Insights
Global Macro Trends
Volume 4.4 • May 2014
Mexico: Different
Investment Lens Required
By Henry H. McVey, Head of Global Macro & Asset Allocation
And Vance Serchuk, Executive Director of the KKR Global Institute
Mexico: Different
Investment Lens Required
KKR Global Macro & Asset
Allocation Team
Henry H. McVey
Head of Global Macro &
Asset Allocation
+1 (212) 519.1628
[email protected]
David R. McNellis
+1 (212) 519.1629
[email protected]
Frances B. Lim
+1 (212) 519.1630
[email protected]
Rebecca J. Ramsey
+1 (212) 519.1631
[email protected]
Jaime Villa
+1 (212) 401.0379
[email protected]
Special thanks to Vance Serchuk,
Executive Director of the KKR Global
Institute, who co-authored this report
and provides valuable geopolitical
advice to the KKR Global Macro & Asset
Allocation Team on an ongoing basis.
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KKR Insights: Global Macro Trends
All
Given both the breadth and depth of a new reform
agenda, we think Mexico is approaching an inflection
point that offers the opportunity to invest in both the
equity and debt of companies that can finally take
advantage of a more level playing field as the prior
regime of monopolistic pricing in several key industries
is disrupted. Importantly, investing in Mexico requires
that an investor look through a different emerging
market lens. Specifically, Mexico is not a pure-play
urbanization story nor is it a low GDP-per-capita story
that has the potential to double overnight. Also, unlike
many of the Asian countries that we visit, Mexico’s
fortunes may actually be non-correlated, or potentially
even inversely linked to China’s success. Rather, with
87% of its exports destined for the United States
and the government committed to expanding trade
agreements with both Asia-Pacific and Latin American
peers, Mexico is much more of an open economy
investment story than many of the other emerging
markets countries many investors know.
“
Always bear in mind that your
own resolution to succeed is more
important than any other.
”
Abraham Lincoln
16th President of the United States
As someone who has been married to a Houston, Texas native for
almost 14 years, it should come as no surprise to folks that I have
spent a considerable amount of time enjoying the many compelling
cultural aspects of Mexico. In fact, I spent my honeymoon in Cabo
San Lucas on the west coast of the country in 2000, and in recent
years my family, often using Houston as a jumping-off point, has
explored various destinations throughout Mexico.
However, over the past few months my trips to Mexico have been
more frequent—but less family-oriented. Specifically, with President
Enrique Peña Nieto’s “resolution to succeed” in delivering broadbased reforms across energy, financial services and telecommunications gaining momentum, my colleague Vance Serchuk, the Executive Director of the KKR Global Institute, and I have visited Mexico
several times to try to better understand what we now believe is an
inflection point in the country’s political and economic history.
Importantly, beyond the robust contacts we now enjoy through the
KKR Global Institute on the geopolitical and macro side, KKR also
has a notable footprint In Mexico though its private equity effort
as well as its 10 portfolio companies, which employ nearly 12,000
people across Mexico.
So what are our big-picture thoughts on Mexico and how should
investors position their portfolios? See below for details:
• Simply stated, Mexico requires a different investment playbook than that of many of its emerging market peers. Already,
consumption is a robust 69% of GDP1, GDP-per-capita is high
at around $11,0002, and urbanization stands at almost 80%3.
Mexico is also an extremely open, services-based economy,
with major bilateral trade agreements with more than 40 countries. Finally, with 87% of its exports going to the U.S. and the
country poised to benefit from growing access to cheap U.S.
natural gas, Mexico is more closely linked to North American
growth – not China’s GDP trajectory4.
• With small current account and fiscal deficits, Mexico has
been a good emerging markets (EM) investment story since
the Great Recession. However, as we describe below in more
detail, we think Mexico has the potential to be a great one if it
executes on the structural reform agenda put forth by President Peña Nieto. All told, potential GDP growth could increase
to approximately 4.5% from 2.8%, we believe.
• Contrary to press reports of late, Mexico is not just a pure-play
energy reform story. To be sure, energy reform is an important
piece of the macro puzzle (e.g., current receipts from PEMEX
account for fully one-third of tax revenues5), but a comprehensive overhaul of the sector is crucial because – without
1Data as at February 21, 2014. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
2Data as at April 13, 2014. Source: World Bank, IMF, Haver Analytics.
it – Mexico cannot achieve the efficiencies in other areas of
its economy, including manufacturing, exports, logistics, and
electricity that it so desperately needs.
• To date, though, Mexico remains a “show me” story. For starters, Mexico’s productivity growth has been running, on average, at only half that of Brazil, 1/8 of India, and 1/16 of China
since 19906. More recently, GDP growth has been lackluster,
consumer confidence is down, and unemployment is rising
again. Our bottom line: The current administration should deliver
not only on its long-term reform agenda to improve productivity
but also on its tactical mandates, including infrastructure spending
and public works, to boost growth during this transition period.
• As the reform agenda gains momentum, we believe strongly
that asset allocators would benefit more from owning smalland mid-cap Mexican equities versus higher profile largecapitalization stocks. Already, since July 2012, which coincides
with the election of Peña Nieto, the Mexico IMC 30 Index, Mexico’s mid-cap index, has outperformed the large-capitalization
index (Mexican Bolsa IPC Index) and the MSCI Mexico by 46%
and 44%, respectively7. Separately, we also think that private
credit and non-bank financing represent notable opportunities,
particularly given 80%+ concentration of the banking sector
by just seven or eight financial institutions that cater largely to
mega-cap and multinational corporations8.
• Though we are positive, the Mexico story still has several key
geopolitical and macro risks. In particular, weakness in rule
of law institutions—and the associated problems of criminality, violence and corruption—still acts as a significant drag on
GDP. All told, Grupo de Economistas y Asociados estimates that
annual GDP would be 600 basis points higher if money spent by
the government on national security went to households to boost
private consumption9. Finally, while the reform agenda of President Peña Nieto is well defined and credible, Mexican history is
littered with reform stories that stumbled in implementation.
Our bottom line: Given both the breadth and depth of the current
reform agenda, we think Mexico is approaching an inflection point
that offers the opportunity to invest in both the equity and debt of
companies that can finally take advantage of a more level playing field as the prior regime of monopolistic pricing in several key
industries is disrupted. If we are right, then Mexico’s equity market
capitalization as a percentage of GDP could increase notably from
its current level of just 40% of GDP (Exhibit 1). From a sector
perspective, we are bullish on real estate, financial services, energy
services, infrastructure, healthcare, and logistics.
6Data as at January 31, 2013. Source: OECD.
7Data as at April 30, 2014. Source: Bloomberg.
4Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
8Data as at December 31, 2013. Source: J.P. Morgan estimates, Central
Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras
(Chile),Superintendencia Financiera de Colombia, Comision Nacional
Bancaria y de Valores (Mexico), and Superintendencia de Banca, Seguros, Y
AFP (Peru).
5 http://www.ri.pemex.com/files/content/Pemex_Outlook_I_120906%20
%28New%20Investors%29_ri.pdf
9Data as at April 11, 2014. Source: Global Source Partners, “Mexico: Outlook
and Challenges Ahead.”
3 Ibid.1.
KKR
Insights: Global Macro Trends
3
Exhibit 3
Exhibit 1
The Potential for Better Equity Representation Relative to
GDP in Mexico Is Now Significant
Stock Market Capitalization as a % GDP
130%
We Expect Mid-Capitalization To Narrow the Gap With
Their Larger Peers…
Average Company Market Cap
8,000
110%
$6,684
7,000
96%
68%
6,000
58%
48% 45%
41% 40%
$5,013
5,000
32% 31%
4,000
Turkey
Russia
Mexico
China
Brazil
Indonesia
Colombia
India
Chile
South Korea
South Africa
3,000
$1,980
2,000
1,000
0
Data as at April 18, 2014. Source: Bloomberg.
IMC30
MEXBOL
MSCI Mexico
Data as at April 30, 2014. Source: Bloomberg, MSCI, Factset.
Exhibit 2
Mexican Mid-Cap Stocks Have Outperformed Large-Cap
Stocks by a Wide Margin Since the Election of Peña Nieto
in July 2012
Exhibit 4
..Driven By Valuation Convergence and Stronger Growth
of Mid-Cap Stocks
Relative Performance of Mexican Mid-Cap vs. Large-Cap Stocks
Indexed: July 2012 = 100
NTM P/E By Sector
IMC30
30
IMC30
MEXBOL
MSCI Mexico
150
25
15
130
Jan-13 Apr-13
Jul-13
Oct-13
Jan-14 Apr-14
Data as at April 30, 2014. Source: Bloomberg, MSCI.
“
Mexico requires a different
investment playbook than
that of many of its emerging
market peers.
“
KKR
Insights: Global Macro Trends
Materials
Telecomunications
Oct-12
Health Care
90
Consumer
Discretionary
Consumer Staples
110
Industrials
5
Financials
10
120
100
4
MEXBOL
20
140
80
Jul-12
MSCI Mexico
Data as at April 30, 2014. Source: Bloomberg, MSCI, Factset.
For investors who run hedged or market neutral portfolios, we also
think that there is significant opportunity. Specifically, while we
expect mid-cap stocks to outperform, we expect many of the largecapitalization stocks to underperform as reforms gain momentum.
On the fixed income side, we favor shorter-duration local bonds,
and we suggest investors begin to gain exposure to the limited
supply of local corporate bonds, financial services in particular.
Importantly, unlike many other EM countries we follow, we do not
think that currency hedging would be required on either the fixed
income or equity side.
Exhibit 5
Mexico Enjoys Both Geographic and Economic Diversity
9-Mar-95
7.45
7.50
30-Jan-95
6.35
7.00
6.50
6.00
27-Dec-94
5.70
5.50
5.00
4.50
4.00
19-Dec-94
3.46
3.50
May-95
Apr-95
Mar-95
Feb-95
3.00
Jan-95
In the end the Mexican peso depreciated almost 40%, falling to
5.70 pesos against the US dollar from 3.46 in a week’s time during
December 1994. Thereafter, it weakened further to 7.91 by year-end
199511. The United States was ultimately forced to intervene, providing $50 billion in loan guarantees to Mexico under the direction of
then-President Bill Clinton and Treasury Secretary Robert Rubin.
