Positive trends evident: corrections anticipated in local markets.

Despite political unrest and overall disappointment from market players and investors, local markets in Mexico have performed favorably in the first half of the year. Although it is probable that this positive trend will continue during the third quarter, local market performance over the long-term is less certain, in part due to the unknown effects of long-lasting high real interest rates. Therefore, careful analysis is necessary to draw a clearer picture of the future trends.

Banco de Mexico's decision to cap short interest rates, the selective impact of soaring commodity prices--most notably oil--and the cautiously favorable scenario predicted for the Mexican economy all support further expansion.

The main piece of news for the local markets came on June 24, when the Central Bank decided to remove the paragraph of its press release to markets which states that Mexican monetary conditions should reflect "at least" those in the United States. As a result, this famous and long-awaited separation from the Federal Open Market Committee (FOMC) arrived at a time when the strong performance in the stock market was causing investors to question whether the trend would continue. If this event did not allow short-term interest rates to drop, it at least capped them at their current 9.75 percent, making equity investments more attractive and extending their gains.

Indeed, soaring commodity prices affected various economies and helped a few. Such has been the case for Mexico. As an emerging market subject to speculative cash flows, high oil prices have served as a deterrent to outflows supporting the peso and peso-denominated assets, and leaving the main services, retail and telecom sectors, unharmed.

The economic outlook is not all bad for the rest of the year. Mixed results in economic indicators in the United States do not pose a threat to Mexican growth. At least, the last FOMC economic policy press release's hawkish tone with respect to economic activity in the United States justifies another 25 basis points more to the Fed Funds Target Rate (leaving it at 3.25 percent). Even the Mexican Central Bank presents a favorable scenario, expecting between 3.5 and 4.0 percent annual growth for the economy in 2005.

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Having reached 13,486 points by the end of June, the Mexican stock market sports a historical high in U.S. dollar terms at 1,284 points. It is important to bear in mind that these positive levels and the good financial reports for the second quarter are supported by a strong currency--a 4.2 percent appreciation of the peso against the dollar. Also, this year we saw a peculiar calendar due to Easter Week falling in March as opposed to April, meaning there were fewer output days in the first quarter this time around that would make the second one look more impressive on both a quarterly and an annual basis.

These are all positive figures that, for a newcomer, would look attractive and inviting. Nevertheless, by the time the companies' quarterly reports for the April-June period are fully digested by analysts, questions will arise with regards to a continuance of the current trends.

To begin with, the last primary auction for the 1-year Cetes came at 9.59 percent. Above this number, a 3 to 4 percent-point risk premium in the stock market is not enough for the next 12 months, especially heading into an election year. High nominal interest rates will prevail: current monetary conditions are bound to continue at least throughout the third quarter despite what many trading floors might be betting on. True, inflation in June edged down to 4.33 percent from 4.60 percent in May, a sizeable drop, but not enough for the Central Bank to consider easing its monetary policy and allow for the overnight rate to move lower.

In fact, these low annual inflation rates come from two consecutive readings of monthly deflation (-0.25 percent in May and -0.10 percent in June), sending real interest rates to an average 10.8 percent. In light of such monetary restrictions, more than one analyst will be revising growth estimates for economic activity in the next quarter.

Adrian Rizo is a native to Mexico City working in Fixed Income and Foreign Exchange Strategy at HSBC Mexico. He is responsible for the development of investment strategies for local debt and foreign exchange markets, writes daily for HSBC's "Emerging Markets Daily Strategist" and collaborates in numerous publications within the Bank's Research Group.