Markets & Economy
Latin American Equities
Mexico: A Wall of UncertaintyMarch 8, 2017
- Uncertainty surrounding the Trump administration’s potential policies is clouding the investment outlook for Mexico and its markets.
- Many in Mexico view the rise of a far-left Mexican presidential candidate as the greatest threat to the country.
- Mexican stock valuations appear elevated and have not yet priced in the political and economic risks facing the country.
- We will look for opportunities to add to positions in select Mexican companies when prices more accurately reflect the risks.
Normally Mexico’s warm destination resorts garner most of the media attention during these winter months. Not so this year.
One of the priorities for President Donald Trump and his new administration is to address the trade deficits and loss of jobs said to have resulted from what he has deemed poor agreements with large U.S. trading partners. Mexico and the North American Free Trade Agreement (NAFTA) are near the top of his list of concerns with regard to these issues. The uncertainty about what changes the administration may recommend or new policies it may implement has darkened investors’ outlook for Mexico and its markets.
We, and several of our colleagues, spent a week in the country in early February, meeting with company executives and with government and policy leaders. Those conversations helped illuminate some of the risks Mexico may face and opportunities it may offer over the next 12 to 18 months. However, we were struck by the strong sense of uncertainty expressed by nearly everyone we met.
The potential steps that President Trump might take to implement his new trade policies could include renegotiating or altogether scrapping NAFTA or imposing a border adjustment tax (BAT) on imports from Mexico. While the aim would be to reduce the trade deficit with Mexico (USD $60 billion in 2015), it is not clear that these aggressive policies would achieve that goal.
If the president decides to pull out of NAFTA, the tariffs would revert to levels stipulated by the World Trade Organization (WTO), which average less than 4% for Mexican goods entering the U.S. The recent depreciation in the peso (7% weaker against the U.S. dollar since the election) has already compensated for this.
This peso weakness creates a challenge to any attempt by the Trump administration to use tariffs or a BAT to reduce the U.S.’s trade deficit with Mexico. Over 80% of Mexico’s exports go to the U.S., and there are no clear alternative destinations for these exports. This means that a large tariff on Mexican goods would simply further weaken the peso, reducing Mexico’s production costs in dollars versus U.S. producers, more or less negating the effect of the tariff on trade volumes.
In addition, economies are highly integrated. For example, Mexico bought 18% of U.S. manufacturing exports in 2015. Mexico-sourced intermediate good inputs also are an important part of U.S. manufacturing supply chains. In other words, the U.S. would also feel the impact of the protectionist policies. Many Mexican exporters are U.S.-owned companies. In fact, nearly 40% of the value added in U.S. imports from Mexico originated in the U.S.
We expect that the rhetoric during the initial rounds of these negotiations will remain heated. In the end, however, we think the most likely outcome will be a more pragmatic solution, such as a renegotiation of NAFTA that does not fundamentally change the terms of Mexico’s access to the U.S. market but updates the treaty with stronger labor standards and more stringent requirements for goods to receive duty-free status. In the meantime, the uncertainty will continue to feed into other areas of the country.
RHETORIC IS IMPACTING MEXICO’S POLITICS
Mexico will elect a new president next year. President Enrique Peña Nieto’s popularity has been on a decline amid corruption allegations and his handling of President Trump, which means his party, the Institutional Revolutionary Party, or PRI, has little chance of winning. As the rhetoric from Washington has become more antagonistic, the protest vote has increased at the expense of the more traditional, moderate parties.
The far-left candidate, Andrés Manuel López Obrador (AMLO), is currently leading the race. It is still early in the election season, and AMLO has several hurdles to overcome before the election, not the least of which is his high negative rating. But his prospects could benefit if relations with the U.S. continue to deteriorate. Many in Mexico view AMLO’s rise as the biggest risk facing the country.
CONFIDENCE IS DOWN AMID THE UNCERTAINTY
Mexico’s economy accelerated a bit during the second half of 2016, with fourth-quarter gross domestic product (GDP) up 2.2% year-over-year. Loan demand and retail sales were both strong, which helped to compensate for the more sluggish growth in the first half of the year. Some of that momentum should flow into the first quarter of 2017. But the prospects for the rest of the year look dimmer. Consumer and business confidence have fallen recently, which should temper consumption and investment.
The peso has been weakening against the U.S. dollar for nearly three years and appears cheap to us. It tumbled immediately after the election but has gradually recovered some of that lost ground. The weaker peso should continue to support net exports. But the decline may feed into higher inflation, which is trending toward 5% as the currency depreciation has passed through to goods like gasoline. Mexico’s central bank (Banxico) has tried to stay in front of accelerating inflation and has raised its benchmark interest rate by a total of 3% since the beginning of 2016. These higher rates will further weigh on growth. While we do not expect the economy to experience a recession, growth will be modest (about 1%). This is not a very healthy backdrop for earnings.
MARKETS ARE OVERVALUED FOR CURRENT REALITY
While the peso seems cheap, valuations for Mexican stocks are not. In fact they remain above their historical average, and earnings estimates have not been cut to account for the more sluggish economy.
Investors may be anticipating a more benign outcome to the current trade tensions or have yet to focus on the economic slowdown or the 2018 elections. Once the market begins to price in these variables, we may find opportunities to accumulate positions in select companies at more attractive prices. The country has a strong institutional framework, a sustainable level of external debt, and an independent central bank. Many of its companies promote strong corporate governance and solid global business policies. These help form a positive foundation for the equity market. But they will not matter until some of the uncertainty surrounding trade policies, the economy, and the election dissipates. And that may take some time.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of March 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.
T. Rowe Price Investment Services, Inc., Distributor.