CHIEF INVESTMENT OFFICE LatAm Insights JANUARY 2018 Mexico: Between a Rock and Hard Spot Jou ain ‘heratie Seatesy In our previous report “Mexico: The Global Pifiata,” we argued that the world would be watching Mexico as the initiol target of President Trump's “America First” policy—the canary in the coalmine, a case study on how Trump would translate his trade policy into action and a preview of what might await other major emerging markets. Today, Mexico finds itself between the North American Free Trade Agreement (NAFTA) negotiation, the "rock" in our metaphoric title, and a “hard spot” in Mexican elections slated for July 2078, highlighted by the one-round presidential ballot. Lack of progress on contentious, key components of NAFTA has begun to worry investors, particularly in Mexico. Through December 19th, Mexico's main equity index dipped 6.4% in local currency terms from its peak in late July. Tacking ‘on a 7.5% depreciation in the Mexican peso over the some time period brings the loss in U.S. dollar terms to 13.996, While Conadian equities have fared better, rising 6.1% In local currency terms, partly reflecting rising oil prices, a 2.94% depreciation in the Canadian loonie may suggest some concer os well BofA Merrill Lynch (BofAML) Global Research expects bumpy and lengthy negotiations but ones that ultimately result in a alee i SD deadlock has deal, yet acknowledges rising odds of the US. withdrawing lexican investors taking from NAFTA, now at one in three. n our view, there is self Sur soo Cinder Meso) — S4PMSKIndes (ada) interest among all countries in favor of an updated NAFTA ww: accord, However, we believe the absence of an agreement i in principle by Q1 2018 woul increase the odds of a US. vs departure elven the potential for sharpened political rhetoric v0 In addition to the Mexican balloting in July, the US. is ws scheduled to hold mid-term elections in November. BofAML Global Research expects the Mexican economy, stuck ae = ‘between a rock and hard spot, to slow given rising uncertainty. a However, any lowdown should remain controled, with support Eeeegreeeagias from solid growth alongside generally contrlled inflation in PLLLELEER ERED | UNC icoeseem ena = ‘view that the environment should favor large cap equities at soe Rad lnes sgl sasotne etairg ures conler ts Soc che nsent ee Brg Daf eee 130.2017 attractive valuations with a penchant for producing US. dollar- tient eeeel = denominated revenues in the face of of increased currency ‘and market volatility. teva ich We Nagener als rae ods an aries fled by Meriiyich are, Fer ih ets teipradrepate eres an Meni SIP. sn athe saicares of ark of Aner Capen BalACOD) Merrill Lynch Investment products. (ark Anata Corporation “Are Not FDIC Insured ‘Are Not Bank Guaranteed ‘May Lose Value (© F017 Bak of eerie Corporation Al gs eee.NAFTA basics NAFTA. a free trade agreement (FTA) shepherded by Presidents George H.W. Bush and Bill Clinton on the US. side, came Into force on January 1, 1994, According to the ‘Congressional Research Service (CRS), the bold accord, which ultimately removed all goods tariffs and most non= tarif barriers, while lberalizing service trade, would serve as ‘a model for future U:S. FTAs, It was the first one to link two developed and wealthy nations with a low-income emerging ‘market country. It also was the first to contain stipulations on worker rights and the environment while Including chapters (on intellectual property rights and an investor-state dispute settlement mechanism, with features unique among all US, FTAs, even today. For Mexico, NAFTA represented a way to fenshrine its market-opening reforms fram the mid-1980s, while for the US. it was an opportunity to expand its growing. ‘export market while fostering politcal inclusiveness in Mexico, According to the CRS, total US. trade with its NAFTA partners has more than trebled since the accord took effect. At just ‘over $1.2 trillion in 2076, it has grown faster versus the rest of the word, and faster with Mexico than Canada, which already had its own bilateral FTA with the US, established in 1989, ‘The two countries were destinations for 34% of total US. exports, wth Canada the leading market, followed by Mexico In second place. Both supplied the U.S. with 259 of its imports, ranking second and third respectively, with China ranking first. AS we see it the tes that bind the U.S. with Mexico go well beyond trade; indeed, at the core tis foreign direct investment—a deeper form of integration—that links the two economies. To wit. since NAFTA came into effect, or between 1994 and 2016, US. firms have invested over $150 billion on an aggregate basis in Mexico, Very few nations, including China, have attracted as much US. capital. US. investment {in Mexico has been sunk in multiple sectors, including ‘manufacturing and services, and has been deployed with two objectives. Fist, many US. firms have tuned to Mexico as 2 lower-cost base of production, boosting their productivity, Competitiveness and ultimately their earnings. Second. Mexico has also emerged as a key market for many US. firms—large ‘and small—over the past two decades, with rising per-capita incomes amiong the country’s expanding middle class a key attraction of Mexico among USS. firms. In other words, evidence suggests that Mexico has emerged