Historic Mexico Elections: A Doom for EWW or a Golden Buying Opportunity?

In a historic election, Mexico has voted in its first female president in over 200 years, with Claudia Sheinbaum of the leftist Morena party securing a landslide victory. This monumental shift not only signifies a progressive leap for the nation but also sets the stage for potential constitutional changes unseen since 1992. 

However, the markets have reacted with caution, viewing Sheinbaum as potentially unfriendly to economic interests, resulting in a significant sell-off of approximately 10% in the iShares MSCI Mexico ETF ($EWW(EWW)). As investors weigh the implications of her administration's policies, the key question arises: does this market dip present a strategic buying opportunity?

The Election Results

Claudia Sheinbaum, the former mayor of Mexico City, has won a historic election to become Mexico's first female president, securing a decisive victory with approximately 58.6% of the votes counted so far.

This election, widely regarded as a referendum on the leftist policies of outgoing President Andrés Manuel López Obrador, has resulted in a substantial mandate for Sheinbaum and the ruling Movement of National Regeneration (Morena) party. President López Obrador has criticized the judiciary for catering to wealthy business interests and advocates for judicial accountability through popular elections

Her win, with a margin of roughly 30 points, marks the largest victory in a presidential election since 1982, reflecting strong support for López Obrador's government, known for its populist and nationalist stance, and successful welfare programs that have maintained high approval ratings.

Sheinbaum's victory not only signifies a continuation of López Obrador's policies but also presents an opportunity for Morena and its allies to achieve a two-thirds majority in Congress. This majority is crucial for passing controversial constitutional changes without needing opposition support, potentially enabling significant reforms in energy laws, the judiciary, and the election agency that López Obrador had championed but could not accomplish due to insufficient votes. This development marks the first time since the early 1990s that a Mexican leader will wield such considerable legislative power.

The election results underscore a pivotal moment in Mexico's political landscape, as they open the door for the most significant overhaul of the country's political system since its democratization in 2000. Political analyst Antonio Ocaranza predicts that the upcoming months will be transformative for Mexico, with López Obrador remaining a powerful figure alongside a Congress aligned with his vision, poised to enact sweeping changes.

The proposed constitutional changes in Mexico could have profound implications for its democracy. These changes include replacing the autonomous election agency, introducing a popular vote for judges including those in the Supreme Court, eliminating autonomous regulators in industries such as telecommunications and transferring their functions to government ministries, and reversing reforms in the electricity industry to give the state utility a greater role. Despite these changes, in her victory speech, Claudia Sheinbaum emphasized her commitment to respecting private investment, maintaining fiscal discipline, and preserving the central bank's independence.

 

AMLO's Track Record

When Andrés Manuel López Obrador (AMLO) took office in 2018, there were significant concerns about his proposed legislation and its potential impact on Mexico's political and economic stability. AMLO, known for his nationalist stance and criticism of Mexican elites, promised a deep transformation aimed at benefiting the poor. Critics feared his policies would lead to institutional erosion and weaken checks and balances. Specifically, there were worries about his plans to replace the autonomous election agency, overhaul the judicial branch by introducing a popular vote for judges, eliminate autonomous industry regulators, and reverse reforms in the electricity sector to favor state utility control. These changes were seen as potentially unfriendly to the market and increasing the likelihood of institutional instability.

 

Despite these concerns, many of the dire predictions did not materialize during AMLO's presidency. He maintained an open economy, upheld free trade, and kept government finances relatively stable, which helped bolster the peso and maintain investment-grade ratings for Mexico. Over the past two years, the Mexican economy demonstrated relatively strong growth, supported by high interest rates, record remittances, and fiscal discipline. AMLO's respect for central bank autonomy and efforts to redistribute wealth through higher wages contributed to the peso reaching its strongest level in nearly a decade.

