29 January 2025
Our investors and readers will be aware of the overweight exposure to Mexico negatively impacting performance in 2024. Below we share the raft of reasons why the investment team have maintained a strong overweight on Mexico by selectively adding to exposure over 2024 when this capital market has been sold off.
This information has been prepared by Northcape Capital, the underlying investment manager for the Warakirri Global Emerging Markets Fund.
The MSCI US$ Mexico Index was down -27% for CY24, materially underperforming the MSCI EM index, which was up +7.5% over the same timeframe. This reflects the fall in Mexican equities in local currency (-7%) and -20% currency devaluation. Indeed, next to Brazil, Mexico has been one of the weakest major equity markets within EM over 2024. The reasons for Mexico’s downturn are two-fold, and relate to elections:
Both factors on face value have potentially negatively impacted Mexico’s long-term growth potential and investment appeal. Hence, the slump in Mexico’s equity market this year.
However, at 31 December 2023 we had 17% of our assets in Mexico, which compares with 19% at 31 December 2024 – so despite the sharp correction in Mexico, we have taken the opportunity to increase our weighting to the country at various times over the year. In fact, we have added to all our major Mexico positions and introduced Walmex (the leading retailer, controlled by Wal-Mart) into the portfolio as well.
Why do we remain very constructive on Mexico in the face of these seemingly negative election results? The answer to this question is multi-faceted, so we address each element in turn.
Whilst having judges publicly elected is not our preferred outcome, we believe the negative impact of Mexico’s new judicial system is probably overstated.
First, all new judges put forward must be vetted for experience by an independent nomination committee, which includes ex-judges and experts with an ability to assess the candidates’ experience and capabilities. Hence, the risk of total political hacks, with no judicial qualifications being elected, does not appear to be valid in our view.
Second, we sense there will be opportunities to review the reform and make adjustments to improve transparency. At the moment the operational aspects of the reform (including review mechanisms) have yet to be finalised, which is creating the current information vacuum, allowing investors to focus on the worst-case scenario in terms of political overreach into the judiciary.
Third, is the concern that the INE (Mexico’s National Electoral Institute), which oversees the country’s elections, would be disbanded, as the previous president had argued. This is not the case. Rather the INE, which ensures Mexico’s elections are “free and fair”, is to be retained under the new Sheinbaum administration, plus it will take over the election operation and monitoring process of the new judicial system. INE has been given increased funding by the new government to ensure its effectiveness.
Claudia Sheinbaum elected Mexico’s new president
Finally, the previous system of independently appointed judges had issues with transparency and corruption, so how much different will the new judicial system be? Only time will tell.
In the lead up to the 2024 election and post-election, Donald Trump has used the threat of significant tariffs against Mexico as a source of political capital gain in relation to US immigration and trade issues.
Trump’s approach in 2024, appears very similar to 2016, as such despite the threats (including recent one of a 25% tariff on all exports from Mexico into the US), we believe it is a negotiation tactic.
In Trump’s 2016-20 term, despite the campaign rhetoric there were no significant tariffs placed on Mexico, rather the North America Free Trade Agreement (NAFTA) was superseded in 2020 by the US, Mexico, Canada Agreement (USMCA), largely keeping all the free trade aspects between these countries.
One aspect of USMCA was a clause for reassessment in 2026 by all parties. Given the highly intertwined trading and investment relationship of all three countries, it’s highly unlikely the USMCA will be scrapped in 2026, rather it will be updated again in our view. Experts we spoke to in Latin America in November said that negotiations on a new updated USMSCA will begin in 2025.
Moreover, once in power, Trump’s statements made in the heat of the election campaign trail are rarely enacted in full, as pushback, dilution comes when the inevitable constraints of getting legislation through the US Senate come to bear. And we note there are many Republican states that greatly benefit from the free trade between Mexico and US.
Nevertheless, to help achieve USMCA rollover, Mexico will have to make progress on its security and will further strengthen its southern border. This should limit migrant flows from Central and South America via Mexico into the US.
Mexico, in our view will also make bigger efforts to better control the fentanyl trade across the border, whilst assisting the US in taking back deported undocumented Mexican nationals.
For Mexico, it is worth making these enforcements, given its exports into the US account for 24% of its total GDP. In our view, it is imperative Mexico does what “whatever it takes” to see the USMCA remain in place, albeit in amended form.
We are already seeing progress. On 28 November, President-elect Trump and Claudia Sheinbaum held their first phone call, and both released statements afterwards saying the talks were constructive.
To quote Trump… “Just had a wonderful conversation with the new President of Mexico, Claudia Sheinbaum. …. We also talked about what can be done to stop the massive drug inflow into the United States ….It was a very productive conversation!” Trump posted on Truth Social.
These are early days but shows that both parties are making efforts to reach an agreement and not get into a very damaging tit-for-tat tariff war.
