2017-01-27 4pm EDT  |  #Mexico #Trump #small caps #IWM #EWW #MXN

The other day I turned on Bloomberg TV and some smart sounding portfolio manager was warning about all the dangers surrounding the Mexican economy, and by extension, their markets. He had all sorts of reasons why investors should steer clear of Mexico. No need for me to repeat them, all you need to do is open your inbox to be inundated with bearish Mexican research pieces. Or crack open the newspaper. Or turn on the TV. Everyone is convinced Trump will crush the Mexican economy.

If I asked you how much the Mexican equity ETF underperformed the Russell 2000 ETF over the past month, you would probably guess 5%-10%, maybe even more. After all, the constant barrage of Trump tweets about Mexico’s taking advantage of America has created an awfully negative atmosphere surrounding the United States’ southern neighbour.

Well, don’t look now, but that notion might be fully priced in.

Over the past month the Mexican stock ETF has actually outperformed the Russell 2000 ETF by 150 basis points. That’s not much for two volatile equity indices, but it is awfully impressive given the terrible environment for Mexican markets.

I don’t have on long EWW short IWM spread on directly. My positions are a little more convoluted with a long Mexican Peso / short Canadian dollar being augmented with a long Eurostoxx / short Russell 2000 spread. But they are based on the same reasoning.

I originally saw the idea of long EWW / short IWM from a twitter buddy TheLongView@hayekandkeynes who describes himself as a “recovering Bridgewater Associates employee.” Great, funny description, and a must follow.

Although I don’t have this exact trade on my sheets, I will focus on his position as it is a cleaner example of exploiting the “all baked in” trade setup.

When Trump unexpectedly won the election, stocks rocketed higher. Although most stocks jumped, small caps screamed higher.

Small cap stocks were perceived to benefit more from Trump’s pro-growth deregulation policies, so they became the poster child for the Trump trade. Hedge funds and other speculators piled into the trade at a rate never seen before.

In the process they drove the Russell 2000 to absurd valuation levels. Whatever way you measure it, small caps are expensive. Stupid expensive. But as the Trumphoria continued, small caps just kept steamrolling over the bears.

On the other side of the coin, the losers in the Trump trade were the countries in his cross hairs for “unfair trade practices.” Although China is probably at the top of Trump’s list, they weren’t as easy prey as the Mexicans, so Trump decided to make an example of them.

The damage from Trump’s rhetoric and aggressive negotiating posture has been severe on Mexican markets.

Although it seems as if Mexico can’t catch a break, the most interesting part of this story has been the price action over the past month. Even with all the Trump tape bombs, the Mexican Peso has been rallying for the past couple of weeks.

So let’s sum this up. Even though everyone and their dog are bullish on US small caps due to Trump’s policies, they have been going sideways for the past few weeks, and have started to underperform other American indices. Meanwhile, Trump keeps bombarding Mexican markets with the most aggressive trade rhetoric seen in the last 80 years, but the Peso is rising on the news.

If there was ever an “all baked in” setup, this is it.

I am long Mexico and short IWM, and although my trade is more complicated with more moving parts, I might just add this spread outright. The Trump news is fully discounted. American small caps are priced for perfection with Mexico priced for disaster. The reality will be something in between…

Thanks for reading,
Kevin Muir
the MacroTourist