Although Mexican fundamentals were consistent with those of years past, the volatility seen in late 2016 continued through the first couple of months of 2017. Exchange rate instability and uncertainty relating to a potential renegotiation or termination of the North American Free Trade Agreement (NAFTA) made investors and other market participants wary and tentative, leading to a slowdown of transactional activity during the first quarter of 2017. As it became evident that changes in Mexico’s relationship with the U.S. and Canada under NAFTA would only occur after a complex and lengthy process and that the window for investors to allocate capital and corporates to stock up on liquidity prior to Mexico’s 2018 elections was shrinking, market participants began to scramble to get deals done prior to year-end 2017.
The Mexican economy has managed to continue its moderate growth. Macroeconomic data shows that GDP will likely increase around 2% this year, compared to 2.5% for the past 2 years. Exchange rate volatility will impact inflation, which will probably increase in excess of 6%; significantly higher than the 3.5% for the prior year. The lead government interest rate has hovered around 7% as the Mexican central bank has had to increase rates regularly over the past year. Still, the Mexican economy maintains its competitive edge with respect to other Latin American economies, based primarily on its legacy of macroeconomic stability, skilled labour (particularly in the manufacturing sector), the integration with the U.S. economy and an open economy. Structural reforms, in particular in the energy sector, have resulted in a large flow of investments. However, an overzealous focus on trade within the NAFTA region, sub-optimal public investment (including in the oil, infrastructure and education sectors) – which in itself can be partly attributed to fiscal policy (including low tax collection levels) – and the failure to generate a sufficiently strong internal consumer base have placed Mexico in a position of vulnerability. Failure to maintain access to markets such as the US and Canada as a result of terminating NAFTA or renegotiating terms that are unfavourable to Mexico would most likely result in higher inflation and the devaluation of the Mexican peso, together with a slowdown of the economy.
2018 will also bring with it presidential and congressional elections. Many state governments will also hold local elections in 2018. The presidential election will be the most likely to influence business activity in 2018 and thereafter. At this point, it seems that this will be a three-way election in which the winner will be hard-pressed to obtain more than 30% of the votes or control of congress. Andrés Manuel López Obrador, a left-wing candidate, has a slight lead in electoral preferences. The candidate for the ruling PRI party, José Antonio Meade, is recognised as a skilled economist; however, he is viewed unfavourably by some by running on the PRI platform, in particular with respect to a perceived inability to fight crime and corruption. A third candidate Ricardo Anaya, will lead a coalition of right- and left-leaning political parties. As has been the case in the past 2 presidential elections, the possibility of Andrés Manuel López Obrador winning the presidency has investors concerned, even more so considering the new protectionist regime in the US. AMLO, as he is known, has been in this position before (leading polls at the start of the presidential election process) and has always faltered; only time will tell if he does again.
Corruption has been a critical issue on the Mexican political agenda, and will certainly be a topic influencing the results of the 2018 elections. Addressing it has become a public demand, and such activity is further scrutinised as part of the NAFTA negotiations. It includes the implementation of anti-corruption policies by international financial institutions participating in the Mexican market, and the recent reforms and enactment of anti-corruption laws and system in Mexico. A demand for legal services associated with meeting such anti-corruption laws and policies can be expected in the near future.
2017 Sector Trends
Transactional activity in 2017 varied greatly across sectors.
Interest in the development and acquisition of projects in the power sector has increased, due in part to the successful auctions for long-term contracts for clean energy, certificates, and capacity. The implementation of several new legal requirements related to land contracting and social and environmental issues applicable to the development of projects is still a topic of some debate. A number of projects awarded in the first and second long-term auctions have now been financed and others are in the process of obtaining finance, with both international and domestic lenders showing interest in funding such projects.
Auctions for exploration and exploitation of oil have resulted in several private entities participating in this sector at a slow but continued pace. In the midstream sector, pipeline development continues, but several of the projects under construction have faced interruptions due to social problems. The most recent developments are the opening of gasoline stations under private brands (formerly, all were PEMEX franchises) and the initial stages of the development of hydrocarbons storage facilities, which has been an area of great interest considering the deficiency in storage capacity in Mexico.
Aside from the new Mexico City airport, which has raised finance and is still under construction, there are no other major public infrastructure projects.
The real estate market in Mexico saw strong activity in 2017. Commercial real estate benefited from stronger demand from a growing services sector, while increased rents and lower vacancies were seen in the retail and office markets. In-fill residential development in Mexico City was very dynamic, as prices for residential products continued their upward trend. A robust manufacturing and logistics sector made demand strong for industrial real estate. The hospitality industry also saw increased activity as developers continued to develop hotels and residential property in resort cities. Private equity investors from Mexico and abroad continued their trend of investment in real estate projects. Multi-family was a sector of particular attention, as the first institutional-grade portfolio was sold and new developments broke ground. The real estate industry was challenged by the currency volatility and increase in interest rates. Nevertheless, lenders continued to fund most real estate asset classes. Even though 2017 was less active in M&A activity than the previous years, FIBRAs acquired stabilised assets from local developers and from international managers divesting their legacy funds.
