Mexico: oil prices are hedged

Mexico: oil prices are hedged We recommend: BUY Mexico MBONO 4.75% 14-6-2018 Why: attractive yield; Mexico is beginning to reap the benefits of the many reforms; Mexico will benefit significantly from the US recovery. We expect that stronger economic growth in the US in the coming period will contribute to lifting the manufacturing industry, economic growth and exports in Mexico. We expect this to lift the trade balance to a more comfortable surplus. Falling oil prices will affect the public finances in 2015, as taxes and royalties from oil-related activities constitute 30% of the public budget. This may potentially spill over into the currency and the effect of the energy reform. However, the Finance Ministry has hedged the risk on the financial markets, which is why there is a limited risk. We still believe that the peso will strengthen against the euro in 2015. The effect of the reform process in Mexico is long in coming, as so far we have only seen moderate increases in economic growth. We still expect the reforms to bear fruit and spill over into economic growth, not least when the energy reform is implemented in earnest in 2015. Domestic demand and exports are beginning to stir, inspiring hope that a true recovery is in the making. Publisher: Jyske Markets Vestergade 8-16 DK - 8600 Silkeborg Macro-economist: Peter S. Øemig +45 89 89 25 50 ps@jyskebank.dk Assisting Analyst: Søren Gyde Sønnichsen +45 89 89 74 07 Soeren.Gyde.Soennichsen@ jyskebank.dk Read more research reports about emerging-market bonds at www.jyskemarkets.com Mexico is a structurally strong case. Gains from the many reforms aiming to eliminate bottlenecks for economic growth through, for instance, investment in infrastructure and education are expected to unfold in the coming years. We believe there is potential of upgrades of the credit rating. According to the risk classification rules this type of product is categorised as AMBER. For investors, purchases of Mexican bonds involve FX risk, interest rate risk and credit risk. Altogether, we expect a 12-month holding-period return of 10.9% (bond and currency). Here, the holding-period return on the bond is 4.3% and the exchange-rate return is 6.3% against the euro. Issues Price Bond ID ISIN code Y-t-m MBONO 4.75% 14-06-2018 100.96 5824002 MX0MGO0000T4 4.45%

Public finances: falling oil prices are hedged Revenue from taxes and royalties related to oil production accounts for around 30% of the public budget or approx. 4.7% of GDP. In mid- November, Finance Minister Videgaray announced that next year's oil income has been hedged - 228 million barrels at a price of USD 76.40 a barrel. This is USD 2.60 less per barrel than the price used in the 2015 budget. In the event that the average oil price is below USD 79 in 2015, the difference will be paid using MXN 7.9bn which has been set aside in a special stabilisation fund. This hedging strategy saved Mexico from a wide public budget deficit in 2009 when oil prices plummeted. This strategy is decisive for Mexico being able to reap the benefits of the privatisation of the energy sector already in 2015. Nevertheless, the level, at which the government is hedged, is considerably lower than the USD 85 a barrel that was the level hedged in 2014. This will mean a tighter public budget in 2015, which may mean lower public spending and investment even though lower oil prices in 2015 have been discounted. Monetary policy: stable core inflation Banxico took the market by surprise when it cut interest rates by 50bp (3.5% to 3.0%) at the monetary-policy meeting on 6 June. The cut was prompted by sluggish growth in the first quarter and moderate inflation outlook. Unchanged leading interest rate Inflation Since the interest-rate cut, inflation has increased to 4.3% y/y. We expect inflation to fall in the last two months of the year but remain above the ceiling of 4%. This should be seen in view of moderate economic growth in Q3 of 0.5%. In November, the central bank lowered its growth expectations for 2015 to 3.5% (against 3.7% previously). Economic growth still appears to be too fragile for the central bank to risk curbing growth with an interest-rate hike. The central bank has previously said that it is not concerned about inflation as long as core inflation remains stable, which it has been for a longer period. Moreover, in annual terms inflation will be curbed in the first months of 2015 by the blow to inflation in January 2014 due to tax increases. We do not expect an interest-rate increase any time soon, but Banxico will keep an eye on the local demand and the US economy. If one of the two picks up in earnest, it will react to keep inflation close to the bank's target. Currency potential Currency: appreciation against euro in 2015 The Mexican peso appreciated against the euro in the first three quarters of 2014 after a weak 2013 in line with the other emerging-market currencies. This is not least due to the prospects of a successful energy reform, which will lift public revenue substantially. However, over the last quarter the EUR/MXN rate traded more or less sideways as the optimism surrounding an actual recovery in 2014 slowed. We still believe that the peso will appreciate against the euro at 12 months term. The appreciation will increasingly come from the increase in foreign investment in the Mexican energy sector in 2015, which will stimulate economic growth via higher public revenue and

