Mexico: Opportunities and Risks on the Path to Reform

Mexico: Opportunities and Risks on the Path to Reform NOVEMBER 19, 2014 Peter Donisanu Global Research Analyst Peter Wilson Global Fixed Income Strategist, London In this Global Perspectives Weekly: Government structural reforms» Despite being a favorite destination for international investors, Mexico has seen rather lackluster economic performance so far this year.» In the second half of 2014, the country has faced new challenges such as a rising U.S. dollar, the oil price slide, and renewed security and corruption concerns.» However, economic growth is likely to accelerate in 2015, and we expect to see an increase in foreign direct investment.» There are risks as well as opportunities on Mexico s path ahead, but the country s journey holds lessons for emergingmarket reform in Latin America and beyond. Investor enthusiasm that greeted Mexican President Peña Nieto s strong structural reform initiatives about opening up the country s oil sector to foreign investment has not been validated by Mexico s economic performance so far in 2014. After growing at a steady four-to-five percent annual rate from 2010 through 2012, Mexico s economy stalled in 2013, with real gross domestic product (GDP) rising just 1.1 percent. And so far in 2014, quarterly growth has been lackluster, with second-quarter GDP just 1.6 percent higher yearon-year. This Global Perspectives Weekly looks at the prospects for Mexico s economy through 2015, and considers what lessons can be learned for other emerging market economies within Latin America and beyond. Reforms and economic growth The latest data suggest that the Mexican economy is recovering, but at a very modest pace. The August Economic Activity Index (IGAE, a monthly GDP proxy) increased by a disappointing 1.3 percent year-on-year. The overall picture is of reasonably firm growth in the manufacturing sector, driven by solid auto production to satisfy strong car sales in the U.S. (see chart 1). But domestic demand is on the weak side, with consumption flat and private investment slightly higher. Overall, growth expectations for 2014 are being revised lower, and are now projected at 2.5 percent, having started the year a full percentage point higher. Solid financial market performance in the first half of the year reflected the fact that many foreign investors kept faith with Mexico s relatively attractive fundamentals, and with the promise of improved performance from the multi-pronged economic reforms initiated by President Peña Nieto. Yet the peso has weakened by 1

approximately five percent against the U.S. dollar since mid-year, reflecting not only the dollar s broadbased strength, but also Mexico-specific concerns, such as the 30 percent drop in the price of oil, and political unrest surrounding the disappearance of 43 student teachers in Iguala in September. Chart 1: U.S. auto sales and Mexico vehicle production Ann'l Sales (Million $USD) US Total Annualised Auto Sales, $ millions 3M MAV (LHS) Mexico total vehicle production, thousand units, 3M MAV (RHS) 17 300 16 280 260 15 240 14 220 13 200 180 12 160 11 140 120 10 100 9 80 2008 2009 2010 2011 2012 2013 2014 2015 Source: Wells Fargo Wealth Management; Bloomberg, 11/18/14 However, amid the uninspiring news on the economic and security fronts, investors continue to be impressed by the ongoing thrust of the reform process. Constitutional amendments passed in December 2013 paved the way for the opening-up of Mexico s oil and gas industry, which was nationalized in 1938. Mexico is the third-largest oil producer in the Americas and has the world s sixth-largest shale gas reserves; however, exploitation of these resources has been hampered by low investment and low productivity in the country s oil monopoly, PEMEX. Secondary pieces of legislation to implement energy reforms were passed in August 2014, helping to create a timetable for private-sector investment in the state oil sector: The release of contract drafts in November 2014; bids in February 2015; and tenders assigned from May to September 