MXN Currency
8.00
Dec-94
While Mexico – like its global peers – enjoyed some healthy economic and stock market gains during the 1991-1993 period, 1994
was quite the opposite. Specifically, the negative effects of high
debt loads, weak government finances, big deficits and a suspect
currency all caught up with the Mexican economy and its investor base. During the course of 1994, Mexican stocks fell 72% on
average, while short-dated interest rates increased from 9.5% in
February 1994 to 41.7% in February 1995, causing massive losses
for fixed income investors10.
Mexico Suffered A Major Crisis Of Confidence In 1994…
Nov-94
“Deserve your dream.” Octavio Paz (Mexican writer, poet and diplomat, 1914-1998)
Exhibit 6
Oct-94
Mexico Since NAFTA
Data as at December 31, 1995. Source: Bloomberg.
Exhibit 7
…Leading to a Decline in Inflation and Sparking a
Secular Bull Market in Fixed Income
40%
Interest Rates Decomposed Between
Inflation and Growth
35%
Inflation
30%
Potential Growth
25%
Short Term Rate
20%
15%
10%
5%
0%
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source: U.S. Department of State, Getty Images.
As the country transitioned out of the Tequila Crisis in 1994/1995
and into NAFTA, the Mexican government implemented a series of
deliberate policies that rewarded stability, including smaller fiscal
imbalances in the public sector, less private sector leverage and
more industry concentration. Not surprisingly, against this macro
backdrop, bond investors were rewarded more than equity investors as the risk premium associated with fixed income investments
in Mexico declined precipitously during this period (Exhibits 6 and 7).
10Data as at December 31, 1994 and February 28, 1995. Source: Bloomberg.
11Data as at December 31, 1994. Source: Bloomberg.
Data as December 31, 2013. Source: Organization for Economic
Cooperation & Development, Haver Analytics.
But the fiscal restraint and industry concentration also stifled
productivity. As Exhibits 8 shows, Mexico’s productivity has been
running significantly below its peers for quite some time. Separately, there has also been too little spending on fixed investment,
which has been running at just around 20% of GDP versus 40%+ in
China12. So, while favorable demographics have been growth supportive, the Mexican economy has clearly been undershooting its
potential, particularly in terms of GDP-per-capita growth.
12Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, China National Bureau of Statistics, Haver Analytics.
KKR
Insights: Global Macro Trends
5
Exhibit 8
Exhibit 10
Industry Concentrations Created Economic Stability, but
Have Also Dented Innovation and Productivity
Mexican IPC Index: Stock Market Cap Concentration
8.9%
1.6%
2.0%
2.8%
4.0%
8.1%
US
Peru
Chile
India
China
Mexico Colombia Brazil
Data as at 4Q13. Source: Conference Board Total Economy Data Base,
McKinsey.
20 20
19
18
21
22
52 52 54 58 55 55
60 54
53
53 52 58
Current
1.1%
18
2012
0.8%
19
2011
0.5%
1.7%
18
2010
0.5%
2.9%
2.9%
20 20
2009
2.1%
2.4%
2.2%
18
2008
2.7%
2.6%
2.2%
Remaining Stocks
20 25 25
29 28 26 24 26 27 27 28 25
2007
3.4%
4.9%
100
90
80
70
60
50
40
30
20
10
0
Next 5 Largest
2006
6.2%
4.8%
5 Largest Stocks
0.8%
2005
Productivity Growth
2002
Labor Force Growth
2004
Decomposition of Annualized GDP Growth
1990-2013
2003
Low Productivity Has Hurt Mexico’s Growth
Data as at March 31, 2014. Source: FactSet.
Exhibit 9
GDP-per-Hour Worked Suggests Mexico Still Has a Long
Way to Go on the Productivity Front
90
Units of GDP-Per-Hour Worked (U.S.$)
Exhibit 11
Industrial Electricity Prices Are a Good Proxy for
Mexico’s Structural Inefficiencies
Electricity Prices for Industry
U.S. $ MWh
80
70
Mexico
126.0
60
U.S.
121.5
115.3
50
40
104.0
102.1
30
114.7
20
86.2
10
MEX
RUS
POL
TUR
KOR
JPN
OECD
ITA
CAN
GBR
ESP
AUS
SWE
DEU
FRA
USA
IRL
NOR
0
63.9
68.3
68.1
67.9
68.2
67.0
68.1
Data as at January 31, 2013. Source: Organization for Economic
Cooperation & Development (OECD).
2007
2008
2009
2010
2011
2012
2013
Data as at April 8, 2014. Source: OECD.
“
Because of its low-cost labor
force, the country is making
considerable progress in
key export sectors like auto
manufacturing.
“
6
KKR
Insights: Global Macro Trends
Looking ahead however, there are several reasons we believe
that Mexico could now enjoy a fundamentally different position in
the global economy. First, while several deficit-heavy emerging
markets are now being tarred with acronyms like the Fragile Five13,
Mexico is emerging as somewhat of a safe haven, given its small
fiscal imbalances and its independent central bank. Second, the
country is now in the “sweet spot” of its demography: The median
13 In 2013, Morgan Stanley declared the Brazilian real, the Indonesian rupiah,
the South African rand, the Indian rupee, and the Turkish lira as the “Fragile
Five,” or the troubled emerging market currencies under the most pressure
against the U.S. dollar.
age stands at just 27 years14. Third, because of its low-cost labor
force, the country is making considerable progress in key export
sectors like auto manufacturing. All told, total trade including both
exports and imports reached a sizeable 65%15 of GDP in 2013. As
a result, the country’s economy has become more industrialized
(Exhibits 12 and 13).
Exhibit 14
Wages Are Now More Competitive With China
Manufacturing Wages (US$ per hour)
3.5
China
Mexico
3.0
Exhibit 12
Trade Is Helping Mexico Become More Industrialized…
2.5
2013 Mexico GDP By Major Industry Category
1994
70%
Industry has
become a more
important sector
of the economy
60%
50%
40%
Agriculture has
become a smaller
share of GDP
30%
20%
29.5%
61.5% 59.6%
1.5
1.0
32.7%
Taxes have
generally declined
4.6% 3.9%
4.5% 3.8%
10%
2.0
2013
0%
Agriculture
and Livestock
Industry
Services
0.5
2002
2004
2006
2008
2010
2012
Data as at December 31, 2013. Source: ILO, INEGI, CEIC, Morgan Stanley
Research.
Taxes on
Products
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
Exhibit 15
Mexico’s Working Age Population Will Peak In 2042,
Twenty-Eight Years After China’s
Exhibit 13
Working Age Population Indexed: 1990 = 100
…And Is Also a Substantial Driver of the Services Sector
Mexico GDP: Trade Services as a % of Services
29%
180
Mexico
Brazil
Chile
Peru
China
2048
160
27%
2033
2026
140
2042
25%
120
2014
23%
100
21%
80
19%
Data as at February 21, 2014. Source: Instituto Brasileiro de Geografia
e Estatística, Instituto Nacional de Estadística Geografía e Informática,
Haver Analytics.
14Data as at July 9, 2013. Source: United Nations World Population Prospects,
Haver Analytics.
15See Shannon O’Neil, “Mexico Makes It,” Foreign Affairs, March/April 2013.
2055
2060
2050
2045
2040
2035
2030
2025
2015
2020
2010
2005
2000
1990
Mar-94
Jun-95
Sep-96
Dec-97
Mar-99
Jun-00
Sep-01
Dec-02
Mar-04
Jun-05
Sep-06
Dec-07
Mar-09
Jun-10
Sep-11
Dec-12
15%
1995
60
17%
Data as at July 12, 2013. Source: United Nations, Haver Analytics.
Fourth, unlike many other EM stories, Mexico’s fortunes are not tied
to a slowing Chinese economy. Rather, Mexico actually benefits
from a close relationship with the United States. Indeed, twenty
years since NAFTA, the U.S. and Mexican economies have become
deeply interwoven with the establishment of regional supply chains.
In fact, U.S.-Mexican trade crossed the $500 billion mark last year,
cementing Mexico’s role as the United States’ third largest trading
partner16.
16Office of the United States Trade Representative http://www.ustr.gov/
countries-regions/americas/mexico
KKR
Insights: Global Macro Trends
7
Exhibit 16
Structural Reforms Could Have a Meaningful Impact on GDP by Some Estimates
Possible Structural Reforms Affect on GDP Growth, (%)
2.5 - 3.0%
+0.1%
Natural GDP Growth
Rate
Labor Reform
4.4 - 4.9%
+1.0%
+0.3%
Energy Reform
Financial Reform
+0.5%
Telecom Reform
New Natural GDP
Growth Rate (2019)
Data as at April 11, 2014. Source: Grupo de Economistas y Asociados, Instituto Nacional de Estadística Geografía e Informática, Banxico and SHCP.
But more important than the aforementioned macro tailwinds at this
point in its economic history is the potential for the current reform
agenda to accelerate structural growth in Mexico. All told, potential
GDP growth could improve to 4.4-4.9% from 2.8%, we believe, by
2019. One can see the building blocks of this potential acceleration in Exhibit 16. If this view is right, then productivity – and hence
GDP-per-capita – should finally start to reaccelerate back towards
levels commensurate with the country’s underlying potential. In addition, as corporate competition is encouraged, the country’s market
capitalization as a percentage of GDP could appreciate meaningfully.
However, to ensure that it takes full advantage of its potential,
Mexico should use the reforms as catalysts to not only break down
current industry rigidities but also to improve participation, productivity, and profitability outside its mega-cap sector to include a
wider swath of companies across more industries. The opportunity
for improvement certainly appears sizeable, we believe. Just consider that electricity prices for industry use were, on average, a full
78% higher in Mexico versus in the United States17.
Exhibit 17
Private Credit in Mexico Is Quite Low…
2012 Domestic Credit to Private Sector by
Banks as a % GDP
184
U.S.
177
Japan
148
Korea
134
China
121
Singapore
118
Malaysia
95
Vietnam
68
Brazil
54
Turkey
51
India
Indonesia
35
Philippines
33
Mexico
28
Data as at July 4, 2013. Source: World Bank, Haver Analytics.
In addition, the government should work harder to open and grow
credit channels back towards more normalized levels. Without
question, this initiative may require a major overhaul of a clubby
banking system that currently seems content to only lend to the
highest quality credits.
