Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
Even before the current Mexican President Manuel Lopez Obrador (AMLO) had taken office, he and his party (Morena) caused a significant sell off in both the equity and currency markets.
It began with his use of a so called “public consultation” to bypass traditional legislative and judicial decision making channels in Mexico. In reality these consultations are organised and payed for by his party and claim their legitimacy through the use of “democratic” votes on various initiatives.
The first public consultation in his role as the incoming Mexican President was to recommend the cancellation of the already one-third completed Mexico City airport. AMLO believed many of the contracts awarded for its construction are riddled with corruption and that as a result it needs to be completely scrapped. The logic behind this decision baffled investors, as the Government has already spent over $5 billion dollars on its construction. It will now have to spend more than $1 billion on its dismantlement as well another $5 to $10 billion to construct a new airport at another location.
This action created a significant amount of concern that other consultations will follow, particularly one that could alter Mexico’s Constitution. Behind these worries is a view by some investors is that AMLO is just another left leaning Latin American leader who will at best emulate the Brazilian example of Lula and Dilma and at worst lead the country into a Venezuelan style disaster.
His plans for the national oil company Pemex, entailing a significant amount of government investment have worried investors that he will not be able to keep his word to keep the fiscal deficit below 1.0% of GDP. At the same time his party has begun to look at the possibility of changing mining concessions and possibly raising taxes on the sector.
Based on his time as Mayor of Mexico City it would appear to us that these concerns seem to overdone. AMLO governed Mexico City in a fairly prudent manner, with a focus on running a balanced fiscal budget. It is also difficult to classify him as a traditional leftist, as evidenced by his hiring of the former Republic Mayor of New York, Rudolf Guliani, as an advisor to help reduce the city’s crime rate.
In actuality a lot of AMLO’s proposed agenda as President is not radical at all, such as running a primary fiscal surplus, reducing wasteful Government spending and opening up many industries to more competition. What frightens investors the most is that his Morena party seems unstructured, as it includes many with widely divergent views. The proposal by one of their Senators to reduce bank fees was one such example.
AMLO will need to govern from the middle in order to implement his agenda. In that sense the recent market turmoil could ultimately turn out to be a blessing in disguise. It will make it clear to AMLO that unorthodox economic proposals can be quite costly to Mexico’s ability to attract capital.
From a valuation perspective, the Mexican market is trading at only 12.5X prospective 2019 earnings, its lowest level in more than five years. The main reason for this discount is the high level of real interest rates. Short term interest rates are 7.5% compared to a projected inflation rate of only 3.5%. Again, uncertainty regarding the AMLO administration’s policies explain why real interest rates in Mexico are above those of Brazil.
At the stock level we continue to find the low cost airline Volaris to be an attractively valued (2019 prospective EV/EBIDTA of 7.5x) play on the growth of Mexican incomes, particularly at the lower end of the economic scale. The company is seeing very strong passenger growth (16% year on year in February) as it effectively competes with the legacy carrier Aero Mexico. Its low cost strategy finds particular favour with those who would normally not be able to afford to fly - as an example over one third of the Mexican population has never flown on an airplane. Additionally, Volaris is now expanding into Central America, where intercountry air fares remain high relative to Asia, Europe or North America due to a lack of low cost air carriers in the region.
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