as a critical source of both supply and demand for US. firms. In the process, the supply chain that ink U.S. firms with their Mexican operations have expanded dramatically over the past decades. This dynamic has helped push and pull cross-border trade; fo instance, a great deal of US-Mesican trade is “relatedsparty trade" or trade that takes place within the frm Example: A General Motors facility in Michigan exchanging auto parts and components with the firms affiliate in Mexico. Trade really stays within the fim; puting this dynamic into perspective, roughly 66% of US. imports from Mexico is really related-party, underscoring the depth and thickness of US. trade and investment tes. In other words, under NAFTA, US-Mexican trade and investment relations have grown in sophistication and complexity, with bi-lateral trade and investment ties expanding and becoming more interlocking. Hence, any serious rupture or disruption in the current agreement Is likely to have wide- ranging implications for corporate America in our view. “EI Relajo’: the confusing and loud debate ‘Avwide range of studies on the effects of NAFTA have produced discordant conclusions. According to the CRS, some studies support NAFTA as having generally boosted trade, economic growth, specialization and global competitiveness forthe economic bloc, particulary through the development of ‘extensive supply chains, In Mexico, NAFTA positively impacted productivity, by allowing Mexican firms quicker adaptation ‘of technological innovations, wile increasing social and economic benefits overall However, other studies point out the difficult in accurately measuring the true impacts of NAFTA, given expanding trade between the three countries beforehand, among other Factors, Alternative studies reason that investor protections have distorted corporate decision- making by reducing country risk, resulting in high-value job opportunities being outsourced to cheaper Mexican labor which has stagnated wage growth and exacerbated inequality in the US. From Mexico's standpoint. opponents argue that gains have been unevenly distributed, pointing to the country’s Gini Coefficient, a measure of wealth inequality, highest among ‘members ofthe Organization of Economic Cooperation and Development as of 2015, Importantly, opponents of NAFTA in the USS. have symbolized these imbalances in the form of the US. trade deficit with its Partners. This is despite many economists arguing against targeting bilateral trade deficits without considering the totaltrade deficit, which is more influenced by structural drivers, such as national savings and investment rates and currency movements, according to the Council of Foreign Relations. President Trump's administration has made reducing the US. trade deficit @ key driver behind his trade policy and thus of the NAFTA negotiations, Progress has been made in modernizing sections of the treaty, touching on telecommunications, digital trade and sanitary and food safety measures, but controversial changes have failed to ‘materialize. Among the most prominent are US. intentions to scrap NAFTA’ dispute settlement mechanism (Chapter 19), \which provides investor protections; to installa S-year sunset, provision, which would automatically terminate the treaty Unless It was renewed by all three countries, and to raise the ‘mandatory threshold for NAFTA-member content from 62.5% to 85% to qualify For duty-free trade. The latter condition, Which applies to the automobile industry, also includes a demand to source SO% of materials from the US. Strategic Interest could yield an agreement BofAML Global Research assigns a two-inthree probability that an agreement ultimately will be reached, We see strategic self-interest as the main motive for compromise. The US'S trade deficit with its NAFTA partners accounts for less than 10% of the total deficit compared to China's nearly 50% share, according to BofAML Global Research (see Exhibit 2), More granuiary, according to Bloomberg, in 2016 combined US. exports to Mexico and Canada were $413.1 bilion, wile combined imports from both countries totaled $5722 bilon, US. exports to China were $135.7 bilan, while imports were $4628 billion. Said differently, US. exports to its NAFTA partners were more than triple those to China, while US. impor from ther were roughiy 259% more than from China. Exhibit 2: The NAFTA deficit is not the 300 pound gorilla In the room (US. trade balance) [. as == C SO be races jo gx te PRDPEDUSDREP EUG Sa ee ch tree ne le Riv atptomnce pares as Key in producing a more symbiotic trading relationship within the NAFTA bloc has been the automotive industry Mexico's developed maquiladora (manufacturing) sector has, in our opinion, played a major roe inthe bloc’s global competitiveness while providing robust demand for US. suppliers. According to Bloomberg, more than 70 House Republicans and Democrats, some from states that voted for Trump, such as Michigan and South Carolina, have expressed their opposition to changes to auto provisions in a letter sent to U.S. Trade Representative Robert Lighthizer. ‘Additionally, Mexico and Canada are important consumers of USS. agricultural goods. The Peterson Institute of Intemational Economics (PIE) notes that a detrimental negotiation may dlisproportionately hurt states that