Mexico

In absolute terms, Mexican markets may correct given their impressive rally and an impending EM risk-off move. Relative to EM however, Mexico will continue to outperform given its unique cyclical and structural macro fundamentals, as well as attractive valuations.

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Mexico is caught between crosscurrents. On the one hand, headline and core inflation are at multi-decade highs. On the other hand, genuine inflationary pressures are subdued, and fiscal and monetary policies are hawkish. Going forward, the economy will decelerate meaningfully, but likely achieve a soft landing as the central bank will be able to cut rates in H2 2022. Further, the nation’s healthy external accounts will put a floor in the domestic slowdown. We continue to overweight Mexico across all EM asset classes.

Executive Summary Mexico: Inflation Is At A Two-Decade High Mexican financial markets – stocks, fixed-income and the currency – will continue outperforming their EM counterparts. The Mexican economy is vulnerable to faltering US growth, but this negative shock will be mitigated by robust auto shipments, tourism revenues and remittances. Notably, Mexican exports will suffer less than those of Emerging Asia and South America. Economic activity in Mexico has barely recovered to its pre-pandemic level. Conditions for a lasting inflationary outbreak are currently absent. Considering these factors, we believe that a major economic bust is not in the cards. Very tight monetary and fiscal policies are favorable for Mexican fixed-income markets as they will slow down the economy and cap inflationary pressures. Mexican assets are likely to be re-rated versus their EM counterparts in the coming years due to geopolitical considerations. On EM Equity Benchmark Recommendation Inception Date RETURN Long MXN / Short BR 2022-07-28   Bottom Line: We continue to recommend investors overweight Mexican equities, and local and sovereign fixed income within their respective EM portfolios. We are instituting a stop buy on Mexican local currency 10-year government bonds. For currency traders, we recommend a long MXN/short BRL position. Feature We have been overweighting Mexican markets on a cyclical and structural basis since early 2018 and this strategy has played out well (Chart 1 and Chart 2). Chart 1Our Calls On Mexican Equities And Currencies Have Done Really Well... Chart 2...And So Have Our Fixed-Income Calls In this report, we elaborate on the reasons why Mexican financial markets – stocks, fixed-income and the currency – remain among our favorites within the EM space, and why they are in a strong position to continue outperforming their EM counterparts, even amidst a US growth slump. Is The Economy Overheating? As in many economies around the world, headline inflation has reached a two-decade high in Mexico (Chart 3, top panel). How big of a threat is it for the Mexican economy? In our view, the Mexican economy has not been overheating, and a wage-price spiral has not yet developed. Hence, inflation in Mexico is not fully entrenched and is not likely to be persistent. First, the business cycle is only now moving from a recovery to an expansionary phase. Chart 4 shows that various segments of the economy have only recently reached – or are nearing – their pre-pandemic levels. Note that the chart shows the series as a three-year rate of change, i.e., the last datapoints compare 2022 with 2019. In brief, economic activity and demand have not yet surpassed their pre-pandemic (2019) levels. Chart 3Mexico: Inflation Is At A Two-Decade High Chart 4Mexico: Economic Activity Is Only Back To Pre-Pandemic Levels Chart 5Mexico: The Labor Market Is Tightening, But Slack Remains Second, according to data from the central bank (Banxico), the output gap remains quite negative at around -4% of potential GDP, suggesting there is plenty of slack in the economy. Third, there is still room for the labor market is tighten further without major upward pressure on wages. The top two panels of Chart 5 show that the unemployment and underemployment rates have not yet dropped to new lows, i.e., they remain above pre-pandemic levels. Further, although average wage growth has accelerated, it remains within its historical range, and is well below core CPI (Chart 5, bottom panel). Finally, Mexico lacks a key driver of genuine inflation, which is mushrooming unit labor costs – defined as the ratio of wages over productivity. Inflation is unlikely to become entrenched unless unit labor costs rise sharply, i.e., unless wage growth outstrips productivity growth. In Mexico, unit labor costs – using real not nominal wages – are actually falling (Chart 6). Please see our latest strategy report for a more detailed explanation of the relationship between unit labor costs and inflation. Chart 6Unit Labor Costs In Mexico Are Falling Overall, rising inflation has by and large not been due to excessive demand, and a wage-price spiral has not yet developed. Consistently, even though alternative core measures of inflation – like trimmed-mean CPI and services CPI – have also risen, they remain much more contained than headline and core CPI (Chart 3, bottom panel, above). This makes Mexico stand apart from Chile, Brazil, and Colombia, where economic overheating has created fertile grounds