Why Mexico’s economic slide continues and a recovery isn’t happening (Part 2)

Market Realist

Cost pressures and price competition add to margin squeezes as employment remains fragile

Continued from Part 1

Modest cost pressures, yet price wars lead to margin squeezes

While the index on input costs increased at the weakest pace ever recorded for Mexico’s PMI, several companies did mention higher raw material prices. Perhaps the increase in oil prices and slight recovery of some commodities are the culprits of these increases, though as of now, they’re not a major concern.
As in other emerging markets, the strengthening of the U.S. dollar versus the local currency has led to costly foreign exchange losses, since many raw materials (especially commodities) trade in U.S. dollars. Since May, the Mexican peso has depreciated almost 7% versus the U.S. dollar, which has put a dent on the portfolio returns of international investors. Nonetheless, the Mexican Peso has remained relatively stronger than other Latam currencies.

Additionally, prices charged are facing the ax, as increased competition is leading to price discounting in order to retain clients and attract new ones. The lower prices due to increased competition combined with a modest cost pressure could eventually develop into a key concern if the price discounts fail to generate enough new business.

Employment losing steam

The employment index showed mild growth, yet the rate of growth was slower for the second month in a row. Only 10% of respondents reported increasing staff, though only 5% reported cutting staff, implying a 52.5 index. 1  The rate of growth is the weakest since January and is likely to drop further, given slowdowns from reduced global trade and lower future business expectations.

Putting it all together

The survey results are mediocre at best. While the economy continues to expand, it’s slowly decaying towards contraction. Recent positive data on global car sales may boost the exports side of the equation, yet it’s still unclear if that will be enough to jump-start the rest of the economy.

For investors, foreign exchange remains a very relevant concern. If the U.S. Fed officially starts tapering off, the market will likely price in additional strength in the Mexican peso, which will cause further foreign exchange losses for international investors.

If Mexico’s economy continues to grow at such sluggish rates, the potential of its country risk rating changing to BBB+ or A- keeps moving farther into the future. The market’s trading at close to 22 times earnings, which is in line with the upgrade expectation but not in line with Mexico’s current BBB rating.

There’s a very valid risk that investors will start to price away the extended horizon to a potential upgrade, especially as politicians start focusing on elections and less on the actions necessary to implement the proposed reforms.

  1. The diffusion index is calculated by adding the percent of respondents showing an increase plus half of the percent of respondents showing no change.

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