Mexico currency and equities benefited in 2022 from proactive monetary policy (the real interest rate is still positive 2.7%), recovery in tourism (7.2% of GDP, on average in the five years pre-Covid) and remittances (2.7%), and, longer-term expectations of growth in inward FDI focused on near-shoring US multinational manufacturing (3.0%).
The search for President Lopez Obrador’s political successor for the 2024 election and democratic backsliding that worsens relations with US President Biden's administration are not severe enough risks to derail the investment thesis.
However, deterioration in the ongoing war among the cartels to control the drug trade could do so. The spillover of even worse insecurity could materially impair near-term domestic economic activity and tourism receipts, and the longer-term growth of FDI driven by near-shoring of US multinational manufacturing.
Mexico's equity market valuation, measured by forward PB or PE, is close to the historical average. This may not sufficiently compensate for the potential escalation in the cartel conflict.
Cartel war
As the 2024 election approaches, an increasing number of instances of the spillover of the ongoing war are likely to be seen.
In the nine-month campaign period prior to the 2018 election, over one hundred politicians were killed in political violence and Mexico's nationwide homicide rate spiked to a new peak.
Mexico is already one of the most dangerous countries in the world. South Africa alone has a higher homicide rate among the large emerging equity markets.
The war over control of the flow of drugs out of LatAm is not new and nor is the fight over supremacy among the key Mexican cartels.
However, the most violent and disruptive episodes follow the fall of a unifying kingpin and the resulting power vacuum – ie after captures (and subsequent convictions and incarcerations) of Felix Gallardo of the Guadalajara Cartel in 1989 and Joaquin Guzman of the Sinaloa Cartel in 2016.
Data from the Mexico government suggests that violence may have ebbed in the past couple of years under the administration of Lopez Obrador but that has not yet been endorsed by third parties like the UN Office on Drugs and Crime.
Moreover, the events of early January 2023 suggest that it is premature to claim that violence associated with this war is on the wane – the arrest of Ovidio Guzman, the son of Joaquin, sparked a wave of attacks in the city of Culiacan.
In addition to the fragmentation of the cartels is the emergence of the Cartel Jalisco Nuevo Generacion.
This group appears as interested in using violent tactics as a means to control the drugs trade, fighting over territory with the Sinaloa Cartel and other smaller cartels, as an end in itself.
The elections of presidents Trump in the US and Lopez Obrador in Mexico have also led to the further erosion of cooperation between the two countries on containing the cartel war.
While Trump reversed gear on trade relations with Mexico and signed a revised treaty – NAFTA 2 or the USMCA – US financial assistance on security fell sharply.
There is as yet no meaningful change on mutual security interests under the Biden administration.
Lopez Obrador appears to have stuck to a policy of effectively leaving the cartels to prosecute their conflict on their own, rather than beef up the Mexican state's efforts or re-engage the US to contain it.
The impact of the cartels is not only on law and order and disruption of the formal economy in Mexico (and the US) but also on corruption.
Mexico scores poorly on measures of corruption relative to regional and broader global emerging market peers. With such a powerful and persistent presence of the cartels, it is not clear how this changes.
Manufacturing near-shoring
The near-shoring of manufacturing is one of the strongest long-term, positive fundamental drivers of the Mexican investment case.
US-China friction creates opportunity for others in low-cost manufacturing as multinationals diversify away from reliance on China.
Mexico has by far the largest and cheapest labour force located near the US.
It also enjoys low trade barriers enshrined under USMCA to boot.
And it has a youthful labour force, which should keep a lid on wage inflationary pressures.
Equity strategy
Mexico equities (S&P/BMV IPC index) are up 25% in total US$ return terms in the past 12 months.
Relative to LatAm, well positioned but expensive
Mexico's investment case stacks up better than that of others in LatAm, eg Argentina, mired in bad policy and facing an election, or Peru, trapped by a dysfunctional relationship between its president and congress – see LatAm EM equity strategy: 2023 outlook (January 2023).
However, having outperformed regional peers (excluding uninvestable, for foreigners, Argentina), its equity market and currency are now more expensive relative to historical averages.
In standalone terms, vulnerable but fair value
The economic policy stance is credible in monetary, fiscal and external account terms:
The real interest rate is positive 2.7%;
The fiscal deficit, gross government debt and the current account deficit are, as a percentage of GDP, respectively, 4%, 60% and 1% (all IMF 2023 forecasts); and
Short-term external debt is below 10% of GDP and is covered over 3x by FX reserves.
Valuations are close to the historical average for equities and above for the currency.
Forward 2023 PB of 2.1x (for 15% ROE) is close to the five-year median.
Forward PE of 14x (for flat consensus aggregate earnings growth and 3.7% dividend yield) is also close to the five-year median.
The real effective exchange rate (REER) implies the spot FX rate has 5% upside. But should REER revert to its 10-year median, that would be imply c10% downside.
However, near-term domestic economic activity and tourism receipts, and the longer-term trend of the near-shoring manufacturing thesis, are all vulnerable to further deterioration in the drug cartel war.