for genuine and persistent inflation. In these countries, part of the inflationary outbreak can be explained by massive pandemic fiscal packages and a slow response from monetary authorities, leading to an overheating scenario. Accordingly, the Mexican central bank will not have to raise rates as much as its regional peers because the Mexican economy is not overheating. Bottom Line: Economic activity in Mexico has barely recovered to its pre-pandemic level. Conditions for a lasting inflationary outbreak are currently absent. Considering these factors, we believe that a major economic bust is not in the cards. Monetary And Fiscal Policies: Ahead Of The Inflation Curve? A tight monetary and fiscal policy mix will slow down the economy and cap inflationary pressures. The central bank is in full hawkish mode, and it will continue raising rates until the end of this year. The basis is that Banxico will be reluctant to go on hold when the nation’s inflation remains well above target. In addition, the Fed is set to continue hiking rates into next year. The US, in contrast to Mexico, is already experiencing a wage-price spiral. The Fed’s tightening will continue supporting the US dollar and weigh on other currencies, including the Mexican peso. In brief, Banxico will at least match the Fed hikes in the reminder of this year. Overall, high and rising borrowing costs in Mexico will restrain domestic demand. Our proxy for the marginal propensity to consume indicates that household consumption will slow down in the coming months (Chart 7, top panel). This will likely lead to a roll-over in core CPI. In fact, the sharp deceleration in narrow money (M1) supply points to cresting inflationary pressures (Chart 7, bottom panel)  On the fiscal front, while left-wing in name, the government of Mexico continues to run one of the most austere fiscal policies in the world. The primary fiscal balance has been around zero and the overall deficit has not exceeded 3% of GDP – even during the peak of the pandemic (Chart 8, top panel). The fiscal thrust in 2022 is expected to be -1.3% of GDP (Chart 8, bottom panel). This will also curtail domestic demand growth, and thereby diminish inflationary pressures. Chart 7Mexico's Growth And Inflation Will Slow Down Chart 8Mexico's Fiscal Policy Has Been Among The Tightest In The World   Furthermore, government policies have also kept inflation at bay by subsidizing the cost of gasoline at the pumps. In effect, this has allowed gasoline prices in Mexico to fall below those in the US for the first time in over five years. Given the high pass-through effect from fuel to other prices in developing economies, this policy will also limit the rise in core inflation. We can expect this subsidy policy to remain in place for the coming months. The basis is that the net cost of this subsidy from March to May has been around $3 billion USD or a mere 0.2% of GDP. Given that the primary fiscal balance is at zero and public debt stands at a manageable 42% of GDP, the government will be able to continue financing this policy with little fiscal risk. Bottom Line: Very tight monetary and fiscal policies are favorable for Mexican fixed-income markets as they will slow down the economy and cap inflationary pressures. The External Backdrop Favors Mexico Relative To Other EMs The global macro outlook will help the Mexican economy and its financial markets outperform their EM peers. In our view, the global economy is experiencing a material growth slowdown. On the one hand, developed countries (the US and the EU) are experiencing a shift from demand for consumer goods (ex-autos) towards vehicles and services. On the other hand, China’s newly enacted infrastructure financing will serve to only offset the fall in government revenues from land sales. Hence, there is little new stimulus for infrastructure beyond what has been approved in the budget plan earlier this year. In brief, China’s business cycle recovery will be U-shaped rather than V-shaped with risks to the downside. This will weigh heavily on developing countries dependent on Chinese imports. Our baseline global macro scenario assumes contracting global trade and a further drop in commodity prices. This is indeed worrisome for Mexico, which is both a major manufacturing hub supplying the US and a commodity producer. That said, the country will likely outperform other EMs during this global downturn for the following reasons. First, Mexico will suffer less from the shift in US household spending from consumer goods towards autos and services due to its unique export composition. Mexican vehicle exports constitute 23% of its total exports, while exports of non-auto consumer goods (excluding food and beverages) make up only 13%. Further, Mexican vehicle exports remain below pre-pandemic levels in unit terms (Chart 9). As the global chip shortage eases, Mexico will experience a boom in auto exports as it increases production. Pent-up demand for cars in the Americas combined with the large share of autos in Mexican exports will help Mexico outperform Asian economies – which export a lot of consumer goods (non-autos) to DM – and LATAM economies that sell commodities. In short, Mexican exports will suffer less than those of Emerging Asia and South America in the coming months. Second, Mexico stands to benefit from the shift in DM/US demand from goods to services due to its large tourism industry. Not only has the number of tourists recently surged, but also the average revenue per visitor has skyrocketed by 50% (Chart 10, top and middle panel). However, the number of visitors is still well below the pre-pandemic level, meaning the upside potential is still substantial. Chart 9Mexican Vehicle Exports Have Much More Upside Chart 10Mexican Tourism Revenues Will Continue Rising   Mexico’s overall tourism revenues will expand given the pent-up demand for travel (Chart 10, bottom panel).   