Mexico has ‘emerged’ as the emerging market of the moment. Amid sputtering economic performance in 2013, President Enrique Peña Nieto introduced a reform package more ambitious than anything that’s come out of an emerging-market government in a decade.
The reforms are aimed squarely at re-igniting the ‘Mexican Miracle’ that modernised the economy between the 1950s and the 1980s. While some investors were losing patience as enabling legislation stalled in the Senate, the logjam broke in mid-July when several Senate committees approved a set of laws to regulate the opening of the oil and gas industries to private investment.
Attracting capital and technical expertise to the energy sector is the centrepiece of Nieto’s reform programme. It’s expected not only to stimulate foreign and domestic investment but also to dramatically lower electricity prices.
One of the recent new laws, for example, will allow electricity producers to sell power directly to customers for the first time. Previously, private generators had to sell power to a state-owned utility that controlled two-thirds of Mexico’s installed capacity. That will boost Mexico’s already strong position as a manufacturing platform; electricity for commercial customers in Mexico costs 73% more than it does for commercial users in the US, says a new study of Mexico by McKinsey Global Institute.
As the first wave of reform proceeds, Mexico’s fiscal and monetary conditions provide an attractive backdrop for institutional investment. While marquee deals like the 100-year GBP bond issue in March grab headlines, analysts and portfolio managers see opportunity in a deep and liquid local debt market, and some are building out investment teams to gain an early edge in the next phase of capital market development. At the time of the century bond’s issue at 5.75%, Moody’s raised Mexico to A3, the country’s highest ever rating, and one level above rankings by Standard & Poor’s and Fitch Ratings.
The upbeat outlook has been a long time coming. After a weak 2013, the government cut its estimate for 2014 GDP growth to 2.3% from 3.3%, and investors eager for a growth surge feared yet another false start.
“Investors may have felt that a recovery in Mexico was to be as elusive as Beckett’s Godot,” says Jan Dehn, head of research at Ashmore Investment Management. “We think this impatience is somewhat misplaced.”
Major reforms reduce the cost structure of the economy, raising the trend growth rate, and those benefits will be realised in coming years. Recent sluggish performance, says Dehn, has resulted mainly from cyclical factors, such as weakness in homebuilding, uncertainty about the reform process itself and slow growth in the US.
To understand the impatience, it is important to understand how the ‘Miracle decades’ create expectations for Mexican economic progress. The Miracle was aptly named, and dreams of resuming such progress are both attractive, and hard to live up to. From the early 1950s to the 1980s, Mexico rapidly industrialised and urbanised. GDP rose by 6.5% annually, and productivity by 4.3%, says McKinsey, and Mexico “was hailed as a model for economic development”.
Volatile energy prices and a series of serious financial crises crushed Mexico’s growth and productivity since 1980. Today’s reforms seek to reclaim Mexico’s position as the standard bearer for emerging market development, in large part by reversing a decade-long slump in oil production. Major global oil companies are heady with anticipation of the end of 76-year monopoly held by state oil company Petróleos Mexicanos, or Pemex.
Energy reform opens up the market for private companies to bid on potential production fields starting in 2015. In terms of investing in Mexico, the timing is “exquisite”, according to Ed Morse, head of global commodities research at Citigroup Global Markets. He was speaking at a conference on Mexico’s oil and gas sector sponsored by the Center for Strategic and International Studies at Johns Hopkins University in July.
“The constitutional amendments that were passed only last December are really a game changer,” says Jesus Reyes Heroles, former Pemex general director and now executive president of EnergeA, an energy consultancy. “Now private investment in Mexico’s energy sector is possible.”
A primary goal, he says, is to enhance economic efficiency, especially in electricity as an input for production. The earliest private opportunities, he says, are building natural gas pipelines and natural gas distribution systems. He expects oil pipelines and multi-fuel storage terminals to be under way in 2015, with some projects involving partnership with Pemex.
All told, the reform programme could add one percentage point to Mexico’s GDP growth trend, says Raoul Luttik, managing director and lead portfolio manager on the emerging markets debt team at Neuberger Berman. Luttik says the structural reforms package meaningfully improves prospects for investing in Mexico’s local debt market. “We are outright bullish on the outlook for Mexico,” he says.
The primary benefit is that the overall policy mix is extremely strong compared with other emerging markets, Luttik says. The new policies range from transformation of the energy and telecommunications sectors, to reforms in politics, taxation and education. Capturing the full economic impact will hinge on the success of the reform programme and, despite some delays, “there’s a strong willingness to implement most proposals”, he adds.
Financially, inflation is well controlled, enabling Mexico’s central bank to make a surprise 50 basis-point cut to its benchmark interest rate to a record low of 3% in June. Mexico’s current account deficit, at about 2% of GDP, combined with inflows from foreign direct investment and portfolio investment, means it’s reasonable to “expect the peso to appreciate more meaningfully”, says Luttik.
Luttik’s base case is that gradual tightening by the US Federal Reserve will not disrupt the improving picture for Mexican local currency debt. Institutional investors, he notes, are mostly underweight emerging-market local currency bonds, but becoming more comfortable with the asset class and gradually raising allocations. Neuberger holds nominal Mexican bonds, and inflation-linked government debt, with the team’s conviction on the country’s prospects expressed through a large duration overweight in its Mexican local debt holdings.
Neuberger also sees potential gains from the local interest rate situation. With 10-year Mexican government bonds trading at a nominal yield of 5.7% and inflation a tick over 3%, the 2-2.5% real rate on a Mexican bond is comfortably above the near-zero return on US Treasuries, says Luttik.
“The risk premium has room for contraction,” he says. Mexico’s local debt market, he adds, is deep and liquid, with “strong interest from major global investors, including sovereign wealth funds”. Luttik says the firm is building its Netherlands-based local currency team for corporate debt: “That’s the next step.”
But while the bond markets present a deep and attractive way into the Mexico story, Mexican equity market opportunities remain limited, says McKinsey, “another sign of Mexico’s lack of economic dynamism”. McKinsey says there are “fewer publicly traded companies today than in 2000, due to acquisitions and a dearth of initial public offerings”.
There are signs that entrepreneurial companies can succeed in Mexico. An example is City Express, a startup middle-market hotel chain that has become number two in the sector countrywide and was recently listed on the Mexican Stock Exchange. But Mexico needs many more such companies to affect overall growth, McKinsey says.