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Time Is Up for Mexico
August 26, 2010
By John R. Taylor, Jr.
Chief Investment Officer
In the last few months, the office has received many positive analyses on Mexico and the Mexican
peso. It is hard for me to believe that so many can ignore so much history and so many blatant signals
of trouble. We can only conclude that the writers have been smoking one of Mexico’s most successful
exports – the one not hobbled by excess government control. The positive arguments seem to depend
on one of two conceptual frameworks. The first is the most academic, focusing almost entirely upon
the internal monetary and economic situation, which shows the government exercising impressive
control over the currency and monetary policy while following well accepted IMF-approved practices in
managing the economy. Unit labor costs are down, money supply growth is low and multipliers are
contracting. With all of these positive macro-economic policies in place, how could things not go well
for Mexico? When one considers that the currency is about 20% cheaper than it was in early 2008, the
argument is that Mexico must be in a good place and the peso must be a good buy against the dollar.
That declining labor cost is a big plus that the southern Europeans do not have, as all the Mexican gain
has come from the weakening currency. The other argument depends on a more mathematical
comparison of the peso with other Latin American economies and with global liquidity and fund flows.
The normal historical correlations seem to have broken down as Mexico is underperforming Brazil,
Chile, and even Colombia and Peru, and the analysts point out that this should not be the case.
Mexico has high yields and foreign mutual funds are accumulating their bonds. Global liquidity should
continue to explode and Mexican two year yields seem higher than they should be, offering real value.
With emerging markets the hottest asset class, why not buy Mexico? As it is lagging, it must be a
better value?

Perhaps Mexico is lagging because it is a worse investment than the others. I would go way beyond
that and say Mexico is a terrible investment. Fully one quarter of the country’s GDP depends on
exports to the United States, and in 2008 Mexican GDP dropped by 10% peak to trough, more than
twice that of the US. The Mexican work force’s two fiercest competitors are Chinese workers and US
workers, both of whom have rapidly improving productivity as well. If the American economy suffers a
recession in 2011, which we believe is a certainty (and now many others agree with us), the pressure
on the Mexican economy will be immense. Labor costs must drop sharply. Recent retail sales are
already falling and on a year-on-year basis are almost static. Tourism was harmed by the swine flue
scare last year and now drug related violence is threatening to do even worse damage. With the death
of major political figures and bomb threats in the news, the only way Mexico will attract tourists is with
rock bottom prices. Just this week, it was announced that Pemex would begin importing oil for the first
time in almost 40 years to keep its refineries running. Although there are technical reasons for this
shift, net oil exports are dropping each year and private projections show Mexico as a net oil importer in
less than ten years. Although Mexico’s future current account prospects look bleak, the external global
financial situation will have an even worse impact on the country. History shows the peso catching
pneumonia every time the US catches a cold: 1977, 1982, 1987, 1994, 1998, 2002, and 2008. The
three most significant collapses came several years after the beginning of a US recession, in 1977,
1982, and 1994. The others came with major equity market declines. As the world is still recovering
from the 2008 recession – and another seems on the way – and a major equity market decline is in our
future, the outlook for Mexico is dire. A 50% collapse in the value of the peso would be an optimistic
outcome and the odds favor a more significant weakening over a five year timeframe.

To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; Page 1

CURRENCY – Europe Long-Term View

Is Germany’s Success Bad for the Euro?
By Jonathan Clark

Germany’s GDP expanded 2.2%

during the second quarter of the
year, accounting for most of the
growth in the Eurozone, and this is
the strongest growth since the
country was reunified in 1990. Many
of the other euro members are
facing stagnation or worse. German
exports rose by 8.2% in the quarter
fueled by machinery and vehicle
sales to the non-European world.
Germany has been the largest
beneficiary of the decline in the euro
earlier in the year, while many of the
Southern European countries have
been unable to take advantage of
this due to a labor cost disadvantage
to Germany of 20-30%. Although German consumer demand grew during the quarter,
the country is implementing austerity measures to save up to $95bln by 2014 through a
combination of spending cuts and revenue-raising measures that will slow the economy.

German unemployment has decreased from 9.1% in January to currently 7.6%. If the
Eurozone had labor mobility similar to the US union of states, workers would move from
struggling European countries to Germany to take advantage of the growing job market.
Due to cultural and language barriers most of the jobs will be taken by Germans and the
Southern European countries will see little benefit from German growth. If the euro is to
survive there must be increased political integration and transfer payments from the
richer to the poorer countries, an idea the German people overwhelmingly oppose.
Germany’s success will exacerbate the differences between the two groups and
could potentially precipitate the demise of the euro. The single currency will be put
to the test as austerity measures will cause the Eurozone to fall back into recession and
weaker members will again be facing the potential for sovereign defaults. The European
Stabilization Initiative Fund will be forced to bail out some of the countries and this will
test the will of the European nations to hold the euro together.

The cycles clearly argue the euro made a significant peak 2½ weeks ago and has
begun a sustained downtrend. It can recover into the early part of the week of
September 6, but should hold below 1.2880 and then resume its downtrend and fall to
our initial target of the 1.1900 area by the week of September 27. This overall weakness
should last into January and the single currency should approach parity.

To contact FX CONCEPTS New York: 1 (212) 554-6830; London: +44 20 7213 9600; Singapore: (65) 67352898; Page 2