“
If there is a ‘swing factor’ in
the Mexico macro story, we
think it starts and ends with the
government.
“
17Data as at December 31, 2013. Source: OECD.
8
KKR
Insights: Global Macro Trends
Exhibit 18
…Which Is Consistent With the View That Overall Credit
Penetration in Mexico Is Subdued
Mexico: Credit as a % of GDP
28.5
43.6
9.9
5.2
Consumer
Mortgage %
Corporate Credit % GDP
Credit % GDP
GDP
Credit % GDP
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
Beyond more broad-based lending, we think that development of
a deeper corporate bond market should also be a priority. To date
though, the Mexican fixed income market has remained largely a forum for primarily sovereign credits. Finally, the government should
deliver on more and better energy production, which we think is a
prerequisite to many of the other aforementioned reform initiatives.
Key Themes/GDP Analysis
In the following section we drill down on some of the key macro
and geopolitical trends in Mexico. In so doing, we break down the
various components of the Mexican economy, including private and
government consumption, exports, and fixed investments. Finally,
we close with some thoughts on Mexican financial services as well
as on criminality and rule of law, which we view as important risk
factors for investors to consider.
as “the perfect dictatorship”—it has since developed into a genuine
multiparty democracy with a strong civil society and independent
institutions including a well-respected Supreme Court, and a
legislature in which no faction controls a majority of seats.
The key question now is how successfully the 2013 reforms are
brought into effect. This involves at least two distinct challenges.
The first and most immediate is the need to adopt secondary legislation in the Mexican Congress. Unlike the constitutional changes of
2013, passage of these bills will not require parliamentary supermajorities. Rather, a simple majority will ultimately be achievable for the ruling party, the Partido Revolucionario Institucional
(PRI). However, the situation remains fluid, so we will need to
watch closely what the proposed bills actually put in place as the
devil will be in the details.
Exhibit 19
The Structural Reform Agenda Is Impressive, Particularly
When Compared to What Was Accomplished During the
Previous 18 Years
Selected Structural Reforms
1993-2011
2012-2013
NAFTA (1994)
Labor
Banxico’s Autonomy (1995)
Educational
Private Pension Reform (1997)
Telecom
Balanced Budget Reform
(2006)
Fiscal
Energy
Financial
Economic Competition
Data as at March 31, 2014. Source: Global Source Partners.
“It’s the Government, Stupid”
If there is a “swing factor” in the Mexico macro story, we think it
starts and ends with the government. The succession of reforms
adopted in Mexico since early 2013 is unprecedented in its scope
and breadth—and certainly the most sweeping since the passage of
NAFTA twenty years ago. While the constitutional changes ending the state monopoly on investment in the energy sector have
naturally captured the greatest international attention, it has been
accompanied by a series of other historic measures, including overhauls in telecommunications, fiscal affairs, education, labor markets and electoral rules. What paved the way to passage of these
measures was the Pact for Mexico (“Pacto por Mexico”), a grand
bargain-like agreement orchestrated in late 2012 by then-Presidentelect Peña Nieto and his team, and endorsed by the three major
Mexican political parties.
The 2013 reforms build upon a foundation of broader economic and
political changes in Mexico since NAFTA came into effect in 1994.
Whereas in the early 1990s, Mexico was still a one-party state—
famously described by Peruvian Nobel Laureate Mario Vargas Llosa
“
We think Mexico is approaching
an inflection point that offers the
opportunity to invest in both the
equity and debt of companies
that can finally take advantage
of a more level playing field.
“
KKR
Insights: Global Macro Trends
9
There is also risk that political momentum behind the reforms could
stall. In particular, Peña Nieto could face internal pressure within
the PRI as 2015 congressional elections approach. As with Prime
Minister Abe and the Liberal Democratic Party (LDP) in Japan, we
have the paradox in Mexico of a long-ruling party that is back in
power after a spell in the political wilderness, with a reform-minded
chief executive who is taking on entrenched, growth-sapping interest groups, which also happen to be the historic base of his own
party. There is also likely to be mainstream resistance in Mexico,
including legal challenges and protests, which could delay reform
implementations that lack decisive public support.
Exhibit 20
PEMEX’s Output Per Employee Is Well Below Its Foreign
Counterparts
Barrels of Oil Produced
per Employee per Day (2012)
Statoil
Ecopetrol
ExxonMobil
BP
For foreign investors, the most important litmus test over the coming
months will be the trajectory of energy sector reform: If Mexico can
get this right, it will unlock the door for other sources of growth and
renewal; conversely, if it stumbles on energy, all other efforts may
prove for naught.
Shell
Petrobras
PEMEX
0
20
40
60
80
We remain optimistic here. Despite concern about the delay of implementing secondary legislation, we are confident market-friendly
laws will pass Congress in the coming months, Our base case is
that it occurs during a special congressional session this summer,
or in the worst case scenario, in the autumn.
Data as at August 10, 2013 for 2012. Source: The Economist, CIDAC
Mexico, Statoil, Ecopetrol, Exxon Mobil, BP, Shell, Petrobras, Pemex
annual reports.
The second challenge is institutional, as the Mexican government
is now planning to establish or beef up its regulations, procedures
and regulatory bodies. In the case of energy reform for instance,
the National Hydrocarbon Commission is expected to be reconstituted, while a new Energy Regulatory Commission is anticipated
as well. Without question, attracting the necessary talent to these
new bodies (e.g., engineers and geologists) may prove challenging
and time-consuming at a time when international companies are
also increasing their staffing needs in Mexico. Mexico also lacks
four-year undergraduate degree programs in oil engineering and
local university-level expertise in this field. However, our contacts
in Mexico indicate that, given the changing nature of the energy
opportunity set, there is an effort underway to recruit Venezuelan
teachers to remedy PEMEX being the sole training mechanism in
the oil services and engineering fields in Mexico.
Parallel to the legislative activity is the “Round Zero” lease allocation, under which it will be determined how much of PEMEX’s
current acreage it is allowed to keep. PEMEX has proposed to
retain 83% of its proven and probable oil reserves, and 31% of its
prospective resources18. Mexico’s Energy Ministry (SENER) has
until mid-September to determine if the company has the fiscal and
technical ability to develop these fields. Following the completion
of Round Zero, the deal making between PEMEX and international
energy companies will begin, as will a secondary process under
which new acreage—including deepwater and shale opportunities—
are opened to auction.
18March 25, 2014, “Pemex presents wish list to energy ministry,” Financial
Times.
Exhibit 21
PEMEX Oil Production Has Been Plagued by Inefficiencies, Resulting In Reduced Production
PEMEX Oil Poduction by Fields, Thousands of Barrels per Day
4000
Cantarell
Ku-Maloob-Zaap
Other
3500
3000
2500
2000
1500
1000
500
0
2003
2004
2005
Source: Pemex, OECD Economic Surveys Mexico 2013.
10
KKR
Insights: Global Macro Trends
2006
2007
2008
2009
2010
2011
2012
Given the availability of low-cost U.S.-produced shale gas from just
across the border in Texas as well as the security challenges surrounding the geography of Mexico’s own shale gas, we think that—at least in
the short to medium term—energy reform is going to be more focused
on oil, particularly using foreign partnerships and new technologies to
yield greater efficiencies at mature fields.
The bottom line here, we think, is that the reform agenda—including energy reform—still faces significant political and operational
obstacles to implementation. As such, we think investor expectations need to be kept in check about the pace of delivery. It will
not happen overnight, and there will certainly be continued bumps
along the way. But that shouldn’t obscure what we see as the far
bigger story, which is that Mexico is one of very few countries in
the world today—either emerging or developed—where smart, effective political leadership is successfully pushing through historic,
market-friendly structural change that could meaningfully boost the
country’s equity market capitalization over the next five to seven
years.
Beyond the reform agenda, however, there is still a lot of day-to-day
work that needs to be done by this government. In particular, we
feel strongly the government should be more effective in pushing
through the necessary spending required to reignite GDP, pay suppliers in the private markets and encourage both consumer and corporate innovation/risk-taking. This was clearly not the case in 2013
as GDP reached a meager 1.2%, which is actually even below the
country’s population growth of 2.0%19. Corporate executives, unnerved by erratic spending patterns of the government early in the
year, retrenched in the second half of the year. At the same time,
consumer confidence tumbled as the fall-out from higher taxes was
not fully understood by the country’s middle class (Exhibit 24).
Exhibit 22
Exhibit 23
Mexico Is Behind Many of its Peers On Government
Spending
2013 Government Consumption as a % of GDP
19.4%
16.6%
13.5%
11.1%
11.3%
7.7%
Indonesia
Mexico
India
China Colombia
Brazil
Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia
e Estatística, Departamento Administrativo Nacional de Estadísticas,
Instituto Nacional de Estadística Geografía e Informática, Central
Statistical Organization, India Badan Pusat Statistik, China National
Bureau of Statistics, Haver Analytics.
In the early parts of this year the government has begun to spend
again. In fact, according to the latest public statistics, the government was running a 62 billion deficit (pesos) as of 1Q2014, versus a
40 billion surplus at the same time year ago20. Meanwhile, based on
our research, business activity in the U.S. appears to be reaccelerating in April/May, which should also help to start to pull economic
activity in Mexico forward.
We Believe That More Government Spending Is
Necessary to Drive Growth in the Economy
Mexico Government Consumption as a % of GDP, 1994-2013
15%
Dec-95
14%
14%
13%
Dec-14
11%
12%
11%
10%
9%
Jun-12
Sep-13
Mar-11
Dec-09
Jun-07
Sep-08
Mar-06
Dec-04
Sep-03
Mar-01
Jun-02
Dec-99
Jun-97
Sep-98
Mar-96
Dec-94
8%
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática.
19Data as at July 9, 2013. Source: United Nations World Population Prospects,
Haver Analytics.
“
Overall, we think that investors
can take some comfort in the
fact that the government has the
capacity to spend quite a bit
more and not affect its standing
in the global markets.
“
20Data as at March 31, 2014. Source: Secretaria de Hacienda y Credito Publico,
Bloomberg.