voted for Trump, such as South Dakota, Nebraska, Montana, and lowa (see Exhibit 3) (10 REPORTS «Lam nies| 10 20 Sauce: The Pcs rst temateal ena aot My 122017 So far not good. Could Trump pull the plug? Despite the desire for a solution, five negotiating rounds between the US, Mexico and Canada have not produced one, resulting in sentiment shifting towards a “Life after NAFTAT scenario, Reuters reported that Mexican officals have been Prepping a “Plan 8 an effort that has included advancing trade talks with other nations such as Braal, Australia, China ‘and Russia, and analyzing tariff and import substitution plans, among other initiatives. Furthermore, Mexico's Foreign Minister Luis Videgaray has said that oughly half ofits trade withthe U.S, doesat fall under NAFTA channels, and that if the accord were to end, trade wouldnt be derailed. Mexico would Face tariffs averaging 3%, presumably under Most Favored Nation (MFN) status under World Trade Organization rules (0 REPORTS - LatAm insights Exhibit 3: Politically difficult for Trump to cut NAFTA ties. Percent of total exports to NAFTA countries in agriculture een Can ea 30 40 50 In the event ofa six-month withdrawal notice issued by the ‘Trump administration, the question becomes whether it has the legal authority to do so. According to the PLE, citing the CRS itis likely that it could issue the notice without the assent of Congress, or the courts. n the sole historical challenge to the presidential Power to terminate treaties, Goldwater v. Carter in 1979, the Supreme Court ruled that President Carters abrogation of the Sino-American Mutual Defense Treaty (SAMD) of 1954 was a Political question, not subject to judicial review. One justice opined that if a resolution requiring Congressional assent had been adopted beforehand, the case may have garnered a closer inquiry. Furthermore, annulment of NAFTA alone would nat alter the US, ‘avr implementing the agreement, HR. 3450, which has been ratified by Congress and is thus under judicial jurisdiction. While—— [NAFTA is efferent from SAMD in that it isa trade agreement = though some would argue Is has foreign policy significance = its similar in that It and H.R. 3450 lack a resolution requiring legislative authorization to withdraw, according to PIE, It would appear that the lac of such a resolution as well as any change to H.R. 3450 from the issuance of a withdrawal notice weakens the case fora challenge in US. courts. Under 1.3450 President Trump can restore MFN taifs or cal for “eciprocal and mutually advantageous concessions" without Congressional approval, though he would need to work with trade advisory committees, the Intemational Trade Commission ‘and Congressional committees in the process. Furthermore, the president may have latitude in determining how much Congress should get involved under the Trade Agreements Act of 1974, Al this does not mean Congress would lack the resources. to push back against President Trump's move to withdraw. Congress could take the aggressive action of passing a joint resolution requiring Trump to seek Congressional authorization before submitting a NAFTA withdrawal notice, under ‘Article 2205 of the agreement. An alternative could be key Congressional committees delaying ather legislative agenda iterns until President Trump gains thelr majority consent. ‘The Outlook and the Hard Spot Uncertainty created by the NAFTA negotiation on one hand and Mexican elections on the other appears to be squeezing the Mexican economy. BofAML. Global Research expects growth in teal gross domestic product to stow to 1.6% from 2.1% on a year-over-year (YoY) basis, pointing out that consumption growth is already contacting. In eal ters, retail sales fel 033 YoY in September, while auto sales fell 10.2% YoY in October. High inflation, which has hampered real wage growth, has pressured Mesico's central bark, Banxico, to Keep interest rates elevated ‘0 contain high inflation and inflation expectations which has slowed consumer credit growth. Investment is expected to remain subdued on elevated uncertainty, which may affect the ‘economy’ long-term potential growth rate. On the postive sie, continued strong growth in the US. could buoy Mexican exports, ‘while consumption may receive a boost on some pre-election fiscal spending In july 2018, Mexico will have national and local Congressional elections, decisions on several governorship, as well as, the presidential contest. At BofAML Global Researchis Year ‘Ahead Conference in Mexico, the local consensus was that the presidential election was too close to call and that ~nti-establishment candidate Andrés Manuel Lopez Obrador (0 REPORTS «Lam nieces (AMLO), of the National Regeneration Movement party, was leading in the pols. Many investors worry that his victory may herald prolonged business uncertainty, particulary in regards to te recently passed energy reform, which opened Mexico's energy sector to private competition and foreign Investment. Others point out constraints on AMLO should he win the presidency Banco after ll remains an Independent institution, a fact acknowledged by his party's platform. Meanwhile, overturning the energy reform would require Congressional majorities, adffiult scenario, according tothe partys business representative, José Luis Beato. Recently AMLO has also