It would be fair to say that Donald Trump is not everyone’s cup of tea. In his short spell in office he has picked fights with seven Muslim countries, argued with supposed allies such as Australia and is engaged in open conflict with America’s judiciary and media establishment. But without doubt the main target of his ire has been Mexico. It’s impossible to second guess the man but it now seems very likely that Trump will fulfil his campaign rhetoric and impose tariffs on Mexican goods, build a wall to deter illegal Mexican immigrants to the US and make life more difficult for those already in the US illegally.
Trump’s anti Mexico stance caused investors to panic and dump the country. After all exports to the US account for 25% of Mexican GDP – by way of comparison UK exports to the EU make up just 13% of Britain’s GDP – so it’s logical to assume that Trump is bad for Mexico. That’s why the Mexican peso tanked to a record low in January and continues to look susceptible to every Trump tweet or rumour. That negative press is great for brave investors because, over the long-term, Mexico looks set to deliver strong returns. Even if you take a worst-case scenario, where Trump carries through on the most extreme versions of his threats, Mexico’s economy will continue to grow while there are specific sectors in the country that should boom.
Not a pretty picture
Trump’s policies don’t look pretty for Mexico. Let’s take immigration. Legal and illegal Mexican immigration to the US has been a great pressure valve for the Mexican economy by helping to keep a lid on unemployment. More importantly it is one of Mexico’s biggest export industries. The remittances sent back to Mexico from workers in the US were worth $26billion in 2016 – more than the country’s oil earnings that year. Trump’s proposals would make it harder for more Mexicans to emigrate to the US illegally, reduce the amount of illegal immigrants already there and tax the flow of remittances. All of which would hit one of Mexico’s major export earners.
Then there is Nafta. Since the North American Free Trade agreement came into effect in 1994, Mexico has managed to turn a $1.3billion trade deficit with the US into a $67billion surplus. The prospect of establishing low-cost operations with tariff-free access to the world’s biggest economy encouraged manufacturers from around the world – but chiefly the US – to establish factories in Mexico’s northern states. The Nafta boom helped to make Mexico the only major Latin American economy that earns more from manufactured exports than commodities. Needless to say Trump’s threat to renegotiate the agreement and impose an import tax on Mexican goods threatens to undermine this incredible industrial growth.
"Mexico has managed to turn a $1.3billion trade deficit with the US into a $67billion surplus…"
Finally you have Mexico itself. President Enrique Peña Nieto got off to a great start after coming to power in 2013 and managed to pass impressive structural reforms that opened up the country’s energy, electricity and telecommunications sectors. But while that bodes well for the long-term, in the short-term the economic growth has been disappointing. Mexico’s economy seems to be meandering at an annual expansion of 2.3%, while a persistent fiscal deficit and inflation has triggered a tightening monetary policy that looks likely to hit consumer-led growth, which until now has been the one bright spot in the economy.
If you have got this far you are probably wondering why anyone would want to invest in Mexico. At a first glance is not a pretty picture but when you dig a little deeper it’s clear that Mexico offers some great opportunities.
Mexico just got cheaper
Since Trump started looking like a serious presidential contender the Mexican peso has fallen 20% against the dollar. But while the arrival of Trump helped to push the Mexican peso to record lows it had been falling for much longer than that. Since its 2008 high the Mexican peso has lost 50% of its value against the dollar. That is great for international investors who want to buy Mexican assets now because they are cheaper in dollar terms. So for example, even though local stockmarket, the Mexbol, is not cheap in local currency, the slide of the peso makes it more attractive for international investors.
The fall in the peso has also been great for Mexico’s manufacturers. Alongside Nafta, it was one of the reasons so many factories were built in the country. Indeed the 20% Trump induced fall pretty much cancels out his proposed 20% import tax. Which is one reason why Mexico’s manufacturers won’t take the beating everyone is expecting. Another reason is that now Mexico is a fully-integrated part of complex cross-border supply chains, it would not make financial sense for companies to create new ones from scratch. Indeed Mexico has several inbuilt advantages. Even with the proposed tax it would cheaper than other North American competitors, the USA and Canada. It also has a steady stream of engineers – it produces more per year than Germany or Brazil - and considerable manufacturing expertise that put it above cheaper rivals in Central America. Meanwhile its close location to the US, which is ideal for transporting bulky items and is increasingly important to the growing trend of ‘just in time’ manufacturing, give it a huge advantage over Asia. Of course some consumer-facing producers may make political decisions to move factories back. For example Ford recently decided to backtrack on a new Mexican factory and place it in the US instead. But that type of political pressures won’t apply to producers of less-visible industrial components or machinery.
The ‘peso effect’ would also ease any problems that could arise from 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.”
Of course this analysis won’t be much consolation to a factory worker who loses his job or a hard-working immigrant sending fewer dollars back to Mexico. But Mexico’s manufacturing or remittances has little direct impact for investors. Industry is underrepresented on Mexico’s stockmarket, and most factories are plants belonging to non-Mexican multinational companies. Sure the wider stockmarket will feel the indirect impact of weaker manufacturing growth through the effect on jobs, salaries and consumer spending but it’s not the deathblow to the Mexican economy that the headlines would have you believe.