2015. This schedule was followed by 24 sets of more detailed regulations to prepare the market for privatesector participation at the end of last month a reflection of the government delivering on its promise that these would be in place by the end of October, sending a powerful message that the government will keep its promises and that Mexico means business and is interested in making this work. 1 Our view Despite increased market volatility in the second half, Mexico s local currency bonds have returned 5.4 percent so far this year through the end of October. Furthermore, U.S. dollar-denominated sovereign issues, which have not been exposed to the peso s fall, have performed even better, returning 10.7 percent over the same period. In our view, Mexico remains one of the more attractive emerging-market destinations for foreign investors. Structural advantages: First, Mexico benefits from several structural advantages, including a large manufacturing sector oriented toward U.S. demand and geographical proximity to its northern neighbor at a time when U.S. economic growth seems poised to outperform most of the developed world. This factor, in combination with a modest recovery in consumption and the investment benefits from reforms starting to gain traction, leads private-sector observers to expect a recovery in the economic growth rate to 3.75 Vehicle Production (Thousand Units) 1 Pablo Zarate, FTI (a global business advisory firm), cited in Bloomberg, 11/7/2014 2

percent next year. 2 The Institute for International Finance (IIF) is even more optimistic, expecting a growth rate of 4.1 percent in 2015, slightly higher than our conservative forecast of 3.5 percent for the coming year. 3 Good governance: Compared to its emerging market peers, Mexico enjoys good governance, and the macroeconomic policy flexibility that results from this. The fiscal deficit is rather high at 4.1 percent, but the overall debt-to-gdp ratio is moderate at just below 50 percent. An independent Mexican central bank (Banxico) targets inflation in a range of between two and four percent. Although consumer price index (CPI) growth is just above this range (October at 4.3 percent), it is expected to fall back towards the three percent mid-point in 2015, and Banxico has the leeway to respond to any unexpected slowdown in growth by cutting rates if necessary. Currently Mexico s official rate is stable at 3.0 percent after a surprise half-point cut in June, and is expected to remain at this level through the second half of 2015, when the central bank may raise rates modestly once the U.S. Fed begins its rate-rise cycle. Chart 2: Reform contribution to GDP growth (percentage point contribution) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Fiscal Telecoms Financial Energy Without Reforms 2015 2016 2017 2018 2019 Source: Wells Fargo Wealth Management; IIF, Mexico Secretaría de Hacienda y Crédito Público, 11/18/14 Oil production: As a large oil producer, Mexico did not benefit from the latest decline in the price of oil, but neither was the country particularly hard hit. At present we are not overly concerned about the consequences of the price drop. We expect a rebound in the price of West Texas Intermediate crude oil to between $90 and $95 per barrel; 4 the Mexican state proactively hedges its oil revenues and the 2015 budget assumes oil prices at $79 per barrel, a level that the Finance Ministry says can be guaranteed through hedging and the country s Oil Stabilization Fund. 5 The current price average of $70 per barrel for Mexican oil remains above estimated deep-water extraction costs in the Gulf of Mexico of $50 per barrel. At current levels we do not expect the prospect for foreign direct investment (FDI) inflows to be significantly damaged. Various other ongoing reforms: And, of course, we need to factor in the anticipated benefits of the ongoing reform program, not just in oil, but in gas and electricity, and non-energy reforms such as telecommunications, finance, education, and the labor market. The Mexican government estimates that successful reforms across these fields could add as much as two percentage points to Mexico s growth rate 2 Bloomberg s median forecast for November 2014 3 Institute of International Finance, Global Economic Monitor, November 2014 4 Wells Fargo Private Bank, Asset Allocation Strategy, November 2014 (p.5) 5 Ernesto Revilla, Finance Ministry Chief Economist, at a news conference in Mexico City, 10/31/2014 3

