Mexican Equities Benefit From US Tensions With China (NYSEARCA:EWW)

Main Thesis & Background

The purpose of this article is to evaluate the current opportunity in Mexican equities. This is a broad, macro-review, but I will highlight a couple of ways to play this space if one ends up being interested. This is my first direct review of Mexican equities as a whole, but I did highlight this idea as an investment theme that I like in 2024 in a macro-review earlier this month. However, the “Mexico play” was part of a wider article and I wanted to take time to dig into this particular theme more closely.

To understand why, consider Mexican equities have been a strong performers over the past year and that momentum has not gone unnoticed. Funds that track Mexican shares, such as the iShares MSCI Mexico ETF (NYSEARCA:EWW) are up handsomely during this bull market:

While I dislike the idea of “buying high”, I have a few reasons to believe Mexican equities have more gains ahead. This is a nation that is benefiting from its trade relationship with the US, continues to attract foreign investment, and stands to capture export opportunities at China’s expense. I will take on each of these attributes in this article, to support why I believe “buy” is the correct rating for Mexican equities going forward.

Thesis Partially Driven By Souring US-China Relations

To begin, I want to emphasize that my thesis here is two-fold. I see opportunities within the Mexican economy in isolation. But expanding on this point, part of this exists because of the ongoing strain in the relationship between the US and China. This has been an issue that has been bubbling under the surface for a long time, but heights new heights during the Trump and Covid-19 eras. Despite a more “moderate” Biden administration at the current helm, stress between the two countries continues to be elevated.

This is something that isn’t just a staged political issue, but one that is on the minds of everyday Americans. For example, when Pew Research Center conducted some polling last year, the net result was the American public views China with an increasingly high level of distrust. This come on the backdrop of increased Russia-China cooperation and other geo-political risks emerging from Taiwan’s recent election.

As you can see, the mood on China is souring, and that is concerning on a global level when looking at both economic and security issues.

But wait, you say, this is an article about Mexico. Why am I talking about China? This is because the US-China trade relationship is one of the most important on the globe – and its shrinking. But this isn’t because US consumers are buying less stuff (quite the contrary). When one stops buying from a source, they simply choose another source. And Mexico has been a direct beneficiary of this dynamic:

What I am trying to convey here is that China’s loss is turning out to be Mexico’s gain. While there are other nations filling the import void from China (i.e. Vietnam, India, South Korea), Mexico is one of the biggest beneficiaries. Its proximity to the US and status as a long-standing manufacturing base for US companies are working in its favor. I believe these are trends that will persist in 2024 and beyond, with US-China tensions being a major factor as to why.

Mexico Is Winning The Trade Game

Expanding on the above discussion, it is important to illustrate just how substantial this trade “pick-up” is for Mexico. While the US has an import trade imbalance for many countries with respect to physical goods, this metric has widened significantly in Mexico’s favor over the past four years. And this is a trend that continues to accelerate, namely because of the reduction in Chinese imports (as mentioned above):

The conclusion I draw here is that Mexican importers continue to benefit from a relatively strong US economy and a desire for US consumers to buy goods outside of those with a Chinese origin. This plays directly into Mexico’s hands and has been an ongoing, sustainable trend for years now. I don’t see the tide turning in any meaningful way going forward – providing a tailwind for Mexican equities.

To play this, there are a couple ETFs that seem like solid choices. Both EWW and the Franklin FTSE Mexico ETF (NYSEARCA:FLMX) are well-diversified across Mexican companies, but have a heavy consumer-tilt. In fact, over 1/3 of the funds’ assets are in the Consumer Staples sector, as shown below, respectively:

The takeaway for me is these ETFs are solid ways to play this trend. The funds hold the exact type of companies that send their goods over the border to America. And, as shown, this is a trend that is only going in one direction – up – at this time.

Foreign Investment Is Growing

My next topic is another one that Mexico has a relative advantage in. This concerns international investment, or foreign direct investment (FDI). The developed world continued to rake-in the advantage in this regard in 2023, but there were exceptions. Still, the disparity is striking, with investors giving up largely on emerging countries like China and those in Latin America, due to heavier investment in the US and Japan:

This may not seem like a benefit for Mexico – but that is where the real good news comes in. While FDI in developing countries fell 9 percent year-over-year, the flow of FDI to Mexico increased by a whooping 21% according to a report from United Nations Conference on Trade and Development.

This offers two buy signals to me. One, foreign investors are confident in the Mexican economy, and that is a very bullish sign. Two, investment is often a boon for sectors related to construction, building, and manufacturing. While EWW is heavily exposed to the Consumer sectors, the Industrials and Materials sectors combine for over 25% of total fund assets. This means that EWW can benefit from both trends of rising exports and higher foreign investment at the same time. That is a win-win in my view.

