Nevermind 'Trump Trade': Long Mexico

|
Includes: EEM, EWW, USO
by: Long/Short Investments

Summary

Mexico’s trade relationship with the US has come under recent tensions, with President Trump’s desire to alter trade deals to make them more in line with US economic interests.

This has the potential to undermine Mexico’s economy, given its reliance on trade.

Mexico’s 15-year bonds are trading near 8% yields, which prices in much of this risk.

Mexico has options even if its trade relationship with the US becomes less influential.

Thesis

Mexico's (NYSEARCA:EWW) sovereign debt (May 2031 maturities) currently trade at yields near 8%. In light of the recent uncertainty over future trade relations with the US, I believe that Mexico's growth has the chance to come in under 2% in 2017 with uncertainty beyond the next 12 months.

However, even if the US trade relationship recedes and the economic rationale behind the peso's depreciation is legitimized (or furthered), Mexico's trade competitiveness will expand internationally to offset some of the effect (i.e., its goods are cheaper and therefore more attractive). The recent sell off in the peso is already working to directly benefit Mexico's trade stature. Moreover, Mexico's has a light debt burden, and the stability of its growth and inflation over the years mitigates some of the volatility that characterizes other emerging markets (NYSEARCA:EEM).

Overview

I wrote up a post on Mexico's sovereign debt back on December 9, so I won't venture too far into the background economic details. To sum up what I wrote then, I believe that Mexico's main financial strengths reside in the relative consistency in its growth and inflation metrics.

But the Trump Administration's desire to renegotiate NAFTA with Mexico or invoke tariffs on Mexican goods to protect US manufacturing provides a threat to the country's growth prospects. Mexico, still fully within the "developing economy" distinction, remains a trade-reliant economy, with the US as its main trading partner. The policy bents of the Trump administration could undermine this distinction.

Mexico's 15-year bonds traded around the 6.5% yield mark in the two years preceding the November US elections. Yields have since expanded 130-140 basis points to reflect the market's perceived increased credit risk.

Last week, the country's Ministry of Finance announced that the country's fiscal budget deficit had expanded to 2.9% of GDP in 2016, up from 2.8% in 2015. It was previously believed that Mexico would make progress in this area by increasing revenues relative to expenditures to diminish the uptake of debt. Nonetheless, expenditures ballooned later in the year with December costs increasing nearly 30% year-over-year. As a consequence, central government debt as a percentage of GDP increased 2.7%, coming to a mark of 36.8% as of year-end 2016 from 34.1% the previous year. In addition to the below-expectations fiscal deficit news, tensions with the US have been attributed to the rise in the 15-years to near-8% yields.

Real GDP came in at 2.3% year-over-year and Mexico's reliance on oil exports for part of its economic growth didn't bode well with prices largely bound between the mid-$20's and mid-$50's for most of 2016. Oil revenues were down 28% in 2016 and accounted for just 8.6% of government revenues. It accounted for 13% and 27% of revenues in 2015 and 2014, respectively. Nonetheless, central government revenues increased 9.1% y/y in real terms and income tax collections expanded by 13.5% y/y to offset some of the decrease.

Despite the favorable tax collection figures, government expenditures increased by 9% y/y, largely caused by a near-tripling in financial investment. Needless to say, Mexico would like to carry out a fiscal consolidation plan, but the uncertainty in revenues from 2017 onward reduces clarity.

The government will need to take caution to avoid any non-essential spending initiatives in the event revenue lags below expectations. GDP might be expected at around 1.5%-2.0% in 2017, though the variance in growth expectations is higher than it would be normally. The increase in central government debt over the past five years has also reduced optionality in spending initiatives, as principal and interest costs now consume a greater proportion of it.

How the Trump Administration's stance on trade will impact Mexico is obviously unknown at this point. Trump's stance is that NAFTA disproportionately benefits Mexico given that free trade on most goods essentially erodes economic borders and Mexico stands to enjoy an inflow of resources that previously constituted inputs into US economic performance (i.e., essentially handing Mexico economic performance for free). From the perspective of the US, this position can make sense if the contribution of domestic production outweighs the additional expense associated with it. For Mexico, it's certainly a blow to the economy when purely considering the economics along the US-Mexico axis.

