CIO WM Research 9 September 2013 Investing in Mexico Monthly strategy update The uncertainty in the timing of the US Federal Reserve's decision to reduce its asset purchases are still weighing on EM assets. Mexican asset classes performed poorly when compared to peers as sluggish local economic performance added additional pressure. We now expect a moderate re-acceleration of exports and investment will drive 2013 GDP growth to 1.6%, from 2.6% previously as consumption lags. The ongoing revival of the US economy should also prove beneficial. Government bonds extended losses in August as rates increased close to 50bps. We remain cautiously positioned on the short end of the yield curve as volatility levels remain elevated. The increase in US Treasury rates has triggered a sharp fall in the USDMXN. Once visibility increases on US monetary policy, we think the peso will appreciate against the USD. Adolfo Acebras, analyst, UBS AG Jeronimo Mariscal, Analyst, UBS AG Table 1. Mexico country profile Mexico Forecasts 2010 2011 2012 2013E 2014E GDP (yoy %) 5.5 3.9 3.9 1.6 3.8 Industrial Production (yoy %) 6.1 3.8 3.6 2.3 3.4 Unemployment Rate (yoy %) 5.4 5.2 5.0 4.9 4.5 Consumer Prices (end of year) 4.4 3.8 3.6 3.9 3.3 Current Account (% of GDP) -0.5-1.0-0.9-1.4-1.6 Overall fiscal balance (% of GDP) -3.4-3.0-2.7-2.5-2.6 Public Debt (Gross) (% of GDP) 35.3 36.0 37.0 37.0 35.0 Source: UBS, as of 06-Sep-2013 The economic outlook for developed market economies keeps improving as manufacturing activity across the US and Europe performs better than expected. In contrast, EM economies are suffering from capital outflows, higher funding costs and lower-thanexpected growth dynamics, Mexico included. Despite lower growth trends during the first months of the year, we think the Mexican economy can achieve decent growth in the years ahead. We view the sluggish data from the first half of the year as a cyclical slowdown explained by a combination of reduced government spending, slower demand for Mexican exports and moderate consumption patterns. However, a re-acceleration of US demand for Mexican exports has been ongoing since July, leading us to expect modest growth for industrial production in the remainder of the year, despite a challenging outlook for the construction sector. Moreover, sentiment towards Mexican assets should improve as the economic and political reform agenda follows through in the weeks ahead. We expect a comprehensive version of the energy and fiscal reforms will be approved during the fourth quarter of the year. However, since these are controversial topics among the Mexican electorate, we do not rule out the possibility of public demonstrations and social unrest while the discussions unfold. The Mexican peso is our preferred local asset class followed by Mexican equities. We recommend maintaining exposure to shortterm peso-denominated sovereign MBonos and inflation-linked bonds and to local high-rated corporates. Fig. 1. We expect US manufacturing to boost local production PMIs for the Mexican and US manufacturing sectors (indexed) 60 55 50 45 40 IMEF ISM 35 Feb-09 Sep-09 Apr-10 Nov-10 Jun-11 Jan-12 Aug-12 Mar-13 Source: Banxico, UBS as of 06-Sep-2013 This report was originally published outside the US and has been customized for US distribution. This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 5.