KKR
Insights: Global Macro Trends
11
Exhibit 24
Consumer Confidence Has Begun to Rebound In Recent
Weeks…
115
Mexico: Consumer Sentiment (Monthly,%)
110
Overall, we think that investors can take some comfort in the fact
that the government has the capacity to spend quite a bit more and
not affect its standing in the global markets. As Exhibit 26 shows,
even with increased outlays in 2014, Mexico’s fiscal deficit is likely
to remain under control. The country’s debt to GDP also remains
modest at 46%, well below Brazil, India and the United States.
Exhibit 26
105
The Fiscal Gap Is Expected to Peak This Year
100
Fiscal Balance
95
Revenue (R)
Expenditures (R)
90
4
% GDP
% GDP
30
85
28
2
Oct-13
Dec-12
Apr-11
Feb-12
Jun-10
Oct-08
Aug-09
Feb-07
Dec-07
Apr-06
Jun-05
Oct-03
Aug-04
Dec-02
Apr-01
Feb-02
80
Data as at April 30, 2014. Source: INEGI, Haver Analytics.
26
24
0
22
20
-2
18
16
-4
Exhibit 25
…Because the Government Has Finally Started Spending
Again
Planned Public Spending in Mexico
Annual Nominal Growth
2014
-4.1
-6
Data as at March 28, 2014. Source: IMF, Haver Analytics.
Exhibit 27
9%
7%
9%
Government Leverage Remains Modest
9%
2013 General Government Gross Debt as a % of GDP
243
Japan
-7%
2009
2010
2011
2012
2013
2014E
E=estimate. Data as at December 31, 2013. Source: Interacciones and
SHOP.
U.S.
105
Singapore
104
India
67
Brazil
66
Malaysia
58
Vietnam
55
46
Mexico
“
There is potential for the current
reform agenda to accelerate
structural growth in Mexico.
“
12
KKR
12
90 92 94 96 98 00 02 04 06 08 10 12 14 16 18
22%
17%
2008
14
Insights: Global Macro Trends
Philippines
38
Korea
37
Turkey
36
Indonesia
26
China
22
Data as at April 8, 2014. Source: IMF, Haver Analytics.
Exhibit 28
Mexico’s Strong Fundamentals Are Reflected in Credit
Ratings and Pricing
300
Russia
5 Year CDS Spread
250
India
200
Turkey
South
Africa
Indonesia
150
Brazil
100
Italy
Colombia
Spain
50
0
Poland
South Korea
A+
A-
BBB
BBB-
BB+
S&P Rating
Data as at April 28, 2014. Source: Bloomberg, S&P Ratings, KKR Global
Macro & Asset Allocation analysis.
Exhibit 29
Low Inflation and a Strong Currency Already Make
Mexico a More Attractive Destination for Foreign Capital
Than Many of Its Global Peers
Decomposition of Emerging Market Country Risk Premium
16.0%
Inflation & Currency Risk
Country Credit Risk
14.0%
12.0%
8.4%
9.0%
8.4%
8.1%
10.0%
7.2%
8.0%
6.0%
4.0%
2.0%
1.4%
2.1%
2.3%
Mexico
Brazil
4.6%
4.1%
South
Africa
India
5.1%
Exhibit 30
The Personal Income Tax Rate in Mexico Appears Too
Low…
2014 Highest Rates of Personal Income Tax
Mexico
BBB+
and the military and federal government21. Moreover, of those that
do pay taxes, both the personal income rate and the VAT appear
too low relative to other countries. Exhibits 30 and 31 provide some
perspective on Mexico’s low tax burden. This imbalance in the
composition of the labor force has placed a large burden on select
individuals and corporations, including PEMEX, that ultimately end
up being responsible for paying the taxes of the entire nation.
5.5%
0.0%
Russia Indonesia
57
56
Sweden
Denmark
Spain
Netherlands
Japan
Portugal
Israel
Ireland
Norway
U.K.
Germany
France
China
Australia
Italy
Greece
South Africa
Chile
U.S.
Turkey
Korea
Argentina
Venezuela
India
Colombia
Poland
Peru
Mexico
Indonesia
Canada
Brazil
Czech Rep
Singapore
Hungary
Russia
52
52
51
48
48
48
47
45
45
45
45
45
43
42
40
40
40
35
35
35
34
34
33
32
30
30
30
29
28
22
20
16
13
Data as of 2014. Source: KPMG International. http://www.kpmg.com/
Global/en/services/Tax/tax-tools-and-resources/Pages/individualincome-tax-rates-table.aspx
Data as at March 31, 2014. Source: JPMorgan, Bloomberg, KKR Global
Macro & Asset Allocation analysis.
Separately, the government should also do more to reduce the
share of the sizeable and highly unproductive informal economy.
All told, the Mexican labor force is composed of approximately 50
million workers, of which we think only a third are formal workers who pay taxes. The remaining two-thirds of the Mexican work
force are evenly split between the informal sector of the economy
21Data as at 2013. Source: OECD. http://www.oecd.org/mexico/OECDSocietyAtaGlance2014-Highlights-Mexico.pdf
KKR
Insights: Global Macro Trends
13
Exhibit 31
…As Does the VAT, Especially When Considering the Size
of the Informal Sector
2014 Indirect Tax Rate / VAT
Hungary
Sweden
Norway
Denmark
China
Finland
Portugal
Poland
Ireland
Greece
Italy
Netherlands
Czech Rep
Belgium
Argentina
U.K.
Austria
France
Germany
Chile
Brazil
Turkey
Spain
Russia
Israel
Mexico
Colombia
New Zealand
Venezuela
Korea
Australia
Switzerland
U.S.
Japan
Canada
27
25
25
25
25
24
23
23
23
23
22
21
21
21
21
20
20
20
19
19
19
18
18
18
18
16
16
15
12
10
10
8
8
position that is expected to improve modestly over time22. Probably
more important to the investment community however, is that Mexican consumers now spend north of $700 billion annually, ranking
them #7 worldwide in absolute dollars consumed. One can see this
in Exhibit 33. Besides its large and growing population base, what
else is interesting about Mexico is that consumption is already a
sizeable part of GDP. Indeed, as Exhibits 32 and 33 illustrate, Mexico
is at the high end of its emerging market peers in this respect.
Exhibit 32
Mexico’s GDP Composition Is Heavily Weighted Towards
Consumption
2013 GDP Composition
Mexico
69
Brazil
China
62
48
36
32
22
12
22
29
18
13
13
3
-1 -2
Consumption Government Investment Net Exports
Exports
Data as at February 21, 2014. Source: Instituto Brasileiro de Geografia
e Estatística, China National Bureau of Statistics, Instituto Nacional de
Estadística Geografía e Informática, Haver Analytics.
5
5
Data as of 2014. Source: KPMG International. http://www.kpmg.com/
Global/en/services/Tax/tax-tools-and-resources/Pages/indirect-taxrates-table.aspx
Longer-term, this approach to tax collection is unsustainable if
Mexico is to modernize. Given this view, we believe strongly that
one of this government’s legacies should be to reengineer its tax
system so that it not only generates more revenue but can also
facilitate spending more on key initiatives like healthcare, education,
infrastructure and technology. No doubt, this task will not be easy.
However, as we have seen in other emerging market countries that
have expanded their tax base and/or reduced subsidies, the benefits
to the countries’ growth trajectories and societal development are
often immense.
Not the Typical EM Consumption Story
Officially known as the United Mexican States, Mexico now boasts
a population of around 115-125 million citizens (Exhibit 33). As
such, the country ranks #11 in terms of total country population, a
“
The good news is that we think the
country’s proximity to the United
States, its flexible currency, and
its competitive wages should all
act as distinguishing features as
China’s role as “manufacturer” to
the world diminishes further.
“
22Data as at 2012. Source: United Nations World Population Prospects, Haver
Analytics.
14
KKR
Insights: Global Macro Trends
Exhibit 35
Exhibit 33
Mexican Consumption Outpaces Many Of Its More
Populous Peers
2013 Private Consumption as a % of GDP
69%
Country
Private
Consumption
US$ Trillions
Consumption
Per Capita
US’ 000
Population
millions
1
U.S.
11.1
35.1
318
2
Japan
3.2
25.5
127
3
China
3.0
2.2
1377
4
Brazil
1.3
6.7
199
5
India
1.1
0.9
1237
6
Russia
1.0
7.1
143
7
Mexico
0.8
6.4
121
8
Indonesia
0.5
1.9
247
9
Pakistan
0.2
1.0
179
10
Nigeria
0.1
0.7
160
Data as at 2012. Source: United Nations World Population Prospects,
World Bank, Haver Analytics.
Exhibit 34
Growth In Private Consumption Has Consistently
Remained Strong
Mexico Private Consumption as
a % of GDP, 1994-2013
70%
Mexico Private Consumption Outpaces Its EM Peers
68%
58%
58%
Indonesia
India
61%
62%
Colombia
Brazil
36%
China
Mexico
Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia
e Estatística, Departamento Administrativo Nacional de Estadísticas,
Instituto Nacional de Estadística Geografía e Informática, Central
Statistical Organization, India, Badan Pusat Statistik, China National
Bureau of Statistics, Haver Analytics.
Mexico’s consumption economy is likely to remain robust in the
coming years as the country enjoys some of the most favorable
demographic tailwinds in the emerging markets. According to the
International Labor Organization, Mexico’s economically active
population will grow by 20% from 2010 to 2020, compared to just
2.9% for China23. Moreover, Mexico’s working age population will
not peak until 2042, 28 years after China (Exhibit 15). Also, as
Exhibit 37 shows, Mexico’s consumers are largely already based in
urban centers, suggesting that the opportunity is to upsell to consumers as GDP-per-capita hopefully reaccelerates. If our analysis
is correct, then the consumer story is quite different than that of a
country like China, which has been more of a direct play on consumers consistently migrating from rural settings to urban areas.
66%
64%
62%
60%
58%
56%
Apr-12
Aug-13
Dec-10
Aug-09
Apr-08
Dec-06
Apr-04
Aug-05
Dec-02
Aug-01
Dec-98
Apr-00
Apr-96
Aug-97
Dec-94
54%
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
“
As financial services reform gains
momentum, we think that any
increase in lending off such a low
base could likely be beneficial for
overall valuations and transaction
volumes in the real estate sector.
“
23Data as at December 2011. Source: OECD.
