset by market share gains in exports. There may also be some deceleration due to fiscal consolidation following the June general elections.

Headline inflation has fallen from a peak of 8.4% year-on-year (y/y), and despite a recent uptick was 4.9% in January; core inflation has continued to ease reaching 4.8%. The inflation target is 3% +/-1% The central bank held its policy rate at 11.25% in January and underlined its belief that rates need to be held at elevated levels for an extended period. Even so, market expectations are for rate cuts to begin in the first half of this year, with the policy rate coming down to 9.25% by year end.

Together with the strong external account picture, underpinned by healthy levels of foreign direct investment (FDI) and strong flows of remittances, the Mexican peso has been strong relative to the US dollar. Some modest easing in the currency may come through as interest rates fall. 

Chart showing Mexican inflation and interest rates

On the fiscal side, the government has proposed a 2024 budget which would lift spending by 8% y/y, equivalent to 1% of GDP. This would take the primary deficit (before interest) from balance to a deficit of 1.2%, and the total deficit to around 5% from 3.3% in 2023. With general elections approaching, a pickup in spending is not a major surprise.

Mexico is a potential beneficiary from the 3D Reset

Schroders views the current shift in global economic regime through the lens of the 3D Reset. This refers to the three “Ds” of decarbonisation, demographics and deglobalisation. These are expected to have long-term implications for the global economy. All are likely to be inflationary, requiring higher interest rates than over the past 15 years, and bringing greater volatility. The 3Ds bring challenges, but also opportunities, and Mexico appears to be well placed to benefit. 

Deglobalisation: Mexico’s long-term success in growing its export and industrial capacity since the early 1990s is well recognised. Exports share of GDP has grown from around 10% to over 40% today. The 1994 North American Free Trade Agreement (NAFTA) boosted exports and in essence today’s nearshoring is a continuation of this trend. While China’s entry into the World Trade Organisation in 2001, did impact Mexico’s market share, it did not derail exports growth.  

Fast forward to today, and the nearshoring phenomenon is once again boosting the outlook for FDI and exports. This is a combination of Asian and European companies nearshoring capacity, primarily for the US market. There are also multi-national companies (MNCs) reshoring/nearshoring capacity from Asia. A large part is driven by a renewed focus on supply chain resilience: “just in time” has been placed by “just in case”. In addition, the challenges of higher and rising wages in the US, together with low unemployment levels, is driving some US companies to offshore to Mexico.

We published a report last year looking at the economies and markets which stand to benefit from de-globalisation. Mexico ranks among the potential long-term winning markets globally, incorporating a macroeconomic scorecard, potential direct stock beneficiaries and number of stocks in the index. And this is not adjusted for Mexico’s prime geographic positioning.  

Chart showing markets benefitting from deglobalisation

Demographics: The populations of many advanced economies are experiencing ageing, with baby boomers reaching retirement. In many cases, there are insufficient young people to replace them in the workforce, potentially creating a scarcity of labour. This raises the prospect of further upward pressure on wages, with implications for inflation and growth in these economies. This is projected to drive a greater focus on new, productivity-boosting technologies such as robotics, artificial intelligence (AI) and automation.        

The demographic challenge described above is not one which Mexico faces anytime soon. More than half of the population is under 30 years of age, meaning that the economy is unlikely to face a lack of workers issue. There has been a doubling in the minimum wage under President AMLO, but Mexico is still competitive in a global context, and it has a geographical advantage with its land border to the US. While technological solutions may resolve some of the demographic challenges, these will not be the solution for all industries. For companies in these industries, some form of nearshoring to Mexico is a natural response for supply into North American markets.  

Chart showing Mexico population pyramid

Decarbonisation: The global economy is in the process of transitioning from fossil fuels to greener energy sources. Higher temperatures and more extreme weather are increasingly having a greater impact and capturing the attention of policymakers. The shift towards net zero emissions is expected to accelerate the decarbonisation of power generation. This is a structural trend that will require quite radical changes to energy systems and infrastructure.

Mexico’s share of primary energy consumption from fossil fuels is about 90%, compared with roughly 80% in the US, 76% in Germany and 50% in Brazil. The picture is more complex than the headline figures highlight, but they demonstrate that there is material scope to reduce the economy’s reliance on fossil fuels.

However, Mexico’s reversal of energy reforms and market liberalisation undertaken by previous president, Enrique Peña Nieto, has led to tensions with the US. President AMLO made legislative changes in 2021 that effectively prioritise the state-owned electricity, and oil & gas companies. This includes the priority distribution of state generated power over private sector owned clean energy sources, as well as issues with permits for renewables. Together with a series of other allegations, this has led the US to pursue consultations with Mexico under the dispute resolution chapter of the USMCA.