Our relatively benign outlook for the second half of the year is based on the expectation of higher manufacturing activity as demand for Mexican exports from the US remains fueled by higher consumer confidence and by the recent surge in manufacturing activity (see Fig. 1). Moreover, investment and capital formation should also accelerate as many significant manufacturers acquire machinery as they approach the end stages of construction work on new factories. However, concerns about consumer demand remain, given our revised expectations for lower job creation. We stay confident that economic growth should re-accelerate in 2014, but the recent slowdown should weigh on medium-term expectations. The Mexican central bank (Banxico) has recently cut the reference rate to 3.75% from 4.0% as a result of the recent setback on economic growth. Supported by benign inflation patterns, Banxico decided to act despite the exchange rate volatility and regardless of the low visibility on US monetary policy (see Fig. 2). We think monetary policy will remain closely linked to economic performance; the recent rate cut should not be considered the beginning of a loosening cycle. We expect monetary policy to remain data-dependent; if the economic reacceleration takes longer than expected, Banxico could take further action. Equities: Outperformance expected, volatility should remain high As a consequence of the local turmoil unleashed by negotiations on the secondary laws of the recently approved reforms, the political tensions in the Middle East and the low visibility on the US Federal Reserve's monetary intentions, the MSCI Mexico underperformed peers in August (see Fig. 3). This negative news flow highly impacted the performance of the USDMXN, which accounted for 50% of the underperformance. Mexican equities should recover towards yearend. Mexico is still one of our preferred EM markets. Nevertheless, volatility will continue as reforms are approved and geopolitical tensions weigh on risky assets, we think. Local equities are set to benefit from better economic momentum and from positive political news flow as reforms are approved. September should be the most important month for President Peña since he took office last December, since Congress will debate and most likely approve structural reforms and secondary legislation related to telecom, education, energy, and tax reforms. We remain positive on the approval of reforms and the long-term positive impact they will have on the Mexican equity market. Moreover, our investment case for the Mexican peso remains intact despite the recent depreciation. We expect the peso will appreciate in the months ahead, further supporting equity performance. Earnings growth expectations for 2013 have been lowered from 22% in January to the current 3.0%. Meanwhile estimates for 2014 were increased to 13% from 8% in the same period. These could be revised downwards once analysts fully incorporate a weak 3Q13 currency. However, consensus earnings growth remains within our expectations of 0 5% for 2013 and 10 15% for 2014. The Mexican equity market should perform well in the months ahead; our preferred sectors are financials, real estate, airports, and infrastructure. Fig. 2. Inflation remains well contained and in line to reach the target Headline and core inflation (yoy, in %) 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% Target Headline Core 2.0% Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Source: Inegi, UBS as of 06-Sep-2013 Table 2. We upgrade mining and downgrade retail Mexico: local equity strategy Sectors Current Previous Food and personal products Retail Healthcare Homebuilders Beverages Financials Industrials Airports Infrastructure Cement Mining Metals Telecom Media Real Estate Source: UBS as of 06-Sep-2013 Preference Fig. 3. Equities' underperformance is largely attributed to the USDMXN MSCI Mexico and MSCI emerging markets performance (31 Jul 2013 = 100) 108 106 104 102 100 98 96 94 92 MSCI Mexico (USD) MSCI EM (USD) MSCI Mexico (MXN) 90 31-Jul-13 7-Aug-13 14-Aug-13 21-Aug-13 28-Aug-13-1.9% -3.1% -6.6% Source: Bloomberg, UBS CIO as of 06-Sep-2013 UBS CIO WM Research 9 September 2013 2
Fixed income: Volatility detracts from risk-adjusted returns The Mexican sovereign yield curve sold off considerably in August following the increase in US Treasury yields. Interest rates on three to five year tenures increased 50bps during the month. Despite the recent rally triggered by the reference rate cut, we think rates could continue to go up as global yields trend higher. Increased volatility detracts from risk adjusted-returns, thus we do not think yields on medium and long tenures properly compensate investors in the current environment. Moreover, liquidity for Mexican sovereign assets is somewhat constrained, the curve is greatly influenced by foreign and local institutional investor flows. Despite the yield increase and the sharp peso depreciation, data suggests international investors continue to have well-anchored positions in local fixed income assets, which we view as positive. However, they have moved along the yield curve into shorter-dated tenures that provide less volatility. Local pension funds have also exited the 20 30 year section of the yield spectrum, adding pressure to long-term yields. Consequently, we do not see technical support for longer dated assets as the most relevant investors will likely be inclined to continue reducing exposure, driving yields higher, rather than buying into these tenures. Table 3. We maintain our previous recommendations Mexico: local fixed income strategy Segment Current Previous