Geopolitics: Threat or opportunity for Mexico

22 May 2018
North American Free Trade Agreement (NAFTA) talks are heating up as President Trump’s 1 June deadline for a favourable agreement fast approaches.

There are concerns that talks may be thwarted by the intensifying campaign for the upcoming Mexican federal election in July as well as the US midterm elections in November. This kind of geopolitics, including the ongoing threat of a global trade war sparked by US president Trump, is making investors nervous. But there are opportunities to be found amidst all of this uncertainty.

This is according to Siboniso Nxumalo, Joint Boutique Head for Global Emerging Markets at Old Mutual Investment Group, who says that Emerging Markets exhibit certain repetitive traits. A heightened sense of fear and uncertainty, like what we’re currently seeing in relation to Mexico, creates increased risk, sending markets and the currency sharply lower,” he explains. “In emerging markets, when markets tumble even the best companies tend to get caught up in the selloff, which is exactly what attracts investors like us. The opportunity to buy great businesses at attractive valuations is usually quite rare but in Emerging Markets they tend to come around more often than one would find in developed markets.”

Nxumalo points out that political noise has a tendency to have an economic impact over time. It’s been no different in Mexico over recent times. “It’s important to remember that economics is based on rules; basic rules that will always take effect over the long term. So while Donald Trump’s threats do create a lot of noise over the short-term, they should be handled with caution.”

Mexico, explains Nxumalo, is currently caught up in the middle of two rogue state presidents. “There’s Trump on the one hand, and Andres Obrado, leader of the extreme left Morena party and, in all likelihood, the next Mexican president, on the other. Much like Trump, Obrado has gained power as an abrasive populist contender and it is widely believed that he will not hesitate to fight fire with fire should he be elected as the next Mexican President. Should this happen before NAFTA negotiations are concluded, he may choose to call Trump’s bluff and exit NAFTA.”

However, do economic fundamentals really warrant an interrelationship between the US and Mexico? Nxumalo notes the economic law of comparative advantage, made popular by David Ricardo. “The law argues that free trade works even if one partner to that deal holds the absolute advantage in all areas of production – that is, one partner makes products cheaper, better and faster than their trading partner.”

In 2016, Mexico exported $373 billion – of which 81% was to the US, making up 28% of Mexico’s GDP. “Looking at these statistics, you would be forgiven for concluding that Mexico is dangerously dependent on the US. However, what isn’t evident from these figures is the fact that 40% of these exported goods are made from US imports,” says Nxumalo.

Mexico currently has the lowest wages, lower even than China, and access to these low wages allows the US to be globally competitive, explains Nxumalo. “Most of the goods imported from Mexico are intermediate goods that are resold as ‘made in America’ goods. Having access to Mexico’s labour pricing advantage is ultimately a globally competitive advantage for the US.”

Nxumalo believes that there is plenty to worry about in Mexico; plenty of uncertainty and a lot of potential change on the horizon. All this noise and uncertainty has taken its toll on the country, but this is creating buying opportunities for investors.

“Take, for example, a company that we currently like, Gentera, a niche finance company that earns attractive returns on its solidarity-guaranteed loans,” says Nxumalo, explaining that Gentera’s unique business model uses a customised underwriting model providing loans to micro-enterprises run by women who otherwise would not have access to funding. Gentera has 2.5 million clients serviced by 17000 employees in multiple geographies in Latin America.

“This unique business model has allowed Gentera to achieve phenomenal revenue growth over the last 10 years, more than 20% year-on-year on average, due to the underpenetrated nature of its target market. The company also still maintains great levels of asset quality through its customised underwriting process, with a non-performing loan ratio of around 2-4% - considering the risk here this is a phenomenal outcome,” adds Nxumalo.

He says, “Following Mexico’s downgrade we saw almost all Mexican banks struggle with the substantial increase in cost of funding, and Gentera was no exception. Markets price economic risk through the capital and currency markets and this resulted in the Mexican reference rate more than doubling, from 3.25% to 7%. Since banks need to raise money from the markets or from depositors, the rapid rise in this rate has had a substantial impact on the bottom line of banks. Clients demand less loans as they become more expensive.

As a result of all this, Nxumalo believes that Gentera is trading at a substantial discount to its average long-term valuation. “This is illustrated in the level investors pay for its assets or price-to-book ratio.” Nxumalo concludes: “All the geopolitical uncertainty surrounding Emerging Markets currently means that we are increasingly finding attractive investment opportunities – such as great companies in Mexico – whose valuations reflect the temporary and cyclical circumstances of the prevailing political and macro landscape”.