Mexico will have the last laugh as Trump builds his wall

Mexico will suffer if Trump’s plans to crimp trade come to fruition. But the country has its own hand to play. Smart investors should buy in now, says James McKeigue.

Donald Trump has already ruffled a lot of feathers during his few short weeks in office so far. But without doubt, the main casualty of the US president’s unpredictability has been Mexico. Trump seems likely to fulfil his campaign promises to impose tariffs on Mexican goods, build a wall to deter illegal Mexican immigrants, and make life more difficult for those already in the US illegally. Exports to the US account for 25% of Mexican GDP (by way of comparison, UK exports to the European Union make up just 13% of Britain’s GDP) – so it’s logical to assume that Trump is bad for Mexico. That’s why investors have panicked and sold out of the country, while the Mexican peso hit a record low in January and continues to wobble at every Trump tweet or rumour. Yet this could provide the perfect buying opportunity for bold investors.

Not a pretty picture

Make no mistake, Trump’s policies don’t look good for Mexico. Take immigration. Legal and illegal Mexican immigration to the US has provided a great pressure valve for the Mexican economy by keeping a lid on unemployment. It’s also a great source of revenue. Remittances sent back to Mexico from workers in the US were worth $26bn in 2016 – more than the country’s oil earnings for the year. Trump’s proposals threaten this source of income – he wants to make it harder for Mexicans to get into the US illegally, to reduce the number of illegal immigrants already there, and to tax remittances too.

Then there is the threat to the North American Free Trade agreement (Nafta). Since Nafta came into effect in 1994, Mexico has turned a $1.3bn trade deficit with the US into a $67bn surplus. Manufacturers around the world (but chiefly the US) established factories in Mexico’s northern states, drawn by the tempting mix of cheap labour and tariff-free access to the world’s biggest economy. Mexico is the only major Latin American economy that earns more from manufactured exports than from commodities. Trump’s threat to renegotiate Nafta and impose an import tax on Mexican goods would undermine this incredible industrial growth.

Finally, Mexico has plenty of homegrown problems. President Enrique Peña Nieto got off to a great start after coming to power in 2013. His structural reforms have opened up Mexico’s energy, electricity and telecommunications sectors. But economic growth has been disappointing, meandering along at 2.3% a year. Meanwhile, a persistent fiscal deficit (the government spends more than it gets in taxes) and inflation have forced the central bank to tighten monetary policy. That’s likely to hit consumer-led growth, until now the one bright spot in the economy.

Mexico just got a lot cheaper

Given all this, why on earth would anyone want to invest in Mexico right now? Because it’s cheap. Since Trump started to look like a serious presidential contender, the Mexican peso has fallen by 20% against the US dollar. But the peso’s decline started long before Trump – it has lost 45% of its value against the dollar in the last ten years. So even though the stockmarket (the Mexbol) is not cheap in peso terms, the slide in the currency makes it more appealing to international investors. The weak peso has also been great for Mexico’s manufacturers – the 20% Trump-induced fall pretty much cancels out his proposed 20% import tax, and even with the proposed tax, Mexico will still be cheaper than anywhere else in North America.

It also makes little sense for companies to move away. Mexico is already fully integrated into complicated cross-border supply chains – starting again from scratch would be expensive. Its skilled workforce (Mexico produces more engineers per year than Germany or Brazil) and considerable manufacturing expertise makes it a better bet than cheaper rivals in central America. And its proximity to the US makes it ideal for transporting bulky items quickly, giving it a huge advantage over Asian producers. Of course, some consumer-facing producers may make political decisions to “reshore” to the US – Ford recently backtracked on a new Mexican factory, for example. But that sort of pressure is less likely to fall on lower-visibility producers of industrial components or machinery.

The “peso effect” would also ease any problems caused by a tax on remittances. As Capital Economics notes, “the inevitable further drop in the peso against the dollar that would occur following news and implementation of any remittance tax would help to offset a decline in the dollar remittance income. That in turn would limit the impact on national income and domestic spending.” In any case, for investors, there is little direct impact from these changes. Industry is under-represented on Mexico’s domestic stockmarket, and most factories belong to global multinationals. Sure, the wider market will feel the indirect impact of weaker manufacturing growth via any damage to employment, salaries and consumer spending, but it’s not the deathblow to the Mexican economy that the headlines might have you believe.

The new oil boom

Amid all the press coverage devoted to Trump’s impact on Mexico, you may have missed a more important Mexican economic story. In January, 12 of the world’s biggest oil companies bid tens of billions of dollars to develop Mexico’s deepwater oil fields. It was the fourth such auction since Mexico began opening up its energy sector to private investors in 2013, and each round has attracted a fresh crop of international players. As a result, even in an era of falling oil prices, Mexico has managed to attract masses of capital and expertise from the international oil industry. Little wonder. Geologists reckon that Mexico is sitting on more than 100 billion barrels of oil equivalent (boe), yet the state oil company, Pemex, has only ever extensively explored 20% of the country.

The areas of interest can be split into three main categories. First, there’s the Gulf of Mexico. The US-owned region of the Gulf is one of the world’s major oil provinces, with more than 4,000 wells drilled. Pemex reckons there could be up to 50 billion boe in Mexico’s area of the Gulf, but just a handful of deepwater wells have been drilled. Second, there’s Mexico’s vast shale oil and gas reserves. According to the US Energy Information Administration, Mexico has the world’s fourth-biggest shale oil reserves, measuring at least 60 billion boe.

The final area of opportunity lies in applying the latest technology to boost production and recoverable reserves from existing onshore and offshore reservoirs. Pemex has been the state piggy bank for so long that it’s been starved of capital to invest in new technology. As a result there are easy gains to be made in reservoirs already producing oil. Put simply, the return of global firms to Mexico is the biggest oil and gas investment opportunity since the fall of the USSR.