Chart 11Remittances Into Mexico Will Remain Robust Third, remittance flows into Mexico will remain robust for now (Chart 11). US nominal wages are rising sharply, and employment among low-skilled workers will not decline much. The basis for this is that there are still many open positions to be filled. Hence, US household nominal income growth, and thereby remittances to Mexico, will remain robust in the months ahead. Finally, even though oil prices will likely drop materially in the coming months for reasons we discussed in last week’s report, the peso will not be affected as much as other commodity currencies. The basis is that oil exports comprise only 6.7% of Mexican total exports. Plus, the government typically hedges a portion of its oil revenues. Thus, Mexico did not benefit a lot from the oil price surge earlier this year, and it will not suffer enormously as crude prices drop further. Bottom Line: Robust auto shipment, tourism revenues and remittances will mitigate the negative shock to the Mexican economy and balance of payments from faltering US growth. Consumer goods (ex-autos) account for a larger share of Asian exports vis-à-vis Mexican exports. Meanwhile, South American countries export a significant amount of commodities. Contracting shipments of consumer goods to the US and the EU will hurt emerging Asian economies significantly while deflating commodity prices will weigh down on the balance of payments, growth and financial markets of South American economies. Overall, Mexico will be a relative winner. Structural Backdrop Chart 12Mexico: Foreign And Domestic Investments Are Turning Around Mexico’s structural backdrop is also somewhat more benign relative to many other emerging economies: As we have written in previous reports, Mexico is in a unique position to profit from the US’s and global multinationals’ nearshoring efforts to shift manufacturing away from China. There is some anecdotal evidence1 and data confirming that this process has started: FDI inflows and capital expenditures are bottoming, and capital goods imports are back to their previous highs (Chart 12). More FDIs will enhance manufacturing productivity and the competitiveness of Mexico’s maquiladora sector. Besides, business confidence has finally recovered to levels prior to the election of president Andrés Manuel López Obrador (commonly known as AMLO). Importantly, while AMLO has been interventionist in the energy sector (oil and electricity), he has not meddled in other industries. Improved business confidence could lead to more domestic investment (Chart 13). Mexico badly needs more capital spending to boost meager productivity growth in domestic sectors. The risk premium on Mexican markets will probably drop relative to other EMs due to geopolitical considerations, i.e., Mexican assets are likely be re-rated versus their EM counterparts in the coming years. The geopolitical confrontation between the US and China might split the world into two competing camps: US- and China-centric geopolitical and economic blocs, with Mexico surely being in the US-centric one. As a result, multinationals as well as US, European and Japanese portfolio investors will feel more comfortable investing in Mexico than in many Asian markets. Some Emerging Asian financial markets might experience international portfolio capital exodus if they join the China-centric bloc. Structural macro parameters – such as the current account, fiscal deficit and public debt, and private sector leverage – are more favorable in Mexico compared to other EMs. Mexico’s current account balance is almost at zero (Chart 14, top panel). Public debt is at 42% of GDP and private credit penetration stands at only 19% of GDP (Chart 14, bottom panel). Even if state-owned oil company PEMEX’s entire debt is taken over by the government, it will add about 8% of GDP to Mexico’s public debt burden, i.e., the latter will rise to only 50% of GDP. Chart 13Mexico: Business Confidence Has Recovered Despite AMLO Chart 14Mexico: Balance Of Payments And Debt Backdrops Are Healthy   These benign macro parameters – coupled with the orthodox and tight fiscal and monetary policy mix – suggest that downside in the peso will be limited. The basis is that global fixed-income investors typically favor currencies where monetary and fiscal policies are orthodox and err on the side of tightness. Finally, banks are well capitalized and their provisions are high. Banks are in a healthy position to finance the nation’s growth. Overall, we are not suggesting that Mexico is free from serious socio-economic problems and that its economy is set to boom. This nation has numerous structural issues like organized crime, corruption in local governments, weak rule of law, low productivity, and