Is Mexico cheap yet?

23 Jan 2017

  • We do not believe that these assets have cheapened sufficiently to offer a compellingly attractive risk/reward
  • 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)
  • The situation Mexico faces is of an unprecedented potential exogenous shock to its business model – a shock, as it were, of bright orange hair

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 for some time. 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 from the perspective of sovereign risk, and in particular dollardenominated bonds and credit default swaps. We do not believe that these assets have cheapened sufficiently to offer a compellingly attractive risk/reward.

Mexican dollar bond spreads (for 10-year external issues) have repriced 40 basis points (bps) since the tight levels of the third quarter last year. They currently appear to only incorporate a (valid and warranted) additional risk premium reflecting the implications of a potentially more protectionist U.S. trade and immigration policy. In our view, these spread levels remain far from pricing in the consequences of a downside scenario should those risks materialize. Any compression in the risk premium requires clarity in the U.S. policy framework. Mexico stands at risk of suffering both on the trade side, with an as yet uncertain prospect for 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 Mexico.

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

The policy prescription? Mexico faces two solutions to the imbalances caused by the U.S. policy change. First, it can incentivize a reorientation of the economy away from imports in order to offset the negative trade balance effects of U.S. barriers. This is achieved most directly by interest rate hikes, which 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 hikes can help absolve Mexico of its northern neighbor’s actions.

Upside versus downside? On the positive side, Mexico’s relative costs of production have cheapened 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 U.S. 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 very significant should the worst materialize. 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).

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