Meanwhile, the electricity sector has also rolled out the welcome carpet. The state electricity utility, the CFE, has been restructured while the market has been opened up to private-sector firms. A new system of long-term power auctions for various forms of power generation gives the stability needed to finance new power plants. But the real draw for investors is that Mexico’s existing power plants are uncompetitive, and produce expensive electricity that newcomers can profitably undercut. There’s also plenty of scope for growth. Mexico currently consumes 60% less electricity per head than the OECD average, and the International Energy Agency (IEA) sees demand rising by 85% by 2040. Meeting this need will take serious investment. The IEA reckons investors will spend $10bn a year on new plants between now and 2040.

All of this investment in the electricity and hydrocarbons sectors will stimulate a boom in the “mid-stream” infrastructure required to deliver and process different forms of energy. For example, Mexico has just 3,000km of oil pipelines compared with 57,000 in the US, notes consultancy Ernst & Young. As for natural gas, Mexico’s 5,500 miles of gas pipelines are dwarfed by Texas alone, with 58,000 miles. The building boom will provide a steady stream of work for engineering and construction companies, steel and cement makers, and the like. This expansion will be supported by a $100bn government-led transport and communications overhaul, which includes more than 200 projects in seaports, airports, roads and railways.

The return of the peso

Clearly all this investment will deliver extra profits for many firms – we look at some exciting ways to play this theme in the box below. But it will also have a big impact on Mexico’s economy – at the very least counteracting any negative Trump effects. First, there’s the rise in foreign direct investment – between now and 2040, the IEA estimates that $240bn will be pumped into the power sector, while $640bn will go into upstream oil and gas, with an extra $130bn invested in energy efficiency. That’s almost $40bn a year. Not all of that investment will come from overseas, of course, but if the early energy rounds are anything to go by, most of it will. Over the mid-to-long-term this flood of capital will help prop up the peso, which is good news for international investors.

Rising oil production and exports will also buoy the peso. Since 2007, Mexico’s oil production has fallen even more sharply than war-torn Libya’s. Mexico produces about 2.4 million boe per day (boe/d), down a third on a decade ago. But the IEA reckons that reform-led growth will push production back up to 3.4 million boe/d by 2040. This will improve the trade balance, further supporting the peso. Finally, the boom in energy, power and infrastructure will counter any Trump-induced loss of manufacturing jobs, boosting consumer spending and the wider economy. None of this will happen overnight – all sorts of scary headlines could push the peso and investors’ sentiment lower. But over a ten-year timeframe Mexico’s economy, especially in the key sectors, is only going one way – up.

James McKeigue is managing editor of LatAm Investor, the UK’s only Latin America-focused investment magazine.

The four investments to buy now

You can track Mexican stocks through the iShares MSCI Mexico Capped ETF (LSE: CMXC), which charges 0.65% a year. It replicates the performance of the MSCI Mexico index, with the weight of the largest companies capped to improve diversification (emerging-market indices can often be top-heavy). Mexico’s market isn’t cheap and it’s skewed towards consumer-facing firms, which aren’t a big part of this story. But the falling peso has made the tracker cheap for international investors – it has fallen by 35% in dollar terms since 2013 – so now looks a good time to buy and hold for a few years.

When it comes to oil there are lots of big names – including Exxon, Shell, BP and BHP Billiton – with stakes in Mexico’s deepwater areas, but you aren’t getting focused exposure to Mexico as the bulk of their operations are elsewhere. If you want a pure play then you have to take a bigger risk – such as with International Frontier Resources Corporation (Toronto: IFR). This tiny Canada-listed oil producer has teamed up with local Mexican petrochemical player Idesa to create Tonalli Energia. In last year’s onshore auction round, this 50/50 joint venture won a block in the Tampico-Misantla basin, which is a reservoir already producing oil where Pemex has drilled seven wells. IFR’s plan is to use new technology to boost production and increase recoverable reserves. This is hardly revolutionary in itself – hungry juniors squeezing more out of assets discarded by the majors is standard industry practice. What matters is that the deal gives IFR a bridgehead in the world’s most exciting oil and gas frontier. Further onshore auctions are planned later this year and IFR will be in pole position to take advantage.

If you want to invest directly in companies listed in Meixco, one firm that looks well placed to benefit from growth in both energy and infrastructure is petrochemical conglomerate Mexichem (Mexico: MEXCHEM). The group has the world’s biggest fluorspar mine, producing salt and fluorite, which it turns into plastics and chemicals used in everything from cement to glass. Its pipelines unit, which makes fittings, systems and tubes for gas, water and electricity transmission, should benefit too as Mexico builds the mid-stream infrastructure to support its energy revolution. Finally, as credit-ratings agency Fitch notes, the US is Mexichem’s least important market, coming after Mexico, Europe and South America. As a result, it does not have much to fear from a renegotiation of Nafta. Its price/earnings (p/e) ratio of 40 looks expensive, but it is below comparable firms, such as US competitor Balchem (on 48), and also below it own five-year average of 49.

Finally, there is a pure infrastructure option, Promotora y Operadora de Infraestructura (Mexico: PINFRA) – literally “Promoter and Operator of Infrastructure”. The firm has three main businesses, each of which should benefit from Mexico’s growth. One makes cement and building materials for the construction industry. Another operates long-term infrastructure concessions, such as ports, bridges and roads. The final unit specialises in building petrochemical and electricity plants. In sum, it should do good business as Mexico embarks on an infrastructure building boom, while a p/e of 15 means it offers a fairly priced way in.

Not many British brokers offer access to the Mexican market, but Interactive Brokers (InteractiveBrokers.co.uk) is an exception. This firm is a US-based broker, but has a UK-regulated division through which it takes UK clients.


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