by 2019 potentially raising it to about five percent (see chart 2). 6 These gains would result from a positive interaction a virtuous cycle of competitive gains, a strengthening of the external account, and enhanced equity and direct investment, all lowering the country s external vulnerability even further. By way of a specific example of the positive impact of reforms, it has been noted that Mexican producers pay 84 percent more for electricity than U.S. firms, due to over-regulation and high local generating costs. De-regulated gas imports from the U.S. will help reduce costs for Mexican industry and improve competitiveness. 7 The implementation of these reforms and the arrival of these expected benefits will need to be monitored closely. Also the broader political situation in Mexico, especially renewed internal security concerns and the corruption problems revealed by the handling of the missing Mexican students in Guerrero, highlight the lack of clarity and communication. Investor perceptions and the economy would likely benefit from a clear governmental lead and a governance reform initiative in this area. But even failing that, if the macroeconomic benefits of reforms translate into social gains, as hoped, then this problem should diminish. If reform benefits trickle down to the 53 million Mexicans (nearly one half the population) who are estimated to be living in poverty, 8 then the narrowing of inequality and the broadening of the domestic consumption base raises the prospect that Mexico could be close to exiting the middle income trap that constrains so many of the world s emerging market economies. Investment implications If the combination of stronger U.S. demand and competiveness-enhancing structural reforms produces the anticipated effect on economic growth, then Mexican equity markets will surely respond positively. As for bonds, a reduction in external vulnerability and greater robustness in the domestic economy should be viewed as unambiguously positive for Mexico s credit rating (A3 Moody s, BBB+ with Standard & Poor s) which likely would see upgrades in due course. This in turn would justify and tighten further spreads on the country s U.S. dollar-denominated debt, currently about 100 basis points over U.S. Treasuries at 10 years. Mexican local debt (known as MBONOs) has been a favorite of international investors, and 10-year maturity bonds offer yields just below six percent in exchange for the acceptance of peso currency risk. If the expected FDI and equity inflows do materialize from 2015 onwards, these should bolster the peso and diversify investment risk in Mexico away from the heavily-owned MBONOs sector. More generally, if the Mexican structural reforms do succeed in improving the growth rate and raising percapita GDP clear of the $10,000 mark that represents the middle-income trap, then it is worth considering the broader symbolic impact this could have in the years ahead: Both on investor sentiment towards emerging markets, and on emerging countries that may seek to emulate such success with reforms of their own. The potential for growth-enhancing reforms in India, for example, is enormous, given the political will and the political strength of its leaders to implement them. The first step is a strong mandate at the ballot box and India s Modi seems to have this. Indonesia too seems to be moving in the right direction. Whether Brazil, the largest economy in Latin America, will be able to follow a Mexican path to reform is more questionable. But, as Dilma Rousseff embarks on her second term as Brazil s president, investors are watching closely to see whether any lessons will be taken from Mexico s experience. 6 Criterios Generales de Política Económica 2014, Finance Ministry, p.161 7 Financial Times Special Report, Mexico Energy, 11/12/2014 8 Financial Times Special Report, Mexico Energy, 11/12/2014 4