Except for a temporary pause at the beginning of the year, M&A continued to be strong, particularly in mid-market transactions. Private equity and sector-specific funds (including energy and real estate-focused funds as described above) were particularly active, in some cases, as a result of investment periods for funds raised during the initial surge in CKD fundraising expiring. If anything, it seems that corporates held back from pursuing inorganic growth, probably as a result of high levels of corporate-driven transactions in prior years.
Capital markets were generally dormant during the first quarter of 2017 but picked up significant steam towards the middle of the year. Issuers flooded the market with potential equity and debt deals. Deals priced consistently during the second and third quarter but started to fall towards the end of the third quarter and the beginning of the fourth, primarily as a result of an excess of emerging market paper coming to market. The domestic market followed a similar path but continued to be strong into the latter part of the year. Local institutional investors continued to dominate the market. Increasing retail investors' participation in market offerings remains one of the challenges. The creation of a new stock market may increase competitiveness in 2018. Activity was consistent through the different asset classes, including debt, equity and quasi-equity products.
Despite the volatility and uncertainty, Mexico has seen a boost in activity on banking and finance transactions, with the purposes of securing access to long-term financing and hedging the risks posed by developments in 2018, which we expect to continue during the first half of 2018 prior to the Mexican presidential elections. Furthermore, the preliminary effects of the energy reform have started to become evident, having resulted in an increase of energy-related transactional activity, including financing transactions. Similarly, real estate transactions have remained active within the M&A, development and financing areas.
In addition to traditional financial institutions, new local lending players have emerged through CKDs and other investment vehicles which intend on focusing on small and medium-sized transactions, resulting in an increase in financing activity, mainly with borrowers with little access to traditional bank financing.
Litigation is still complex in Mexico. Form over substance continues to encourage lengthy and inefficient processes. Even advances in judicial training and sophistication of local and federal courts have recently been overshadowed by a “human rights” approach to the interpretation of commercial transactions which has, in a handful of visible cases, undermined structured transactions. Most practitioners and business participants view the Mexican legal system as a robust set of laws that provide clear and adequate protection to persons engaging in business within Mexico, although the training and expertise of judges need to improve.
Mexico is no different from its Latin American peers in respect to taxes. It maintains a high corporate income tax rate of 30%, yet it still collects among the least tax in this region as a percentage of its GDP. This is partly due to the generalised tax evasion that is in many ways the product of the existence of a very large informal economy. Most importantly, however, it is the result of the abuse by the formal economy of various tax schemes that go from illegal outsourcing to avoid payroll taxes to the purchase of fake invoices. This environment forced the Mexican tax authorities to put in place a very sophisticated digital platform through which taxpayers pay their taxes, file their tax returns, issue their invoices, file their accounting records and manage their bank accounts. Today, payment of taxes in Mexico could be automated based on the Tax Administration Service's digital platform, and tax authorities are also starting to audit electronically, which is a game-changer for all taxpayers who do not normally pay attention to all the formalities that Mexican tax law requires.
Despite the Mexican government maintaining its policy to reduce generalised tax incentives, we expect it will continue to grant targeted incentives that are relevant for multinational companies doing business in Mexico, such as the maquiladora regime, and to foreign investors, mainly related to large real estate or infrastructure projects. The government is also finding a good source of revenue in indirect taxes, such as VAT and excise taxes on gasoline and diesel, soft drinks, alcohol, cigarettes and other generalised consumer products, which has been a good way to compensate the poor collection record of income tax. The development of the Tax Administration Service's digital platform will continue to evolve and taxpayers would have to start benefiting from it, as it may significantly reduce its management cost; however, they will have to learn to operate in an environment where tax authorities have full view of all of their operations in real time.
The US tax reform will also play a significant role in Mexico. Although a thorough analysis should be made once the definitive reform bill is passed, both the Mexican governmental authorities and the private sector should evaluate how these reforms could impact Mexican investments and should therefore assess the implementation of the appropriate measures to counter any negative outcomes. Currently, the newly appointed Mexican Minister of Finance José Antonio González Anaya has taken the position that it would still be premature for Mexico to react with a parallel tax reform. However, he has not rejected the possibility of enacting a tax reform prior to President Peña Nieto leaving office in order to preserve foreign investments in Mexico.
The course of the Mexican economy and levels of transactional activity for 2018 will be dictated primarily by two unknowns: the fate of NAFTA, and the 2018 elections. An unfortunate result in one or the other may significantly alter the economic landscape not only for 2018 but for years to come. 2018 may be one of the more difficult years to predict in recent history. The hope is that investors and market participants will be cautious but that investments and financings will continue to flow.