increasing demand for the Mexican peso. Against the US dollar, we expect the peso to trade sideways, which can be ascribed to the fact that a large part of the lift of the Mexican economy must come from a recovery of the US economy, which will improve the Mexican trade balance and current account and thus cause the peso to appreciate. The reform initiatives have resulted in an upgrade of the credit rating by Moody's to A3. This is Mexico's first A rating. We believe that there is potential of further upgrades of the credit rating by the other credit rating agencies. But this will require markedly stronger signs of a healthy economy than we expect to see in 2015. Reform benefits: long in coming The energy reform accounts for the largest part of the expected contribution to economic growth of 1.75 percentage points from the reforms. We will not begin to see the effect of this until the licenses have been allocated in 2015. The first bid round for private enterprises on contracts in the energy sector is scheduled for the first quarter of 2015, and the first licenses are expected to be allocated in May 2015. Lasting low oil prices may turn out to have a negative effect on the benefits of the energy reform if the demand for the licences offered is burdened by the profitability of the oil production. The effect of the many reforms has, however, so far been slightly disappointing, but weak economic growth in the US, domestic problems in the construction sector and weak public spending and investment have kept economic growth down. Macro: lift in exports Exports have begun to stir and the first data for Q4 indicate that we will see the expected contribution to economic growth in late 2014 and during 2015 when the US economy picks up. The US recovery is essential for the Mexican economy as Mexico is a nation with a large manufacturing industry and the US accounts for 75% of Mexican exports. Oilrelated exports have been relatively weak. We find that falling oil prices are not a paramount risk for the trade balance as oil exports only account for 0.3% of GDP. Contribution to potential growth from reforms Structural reforms Contribution GDP growth Energy reform 1.0 percentage point Financial reform 0.4 percentage point Fiscal policy reform 0.1-0.2 percentage point Telecommunication reform 0.2 percentage point Total exclusive of labour and education reform 1.7-1.8 percentage points Source: The Ministry of Finance FX targets Spot 12 months EUR/MXN 17.48 16.33 USD/MXN 14.12 14.20 MXN/DKK 0.43 0.46 The targets are from FX Spot On, 2 December 2014 (Spot rates from 4 December 2014). Credit rating Local Foreign Outlook Moody s A3 A3 Stable S&P A BBB+ Stable Fitch A- BBB+ Stable Domestic demand is beginning to pick up after being burdened by weak residential construction. Among other things, this has been a consequence of insufficient implementation of infrastructure projects since the government administration has been busy with other tasks (reform initiatives) and has therefore been slow to approve projects. GDP growth for Q3 was moderate at 0.5% q/q, which prompted the central bank to lower its GDP forecast for 2014. The construction sector showed strong signals (1.7% q/q) while the mining sector fell back by 0.5% q/q, which alone can be ascribed to falling oil production. It was more disappointing that the service sector only grew by 0.5% q/q, as it is a good indicator of local demand, and the important manufacturing sector only grew by 0.4% q/q.

Risks Investors assume interest-rate, credit and FX risk when buying Mexican bonds. Furthermore, the following factors involve risks: the Fed's monetary policy and the economic development in the US; Mexico s dependence on oil and hence the oil price.

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