 

As Claudia Sheinbaum prepares to take office, she inherits an economy that, despite its stability, faces challenges such as a security crisis and a widening budget gap. Sheinbaum, a political protégé of AMLO, is expected to continue his policies while addressing these issues. Market participants are closely watching how she will handle the significant constitutional legislative majority left by AMLO, especially in terms of implementing the broad reform agenda he submitted to Congress. Her administration's ability to navigate these reforms will be crucial in determining Mexico's future political and economic trajectory.

Mexico's Fiscal Issues

Mexican president-elect Claudia Sheinbaum will face the challenging task of fulfilling her campaign promises to enhance social programs, despite inheriting a significant budget deficit from her predecessor, Andrés Manuel López Obrador. López Obrador, after maintaining tight spending policies for most of his term, increased expenditures in his final year to complete key infrastructure projects and expand welfare programs, raising the deficit to 5.9% of GDP in 2024, up from 4.3% in previous years. This fiscal situation leaves Sheinbaum with the dilemma of either controlling spending or risking a decline in Mexico's creditworthiness.

Economists, analysts, and former officials suggest that the solution lies in some form of tax overhaul to boost government revenues, even though Sheinbaum has indicated she has no plans to raise taxes. Current expenditures, including pensions, public debt servicing, and federal transfers to states, consume more than half of Mexico's 9.07 trillion pesos ($535 billion) budget. Furthermore, the state oil company Pemex is no longer the financial asset it once was. Former finance minister Ernesto Cordero highlighted the enormity of the challenge, emphasizing the need for strategic financial planning to support Sheinbaum's policy goals.

 

Mexico's public finances are under pressure, and traditional methods of increasing tax revenue are becoming less effective. López Obrador's administration had increased tax revenue by clamping down on tax evasion and settling disputes with large corporations, resulting in a 48% nominal rise in tax revenue from 2018 to 2023. However, this strategy is not sustainable long-term. Mexico's tax revenue as a percentage of GDP remains significantly lower than that of its peers, at 16.9% in 2022 compared to the 34% average for OECD members and 21.5% among Latin American countries. Experts propose reforms such as improving property and vehicle taxes, tweaking corporate profit taxes, and introducing green taxes and Pemex royalties.

 

Addressing the fiscal deficit will be Sheinbaum's most pressing task. The deficit was exacerbated by López Obrador's last-minute spending on infrastructure and welfare. Reducing the deficit will be challenging due to ongoing social spending and support for Pemex, compounded by the depletion of the country's rainy day funds. To attract private investment and leverage the nearshoring trend, Sheinbaum will need to ensure reliable energy supplies and stable regulatory conditions. Enhancing public security is also essential to foster investment and economic growth. Despite the rise in debt being comparable to previous administrations, the sustainability of increased spending commitments, such as pensions and welfare programs, remains a concern for the new administration.

 

PEMEX and Energy

State-run Petróleos Mexicanos (Pemex) poses significant challenges for incoming Mexican president Claudia Sheinbaum. As the world's most indebted oil company, Pemex has transformed from a major revenue source, once contributing over 44% of government income, into a financial liability. With over $101 billion in debt, Pemex relies heavily on tax breaks and government cash injections to meet its financial obligations, presenting a substantial risk to the country's fiscal stability.

 

Pemex's debt has escalated to such an extent that it faces difficulties accessing debt markets, as investors demand higher interest rates to finance its operations. The current administration has attempted to reduce Pemex's debt by relying more on federal cash transfers rather than borrowing. Despite these efforts, the company faces substantial principal payments of $6.8 billion due in 2025, which adds to the financial strain on Sheinbaum's administration.

 

Sheinbaum has indicated her intention to continue the policies of her predecessor, Andrés Manuel López Obrador, who aimed to reinforce Pemex's dominance in the oil industry. López Obrador invested billions to boost refining capacity with the goal of making Mexico self-sufficient in motor fuels. However, Sheinbaum, with a background in environmental science, has also emphasized a commitment to renewable energy to meet future needs. How she plans to balance the support for Pemex with her renewable energy goals remains unclear, adding another layer of complexity to her administration's strategy.