Supply-Chain Worries Also Benefit Mexico

The next area of discussion also focuses on international trade and Mexico’s advantage there-in. This touches on supply-chains, which became front and center during the Covid-19 induced lockdowns. Many nations, companies, and consumers began to realize just how inter-connected the world is – and how many of the goods they rely on originate far away. This makes economic shutdowns and other trade disruptions very painful, and the tenor out of Washington is to bring supply-chains closer to home – if not as domestic as possible!

While Covid-lockdowns are well behind us, that is not the only source of trade disruption. The Russia-Ukraine conflict in Europe is one, as is the most recent Houthi-led attacks on shipping lanes in the Red Sea. This has been disrupting commercial shipping in a very important global trade route:

The net result has been higher shipping costs, longer delivery times as commercial tankers seek alternative routes, and a renewed focus on the volatility of international trade.

While none of this is “good” news by any stretch, it does have potential to offer Mexican exporters and manufacturers an opportunity. When considering US-bound exports, Mexico has some of the lowest landed costs as a percentage of the value of what is being exported. This is due to its proximity and the fact that Mexico has options when it comes to shipping – air, rail, truck, or sea. This is in contrast with trading partners outside the North America continent that have to rely on air and sea – more expensive modes of transportation. The Mexican advantage here is quite clear:

The significance for investors is that Mexico has substantially lower shipping costs to the United States – compared to both China and most other countries for that matter. The is a net benefit most of the time, but especially when we see violence disrupting international trade routes. It makes importers rethink their strategic partnerships and could help accelerate the ongoing trend of more US-bound trade from Mexico. Again, this is a bullish factor for Mexican ETFs.

Risks To Consider

As with every investment I discuss, an examination of risks is paramount. This is especially true for a country-specific ETFs like EWW and FLMX, but even more so since Mexico is an emerging market/country. That poses additional risks that investors who normally focus on US stocks (i.e. the S&P 500) may not be used to. Emerging markets are not the same as developed markets and often are accompanied by geo-political risks, currency risks, and tend to have more volatility than their developed counter-parts. While these risks can be balanced out by the opportunity inherent in this investment idea, one should carefully consider these risks before deciding if such a play is right for them.

The first risk to highlight for Mexico is a common theme among many emerging markets. This is corruption, which can lead to graft that depresses corporate earnings and can discourage private investment in a specific territory, region, or entire country. While this risk is not “unique” to Mexico, it is a critical one, as the country ranks quite poorly on the corruption index:

Mexico is actually well behind countries in the Middle East, Asia, Africa, and Latin America – which is quite disappointing considering it should be a relatively stable democracy in North America. But corruption and organized crime have been problems for a long time and those issues remain thorns in the side of the economy. While we can look ahead and expect improvements in the future, that should not minimize the risk of investing in Mexican companies right now.

Another risk I mentioned is currency risk. This is another area to highlight because Mexico’s central bank has kept their benchmark rate quite high relative to the globe. While the Federal Reserve here in the US had raised rates aggressively in 2022 and early 2023, this led to the USD appreciating against many foreign currencies. But the Mexican peso stood out as a currency that actual became more valuable against the USD, not less, over the past year:

This is a mixed bag for foreign investors in Mexican equities. On the one hand, a stronger local currency means more buying power for Mexican consumers. This can improve economic activity and drive imports, which can be a bullish tailwind for the underlying companies in Mexico’s benchmark.

But the other side of the coin is that, as the Mexican peso rises in value, exports become more expensive. This can counter-balance the trade advantage that Mexico is enjoying relative to China and other countries that I discussed at length in this review. If this export-driven growth story becomes pressured, or even reverses, because of the strengthening local currency, that poses a major challenge to my overall buy thesis.

Again, the story here is not all bad. A stronger Mexican peso has led to domestic consumption, keeping retail sales elevated despite inflation:

This will help support domestic growth and the domestic-oriented companies within the fund’s portfolio. For example, the Financials sector tends to perform well when the consumer is healthy and spending.

But, as with most things in life, there are risks to the peso’s appreciation for US investors. So weigh this, along with the political environment very carefully when doing an evaluation of these funds.

Bottom-line

Mexican equities – and the ETFs that track them – have seen a big surge over the past year. While that may make a case for being cautious here, I see more upside ahead. I think the Mexican economy, and exporters more pointedly, will continue to siphon off trade from China due to escalating US-China tensions in the short-term. Further, a stronger peso has kept the domestic economy humming as growth has been positive and retail spending has been increasing. Finally, war in the Middle East and attacks on shipping routes in the Red Sea are providing catalysts for US-based importers to look for suppliers closer to home. This plays directly into Mexico’s hands. As a result, I believe a “buy” rating for Mexican equities makes sense in 2024, and will be initiating a position in this fund in the near term.