KKR
Insights: Global Macro Trends
15
Exhibit 36
Exhibit 38
Mexico’s Working Age Population Offers a Sharp
Contrast to China
Mexico’s Private Credit Growth Has Lagged Badly
Relative to Its Peers
Working-age Population (2010A to 2035E, % change)
Credit of the Private Sector as a % of GDP
120%
India
36.5%
100%
Mexico
Brazil
Chile
Mexico
US
Colombia
26.4%
80%
Brazil
14.3%
USA
UK
40%
3.7%
20%
-2.2%
Note: Working-age population is aged 15 to 65 years old. Source: UN
Population Division (2011) and the Economist Intelligence Unit.
Exhibit 37
Growth in GDP-per-capita Has Yet to Catch Up With
Urbanization
Urbanization Versus Per Capita GDP
50,000
Singapore
United Arab
Emirates
Israel
2011
2012
2010
2010
2009
2007
2008
2006
2005
25%
Korea
Greece
Russia
China
Turkey
Brazil
Mexico
0 India
20
40
60
80
100
2012 Urban Population % Total Population (%)
Data as at April 13, 2014. Source: World Bank, IMF, Haver Analytics.
Another key feature of the Mexican economy is that total consumer leverage, including both bank and non-bank lending, is low
at around 25% of GDP (Exhibit 38). This capacity is significant
because it means that current consumption trends are likely to
be maintained or potentially even accelerate as the government’s
financial services reform takes hold over the next few years. By
comparison, other Latin American countries have seen their consumer debt surge in recent years, which has been a major – though
potentially unsustainable – contributor to GDP growth. One can see
the magnitude of the differential in Exhibit 38.
KKR
2005
Real GDP Growth Has Not Translated Into Real GDP-percapita Growth…
30,000
10,000
2003
Exhibit 39
40,000
20,000
2001
But not all the news is good news on the consumption front. In
particular, because productivity growth has not been as strong at
a time when Mexico is consistently adding significant numbers to
its workforce, its GDP-per-capita is not growing as fast as many of
its global peers. So while the country has enjoyed its “demographic
dividend” on the consumption front, there has not been the same
level of a multiplier effect that we have seen in other EM countries
when GDP-per-capita increases too.
U.S.
Indonesia
16
Data as at April 8, 2014. Source: IMF, Haver Analytics, CEIC, EMED,
Emerging Advisors.
Insights: Global Macro Trends
GDP-Per-Capita US$ CAGR 2013 vs. 2000
2012 GDP-Per-Capita (US$)
60,000
2004
-19.0%
2002
0%
-6.3%
2000
China
2000
Spain
Japan
60%
8.7%
20%
Russia
China
15%
Indonesia
Brazil
10%
India
Turkey
5%
Mexico
U.S.
0%
0%
2%
4%
6%
8%
10%
Real GDP CAGR 2013 vs. 2000 (%)
Data as at April 8, 2014. Source: IMFWEO.
12%
Exhibit 40
Exhibit 42
…As GDP Has Been Dampened by the Lack of
Productivity Growth
Unit Labor Costs For Mexico Have Risen at a Much
Slower Pace Than For China
Productivity Growth, CAGR, 1990-2013 (%)
Unit Labor Costs
2005 = 100
8.1%
200
Mexico
China
180
160
4.0%
140
2.8%
0.5%
0.5%
1.6%
1.1%
2.0%
120
100
80
Data as at 4Q13. Source: Conference Board Total Economy Data Base,
McKinsey.
The major culprit is the lack of real wage growth, which has been
stagnant for years. In fact, as Exhibits 41 and 42 show, Mexico has
really only maintained competiveness by restraining wages, not
improving productivity and/or innovation, since the Great Recession. While this approach represents one potential way to maintain
economic relevance, it is one that has neither high barriers to entry
nor creates long-term competitive advantages, in our view.
Exhibit 41
Real Salary Growth Has Remained Largely Unchanged
Since 2007
Real Salary Growth y/y
2000-2007 CAGR = 3.14%
10.00%
2007-2014 CAGR = -0.12%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
Data as at May 6, 2014. Source: OECD Economic Outlook Database,
Haver.
So against this backdrop of strong population growth but more
tepid growth in both salaries and GDP-per-capita, where are the key
areas for investment linked to consumption? Our thoughts are as
follows. First, we expect wellness, beauty, and healthcare to remain
important areas of long-term secular growth. At the moment, private healthcare accounts for about 50% of total healthcare spending, but we expect this segment of the market to grow much more
sharply in the coming years24. Key to our thinking is that, as Exhibit
43 underscores, Mexico still appears to be significantly underrepresented in overall healthcare spending. However, a recent survey
undertaken by the World Bank estimates that 25% of Mexicans with
public insurance already have some form of private insurance, a
percentage we think will grow meaningfully in the years ahead.
Second, we think that the financial services industry has the potential to be a big winner. Specifically, we think firms that can provide
deeper and broader penetration of basic financial services products
to a growing base of consumers are likely to perform quite well.
Key areas on which to focus include auto insurance, life insurance,
and private credit in fast-growing consumer-related industries.
Also, the payments arena should continue to be an area of particular growth within Mexico.
-4.00%
-6.00%
Dec-13
Dec-11
Data as at March 31, 2014. Source: INEGI, Haver Analytics.
Dec-12
Dec-10
Dec-09
Dec-08
Dec-07
Dec-06
Dec-05
Dec-04
Dec-03
Dec-01
Dec-02
Dec-99
Dec-00
-8.00%
“
We think that the financial
services industry has the
potential to be a big winner.
“
24Source: OECD Reviews of Health Systems – Mexico, published July 2005.
KKR
Insights: Global Macro Trends
17
Exhibit 43
We Believe Health Care Will Increasingly Become a
Focus of the Middle Class In Mexico
2012 Health Expenditure per Capita (US$'000)
U.S.
Japan
U.K.
Italy
Spain
Chile
Brazil
Argentina
Russia
Turkey
Mexico
Venezuela
Colombia
China
Philippines
Indonesia
Vietnam
India
8.9
4.8
3.6
3.0
2.8
1.1
1.1
1.0
0.9
0.7
0.6
0.6
0.5
0.3
0.1
0.1
0.1
0.1
Exports Represent the Crown Jewels in the Mexican GDP Story
There are certainly many compelling features to the Mexican economy, but its export businesses are the country’s economic crown
jewels, in our view. All told, they now account for almost 35% of its
economy (Exhibit 45), compared to just 12% in the United States.
Besides its dominance in Latin America, a key part of Mexico’s
export success has been the country’s ability to effectively leverage
its proximity to the U.S.
Data as at April 13, 2014. Source: World Development Indicators, Haver
Analytics.
Exhibit 44
Mexico Ranks Number One by the OECD in Teachers’
Salaries and Compensation Expenditures
Mexico and OECD Average of Teacher's Salaries and
Compensation of All Staff as % of Education Budget 2010
Mexico
country’s pupil-to-teacher ratio is quite high at 29.9:1 in secondary
education; in primary education it declines just marginally to 28:126.
Interestingly though, Mexico currently spends more than any other
country tracked by the OECD on teacher compensation. One can see
this in Exhibit 44. Finally, we believe that consumer “value” plays
will likely perform well if we are right that wage growth will remain
more contained than in other EM countries. To be sure, aspirational
brands can perform too, but Mexico’s limited annual salary increases mean that a different approach is required to invest behind
consumption stories in Mexico than in places like China and Brazil.
Within its export sector, manufacturing has accounted for over
80% of total exports since 2000. Petroleum, agriculture and mining
account for the rest as one can see in Exhibit 46. Importantly, as
Exhibit 45 shows, Mexico’s export economy is not only large but it
is also gaining GDP share. In 2013, for example, Mexican exports
reached 31.5% of GDP, versus 12.5% for Brazil, 24.4% for China, and
24.7% for India27.
Exhibit 45
Exports Have Been Rising Steadily Since 1994
Mexico Exports as a % of GDP, 1994-2013
OECD Average
93.3%
83.1%
35%
78.2%
62.0%
30%
25%
20%
15%
Teacher's Salaries
Compensation of Staff (all
together
Aug-13
Apr-11
Jun-12
Feb-10
Oct-07
Dec-08
Aug-06
Apr-04
Jun-05
Dec-01
Feb-03
Oct-00
Aug-99
Apr-97
Jun-98
Feb-96
Dec-94
10%
Data as at 4Q2013. Source: Instituto Nacional de Estadística Geografía e
Informática, Haver Analytics.
Data as at 2010. Source: Mexico Education at a Glance 2013: OECD
Indicators.
Third, given that Peña Nieto has made educational reform one of
his primary pillars, we see education and related services as a
potentially attractive area for investment. According to the OECD,
the time 15-29 year old Mexicans spend in formal education ranks
among the lowest in the world – a full two years below the OECD
average and just barely above Brazil and Turkey25. Meanwhile, the
25Data as at 2013: Source: OECD: Education at a Glance 2013 Mexico.
18
KKR
Insights: Global Macro Trends
26Data as at 2013: Source: OECD: Education at a Glance 2013 Mexico.
27Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia e
Estatística, Instituto Nacional de Estadística Geografía e Informática, Central
Statistical Organization, India, China National Bureau of Statistics, Haver
Analytics.
Exhibit 46
Exhibit 47
Exports Are Dominated by Manufacturing
Breakdown of Exports, %
Average From 2000-2013
Agriculture,
2.9%
From 2007-2012, Wages in China Increased 13%, While
Mexico Recorded No Growth
Minimum Wages Per Month in US$
Mining,
0.7%
China
Philippines
Vietnam
Mexico
Indonesia
250
Petroleum,
13.3%
200
150
100
Manufacturing,
83.2%
50
0
2007
How did it gain such momentum? Well, after a serious setback following China’s inclusion in the WTO around the turn of the century,
Mexico has worked hard to reassert itself as a viable manufacturer.
Several things have gone its way. First, productivity in the auto
manufacturing sector has improved nicely, which has become the
flagship of the country’s export economy. In fact, auto exports from
Mexico to the U.S. more than quadrupled from 1993 to 2013, and
the country is expected to topple Japan as the #2 auto exporter to
the U.S. this year28. Second, as China’s wages have increased, the
spread between labor costs is now virtually non-existent, as one
can see in Exhibit 47. As part of this drive to maintain competitiveness, Mexico has also embraced favorable immigration policies with
neighboring countries. This approach has helped to keep domestic
wage growth in check as multinational companies look to relocate
manufacturing away from China and back towards regional hubs.
