Building momentum: ratings upgrades, housing sector boost economic outlook.

In late January, the S & P ratings agency published a glowing report alongside its decision to upgrade Mexico's foreign currency rating:

"The upgrade reflects the gradually increasing macroeconomic stability attributable to steady improvement in external liquidity and deepening domestic financial markets, resulting in greater resilience to potential negative shocks. ... Growing domestic debt markets are allowing Mexico to sidestep one of the historic weaknesses of most Latin American sovereigns, namely the inability to raise fixed-rate, long-term debt in local currency."

The Moody's ratings agency had announced a similar move in early January. These two important signs of confidence, combined with the much-anticipated inclusion of local pension funds (or Afores) in the Bolsa and strong fourth-quarter operating results, fueled a 5 percent year-to-date rise in the national stock market.

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Another important factor affecting the Mexican capital markets has been the apparent victory by the Central Bank in its war on inflation ... at least for the moment. The announcement in mid-February that January had produced zero inflation brought great relief to capital markets, most notably the bond market. As a result, the Central Bank left monetary policy unchanged in February.

The peso had been trading within a range of 11.15 to 11.30 over the past few months, but now it appears to be firmly within an 11.15 to 11.20 range. This important technical breakthrough could indicate a period of sustained peso strength for the first quarter of 2005. The flipside being that this could then heat up the inflation rate in the medium term.

The Housing Sector

Perhaps the most telling evidence of the strength of Mexico's stock-listed housing sector over the past few years is how expensive these shares are in comparison to similar stocks in North America and Europe.

In fact, Mexican home building stocks are trading at the highest premiums in their history. Using a price-per-earnings ratio that incorporates projected earnings for 2005, we see Mexican home builders trading at levels around 15 times price-per-earnings 2005. Meanwhile, U.S. housing stocks trade around 8 times price-per-earnings 2005.

The market faces an interesting dilemma. There is little doubt that this sector will continue to grow at a tremendous rate for years to come. Furthermore, direct foreign capital investment in the housing sector will surely add an element of "the sky is the limit" mentality to growth prospects.

A prime example is the joint venture between Prudential Real Estate Corporation and Corporacion GEO. In this instance, Prudential committed US$175 million to increasing GEO's land bank on which to build future homes. But, as the future multiples indicate, it seems investors already have factored this into their pricing models. Hence the dilemma.

We may be nearing a "good news, bad news" scenario, where on one hand prospects for growth and margin expansion seem very bullish. But on the other hand, investors' excitement for the sector has created an expensive environment. This likely points toward profit-taking in the medium term.

Because housing stocks arguably have been the main driver of the Mexican equity market, this situation could temper any near-term equity rallies in Mexico. The big losers could be those who diverted part of their savings into the equity market.

I say this because January 17 was the first day Afores could be invested in equities. The temptation to invest in the highest growth sector in the Bolsa might be too strong for local Afores managers. One probable result would be that U.S. and European investors, who in many cases have earned returns of over 100 percent in the past two years, end up selling their shares to Mexican Afores managers.

INDEX                            31/01/'05      NOMINAL
                                 Index      Monthly  Accrued

STOCK MARKET
IPC                              13,097.12   1.4%     1.4%
INMEX                               758.26   1.2%     1.2%
MUTUAL FUNDS
Equity                            3,535.35   0.5%     0.5%
Debt for Individuals              4,310.59   0.5%     0.5%
Debt for Corporations             1,705.83   0.6%     0.6%
ECONOMIC ACTIVITY
Industrial                        4,978.75   0.0%     0.0%
Retail                           16,383.95   0.9%     0.9%
Non-Financial Services           11,468.62   0.4%     0.4%
Insurance and Banks               7,973.87  17.3%    17.3%
Broker Firms                        466.98   0.0%     0.0%
Financial Groups                    565.51   4.1%     4.1%
SECTOR
Mining                           16,600.52  -0.5%    -0.5%
Industrials                       4,205.98   1.1%     1.1%
Construction                     22,421.22   5.0%     5.0%
Retail                           20,015.56  -0.1%    -0.1%
Communications & Transportation  56,396.95   0.1%     0.1%
Services                          1,948.02   4.9%     4.9%
Holding Companies                 4,375.54  -0.5%    -0.5%

INDEX                                REAL (1)        DOLLARS (2)
                                 Monthly  Accrued  Monthly  Accrued

STOCK MARKET
IPC                               1.4%     1.4%     1.1%     1.1%
INMEX                             1.2%     1.2%     0.9%     0.9%
MUTUAL FUNDS
Equity                            0.5%     0.5%     0.2%     0.2%
Debt for Individuals              0.5%     0.5%     0.2%     0.2%
Debt for Corporations             0.6%     0.6%     0.3%     0.3%
ECONOMIC ACTIVITY
Industrial                        0.0%     0.0%    -0.3%    -0.3%
Retail                            0.9%     0.9%     0.6%     0.6%
Non-Financial Services            0.4%     0.4%     0.1%     0.1%
Insurance and Banks              17.2%    17.2%    16.9%    16.9%
Broker Firms                      0.0%     0.0%    -0.3%    -0.3%
Financial Groups                  4.1%     4.1%     3.8%     3.8%
SECTOR
Mining                           -0.5%    -0.5%    -0.8%    -0.8%
Industrials                       1.1%     1.1%     0.8%     0.8%
Construction                      5.0%     5.0%     4.7%     4.7%
Retail                           -0.1%    -0.1%    -0.4%    -0.4%
Communications & Transportation   0.1%     0.1%    -0.2%    -0.2%
Services                          5.0%     5.0%     4.5%     4.5%
Holding Companies                -0.6%    -0.6%    -0.8%    -0.8%

(1) January inflation: 0.0%
    January-January inflation: 0.0%
(2) January depreciation: 0.3%
    January-January depreciation: 0.3%

Information provided by AMCHAM economist Jose Antonio Hernandez Balbuena

Ramon Ruiz ([e-mail]) is a managing partner of Vintage Partners.