EWW ETF: Surprising 2022 Winner, Mexican Stocks Can Keep Going

The iShares MSCI Mexico ETF (NYSEARCA:EWW) provides targeted exposure to a basket of leading Mexican companies. Even as global stocks faced historic volatility in 2022 amid the challenging macro backdrop, EWW emerged as an outlier, with the fund generating a positive return. The setup here considers the combination of encouraging economic data from the country that has helped lift the Mexican Peso as one of the best-performing currencies in the world. Indeed, the rally in EWW has accelerated in recent weeks and now trading just a few points from its highest level since 2015.

We last covered the fund early last year with a decisively bullish article citing a positive outlook for the underlying companies. The update today highlights recent macro developments and the trends to watch for the key underlying companies. In our view, Mexican stocks are well-positioned to continue outperforming going forward.

What is the EWW ETF?

EWW with over $1 billion in assets is the largest country-specific ETF investing in Mexican stocks. The fund technically tracks the “MSCI Mexico IMI 25/50 Index” based on a market cap weighting methodology, with adjustments made for liquidity factors. The “25/50” figures in the underlying index names simply mean that a single stock may not represent more than 25% of the fund while the combination of all stocks with a greater than 5% weighting may not exceed 50% of the fund’s total assets.

We’ll also note that the fund expense ratio at 0.50% is generally in line with comparable country ETFs. Finally, EWW distributes a semi-annual dividend based on the underlying portfolio income, with a current forward yield listed at approximately 2.9%.

Going through the current portfolio with 44 holdings, EWW has a wide range of companies covering different sectors. Consumer staples names represent 31% of the fund, followed by financial sector stocks at 18%, and the communications sector at 17%.

EWW does a good job of capturing local-market dynamics, which is in contrast to other country ETFs where the portfolio may be more concentrated in commodity exporters where the performance is based more on global macro trends. Keep in mind that most companies in EWW generate sales and income in the Mexican Peso currency, which ends up adding a layer of FX risk. As we will highlight below, FX exposure has worked in its favor over the past year but adds to the potential volatility.

The largest current holding is America Movil, S.A.B. de C.V (AMX) with a 14% weighting. For reference, that acronym simply refers to the corporate structure as a “publicly held company”. AMX is the largest telecom group in Mexico while having diversified operations across other Latin American countries. From a high-level perspective, an emerging middle class through an increasing penetration of mobile devices and broadband internet still converging with levels in developed countries has been a growth driver for AMX, which we expect to continue.

Local banks are well-represented in the portfolio, including Grupo Financiero Banorte (OTCQX:GBOOF) with an 11% weighting. Down the portfolio, other financial institutions include Grupo Financiero (OTCPK:GPFOF) with a 2% weighting. Naturally, these names are best positioned to capture credit activity with exposure to different sectors and growth themes. An ongoing “financialization” of the Mexican economy with more consumers entering the banking system translates into significant growth opportunities.

We like to think of the consumer staples names in the portfolio as covering the “Mexican blue chips”. This includes “Walmart de Mexico”, the country’s largest retailer and technically a subsidiary of the global corporate Walmart Inc. (WMT) group. Another important name is Fomento Económico Mexicano (FMX) which is the largest independent “Coca-Cola” bottler in the world while also operating convenience stores in the country. Grupo Bimbo (OTCPK:GRBMF) is a packaged foods multinational with a brand portfolio of bakery products sold worldwide.

Finally, we can bring up some of the industrial names. We covered Cemex (CX) with an article last year and the company has been a stronger performer as a mega concrete producer including through operations in the U.S. A group of airport operators including Grupo Aeroportuario del Pacífico (PAC), Grupo Aeroportuario del Centro Norte (OMAB), and Grupo Aeroportuario del Sureste (ASR) have all been big winners benefiting from the recovery in air travel. Putting it all together, EWW is driven by a diverse group of stocks, with the performance accelerating in recent months.

Mexico Macro Update

When looking at Mexico, the headlines often end up unfavorable in terms of persistent challenges in dealing with crime and public safety, or political scandals. That being said, the key for investors should be to focus on the hard economic data, which appears to have at least evolved more favorably compared to a low base of expectations.

In November, Fitch Ratings reaffirmed Mexico’s sovereign credit rating at (BBB-), which is the first step of investment grade. The report highlighted how the government has continued to show a commitment to maintaining a stable public debt level through a modest fiscal deficit.

This is important because one of the fears from the election of left-wing President Andrés Manuel López Obrador (AMLO) back in 2018 was the possibility of extreme socialist-type policies undermining the country’s finances. Nearly four years later and through the pandemic, the actual governing actions appear to have tilted more toward the side of centrism.

The other dynamics at play consider external accounts that have been well-supported by a narrow current account deficit and strong trade, including the benefit of elevated oil export prices. Separately, there is also a theme of “near-shoring” where Mexican manufacturing looks increasingly attractive to U.S. companies and other trade partners amid inflationary cost trends that defined the past year.

While inflation has been a challenge like the rest of the world, the Mexican economy has been otherwise resilient and on track to post a GDP growth rate near 3% in 2022 capturing the wave of a pandemic recovery. According to the research firm “Itau Economics”, Mexico is expected to see another year of positive GDP growth in 2023 of 1.3%, averting a recession. For the year ahead, an expectation for inflation to slow considerably opens the door for improving economic conditions looking out toward 2024.

The setup here is in large part thanks to the autonomy and independence of the Central Bank, which is also an encouraging outcome compared to the initial hesitations of the AMLO administration. The group’s effort at hiking rates to fight inflation appears to be working and helps explains the equity market strength more recently. For context, the monetary policy rate in Mexico ended 2022 at 10.5%, up from 5.5% in 2021.

The result is that the effectively large carry, as the spread of interest rates above 7.8% inflation, has directly helped the Peso currency strengthen as an FX fundamental. The trend is evident with the Peso appreciating by nearly 9% over the past year against the Dollar, which is in contrast to the direction of almost every other foreign currency. The strong Peso has also helped to limit imported inflationary pressures and add to investor confidence. As a reference, the inverse USD to MXN exchange ratio is currently quoted at $18.65, the lowest level since before the pandemic.

What’s Next for EWW?

Looking at the ETF price chart going back an entire decade, the first observation is that EWW is trading near the upper end of a trading range that has been in play since 2015. A breakout higher from here would represent an important milestone for a market that has been fickle in terms of generating consistently positive returns for investors.

The bullish case is that economic conditions not only in Mexico progress more positively, but also that the world economy begins to recover as inflationary pressures ease and trade activity rebounds. For EWW investors, it will also be important for the Mexican Peso to continue climbing or at least remain stable, consolidating recent gains as supportive of the share prices of the underlying stocks priced in Dollars.

Considering the recent strength in U.S. equities with the rally in the S&P 500 (SPY) over the last several months, we believe EWW could outperform to the upside as a high-beta trade on improving U.S. conditions given the country’s close trade relations. A recovery in the U.S. would be positive for Mexico through boosted investor sentiment and the pace of capital investments.

On the other hand, the main risk to watch would be a deterioration in those same economic indicators. A leg lower in global growth defined by a sharp reduction in trade with surging unemployment would bring a new round of financial market volatility that would end up pressuring Mexican stocks. The possibility for a resurgence of inflation in Mexico, or some new instability in the Government in terms of Central Bank independence or direction of fiscal policy would also open the door for a repricing lower.