Are Mexican assets cheap yet?

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Looking at Mexican assets as a whole, the short answer is no

A longer answer necessarily distinguishes between different Mexican assets. Some may argue, and indeed traditional valuation metrics such as Purchasing Power Parity (PPP) and the Big Mac Index demonstrate, that the Mexican peso is arguably cheap and has been so for some time (see Exhibit 1 below).

There is no indication that the peso, which has been weakening nearly continuously for four years now, has reached a bottom, however. For clearer signals, we look at sovereign risk, and in particular that of dollar-denominated bonds and credit default swaps. We do not believe that these assets have cheapened sufficiently to offer a compellingly attractive risk/reward profile.

Mexican dollar bond spreads (for 10-year external issues) have repriced by 40bp since the tight levels of the third quarter of 2016. They currently appear to only incorporate a (valid and warranted) additional risk premium reflecting the implications of a potentially more protectionist US trade and immigration policy.

In our view, these spread levels are far from pricing in the consequences of a downside scenario should those risks materialise. Any compression in the risk premium requires clarity on the US policy framework. Mexico stands at risk of suffering both on the trade side, with an as yet uncertain prospect of tariffs on imports from Mexico, as well as on the investment side, where we see a far more challenging environment for new foreign investment in the country.

Why is this so important?

Mexico’s economic model can be summarised as essentially a factory for the US, funded externally either via direct investment or portfolio flows. Both pillars of this model have suffered from President Donald Trump’s pronouncements, with potentially weaker exports and an impaired financial account via less foreign direct investment (FDI) as the base case expectations over the next few years.

Exhibit 1: A number of valuation metrics suggest that the Mexican peso is cheap – the graph compares the real effective exchange rate of the peso and that of the Chinese yuan and suggests an enormous gain in competitiveness for Mexico over the past five years via weakness of the peso and low inflation.

Source: Bloomberg, BNP Paribas Investment Partners, as of 20/01/17

The policy prescription?

Mexico faces two solutions to the imbalances it faces as US policy changes. First, it can incentivise a reorientation of the economy away from imports to offset the negative trade balance effects of US trade barriers. This is achieved most directly by interest rate rises which would slow the domestic economy. Second, it can increase the relative attractiveness of Mexican peso-denominated debt for foreigners by raising the rate of interest paid on such issues. Either way, we end at the same solution: only further interest rate rises can help absolve Mexico of its northern neighbour’s actions.

Upside versus downside?

On the positive side, Mexico’s relative costs of production have fallen enormously. Additionally, the tightening in fiscal and monetary policy already underway in response to the situation will assist in rebalancing external accounts and reduce Mexico’s vulnerability to financing. The policy response domestically is entirely orthodox (other than an attempted currency intervention) and if it coincides with a scenario where US protectionism turns out benignly, from an investment perspective, Mexico certainly has the potential to be the ‘Brazil’ of 2017: higher real rates, weaker domestic demand, slower growth and an improved external balance.

On the negative side, Mexico’s vulnerability arises from the build-up of enormous liabilities in its international investment position: the stock of potential outflows is significant should the worst materialise. Indeed, it is conceivable that Mexico experiences the first-ever local currency debt crisis, in which its strength (having redenominated the bulk of government debt into locally denominated bonds) becomes a liability (as this market has been heavily sponsored by foreigners historically and these investors are not bound to the local market and can choose to exit, en masse).

Some numbers around this. As of the third quarter of 2016, the country has USD 1.1 trillion of external liabilities. Of that, just under half (USD 500 billion) is FDI and thus assumed to be stable (assuming protectionism does not prompt divestment here, but rather just a slowdown in new FDI). The important numbers are the potential ‘hot money’ liabilities that are vulnerable to reversal: portfolio and other investment in debt (and, to some extent, equity). The country has USD 612 billion of such liabilities, of which around USD 476 billion is in debt instruments and USD 136 billion in equity. At least USD 180 billion of that exposure in debt instruments is to the general government.

Conclusion

In summary, Mexico could face of an unprecedented exogenous shock to its business model – a shock, as it were, of bright orange hair. Any scenario whereby the immense stock of debt held by foreign investors is divested or not rolled over holds significant downside potential for Mexican assets. Is there value in Mexican assets? Potentially there is value in the peso, not yet in (local currency) bonds with interest rates still on the rise, and certainly not in external credit.

This article was written by L. Bryan Carter and Hardeep Dogra


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