Mexican wave

Fund Strategy - 10 Sep 2012 | By Rodrigo Amaral

At the London Olympics’ football final, Brazil was the fancied team but it was Mexico who took the gold. The match at Wembley reproduced on the football field a feeling that has become quite common among emerging market investors in 2012. Mexico, a country that not long ago had been labelled by US officials as a serious candidate to the status of failed state, has been a darling of markets for several months.

At the same time, other emerging markets that were much more hyped in recent years, Brazil included, have got the stink eye from investors. Today, when one talks about the Tequila effect on markets, rather than a crisis spreading around the developing world, it is more likely to refer to the hangover of traders that have celebrated a successful bet with Mexican assets.

Mexico’s positive image with markets may sound odd for people who are only used to hearing the name of the country mentioned when a new horrible drug-linked massacre is reported by the media. Mexicans still surely face lots of problems and there is much to be done before they can even aspire to get anything near to their northern neighbours in the US or Canada.

However, in the selective view of markets, Mexico has looked like a piñata that holds the promise of the juiciest rewards. The country has done quite a good job when it comes to putting the economy in order in recent years. Good enough in fact to attract high amounts of foreign investment and to justify an 11 per cent boost of the local stock exchange in the first seven months of 2012. Stocks have moved down a bit since the end of July but Mexico remains one of the hottest equity markets in the emerging world so far this year.

The enthusiasm was illustrated by Nomura Global Securities, which in July decreed that in the next 10 years Mexico will become the largest economy in Latin America, overcoming even the much more populous Brazil. For the moment, however, Mexicans are likely to be happy with the opportunity to ditch the tag of laggards of Latin America. Because that was exactly how markets saw Mexico not long ago. And with good reason too: in the 10 years to 2012, the economy grew by a pitiful 2 per cent a year, half the rate recorded by peers like Argentina, Chile and Colombia and one third of Peru’s.

Now expectations and hard data have changed the picture completely. In the second quarter alone, the economy grew by 4.1 per cent on an annual basis, according to the Government.

Nomura has forecast that GDP will grow between 3.5 per cent and 4.5 per cent a year in the next decade, benefiting from an inflow of foreign direct investments, the rise in labour costs in China and beneficial demographic trends, as Mexico has a fast growing and young population. Furthermore, private sector debt remains at a tiny 20 per cent of GDP, a trickle compared with the levels of developed nations, and the bank believes that lending in the country could grow by up to 17 per cent a year without creating problems to the economy.

The fiscal position of the Government is healthy, although the state sector has been under pressure to put spending under control, and inflation has been kept within an acceptable range. If the price of oil, Mexico’s main commodity, holds in the long run, the country’s accounts should improve further. Conditions could be set therefore for a strong period of solid growth, especially if the US, the key exports market for Mexican companies, starts to show some sprightliness too.

So things look good in the long run and this year, a number of factors have combined to help Mexican markets to perform strongly, according to Daniel Isidori, the manager of Treadneedle’s Latin American fund.

Firstly, Mexico went through a long presidential election campaign, a kind of event that, per se, always helps the economy to do better than otherwise. Markets were happy with the result of the vote, as Enrique Peña Nieto, the candidate of an old, but supposedly reformed dominant party, the PRI, defeated a rival that was not shy of expressing his anti-market feelings. “The result of the election has been seen in a positive light by markets, because the country needs to make a certain number of reforms, and it is believed that the candidate who won the election can push them forward,” Isidori says.

The power of contrasting perceptions is helping too. Mexico is benefiting from the fall from grace of other markets, especially their football rivals of Brazil, which have not only lost the Olympic gold to Mexico, but also much of the bullion sent to emerging economies by global investors. “Mexico has also performed well because Brazil has done badly,” Isidori says. “If you want to keep your money in Latin America, Mexico was the place to be earlier this year.”

Other regional economies that are seen in a good light by markets have either become quite expensive, like Chile, or offer little liquidity, the case of Colombia and Peru.

Domestic factors have provided a further boost to capital markets. Mexico has reformed its pension system, increasing the role of private pension funds, which have started to pile assets up.

As they chase performance for their investments, fund managers have thrown a lot of money in the direction of equity markets. Assets under management increased by more than 21 per cent in the year to August, according to Banorte Ixe, a local bank. And almost 20 per cent of the money is invested in equities, a ratio never seen before. Even though more than half the equity allocation goes to international exchanges, especially in the US, the sheer amount of money invested in the not very large Mexican stockmarkets has helped to lift the price of shares.

In recent weeks, the IPC, the main index of the Mexican stock exchange, has retreated somehow. This was a result of investors cashing out and also of the perception that valuations have approached rock-bottom in other emerging markets, according to Isidori. “Some portfolios are switching out of Mexico, as investors take profits and are now looking at markets that have underperformed of late, like Brazil,” he says. But he maintains there are still plenty of opportunities for equity investors who are keen to take a closer look into the country.

