ClO REPORTS Investment Insights Mexico: the Global Pifata Like a pinata, Mexico's economy contains many long-term ‘goodies inside, Among those is a demographic dividend, ‘creating a sustained, propitious environment for economic growth. Meanwhile, low Financial penetration of the population leaves ample room for credit to be used as a lever for growth, ‘To unlock Mexico's economic potential, between 2012 and 2014, an ambitious reform agenda was passed, To name a ‘lew, education reform seeks to maximize the demographic dividend by enhancing scholarship, while financial reform Is ‘aimed at availing liquidity for small businesses and households, accelerating development and reducing inequality. These and other reforms would provide Further momentum forthe word's 11® largest economy on a purchasing power party bass its 11" and 128 largest exporter and importer respectively and 7 biggest vehicle producer worldwide. Mexico's openness to the global economy is reflected in the Mexican peso as the 2% most globally traded emerging market ‘currency (behind China's yuan) and @ generally acknowledged barometer of risk-taking in financial markets. Mexico has become globalization’ pinata, Donald Trump's rhetoric on trade risks shattering this pinata, With al the rewards from structural reform and favorable ‘demographics falling by the wayside. A 6 5% depreciation of the peso since Trump's election victory on November 8" to March 10" serves notice on the potential damage to Mexico's economy from rising tensions, As the opening target of Trump's “America Fist” policy, the world Is watching Mexico. The ‘Mexican economy can be sean as a canary In the coalmine, a ‘general case study on how Trump translates his policies into action and what may await other major emerging markets. Positioned to grow in a globalized world Mexico's demographic dividend Is the result of @ prolonged {and ongoing surge in the proportion of working-age adults relative to non-working dependents. The median age of the ‘cGuntry’s population Is 28, nearly 10 years below that of the ‘APRIL, 2017 Chief investment Office Rodrigo C. Serrano Ver est Joseph P. Quinlan Head of Make Thematic Strategy. Banke Aer lob stn 2 Irvesese Marageront US. population, according, to The World Factbook, published by the U.S. Central Intelligence Agency. What's more, female participation in the workforce Is very low, at 46.6%, versus the Organisation for Economic Co-operation ‘and Development (OECD) average of 63% as of 2015. ‘Aithough income per caplta in the country has seen a gradual rise since 2012, the female labor force participation rate has declined, signaling an opportunity to tap Into the lucrative, potential market. Finally, reducing the natior's informal labor sector, constituting Just over 5796 of total employment as per the OECD, is another potential growth generator. ‘The Mexican government has taken notice, passing numerous reforms aimed at addressing economic, politcal, and social shortfalls, and thus unleashing pent up demand. According to the OECD's 2015 Going for Growth report, Mexico has far outperformed the G7, European Union, and its peer ‘OECD members in taking significant action towards the ‘organization's suggested reform recommendations (Exhibit 1) Exhibit 1: Mexico Has Been a Star Reformer— (Share of OECD Reform Recommendations with Significant Action Taken) Toma ay” raw" Sot” Mer ee ‘Saye: OC, Gog Grom 205; "er OECD ceuneasince Che Esra nga Medes Pal and Tuy See uc cots Gece Pig ardspan espe Wea Manager res wolable rods and serices offered by Merl yrch Pete Ferme Sith eaparted IWLPF&S rosters broker dest ané Meriter SIPC 2c other bears of Banko evi Compaction BafA Cp) 8S Merrill Lynch Investment rot Bank of aia Coreration ‘Are ot FE Tred "rs Not Banik Garand May tose Vale (©2017 Barkol Paria Corporation AGS sandRecent financial reforms were aimed at increasing inclusion in Financial markets by expanding access to credit for small ‘and medium businesses and households. n a 2014 report published by the World Bank, Mexico had a mere 39% of Its population with an account ata financial institution, ‘compared to the LATAM average of 51% and the US, at 94%, Meanwhile, education reform Is critically needed to improve human capital and unlock the economy's long-term growth potential. However, structural reforms in this area have implementation gaps and, even after being fully put in place, it could take some time before the economic and ‘social benefits materialize. The country scored well below the OECD average in the 2015 Program for International Student Assessment (PISA. Mexico's energy reform, enacted in 2013, is viewed by many as the most important in scope. By lberalizing the nation's energy sector the reform aims to address a protracted decline in oll production, aging infrastructure, and limited technological development. Despite Unfavorable extemal conditions, successful auctions have sown the seeds for sustained investment in the country and a brighter future. Other reforms focus on expanding the nation's tax base and reducing dependency on oil revenues, opening up the telecommunications and broadcasting sectors to foreign investment, and enhancing the rule of law and reducing, corruption, which would improve regulatory credibility and Increase confidence towards investment. In addition to the structural reforms laid out during President Enrique Pefta Nieto's administration, Mexico's increased Integration into the global economy has also proved to be a catalyst for growth, The country signed 12 free-trade ‘agreements encompassing 46 countries. tis a participant in ‘9 economic cooperation agreements and maintains 32 accords Promoting reciprocal investment promotion and protection, {tis a member of the OECD, the World Trade Organization (WTO) and the Asia-Pacific Economic Cooperation. As a representative of the North American Free Trade Agreement (NAFTA) it has become the 3" largest goods trading partner of the US. with an estimated $5835 billion in tatal trade in 2015, according to the Office of the US. Trade Representative. These connections have transformed Mexico into a diversified ‘manufacturing-based, with total trade comprising aver 70% of its Gross Domestic Product (GDP) and a dominant player in the global automotive industry. A broken pifiata would be painful Rising trade tensions between Mexico and the U.S. have clouded tne near and long-term outlook. For Mexico, the peso's selloff and an il-timed 20% hike in ges prices, known locally as the gasolinazo, have led to increased social unrest. Barco, the country’s central bank, has hiked its policy interest rate 7 times since late 2015 to 625% to defend the peso and lean back ‘on rising inflation expectations. Meanwhile, President Enrique Peta Nieto's approval rating remains near the lowest level for “any president since March 1995, as per Bank of America Merril, Lynch (BofAML) Giobal Research. He is criticized for coruption allegations and faling to stop Mexico's mounting crime, while his reforms failed to produce the robust economic growth promised at the start of his term—the Central Bank of Mexico recently trimmed its growth forecast for 2017 to between 1.3% t0 2.3% to account for US. protectionist policies and collapsing consumer and business confidence. Inthe medium to longer-term, both Mexico and the US. face risks. For Mexico, its intricate connection with the US—with ‘over 80% of ts exports northbound and a remarkable Correlation between the growth ofthe two nations’ industrial sectors—exposes the double-edged sword of economic ‘openness (Exhibit 2). Fears of continuing trade tensions risks| staling investment this year. as a considerable portion of USS-Mexico trade is done between American multinational corporations and ther foreign afilates. In addition, without tarif- free access to the wealthy US. market, other counties with large ‘operations in Mexico may consider cutting back investment. Exhibit 2: U.S. and Mexico—Strong Links US Industrial Production —— Mexico Industrial Production "or Over Ye Gage) Pom 2003 2008 2007 2008 2008 (10 REPORTS vesmen insighnsMeanwhile rising interest rates could increase the prospect ‘of recession, raise the likelihood of a serious challenge by ‘an anti-establishment party in Mexico's 2018 Presidential lection and call lato question Mexico's commitment to implementation ofits panoply of reforms, Such a prospect ‘would weigh on the country’s investments, where foreigners. ‘owa 35% af local-currency government bonds, the highest ‘among Emerging Markets. In addition, the stock of foreign portfolio investment clocks at 40% of GDP, according to the International Monetary Fund (IMF) For the US, the risk, while not equally damaging, are significant. 12015, Mexico was its second largest goods export market. With its highty developed moguiladora (manufacturing) sector, ‘Mexico is pivotal partner forthe praduction of autarnobiles. According to a Center for Automotive Research in January 2017, US. content of vehicles imported from Mexico to the US. Is 40% from 5% before NAFTA was signed. Furthermore, comments ‘made by the Mexican Minister of Economics suggest a mirroring by Mexico of protectionist measures taken by the US, damaging business confidence, Moreover, the global community would ‘ake notice, given a possible violation of WTO rules. Worsening conditions in Mexico may ironically reignite legal immigration, increasing border tensions, Battered but not broken Fortunately ths is not our base case, Mexico's economy has remained resilient, given advanced implementation of various reforms, such as tax policy, financial sector liberalization, ang competition reform, according to the OECD. Furthermore, 2 weakening peso has nat been all bad: US. dallar remittances to Mexico have buoyed consumption, Although BofAML Global Research expects real GDP growth to slow this year to 1.25%, the peso should continue to act as a shock absorber, shifting consumption towards local goods and services. However, a clouded US. policy outlook and uncertainty surrounding the 2018 Mexican elections should eventually reduce domestic Investment and foreign direct investment. The balance of risks Is skewed to the downside. Meanwhile, headline inflation is forecast to peak at 6 0% mid-year—leading Banxico to raise Its policy interest rate to 6:75%—but fall back in the second half ofthe year to under 4.0% in 2018. From a US. policy standpoint, BofAML. Global Research expects NAFTA to be adjusted marginally, but with negative headlines for months to come, While it's not expected that the border-adjustment tax (BAT) will passin its current form, if at all, this policy is where the risk for global trade lies. “The latest developments between the US. and Mexico are being closely scrutinized werldwide. As Trump's opening target ‘of an “America First” policy, Mexico can be seen as a canary in the coalmine, a general case study on how Trump translates his policies into action, itis critical that cooler heads prevail and tensions do not escalate into action, IF so, global sentiment. ‘may shift negatively leading to a pause in investment decisions ‘worldwide, and nip the current global cyclical recovery in the ‘bud, Trump must not take too literally his “America First” policy, for everyone would ultimately carne last. (0 REPORTS «Ivesimen nighCHIEF INVESTMENT OFFICE Chiistopher Hyzy het este Offcor Bark ofnerca bal Weal and investment Manager. Mary Ann Bartels Karin Kimbrough Niladri Mukherjee Head of Meni ch Wea Head of etme Stotegy Drectr of Patol State, Management Poole Srategy | MerilLyech Wea Management| raat Baring x vestnant Grup (BIG) [Nicholas Giorgi | “Tony Golden | Emmanuel D.Hatzakis | Marci McGregor | Rodrigo C. Serrano | John Veit Ve rset Oreeor Drea heater ‘en Present ‘recor Invesng hes nding the possible of pc Te ves an opons epee ae ute aching with ie at ay me. ae oy fram viens eresty eric ran of efits hese ens ae prod fr nfomaens pupses nan shoukrat be se orcs ara recomend of an serie, sean ecto, "This materia wa prepared by the Global Westh nvestment Management (CW Chef lnvestment Oe ad isnot a pbiation of ofA Meriliynch Global Research The views expressed re thas of he GMM he Investment Ofc ony ad are subject to chang. 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