I’ve always had a problem with the standard narrative that you hear about emerging markets (EM). Investors are constantly hearing, or telling, stories about how you must have exposure to EM because these countries have much stronger growth rates and prospects than the developed world, how EM countries have far superior demographics, or how EM countries have much lower public/debt to GDP ratios. An example I like to provide that exposes these myths is to consider a country that has grown 6.2% per annum for 10 years, has decent demographics, has a public/debt GDP ratio of less than 40%, and just to cap it all off has a world class education system and strong political institutions. That country is Ireland in 2007. As the Irish example shows, there are many more important things to look at, not least real credit/GDP growth rates and rapidly rising real estate prices (the two are obviously connected).
The reality is that emerging markets always have been, still are, and will most likely continue to be all about global capital flows. Global capital flows are themselves very cyclical, so when the global growth outlook is improving you find that capital flows from developed markets (DM) to the juicier yields in EM, and EM therefore typically outperforms. When the global growth outlook is deteriorating, capital tends to flow back from emerging markets to developed markets. Hence the comment on this blog in July last year that the market was priced as if EM was a safe haven from developed market woes, and the market was therefore smoking crack.
The EM countries that are particularly exposed to these global capital flows are the ones running large current account deficits, since by definition countries running current account deficits are reliant on capital inflows from abroad to fund themselves. A ‘sudden stop’ or reversal in these capital flows leaves these countries very vulnerable. We saw this dynamic play out in a big way in 2008, and saw it again last year when DM equities outperformed EM equities despite all the problems being in the Eurozone. Unsurprisingly, the countries that saw their currencies get hit the hardest in 2011 were generally those EM countries running large current account deficits – the South African Rand fell 10.5% against the euro, while the Turkish Lira fell 8.6%, the Polish Zloty 6.7% and the Indian Rupee 4.7%.
Another currency that fell quite sharply last year was the Mexican Peso, which tumbled more than 5% against the euro and by more than 8% against the US dollar. This wasn’t due to Mexico running a large current account deficit (it’s running a small 0.5% deficit). In fact the Mexican Peso was hammered in 2007-08 too, falling 12% against the Euro and 7% against the US dollar. Ongoing peso weakness in 2009 was partly Swine Flu related, and the peso’s high beta characteristics probably owe something to it being one of the most liquid EM markets, but whatever the reason the Mexican peso is looking very cheap to us. And it’s not just the currency that looks attractive – in a world of negative real yields, Mexican real yields stand out as being huge (Mexican core inflation is 3.3%yoy, 10 year nominal Mexican local currency bonds, or Mbonos, yield over 6%). These high real yields aren’t because of any concerns regarding credit risk, since Mexico is one of the best quality EM debt issuers – Mexico is actually also considered a developed market, having been admitted to the widely followed Citigroup World Government Bond Index in October 2010. We like Mexico, and were buyers of Mexican local currency bonds earlier this year.
These positive views about Mexico were reinforced recently following a highly informative week in Mexico City, kindly set up by HSBC, where I met key members of the government and central bank to gain a better understanding on economic issues, and where I spoke to pollsters and political analysts to get a handle on Mexican politics ahead of the elections in July this year. Below are the main takeaways.
Firstly politics. Financial markets have a tendency to become very excitable around elections, and this occurs not just in EM countries but in developed markets too. Almost always this volatility (which is normally volatility of the bad kind) turns out to be unjustified. To cite a couple of examples, consider how Peruvian asset prices sold off sharply last year when left wing candidate Ollanta Humala was voted in, but asset prices then recovered rapidly when markets realised he wasn’t Chavez. And consider the UK in 2010, when asset prices wobbled on political instability fears as it became increasingly likely the UK would have a rare coalition government, but how the UK is now seen (rightly or wrongly) as one of the world’s few ‘safe havens’.
The last general election in Mexico in 2006 was another example of this unjustified volatility. The election saw a near dead heat with the centre right PAN candidate Felipe Calderon defeating the left wing PRD candidate Andrés Manuel López Obrador by fewer than 250 thousand votes, or 0.56% of the vote. As uncertainty escalated in the run-up to the election from February to June 2006, the Mexican peso was the sixth weakest currency in the world and Mexican government bonds performed poorly. After the election result was announced, López Obrador, the PRD candidate, reacted by claiming electoral fraud and instigated massive marches in Mexico City, a city in which he was very popular following a successful stint holding a position akin to mayor. After losing in his attempt to get the result overturned, he and his supporters embarked on an ultimately unsuccessful two month blockade of one of the main roads in the heart of Mexico City.
