March 15, 2013

Trade deals, a surge in manufacturing, and a burgeoning middle class are boosting Mexico's economy. A new government is attempting to bring about structural reforms that would increase wages, improve education, and reform taxes, making the country a promising long-term investment opportunity.

Only four years ago, a drug war, widespread poverty, and rampant political corruption hobbled Mexico's prospects so deeply that the U.S. government declared the country at risk of becoming a "failed state." While Mexico continues to battle crime and poverty, the nation has made tremendous strides recently toward getting its economy on a sustainable growth track and repairing its blighted image.

Coming of Age

Mexico's recent success started with a flurry of free-trade deals it signed beginning in the late 1980s. Partly as a result of these deals, an increasing number of multinationals have set up shop in the country to capitalize on its inexpensive labor and proximity to the U.S. The manufacturing surge has been driven by rising wages in China, higher transportation costs, and demand for faster turnaround times among U.S. businesses. Mexico's banking system and corporate governance rules have also improved, making investing in the country more attractive. These factors have contributed to Mexico's strong growth in recent years, which has helped move more Mexicans into the middle class and increased consumer spending.

For much of the past decade, Brazil captured Latin America's spotlight. That's not surprising given that Brazil accounts for nearly 60% of the MSCI EM Latin American Index and its stock market surged a cumulative 921% in the 10 years through 2012. Brazil remains a powerhouse, and T. Rowe Price analysts and portfolio managers continue to identify high-quality Brazilian companies trading at reasonable valuations.

But while Brazil's economy has weakened over the past two years due to slowing raw materials demand from China, Mexico's growth has remained surprisingly resilient. The country's gross domestic product (GDP) grew faster than Brazil's in 2011—the first time it had done so since 2006—and appears set to eclipse it again in 2012, although the data have yet to be determined. The difference in growth rates has helped draw foreign investors into Mexican stocks. The country's domestic IPC Stock Index has outperformed Brazil's Bovespa Index since early 2010 and climbed to record highs at the end of 2012.

"Because Brazil has slowed, investors want to look at the next most obvious market in Latin America, which is Mexico," says José Costa Buck, portfolio manager of the T. Rowe Price Latin America Fund, which invested about 62% of its assets in Brazilian stocks and 21% in Mexico as of the end of 2012. Another 9% of the portfolio is invested in Chile, which also boasts a growing middle class. The portfolio also has exposure to the region's fast-growing markets of Argentina, Peru, Panama, and Colombia. Costa Buck, who travels extensively throughout the region, recently reduced the allocation to Mexico due to the strong rally, which he believes has pushed up stock prices to expensive levels. However, he says, the country's long-term prospects are favorable.

Made in Mexico

Mexico has gained much of its growing appeal as a manufacturing platform at the expense of China, which is losing some of its luster as the world's low-cost producer. "Some of the companies in which we invest view Mexico as the new China because it is a relatively low-cost manufacturer, and costs associated with China have risen," says Greg McCrickard, portfolio manager of the T. Rowe Price Small-Cap Stock Fund, which has invested in U.S. companies that have benefited from "nearshoring" by moving part of their production to Mexico.

Curt Organt, a T. Rowe Price equities analyst, recounts the story of a manufacturer of commemorative plaques and memorials that moved part of its production to Mexico from the U.S. due to rising materials costs. "When you're faced with higher basic materials costs, you can either increase the price of your product or reduce labor costs," he explains. "By relocating a portion of its manufacturing to lower-cost areas, the company was able to weather the rise in commodity prices."

Putting Poverty Behind Them

Trade Deals Bear Fruit

The seeds of Mexico's attractiveness as a global manufacturing hub began in the late 1980s, when the nation started restructuring its economy and became more open to global trade by signing pacts that lowered trade barriers. The most notable of these was the North American Free Trade Agreement, which Mexico, Canada, and the U.S. signed in 1992, creating the largest single market in the world.

To date, Mexico has signed 12 free-trade agreements (FTAs) involving 44 countries. The FTAs reduce or eliminate tariffs on parts that Mexico-based companies import and on the finished goods they export, making trade more competitive on a global scale. This cost advantage, combined with Mexico's proximity to bigger and richer markets like the U.S., Canada, and Brazil, is a key reason why industrial giants and automakers have built plants and factories in Mexico in recent years.

