How the tables have turned in Mexico

One year ago, the outlook for Mexican financial markets was pretty bleak. Uncertainty related to US trade policy reforms under President Trump, together with domestic policy changes, had overshadowed the outlook for some time.

Economic growth had slowed even before the Covid-19 pandemic. The government’s response was very limited and on a different path to that of most other governments globally.

Fast-forward 12 months, however, and the outlook has changed significantly. The discovery and distribution of vaccinations globally is of course an important factor, but there is much more than meets the eye in Mexico.

The country may be a smaller part of the emerging market investment universe today, but within the Latin America region it remains an important market, comprising 25% of indices such as the MSCI EM Latin America. 

What’s driving the economic recovery?

The economy expanded by 19.7% year-on-year in Q2, with manufacturing and the external sector leading the recovery. The robust rebound in the US economy has been a major supporting factor. Indeed, strong remittances from Mexicans working in the US have provided additional support. Total remittances are up by 22% in US dollar terms year-to-date.

Consumer confidence is returning and the lifting of restrictions such as social distancing protocols is also beneficial. On a quarter-on-quarter basis, growth was 1.5%, driven by a more meaningful recovery in services. Although the service sector recovery may yet be buffeted by the latest wave of Covid-19 cases, the medium term recovery should be underpinned by vaccines. 

Mexico’s vaccination programme has been slower relative to other countries in the region. Close to 33% of the population had received at least one dose as of 25 July. Sadly, daily new cases of Covid-19 have been rising again, albeit not to the extent seen in previous waves.

There may well be near term impact from further cases, but the fact that distribution is taking place is positive and the estimated immunity rate is high. This provides confidence that societal and economic normalisation will continue to progress as we move through the year.

Against this backdrop, the IMF recently upgraded its outlook for economic growth in Mexico. It now forecasts an expansion of 6.3% this year.

Has the unorthodox response to Covid-19 worked?

Mexico’s central bank was very orthodox throughout the pandemic. It cut the policy rate by 300bps to 4% to provide support to the economy. It also drew on a swap line with the US Federal Reserve to ensure the smooth functioning of financial markets. With the economy now in recovery mode, and inflation picking up, the policy rate was hiked by 25bps to 4.25% in June.

However, Mexico did not provide a significant fiscal stimulus package in response to Covid-19. In this regard, Mexico was almost unique globally. Instead, President Andrés Manuel López Obrador, or AMLO as he is widely known, committed to a reallocation of resources and austerity measures, rather than debt issuance. Aside from loans to small businesses, the majority of support has come through existing social benefits programmes.

AMLO entered office in 2018 with an anti-establishment agenda. However, despite plans to increase social support and deliver infrastructure investment, he also pledged to deliver fiscal discipline and a balanced budget. AMLO is firmly against increasing the country’s debt levels, citing the impact of debt hangovers from previous crises such as the Tequila crisis of 1994.

This strategy was undoubtedly risky – and there has been some political fallout, which we will come on to – but the fact is that the fiscal accounts in Mexico are healthy. The economy will not face a fiscal drag this year, and neither will there be any political wrangling over deficit funding. The contrast with most other regional markets is quite stark on the fiscal front.

And thanks to the strength in manufacturing and also from remittances, the current account has moved to a large surplus position. So the external accounts picture also looks firm.

What can we interpret from midterm election results?

Midterm legislative elections were held in early June, with mixed results for the president and his National Regeneration Movement (MORENA) party. MORENA and its allies lost its super majority, but retained a simple majority in the lower house. The outcome is significant because MORENA has a majority in the senate, and control of both houses would enable it to amend the constitution. From an investment perspective this may be welcome as it could provide a better balance of power between political parties.

The approach to managing the pandemic has impacted AMLO’s popularity. Pre-pandemic, his approval rating stood at 70%. It has fallen to 59%. This loss of political capital, while notable, has been significantly less in comparison to other countries through the crisis, but likely had some influence on the midterms results. And it is despite other countries spending far more. Sadly though, the human impact has been equally as tragic as in other regional markets.

One explanation for the reasonably limited political ramifications may be Mexico’s uniqueness within the region. The size of its government is small, and companies and individuals are not accustomed to receiving government support. Expectations were perhaps set at a lower level.

There may well be further ramifications as we move beyond the pandemic, and various enquiries take place. At this point, AMLO appears to have, however fortuitously, navigated the crisis reasonably well and the political outlook is relatively stable. 

Cheap valuations underlined by investor behaviour

Mexican equity valuations have picked up, but remain attractive relative to history. The MSCI Mexico Index trades on a forward price-earnings ratio of 14.2x, relative to the MSCI Emerging Markets Index at 13.1x and the MSCI EM Latin America Index at 9.5x. We expect earnings in a number of the more economically sensitive areas of the Mexican economy, notably among banks and industrials, to pick up this year. On a price-book basis, the MSCI Mexico Index is at 2.0x, compared to 2.1x for broader emerging markets, and 2.1x for the Latin America region.

There are other important indicators which suggest that valuations remain attractive. First, we continue to see insiders buying equities. In a number of other global markets, developed and emerging, there are pipelines of initial public offerings (IPO), typically at high valuations. In Mexico the dynamic is the opposite. The market has not witnessed an IPO in over a year and a number of companies have taken steps to delist from public markets. 

For example, in May, the controlling shareholders of dairy company Grupo Lala announced plans to take the company private. Meanwhile, a private equity investor in airport operator OMA moved to increase its stake, acquiring up to 25% of the company. And Grupo Santander, the Spanish-listed parent company, made an offer to buy out minority shareholders in its Mexican-listed subsidiary. In all these cases, and there are many more, the motivating factor behind the corporate action is the low valuation.

Second, investor concerns about the domestic regulatory environment appear to be easing. For example, despite all the headlines and uncertainty created by energy sector regulation, US company Sempra Energy launched a bid to acquire Mexican gas distributor Ienova. Railways is another sector which has been subject to regulatory uncertainty under the current administration. And yet Canadian investors have been involved in a bidding war over Kansas City Southern, which is US-listed but has almost half its assets in Mexico. All this indicates that investor unease over policy has moderated, especially when one considers that the actions came prior to the midterm elections.   

It’s not about how we got here, but the path forward

Like many Latin American countries, the pandemic’s impact has been significant. The human toll alone has been shocking, and there are wider ramifications for the economy and livelihoods. The -8.3% contraction in GDP last year was the worst performance since the 1930s.    

So the somewhat brighter picture that we see today is as welcome as it is surprising. The cyclical recovery is flourishing and we continue to identify attractive opportunities. The near term path looks clear, but the extent to which momentum can sustain may be dependent on a number of factors.

The strength of the US economy will undoubtedly remain important, and policy issues have not disappeared. On the domestic front, however, we are encouraged by the business environment, which is helping to foster entrepreneurial activity. Mexico is currently experiencing a boom in private equity. And while many of these exciting new companies are not yet listed in public markets, they are attracting interest from global investors. This is an encouraging sign, especially against the backdrop of the past year.