 

Navigating Pemex's financial challenges will require Sheinbaum to strike a delicate balance between maintaining fiscal discipline and supporting the company's operations. The future of Pemex is crucial not only for Mexico's economy but also for Sheinbaum's broader environmental and economic policies. She will need to address Pemex's debt while also fostering investment in renewable energy to ensure a sustainable and diversified energy future for Mexico.

 

Mexico and Near Shoring

 

Mexico is poised to benefit significantly from the trend of nearshoring, as U.S. companies relocate factories closer to home, away from China. The incoming administration aims to capitalize on this by leveraging the U.S.-Mexico-Canada Agreement (USMCA) and Mexico's geographical proximity to the U.S. Sheinbaum has emphasized making the USMCA a cornerstone of Mexico's economic development. Despite these intentions, broad-based economic and foreign investment growth from nearshoring has yet to be fully realized.

 

Sheinbaum's administration plans to develop 100 industrial parks to attract manufacturing plants leaving China. This ambitious plan will necessitate expanding the country's electricity supply, which has been hampered by policies restricting foreign and private investment. Additionally, water shortages are worsening across the country, posing further challenges to communities and manufacturing plants. The country's industrial parks are nearing capacity, highlighting the need for further development. Mexico's recent achievement of surpassing China as the top foreign supplier of goods to the U.S. underlines its potential as a nearshoring hub.

 

Foreign direct investment in Mexico has remained strong, primarily driven by reinvestments from companies already operating in the country. This trend aligns with a significant increase in imports of equipment and machinery. However, several challenges need to be addressed to fully realize Mexico's nearshoring potential. These include improving infrastructure, particularly electricity, combating widespread crime and corruption, and reducing bureaucratic red tape.

 

Market Reaction

 

Following the election results, the peso fell 2.43% to 17.44 per dollar. The wide margin of victory for Mexico's ruling party raised concerns that the nationalist movement now has the authority to enact constitutional changes that opponents argue could weaken the country's democracy and increase state involvement in the economy. This led to a significant market reaction, with the Mexican peso sliding to its weakest level since November, and the stock market's benchmark IPC index dropping 6%, its largest percentage decline since the onset of the coronavirus pandemic in March 2020. The iShares MSCI Mexico ETF (EWW) fell 10.7% on heavy trading volume.

 

The declines in both the currency and the stock market reflect investor fears about Mexico's future and the potential for capital outflows. Gabriela Siller, head of analysis at Mexico's Banco Base, noted that these market movements are evidence of concerns about the country's economic stability and the impact of the proposed constitutional changes.

 

Does the Pullback Present an Opportunity in the EWW?

This is the million dollar question for investors. The iShares MSCI Mexico ETF (EWW) is the cleanest way to invest in Mexico. The country prepares for potential landmark changes. Many view the potential moves as being unfriendly to the markets but many felt that way about AMLO's measures, yet equities were able to push higher during his tenure.

One thing the market hates is a lack of clarity. There is an argument to be made that the clear cut victory by the Moreno party provides a clear direction for the economy. This may entice investors, especially given the uncertainty facing U.S. markets which are facing a tighter race and perhaps a split government that could lead to stalemates around necessary reforms. 

The EWW offers exposure to a broad range of companies in Mexico as it targets national stocks. It is a way for an investor to express a single country view. The investment aims to mirror the performance of the MSCI Mexico IMI 25/50 Index. The fund typically allocates at least 80% of its assets to the securities included in its underlying index and to investments that exhibit similar economic characteristics. The underlying index is a free float-adjusted, market capitalization-weighted index that tracks the performance of large-, mid-, and small-capitalization segments of the Mexican equity market. This fund is non-diversified.

The EWW ETF, launched on March 12, 1996, has an expense ratio of 0.50%. It tracks the MSCI Mexico IMI 25/50 Index and has a 30-day SEC yield of 2.41%. The fund holds 43 different assets, with total net assets amounting to $2.104 billion. The ETF is listed on the NYSE Arca exchange under the ticker EWW.

