In early June I attended the Mexico Private Equity Day conference in New York hosted by AMEXCAP, the association of Mexican private equity firms. The mission of AMEXCAP is the dissemination of information on industry opportunities, challenges, and trends for private equity investment in the country. Given President Trump's often inflammatory rhetoric during the campaign and since his election about building a wall at the Mexican border and renegotiating the North American Free Trade Agreement (NAFTA), I thought it would be beneficial to provide you with the Mexican perspectives on these and other matters.
From a macro perspective, the Mexican economy is accelerating with first quarter of 2017 GDP at 2.8% compared to 2.1% for the fourth quarter of 2016. Mexican micro-economic reforms to open up the energy and telecom sectors to private investment are beginning to bear fruit, particularly in the energy sector.
Mexican production is not simply low cost manufacturing, but rather highly complex, value-added production. The three countries of NAFTA are highly interdependent and integrated from a production standpoint and each party understands and appreciates its role in the supply chain. Imports and exports within the NAFTA block are expected to increase rather than decrease despite Trump's rhetoric. Many conference speakers held the view that Trump's preferences for U.S. strategic direction had met with institutional constraints by the Federal government which would result in compromise. For example, the U.S. withdrew from the nascent Trans-Pacific Partnership (TPP) but longstanding NAFTA is still on the books and progressive renegotiations are expected. Conference panelists generally expected the news flow on NAFTA would be relatively quiet until the 2018 Mexican presidential election process picks up steam.
In a speech on macroeconomic conditions, Gerardo Rodriquez a BlackRock emerging markets portfolio manager forecasted upside to GDP growth for developed market economies as we enter the final years of this expansionary cycle. This trend in turn is accelerating the emerging market economic expansion led by the manufacturing sector based on improving purchasing manager indicators (PMIs). As the BlackRock chart below depicts, Mexico and its LaTam peer Brazil are two of several emerging economies with PMIs that are in positive territory and improving.
As the chart below depicts, emerging market analysts are beginning to revise GDP growth forecasts for emerging markets upward. After bottoming out in 2015 at about 4.25% annual growth, emerging market economic growth as a whole is expected to accelerate to approximately 5.0% for 2018. Similarly, after several years of downward revisions, GDP growth forecasts for Mexico are likely to be revised upward for this year and next. The consensus GDP growth forecast for Mexico for 2017 is presently at 1.8% and very much in line with U.S. growth forecasts.
BlackRock's Rodriquez cited a common issue with growth forecasts in that analysts were consistently revising GDP growth forecasts down over time in years just after the 2008/09 crisis. In hindsight, analysts had anticipated quicker economic recoveries than what actually happened. This issue was universal across developed and emerging markets. He theorized that perhaps analysts are now being too conservative with growth forecasts after this period of being too optimistic on economic growth.
The Mexican private equity business is a growing and vibrant part of Mexico's economic development. In some respects the Mexican private equity market has recently jumped into the fast lane. According to a recent report by Bain Consulting on global private equity, the once nascent industry in Mexico reached a number of milestones in 2016 as the industry invested around government privatizations in the energy and telecom sectors. In terms of number of transactions, firms, and broad ecosystem, private equity in Mexico has a low penetration rate compared to Brazil and other emerging market peers, but the industry is experiencing robust growth in Mexico. For example, there were more private equity deals in Mexico in 2016 than in Brazil.
One significantly positive secular trend that will drive the Mexican private equity industry is legislation in the past decade that opened private equity investments to Mexican pension plans. The age of the average Mexican worker is only 42. This is much lower than the average pensioner in the U.S. and other developed economies. From an investment perspective the longer term nature of these pension liabilities for the average Mexican worker makes private equity an attractive asset allocation alternative for these theoretically more risk tolerant and less liquidity sensitive investors.
Others acknowledged that in this globally competitive world private equity investment is an international play. The broad capital needs for Mexico for private investment are competing for investment dollars with other developing nations like Turkey, India, and Indonesia. Broadly speaking the private equity asset class in Mexico is uniquely positioned to back the best entrepreneurial firms, but this was viewed as both a blessing and a curse as there is a "scarcity of top managers who think like owners." At this stage in the development of Mexico's private equity ecosystem, there is a clear shortage of successful operators that have experience creating successful entrepreneurial enterprises. Mexico's entrepreneurial class is still in its development phase.
