MEXICO: THE SMART INVESTMENT ALTERNATIVE.
José Arnulfo Rodríguez San Martín, Deputy Director of Investment Analysis at brokerage house Acciones y Valores Banamex reviews the economic fundamentals and market forecasts to make his case*.
In this Summer’s Olympic Games, the Mexican Olympic team won the football gold medal in a decisive match against favourites Brazil at Wembley Stadium. This event raised a question – is possible for the Mexican financial markets to emulate the success of its soccer team and become the best asset allocation alternative for international capital markets for the remainder of 2012, 2013 and even the years to follow? I would suggest that the economic fundamentals and market prospects make that a real possibility. My key arguments leading to this conclusion are:
1. The healthy state of public finances, favourable external accounts and improved growth prospects.
2. The political possibility that long-awaited structural reforms in the field of public finances, labour and energy could be implemented and executed, which could in turn lead to an improvement in Mexico’s sovereign debt rating – presently rated one notch above investment grade – and steer the country onto a path of stable growth.
3. The prospect of high returns in both equity and bond markets. The first sustained by strong local market performance and the second due to the high yields offered by local government bonds that could represent a clear credit arbitrage opportunity for international investors, especially when the solid Mexican public finances are considered.
In spite of the adverse international financial and economic environment, the Mexican Stock market will probably be one of the most profitable markets in 2012 and certainly has been the most resilient one over the last few difficult years. Looking ahead, higher economic growth expectations for Mexico linked to higher expectations for economic recovery in the US, lead to a positive forecast for Mexican stock markets. This perspective, while being good in itself, could be greatly improved by the approval of important structural reforms and the upgrade of Mexico’s sovereign debt rating before mid-2013.
1) Mexican Stock Market Performance (USD)
International Stock Market Performance (USD)
Colombia -19.2 18.3
Mexico -13.4 18.0
S&P 500 0.0 11.8
India -36.5 9.3
DJIA 5.5 7.8
UK -6.0 5.7
Peru -13.3 5.1
Europe -11.4 2.7
Japan -14.5 -0.1
China -18.0 -4.7
Brazil -27.1 -5.6
Source: Accival with Reuters data
Economic growth and public finances
In the next couple of years the two main concerns that investors around the world will face are the following: poor economic growth and huge fiscal imbalances in several of the developed countries, which might lead to sovereign debt downgrades, reductions in bond prices and episodes of foreign exchange volatility. In light of these indicators one is led to the conclusion that Mexico presents a privileged position for investors in a world filled with uncertainty:
• Mexico’s 2012 forecasts for real economic growth fluctuate between 3.5% and 4.0%. This is a pretty good growth rate, especially when growth forecasts for USA – Mexico´s main commercial partner – are under 3.0%. This gained greater significance after the Presidential and congressional elections held in July, which suggest that Mexico is on track track to approve structural economic reforms that might be able to strengthen the internal market and contribute an additional source of economic growth.
• With a 40% public debt to GDP ratio and a 2.5% fiscal imbalance for 2012, Mexico presents a solid public finance scheme. Despite these figures international ratings agency Standard & Poor’s has kept Mexico’s sovereign rating at BBB, one notch above investment grade but seven notches below France and eight below Germany. However, the Credit Default Swap market has recognized Mexico’s superior credit quality by assigning risk premiums – measured as the spread over Treasury bonds – as only a bit higher than Germany’s and even lower than those for France. This evidence suggests that the markets could be discounting an improvement in Mexico’s sovereign debt rating in the near future.
• The yield to maturity for the 10-year local currency Mexican Bond began 2012 at 7.0%, but by mid-August had fallen to 5.4%, with an increasing effect on the bond’s secondary market prices and therefore producing important capital gains for tenors. This movement could be interpreted as another market reaction anticipating an improvement in the Mexican sovereign debt rating. However, even after this significant adjustment, yield rates offered by Mexican bonds still represent a very attractive investment opportunity, especially for international investors whose opportunity cost, judged against the US 10-year Treasury Note yield, fluctuates below 2.0%.
2) S&P: Credit Rating vs. 5Yr CDS
Source: Accival with Reuters data.
Friendly rate policy
Mexico’s foreign exchange rate policy is friendly to foreign investors since it is characterized by absolutely free currency convertibility at market rates, perfect capital mobility without restrictions or taxes, and a highly liquid market with many international participants. As a consequence the Mexican peso has become a good hedge currency against international volatility episodes, such as the US financial system crisis in 2008 and the Greek financial struggles in 2011. On the other hand, in the last twelve years Mexico’s manageable current account deficit – less than 2% of GDP – has been surpassed by a capital account surplus leading to an international reserve accumulation of approximately US$160 billion; a historical record for the country.
3) Local Currency Performance
Source: Accival with Reuters Data.
In the last decade Mexico has developed an outstanding record of economic stability and adequate fiscal and monetary policies. However, rating agencies have been reluctant to improve Mexico’s sovereign debt grade for the following two arguments: first, Mexico’s slow rate of economic growth – a questionable argument this year – and second, its dependency on oil exports that represent about 35% of total Government income. In order to solve these structural problems and provide Mexico with a renewed economic framework capable of improving productivity, boosting economic growth and isolating public finances from oil price fluctuations, three structural reforms have been proposed:
1) Fiscal reform aimed at increasing the taxable base, rationalizing public expenditure and the introduction of universal consumption taxes linked to a universal social security system.
2) A labour law reform that will provide flexibility to the labour market by reducing the fixed costs of hiring and the approval of flexible hiring procedures.
3) An energy reform that will allow private investment in the energy sector. At the outset it will only allow investment in electric energy generation, and eventually oil extraction, which remains a delicate issue that will require a constitutional amendment.
In the last fifteen years these reforms have been proposed by different Presidential administrations but haven’t been approved due to a lack of consensus amongst the different political parties in Congress. The general election for President, Senate and House of Representatives held last July, resulted in a change of the ruling party in the Presidency, although it failed to obtain a majority in the Congress. Nevertheless, the main political parties have declared their intention to discuss these reforms in order to provide the structural changes required by the country. The achievement of a general consensus amongst the main political parties would make it feasible to see some of these reforms approved before mid-2013, in which case Mexico will definitely be the smart investment alternative.*With special recognition to the Debt Analysis and Research Team in Mexico ©BestExecution | 2012