softened his tone on repealing te reform. However, while the prospect of AMLO successful taking direct action on Mexico's energy reform seems low, shoud he win the presidency his confrontational style may not mesh well wit President “Trump, which may complicate NAETA negotiations should they spll ito late-2018 and 2018. “These uncertainties call for caution when investing in Mexican equities, BofAML Global Research recommends focusing on attractively priced large cap companies that can produce US. dollar-denominated revenues, high dividends and strong free ‘cash flow, while avoiding small and mid-cap equities. From the perspective ofthe Chief Investment Office, within our ‘general overweight on emerging markets we particulary lke ‘countries that have undertaken reforms to improve ther long- ‘term potential economic growth rate, such as India. Mexico has bbeen a star reformer over the past years, a development we have previously covered, Unfortunately the country’s economy, ‘seemingly stuck between a rock and a hard spot, makes it an ‘exception For a conservative to moderate investor, we Continue to urge prudence, at least until the irection ofthe NAFTA. ‘negotiation becomes clearer. A more aggressive investor may see ‘a surprise positive conclusion to the NAFTA negotiation inthe first half of 2018. This could potentially act as an upside catalyst, leading toa reacceleration in Mexican economic growth, an ‘appreciating peso and stronger earings. In the broader sense, while the CIO currently forecasts a continued globel cyclical recovery boosting eamings and ‘equity prices, we remain viglant to the prospect of the US. trade relationship with Mexico and other countries coming, under further strain. The continued forces of globalization and ‘technology, which have strained notable segments of the labor force, have seemingly strengthened the winds of populism. ‘One cannot rule aut the risks of growing protectionism and its Implications for the investment outlookMarkets in Review [=z nae ere Chile 30116 66 5 Peruvian 10% 527529, = So aa as perry nstoa HE = com Soe Prior ee 3127562 B32 Be ees nec SE a a Chen Peso Gola GMs eee e775. 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These talands underpin real GOP and ifiaion Forecasts of 30% and 3936 respecthely for 2018 from BotA Meri Lynch (fAML) Global Research, Morne ts equity overweight recommendation, with an 85.000 price arget forthe Bovespain 2018, rests on 204 eanings growth. mast fram censumer-relted seco, Risks to the autok ince a delay of social secur reform and the ‘presidental election on October 7h. an event that nthe past has rested in equity vl, "= Colombia: While BofAMAL. Gcba Research expects real GP growth of ‘30% in 2018. on the back of monetary struts equity undewelghe recommendation stems fram a ack of upside catalysts amid curent Challnges, such as arising scl dec, compton scandal nd ipementation ofthe FARC peace deat Negative views on some ofthe ‘most ul compares in the markets another factr. 1 Argentina: A better than expected paramentary miter rest on (October 22nd for Presiden Mauricio Macs party, Cambleros, arpors ‘contnved economic refoms Expanding investment in 2016 s expected te deve real GDP growth of 32%, wth inflation detnng to T65% from 226% 2017, according to BofAML Global Reseach Risks net year ‘clade the coun’ Fiscal cect and tigh Financing needs ($50 bon, parla if bal interest ates rise at more than a gral pace 1 Peru: GofAMl Global Research expects sn acceleration in ral GDP wth to 36% n 2018 and recommends an equty overweight PLB investment, a econstrvton efor and infrastructure projects, coupled with monetary stimulus re expected tobe growth vers. Aik to the oulecksconéring pltcal tumal, as President Pedro Pablo canis may face Impeachment, de to his potetialmehement the Odebrecht sands (10 REPORTS «LatAm insightsInvesting te possible los ef rnp Te views nd opis exes suc chang what noe any, nd mayer rm ies excess Meriter anf ts ats These ews eprom paposes oy and shod et be usedorcansvdasarecormendin f aysenie cy erst ‘Thismatral was prepared bythe Global Wealth & nvestment Management Chie Investment Fc (CMA CIO sedis nat publication of BetA Merl Lynch bal Research. ‘he wews expressed are thote of the GMM Che Investment Ofc oly and are subject to change. 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Miter Meri Lynch nor any of afBilts ofan advsrs provide legal tax or accounting advice. You shoul consul you ga andor tax iorstefore making any Sand dedons. loves fave vaning peso Some fhe rks ed with tes ete pasty tat the ve ofthe stax ay actante a sponser evens Speci te Conese mats ass con paar vc eens nthe US or ct oe ali ees, nfton ard ava rks nessa ghettos my be subject opener att Nos riko sf ncome apical hn scsi higher ae aegnes ‘vestments non secresinebrespecalis, reg rg cureeyiskand hss oss vit toes pola cononiccraterdapments. These fas at magnetar inasurems male emerges lnnsten' na Coa aso Secor yose acer keto xk of esate and seca cncnton, “ating noes is spe nd cane eer te Mat kes Ue cranes ay cate raphy based on narerus ots nding charges sng nd demand rears weste: ice pres meu ade; fa monetary an extn coral rans; dre an fregn poli and con evs alps seas: chalga eps: arddhagesin ists, (©2017 Bark ot etc espraton Alege sayervat, BS Merrill Lynch