Weekly Capital Markets Activity (11/07/14 11/14/14) Global Equity Markets Global Sovereign Bond Market Commodity Prices Wk MTD YTD Yield Wk Chg (BPS) Price WK MSCI All Country 0.6% 0.2% 3.2% Italy 2.35-3.0 Energy -- -5.8% MSCI EAFE 0.8% -0.3% -5.2% Spain 2.13-3.0 Brent Crude Oil $/bbl $79.4-5.4% DAX (Germany) -0.4% -0.8% -3.1% France 1.14-4.5 Natural Gas $/MMBtu $4.02-8.9% CAC 40 (France) 0.3% -0.7% -1.7% Germany 0.79-3.2 Agriculture -- 2.1% FTSE 100 (UK) 1.3% 1.6% -1.1% Greece 7.97 3.0 Corn $/bushel $3.94 3.6% FTSE MIB (Italy) -0.7% -4.1% 0.0% Portugal 3.19-8.9 Soybean $/bushel $10.23-1.4% IBEX 35 (Spain) 0.2% -3.1% 2.5% UK 2.12-8.6 Precious Metals -- 1.9% Nikkei (Japan) 3.6% 6.6% 7.4% US 2.32 2.3 Gold Spot $/oz $1,189 0.9% MSCI EM 0.3% -2.5% -1.1% Japan 0.48 0.0 Silver Spot $/oz $16.31 3.3% Shanghai SE (China) 2.5% 2.4% 18.2% India 8.22 0.7 Industrial Metals -- -0.2% BSE 100 (India) 0.6% 0.6% 32.7% LME Aluminum $/Mt $2,029-1.5% KOSPI (South Korea) 0.3% -1.0% -3.3% LME Copper $/Mt $6,778-0.2% BOVESPA (Brazil) -2.7% -5.2% 0.5% Livestock -- 2.2% Mexico IPC -2.8% -3.7% 1.0% Lean Hogs $/lb $0.93 4.9% Live Cattle $/lb $1.71 1.7% Mexico IPC BOVESPA (Brazil) KOSPI (South Korea) BSE 100 (India) Shanghai SE (China) MSCI EM Nikkei (Japan) IBEX 35 (Spain) FTSE MIB (Italy) FTSE 100 (UK) CAC 40 (France) DAX (Germany) MSCI EAFE MSCI All Country Headline Equity Markets One-week Change IndustMet -0.2% Commodities Energy -5.8% PrecMet 1.9% Ag 2.1% Livestock 2.2% Graphic represents the average sector weights of the S&P GSCI, Rogers International Commodity, and Bloomberg Commodity indices as of 11/14/14. Energy 49%; Agriculture 26%; Precious Metals 12%; Industrial Metals 9%; Livestock 4%. Data in this graphic represents the one-week change in sector price according to their respective Bloomberg Commodity Index Family. -4% -2% 0% 2% 4% Currency Table (Pairs) Currency Table (Change in Pairs) Cross rate as of 11/14/14 One Week Change: 11/07/14-11/14/14 USD MXN INR BRL CNY AUD CAD CHF GBP JPY EUR USD MXN INR BRL CNY AUD CAD CHF GBP JPY EUR EUR 1.25 16.95 76.89 3.26 7.64 1.43 1.41 1.20 0.80 145.7 EUR 0.6% 0.5% 0.6% 2.4% 0.7% -0.7% 0.2% -0.2% 1.9% 2.1% JPY 0.01 0.12 0.53 0.02 0.05 0.98 0.01 0.82 0.55 0.69 JPY -1.4% -1.7% -0.8% 0.2% -1.3% -2.7% -1.7% -2.2% -0.2% -2.0% GBP 1.57 21.21 96.7 4.08 9.61 1.79 1.77 1.50 182.2 1.25 GBP -1.3% -1.3% -0.8% 0.4% -1.2% -2.6% -1.6% -2.0% 0.2% -1.8% CHF 1.04 14.11 63.97 2.71 6.39 1.19 1.18 0.67 121.3 0.83 CHF 0.7% 0.7% 0.8% 2.4% 0.9% -0.6% 0.4% 2.0% 2.2% 0.2% CAD 0.89 11.99 54.30 2.30 5.43 1.01 0.85 0.57 ##### 0.71 CAD 0.4% 0.3% 0.7% 2.0% 0.5% -1.0% -0.4% 1.7% 1.9% -0.2% AUD 0.88 11.84 53.68 2.28 5.36 0.99 0.84 0.56 ##### 0.70 AUD 1.3% 1.2% 1.3% 3.1% 1.5% 1.0% 0.6% 2.6% 2.8% 0.7% CNY 0.16 2.21 10.07 0.42 0.19 0.18 0.16 0.10 18.97 0.13 CNY -0.1% 0% 0.0% 1.6% -1.4% -0.5% -0.9% 1.2% 1.4% -0.7% BRL 0.38 5.20 23.71 2.36 0.44 0.43 0.37 0.25 44.69 0.31 BRL -1.7% -1.7% -1.2% -1.6% -2.9% -1.9% -2.6% -0.4% -0.2% -2.4% INR 0.02 0.22 0.04 0.10 0.02 0.02 0.02 0.01 1.88 0.01 INR -0.4% -0.5% 1.2% 0.0% -2.1% -1.1% -0.6% 1.0% 1.0% -1.0% MXN 0.07 4.55 0.19 0.45 0.08 0.08 0.07 0.05 8.59 0.06 MXN 0.0% 0.4% 1.7% 0.2% -1.2% -0.4% -0.6% 1.5% 1.5% -0.5% USD 13.53 61.72 2.60 6.13 1.14 1.13 0.96 0.64 116.3 0.80 USD 0.0% 0.1% 1.7% 0.1% -1.3% -0.4% -0.7% 1.3% 1.5% -0.6% This table represents a cross-currency pair in a matrix format. The column on the left denotes the local currency and the row at the top of the table the foreign currency. For example, if the local currency is EUR (euro) and the foreign currency is USD (U.S. dollar), then 1 euro buys $1.25 U.S. dollars (as of 11/14/14). This table represents the one-week change for a given cross-currency pair. A positive value indicates that a local currency has appreciated (or you can buy more of a given foreign currency). The inverse is true for a negative value. 5

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