Morgan Stanley: What's Behind Mexico's Extraordinary Resilience?

Mexico’s stock market is one of the few equity markets around the globe posting a positive return since the beginning of the year, Gray Newman and Daniel Volberg point out in Morgan Stanley's latest Global Economic Forum. And Mexico’s peso broke through levels in April that it has not seen in over two years. What can explain this puzzling - welcome, but puzzling - behavior from a market so closely linked to the U.S.?

Newman and Volberg believe there are three anomalies that explain this behavior: on the real economy front, on the energy front and on the monetary policy front.

Real Economy Anomaly

While Morgan Stanley expects the Mexican economy to decelerate in 2008, there are few signs of any pronounced slowing. GDP and industrial production showed robust growth in January. Mexico's industrial production does move in tandem with that of the U.S., with time lags, but note that U.S. industrial production has not experienced the sharp collapse as seen in 2000.

Energy Anomaly

With oil trading above U$100 a barrel, and a fourth year of falling oil production, Mexico is considering energy reform:

As of yet, the authorities have only recently provided a public diagnosis of the challenges facing Mexico’s oil monopoly and have presented no bill to either house of congress. While the political maneuvering continues to provide surprises, we suspect that the authorities will gain enough support to modify the framework within which Mexico’s oil company, Pemex, operates. The bill - whether passed in April or in an extraordinary session later on - will represent a starting point, but is likely to be approved without a series of accompanying initiatives needed for it to be fully effective. The complementary legislation should come later in the year. We suspect that the changes will be underestimated by many observers. Indeed, we suspect that the administration would prefer to downplay the changes in an attempt to limit the political fallout. We also believe that the changes will represent an important step in allowing a ‘competition of models’ in the energy sector.

Monetary Anomaly

This third anomaly, according to Newman and Volberg, is the reluctance of Mexico’s central bank to join the Fed in cutting interest rates. Morgan Stanley expects Banco de Mexico to keep its rates unchanged for most, if not all, of the year. This is attributed to three factors: demand pressures are not the force behind Mexico's inflation; inflation was expected to appear worse in the first half of 2007, before improving; and Banco de Mexico faces much less pressure than the Fed to ease up on its rates. The effect on the peso, though, may add to pressures on the central bank.

In conclusion:

Until, and unless, the US recession produces a much more substantial downturn in industrial production, Mexico is likely to see softening in its economy but not the sharp downturn that many appeared to have feared. This, in turn, has given Banco de Mexico more room to conduct monetary policy with a greater degree of independence from the Fed than most expected.

The most positive news in 2008, however, is not likely to come from the real economy or from Mexico’s inflation picture, but from progress in providing greater competition in Mexico’s energy and telecommunication space. Neither of these moves would immunize Mexico from a US slowdown, but both should help to improve Mexico’s greatest challenge - to boost the pace of potential economic growth.

Comments

[User 175990]

One important factor in allowing Mexico to maintain a robust industrial sector is the inability of American manufacturers to raise prices or substantially increase productivity. This leaves the option of taking advantage of Mexico's low labor costs. I work for a Japanese company that employs 30 engineers at an average hourly cost of about $4.50usd, line operators for $50us/week etc. This company is in the process of downsizing it's plant in Ohio, while upsizing in Mexico. This trend should last and benefit Mexico if the recession doesn't get too severe and stagflation continues for an extended period.

[MexicoInvestor]

Right on target! Deep, smart analysis. I couldn't agree more with your comments, from my long-time Mexico resident and investor point of view.

[Josh Stern]

Nice column. Does your name have a middle initial that could distinguish it from Gary B. Smith and Gary D. Smith, who have both published a lot about equity related topics on the web?

[quality]

Interesting thesis that the current Mexican administration is underplaying the changes in energy policy to soften political opposition. Its a provacative observation and may well be true. I think by hook or by crook Mexico has gotten a good administration that is showing an impressive level of competence.