Mexico: Trade War Has Only Created Buying Opportunity

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Includes: EWW, FLMX, HEWW, MEXX, MXE, MXF
by: Nairu Capital
Summary

Mexican equities as well as the peso have been underperforming Latin American peers over the past three years.

Valuations in the country remain heavily depressed, while their long-term top line growth potential is high.

The 5% tariff threat from the United States was likely a bluff, as the U.S still needs cheap countries to import from.

With the country's relative performance bottoming out, it may be a good time to make a long-term investment.

Mexico is likely to emerge from its "near-recession" with strength.

Last July, I wrote a long Mexico article based on the iShares MSCI Mexico Capped ETF (EWW). Needless to say, I have yet to be proven correct. While the "Obrador election rally" I expected did occur, it was short-lived, as the October global equity crash pushed the Mexican peso significantly lower. In my book, being early is being wrong, but an attractive opportunity is even better at a lower price. Thus, I maintain my long-term bullish stance on Mexico and expect its equity market to outperform peers over the months to come.

The Mexican economy is one of the least indebted major global economies and has significant long-term GDP growth potential. The government currently runs a very small 2% of GDP deficit, and households have ample room to expand credit. Trade uncertainty with the United States has pushed the peso and equity market below reasonable levels. Valuations are less than half that of the United States, and its sector allocation favors cyclically defensive industries.

While continued economic uncertainty may push equities even lower, I expect Mexico to outperform its Latin American peers over the coming six to twelve months.

Relative Performance at Support

One of my favorite ways to analyze performance of a country is to compare it to a regional benchmark that excludes the country in question. I have found that often countries, sectors, or even commodities that underperform their benchmark by a wide margin often pick up steam and outperform in the following time period. As with all investment "rules," this is not always the case, but it still can be a useful guide.

In this scenario, we will compared the performance of the (EWW) Mexico ETF to an equal-weighted combination of Brazil (EWZ), Argentina (ARGT), Colombia (ICOL), Peru (EPU) and Chile (ECH). Of these countries, Mexico has been a weak investment over the past three years. See below:

(Source: Google Finance)

Note, performance is indexed to 1, so a measure of "2" corresponds to 100% depreciation profit.

As you can see, Latin American countries saw stellar performance from 2015 to 2018, with many countries seeing 100% upside, while Mexico went nowhere. Since the short-lived emerging markets bull market ended at the beginning of last year, Mexican stocks have been falling at a steady rate.

To see this more clearly, let's go to a relative performance chart of the two. This is the above Mexico index divided by the benchmark index. Technically, this is the performance of a long Mexico-short benchmark strategy that is rebalanced daily, or the alpha generated by Mexico compared to its benchmark.

(Source: Google Finance)

As you can see, those global factors that affect both Mexico and its benchmark are now removed from the chart because they are canceled out by hedging. Thus, we can see true "idiosyncratic" performance much more clearly.

Looking at it from this angle, Mexico is currently just under a relatively strong support level in place since 2018. Accordingly, I expect the country to outperform the benchmark in the following months as relative performance bounces off support and reverts toward its mean.

Of course, this can happen in a variety of ways. Ideally, EWW would rise more than its benchmark, but it could also occur simply by falling less than the benchmark. If this current wave of trade war tensions continues to grow, then most likely, Mexico and all Latin American countries will fall. Still, Mexico has been falling less than its peers over the past week, and I expect that trend to continue over the next few months.

Comparative Fundamentals Strong

Another way I like to evaluate single-country ETFs is by looking at the valuation of their holdings compared to the globe. Many compare valuation multiples to historical standards, but that method is slightly flawed, as low global interest rates has fairly allowed stocks to command higher valuations. Thus, it is more useful in the medium term to use comparative valuation.

Here is the current median "EV/EBITDA" by country:

(Self-sourced)

Note, all the companies used to take this measurement are included in the EWW ETF.