Amidst all the press coverage devoted to the Trump Mexico saga you may have missed a more important story. In January a dozen of the world’s biggest oil companies committed tens of billions of dollars to develop Mexico’s deepwater oil fields. It was the 4th auction, since Mexico began the historic process of opening up its huge energy sector to private investors, and each round has attracted a fresh crop of international players.
Peña Nieto’s 2013 energy reform reversed a central tenet of Mexican politics since the 1930s – namely that Mexico’s oil should be owned by the Mexicans. That political victory was followed up by an equally impressive business one. In an era of falling oil prices Mexico managed, after a few teething problems, to attract masses of capital and expertise from the international oil industry. Of course a pretty auction system on its own isn’t enough to attract the oil majors. The reason they are so excited is that Mexico has ridiculous amounts of oil.
Geologists estimate that Mexico is sitting on more than 100 billion barrels of oil equivalent (boe), yet during its monopoly the state oil company, Pemex, only extensively explored 20% of the country. The areas of interest can be split into three main categories. Firstly you have the Gulf of Mexico. The US-owned part of the Gulf is one of the world’s major oil provinces with more than 4,000 wells drilled. Pemex estimates that there could be up to 50 billion boe in Mexico’s part of the Gulf but so far just a handful of deepwater wells have been drilled. Mexico also has great shale oil and gas reserves. According to the US Energy Administration Agency, the country has the world’s fourth-biggest shale oil reserves, measuring at least 60 billion boe. The final area of opportunity is 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 has been starved of capital to invest in new technology. As a result there are easy gains to be made in already-producing reservoirs. In short, the return of international firms to Mexico is the biggest oil and gas investment opportunity since the fall of the USSR.
Turning the lights on
It’s not just the oil and gas industry that is opening up. The electricity sector has also rolled out the welcome carpet for international investors. The state electricity utility, the CFE, was restructured by the reform while the market was opened to private-sector firms. Meanwhile a new system of long-term power auctions for various generation types gives the stability needed to finance new power plants. Again, while it helps to have a well-designed system the real attraction for investors is that Mexico’s existing power plants are uncompetitive and produce expensive electricity that newcomers can profitably undercut. A backdrop of growing demand also helps with the International Energy Agency (IEA) predicting that Mexican electricity demand will increase 85% by 2040. Long-term predictions like that are impossible to get exactly right but given that Mexico currently consumes 60% less electricity per capita than the average of other members of the OECD club of developed nations, it seems fair to assume that demand will grow. And, because power stations are not cheap, meeting that demand will require serious investment. Indeed the IEA estimates that investors will spend $10billion a year between now and 2040 building 120 GW worth of new Mexican power plants – with about half being based on renewable energy.
All of this investment in hydrocarbons and the electricity sector will also stimulate a boom in ‘mid-stream’ infrastructure needed to deliver and process different forms of energy. Take oil pipelines for example. Auditor EY notes that Mexico has just 3,000 km of oil pipelines compared to 57,000 km in the US. The difference is even more marked in natural gas where Mexico’s 5,500 miles of pipelines are dwarfed by the US state of Texas alone, which has 58,000 miles of gas pipelines. The building boom is going to provide a steady stream of work for engineering and construction companies, steel and cement makers and the like. This wave of infrastructure is also being supported by a $100billion government-led transport and communications overall, which includes more than 200 projects in seaports, airports, roads and railways.
"Mexico has just 3,000 km of oil pipelines compared to 57,000 km in the US…"
Clearly the mass of opportunity in hydrocarbons, electricity and infrastructure is going to result in extra profits for firms in those sectors. But it’s also going to have a massive impact on Mexico’s economy - at the very least counteracting any negative Trump effect if not more. The first way that it makes itself felt is through the increase in foreign direct investment. According to the IEA the energy reform will cause investors to put $240billion into the power sector and $640billion into upstream oil and gas between now and 2040. With an additional $130billion invested in energy efficiency. That totals out at almost $40billion per year. Not all of that investment will be foreign of course, but if the early energy rounds are anything to go by, the majority will be. In 2015, before a Trump presidential challenge was even mooted, Mexico received $28billion of FDI. Now, regardless of whatever policies Trump decides to enact, Mexican FDI is set to be significantly higher for the next two decades. Over the medium to long-term this flood of inward capital will help to support the peso, which is great for international investors like us. If the peso is worth more in a few years then our Mexican investments are too. The peso will get another boost from rising oil production and exports. Since 2007 the decline in Mexico’s oil production has been even more dramatic than war-torn Libya’s. Mexico currently produces about 2.4 million barrels of oil equivalent per day (boe/d), down a third from a decade ago. But the IEA reckons that the reform-led growth will push production back up to 3.4 million boe/d by 2040. The impact of extra oil exports on the trade balance will give further support to the Mexican peso. Finally the boom in energy, power and infrastructure will help to counter any Trump-induced loss of manufacturing jobs and thus give some impetus to consumer spending and the wider economy.
None of this will happen overnight. In the short-term all sorts of scary headlines could push the peso and investor sentiment lower. But over a ten-year timeframe Mexico’s economy, especially in the key sectors, is only going one way – up.
A version of this article first appeared in MoneyWeek on the 3rd of March.