The trade deals have been productive. Mexican exports soared more than fivefold, from $60.8 billion in 1994 to $349.6 billion in 2011, according to the U.S. Congressional Research Service (CRS). Total imports over the same period climbed more than fourfold from $79.3 billion to $350.9 billion. Exports as a percentage of GDP in 2009 stood at 27.7%, exceeding China's 26.7% rate, marking the first time Mexico had surpassed China in many years, according to World Bank data.

Over the past several years, the two countries' exports as a portion of GDP have been roughly even—an indication of how much Mexico has closed the manufacturing competitiveness gap with China. Mexican exports have also moved steadily up the value chain as companies churn out increasingly sophisticated products. The country's top five exports in 2011 were crude oil, passenger cars, flat-screen TVs, mobile phones, and delivery vehicles, according to the CRS report.

Investing in Mexico

Many T. Rowe Price managers have sought to capitalize on Mexico's booming export sector by investing in the infrastructure that makes increased trade possible. Several T. Rowe Price funds, including the Growth Stock Fund, Mid-Cap Growth Fund, and Small-Cap Stock Fund, own significant stakes in domestic railroad and trucking companies for which ferrying raw materials into Mexico and delivering finished goods across North America is a growing part of their business.

The outlook for cross-border rail traffic has greatly improved thanks to major infrastructure upgrades in Mexico. The country's largest railroad, Ferrocarril Mexicano (Ferromex),* spent $2.1 billion to improve its railways over the past 13 years, which has reduced shipping times and increased capacity.

The rise in exports has helped foster domestic consumption. Robust growth and slow inflation, helped by a strong central bank, have enabled millions of Mexicans to join the middle class—defined as those earning $10 to $50 per day—making the country one of Latin America's leaders in middle-class growth over the past 15 years, the World Bank said. "When you have low unemployment, increasing real wages, modest inflation, relatively low interest rates, and growing consumer credit," Costa Buck says, "it all translates into a growing middle class."

To capitalize on this trend, Costa Buck favors consumption-driven sectors like financials and consumer discretionary, which he thinks have the most promising prospects as incomes rise and consumer credit becomes more widespread. Corporate governance, which has often suffered in Latin America, has also improved markedly in Mexico. "We rarely encounter questionable actions," he says. "Corporate governance is generally very solid in Mexico."

Export Expansion

The Peña Nieto Effect

The newly elected reform government of Enrique Peña Nieto appears to be driving some of the investor enthusiasm. Peña Nieto has moved to push through ambitious reforms, targeting improvements in taxes and education, in an effort to unlock the country's economic potential. Among his boldest proposals: opening up Mexico's heavily protected oil and gas industry to private investment. "There's a lot of optimism that this new government will be able to pass some structural reforms in tax and energy policies over the next couple of years," says Costa Buck. "The hope is that it will give Mexico more flexibility and productivity and the potential to expand GDP growth."

Peña Nieto's reform agenda is supported by the major opposition party, a key difference from previous governments that have failed to enact reforms. Together, the ruling and main opposition parties now have the two-thirds majority in both houses of Congress needed to pass legislation. Last November, the government passed a labor reform law making it easier for companies to hire and fire workers.

"The labor reform law was a big deal because the labor market in Mexico is very rigid, and companies don't want to hire people since it's very expensive to fire them," Costa Buck says. "This is a reform that has been pursued by different governments in the past, and finally it was approved."

Despite its economic revival, Mexico faces significant challenges. While the country has made great strides in lifting living standards, more than half of Mexico's population remains in poverty. Organized crime continues to rear its head, though the country's homicide rate, which climbed for four straight years starting in 2008, began to subside in 2012. Political challenges also remain. Hopes for reform are so high that any setback in Peña Nieto's agenda could halt the rally in Mexico's stock market, which gained 18% in 2012 and outpaced the broader emerging markets universe.

Given the country's remarkable turnaround over the past few years, however, the chances of Mexico reverting to its status as Latin America's chronic underachiever appear slim. "Mexico continues to make great strides toward modernizing its economy and reducing corruption," Costa Buck says. "While stocks have performed well recently, we think the long-term prospects for many of the companies in which we invest are promising."

* Ferrocarril Mexicano was not held by any of the funds in this article as of 12/31/12.