The situation today is very different. The PRD’s López Obrador is running for President again, but despite having a fiercely loyal group of supporters, his behaviour following the 2006 election has cost him significant political capital and he is languishing in third place in the polls. In second place in the polls is Josefina Vázquez Mota, the ruling party PAN’s recently nominated candidate, who is the first female candidate from one of the main parties. But Vázquez Mota too has significant ground to make up on the clear front runner, the chisel jawed Enrique Peña Nieto, who has about 50% of the vote in the polls and is candidate for PRI, the party that held power for over 70 years prior to PAN’s victory in the 2000 election.
Given recent events, though, Peña Nieto is more than capable of blowing his lead. The strength of his vote among women (who at rallies chant what can loosely be translated as “my chocolate, I want you for my mattress”) was recently called into question after Peña Nieto disclosed that he has had two children during extramarital affairs when married to his now deceased first wife (he has remarried a Mexican soap star, which cynics see as a bit of a publicity stunt). He has recently been accused of being sexist – when asked about the price of tortillas in December he got the answer completely wrong and replied ‘I am not a housewife’. And to add to his gaff prone image, at a recent international book fair where he was promoting his own (ghost written) book, in response to a question on which three books had influenced him, he floundered for a number of minutes before saying the Bible and then mixed up the authors and titles of other books. But even in the unlikely event of Peña Nieto losing his lead before polling day, it’s difficult to see that markets will be ruffled by Vázquez Mota keeping PAN in power – in fact it may even be seen as a good thing.
The strength of the Mexican economy is more obvious than that of its politics. The weakness of the Mexican peso has been a boon to Mexican industry, and auto manufacturers such as Nissan, Mazda, Toyota, GM and Chrysler have been investing heavily in the country. Interestingly ( and this tells you as much about Chinese headwinds as Mexican tailwinds), Mexico is seeing a reversal of what happened in 2001, when companies up and left to go to China. In 2001, Mexican wages were 250% higher than Chinese wages so it made a lot of sense to shift production to Asia, but by 2007 the gap had fallen to 40% and now the difference is only around 10-15%. Today it is much more economical to manufacture in Mexico and export to the US, where 78% of all Mexican exports end up, than to export to the US from China (as an aside, this trend of moving production away from China will have interesting dynamics on shipping rates, or given the recent collapse in rates perhaps it already is having an effect).
The Bank of Mexico (or ‘Banxico’), headed by the highly respected Agustín Carstens, forecasts that the Mexican economy will grow a robust 3-4% this year, and although the recent drought is causing a temporary uptick in headline inflation, core inflation stands close to a record low. Credit growth is not too hot, and is coming from low levels of penetration. The economy is in strong fiscal shape thanks to reforms in recent years such as the 2006 Budget and Fiscal Responsibility Law and 2007 Integral Fiscal Reform, and last year’s budget deficit of 2.5% is likely to slightly improve in 2012. Central government debt remains very manageable.
Mexico has also succeeded in greatly reducing its reliance on foreign currency denominated debt (ie external debt) by maintaining its policy of issuing 80% of its debt in local currency and the remainder in foreign currency. A side effect of this policy has been foreign ownership of the local currency bond market dramatically increasing to about 44%, although Mexico’s recent inclusion in the Citigroup World Government Bond Index means that unlike in a number of other EM countries, ownership is spread across a diverse number of investors rather than dangerously concentrated in a small handful of large global bond investors. All of these supportive factors made the central bank’s tirade against the rating agencies that I heard understandable – they had a point when they argued that the agencies’ methodologies are flawed, unfairly penalising not just Mexico but a number of EM countries versus a number of better rated but far less solvent developed countries. Indeed, judging by the default risk implied by the credit derivatives market, the market has long agreed.
