This insight was originally published on July 15, 2010 for subscribers. RISK MANAGER SUBSCRIBERS have access to SELECT MACRO content in real-time.





Oh, down in Mexico
I never really been so I don't really know
Oh, Mexico
I guess I'll have to go
 - James Taylor
Conclusion:  We are short Mexico via the etf EWW due to its exposure to sequentially slowing growth in the U.S., drug wars that are accelerating, and declining oil revenue.

On July 6th we initiated our short position in Mexican equities.  Currently, we are down -1.8% on the position.  As Risk Managers, we aren’t happy being down on any position, even if just a couple of percent.  Call us lucky, or call us Risk Managers , but we have fortuitously only used one allocation for this position, so we still have the opportunity to average down up to three total allocations.
The short thesis for Mexico is threefold: oil, drug wars, and U.S. exposure.

  • The oil industry in Mexico is nationalized via PEMEX, the Mexican oil conglomerate.  In 2004, Mexico was producing 3.5 million barrels per day and that number is expected to be 2.5 million barrels in 2010, or a 29% decline over six years.  The bulk of this decline has come from the Cantarell field, which has declined ~70% from its peak production in 2004 (2.1MM barrels per day).  In the most recently reported quarter ending March 2010, oil production by Pemex was flat y-o-y, but the long term trend of declining volumes remains intact.
  • PEMEX funds an estimated ~35% of the federal budget of Mexico, so as the production of oil declines over time, the federal government will be required to find other sources to fund its budget, or will be required to cut government spending.  In terms of general economic growth, the declining aspect of this national funding mechanism will be a sustained headwind well into the future. The chart below of Mexican oil production on a daily basis shows this clear trend of declining production.





Drug Wars:

  • In 2009, there were more than 6,500 fatalities attributed to Mexican drug wars.  To put this in perspective, in the totality of the Iraq War, over an almost six year period, less than 4,500 U.S. troops were killed.  Based on year to date results in the Mexican drug war, the number of fatalities is expected to exceed 10,000 in 2010.  Currently, the Mexican government has over 45,000 troops directly focused on the drug war.  As the drug war continues to accelerate, alongside the headlines of murders, it will have a direct and significant impact on one Mexican industry: tourism.
  • Tourism is one of the most important industries to the Mexican economy.  Globally, Mexico ranks tenth in tourism with more than 23 million tourist visitors every year.  In 2008, U.S. dollar spending by tourists was north of $13 billion.  In aggregate, tourism contributes roughly 13% of Mexico’s GDP.  Clearly as drug war violence accelerates, as it is, it will have a negative future impact on the tourism industry, a key driver of the Mexican economy.


Trade with the United States:

  • Given the massive shared border and the nature of the North American Free Trade Act, Mexico is inextricably tied the economic fortunes of its largest trading partner, the United States.  Mexico is the United States’ third largest supplier of goods at ~$177 billion in 2009, which is more than 15% of Mexican GDP.  The United States is Mexico’s single largest export market.  Therefore, as the United States slows, so too will Mexico.
  • In an attached chart we’ve outlined GDP growth in Mexico versus the United States.  The data for the past few years show us, not surprisingly, that there is a high correlation of growth rates between the two countries.  Additionally, the last down turn indicated that the Mexican economy has a tendency to overreact to the downside versus the United States.  Specifically, in 2009 Mexico experienced negative growth of -7.9% and -10% in Q1 and Q2 of 2009, which lagged the troughs in U.S. GDP growth of -5.4% in Q4 2008 and -6.4% in Q1 2009 by one quarter.

Given these systemic risks to Mexican GDP growth, we continue to like Mexico on the short side and will average in as prices permit.





Daryl G. Jones
Managing Director

The Week Ahead

The Economic Data calendar for the week of the 16th of August through the 20th is full of critical releases and events.  Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.


The Week Ahead - c1

The Week Ahead - c2

Latin America CDS ... Risk Is Always On

Conclusion: CDS Spreads are widening from Europe to Latin America, which may spell near-term trouble for U.S. equities.


