By HENRY H. MCVEY, VANCE SERCHUK May 19, 2014

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.

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 broad-based 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 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 small- and mid-cap Mexican equities versus higher profile large-capitalization 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.

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 large-capitalization 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.

Mexico Since NAFTA

“Deserve your dream.” Octavio Paz (Mexican writer, poet and diplomat, 1914-1998)

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.

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.

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).

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.

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 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).

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.

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.

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.

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.

“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-President-elect 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 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.

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.

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.

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.

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.

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.

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).

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.

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.

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 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.

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 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.

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.

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.

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.

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.

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.

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 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.

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.

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.

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.

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.

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.

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 comparatively inexpensive U.S. gas and electricity—has such broad-reaching implications.

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.

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.

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.

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.

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.

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.

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).

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.

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 non-banks 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.

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.

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.

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.

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.

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 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.

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.