For example he likes the prospects for Mexican petrochemicals firms as he says there is a significant chance that the sector will go through extensive changes the future.

Many economists believe that the restructuring of Pemex, the giant state-owned oil company which has tentacles spread around all kinds of related activities, is one of the most urgent reforms that president Peña Nieto will have to tackle. Pemex contributes with a large chunk of the Government’s budget via tax payments, but it has become cumbersome and little efficient in the course of the years, something not unheard of when state-owned monopolies are concerned.

Companies that have carved themselves a position in the market that will enable them to take advantage of joint ventures or other initiatives taken by Pemex to change its ways could deliver juicy results in the future, Isidori says.

A much loved theme by emerging markets investors is the rise of the middle classes, and Mexico can offer some exposure to this phenomenon. Millions of people are moving upwards in the socioeconomic pyramid and as a result are spending ever more money in basic goods and the amenities of life.

“Consumption in Mexico has been stronger this year,” says Nick Robinson, a São Paulo-based fund manager at Aberdeen.

One example is the housing market, a promising but tricky industry in many emerging markets.

“The most interesting sector currently is the house builder one”, says Jonathan Asante, the head of global emerging market equities at First State. “These companies are very unpopular with investors, having been extremely popular seven years ago. But nothing has arguably really changed much with their business model. The weakness here is that house building tends to be a weak franchise in the medium term and hence the highest quality of these should only be bought in moderation even at cheap prices, if at all,” he remarked.

For his part, Isidori likes the prospects for companies like FEMSA and Arca Continental, which are directly exposed to the willingness of Mexicans to consume. The former has a promising retail operation that is benefiting from improvements in the quality of life of millions of Mexicans. The latter is emerging as winners in the process of consolidation of companies that bottle and distribute Coca-Cola, a huge market in the country (and one where FEMSA is also a heavyweight).

Another stock Isidori highlights is Genoma Lab, a producer and retailer of drugs and cosmetics which offer a presence not only in Mexico, but in other Latin American markets too.

Genoma Lab, in fact, is an example of a company that is doing a good job in reaching out to Mexicans who live in the US, a fast growing and increasingly prosperous group that is courted by the corporate sector as much as by American presidential candidates.

Another such firm is Grupo Alfa, which works in a number of industries, including the production of auto parts and frozen food, and which draws considerable revenue from the northern shores of the Rio Grande. “We should not forget that there is another Mexican population inside the United States,” Isidori says. “They have similar tastes of their Mexican relatives, but more money to spend in products and services. It is a very interesting market for Mexican companies.”

The robustness of the US economy is, indeed, a decisive factor behind the performance of many Mexican stocks. “Around 80 per cent of Mexican exports go to the US, so its economy is to a large extent dependent on the health of the American economy,” Robinson says. “And in the past few months data coming from the United States is looking a little better, especially those related to the housing market.”

A vibrant US housing sector, in particular, would be good news for the Mexican economy, he points out. “A lot of Mexicans will go to the United States to work in the housing industry, and those workers will send remittances back to Mexico.”

Analysts say that much of the enthusiasm showed by investors for the country is in fact a reflection of the more positive view that markets have borne about the US earlier this year - at least compared to all the dreadfulness that has come out of Europe. Isidori notes that any economic growth achieved by the US trickles down to Mexico in the form of a higher volume of exports, as the two countries have a privileged trade relationship in the context of the North American Free Trade Agreement, Nafta, which also includes Canada.

At the same time, a more buoyant US economy means that many more dollars are sent down to Mexico in the form of remittances by immigrant workers to their families, boosting consumption at home. It could be argued that Mexico has done well despite the struggles of their Northern neighbours, which indicates much more positive performance could take place once the US leaves its economic woes behind.

However grabbing a piece of the feel good story in Mexico is not an easy task for international investors. Differently from other emerging economies that have been on the good side of markets for longer, it can be hard for investors in the UK, for instance, to find ways to get exposure to the Mexican market.

An option for those who already do business in the US is to look at companies that list in New York via American Depository Receipts, ADRs. A handful of Mexican companies also list their companies in the Latibex trade platform at the Madrid Exchange.

Mexican-only funds are hard to come by, though. A number of them are available in the US market, but not in the UK. A more reaslitic option could be to invest in Latin American funds that allocate part of their portfolio to Mexico. But even then the share of portfolios composed by Mexican securities will be about 20-30 per cent of total assets at most.

If the Mexican economy continues to develop, however, the time could come for more investors to look for ways to expose their portfolios directly to the country. It is likely to take some time, in any case, for investment options to be more widely available. There are relatively few Mexican companies with shares listed in the stockmarket, despite all the interest shown by investors of late.