high concentration (oligopolistic structure) in select industries that enable their pricing power and make inflation persistent. However, compared with many other developing countries, Mexico’s profile is slightly more favorable, especially adjusted for its financial market valuations. Investment Recommendations To come up with an investment strategy for Mexican financial markets, we must incorporate our global macro view. Two of our broad macro themes are: (1) the Fed and the US stock market are on a collision course;  and (2) the US dollar will continue overshooting. Together these suggest that, in absolute terms, Mexican financial markets and the exchange rate remain at risk of selling off in the coming months. Nevertheless, we reiterate our overweight stance on Mexico across all EM asset classes: stocks, local bonds, sovereign credit and currencies. Equities: Keep overweighting Mexico within an EM equity portfolio. Mexican equity valuations remain attractive in absolute terms and relative to EMs based on the various multiples (Chart 15 and Chart 16).  Chart 15Mexican Stocks Are Cheap In Absolute Terms!... Chart 16...And Are Also Attractive Relative To EM Furthermore, relative bond yields between Mexico and mainstream EM will drop. This will support the outperformance of Mexican equities versus EM non-TMT stocks and the overall EM benchmark. Currency: The Mexican peso is vulnerable in the near term as the Fed continues ratcheting up interest rates and the US economy slumps. However, the peso is cheap, and its depreciation will be more limited compared to other LATAM countries.  Therefore, we recommend investors long the MXN and short the BRL. Not only are Mexico’s macro variables more favorable than those of Brazil, but also the peso is cheap while the Brazilian real is slightly expensive (Chart 17). We elaborated on Brazil’s macroeconomic, financial and political outlook in our May 17 report. Sovereign credit (US dollar bonds): We continue to recommend an overweight position in Mexican sovereign credit within an EM credit portfolio. The rationale for this is Mexico’s benign structural macro parameters, as discussed above. Local currency bonds: 10-year local currency bond yields at 8.8% offer very good value. Weighing long-term pros and near-term cons, we are instituting a stop buy trade on Mexican 10-year domestic government bonds when either yields hit 10% or the MXN/USD reaches 22.5 (Chart 18). Chart 17Go Long MXN Versus BRL Chart 1810-Year Domestic Mexican Bonds Offer Good Value Chart 19We Have Been Betting On Yield Curve Flattening For now, we continue betting on further yield curve inversion. We instituted this position on August 12, 2021 and it has been very profitable (Chart 19).   Juan Egaña Associate Editor juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     George Lei and Michael O’Boyle, “Mexico’s ‘Super Peso’ Shocks Traders Who Were Betting On Wipeout,” Bloomberg, July 26, 2022, www.bloomberg.com.

Executive Summary Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies have lagged the surge in crude prices. This has been specific to the currency space since energy stocks have been in an epic bull market.Both cyclical and structural factors explain this conundrum.Cyclically, rising interest rate expectations in the US have dwarfed the terms-of-trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy (Feature Chart).Structurally, the US is now the biggest oil producer in the world (and a net exporter of natural gas). This has permanently shifted the relationship between the foreign exchange of traditional oil producers and the US dollar.Oil prices are overbought and vulnerable tactically to any resolution in the Russo-Ukrainian conflict. That said, they are likely to remain well bid over a medium-term horizon, ultimately supporting petrocurrencies.Petrocurrencies also offer a significant valuation cushion and carry relative to the US dollar, making them attractive for longer-term investors.Tactically, the currencies of oil producers relative to consumers could mean revert. It also suggests the Japanese yen, which is under pressure from rising energy imports, could find some footing, even as oil prices remain volatile.RECOMMENDATIONINCEPTION LEVELINCEPTION DATERETURNShort NOK/SEK1.112022-03-24-Bottom Line: Given our thesis of lower oil prices in the near term, but firmer prices in the medium term, we will be selling a basket of oil producers relative to oil consumers, with the aim of reversing that trade from lower levels.FeatureOil price volatility is once again dominating global market action. After hitting a low of close to $96/barrel on March 16th, Brent crude is once again at $120 as we go to press. Over the last two years, Brent crude has been as cheap as $16, and as expensive as $140. Energy stocks (and their respective bourses) have been the proximate winner from rising oil prices (Chart 1).Related ReportForeign Exchange StrategyWhat Next For The RMB?In foreign exchange markets, the currencies of commodity-producing countries have surprisingly lagged the improvement in oil prices (Chart 2). Historically, higher oil prices have had a profound impact on the external balance of oil producing versus consuming countries in general and petrocurrencies in particular. Chart 1Energy Stocks Have Tracked Forward Oil Prices  Chart 2Petrocurrencies