Despite the Mexican economy’s obvious strengths though, many investors remain deeply frustrated that the economy hasn’t performed considerably better given the country’s oil windfall. In 1971, a Mexican fisherman named Rudesindo Cantarell complained to Mexico’s state owned oil company Pemex over what he thought was an oil spill that was ruining his fishing nets. Pemex asked Cantarell to show them where this had occurred and it was confirmed in 1976 that the fisherman had found an oil seep from what is one of the biggest oil fields ever discovered (the field’s structure is actually a result of the asteroid impact in the Gulf of Mexico that is believed to have wiped out the dinosaurs 65 million years ago). At its peak production in 2004, the Cantarell oil field produced 2.1 million barrels per day, which at the time made it the second most productive field in the world after Saudi Arabia’s ginormous Ghawar field. In 2010 Mexico was still the seventh biggest producer of crude oil, ahead of Norway, the UK, Venezuela (which has the world’s largest proven oil reserves), Iraq and Brazil. About 35% of Mexican government revenues are from the oil industry.
The worry is that Mexico won’t be able to rely on the oil windfall to anything like the same extent in future. Production in Cantarell has declined exceptionally rapidly, falling to just 400 thousand barrels per day in November last year. Mexico could become a net oil importer by the end of the decade, which is ridiculous given the large reserves that Mexico still has. Mexico isn’t just blessed with oil reserves either – it is estimated to have the fourth biggest reserves of shale gas in the world that has barely been tapped at all, and the sad reality is that Mexico’s inefficient state monopolies are unable to take advantage of this (despite its gas reserves Mexico is importing gas from the US).
This is where Mexican politics meets economics. Reform has long been slow and it’s becoming urgent. Reform is most obviously needed in the energy sector (the General Director of the Mexican auto industry specifically cited power as a region where Mexico is not at all competitive) but there is little prospect of anything changing soon because Mexico’s constitution states that all oil and gas belongs to the Mexican state, which is a belief that has been hard wired into the Mexican psyche (Pemex was created in 1938 following the expropriation of foreign owned oil assets). Inefficiencies are not limited to energy either – whole swathes of Mexican industry, ranging from telecoms to media, are dominated by rent seeking behaviour where the powerful have no incentive to introduce competition and change the status quo. Reforms require a two thirds majority in congress, which has been historically difficult to achieve and worryingly the front running PRI party have been keen to veto proposed reforms in recent years.
Finally, drugs. As widely publicised, parts of Mexico have become dangerous with the areas bordering the US essentially lawless. The Mexican State of Chihuahua and its largest city Juarez were described by government security staff as being ‘worse than Iraq’. Violence has fallen slightly since the peak in mid 2010, but it’s difficult to argue that the crackdown has been a huge success (although 80% of the population approves of the government’s policies). Longer term, Mexico probably faces two choices – legalise drugs, or go the route of Colombia and seek involvement from the US military (the second option is far more likely to happen). In terms of the bigger picture, it’s very difficult to see how the drug problem in Central America can be eliminated. It’s like squeezing a balloon – Mexico’s drug clampdown has simply resulted in a big escalation of violence in countries where there are fewer resources to throw at the problem such as in Guatemala, Honduras, El Salvador and the Dominican Republic. Drug cartels are merely trying to meet the big demand that continues unabated from the US, and where there’s demand, there’s supply.
It’s worth putting the drug war in Mexico into perspective though. Mexico still has a lower homicide rate than Brazil at around 20 homicides per 100 thousand, and murders are much lower than in a country such as Jamaica that has a homicide rate above 50 per 100 thousand. Furthermore, while the government estimates that areas with major drug issues see economic growth about 2% below safe regions, it’s not apparent that there has been much effect on the Mexican economy as a whole (although given the government is spending 1.5% of GDP trying to combat the problem there is surely some impact). So while security is clearly an important issue for the population, it shouldn’t be a major influence on the decision whether or not to invest in Mexico.
Overall, the high yields on offer in Mexico more than justify the risks in my opinion, with the caveat as mentioned at the beginning that Mexican assets are subject to global capital flows like any other EM asset. On this point, though, it’s interesting to note that Brazil’s changing IOF tax policies on bond holdings is encouraging all those yield chasing ‘Mrs Watanabes’ in Japan to look at Mexico as a carry trade alternative to Brazil in the region. If Japanese investor interest results in even half the Japanese capital flows that have gone into Brazil in recent years then this would be a major boost to not just future Mexican borrowing costs but to the Mexican Peso too.