As my colleague Matt Hedrick pointed out in a note today, European sovereign CDS has risen 15-30% week-over-week for many countries, which is attracting some Manic Media attention back to Europe’s sovereign debt issues.


Latin America CDS ... Risk Is Always On  - 3


Shifting gears to Latin America, we have seen a similar weekly up move in these CDS markets – most notably Venezuela and Argentina (up 112bps and 44bps, respectively). In what consensus is calling “risk-on”, these global CDS moves suggest risk is back in the global marketplace. We’ll take the other side of that statement, however, as risk is always on in financial markets.


Latin America CDS ... Risk Is Always On  - 1


Broken down individually, we see that Venezuela recently agreed to pay debts to Colombian exporters in the area code of $800 million, which is obviously a large incremental strain on the country’s budget. In Argentina, things appear much worse and could be the start of a longer term issue that could lead the country to eventual default. The Argentinean Central Bank is boosting the amount of short term sovereign debt to absorb the excess liquidity from their recent dollar purchases. In this effort to reduce inflation, which has surged to a four-year high of 11%, the bank has boosted the nominal amount of short term debt sold in weekly auctions by 67% Y/Y! What’s worse, they are doing it at incredibly high rates. On August 10th the central bank sold notes maturing in 679 days at a yield of 14.8%, which is ~1430bps higher than 2-year U.S. Treasury notes. Regardless of how effective this proves to be in the short term, we’ll take the other side of Argentina being able to comfortably finance this unsustainable borrowing over the next two years – particularly in light of our bearish outlook for global growth.


Over the next couple of years we’ll find out whether Argentina is doing the right thing from a monetary policy perspective. What we don’t have to wait as long for is where the S&P is likely headed. On today’s Morning Call, Keith mentioned that he might not be bearish enough on the U.S. consumer – which is incremental to our street-low U.S. 2011 GDP estimate of 1.7%. While we aren’t yet ready to revise down our estimates, we still believe the S&P at these levels is a severe disconnect from the reality that is U.S. economic and fiscal health. The Latin American CDS markets agree with our assessment.


Using an equally-weighted basket of CDS spreads for six select Latin American countries, we found that moves in these credit markets are a decent proxy for the direction of the S&P 500 in the following week. The inverse correlation in this relationship has an r-squared of 0.72 over a 5-year duration, which is reasonably significant from a statistical perspective. Given the current week-over-week move in Latin American CDS, we can cautiously expect the S&P 500 to trade down from the current ~1080-1090 range next week. We express caution because, obviously, correlation does not equal causation. Keeping that in mind, the inverse relationship is what matters here as it relates to globally interconnected risk management.


Risk is always on.


Darius Dale



Latin America CDS ... Risk Is Always On  - 2

Early Look

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Is This the Peak of European Growth?

Position: Bullish Bias on Germany (EWG); Long the British Pound (FXB)


The negative reaction from European capital markets to positive Q2 GDP numbers out of Europe today is another confirming signal of our call for “trouble ahead” in the region in the back half of the year.


We’ve maintained a bullish bias on Germany over the last weeks. Certainly the outperformance of Germany’s Q2 GDP print (2.2% Q/Q, the largest quarterly gain in over 20 years) over its European peers has also translated to its equity market outperformance: the spread of the DAX over Greece’s ASE is 2700bps! (see charts below)


Is This the Peak of European Growth? - mh1


Is This the Peak of European Growth? - mh2


However, our outlook on Germany and the region still remains cautious in 2H10. Importantly, we’re still looking for the DAX to confirm its TREND line of support at 6076 before we’re a buyer. We believe that August and September European data will be especially critical for it will show an inflection point to the downside.


Certainly Germany’s strong Q2 growth is in line with the fundamentals we’ve followed over the last months:  a weak Euro (esp. in May/June) boosted exports, German exports found strong demand from China, the country’s employment and inflation picture remains stable, and comps have been “healthy”, especially when compared with bombed out levels in 2009.


Yet the inflection we’re expecting to see has yet to show up in the data, both due to the skew in the numbers because of the World Cup in the early summer and the impact that austerity measures issued throughout European countries will have in 2H10 and 2011, namely in choking off growth.  