Have Lagged Oil Prices Based on the observation above, this report addresses three key questions:Are there cyclical factors depressing the performance of petrocurrencies?Are there structural factors that have changed the relationship of these currencies with the US dollar?What is the outlook for oil, and the impact on short term versus longer-term currency strategy?We will begin our discussion with the outlook for oil.Russia, Oil, And PetrocurrenciesA high-level forecast from our Commodity & Energy Strategy colleagues calls for oil prices to average $93 per barrel this year and next.1 The deduction from this forecast is that we could see spot prices head lower from current levels this year but remain firm in 2023. From our perspective, there are a few factors that support this view:Forward prices tend to move in tandem with the spot fixing (Chart 3), but recently have also been a fair predictor of where current prices will settle over the medium term. Forward oil prices are trading at a significant discount to spot, suggesting some measure of mean reversion (Chart 4). Chart 3Forward And Spot Oil Prices Move Together  Chart 4The Oil Curve And Spot Prices There is a significant geopolitical risk premium embedded in oil prices. According to the New York Federal Reserve model, the demand/supply balance would have caused oil prices to fall between February 11 and February 25 this year. They however rose. This geopolitical risk premium has surely increased since then (Chart 5).Chart 5Oil Prices Embed A Significant Geopolitical Risk Premium Russian crude is trading at a sizeable discount compared to other benchmarks. This means that the incentive for substitution has risen significantly. Our Chief Commodity expert, Robert Ryan, noted on BLU today that intake from India is rising. This is helping put a floor on the Russian URAL/Brent discount blend at around $30 (Chart 6). Oil is fungible, and seaborne crude can be rerouted from unwilling buyers to satiate demand in starved markets.A fortnight ago, we noted how the US sanctions on Russia could shift the foreign exchange landscape, especially vis-à-vis the RMB. Specifically, RMB-denominated trade in oil is likely to increase significantly going forward. China has massively increased the number of bilateral swap lines it has with foreign countries, while stabilizing the RMB versus the US dollar.2Finally, smaller open economies such as Canada, Norway and even Mexico are opening the oil spigots (Chart 7). While individually these countries cannot fill any potential gap in Russian production, collectively they could help in the redistribution of oil supplies. Chart 6Russian Oil Is Selling At A Discount  Chart 7Small Oil Producers Will Benefit From High Prices The observations above suggest that the currencies of small oil-producing nations are likely to benefit in the medium term from a redistribution in oil demand. Remarkably, there has been little demand destruction yet from the rise in prices, according to the New York Fed. This suggests that as the global economy reopens, and the demand/supply balance tightens, longer-term oil prices will remain well bid.The key risk in the short term is the geopolitical risk premium embedded in oil prices fades, especially given the potential that Europe, China, and India continue to buy Russian supplies. We have been playing this very volatile theme via a short NOK/SEK position. We are stopped out this week for a modest profit and are reinitiating the trade if NOK/SEK hits 1.11.On The Underperformance Of Petrocurrencies? Chart 8Petrocurrencies Have Lagged Terms Of Trade The more important question is why the currencies of oil producers like the CAD, NOK, MXN or even BRL have not kept pace with oil prices as they historically have. As our feature chart shows (Chart 8), petrocurrencies have severely lagged the improvement in their terms of trade. This has been driven by both cyclical and structural factors.Cyclically, the underlying driver of FX in recent quarters has been the nominal interest rate spread between the US and its G10 counterparts. We have written at length on this topic, and on why we think there is a big mispricing in market behavior in our report – “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant.” In a nutshell, two-year yields in the G10 have been lagging US rates, despite other central banks being ahead of the curve in hiking interest rates. This means that rising interest rate expectations in the US have dwarfed the terms of trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy.Structurally, the US is now the biggest oil producer in the world (Chart 9). This means the CAD/USD and NOK/USD exchange rates are experiencing a tectonic shift on a terms-of-trade basis. In 2010, the US accounted for only about 6% of global crude output. Collectively, Canada, Norway, and Mexico shared about 10% of global oil production. The elephant in the room was OPEC, with a market share just north of 40%. Today, the US produces over 14%, with Russia and Saudi Arabia around 13% each, the US having grabbed market share from many other countries. Chart 9The US Dominates Oil Production  Chart 10The US Dollar Is Becoming Increasingly Correlated To Oil As a result of this shift, the positive correlation between petrocurrencies and oil has gradually eroded. Measured statistically, the