In our view, China is a more important adversary than Mexico for the US in any case. Accordingly, the US focus for trade restrictions will be largely on China, as was the case in Trump’s first term. Trump’s appointment of Sen. Marcio Rubio, as US Secretary of State, who is one of the most hawkish elected officials in the US regarding US policy on China, highlights his intent.
Note – Rubio was among several US officials Beijing has banned from entering China from 2020 – after the first Trump administration moved to punish China for its handling of Hong Kong and Xinjiang, the latter is home to China’s Muslim minority Uyghurs. Just as we were going to press it was also announced that renowned China hawk Peter Navarro – author of the book ‘Death by China’ – will join the Trump administration as Senior Counselor for Trade and Manufacturing.
An appointment further underlining Trump’s tough stance on China. Moreover, we strongly suspect that the US would not want to punish Mexico to the extent that it moves closer to China in relation to economic and potential military cooperation. This would be seen as a foreign policy failure in Washington, having Mexico, on its southern doorstep, federate with China, and potentially with its friends as well – Russia, Iran and North Korea!
Source: Northcape Capital
Mexico holds enormous geopolitical “strategic value” to the US, simply by way of the long US-Mexico border (3,200km) and size (large land mass, resource base and labour pool with 150m population). These perpetual elements are in Mexico’s favour and are often underestimated, in our view.
In our most recent assessment of EM capital markets stability, we rated Mexico as “Medium Risk” – see exhibit on previous page. On the positive side, Mexico’s government debt levels are not excessive at 46% of GDP, with relatively low levels of foreign currency debt at 7% of GDP. The current twin deficit (budget deficit plus current account) is elevated at 4.6% of GDP, however the government has a credible plan to reduce its budget deficit in 2025.
As such, Mexico’s financial stability risks have the potential to improve. Importantly, Mexico has an independent central bank and a free-floating currency, so its capital markets operate with integrity.
Investors know that a high bar is set for returns on capital for stocks to make it onto the Northcape EM Approval List, and ultimately into our portfolio. With respect to Mexico, we have found its equity capital market to be well endowed with companies earning strong returns on capital.
Indeed, as the exhibit below shows the weighted average return on equity (ROE) for the Mexican stocks held within the Northcape portfolio is currently 28%. The Mexican stocks we own are some of the highest ROEs names in our current portfolio and delivering returns well above the current weighted average ROE for the portfolio at 24.0%.
Moreover, the valuation is lower with our Mexico position’s weighted average P/E at 14.9x versus portfolio’s weighted average 17.4x. The dividend yield at 4.7% for our Mexico stocks is almost double the portfolio’s weighted average. The weighted average Scope 1 and 2 emissions of our Mexican positions at 0.86mt, is also much lower than portfolio’s weighted average at 2.36mt.
Following its -27% slump in 2024, the Mexican equity market valuations are now at 15-year lows. Specifically, the 12-month forward EV/EBITDA ratio stands at 5.2x, which is 27% below the historical average and more than two standard deviations below the norm.
By way of our own valuation approach, Mexican stocks are also cheap. Specifically, when we use our DCF framework considering our assessed Cost of Equity for Mexico (under our sovereign risk framework), we find our Mexican stocks are trading at significant discounts to our DCF valuation, averaging about 25%.
Finally on currency, it is interesting to note that the Mexican Peso (MXN) versus the US$ has fallen -27% to 20.6 from its high point in 2024. This is the same level of devaluation that occurred in 2016, at the time of Trump’s first election to the US presidency. From January 2017 to February 2019 (3 years) the Mexican peso appreciated by 15% versus the US$, with much of this gain occurring in 2017.
This suggests that like 2016, in 2024 the Mexican currency has potentially already factored in the negative impact of Trump’s campaign rhetoric. Accordingly, if the worst-case scenarios do not occur, it is very probable the Mexican Peso will stabilise, and potentially improve its relative valuation versus the US over 2025, creating additional upside for our investments in Mexico.
Source: Northcape Capital
In conclusion, we have maintained a strong overweight to Mexico by selectively adding to our exposure over 2024 when this capital market has been sold off. There is a raft of reasons for this portfolio action which include:
For more information, please contact us on 1300 927 254 or visit Warakirri Global Emerging Markets Fund.
The information in this document is published by Warakirri Asset Management Limited ABN 33 057 529 370 (Warakirri) AFSL 246782 and issued by Northcape Capital ABN 53 106 390 247 AFSL 281767 (Northcape) representing the Northcape’s view on a number of economic and market topics as at the date of this report. Any economic and market forecasts presented herein is for informational purposes as at the date of this report. There can be no assurance the forecast can be achieved. Furthermore, the information in this publication should only be used as general information and should not be taken as personal financial, economic, legal, accounting, or tax advice or recommendation as it does not take into account an individual’s objectives, personal financial situation or needs. You should form your own opinion on the information, and whether the information is suitable for your (or your clients) individual needs and aims as an investor. While the information in this publication has been prepared with all reasonable care, Warakirri and Northcape do not accept any responsibility or liability for any errors, omissions or misstatements however caused.