Contrary to popular belief, NAFTA has been one of the greatest deals that America has ever negotiated, and undoing it will send the American economy into depression, causing shares of the SPDR S&P Index (NYSEARCA:SPY) to drop in excess of 40%.
In basic economics, you learn that trade, when it's fair, always benefits both economies. Sure, manufacturing can suffer, but services might thrive. There are always winners and losers, but as long as there are more winners, trade is good. Donald Trump campaigned on the promise of repealing NAFTA, and recently, he has been on a tweeting campaign against Ford (NYSE:F), General Motors (NYSE:GM), Toyota (NYSE:TM), Carrier, etc. Thanks to this campaign, Ford announced the cancellation of a $1.6 billion plant in Mexico. If things continue their course, we believe it's only a matter of time before Canada and Mexico retaliate, and we find ourselves in the middle of a trade war.
To understand the magnitude of the consequences of a NAFTA repeal or a trade war, let's look at the trade figures for 2015. According to the Office of the United States Trade Representative, trade between Mexico and the United States totals an estimated $583.6 billion. Mexico represents the number 2 market for American goods. Mexico bought $236 billion of American goods. US's exports to Mexico are almost the same as the 28-country European Union and twice as large as China for which the US only exported $116 billion. Then, exports to Canada amounted to $280 billion. When you combine Mexico and Canada together, you realize that the US depends on just these two countries for $516 billion out of $2.23 trillion of exports (23% percent is concentrated in two countries).
Should NAFTA were to be undone and the talk becomes a real threat, we would recommend investors to buy January 2019 SPY puts with a strike price of $140 trading January 19, 2017, for $3.53 a piece. This is a trade betting on a significant increase in implied volatility for returns in excess of 300% (More on that in the trade section). We further recommend that investors aggressively bet against shares of Wal-Mart (NYSE:WMT) should that scenario were to occur. As the graph below shows, Wal-Mart's sales in Mexico have been growing at double digits. Mexico is by far the second most important country for the company, and its shares would crater if Mexico were to retaliate against or impose tariffs on American goods and or trade restrictions on American companies. Most of the emerging market growth for Wal-Mart is experienced in Mexico. Wal-Mart Mexico CEO Guilherme Loureiro said that the company's goal is double sales of the company by 2024. Sales of Wal-Mart outside of the US in 2016 are expected to amount to $123.4 billion or 25.6% of its revenue.
American Investments Under Exposure
The consensus today is that protectionism would bring jobs back, manufacturing would come back to towns and the dollar would significantly strengthen. But the truth is that American companies are heavily invested in Mexico. A depreciating peso, which is already on the verge of a panic, combined with restrictions on goods coming into the market, would render many Mexican and Canadian investments worthless. The US currently accounts for more than 40% of foreign direct investment in Mexico and more than 18,000 companies with U.S. investments operate there. And since 1996, an average of 46% of foreign direct investment has come from the US. On average, since NAFTA, Mexico has received approximately an average of $53 billion in foreign investments. That means 22 years of American companies pouring on average $24 billion annually into Mexico. That's a total of $528 billion of investment exposure in Mexico. But is the consensus always right?
The Contagion Effect - Started in Mexico Ended in Asia
When NAFTA was signed in 1994, there was a general consensus for Mexicans that the treaty was going to be beneficial for everyone. Bankers pushed adjustable rate mortgages to millions of Mexicans in the two years before the treaty was signed. Their premise was that once NAFTA was signed, billions of dollars in new capital would flow into the economy and interest rates were going to go down. American banks approached Mexican banks and sold them interest rate swaps that would make them profit from this event. All while encouraging speculators to heavily short the peso later in 1994.
When the treaty went into action, the exact opposite happened. American goods flooded the Mexican market while Americans had no taste for Mexican goods. American goods were the reflection of perfection, of electronics that didn't go bad, and of clothing that lasted for decades. Wal-Mart, Kmart, Domino's Pizza (NYSE:DPZ) and Sears (NASDAQ:SHLD) pioneered this effort, and it would take three hours in line just to get inside of the first Wal-Mart in Mexico. This 244,000 square facility opened in the fall of 1993, and it was used as the last stepping stone to gain congressional ratification of NAFTA. It was a wonderful vision of free trade: Americans selling, people in poorer countries gratefully buying.
To such was the extent of demand for American goods that factories all across Mexico shut down. Companies left and right went out of business unable to compete against America, and hyperinflation reached 52% in 1995. Mutual funds liquidated emerging market assets and contagion spread. It started in Mexico and ended with the Asian crisis.
Interest rates in Mexico climbed to over 52% in 1995 from 15% in 1994. All those adjustable mortgages defaulted, millions of Mexicans lost their homes, Mexican companies defaulted on their debt all while losing their market share to American companies due to their lack of competitive goods not to mention that the financial sector was obliterated with derivative loses.
Source: Interest Rates in Mexico - Focus Economics
The Mexican Peso has Devalued GDP Contracts by 30%
Truth is Mexican companies weren't even close in quality, technology, and logistics to compete with American goods. Interest rates went through the roof and Mexico's economy went into shock. GDP went from $456 billion in 1994 to $310 billion in 1995. The Mexican government ran out of forex reserves to keep the Mexican peso peg on the dollar and a devaluation ensued.