dollar had a near-perfect negative correlation with oil around the time US production was about to take off. Since then, that correlation has risen from around -0.9 to around -0.2 (Chart 10).A Few Trade IdeasThe analysis above suggests a few trade ideas are likely to generate alpha over the medium term:Long Oil Producers Versus Oil Consumers: This trade will suffer in the near term as oil prices correct but benefit from a relatively tighter market over a longer horizon. It will also benefit from the positive carry that many oil producers provide (Chart 11). We will go long a currency basket of the CAD, NOK, MXN, BRL, and COP versus the euro at 5% below current levels.Chart 11Real Rates Are High Amongst Petrocurrencies Sell CAD/NOK As A Trade: Norway is at the epicenter of the likely redistribution that will occur with a Russian blockade of crude, while Canada is further away from it. Terms of trade in Norway are doing much better than a relative measure in Canada (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate. Chart 12CAD/NOK And Terms Of Trade Follow The Money: Oil now trades above the cash costs for many oil-producing countries. This means the incentive to boost production, especially when demand recovers, is quite high. This incentivizes players with strong balance sheets to keep the taps open. This could be a particular longer-term boon for the Canadian dollar which is seeing massive portfolio inflows (Chart 13). Chart 13Canadian Oil Export Boom And Portfolio Flows On The Yen (And Euro): Rising oil prices have been a death knell for the yen which is trading in lockstep with spot prices. Ditto for the euro. However, the yen benefits from very cheap valuations and extremely depressed sentiment. Any temporary reversal in oil prices will boost the yen (Chart 14). In our trading book, we were stopped out of a short CHF/JPY position last Friday, and we will look to reinitiate this trade in the coming days.  Chart 14The Yen And Oil Prices  Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comFootnotes1 Please see Commodity & Energy Strategy Weekly Report, “Uncertainty Tightens Oil Supply”, dated March 17, 2022.2 Please see Foreign Exchange Strategy Special Report, “What Next For The RMB?”, dated March 11, 2022.Trades & ForecastsStrategic ViewTactical Holdings (0-6 months)Limit OrdersForecast Summary

Highlights Mexico has been experiencing stagflation: core inflation has risen sharply while the level of domestic demand in real terms is well below its pre-pandemic level. Going forward, tight fiscal and monetary policies will put a lid on domestic demand, easing inflationary pressures. The two main upside risks to Mexico’s inflation are a continuous rise in global food prices and broad EM currency depreciation causing a setback in the peso. Weighing pros and cons, we reiterate our overweight stance in Mexican equities, local bonds and sovereign credit within their respective EM portfolios. Fixed-income investors should stay with the yield curve trade: pay 1-year and receive 10-year swap rates in Mexico. Feature Mexican assets have been among the top performers in the EM space this year. However, there is one force which threatens to upset its economic recovery and financial outperformance versus its EM counterparts: inflation. In Mexico, core and headline consumer price inflation rates are at worrisome levels, rising well above the central bank’s target range (Chart 1). In our view, this overshoot in Mexico’s inflation will not be enduring. A combination of domestic demand weakness and a relatively firm currency will reduce core inflation in the coming months as projected by our inflation model (Chart 2). Chart 1Mexico: Inflation Is Well Above The Central Bank's Target Range Chart 2Will Mexico's Core CPI Roll Over In The Coming Months? We therefore maintain our overweight stance in Mexican equities, local bonds and sovereign credit within their respective EM portfolios. While Mexico has a number of problems and vulnerabilities - as discussed in The Stars Are Aligning For Mexico report - its financial markets offer a better risk-reward profile than the rest of EM. Stagflation And Its Causes Chart 3Mexico: Domestic Demand Is Below Pre-Pandemic Levels Mexico’s core consumer price inflation has surged while the post-pandemic domestic demand recovery has been mediocre – the level of consumer spending and capital expenditures in real terms are well below their pre-pandemic level (Chart 3). This qualifies as stagflation. When addressing inflation concerns in any country, the first question we must ask ourselves is what the underlying causes of broadly rising prices are, and if these factors will persist. While Mexico shares many characteristics of the post-pandemic worldwide spike in inflation, there are also some intrinsic factors that have contributed significantly to the rise in its inflation. Among common inflation factors affecting many economies around the world are high commodity prices, supply constraints, easy monetary policy and the release of pent-up demand from the economic reopening. On the other hand, it is worth noting those particular forces that have pushed inflation higher in Mexico: Chart 4Un- And Under-Employment Rates In Mexico Did Not Rise A Lot Mexico’s labor market did not collapse during the pandemic, which prevented household