Exploit the panic to buy Mexico on the cheap

Rioting protesters, a shrinking economy it's little wonder international investors are fleeing Mexico. It's all a rude awakening for Enrique Pea Nieto, a golden boy of Mexican politics, who until now, had enjoyed a honeymoon start to his presidency.

I've been bullish on Mexico since mid 2012, the market is up overall since then. But it's certainly been something of a rollercoaster ride, and I can see why many are beginning to lose faith. But should we join the rush for the exits?

Let's examine what exactly has been going on in Mexico recently before we jump to rash decisions.

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First up, let's deal with the growth figures. There's no point brushing these under the carpet, no one wants to invest in a shrinking economy. Good economic growth is an essential component of the emerging-market story. After all, if these places aren't growing faster than the UK, what's the point of investing in them?

In August, Mexico came out with some truly shocking second quarter GDP figures. Instead of growing slightly, as had been expected, the economy shrank by 0.7%. It was a nasty surprise and probably cost short-term traders a lot of money. But longer-term investors don't need to change course at every new bit of data. Indeed, the signs are that this was a one-off and that Mexico still has good growth prospects.

As Capital Economics notes, "leading indicators suggest that growth will be stronger in the second half of this year. For example, the US ISM manufacturing index hit a twenty-five month high in August and is consistent with Mexican industrial production growth accelerating to around 5% y/y by year-end."

The thing to remember is that, despite its hard work to diversify its export partners, Mexico is still to a large extent a leveraged play on the US economy. If America does well, then so will Mexico, and for now the US recovery still looks pretty solid. Moreover, this type of market panic is great for Mexico. As investors have left, the value of its currency has plunged against the dollar, helping to make its already powerful manufacturing export machine even more competitive.

The battle against gang violence

Another major factor to think about with Mexico is security.It's no secret that Mexico has been unsettled by tragic and brutal gang violence and I reasoned that if the new president could improve the situation, it would help investors. Unlike tax or energy, it is much harder to quantify the effects that this peace dividend' may have on the economy. After all, Mexico has continued to grow regardless of the problems. Nevertheless, stable countries tend to make better investments in the long run.

On this front, however, there are less tangible signs of improvement. Sure there have been a lot of high-profile arrests, but as we've seen before, arresting a king-pin often just leads to more violence as the lieutenants battle for control of the organisation. Perhaps the biggest change has been how the government has handled the perception of the violence. Unlike the previous administration, which was always keen to trumpet its war against the cartels, Pea Nieto has tried to downplay the issue. The joke doing the rounds at the moment is that he's brought in Argentina's official financial statistics team to work on Mexico's crime numbers.

Then we come to the protests and reforms. One of the reasons that Pea Nieto enjoyed such a flying start to the presidency was his willingness to tackle the structural problems that had tormented the Mexican economy for years. He managed to unify the opposition parties through a patriotic-sounding reform package called Pact for Mexico' and delivered some early successes. This caught the attention of investors, who liked the idea of a wave of reforms unlocking productivity gains in Latin America's biggest manufacturer.

Pea Nieto's reform unveiling

But two of Mexico's biggest problems, energy and the fiscal regime, are interlocked on multiple levels creating a Gordian knot of politics and economics that, until now, most Mexican presidents have left well alone.

One part of the problem is that Mexico's tax system needs reform. At just 14% of GDP, its tax take is below the Latin American average of 18%, and well below the developed world average of around 30%. That's a problem because Mexican people increasingly expect more of a social safety net. And before any libertarians among you start bleating about the dangers of big government, take a visit to a small-town Mexican public hospital trust me, they need the extra investment.

Raising the tax take is never going to be popular, but in Mexico's case it's even more complicated, because at present, most of it comes from state oil company Pemex. The national giant's tax bill currently provides about a third of the government budget, which means that any fiscal reform needs to be an energy reform too. And, as if things weren't complicated enough, Mexico also desperately needs energy reform in its own right. That's because Pemex, whose coffers are drained by its tax obligations, hasn't been able to invest in new fields and its production is falling. Annual production has gone from 3.4 million barrels in 2006 to just 2.4 million barrels today.

So, last week, Pea Nieto unveiled his much touted answer to the problem. It basically involved raising extra money by taxing the rich, the big corporations and people who drink fizzy drinks. Meanwhile, he has engineered an energy reform that would allow Pemex to bring in investment from international oil companies.

The result? The left attacked him for being part of some neoliberal plot to steal the oil, and along with thousands of teachers smarting over a previous reform, took to the streets to protest. The right weren't happy either, and accused him of being weak and watering down his reforms.

But while Pea Nieto may not be feeling too popular right now, I think he's played a decent hand. The fact is that the current situation is so bad that even a watered-down reform would be a big improvement.

A much needed boost to the economy

Fiscal reform and energy reform are two crucial factors that could really unlock faster growth in Mexican GDP. So now that action has been taken and they're a lot closer to being delivered, I am even more bullish than I was back then.

The challenging question, however, is how to play these changes.Many big companies, including significant donors to Neito's campaign, are the ones getting hit by reforms.Cosy oligopolies such as Carlos Slim's America Movil, are being hit by changes in the telecoms sector. The house builders' land banks have been rendered worthless by the (smart) government ruling to end suburban sprawls and focus development on inner city areas. And Mexico's soda producers, who for years have made a roaring trade out of Mexicans' love of all drinks fizzy, look like they're going to get hit by a soda tax. Fair play to Pea Nieto if he is a neoliberal stooge, he has a funny way of showing it.

The reforms look likely to deliver a bit of short-term pain to the sectors mentioned above. While other elements of reform, such as closing tax loop-holes and introducing competition, will make life difficult for a few more. But in the longer run, these structural reforms will boost the economy.

I know that GDP growth and stock-market returns are not always related. Indeed, in some cases (think China), they seem to go in different directions. But I do believe that, now that the short-term hits are priced in, these reforms will be good for the Mexican stock market. Why? Because of the change of attitudes towards emerging markets.

Mexico still set to reward investors

The recent sell off came as a wake-up call to investors that had been happy to plough their money into any exotic-sounding place with a decent growth rate. But now investors are starting to become a lot more cautious about emerging markets. And when the benefits of Mexico's structural reforms kick in, it is likely to stand out as one of Latin America's fastest growing economies.

I also agree with Tony Volpon from investment bank Nomura, who fancies it to overtake Brazil as the region's biggest economy. That's not so important in itself, but it is the sort of symbolic event that's likely to attract even more interest from investors.

I've picked out individual Mexican stocks that I like in previous New Worlds. But when, MSCI Mexico IMI Capped UCITS ETF, gets down to levels that I think are good value, like now, I'd suggest people take advantage and top up their holdings. Remember, it's a long-term investment and there could be plenty of upsets along the way.

On Wednesday, for example we'll get an update from the Fed that could cause more carnage in emerging markets. But in the longer-term, as we enter this new phase of emerging market investment, I believe Mexico will stand out and reward investors.