Third, as Exhibit 48 below shows, the ease of doing business in
Mexico is improving, particularly as the trend towards regional “near
sourcing” has gained the upper hand versus global outsourcing.
“
Importantly, Mexico’s export
economy has not had to deal with
some of the currency headwinds
that other regions of the world,
Europe in particular, have
confronted in recent quarters.
“
2009
2010
2011
2012
Data as at June 1, 2012. Source: World Bank Doing Business
Employment Data.
Exhibit 48
It’s Easier to Do Business in Mexico Than in China
Ease of Doing Business Index
1=Most Business Friendly Regulations
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática.
2008
Mexico
108
93
90
62
83
06
42
07
53
09
96
79
78
41
08
99
91
56
43
05
China
51
53
35
10
11
12
13
Data as at November 7, 2013. Source: World Bank, Haver Analytics.
28Data as at January 31, 2014. Source: ISH Automotive, Bloomberg.
KKR
Insights: Global Macro Trends
19
From a destination perspective, we now estimate that around 87%
of Mexico’s exports go to the U.S. One can see this in Exhibit 49.
So while many emerging market countries like Brazil and Indonesia are linked to China, Mexico is more closely akin to a U.S. “back
door” play. Mexico is also working hard to become even more of a
Latin America influence. Last year for example, Mexico formed the
Pacific Alliance with Colombia, Chile and Peru—a highly ambitious
free trade and regulatory framework that we expect will expand to
include others over time.
Beyond increased trade with its continental neighbors, Mexico also
has been extremely aggressive in signing free trade agreements
outside the Western Hemisphere, including ones with the EU, Japan
and Israel. All told, Mexico has trade agreements (FTAs) with over
40 countries, which is actually more FTAs than the U.S. and China
have combined. In addition, Mexico is a member of the 12-nation
Trans-Pacific Partnership (TPP), under negotiation now, which we
think has the potential to accelerate Mexico’s commercial linkages
with the economies of the Asia-Pacific region.
Exhibit 50
…With Manufacturing and Intermediate Goods the
Largest Exports On a Percentage Basis
Mexico: Exports by Commodity (%)
Consumer
Goods
11%
Manufacturing
40%
Intermediate
Goods
26%
Mining 1%
Agriculture
2%
Exhibit 49
Mexico Is Highly Levered to the U.S…
Petroleum
7%
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
Mexico: Exports by Country
Central America
2%
South America
4%
U.S.
87%
Capital
Goods
13%
Europe
7%
But outside of the auto industry, productivity is not as strong. One
can see this in Exhibit 51, which shows that – outside of Transportation & Equipment (which is largely cars), Primary Metals, and
Miscellaneous – Mexico has actually been losing a reasonable share
of U.S.-destined exports to Chinese manufacturers. Moreover, many
of its market gains have actually come at the expense of Canada,
Japan and the United Kingdom, not other low-cost competitors like
China.
Other
0%
Data as at December 31, 2013. Source: Instituto Nacional de Estadística
Geografía e Informática, Haver Analytics.
20
KKR
Insights: Global Macro Trends
“
What we see as the far bigger
story is that Mexico is one
of very few countries in the
world today—either emerging
or developed—where smart,
effective political leadership is
successfully pushing through
historic, market-friendly
structural change that could
meaningfully boost the country’s
equity market capitalization over
the next five to seven years.
“
Exhibit 51
Market Share of U.S. Manufacturing Imports (NAICS Categories): Mexico vs China
% of Total
Mex Exp
to US
US Mkt Share (2013)
US Mkt Share Gain
(2000-2008)
US Mkt Share Gain
(2009-2013)
Gain of Mkt Share
vs China
Mexico
China
Mexico
China
Mexico
China
2000-2008
2009-2013
Transportation and Equipment
28.2%
23.6%
4.1%
0.4%
2.1%
6.6%
0.9%
-1.7%
5.7%
Computer and Electronic
18.8%
14.6%
45.7%
1.5%
26.1%
0.0%
9.5%
-24.6%
-9.6%
Electrical Equipment
7.6%
23.7%
39.4%
-1.0%
12.4%
0.4%
4.5%
-13.4%
-4.1%
Machinery
5.6%
10.7%
17.0%
2.5%
7.9%
2.8%
3.3%
-5.3%
-0.5%
Primary Metals
3.9%
11.5%
4.8%
2.0%
8.2%
4.1%
-6.2%
-6.2%
10.3%
Miscellaneous
2.6%
6.5%
34.7%
1.0%
9.0%
0.9%
-5.6%
-8.0%
6.4%
Fabricated Metals
2.5%
11.1%
30.9%
-2.0%
16.3%
1.0%
1.6%
-18.3%
-0.5%
Food
2.3%
11.7%
7.2%
2.6%
4.9%
3.0%
-0.6%
-2.3%
3.7%
Chemicals
1.9%
2.7%
8.6%
-0.6%
4.6%
0.3%
1.7%
-5.2%
-1.4%
Plastics and Rubber Products
1.5%
8.8%
34.1%
0.8%
16.1%
1.6%
2.9%
-15.3%
-1.3%
Apparel
1.4%
4.5%
39.0%
-8.1%
21.2%
-0.8%
4.6%
-29.2%
-5.4%
Beverage and Tobacco
1.2%
16.1%
0.3%
0.3%
0.0%
1.3%
0.1%
0.3%
1.2%
Petroleum and Coal
1.0%
3.1%
0.3%
2.2%
-0.5%
-1.8%
0.0%
2.7%
-1.8%
Nonmetallic Minerals
0.9%
12.5%
33.2%
1.6%
12.8%
0.8%
3.8%
-11.2%
-3.0%
Leather and Allied Products
0.8%
5.4%
65.5%
-1.3%
16.2%
0.4%
-4.2%
-17.5%
4.7%
Furniture and Related
0.7%
6.3%
57.8%
-2.1%
27.2%
2.0%
0.6%
-29.3%
1.4%
Paper
0.4%
5.1%
15.9%
1.3%
8.9%
1.6%
3.6%
-7.5%
-2.0%
Textile Product Mills
0.3%
4.1%
52.4%
-5.7%
25.1%
-0.3%
3.2%
-30.8%
-3.5%
Textile Mills
0.2%
6.8%
26.7%
-0.8%
13.2%
-0.1%
7.7%
-14.0%
-7.7%
Printing and Related Activities
0.2%
8.8%
46.3%
0.6%
21.0%
1.6%
8.6%
-20.4%
-7.0%
Wood Products
0.1%
1.2%
22.6%
-0.5%
15.0%
0.0%
1.7%
-15.5%
-1.7%
Total Manufacturing
81.9%
12.3%
23.9%
-0.8%
11.4%
2.2%
2.6%
-12.2%
-0.4%
Total manufacturing
ex-Transportation
53.7%
9.9%
28.3%
-0.6%
12.6%
1.0%
3.5%
-13.2%
-2.5%
Source: Could China Steal Mexico’s Manufacturing Thunder, USCB, UBS, April 3, 2014.
While we think that wage costs (which typically make up around
18-20% of overall manufacturing production costs) are competitive, Mexico is significantly disadvantaged in other areas. Indeed,
as Exhibit 52 shows, Mexico has not enjoyed much success in
areas where energy intensity is high. This dichotomy is one of the
key reasons why we think that the indigenous energy reform—but
just as importantly, the potential for growing access to compara-
tively inexpensive U.S. gas and electricity—has such broad-reaching implications.
KKR
Insights: Global Macro Trends
21
Exhibit 52
Exhibit 53
High-Energy-Intensive Sectors Could Increase
Competitiveness With Energy Reform
Mexico's Manufacturing Output (3mma SA, 2008=100)
KKR GMAA Decomposition of Estimated USD-MXN
Long-Term Fair Value of the Mexican Peso Is Driven by
Inflation and Growth Differentials
13.39
14.00
High energy intensity
150
13.50
Low energy Intensity
140
0.68
13.00
0.01
13.00
130
+24%
120
0.31
12.50
12.00
110
11.50
100
Importantly, Mexico’s export economy has not had to deal with
some of the currency headwinds that other regions of the world,
Europe in particular, have confronted in recent quarters. In fact, the
Mexican peso is one of the few currencies not to trade back through
its 2007 levels, despite relatively strong economic fundamentals.
To be sure, we expect foreign direct investment (FDI) to increase
meaningfully over the next few years. However, even with this
tailwind, the local currency will likely remain “in play,” as one local
described his currency outlook to me. On the one hand, the central
bank wants the currency strong enough to dampen any increase
in inflation expectations. On the other hand, a weak currency can
at times provide a much needed boost to its fast growing export
industries. Given such strong nationalist sentiment among locals
towards Mexico knocking off some of its Asian competitors in the
export arena, this viewpoint has been strongly communicated to the
government and central bank by business leaders throughout the
country. Importantly, when Agustin Carstens, who has served as
Governor of the Bank of Mexico since 2010, thinks about monetary
policy, he starts from a position of strength. Key to our thinking is
that the country has not had to use any form of quantitative easing
(QE) post the financial crisis to help stabilize over-indebtedness in
any sector of the economy. In addition, Mexico’s international liquidity position is quite strong as net reserves (i.e., total reserves minus
gold) are now larger than both the U.S. and the lion’s share of its
Latin American peers.
22
KKR
Insights: Global Macro Trends
Fair Value
5-years
Forward
Data as at April 8, 2014. Source: IMF, KKR Global Macro & Asset
Allocation analysis, Haver Analytics.
Exhibit 54
Valuation Relative to Per Capita GDP Growth Is Fair
50
FX Valuation, % Above/(Below) USD
at Purch. Power Parity
Data as at January 31, 2014. Source: DataStream, Morgan Stanley
Research.
Inflation
Differential
80
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Growth
Differential
90
Valuation/Per
Capital GDP
Spot
11.00
R² = 0.7773
30
10
(10)
(30)
Mexico
(50)
(70)
0
10,000 20,000 30,000 40,000 50,000 60,000 70,000
2014 GDP-Per-Capita, $US
Data as at April 8, 2014. Source: IMF, KKR Global Macro & Asset
Allocation analysis, Haver Analytics.