incomes from plummeting as in the rest of Latin America. Chart 4 shows that the unemployment and underemployment rates in Mexico rose much less than those in Brazil or other Latin American countries. This is because throughout the past year and a half, Mexico’s social distancing measures were milder than they were in the rest of the region. This lack of measures has meant less in the way of job losses, though it has contributed to one of the world’s highest death tolls and infection rates. On the supply side, many businesses in Mexico folded. As a result, supply has been seriously reduced and, with less competition, those businesses that remain afloat have gained pricing power. Mexico had one of the world’s lowest pandemic aid programs in the world, worth only around 1.2% of GDP. This was particularly rough on small businesses, which only received an equivalent one-time $1,100 USD loan to cover losses. Data from the National Institute of Statistics and Geography (INEGI) shows that 21% of established businesses closed down in 2020. Finally, high inflation can be attributed to structurally low competition and lack of productive capacity. As we wrote in a previous report, the prevalence of oligopolies in many industries and the lack of investment have led to sluggish productivity growth in Mexico, which has created fertile conditions for higher inflation. Chart 5Mexico Has Not Been Investing In general, Mexico is a very underinvested country. Chart 5 shows that real capital expenditures as a share of real GDP have been dwindling since 2008 to a very low level of 17.5% of GDP. Capacity has not been expanding sufficiently for many years. This and the demise of many businesses during the pandemic have created conditions where output cannot match even a modest increase in demand. Such a phenomenon also leads to structurally high household and business inflation expectations, which facilitates the pass-through effect of higher commodity prices. Bottom Line: Mexico’s inflation outbreak has happened not due to booming demand but to lagging supply. Hence, the current episode has stagflation undertones.   The Inflation Outlook Going forward, tight fiscal and monetary policies will put a lid on domestic demand, easing inflationary pressures: Commercial banks’ credit is very weak for both consumers and companies (Chart 6). This and decelerating money supply foreshadow a slowdown in domestic demand (Chart 7). Chart 6Mexico: Private Sector Credit Is Sluggish Chart 7Narrow Money Points To Economic Weakness Chart 8Wage Growth Is Zero In Real Terms Average nominal wages per worker have rolled over dramatically, and in real terms (deflated by core CPI) wage growth is zero (Chart 8). This will limit household purchasing power. The inflation overshoot in Mexico has not been very broad-based. Our measure of trimmed-mean core inflation has already rolled over, and services inflation remains within the central bank’s target range (Chart 9). There are higher odds that inflation will not be persistent and enduring when it is not generalized across various goods, services and industries. Further, economists and analysists do not see broad-based inflationary pressures in the economy – their inflation expectations have not broken out (Chart 10). These data are from a monthly survey by the central bank (Banxico) which polls local and foreign banks and financial analysts. Chart 9The Inflation Overshoot Is Not Broad-Based Chart 10Inflation Expectations Are Contained The government and central bank have been and will continue pursuing very orthodox fiscal and monetary policies. Banxico is committed to keeping inflation under control to maintain its credibility: the tightening they have undertaken will cap inflation and inflation expectations from running away. In real terms, the policy rate remains at historical lows around zero percent (deflated by core and trimmed-mean inflation) (Chart 11). Odds are Banxico will push the real policy rate above 1% either through lower inflation and/or higher nominal rates. In terms of fiscal policy, there are no imminent worries of inflation triggered by fiscal profligacy. President AMLO continues to run the tightest fiscal policy in the region, maintaining a primary fiscal surplus throughout most of the past year and a half (Chart 12). Chart 11Banxico Will Push Real Rates Well Above Zero Chart 12Fiscal Policy Is Modestly Restrictive Next year’s budget proposes a 0.3% primary deficit and a nominal 3.8% growth in primary expenditures. The latter implies negative fiscal spending growth in real terms next year. This signifies a tight fiscal stance. Consistently, the fiscal thrust will be zero in 2022. Chart 13Mexico: Balance Of Payments Dynamics Are Healthy Externally, balance of payments dynamics will remain healthy, which will support the peso. A firm currency will exert downward pressure on inflation and inflation expectations: To begin, Mexico is in the advantageous position of being more exposed to the US business cycle than to China’s “old economy”. Therefore, unlike for other EM and regional peers, a slowdown in China’s construction and infrastructure sectors (and thereby possibly raw material prices) will not be very negative for the Mexican economy. The benefits from this exposure to the US economy is seen through the surge in Mexican non-energy exports, already