The ETF trades at a reasonable valuation of 11.5x forward Price to Earnings. 

The EWW ETF has shown strong performance across various time periods. Over the past year, the fund achieved a NAV return of 18.60%, with a market price return of 19.10%, closely matching its benchmark return of 19.00%. Over three years, the NAV return was 19.43%, and the market price return was 19.66%, slightly below the benchmark's 19.83%. For the five-year period, the fund returned 12.36% in NAV and 12.50% in market price, compared to the benchmark's 12.76%. Over ten years, the NAV return was 2.99%, and the market price return was 3.04%, while the benchmark returned 3.33%. Since inception, the fund has achieved a NAV return of 9.24% and a market price return of 9.25%, slightly below the benchmark's 9.79%.

The top 10 holdings of the EWW fund include a diverse array of major Mexican companies. The largest holding is GPO Finance Banorte, which makes up 10.69% of the fund's portfolio, followed by Fomento Economico Mexicano at 9.57%, and Walmart de Mexico V at 8.30%. Other significant holdings include America Movil B at 7.11%, Grupo Mexico B at 7.50%, and Cemex CPO at 4.56%. These companies represent a broad spectrum of industries, reflecting the fund's comprehensive approach to the Mexican equity market.

Rounding out the top 10 holdings are Grupo Financiero Inbursa Series O (2.86%), Grupo Bimbo A (2.87%), Grupo Aeroportuario del Pacifico (3.55%), and Grupo Aeroportuario del Sureste B (3.22%). Collectively, these top 10 holdings constitute 62.61% of the fund's total assets. The fund's heavy weighting in these companies indicates a strategic focus on key sectors and leading corporations within the Mexican market.

The EWW ETF's sector allocation is heavily weighted towards Consumer Staples, which comprises 32.60% of the portfolio. Financials follow with a significant 21.04% allocation. Materials account for 13.53% and Industrials for 12.76%. Communication services make up 9.75% of the fund, while Real Estate represents 7.96%. The fund has smaller exposures to Consumer Discretionary at 1.71%, Health Care at 0.47%, and Cash and/or Derivatives at 0.19%. This sector breakdown highlights the fund's focus on essential consumer goods and financial services, with notable investments in basic materials and industrial sectors.

The long-term chart of the EWW sets up as a nice cup and handle when we look at it on the yearly.

EWW Yearly

The monthly chart also sets up well for investors as this has been on a steady rise since hitting Covid lows back in early 2021. We would note that this rally has also come amidst AMLO's "market unfriendly" reign. 

EWW Monthly

Conclusion

To be clear, the rally has occurred alongside an extraordinary amount of wealth creation by central banks, as evidenced by the rise in fiscal debt. However, clarity is essential, and we anticipate more of it as Sheinbaum begins to unveil her plans and investors gauge her legislative agenda with the supermajority.

One positive aspect of the EWW is its significant allocation to Consumer Staples. This sector could benefit as Sheinbaum implements initiatives to lift constituents out of poverty, potentially increasing their purchasing power. 

How Sheinbaum addresses fiscal debt will be crucial for investors. If she enacts significant tax hikes targeting financials and capital gains, it could present a substantial headwind for equities. However, she will need to balance the need for increased revenue with the goal of making Mexico an attractive destination for nearshoring, which should help keep tax increases within reason.

In conclusion, Sheinbaum's rise should not be seen as a death knell for the EWW and Mexico's equity market. Investors should be mindful of the country's challenges and the potential for significant constitutional changes. AMLO's legislative actions before his retirement, particularly in September, should be closely monitored. Historically, this is a weaker period for U.S. markets and precedes the Presidential elections. 

Our main takeaway is to wait for Sheinbaum to make specific announcements before taking any action. The current pullback in the EWW could represent a buying opportunity, but it is prudent to wait and gain a clearer understanding of the country's direction before making investment decisions.

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