Sovereign 1-5 years Sovereign 5-10 years Sovereign 10-15 years Sovereign 15-30 years Sovereign real rates (UDIs) Corporate bonds - floating Corporate bonds - fixed Source: UBS as of 06-Sep-2013 Preference Fig. 4. General increase in yields +50bps Mexican yield curve in August (interest rates in %) We think investors are well-advised to maintain exposure to maturities within 1 5 years, both in the nominal and inflation-linked pesodenominated sovereign universe. Corporate credit: Spreads reach all-time lows After the recent sell-off seen in EM asset classes, Mexican corporate spreads decreased to all-time lows. Moreover, quasi-sovereign spreads also contracted significantly, some even reaching negative territory (see Fig. 5). We do not think corporate spreads should contract further, as we believe the potential positive impact of the energy and fiscal reforms is already priced in. Long-term credit issuance in the first eight months of the year increased 39.8% compared to 2012. The total amount of corporate credit in the local market reached its highest level, and sums up to 2.68% of GDP at the end of August. We expect credit issuance to rise further in the months ahead as global rates stabilize and macroeconomic conditions in Mexico improve towards year-end. Mexican corporates should benefit from the expected economic recovery in 2H13. We maintain neutral positioning on local corporate credit in USD and MXN in our local investment strategy and advise investors to wait for more attractive and less volatile opportunities to rebuild positions. Furthermore, on current holdings we favor a balanced mix of fixed and floating-rate securities with maturities of no longer than 10 years from well-known and high rated credit issuers. The USDMXN is one of our preferred EM currencies The Mexican peso remained under pressure in August as interest rates in the US continued rising. We think the current market view on the reduction of the asset purchases is slightly too bearish, which could translate into some near-term support for EM currencies, including MXN. However, bouts of volatility remain likely given the uncertainty surrounding the US Federal Reserve's intentions. A solid fiscal stance and positive current account dynamics versus peers should continue to support the currency pair in the medium term. Additionally, the USDMXN should greatly benefit from a healthier US economy and from the expected industrial and manufacturing rebirth. Source: PIP, UBS as of 06-Sep-2013 Fig. 5. Credit issuance should accelerate in 2H13 Annual credit issuance (MXN billion) 300 250 200 150 100 50 0 14 39 81 140 142 143 167 169 163 248 225 225 154 01 02 03 04 05 06 07 08 09 10 11 12 13* * first 8 months of the year; Source: Accival, UBS as of 06- Sep-2013 UBS CIO WM Research 9 September 2013 3
Once the US monetary policy stance becomes clearer, we think the peso will appreciate against the USD as the Mexican reform agenda proceeds and economic momentum re-accelerates. Our three, six and 12-month forecasts stand at 12.3, 12.2 and 12.0, respectively. Fig. 6. Low visibility on US monetary policy pressures the MXN US 10-y interest rate (in %) and USDMXN 3.1 13.6 Risks to our investment case Most of the upside potential for our Mexico investment case depends on reform approval. Depending on the scope of the approved reforms, the potential growth of Mexico's structural capabilities is unique in EM. However, investors should be willing to tolerate shortterm obstacles and the potential risk of a political lock-down that could block the reform agenda. 2.9 2.7 2.5 2.3 2.1 1.9 10-year UST USDMXN (rhs) 13.4 13.2 13.0 12.8 12.6 12.4 12.2 1.7 12.0 1.5 11.8 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Source: Bloomberg, UBS as of 06-Sep-2013 UBS CIO WM Research 9 September 2013 4
Appendix Investors should be aware that Emerging Market assets are subject to, amongst others, potential risks linked to currency volatility, abrupt changes in the cost of capital and the economic growth outlook, as well as regulatory and socio-political risk, interest rate risk and higher credit risk. Assets can sometimes be very illiquid and liquidity conditions can abruptly worsen. WMR generally recommends only those securities it believes have been registered under Federal U.S. registration rules (Section 12 of the Securities Exchange Act of 1934) and individual State registration rules (commonly known as "Blue Sky" laws). Prospective investors should be aware that to the extent permitted under US law, WMR may from time to time recommend bonds that are not registered under US or State securities laws. These bonds may be issued in jurisdictions where the level of required disclosures to be made by issuers is not as frequent or complete as that required by US laws. For more background on emerging markets generally, see the WMR Education Notes, "Emerging Market Bonds: Understanding Emerging Market Bonds," 12 August 2009 and "Emerging Markets Bonds: Understanding Sovereign Risk," 17 December 2009. Investors interested in holding bonds for a longer period are advised to select the bonds of those sovereigns with the highest credit ratings (in the investment grade band). Such an approach should decrease the risk that an investor could end up holding bonds on which the sovereign has defaulted. Sub-investment grade bonds are recommended only for clients with a higher risk tolerance and who seek to hold higher yielding bonds for shorter periods only. Please note that these bonds may not necessarily be registered with the US Securities and Exchange Commission nor blue-skyed in the US. 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