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LatAm: short BRL/MXN Our top contrarian trade in Latin American markets is selling BRL/MXN (spot 6.00, target 5.00, stop 6.75). The trade benefits from valuation, positioning and our views of the expected effects of the US election on the Brazilian and Mexican economies. MXN 10% undervalued, BRL 5% overvalued We estimate the Mexican peso is about 10% undervalued while the Brazilian real is about 5% overvalued, based on our Compass valuation model. The model provides estimates of long-run equilibrium trade-weighted exchange rates consistent with the convergence of current account balances toward levels that are in line with country fundamentals that determine savings and investments. Mexico’s real exchange rate index is at its lowest since at least 1999, and about 35% cheaper than its long-run average. Brazil’s real exchange rate has risen sharply in 2016 and is now around 8% stronger than its long-run average (Chart 48). LatAm under Trump’s world We believe the election of Donald Trump as the next president of the US will be negative to Latin American economies. His economic plan will likely involve a significant fiscal expansion, perhaps tighter monetary policy and some protectionist’s measures. These will likely lead to higher US rates and a strengthening of the US dollar. Higher international interest rates are a negative shock for emerging economies and any acceleration in US economic growth will be skewed to domestic nontraded goods. We think Brazil’s economy will likely be more negatively affected since its strategy to gradually reduce budget deficits is based on low global rates, capital inflows and higher domestic growth. Mexico, on the other hand, may benefit on relative terms from a construction and infrastructure boom in the US. Any revival in US manufacturing would also be good for Mexico, particularly if Trump’s protectionist measures are not as substantial as feared. Market is not positioned for a MXN rally and BRL selloff Selling BRL/MXN is a contrarian trade. Foreign investors are significantly long BRL according to our positioning index based on BM&F data. Market positioning by local investors is even more stretched toward long BRL. On the contrary, speculative investors are short MXN according our positioning index based on CFTC data (Chart 49). So positioning unwinding would actually help our short BRL/MXN strategy. Chart 48: Real exchange rate is cheap in Mexico, expensive in Brazil Chart 49: Market is positioned long BRL and short MXN 450 450 3 Long BRL and MXN positionining 3 Long-run average = 100 2.9 2.5 130 130 2 ' 1.5 1.5 110 110 1 my | 0.5 0.5 90 90 0 0 0.5 0.5 70 70 -1 -{ 1.5 1.5 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 2013 2014 2015 2016 Brazil real exchange rate ~—-—=Mexico real exchange rate == Long BRL position —— Long MXN position Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg 26 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Bankof America “2 Merrill Lynch HOUSE_OVERSIGHT_014756