Banks suffered a triple whammy: their corporate customers defaulted, their variable interest mortgages defaulted and their interest rate swaps went completely against them. A $50 billion rescue package orchestrated by the IMF, US Treasury, Federal Reserve, the Bank for International Settlements, and Goldman Sachs happened. Mexico was forced to let foreigners compete in the banking industry, and within eight years foreigners controlled 80% of Mexican banking assets.
The Mexican peso went from $3.42 to a dollar to $8.05 to a dollar within a year.
Source: IMF - The Mexican Peso Crisis and its Aftermath
It was then that American companies sitting on billions of newly made profits and a devalued peso which made their dollars worth a lot more went on a shopping spree buying Mexican assets left and right for pennies on the dollar. The main winner was Wal-Mart.
Wal-Mart Conquers Mexico
By 2003, Wal-Mart was already the largest employer in Mexico and its sales were 11 billion. More than the entire tourism industry at the time. Mexico was and continues to be the biggest market for the company outside of the US. As this masterpiece from the New York Times describes it: Wal-Mart Invades, and Mexico Gladly Surrenders.
Mexicans suffered highly from NAFTA. They lost their homes, their local brands, their manufacturing, their financial sector, and their jobs when NAFTA came to Mexico. America enjoyed one of the most prosperous decades in the years ahead and a deficit surplus was achieved. It's an abomination for them to hear that NAFTA was a bad trade deal for Americans when in reality Mexico lost so much more.
NAFTA was a much better version of the flawed shared currency European Union. Thanks to NAFTA, America is stronger, more Mexicans are going back to Mexico than coming here illegally as they find jobs at home, and American companies are stronger and more profitable.
Effects of a Trade War
Let's start with the obvious.
Mexico's Economy Will Collapse
If a $50 billion financial rescue package in 1995 that sent shock waves all around the world isn't a good enough lesson, imagine what would happen to the world financial system when the US, which accounts for 70% of all Mexican exports, shuts its doors to Mexico. The size of the financial system in Mexico is now four times bigger than back then.
American Investments Collapse
Imagine a $2 billion Ford factory built to send cars to the US suddenly finds out that tariffs at the border are 35%. The economics of assembling cars in Mexico are lost and any competitive advantage of keeping the factory open is lost. Imagine the company sells the plant for a loss at one-fifth of its cost. As mentioned earlier, $528 billion in investments are traceable back to the US, plus many companies have reinvested their locally made profits. Just a 40% currency devaluation, combined with obsolete factories and a contagion effect, and you can see the worth of those investments reduce by at least 60%. Those are losses in excess of $300 billion.
The second risk comes from a heavily indebted Mexico whose sovereign debt market issues $1 trillion per year, where 60% of the sovereign debt is owned by foreigners and where Mexico's debt to GDP is at an all-time high.
The case for a 40% drop in the S&P is easy. When China devalued its currency by 2% overnight, it sent a shock wave throughout the rest of the world. That combined with weak oil prices sent the S&P down 10% almost overnight. Mexico is a much bigger partner than China and America depends more on Mexico for exports. A collapse in Mexico would have a much more severe impact on the American economy. More than $300 billion in investment losses, derivative losses on Mexican sovereign debt insured by American banks, a 40% reduction on American exports to Mexico would be equal to stopping trade with China altogether, and more than $100 billion exposure of American banks to Mexican sovereign debt. Then, on top of that, you have the contagion effect around the world. A new global bear market would occur.
Should a full repeal of NAFTA become imminent, or should a trade war start with Mexico and Canada, we recommend investors purchasing $140 SPY puts with a January 2019 expiration. They last traded at $3.53 per contract (Investors shouldn't follow this trade unless the events described happen first. Without retaliation, we aren't bearish on the economy).
The following graph explains the profit potential for what would theoretically happen if you entered a trade today and seven months from now, the prices were where the graph is. Your original investment for 10 contracts would be $3,530 plus trading fees. This graph also assumes today's implied volatility prices. In other words, it assumes the slide would be so slow that option prices wouldn't be affected by an increase on implied volatility. This graph is only for the sake of calculating time decay and profit potential on your investment.
Truth is a repeal of NAFTA would send shares of the S&P dropping even faster than the Chinese currency devaluation overnight. If that were to be the case, our original investment could see gains in excess of 400% overnight. But even if it was a moderate slide from a trade war, we would be sitting on gains of more than 200% with just an approximately 10% correction. The bet on this trade is on a rapid increase in option prices due to a large move to the downside. Our $140 puts could suddenly be worth $15 a piece, up from $3.53 currently right now, for gains in excess of 300%.
On Wal-Mart, we would buy January 2019 puts with a $50 strike trading on January 9 for $2.33 a piece. We would expect a drop to that level will make our original $2,330 plus trading fees in excess of $10,000. We have attached a graph again with an assumption for prices seven months ahead (August 18, 2017). Again, we would use it to calculate time decay on our investment and profit potential.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.