Why outflows are threatening emerging markets (Part 6 of 6)
A nugget of hope
Mexico is perhaps one of the best-positioned emerging markets, though it’s not a rosy story either. Mexico has an advantage in that its economy is very closely tied to that of the United States. This means that a pick-up in the U.S. market should overflow into the Mexican equity market. As the U.S. economy picks up and tapering scales back, Mexico will benefit from having the United States as its biggest trading partner.
Mexico’s currency faced strong devaluation, like many other emerging market currencies. But the difference is that Mexico has a credible reform agenda that has gained a lot of traction in terms of implementation in recent months. The peso has strengthened and is currently trading right in the middle of the 12-to-14-peso-per-dollar range it has traded at over the past three years. Further strengthening seems more likely than depreciation given the reforms momentum.
Mexico’s reforms are comprehensive and address several industries and well as Mexico’s competitiveness by addressing bureaucracy. Should the reforms advance as planned, Mexico’s sovereign rating will likely upgrade. An upgrade would decrease Mexico’s cost of funding, which is the key problem faced by most troubled emerging markets.
Caution ahead
The borrowing cost reductions at which Mexico would be able to issue debt would cushion the increase in global interest rates that are occurring as a result of the decreased inflows. Plus, lower borrowing costs for the country would spill over into the local economy. This would support further investment in growth and productivity as well as attract increased foreign investment.
Consequently, a ratings upgrade would support further valuation-multiple expansion, boosting the equities market. Given that the foreign exchange risk seems limited, Mexico seems well positioned in the medium to long term. However, the reforms will take time to implement and investors should beware, as Mexico is the best house in a bad neighborhood.
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