The current median "EV/EBITDA" for Mexico is just under 8.5X. While valuations may be lower in Russia, Argentina, and Poland, it is fair to say that Mexico has lower geopolitical and economic risks. Even more, the current main sectors in the EWW ETF are primarily in low-risk areas of the economy, such as consumer staples and telecommunications.

Here is the current sector breakdown from the iShares website:

(Source: iShares)

Consumer Staples globally commands a higher valuation than the other sectors, as it has much lower cyclical risks. Mexico has most likely been an underperformer, because these companies benefited less from the brief, but aggressive, economic rebound from 2016 to 2018.

Going forward, the country's slightly defensive sector allocation, along with its lower comparative valuation, make it a strong reward-for-risk opportunity. If a prolonged recession occurs, the equity market will fall, but it is less likely to fall as much as its peers.

Mexico May Benefit From Trade War

Many analysts proclaim that the Mexican stock market will be badly hurt by falling U.S demand and the ongoing trade war. They fail to account for the fact that the U.S. will need to import more from countries like Mexico, where it has no tariffs to compensate for a rise in tariffs globally.

Mexico's president, Lopez Obrador, does not want to go down the same path as China. He reacted immediately to stop any possible tariffs against Mexico and has shown that he wants to maintain a positive relationship with Trump, something that was less true with the previous Mexican president. If anything, the possibility of European car tariffs is could be a positive catalyst for the country, as just over a quarter of Mexico's exports are vehicles.

All Eyes on the Peso

The Mexican peso is perhaps the largest risk when it comes to investing in the country. That said, while the currency has been plummeting following the recent trade war ramp-up, I think the peso is a strong long-term buy.

Unlike most of the world, Mexico has very low public debt-to-GDP of 46% and extremely low household debt-to-GDP of 16%. This gives the economy greater fiscal responsibility and enormous room to drive GDP growth by increasing household credit. Further, of the country's debt, it only has an external debt-to-GDP of 36%, so it is much less exposed to the U.S. dollar than many of its emerging market peers.

Unfortunately for investors, the peso has been lumped together with the rest of emerging market currencies and has fallen considerably with the Chinese yuan. Here is a chart of EWW compared to the peso (MXN/USD) over the past few years:

(Source: Trading View)

As you can see, the bulk of the negative performance in EWW can be tied to the currency. Overall, I believe that the peso is seriously undervalued when compared to global currencies. The current government 10-year bond in Mexico pays a 7.5% interest rate, while the inflation rate has fallen to under 4%. Thus, the peso has very large carry trade potential in this negative-yield world. Further, I expect the country's exports to expand and for its current account to rise toward positive territory as U.S. imports rise.

That said, all emerging market currencies are tied together by global demand for U.S dollars. If you need dollars to finance external debt, then currency fundamentals like interest rate differentials and trade flows do not matter much in the short run. The current U.S. dollar strength poses a major risk to investing in any emerging market economy unless you have a hedged position.

Risks To The Bottom Line

Overall, the Mexican economy is more solvent and fiscally responsible than its emerging market peers. The country has very large upside growth potential if the government can encourage household credit expansion.

While the country is heavily dependent on the U.S for trade, it is likely that its exports will rise as U.S. imports from China and Europe decline due to tariffs. Mexican President Lopez Obrador has shown that he will do what it takes to keep trade from going sour, and I expect the peso to eventually benefit.

Of course, if global economic uncertainty rises and the Mexican economy falls into a longer recession, then Mexico will make for a poor investment. Further, if the current wave of trade warring continues to rise, then the peso will likely continue to fall. However, to me that event would only make Mexico a more valuable long-term buy.

Global recession or not, I expect Mexico to outperform its Latin American peers over the next six to twelve months and for the country to perform very well over the next bull market.

Interested In Closely Following Global Events?

We will soon be launching our first marketplace service, "The Country Club." This will be a dedicated service that focuses on single-country and regional ETFs with the goal of helping our subscribers diversify globally and a better grasp on how world events will affect their portfolio. We keep a close eye on Mexico and its peso and will be providing subscribers further updates on this idea. Please give us a "Follow" if you would like to be notified upon our launch!

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.