Is Mexico’s resurgence losing steam?
Is Mexico’s resurgence losing steam?
Latin American equities have made a strong start to 2022. The MSCI EM Latin America Index is up by more than 10% year-to-date, as at 26 April. This is relative to a fall of -14.4% for the MSCI Emerging Markets Index.
The sharp rise in global commodity prices, with the S&P GSCI Commodity Index up over 32% so far this year, has been a key driver of market gains. All of the Latin American markets except Mexico, which is slightly down year-to-date, have posted positive returns.
We review the reasons for this performance divergence, and assess the outlook more generally.
Why Mexico has lagged Latin peers year-to-date
It is worth recalling that Mexico was the best-performing Latin American market in 2021, and among the strongest in the MSCI Emerging Markets Index.
Mexico is an export-oriented economy, but in contrast to most other Latin American markets, manufactured goods dominate. It has been a beneficiary of strong US GDP growth, and hence export demand. The strong US economy has also fed through to robust remittance flows from Mexicans living in the US, and remittances to Mexico rose by 27% in 2021. Year-on-year (y/y) remittance growth has remained healthy in Q1 of this year, but moderated to 16.3% in February. There is a risk that this cyclical rebound could be set to cool.
The strong recovery in manufacturing exports is shown in the chart below. One point to note is the impact of global supply chain disruption, with a shortage of microchips hitting the car manufacturers, though automotive exports did show a strong pick-up in February.
Mexico is not dependent on commodity exports, and is now a net importer of fuel, as the chart below highlights. As a result, the economy has not had the terms of trade boost that other markets have recently enjoyed.
In addition, the structure of the Mexican equity market differs from many Latin American peers, and has also been a factor in underperformance relative to regional peers this year. In Mexico, the consumption sectors, notably consumer staples, represent a greater market share than commodity producers. Consumer staples companies have in many cases been affected by rising agricultural input costs, and have performed poorly so far this year.
What is the outlook for GDP growth?
Economic performance at the end of 2021 and early this year has shown a significant slowdown. Some of the drivers are temporary but have not eased, including supply chain disruptions, Covid, and a change in regulation to the labour law regarding outsourcing of personnel.
Manufacturing and non-manufacturing PMI indicators have turned negative, consumer confidence is down and retail sales growth slowed to 4.9% y/y in December, below an expected 6.0%. GDP growth expectations for this year have been downgraded from 2.8% at the start of the year to 2.1%, and could see further pressure.
In the longer term, “nearshoring” of manufacturing production to Mexico has potential to continue to support growth. This is in part a result of companies seeking to diversify supply chains away from China, and to some extent prioritise supply chain reliability/security over cost efficiency; an issue flagged by the pandemic as much as geopolitical tensions in recent years. It is also driven by the structural labour shortage in the US and associated wage rises. Nearshoring in Mexico has so far been led by Chinese companies setting up production facilities close to the US, as well as in the US. In the context of nearshoring more generally, energy sector reforms, which we discuss below, bear close monitoring, given potential implications for trade, notably with the US.
The balance sheet outlook
From a balance sheet perspective, Mexico’s external accounts remain solid, even if the current account surplus has come down. Fiscal maturities over the next year are low, foreign direct investment (FDI) remains at a healthy level and remittance inflows continue to be strong. Mexico is no longer a net fuel exporter so higher oil prices will weigh on trade. But there continues to be a spillover effect from the US both in terms of demand for exports, and remittances.
On the fiscal side, Mexico has a relatively small government and maintained an orthodox approach through the pandemic. The fiscal accounts are healthy, even if fiscal revenue growth of 5.6% in real terms lagged expenditure growth of 6.4% in 2021. Although President Andrés Manuel López Obrador, or AMLO as he is widely known, came to power in 2018 with plans to increase social support and deliver infrastructure investment, he also committed to fiscal discipline.
Inflation has continued to accelerate
Inflation has been surprising negatively, and reached close to 7.5% y/y in March; a 20-year high. Like other emerging market (EM) and developed market economies, this has been driven by higher food and energy prices, as well as the impact of supply chain disruption.
The central bank responded with another 50bps rate hike in March, taking the policy rate to 6.5%. Higher rates may further dampen growth, although credit penetration is very low relative to other EM, and as a result monetary policy has a smaller impact on the overall economy.
As discussed, rising commodity prices have been a major tailwind for net commodity-exporting countries this year. Latin America has been at the forefront, and while the Mexican peso has appreciated against the US dollar, gains have been more modest.
The real exchange rate remains above its five year average, but continues to be below the long term average, as shown below.
Why policy concerns are attracting attention again
Although AMLO has stayed true to his commitment to fiscal restraint, his anti-establishment agenda has been a concern since his election in 2018. Midterm elections last year served to ease policy uncertainty, as AMLO’s National Regeneration Movement (MORENA) party and its allies lost their super majority in the lower house. This limits the prospect of constitutional change, which would require a two-thirds majority in both chambers. Even so, AMLO still has a high approval rating among the general population of around 65%, and MORENA and its allies have a simple majority.
Last year, the government passed an Electricity Industry Law that had been subject to Supreme Court review on the basis that it was not constitutional. However, in April the Supreme Court narrowly validated the majority of the bill. There are several legal hurdles which remain before the law can be applied in practice, and the implementation details remain unclear, but the overall implications are negative.
The Electricity Industry Law provides the state utility company, Comisión Federal de Electricidad (CFE), exclusive electricity generation rights for over 50% of total generation; current market share is 38%. It also requires that the CFE is the first to distribute electricity, ahead of private players, many of whom had received incentives to invest, and regardless of whether it is renewable or fossil fuels. The consequences could include higher electricity prices, potentially bankrupt private players, and effectively abandon energy transition plans, with environmental implications. Some elements also appear to violate the USMCA, which has resulted in lobbying from the US.
A broader energy reform bill, that would have effectively annulled many of the changes made in 2013 under former President Enrique Peña Nieto, was rejected by the Senate on Easter Sunday. It would have a required a constitutional amendment to pass.
In response, MORENA has passed legislation to nationalise Mexico’s lithium reserves, which only required a simple majority vote. There is limited investment and production of lithium in Mexico at present and the initial impact is limited but it creates longer term issues and adds to the list of policy concerns.
What do valuations look like?
Mexico trades on a 12-month forward price-earnings (P/E) ratio of 13.6x, relative to an aggregate 11.0x for the MSCI Emerging Markets Index.
As the chart below shows, Mexico’s P/E ratio is now slightly above its historical average.
Valuations are more favourable on a price-book and a dividend yield basis, and on a combined basis still rank on the cheap side relative to history. However, the degree of cheapness has moderated since the beginning of the year.
Our view on Mexico
We have moderated our view on Mexico, and are now relatively neutral in our outlook. The path from this point looks dependent, at least in part, on US growth.
US economic activity is firm but may be set to fade, along with global trade more generally, even if the timing is unclear. This could squeeze out demand for manufactured goods, and there is already a shift underway from goods to services. We are already seeing signs of a slowing cyclical recovery reflected in the performance of domestic cyclicals including banks, cement and real estate stocks.
Meanwhile policy concerns have returned. Although the implications are so far limited, the direction of travel is concerning. After being one of the best performing equity markets in 2021, valuations have risen and momentum has turned, making the risk reward balance less appealing.
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