surpassing pre-pandemic levels (Chart 13, top panel). This has occurred even though auto production has been derailed by parts/semiconductor shortages. As auto production revives, Mexican exports will expand further. With such robust exports, the trade and current account balances will remain at healthy surpluses (Chart 13, middle panel), continuing to support the peso going forward. Another positive development for this nation is the massive boom in remittances (Chart 13, bottom panel). Even if they begin to slow down in the coming months, their flow will remain well above pre-pandemic levels. Mexico will also profit from high oil prices. Even if oil prices drop from their current level, they will likely remain relatively elevated (say, above $60 per barrel) in the coming months. In addition, stable political dynamics in Mexico will reduce the chances of sudden depreciation moves in the currency. In fact, Mexico’s political landscape remains the most stable in Latin America.  Bottom Line: Odds are that core CPI will rollover in early 2022 (Chart 2, above). A Play On The US Industrial Boom As we discussed in the report titled Industrials As Equity Sector Winner In The Coming Years, the US will continue experiencing an industrial boom and this will spill into Mexico. In brief, Mexico is one of the few plays in the EM universe to benefit from the US industrial boom. Mexico is in a unique position to attract domestic and foreign capital inflows to its manufacturing industry. International reshoring efforts, its geographical and diplomatic closeness to the US, its well-established maquiladora sector and its cheap currency all serve to allow Mexico to benefit from the US industrial boom. In this context, FDI inflows will have a secular rise over the coming years (Chart 14, top panel). Capital goods imports are reviving (Chart 14, bottom panel). Rising imports of capital goods bodes well for the nation’s productivity, competitiveness and exports in the years to come. Upside Risks To Inflation Even though we are betting on diminishing inflationary pressures in Mexico, there are some upside risks to inflation. These factors are external: As in many developing economies, in Mexico food accounts for a very large weight in the CPI basket and food prices have material impact on inflation expectations and, hence, broader inflation. If global corn and wheat prices continue their impressive rally (Chart 15, top panel), they could sustain high inflation prints in Mexico. Chart 14FDI Inflows To Mexico Are Set To Revive Chart 15Rising Food Prices Pose An Upside Risk To Mexico's Inflation Critically, oligopolies in Mexico’s baked products sector have enjoyed high pricing power and amplify the effect of high global grain prices on domestic inflation. The CPI measure for food – and bread, tortillas and cereals in particular – is running at 8-10% (Chart 15, bottom panel). In comparison, cereals and bakery inflation for the US is at just 3.5%. Lower commodity prices (due to weakness in China’s economy) and rising US bond yields could induce EM currency weakness. Typically, the MXN depreciates significantly when EM currencies weaken as many investors short MXN – one of most liquid EM currencies –as a hedge for their long EM positions. If this scenario transpires and the peso relapses meaningfully and for several months, the rollover in core CPI will be modest or delayed. Investment Implications Equities: We recommend that investors maintain an overweight stance in Mexican stocks within an EM equity portfolio (Chart 16). Weak consumer spending is a risk to share prices. However, the outlook for many other EM bourses is worse. That is why we maintain our overweight in Mexico. The Mexican bourse remains cheap according to its cyclically-adjusted P/E ratio both in absolute terms and relative to the EM benchmark (Chart 17). Chart 16Mexican Stocks In Absolute Terms And Relative To EM Chart 17Mexican Equities Offer Value Chart 18The Mexican Peso Is Cheap Currency: The Mexican peso remains one of our favorites in the EM space. While we are negative on EM currencies versus the US dollar, we believe the MXN will outperform the rest of its peers outside a potential EM volatility-driven selloff period. Particularly, the peso remains cheap according to its real effective exchange rate (Chart 18). Fixed Income: We continue recommending overweight positions in both local bonds and sovereign credit within their respective EM portfolios. An orthodox macro policy mix, relatively stable political dynamics, healthy balance of payments as well as contained inflation will help Mexican fixed-income markets outperform their EM counterparts. Further, Mexico is one of the few countries worldwide that has actually lowered its public debt-to-GDP ratio below pre-pandemic levels, and it remains at a low 50% of GDP. Finally, we reiterate the following yield curve trade: pay 1-year and receive 10-year swap rates in Mexico. While Banxico will likely hike rates further making the short end of the curve vulnerable, long-dated local bond yields/swap rates have limited upside. We expect the yield curve will continue flattening. Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth Chart 6US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Chart 10       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades