We are working our way through the most desperate times for financial markets in living memory. At s...
We are working our way through the most desperate times for financial markets in living memory. At such a time we would expect 'risky' markets such as Latin America to produce some of the worst returns. In this sense, Brazil has performed true to type -47% this year. Yet despite Brazil's weakness, Latin funds are among the best performing this year. The reason is simple: Mexico.
Despite recent weakness, Mexico remains one of the best performing equity markets in the world. Furthermore, the Mexican peso has appreciated slightly against the US dollar. For the casual observer, this is hard to explain. After all, Mexico is so dependent on the US these days ' surely, it will be dragged down by US woes? And then there's Argentina ' it has got to go, and then what price Mexico?
It is very easy to paint a dismal picture. A US recession kills Mexican exports. The Mexican economy sinks, capital flows dry up, a balance of payments crisis brews, the exchange rate collapses, inflation surges, interest rates go up (in a recession), and investors loose all their money (again).
So why has this not happened? The key point is that interest rates have fallen. Why is this surprising? In emerging markets, interest rates usually rise when the economy slows because of rising credit concerns. This is currently the case in Argentina and Brazil, and it usually happens in Mexico. But not this time. In fact, Mexico is going through a normal economic cyclical for the first time in 30 years. As the economy has slowed, interest rates have fallen.
The fall in interest rates has been dramatic. At the start of the year they were 18%, today they are 10%. Before the US tragedy, they fell below 7%, the lowest rate since 1968. In real terms, interest rates have fallen from 12% to 4%.
In our view, this downward shift in real interest rates in Mexico is structural. Mexican 'risk' is falling as markets discount the evolution of Mexican democracy and the benefits of integration with the North American economy.
What does this mean for the Mexican equity market? ' everything. During the 1995-2000 period, real interest rates averaged 10% and the equity market traded between 8-12x P/E. During this period, Mexico was not a democracy, it had a bankrupt banking system and its sovereign debt was below investment grade. Today with real interest rates at 4%, its banking system is sound, its sovereign debt has investment grade and it has adopted a plural political system. It sells at 10x earnings.
This low valuation explains why Mexico has proven so resilient. The equity market is gradually beginning to adjust to the new real structure of interest rates. The new interest rate equilibrium should mean Mexico sells above its historic P/E range of 8-12x. This year's relative performance is just the start of Mexico's re-rating.
Lower real interest rates.
Low valuations explain Mexican resilience.
Structural change has taken place.
Exports to the US.
Argentina likely to default.
Slower foreign direct investment.
Dominic Rossi is a Latin America fund manager at Zurich Scudder Investments
Two global vehicles
'Further plug advice gap'
Must appoint separate CEOs and boards
Advisers do come out well
Will report to Mark Till