Time Is Up for Mexico

In the last few months, the office has received many positive analyses on Mexico and the Mexican peso. It is hard for me to believe that so many can ignore so much history and so many blatant signals of trouble. We can only conclude that the writers have been smoking one of Mexico’s most successful exports – the one not hobbled by excess government control. The positive arguments  seem to depend on one of two conceptual frameworks. The first is the most academic, focusing almost entirely upon the internal monetary and economic situation, which shows the government exercising impressive control over the currency and monetary policy while following well accepted IMF-approved practices in managing the economy. Unit labor costs are down, money supply growth is low and multipliers are contracting. With all of these positive macro-economic policies in place, how could things not go well for Mexico? When one considers that the currency is about 20% cheaper than it was in early 2008, the argument is that Mexico must be in a good place and the peso must be a good buy against the dollar. That declining labor cost is a big plus that the southern Europeans do not have, as all the Mexican gain has come from the weakening currency. The other argument depends on a more mathematical comparison of the peso with other Latin American economies and with global liquidity and fund flows. The normal historical correlations seem to have broken down as Mexico is underperforming Brazil, Chile, and even Colombia and Peru, and the analysts point out that this should not be the case. Mexico has high yields and foreign mutual funds are accumulating their bonds. Global liquidity should continue to explode and Mexican two year yields seem higher than they should be, offering real value. With emerging markets the hottest asset class, why not buy Mexico? As it is lagging, it must be a better value?

Perhaps Mexico is lagging because it is a worse investment than the others. I would go way beyond that and say Mexico is a terrible investment. Fully one quarter of the country’s GDP depends on exports to the United States, and in 2008 Mexican GDP dropped by 10% peak to trough, more than twice that of the US. The Mexican work force’s two fiercest competitors are Chinese workers and  US workers, both of whom have rapidly improving productivity as well. If the American economy suffers a recession in 2011, which we believe is a certainty (and now many others agree with us), the pressure on the Mexican economy will be immense. Labor costs must drop sharply. Recent retail sales are already falling and on a year-on-year basis are almost static. Tourism was harmed by the swine flue scare last year and now drug related violence is threatening to do even worse damage. With the death of major political figures and bomb threats in the news, the only way Mexico will attract tourists is with rock bottom prices. Just this week, it was announced that Pemex would begin importing oil for the first time in almost 40 years to keep its refineries running. Although there are technical reasons for this shift, net oil exports are dropping each year and private projections show Mexico as a net oil importer in less than ten years. Although Mexico’s future current account prospects look bleak, the external global financial situation will have an even worse impact on the country. History shows the peso catching pneumonia every time the US catches a cold: 1977, 1982, 1987, 1994, 1998, 2002, and 2008. The three most significant collapses came several years after the beginning of a US recession, in 1977, 1982, and 1994. The others came with major equity market declines. As the world is still recovering from the 2008 recession – and another seems on the way – and a major equity market decline is in our future, the outlook for Mexico is dire. A 50% collapse in the value of the peso would be an optimistic outcome and the odds favor a more significant weakening over a five year timeframe.