Whilst renewable energy is not a priority for the current administration, the potential is clear. Indeed, the energy reforms passed under the Peña Nieto government led to significant foreign investment in the sector, which explains the issue above. A presidential election is scheduled for June. The front-runner Claudia Sheinbaum is from AMLO’S MORENA party. Whilst Sheinbaum has pledged to retain at least 54% of power generation in state hands, she has discussed the need to accelerate the renewable energy mix, and to improve efficiency at the state oil & gas company. Indeed, her background as a scientist with a PhD in energy engineering, and who has been a member of the Intergovernmental Panel on Climate Change (IPCC) points to a potentially more pragmatic approach to energy policy.

Why elections are an area to monitor

Mexico is set to hold general elections on 2 June this year. These include presidential, congressional and gubernatorial ballots. From a policy perspective, the elections bear close monitoring, particularly as the presidential term is for six years, and it’s worth bearing in mind that there is no run-off. All of the lower house and senate seats are also up for election.

The presidential election appears to be Claudia Sheinbaum’s to lose. The MORENA party candidate has led opinion polls for some time, and is ahead of the next placed candidate, Xóchitl Gálvez, by a wide margin. Galvez is the candidate representing the alliance of the three main opposition parties, the National Action Party (PAN), Institutional Revolutionary Party (PRI), and Party of the Democratic Revolution (PRD).

Sheinbaum has so far appointed a mix of AMLO staff, as well as some members from academia and other political parties. While Sheinbaum is projected to continue the policy decisions of AMLO, the exact path and potential deviation remains unclear.

With regards the congressional elections, a status quo result appears to be the most likely outcome at this point. This would see MORENA retain simple majorities in both the upper and lower chambers. That would provide sufficient power to legislate reforms, but without the ability to change the constitution, which would be required for more controversial reforms such as to pensions or the supreme court.

What are the risks to this outlook?

The direction of the US economy remains key for Mexico, given the important trade linkages, and remittance flows. The latest economic indicators in the US remain relatively robust, with hard landing risks diminishing.

The US presidential election is highly relevant for Mexico and the path for future trade relations. In the US, opioid smuggling and illegal immigration through Mexico remain key issues for some of the electorate and wider relations. Crucially, the USMCA, signed in 2018 during the Trump administration, has a sunset clause that requires all signatory countries to sign again in 2026. This opens up the potential for a tough renegotiation, even if there is ultimately no change to the agreement itself. Recall that there is ongoing disagreement relating to energy policy. Uncertainty on this front could at the very least drive volatility in nearshoring linked stocks.

Unconventional policy proposals have undermined Mexican institutions and been a concern for markets under AMLO. However, MORENA’s lack of a supermajority has constrained its ability to pass reforms that require a constitutional change. While there is growing hope for a more pragmatic policy approach under a prospective Sheinbaum presidency, a package of 20 legislative proposals was sent to congress in early February. These include plans to make constitutional changes to the judiciary, pensions, salaries, and elections among others. It seems unlikely that these will pass, but the narrative remains negative heading into elections.  

What do valuations look like?

On a Z-score basis, a measure of how far valuations are from the historical mean, Mexico continues to rank as cheap, and towards the most attractively valued in EM. However, both its ranking within EM, and the degree of cheapness have decreased vis-à-vis 12-months ago.

Chart showing equity valuations in emerging markets

From a currency perspective, the Mexican peso is close to its long-term average on a real exchange rate basis. It is almost 20% ahead of its five-year average. It follows strong performance of the currency last year, with the peso gaining around 15% against the US dollar. There is a risk of some modest weakness as the central bank begins to loosen monetary policy.

Chart showing exchange rate for Mexican peso

Our view on Mexico

We continue to hold a neutral view on Mexico. The country is a beneficiary of deglobalisation and the growth of nearshoring, which if it continues as some forecast has potential to be a multi-year plus theme. These areas could still experience some turbulence along the way, given outperformance in recent years, and if trade tensions with the US worsen. That said, market volatility stemming from US or domestic politics could provide an opportunity.

Mexico is also a defensive market in an EM context. However, domestic policy concerns persist, following several years of institutional weakening, and the legislative agenda remains concerning, even if limited proposals will pass. General elections are scheduled for June, and are likely to create uncertainty in the coming months. The US presidential election in November could also generate some volatility, particularly under the scenario of a Trump victory.

The long-term outlook remains positive for Mexico, but the coming months may see some disruption. In addition, stock opportunities at this juncture are more constrained, even if aggregate equity market valuations are reasonable.

Authors

Robert Davy
Emerging Market Equities Fund Manager
Andrew Rymer, CFA
Senior Strategist, Strategic Research Unit

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For illustrative purposes only and does not constitute a recommendation to invest in the above-mentioned security / sector / country.