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2006: trading gains for stability; The efforts of the Mexican government to armor the economy against any possible shocks persist.

With 2006 just around the corner, analysts very rarely disagree on the expected behavior of financial markets. The rally in asset prices that began in the United States over Thanksgiving weekend and carries on through the New Year tends to spill into emerging markets. Therefore, the discussion on what is to come afterwards is timely enough.

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If we look back on 2005, a year that supplied an extra dosage of political and economic surprises for Mexico, we might as well crunch the numbers and call it a day. For instance, the Mexican Stock Market has risen 40 percent since January and through mid-November, marking a historical new peak almost every month, and most frequently during the second semester, reaching 16,350 points in November.

Peso-denominated government bonds also rallied in the second half of the year, averaging 80 basis points in gains. Although foreign players reduced their participation in long-term notes, there has been enough demand from local participants to seize the chance. External debt was also boosted this year through various government strategies. The most important came early in November when the Finance Ministry anticipated the amortization of US$1.41 billion, roughly 3.0 percent of the total outstanding dollar-denominated bonds in external markets. As a result, sovereign spreads, or country risk for Mexico reached an all-time low at 97 points, measured by the HSBC's Emerging Sovereign Debt Index (ESDX).

This presents even better returns for foreign investors, since the peso has appreciated 5.7 percent to the U.S. dollar year-to-date thanks to the widening of interest-rate spreads between Mexico and the United States after a more aggressive monetary stance by Banco de Mexico than that of the Federal Reserve. This in turn has helped achieve price stability in Mexico while the United States has suffered greatly from high energy prices. In fact, October CPI reached 3.05 percent year-on-year in the former, while in the latter the CPI annual rate is at 4.3 percent.

Nevertheless, the sustainability of this scenario raises red flags about speculative bubbles. With the broad expectation that monetary conditions in the United States will continue tightening, the opportunity cost for equity investments will become higher. This argument is crucial because the 10-year U.S. Treasury bonds have been unable to rise above 4.68 percent (which is also the average yield since 2000), which has boosted investment in stock markets, made emerging countries' debt more attractive and reduced the risk premium for assets.

Next year should be one of stability. The efforts of the Mexican government to armor the economy against any possible shocks by means of reducing external debt and strengthening the local fixed-rate bonds market persist. Additionally, because the positions of market participants lure interest rates to come down, setting the floor for the overnight interest rate will continue to be imperative--and closer than we think. Currently at 8.75 percent after four consecutive monthly cuts, the interbank funding rate would be the anchor of financial stability in a year of presidential elections, especially if its American equivalent rises to, say, the 4.50 percent level expected by the market consensus.

That said, it is more sensible to expect a correction in stock prices, from which the peso can suffer a bit. It is then once again up to financial authorities to maintain price stability and improve the country's investment profile, and although there is still a long way to go, the outcome so far is promising.

Adrian Rizo is responsible for the development of investment strategies for local debt and foreign exchange markets at HSBC Mexico.
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Title Annotation:MARKET MOVES
Author:Rizo, Adrian
Publication:Business Mexico
Geographic Code:1MEX
Date:Dec 1, 2005
Words:600
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