“That is always a problem for us, investors,” Isidori says. “Some companies will launch IPOs in the near future, like the Mexican unit of Banco Santander. But there are still few listed companies in the market.”

He points out that the weight of Mexico in the main emerging market indexes has actually decreased in recent years, a refelction of how much the country lagged other Latin American economies in the perception of investors. In fact, there has been nothing like the wave of Brazilian IPOs that flooded the market in the 2000s. Although investors are often abuzz with rumours that new companies will open up their capital, IPOs have not been launched as often as investors might wish.

“From the viewpoint of a listed investor Mexico offers quite a limited selection of acceptable quality companies because the economy is still dominated by a few wealthy families,” says Asante.

Which takes us to the risks that investors must keep in their minds if they decide to get into the Tequila wagon.

Even though Mexico has gone a long way towards putting its house in order, it remains as much a work in progress as other emering markets. The very structure of the Mexican economy, where large groups enjoy of oligopolistic positions in their markets, creates risks even for companies that have for some time caught the eye of investors. Action has started to be taken by the authorities to break up the stronghold that a few mammoth economic groups have on markets like telecommunications, oil and gas and others.

“Many of the better quality stocks are fully priced and all bear the risk that their near-monopolies need to be eroded over time for the country to move forward,” Asante says.

According to him, many Mexican companies are aware of the changes that are set to take place in their markets and have started to look forward in the search of new business opportunities and greater efficiency.

“Partly because of family dominance, the economy is less dynamic than those in Asia or indeed north of the border in the USA,” he says. “Some of the better Mexican businesses have realised this and will increasingly expand outside their home base where they will in some cases face serious competition for the first time.”

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Injecting more competitiveness in the economy is only of the challenges that the forthcoming government of Enrique Peña Nieto will have to face once he takes over, in December. Another is to reduce the weight of the informal economy, which today employs about one out of every three workers in the country.

As BBVA, a bank, noted in a recent report, high levels of informality are closely related to low levels of economic development and poor productivity. Bringing more of the economy into the tax-collecting formal sector is therefore a much needed task for the new government.

The recipe to achieve such a goal is well-known, but not an easy one to implement. Analysts say that Mexico needs to make it easier for entrepreneurs to come into the formal economy. The tax system needs to be simplified so that small companies do not feel drowned by costs and red tape.

In the World Bank’s Doing Business report, Mexico is ranked 75 out of 183 countries as a place that favours entrepreneurs who want to start a business. It is a not a good grade, although other Latin American countries, including Brazil, fare even worse. More worryingly perhaps, Mexico lost nine positions in this particular item, which indicates that incentives to open up a formal company are not getting any better.

It does not help either that wages in the formal economy are not high, just the opposite, and many workers prefer to earn a little more by dodging the taxman. And this is a particular tough problem to tackle. Low labour costs are widely seen as one of the most important competitive advantages of Mexico, especially for US firms that have transferred production lines south of the border. So any initiatives taken by the Government to increase the value of the wages paid by the private sector, making tax-paying jobs more attractive ot workers, are set to hit the ability of Mexico to compete with other low cost economies.

CEESP, a Mexico City-based economic think tank, has noted that the creation of more jobs in the formal economy is a necessary step to reduce poverty levels, another of the problems faced by Mexico.

Although the country can boast having the world’s richest man in telecom magnate Carlos Slim, dozens of millions of Mexicans can still barely make ends meet. To bring people out of poverty, CEESP says more private investment is required, and for that to take place the country needs to offer more legal certainty by reforming its judicial system. The list of urgent reforms needed to guarantee prosperity in the long run also includes the energy sector, the education system, the labour market and many other items. And that is without digging into the security realm, a big concern for foreign investors, as the country engages in a desperate fight against powerful drug cartels.

The task is a huge one, and the new government will have to show all its ability to strike the right notes. And reforms are necessary to help Mexico weather the woes that are likely to come from abroad for quite a while yet.

BBVA stresses that one of the positive factors behind Mexico’s recent performance has been the strength of the domestic market, which has helped to offset the bad news that emanate from Europe and the US. But the bottlenecks in the economy mean that even the most sanguine growth forecasts are not really that impressive. BBVA itself estimates that the Mexican GDP will end 2012 3.7 per cent higher than it started, a good but not extraordinary number.

Next year, the rate of growth should reach 3 per cent, which, according to many forecasts, would put Mexico again behind the likes of Brazil. Considering Mexico’s previous history when growth busts alternated with nasty financial crisis and bouts of political instability, a period of steady though unspectacular progress will certainly be welcome. But investors and Mexicans alike would rather see the country live up to its considerable potential.

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