How this turns out is anyone's guess. Many of Trump's economic advisors do not share his opinions on trade. The US can unilaterally pull out of NAFTA if negotiations on a trade policy alteration are unable to be made. In my view, the only way a deal could be favorable to Mexico (in terms of a more protectionist stance out of the US), is if it causes the peso to sell off to a point where its trade competitiveness accelerates among other trading partners to offset the diminished partnership with the US.

The nice thing is that for market participants, any bad news, deterioration or potential deterioration in one or more economic metrics typically allows yields to increase to compensate for the extra risk inherent.

In the previous post mentioned earlier, I placed Mexico's country-risk premium at 5.96% (the yield I would need, at the very minimum, on the 15-years). This already integrated in the potential trade policy change, as this was harped on during the campaign trail ad nauseum. I have the current premium at slightly above 6% due to the slight deterioration in the fiscal budget metrics. Mexico is still nonetheless very deserving of investment-grade status and low A/high B standing, as the big three credit rating agencies place its sovereign debt currently.

Long, Short, Neutral?

I already gave this away in the post's title, but I recently decided to go long Mexico's 2031 maturities once they went over 7.8% yield. This was done in the context of a pair trade shorting Japanese government bonds, and that other half can be the subject of a future post. With US equities markets yielding around 3.9%-4.3% in terms of forward real returns expectations (to go along with the high volatility inherent in the equities market), going over to lower-volatility and higher-yielding portions of the credit market seem to be the better option. Yields still are not ideal, but when rates are negative 100-200 bps in real terms (nominal rates minus inflation) throughout the developed world, high-single yields for non-zero risk is to be expected.

Factoring in a combination of leverage, commissions, borrowing costs, and inflation, and forex hedging, I would expect this trade to yield 11.5%-12.0% in real terms assuming things go well, with an "expected value" return of 10.5%-11.0%, factoring in default probabilities.

Final Thoughts

Mexico's economic growth is expected to subside slightly. This will adversely impact tax receipts, which will expect to grow deficits and expand central government debt. However, Mexico is still a relatively lightly leveraged economy. With Japan's government debt at 230%+ of GDP and Greece perhaps pushing 200% of GDP soon (and perhaps 250% and 300% eventually), Mexico is still a long way's from truly being burdened by its debt load.

Possible upside in these bonds could come in the form of "lower for longer" US interest rates. Many emerging markets have debt issued in US dollars (the world's reserve currency) to better legitimize the debt. If US rates stay lower, this reduces the value of the dollar and relative borrowing costs. Weak US data that largely drove Federal Reserve dovishness helped emerging markets in the front half of 2016.

Mexico's business cycle runs larger in sync with that of the US, though this correlation could break down if the trade relationship is attenuated. Nevertheless, Mexico has regularly been an emerging market that has displayed less volatility relative to other emerging markets. Its growth and inflation stability to go along with a relatively light degree of leverage makes it a more stable emerging market option.

The country's oil (NYSEARCA:USO) revenue will be better in 2017 than 2016. I expect oil prices to remain in the low- to mid-$50's per barrel through most of 2017, although a deterioration in the OPEC deal and movement on inventory levels could begin to compel the market to break out of its sideways trend.

Regarding foreign exchange risk on sovereign bond transactions, I always recommend hedging out currency risk by buying equal monetary amounts of the sovereign debt and a fairly stable reserve currency against the foreign currency (e.g., USD/MXN).

I believe the "doom and gloom" on the trade front is overworked, which has produced a large part of the yield spikes since November. If the US indeed moves toward a more protectionist bent and the sell-off in the peso is warranted, this would render Mexico's exports more competitive on a global scale. While a drop in trade activity with the US would indeed be a bad thing, Mexico's trade standing with the rest of the world could actually increase in conjunction and offset some of the effect.

Disclosure: I am/we are long 15-YEAR MEXICAN GOVERNMENT BONDS (ISIN: MX0MGO0000P2); USD/MXN.

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.