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Takeaway: As a result of Nieto’s reform agenda, we think Mexican financial markets are likely to overlook cyclical headwinds in 1Q & continue higher.

SUMMARY BULLETS:

  • We think the momentum underpinning President Nieto’s economic reform agenda is likely to continue – particularly in light of the tri-party “Pact For Mexico” – and we anticipate Nieto and his cabinet to push hard for reforming the country’s struggling oil and gas industry in a way that may have broader positive implications for  Mexican corporations as a whole.
  • While it’s true that the country’s financial markets may be “priced to perfection” at the current juncture, we don’t necessarily find it prudent to short Mexican equities or the MXN on a pending cyclical erosion of the country’s underlying economic fundamentals in 1Q13. 
  • We do think Mexican financial markets may pull back to some degree, but we anticipate any weakness to be reasonably well-contained with respect to the intermediate-term TREND.
  • All told, absent any meaningful hiccups on the reform front (political risk runs high given that no party has an outright majority in either the Lower House or Senate and the PRI’s history of perceived corruption), we anticipate Mexico to continue to work for investors who have capital allocated to the  country’s financial markets.

As a point of process, whenever we begin to vet a particular country’s fundamental merits for investment (long or short), we first start off with our proprietary triangulation of the country’s trailing and future GROWTH/INFLATION/POLICY trends. When Mexico’s 4Q12 data is done being reported, it is likely to show a directionally positive delta from Quad #3 to Quad #1 on our G/I/P analysis, followed by a return in 1Q13.  

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The former delta was good for an +8.6% move on the Dow Jones Mexico Stock Index from its late-AUG cycle-low to the current price of ~2,830. The latter (i.e. pending) delta could result in a -6.5% pullback to our TAIL line of support (from current prices), but we think any potential weakness is to be ultimately faded by long-term investors, as positive POLICY developments should continue to perpetuate positive headline risk and inflows of international capital into the Mexican economy.

Yesterday, Mexico’s Education Minister Emilio Chuayffet said that President Enrique Peña Nieto’s recently-proposed constitutional amendment to overhaul Mexico’s education system “responds to a justified public outcry for better education, ending practices that have diminished it.” Having Chuayffet on board with the agenda likely means Mexico’s new president will be able to garner the two-thirds majority required in  Mexican parliament to amend the country’s constitution (in addition to a majority of the country’s 31 state legislatures).

It should also be noted that the leaders of both opposition parties – National Action Party (PAN) and the Democratic Revolution Party (PRD) – have praised the agenda and will likely support the passage of the bill in good faith of their “Pact For Mexico” alliance, which is somewhat of a historic political development in the sense that all three main parties are on board with political cooperation.

It’s also important to note that Mexico’s education system ranks last out of 34 OECD countries for enrollment rates of high school-age students – despite having spent more of its public budget on education than all of the countries in the OECD's survey. All told, we think  President Nieto’s proposal to create an independent institute to evaluate schools and foster competition for jobs and promotions based on performance is structurally positive for Mexico’s long-term GROWTH outlook, as is the recently ratified labor bill.

That piece of legislation ended years of legislative impasse and will improve the stock of human capital in Mexico, as well as becoming a likely tailwind for wage growth stemming from a more competitive labor market; currently ~1/3rd of Mexican workers are in the informal sector. Specifically, the new labor regulations promote greater transparency in union leadership and union finances, as well as allowing temporary and trial-basis contracts, hourly wages, regulating outsourcing and limiting the amount of back-wages workers can collect if they win legal disputes with employers.

Notably, the aforementioned labor and education reforms should be taken in conjunction with President Nieto’s plan to balance the Mexican budget in the upcoming fiscal year, officially offsetting a +2.3% increase in spending with a projected +5% increase in non-oil tax collection (tax receipts from PEMEX alone account for ~33% of all federal income). It’s important to note that Mexico’s sovereign budget hasn’t been balanced since 2007, so anything in the area code of balance budget represents meaningful fiscal tightening that should prove supportive of further gains in the peso. The MXN is up +9.2% YTD vs. the USD as investors have increasingly speculated on Banxico, the country’s central bank, ending its 3.5-year streak of all-time low POLICY rates amid the YTD acceleration in Mexican consumer prices.

 

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Regarding the point on non-oil tax collection, he’s planning to increase the government’s grip on other state-owned companies; to the extent his drive is incredibly punitive, we think the market could pull back in anticipation of further measures (a la Brazil). That said, however, we view that as reasonably unlikely at the current juncture, given his leanings on reforming Mexico’s oil industry – specifically allowing for greater private investor participation.

Such investment is very much needed to arrest the secular decline of the Mexican oil industry: crude oil production has plunged by nearly one-fourth from ~3.8M bpd in 2005 to ~2.9M bpd per the most recent data; over the last five years Petrobras has drilled 101 deep water wells on the strength of increased private sector participation while PEMEX has drilled only 18. PEMEX believes further investment in the deep-water wells across the Gulf of Mexico could grow prospective reserves by ~50%.

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It’s worth noting, however, that PEMEX’s investment budget has surged +145% since 2006 while proven reserves declined from 16.5 billion barrels in 2006 to 13.8 billion barrels last year. In light of this, I do think public-private JVs are likely to be the most probable focus of any near-term reform(s). There’s also increasing chatter of removing the current gasoline subsidy, though anything on this front is mere hearsay for the time being.

All told, we think the momentum underpinning President Nieto’s economic reform agenda is likely to continue – particularly in light of the tri-party “Pact For Mexico” – and we anticipate Nieto and his cabinet to push hard for reforming the country’s struggling oil and gas industry in a way that may have broader positive implications for  Mexican corporations as a whole. Other broad avenues for investor-friendly reforms (i.e. areas that require increased political attention) are highlighted in the chart below:

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While it’s true that the country’s financial markets may be “priced to perfection” at the current juncture, we don’t necessarily find it prudent to short Mexican equities or the MXN on a pending cyclical erosion of the country’s underlying economic fundamentals in 1Q13. We do think Mexican financial markets may pull back to some degree, but we anticipate any weakness to be reasonably well-contained with respect to the intermediate-term TREND. Our quantitative risk management levels for the Mexican equity market are included in the chart below.

Darius Dale

Senior Analyst

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