Latin America

Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist  Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week).  Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories.  While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes   Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD  Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Chart 10   Footnotes 1     Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2     Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021.  3    Please see Precious Metals commentary in the Commodity Round-Up section. 4    The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables.  It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere.  Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion.   Investment Views and Themes Strategic Recommendations

Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded.  Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1  If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics.  In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective.  Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries.  Chart 2Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield.   Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome.  A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014.  French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified.  Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat.  Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States.   Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless.   Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive.   Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1  “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Section II: Appendix: GeoRisk Indicator Russia United Kingdom Germany France Italy Canada Spain Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

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 Faced with record low approval ratings, President Bolsonaro will try to cling to his seat by all means possible, and his attacks on state institutions will escalate. This will further destabilize the socio-political situation in Brazil.    We maintain that Bolsonaro will abandon fiscal austerity to secure decent income growth in an attempt to beat ex-President Lula in the upcoming elections in fall 2022. Economic growth will again underwhelm as the modest fiscal loosening contemplated by the government will be offset by draconian monetary policy tightening. We reiterate an underweight stance on Brazilian equities and local currency bonds and continue shorting the BRL versus the USD. Feature Our views on the increasing volatility of Brazilian politics and the unsustainability of fiscal austerity ahead of the 2022 elections have played out well. The BRL is back to its pandemic lows, and stock prices have collapsed on the back of rapidly rising rates (Chart 1) and as investors realize that the odds of Bolsonaro winning a second term are falling rapidly, forcing him to abandon the fiscal austerity drive. In our past report on Brazil, we argued that the probability of ex-President Luiz Inácio Lula da Silva wining next year’s elections is very high. Chart 2 illustrates that Bolsonaro remains considerably behind former President Lula in first-round voting intentions. Also, we contended that Bolsonaro’s plunging popularity will make him more erratic and desperate ahead of the presidential elections taking place a year from now. Chart 1Rising Interest Rates Wreaked Havoc On Share Prices   Bolsonaro was dealt a massive blow last week as the Senate committee investigating the administration’s handling of the pandemic recommended he face criminal charges over the mismanaged response, which resulted in one of the highest death tolls in the world. This is weighing on his already extremely low approval ratings. In order to combat his low and falling popularity, we expect that, on one hand, Bolsonaro will continue his attacks on state institutions and, on the other hand, increase fiscal spending. Politically, it is not likely that Bolsonaro will face indictment or criminal prosecution during his term, since both the attorney general and the head of Congress – which are the ones who could spearhead these procedures – are allies of the President. Nevertheless, these accusations will serve as fuel for Bolsonaro’s political opponents for next year’s elections. While Bolsonaro still has support from the big coalition of centrist parties in Congress – known as the Centrão – they might not be particularly loyal. For example, in 2016, they were critical to the impeachment of ex-President Dilma Rousseff as they withdrew their backing of the President. All in all, we believe Bolsonaro will further rally his dire-hard supporters. There is already a precedent to this: last month, a large-scale pro-Bolsonaro rally ended in blockades across the country. As the odds of the President losing the elections and facing criminal convictions rise, he will cling to his seat by all means possible. This will further destabilize the sociopolitical situation in Brazil.    In fiscal matters, the government unveiled another cash-handout program last week to support lower-income households. This caused a riot in Brazilian markets, as it implies a break of the fiscal spending cap and caused the resignation of several senior members of the Treasury. We have long argued and maintain our view that the government will abandon fiscal austerity for two reasons: 1. Bolsonaro must secure decent income growth if he expects to beat Lula in the upcoming elections in fall 2022. Given that (1) the level of economic activity and, hence, income remain very low; (2) inflation is “eating” into mediocre income growth; and (3) surging interest rates will depress the economy further in 2022 (Chart 3), he has no choice but to resort to fiscal spending to support the economy going into next year’s presidential elections. 2. To secure fiscal sustainability, i.e., to halt the rise in the public debt-to-GDP ratio, Brazil has to (1) either achieve a nominal GDP growth rate that is continually above government borrowing costs; or (2) run persistent and sizable primary fiscal surpluses. On the first one, government borrowing costs are surging anew above nominal GDP growth (Chart 4). This entails a renewed rise in the public debt-to-GDP ratio. Chart 3Brazil's Economy: Another Downleg Is Looming Chart 4Brazil: Public Debt Dynamics Remain Unsustainable   The second condition is politically unfeasible. Brazilians are experiencing fiscal austerity fatigue and the government will not double down on fiscal hawkishness ahead of the elections. Notably, the modest fiscal loosening that contemplated by the government will be offset by draconian monetary policy tightening. Net-net, nominal GDP growth will be materially below government borrowing costs. The latter are set to rise as the Treasury refinances its debt at higher interest rates next year. In recent years, the government has drastically reduced the maturity profile of its debt making itself vulnerable to rising interest rates. We maintain that the only politically feasible way to reduce the public debt-to-GDP ratio is through permanently higher inflation while capping government borrowing costs. However, it will be devastating for the exchange rate because it will entail an extended period of low/negative real rates. Bottom Line: Brazil’s political and fiscal woes are not over yet. President Bolsonaro will continue to act erratically over the next year and fiscal unorthodoxy will become prominent. Investment Recommendations Chart 5More Downside For Brazilian Stocks We reiterate our underweight position in Brazilian equities within an EM equity portfolio. The Bovespa index will likely continue dropping in absolute terms and relative to the EM equity benchmark (Chart 5). Bank stocks are especially vulnerable as high interest rates will lead to a new round of rising NPLs and NPL provisioning. As Chart 6 demonstrates, a new NPL provisioning cycle (shown inverted) will be detrimental for bank share prices. We have been recommending investors short the BRL versus the US dollar since March 25 and this recommendation remains intact. In fact, the BRL has been depreciating despite the rally in global commodity prices (Chart 7). This is due to Brazil's weak domestic fundamentals. Chart 6Will Brazilian Bank Stocks Test New Lows? Chart 7Surging Commodity Prices Have Not Helped The BRL   As to fixed-income markets, we have been underweight local currency bonds but overweight sovereign credit within their respective EM portfolios. The rationale to favor sovereign credit over local currency bonds is that the government has little foreign currency debt and will not default on it. However, it seems that sovereign credit investors are surprised by Bolsonaro’s pivot toward more fiscal stimulus. In view of our outlook for more political volatility and the President’s desperate attempt to use fiscal policy to boost growth ahead of next year’s elections, it makes sense to use a near-term rebound to downgrade Brazil’s sovereign credit from overweight to neutral. Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes

Highlights Gabriel Boric – a popular independent left-wing candidate – will likely win the presidential elections. Chile’s financial markets will remain very turbulent with a downward bias until the second voting round in mid-December. We are downgrading Chilean stocks to underweight within an EM equity portfolio. Continue shorting the peso versus the US dollar. Feature Chart 1Chile: Stock And Bond Prices Are Plunging Chilean financial markets have been clobbered ahead of the presidential and legislative elections taking place a month from now on November 21 (Chart 1). In case no presidential candidate wins more than half of all votes, a second round will ensue on December 19. Odds are rising that Gabriel Boric – a popular independent left-wing candidate – will win the presidential elections, albeit only in the second round. Hence, financial markets will remain very turbulent with a downward bias until the second round in mid-December. The odds of Boric winning the presidency have increased in the past couple of weeks. This is mainly due to a scandal hitting the leading center-right candidate Sebastián Sichel, as it was revealed that he withdrew funds from his pension savings. He lost credibility in the eyes of voters as he had been opposing further pension withdrawals. This has inadvertently increased support for far-right candidate José Antonio Kast, who favors extreme conservative economic and social policies. Faced with the choice between the extreme right and the left, voters will most likely go for the latter. Further, given Boric’s track record as an independent and pragmatic dealmaker, he will appeal to centrist voters during the second-round runoff. We believe Boric will win the election as his policy proposals are broadly in line with protester demands from 2019: higher public spending on education and health, public pension reform, and increased tax collection from wealthy individuals and corporations. Further, he will use the fact that he beat communist Daniel Jadue in the primaries and that he opposes socialist autocratic regimes in Latin America to help him gain centrist voters in the second round. Nevertheless, this impending shift to the left in macro policies has scared local and foreign investors. There has been a crash in Chilean fixed-income markets with 5-year and 10-year bond yields surging by 450 and 410 basis points, respectively, since February of this year (Chart 1, bottom panel). Chart 2Chile's Central Bank Will Hike Rates More Further, headline and core inflation have surged above the central bank’s target range and wages have been accelerating (Chart 2).  The central bank will therefore hike rates by another 125 basis points so that the policy rate reaches at least 4% by the end of the year, slightly above its neutral policy range of 3.25-3.75%. Withdrawals from private pension funds are also putting upward pressure on local bond yields. Private pension funds owned 54% of outstanding domestic government bonds in Q2 2020 and 45% at the end of Q2 2021. Both expected withdrawals and massive losses are forcing them to reduce their bond holdings. High interest rates are in turn producing a derating of the equity market (Chart 3). Rising borrowing costs will also lead to a slowdown in the economy. Besides, the 2022 approved government budget entails a major fiscal drag. The new president takes office only in March 2022, so fiscal easing is not expected until then. Importantly, business confidence will dampen as the business community realizes that the shift to the left is unavoidable. This will derail investment and hiring for now. Concerning the exchange rate, the peso has been depreciating despite high copper prices (Chart 4). The currency will continue depreciating due to capital outflows, especially from locals. High net worth individuals will continue expatriating capital for now as Boric is advocating higher taxes for such individuals. Chart 3Rising Rates Are Headwinds For Stocks Chart 4The CLP Has Decoupled From Copper Prices We are downgrading Chilean stocks from overweight to underweight and reiterate our short recommendation in the Chilean peso versus the US dollar. We argued that Chile would shift to the left in our December 2019 Special Report, and downgraded this bourse to underweight in July of last year on the back of further political volatility. However, we decided to upgrade this market to overweight in May 20th of this year. Our primary assumption has been that the nation is undergoing a major shift of policies from neoliberalism to the left. However, we did not foresee that this transition could so fiercely affect share prices given that their relative valuations to the EM equity benchmark were already attractive early this year. All that said, we maintain our view that such a shift to the left is not necessarily devastating for the country in the long run. Chile is not set to become Argentina or Venezuela. Boric is advocating for a larger role of the state in the economy, but not in the form of price and currency controls or nationalizations. Instead, he is proposing higher public spending on social programs and increasing the tax burden on the rich. Overall, we believe that this election and the new constitution will pivot Chile’s social and economic model into that of a Welfare State (akin to Canada and Scandinavia) and not into a full-blown socialist model. Chart 5The Wages-Profit Mix Is More Unequal In Chile Than In The US Chart 5 shows that Chile has been a very unequal society – much more so than the US. Hence, neoliberal policies have become very unpopular and thereby unsustainable. If Chile does not undertake income and wealth redistribution policies now, the outlook will be heightened protests and violence, and the ultimate outcome could be a more radical shift to the left entailing nationalizations. Bottom Line: Downgrade Chilean stocks from overweight to underweight within an EM equity portfolio. Continue shorting the peso versus the US dollar.   Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com