Taking a look at the charts below, “risk-on” in Europe has shown up over the last week.  Sovereign CDS for many European countries rose ~15-30% over the last week and Greece continues to flash weakness, with its 10YR bond yield spread over German Bunds busting out (see charts below).  As a reminder we believe that sovereign debt risks in Europe are not rear-view.  Debt come due this year and next is one outstanding issue that the ‘PIIGS’ will continue to wrestle with.


We remain long the Pound (FXB) with a trading range for the GBP-USD of $1.54-$1.61.


Matthew Hedrick


Is This the Peak of European Growth? - mh3


Is This the Peak of European Growth? - mh4


Tax Free Weekend – Enter the Most Exposed

While last weekend kicked off tax free weekend 2010 for most states, there are a few noteworthy call outs as we head into another key tax free weekend – most importantly the addition of Illinois and Massachusetts to the list since our last post on the topic (see “To Be or Not To Be Tax Free” on 7/7). Neither state participated with an event last year.  However with both states landing in the bottom quintile of the Forbes State Debt rankings at #50 and #42 respectively, we are a bit surprised to see them added to the list given the importance of incremental sales tax as a source of revenue.  Clearly a balance is being struck here between local politics, the consumer, and business climate.  Here are a few other notable observations:

  • Illinois has the 2nd greatest budget gap in dollars at $5Bn behind…you guessed it, California at $9.1Bn.
  • Of the top 5 states most exposed to teens in the 15-19 year-old demographic (CA, TX, NY, FL, IL), California is now the only one NOT to offer a tax free holiday.
  • In addition to FL and MD, IL and MA now join the list of new states adding events vs. last year, adding 10 and 2-day tax-free events respectively.


With both the Midwest and Northeast underperforming other regions since the end of June according to our SportsScan trend data, state government clearly sees these events as an opportunity to stimulate both local demand and stimulate consumer purchasing habits alike. The results of these efforts will be a key focus come September sales day when we begin to see just how successful these stimulus efforts ended up.


Tax Free Weekend – Enter the Most Exposed - TeenStateExp 7 10


Tax Free Weekend – Enter the Most Exposed - TaxHoliday StateDebtRank 8 10


Tax Free Weekend – Enter the Most Exposed - TaxHoliday 1 Sched 8 10

Tax Free Weekend – Enter the Most Exposed - TaxHoliday 2 Sched 8 10




The preliminary readings from the University of Michigan Surveys of Consumers improved marginally in August.  This marginal uptick is not being confirmed by Mr. Market – XLY is the worst performing sector today.  Furthermore, the two most important indicators in the national economy today – jobs and housing – are indicating that the narrative of recovery is, in fact, a fallacy.


The University of Michigan “preliminary” index of consumer sentiment climbed to 69.6 following 67.8 in July (which was the lowest since November 2009) and consensus of 69 (according to Bloomberg).  The measure of current conditions rose to 78.3 from 76.5 last month and the measure of consumer expectations for six months from now, increased to 64.1 from 62.3. 


The Consumer Sentiment Index is down 4.0% YTD and still 28% below the peak level of the chart - January 2007.


The big positive for the country over the past couple of weeks has been the developments in the Gulf and the positive spin around the cleanup efforts.  Aside from that there is not much else to write home about. 


The August preliminary reading might be a welcome sign for the “back-to-school” season, but it’s still going to be a hit-or-miss back-to-school season for some retailers, as suggested by advance retail sales figures reported today.  Consumers continue to send mixed signals when it comes to the economy and spending.


A separate survey by the Prosper group done in the month of August suggested that a recovery is down the road “when 40.6% feel worse off financially compared to a year ago” and “only one in ten says they are better off.” 


Lastly, while prices at the pump are only up $0.14 YoY, 68.1% of consumers surveyed say gas prices are still impacting their purchase decisions.


Despite the slight uptick in consumer confidence, the Consumer Discretionary (XLY) is the worst performing sector today.  We remain bearish on the intermediate term TREND for consumer spending.


Howard Penney

Managing Director




CONFIDENCE - GASPING FOR AIR - current conditions



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