Position: Short Mexican equities via the etf EWW.
Conclusion: The outlook for Mexico’s macroeconomic health is tepid at best and incremental data points suggest there is more downside to come.
Last Thursday, Daryl Jones, our Managing Director of Macro, wrote a note outlining our short thesis on Mexico. In summary, the conviction is three-pronged: overreliance on oil, slowing growth in the U.S., and a drug war that by official estimates shaves a full percentage point off of GDP each year. In addition to these headwinds, additional bearish points on housing and government funding spell incremental trouble for the Mexican economy.
The first prong of our bearish outlook on the Mexican economy is an unhealthy reliance on oil will continue to be a headwind for the Mexican government’s budget, as oil production in the country continues to decline – down 29% in the last six years. The State-run oil conglomerate PEMEX funds an estimated ~35% of the federal budget, so as these funds continue to erode, the Mexican government will have to look elsewhere for support. While a substantial rise in the price of crude would be positive for the Mexican economy, we do not see that as a likely outcome for now. Oil is broken from an intermediate term TREND perspective ($78.50). We have been vocal in the past couple of months suggesting REFLATION based on U.S. dollar debasement will be less of a supportive factor this time around, as waning demand from tightening in China and economic slowing in the U.S. (the two largest consumers) continue to weigh on the price of crude oil (down 2.6% in the last month). As a point of note, the Mexico Bolsa Index has a 0.81 r-squared to the price of crude oil on a TREND duration.
The second prong of our bearish outlook for the Mexican economy concerns its leveraged exposure to the U.S. from a trade and investment perspective. Last year, 80% ($177 billion or 15% of Mexico’s GDP) of Mexico’s exports went to the U.S. A slowdown in U.S. consumption, of which we have a great deal of conviction (see Hedgeye Macro’s Q3 Themes: American Austerity & Housing Headwinds), is very negative to Mexican growth and job creation. This setup suggests Mexican retail sales will roll over hard from the 23-month high of 5% Y/Y in May of 2010.
The third prong of our bearish outlook for Mexico’s economy is the most obvious from a news flow perspective – drug wars. Weakness in May retail sales along the U.S. border (the most prominent area of violence) only tells part of the ominous story which has plagued Mexico for quite some time. Mexico has had upwards of 25,000 organized crime deaths related to the drug war since 2006 with 28% (7,048) of them occurring this year alone! The impact of violence is the single greatest threat to the Mexican economy, according to 57% of Mexican executives – up from 49% in March and 22% in December 2009. Furthermore, tourism, which accounts for 13% of Mexican GDP in aggregate, will continue to suffer as a result of the uncontained drug-related violence.
Mexico’s reliance on the U.S. for investment and aid is having an incremental negative effect on the Mexican government’s drug war efforts. According to a recent report from the U.S. Government Accountability Office, the U.S. has delivered only about 9% of the $1.6 billion in drug-war aid promised to Mexico and Central America, citing a lack of staff and funding. If the effects of American Austerity continue to gain steam, reprieve in the form of a U.S. hand-out may be unlikely in the near term.
Speaking of hand-outs, Mexico is seeking a $1 billion loan from a Chinese development bank and another $500 million from the World Bank to finance home lending. Sociedad Hipotecaria Federal (SHF) needs further funding to inject liquidity into Mexico’s mortgage market, even after receiving a $1 billion loan from the World bank in 2008 and installments of a $2.5 billion credit line from the Inter-American Development Bank. Rising delinquencies (delinquency rate +350bps Y/Y) brought on by the sharp increase in unemployment last year has SHF looking for further funding to finance an estimated 1 million mortgage loans this year. While the Chinese loan may be signed as soon as September, the delay or denial of either facility would be very bearish for the Mexican housing market – particularly if you factor in the employment headwinds brought on by a slowdown in the U.S. economy.