We can see the development of an entrepreneurial class manifested in economic statistics. As the chart below depicts, Mexico's productivity growth has been one of the lowest in the world. Mexico's productivity growth from 1980 to 2010 was 0.25%. This compares to the leaders in productivity growth of 1.5% to 2.0% for Ireland, South Korea, and China. Meanwhile, the developed U.S. experienced productivity growth at twice the pace of Mexico at 0.5%.
There were several speakers who touched on the underlying factors driving Mexico's low productivity growth. The two most often cited factors were rule of law and control of corruption. Enhancement of rule of law will be an important aspect to continued development of the private equity market in Mexico. For example the Mexican government is moving forward with its goal of privatizing the energy sector. The government has been holding auctions on exploration and production opportunities in Mexico that would previously have been solely the domain of the state-owned energy company Pemex.
Here are some noteworthy comments on this topic. One panelist shared a comment by a Houston-based energy CEO who indicated that she likes Mexican reservoirs but said that "it seemed like the Mexican government went around the world looking at energy concession contracts and picked the most complex and onerous provisions as requirements for the Mexican auction contracts." Another large energy investor raised questions about Mexican rule of law and the lack of separation of the judiciary branch of government.
BlackRock's Rodriquez stressed this issue as well. He indicated the rule of law and control of corruption continue to be the most significant challenges for LaTam. The World Bank ranks countries on these development factors as well as several other worldwide governance indicators.
The following table displays Mexico's percentile rank against all other countries on the World Bank's rule of law governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010 and 2015 rankings. Mexico lags Brazil and the region but perhaps even more telling its percentile rank in 2015 is below where it was in 2005.
This next table shows the World Bank's percentile rank of Mexico on its control of corruption governance indicator as compared to Latin America & Caribbean region and Brazil for 2005, 2010, and 2015 rankings. Once again Mexico's rankings lag the region and Brazil. Perhaps more disturbing is the precipitous drop in Mexico's ranking from 2005 to 2015.
BlackRock's Rodriquez noted that there are limited historical examples of emerging market countries piercing the ratio of 20% of U.S. GDP per capita. South Korea is one longer term example of a country that was able to continue on a steady path of wealth and prosperity for its people. China has just recently moved its GDP per capita to 25% of U.S. GDP per capita. Chile is a LaTam country that stands out as favorable player on this metric. Rodriquez cited that the reasons for the productivity lag in Latin America and the reason emerging market countries generally plateau around the ratio of 20% of U.S. GDP per capita is a) rule of law, b) control of corruption and c) failures in the education system. Research by Rodriquez indicates that GDP per capita is highly correlated to good scores on these three institutional development measures and the 20% ratio of U.S. GDP per capita threshold or ceiling reflects this dynamic.
This final chart below from Rodriquez's presentation depicts this phenomenon. The y-axis ranks countries on these three measures against the median percentile score represented at the zero horizontal line and the x-axis measures GDP per capita in U.S. dollar on a purchase price parity basis (PPP). Note that while Mexican GDP per capita has grown from 1996 (MEX'96) to 2015 (MEX'15), Mexico remains ranked below the median on these governance scores. Meanwhile, Chile (CHL) GDP per capita and governance rankings are both higher than Mexico and on par with South Korea (KOR). So in short, Mexico and other similarly situated developing countries could have higher GDP growth if they can meaningfully address their weak institutional oversight of rule of law and control of corruption.
In his recently published book "Am I Being Too Suble?: Straight Talk From A Business Rebel" billionaire and highly successful investor and entrepreneur Sam Zell wrote, "When you invest in emerging markets, you're trading rule of law for growth." Based on BlackRock's analysis by Rodriquez, the important corollary to this frictional cost of emerging market investing is that the leadership of emerging market countries, like Mexico, are sacrificing even higher GDP growth along with greater wealth and prosperity for their people by not addressing the meaningful productivity costs of weak institutional governance of rule of law and corruption.