Looking ahead, we believe that the government should work hard
to extend its strength in autos to other export sectors, including
aerospace and pharmaceuticals. The good news is that we think
the country’s proximity to the United States, its flexible currency,
and its competitive wages should all act as distinguishing features
as China’s role as “manufacturer” to the world diminishes further.
Moreover, if Peña Nieto is successful in his energy reform and as
new pipeline infrastructure increases Mexican access to cheap U.S.
gas, we think the potential for a greater number of strong export
sectors could increase meaningfully, which would be bullish for
growth and the country’s fiscal deficit.
More Investment/Infrastructure Needed to Boost Long-Term GDP
Growth
As folks who travel to emerging markets quite frequently, Vance
and I sometimes use the travel time from the airport to the hotel as a proxy for fixed investment and infrastructure woes. Sao
Paulo and Jakarta often take the prize for the longest commutes,
but Mexico City can sometimes be a problem too. This comparison should not come as a huge surprise, as Mexico has generally
underinvested in infrastructure for years. In fact, as one can see in
Exhibit 55, Mexico’s investment spending is barely above Brazil, but
below Indonesia, Colombia and China.
Exhibit 55
Exhibit 57
Investment per Capita Is Quite Low
Investment Per Capita US$
$10,000
$9,000
2000-2013
CAGR 1%
$7,000
$6,000
2000-2013
CAGR
19%
$5,000
$3,000
2013 Investment as a % of GDP
47.8%
$2,000
$1,000
32.7%
20.4%
21.5%
24.9%
2013
2000
$8,000
$4,000
Investment In Mexico Lags Demand…
1990
1980
2000-2013
CAGR
13%
2000-2013
CAGR
2000-2013
9%
CAGR
2%
2000-2013
CAGR
16%
$0
27.6%
India Indonesia China
Mexico
Brazil
U.S.
Data as at April 8, 2014. Source: IMF WEO estimates for the year 2013.
Exhibit 58
Brazil
Mexico Indonesia Colombia
India
China
Data as at December 31, 2013. Source: Instituto Brasileiro de Geografia
e Estatística, Departamento Administrativo Nacional de Estadísticas,
Instituto Nacional de Estadística Geografía e Informática, Central
Statistical Organization, India, Badan Pusat Statistik, China National
Bureau of Statistics, Haver Analytics.
The New Administration Has Proposed a 71% Increase in
Infrastructure Investment
National Infrastructure Plan, Investment Breakdown
Comparison, US$
2007-2012
Exhibit 56
…This Is Particularly True In Infrastructure Spending
Infrastructure Spending as a % of GDP
Indonesia
Mexico
India
China
12%
10%
2014-2018
Infrastructure
$73.7
$101.5
38%
Energy
$159.8
$299.8
88%
Water
$20.5
$32.1
57%
Total Comparable
$253.9
$433.4
71%
8%
Health
$5.6
6%
Housing
$143.1
4%
Tourism
$13.9
2%
Total Investment
$596.1
0%
2005
2006
2007
2008
2009
2010
2011
Data as at 2011. Source: CEIC, V Informa de Gobierno, Morgan Stanley
Research.
Given its sizeable and growing population, Mexico’s investment per
capita also remains low – too low, in our view. One can see this in
Exhibit 57. While this approach does help to keep the fiscal deficit in
check, it is a direct detriment to both long-term growth and productivity. Moreover, as the exhibit also shows, growth in investment per capita
is now badly lagging many of its emerging market peers since 2000.
% Growth
Data as at April 30, 2014. Source: Barclays, Office of the President of
Mexico.
So our bottom line is that increased public spending on investment
and infrastructure is hugely critical to Mexico achieving its potential
as a nation. Importantly, investment and infrastructure is needed
across Mexico’s major industries and regions to avoid some of
the slow growth/higher inflation environments that we have seen
unfold in Brazil and India in recent years from inadequate levels of
investment.
KKR
Insights: Global Macro Trends
23
If there is good news, it is that Peña Nieto seems to have embraced
this critique, announcing recently an ambitious target of 7.75 trillion
pesos (approximately $596 billion) in infrastructure spending over
the next five years—versus the $340 billion plan put forward by his
administration just a year ago. According to Finance Minister Luis
Videgaray, six of every ten pesos for these projects will come from
federal and state budgets, with the balance from the private sector.
As Exhibit 58 shows, this total would not only be significantly more
than the previous administration of Felipe Calderon but also would
help to narrow some of the investment deficit Mexico now faces
relative to some of its other emerging market peers. To be sure, not
all this spending will take place overnight, but the increases Peña
Nieto is proposing are now sizeable enough to actually make a difference, we believe.
Exhibit 59
Mexico Has the Lowest Share of Bank Credit as a % of
GDP in Latin America
Credit Origination From Traditional Banks as a % of GDP
Mortgage Loans % GDP
78.7
Commercial Loans % GDP
Individual Loans % GDP
53.1
Total Loans % GDP
35.2
29.4
15.1
Financial Services: Plumbing in Need of Repair
Lending. While not a formal component of GDP, we think any thorough country analysis should have some overview of the banking
sector. Indeed, if the credit is either too stagnant or not being allocated properly, then the economic “plumbing” required to sustain
growth is likely broken. In the case of Mexico, our view is that the
plumbing is working, but it certainly would benefit from some repair. Specifically, it needs to be larger and more efficient, which we
view as a tremendous opportunity for investors.
At its most basic level, credit penetration in Mexico is remarkably
low, particularly on the consumer side. In fact, as Exhibit 59 shows,
total credit originated by private banks is only 15.1% of GDP, the
lowest among the major Latin American economies. Not surprisingly limited access to traditional bank lending for households and
small- and medium-sized businesses (SME’s) has been a structural
headwind to GDP growth.
Chile
Brazil
Colombia
Peru
Mexico
Data as at December 31, 2013. Source: J.P. Morgan estimates, Central
Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras
(Chile),Superintendencia Financiera de Colombia, Comision Nacional
Bancaria y de Valores (Mexico), and Superintendencia de Banca,
Seguros, Y AFP (Peru).
Exhibit 60
Non-Banks Dominate the Credit Origination Process
Credit as % of GDP By Type of Originator
60
Dec-95
52.7
50
Bank
Non-Bank
Dec-13
43.6
40
Mar-06
27.5
30
28.5
20
10
15.1
0
95
“
Because of its low-cost labor
force, the country is making
considerable progress in
key export sectors like auto
manufacturing.
“
24
KKR
Insights: Global Macro Trends
97
99
01
03
05
07
09
11
13
Data as at December 31, 2013. Source: Banco de Mexico.
A quick review of the banking sector explains why credit penetration is strikingly low. Consider the following. After a history of
frequent crises that led first to nationalization of the banks in the
1980s and then privatization of the banks in the early 1990s, the
sector ultimately found stability when NAFTA opened it to foreign
investment. But with this stability came significant concentration.
All told, the top five banks in Mexico (four of which are owned by
foreigners) account for 73% of bank loans; moreover, they dominate
bank intermediation for large companies and multi-nationals based
in Mexico (Exhibit 62).
Exhibit 61
Exhibit 63
Interest Rates Charged for Consumer and Business Credit
by Non-Banks Are Quite High
Type of Loan
Average Annual Interest Rate
Small Business Loans
28%-32%
Used Car Loans
24%-30%
Durable Goods Loans
40%-50%
Payroll Loans
50%-65%
Microcredit
90%-110%
Mexican Banks Are Amongst the Most Profitable in Latin
America …
2013 Return On Equity Minus Policy Rate (%)
17.0
11.9
11.0
9.6
Data as at November 12, 2013. Source: Crédito Real.
5.8
Concentration in the banking sector is not uncommon in Latin
America. But what is unique to Mexico is that 60% of bank loans
are originated by the Mexican subsidiaries of large foreign banks. In
essence, lending decisions are not being made in Mexico City, but
instead in Madrid, London and New York. Besides this lack of connectivity to the local economy, there have been few incentives for
change, given the high level of profitability of Mexican banks. One
can see this in Exhibit 62 and 63.
On the plus side, we think that the reform package being implemented by Peña Nieto will encourage increased competition in the
banking sector, which should ultimately drive down the high level of
interest rates to households and SME’s (Exhibit 64). We are particularly encouraged by the proposed laws aimed at improving the legal
framework to allow for a streamlined bankruptcy process. We also
believe that allowing the development banks to play a larger role in
lending will help increase credit creation. However, these are broad
and ambitious goals which will likely take years – not months – to
materialize.
Peru
Mexico
Chile
Colombia
Brazil
Data as at December 31, 2013. Source: J.P. Morgan estimates, Central
Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras
(Chile),Superintendencia Financiera de Colombia, Comision Nacional
Bancaria y de Valores (Mexico), and Superintendencia de Banca,
Seguros, Y AFP (Peru).
Exhibit 64
….Despite Having the Lowest Leverage
2013 Loan-to-Deposit Ratio (%)
143.6
113.5
Exhibit 62
101.3
97.6
95.6
Peru
Colombia
Mexico
Banking Sector Concentration Is Not Unusual in Latin
America, But Foreigners Own Most of the Mexican
Banking Sector
% Foreign Ownership
Top 5 Bank Loan Market Share
87
76
73
80
72
72
Brazil
Data as at December 31, 2013. Source: J.P. Morgan estimates, Central
Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras
(Chile),Superintendencia Financiera de Colombia, Comision Nacional
Bancaria y de Valores (Mexico), and Superintendencia de Banca,
Seguros, Y AFP (Peru).
40
20
Chile
20
0
Peru
Chile
Mexico
Colombia
Brazil
Data as at December 31, 2013. Source: J.P. Morgan estimates, Central
Bank of Brazil, Superintendencia de Bancos e Instituciones Financieras
(Chile),Superintendencia Financiera de Colombia, Comision Nacional
Bancaria y de Valores (Mexico), and Superintendencia de Banca,
Seguros, Y AFP (Peru).
