Net-Net Weekly: Mexican Equities And Global Trade

| About: Industrial Select (XLI)

Summary

Mexican equities are down almost 40% from their peak in 2013.

Trump's aggressive trade rhetoric has caused investors to over-hedge their bets.

Patience is often most critical in distressed investing.

Political events, especially unforeseen shocks, often create investment and trading opportunities. Most often, we only notice this in hindsight, but sometimes the opportunity is hidden in plain sight.

Politicians will say what they need to in order to win the election, this isn't news. Donald Trump is possibly one of the greatest examples of this.

Interestingly, Rasmussen Reports (A media company specializing in collection, publication, and distribution of public opinion information), recently reported some insightful statistics. Only 4% of voters think that politicians follow through on their promises, while 83% don't believe they will, with the rest undecided. Source: Rasmussen.

Contrarian investing is almost as difficult as shorting, primarily because you are going against a large group of well-informed investors on the other side; power does lie in numbers.

Trump's rhetoric on Mexico, which likely falls into the 4% referenced above, is in my opinion a great investment opportunity based on: the shock of Trump's election, his harsh rhetoric towards our largest trading partners, and the misunderstood risk of NAFTA being renegotiated.

Mexican stocks as shown by the iShares Mexico ETF (NYSEARCA:EWW) are down ~40% from their high in 2013, around the time the dollar strengthened significantly. Further, they are down roughly 20% since Trump's election on Nov 8. I think this is an overreaction based on his rhetoric, and while hard to prove quantitatively, we have a few clues.

Firstly, Mexico is the 3rd largest trading partner of the United States, so if Trump is going to increase infrastructure and capital spending they will benefit if NAFTA is not renegotiated. I agree that's a big if.

From the United States Trade Representative: U.S. imported $316B from Mexico in 2015, exporting $267B, a roughly ~$50B deficit. Mexico has become a large manufacturing hub since NAFTA was implemented, along with a lower cost base and improving capital protections.

Here's the most important reason in my opinion that Trump won't follow through to the extent he has claimed. "According to the Department of Commerce U.S. exports of goods and services to Mexico supported an estimated 1.1 million jobs in 2014 (latest data available), roughly 90% good and 10% service related." Needless to say disrupting this immense flow of goods and services would be political suicide.

Another clue that supports my bullishness is the performance of industrial stocks. The industrial ETF (NYSEARCA:XLI) is up roughly 10% since the election, while looking inside some companies are up over 15%. Specifically, Caterpillar (NYSE:CAT), Cummins (NYSE:CMI), General Electric (NYSE:GE) have seen their biggest jumps in years based on projected fiscal stimulus.

Historically, XLI and EWW have been 66% correlated since 1998 (Source: Portfolio Visualizer). There is thus a large gap in recent performance, roughly 30%. If the value-creating fundamentals of our 3rd largest trading partner haven't been permanently disrupted by Trump's rhetoric, then the reversion trade should benefit holders of EWW, all else held equal.

Summary

Investors are very likely overreacting to Trump's rhetoric regarding trade. Mexico is our 3rd largest trading partner and he won't want to disrupt 1.1 million jobs if his goal is to grow our economy. Industrial stocks, which trade with Mexican stocks two-thirds of the time, are out-performing by 30% since the election. If you can stomach being a contrarian as well as heightened volatility, as shown by implied volatility (52% vs. 27% hist.), then you will very likely be rewarded when the dust settles and the rhetoric dies down.

Disclosure: I am/we are long EWW.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.