KKR
Insights: Global Macro Trends
25
Exhibit 66
Exhibit 65
The Costs of Financing Appear Excessive In Many Instances
Mexico: 2013 Average Annual Interest Rates (%)
A+/A Office Rents in Mexico Are Significantly Below Peer
Cities…
Average Class A/A+ Office Asking Rent
80
26.0
11.0
5.8
USD Per Square Meter, Monthly
31.0
70
60
50
40
30
20
10
So our bottom line is that given the low level of credit penetration
and rigid structure of the existing banking system, there are currently ample opportunities for both local and foreign non-banking
entities to provide the financing necessary to fund what we believe
could be a much faster growing and more innovative SME sector
over the next few years. In doing so, not only would these nonbanks help to play a critical role in the evolution of the Mexican
corporate landscape, they would also be in a position to earn attractive returns with a lower risk profile than may be available in other
parts of the emerging markets.
Real Estate. Beyond bank lending and other forms of financing, we also
think that real estate is an essential part of the Mexican financial services landscape. Interestingly though, unlike other EM countries that
have benefitted mightily from low rates and access to global capital,
commercial and retail real estate prices in many of Mexico’s major cities, Mexico City in particular, are amongst the lowest in Latin America.
Buenos
Aires,
Argentina
Mexico City,
Mexico
Data as at December 31, 2013. Source: J.P. Morgan estimates, Comision
Nacional Bancaria y de Valores (Mexico).
Santiago,
Chile
Commercial
Bogota,
Colombia
Mortgage
Panama
City,
Panama
Credit Card
Sao Paulo,
Brazil
Consumer
Loan
Rio de
Janeiro,
Brazil
0
Data as at December 31, 2013. Source: CBRE.
Exhibit 67
…While Retail Asking Rents Appear Particularly Attractive
Average Retail Asking Rent ($/sq. meter per month)
250
200
150
100
50
0
Brazil Colombia
Peru
Chile
Mexico Panama
Data as at December 31, 2013. Source: CBRE
We believe there are two primary reasons behind the low prices.
First and foremost, insecurity has been a longstanding concern in
the region, and in many instances, multinationals have – until recently – based their Latin American hubs out of Brazil, not Mexico.
Second, some of the largest sectors of the economy have been
closed to foreign investment, which has kept pricing more local.
In the past the Mexican real estate market was limited to developers and sophisticated private investors. However in 2011, the Fibra
(REIT) market was created in order to provide access to the real
estate market in a liquid vehicle for income-oriented investors such
as local pension funds (Afores). The Fibra structure also provides
foreign investors access to the Mexican real estate sector.
However, as we look ahead, we believe that both these trends are
now subsiding and that given the low rents, high-end retail and office space in Mexico City is particularly attractive. Indeed, as Exhibit
66 shows, asking rents for A+/A office space are among the lowest
in Latin America at approximately $25 per square foot. As foreign
firms in the energy, telecom and financial sectors enter Mexico on
the back of a more level playing field, we believe rent prices will
likely converge over time towards other major Latin American cities. As Exhibit 67 shows, we think that retail properties are particularly attractive at current valuations.
Similar to U.S. REITS, Mexican Fibras are pass-through entities
which distribute most of their earnings in the form of dividends.
The universe of Fibras is relatively small (and growing), but still
offers diversity to investors looking to gain exposure to the asset
class. Most Fibras specialize in different sub-sectors of the real
estate market such as industrial, retail and commercial.
26
KKR
Insights: Global Macro Trends
So against this macro backdrop, we think that commercial real
estate provides an interesting way to participate in not only the
compelling local demographics but also the increased interest in
Mexico by foreign corporations looking to benefit from a more level
playing field. Moreover, as financial services reform gains momentum, we think that any increase in lending off such a low base could
likely be beneficial for overall valuations and transaction volumes in
the real estate sector.
Criminality and Rule of Law—Mexico’s Achilles Heel?
Beyond the obvious risk of reform implementation highlighted
earlier in this essay, we think that Mexico’s rule of law challenges
should be considered by all investors.
In recent years, the scope of Mexico’s violence and criminality
problem has seized headlines. Last year there were approximately
50 percent more homicides in Mexico than in the U.S., despite less
than half the population. All told, Mexico now accounts for approximately half of all homicides in the OECD29. There are as many
murders in Mexico in a week as in Spain in a year, and only two
countries in the world have more homicides in absolute terms—
Brazil and India30. Unsurprisingly, on survey after survey, Mexicans
indicate that public safety is their number one concern.
Although often portrayed in the U.S. as the outgrowth of a narcotics/illegal drug problem, Mexico’s violence is better understood as
the consequence of the country’s weak rule of law institutions and
the rise of resilient, adaptive, entrepreneurial criminal networks.
Although these networks have historically derived much of their
revenue from the production and shipment of narcotics, they have
increasingly diversified into other illicit, lucrative activities as
well. According to Mexican officials, for instance, the top source of
income for the Knights Templar cartel in Michoacan has shifted to
illegal mining (particularly iron ore), logging, and the extortion of
local agribusiness31.
While the presidency of Peña Nieto’s predecessor, Felipe Calderon
became defined by its bloody and ultimately indecisive struggle
with the cartels, Peña Nieto entered office inclined to deemphasize
an overt security agenda, focusing instead on the governance and
economic reforms described above. The government believes that
its new low-key approach has yielded dividends as evidenced by an
apparent nationwide reduction in intentional homicides in 2013. In
addition, since January 2014, Mexican security forces have moved
forcefully to restore security in Michoacan, where conditions badly
deteriorated last year, and successfully carried out a succession of
operations that have resulted in the killing or capture of high-level
cartel leaders.
Despite some high profile successes, however, we are less bullish. While security has improved significantly in some parts of
the country (e.g., Ciudad Juarez and Monterrey)—it has remained
constant or deteriorated elsewhere, including not only Michoacan
and neighboring Guerrero on the Pacific coast, but also Tamaulipas
and Mexico State. What we appear to be seeing is, to some extent,
a redistribution of violence—from urban to rural areas, and from
29Data as at 2013. Source: OECD Better Life Index.
30Ibid.29.
31 http://america.aljazeera.com/watch/shows/fault-lines/multimedia/
timeline/2014/5/timeline-the-riseofvigilantisminmichoacainmexico.html
the north to the center and the south. In addition, we fear the calm
in some places may be more illusory than real. Several Mexican
geopolitical analysts with whom we spoke suspect the reduction
in violence in some areas does not signify the defeat of the cartels
there, but rather the domination of the area by a single criminal
network and its tacit agreement not to wage open war. Perhaps
most worrisome for investors should be the significant growth of
kidnapping—which has quadrupled since 200732— and of extortion,
even as the number of murders may be decreasing.
Ultimately, Mexico’s criminality and security problems are inseparable from its under-resourced rule of law institutions—courts,
police and prisons. There is no quick or easy solution for this.
While there have been pockets of improvement, what is ultimately
required is massive, long-term investment in these perennially
under-resourced bodies. Although there are signs that some in the
government grasp the scope of the problem and are pushing in the
right direction, including passage of the long-delayed penal code
this spring, we do not yet see a comprehensive national strategy
commensurate with the challenge.
Although inherently difficult to quantify, Mexico’s violence carries a
heavy economic cost. INEGI, the country’s national statistics office,
estimates that direct material losses from violence are $16.6 billion
per year, approximately 1.3% of GDP33. But indirect costs—in lost
productivity, investment and misdirected resources—are clearly far
higher; last year, for instance, Mexico’s health minister estimated
violent crime cost between 8-15% in annual economic output34.
Does this mean that high hopes for Mexico are misplaced? Ultimately we don’t think so. Although violence and weak rule of law
in Mexico will remain a significant drag on growth and could cast a
cloud over Peña Nieto’s reform accomplishments, we think the risk
of the country being overwhelmed by these problems is exaggerated.
“
Mexico has maintained
competiveness by restraining
wages, not improving
productivity and/or innovation.
“
32“Mexico’s Drug War Leads to Kidnappings, Vigilante Violence,” Time Magazine,
January 17, 2014.
33Data as at 2013. Source: INEGI, KKR KGI Research.
34Ibid.33.
KKR
Insights: Global Macro Trends
27
Conclusion: Mexico Likely to Be a More Important Part of Any
Latin American Strategy
In targeting an overweight position in small- to mid-capitalization
equities, private credit, and private equity in Mexico, we are making
a statement that—beyond the country’s compelling demographics—
Mexico’s reforms will make a difference over the next five to seven
years. We are also wagering that the reform agenda extends beyond
energy to include other sectors, so that there is a real possibility
of the productivity improvement we think this country desperately
needs to reach its potential. If we are right, the benefits to the
capital markets that investors may enjoy by a true leveling of the
competitive playing field would be quite significant.
Importantly, investing in Mexico requires that an investor look
through a different emerging market lens. Specifically, Mexico is
not a pure-play urbanization story nor is it a low GDP-per-capita
story that has the potential to double overnight. Also, unlike many
of the Asian countries that we visit, Mexico’s fortunes may actually
be non-correlated, or potentially even inversely linked to China’s
success.
Rather, with 87% of its exports destined for the United States and
the government committed to expanding trade agreements with both
Asia-Pacific and Latin American peers, Mexico is much more of an
open economy investment story than many of the other emerging
markets countries many investors know.
To be sure, there are obvious risks to investing in Mexico, including
corruption and criminality. Also, similar to what we see in Indonesia
and Philippines, valuations in the public markets can at times feel
rich, so point of entry does matter. Finally, as we have documented
throughout this piece, productivity outside the auto sector is still
quite weak.
Our conclusion: Mexico’s macro tailwinds, coupled with the potential that the current historic reform agenda provides, warrant investor attention. Importantly, this country has a credible central bank
with strong policies, and its government is moving towards more
openness, not less, which distinguishes it from almost every other
emerging market country we visit. Also, there is no credit overhang
that should impede growth or monetary/fiscal policy. Over time, we
believe, this backdrop should reward investors who too appreciate
that Mexico is an emerging market opportunity that is best addressed through a more innovative macro-focused lens.
28
KKR
Insights: Global Macro Trends
“
So against this macro backdrop,
we think that commercial real
estate provides an interesting
way to participate in not
only the compelling local
demographics but also the
increased interest in Mexico
by foreign corporations looking
to benefit from a more level
playing field.
“
KKR
Insights: Global Macro Trends
29
30
KKR
Insights: Global Macro Trends
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KKR
Insights: Global Macro Trends
31
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