Why the Mexican Peso Could Perform

Summary

• Mexico’s trade balance has dramatically improved since 2017.
• The country has favoured fiscal and monetary stability over economic growth.

Market Implications

• Short term – Neutral MXN, given the strong rally and US growth slowdown.
• Medium term – Positive MXN, given the improving trade balance, low positioning and the FX-positive fiscal/monetary response.

Emerging markets (EM) have become a big focus for investors in recent weeks. While EM markets may initially rally in tandem, as time goes on, investors will start to focus on individual EM country fundamentals. Perhaps, the most interesting markets could be Mexico – it has bucked the trend of other EM countries by being more cautious on monetary and fiscal stimulus. But this has come at the cost of weaker growth. Here we lay out the main consideration for the Mexican peso (MXN) and why it could be a good medium story.

Two Important Characteristics of MXN

1. MXN as EM proxy. The Mexican peso (MXN) is the 15^th most traded currency in the world and the fifth most among emerging markets (EM) after the Chinese yuan, Hong Kong dollar, Korean won and Singaporean dollar. The average daily turnover of the MXN was USD114bn in 2019, well above the Russian ruble (RUB) or the Brazilian real (BRL) – each with USD70bn in turnover. Moreover, the MXN trades continuously, with a larger liquidity window (from 12am to 10pm UK time) than most other EM currencies. For these reasons, the MXN is an important barometer of EM risk and often used as a proxy for other EM markets when those markets are closed.
2. Strong exposure to US growth. Mexico is the US’s second-largest trading partner, while the US is, by far, Mexico’s largest. Almost 80% of its exports go to the US, accounting for more than 30% of its GDP – mostly concentrated in vehicles, electrical equipment and machinery. The US is also Mexico’s largest source of remittances (1.4% of GDP in 2019) and FDI (4.4% of GDP in 2018), which has a critical impact on the domestic economy. Unsurprisingly, Mexican GDP closely follows US GDP, with higher fluctuations.

A Resilient External Balance

For EM currencies, the direction and sustainability of the current account is crucial. In that context, Mexico stands out. Its trade balance has improved dramatically since 2017 and is now well in surplus (Chart 1). Three things have driven this:

1. The non-oil balance on the back of a competitive currency – MXN weakened by 60% in 2013-18.
2. A weak domestic economy – five consecutive quarters of economic contraction since 2Q19.
3. Strong US growth.

In 2020, the trade balance reached an all-time high, reflecting a strong rebound in manufacturing exports to the US but sluggish domestic activity. Going forward, a slowdown in US activity could be a drag on exports, but positive vaccine news supporting oil exports and tourism flows (the latter have collapsed from 1.5% to 0.5% of GDP) could offset this.

Importantly, rather than domestic growth, strong export growth has supported MXN (and other EM FX). Typically, this growth comes from global growth, commodities prices and the dollar. Overall, there is strong correlation between the one-year change in Mexico’s trade balance and the exchange rate (in 2013-14, the oil price boom temporarily inverted the correlation, Chart 2). This alone suggests there is scope for MXN to strengthen.

Fiscal and Monetary Conservatism

Aside from the trade balance, fiscal sustainability issues have often dominated Latam currencies. A good example is the dramatic underperformance of the Brazilian real since 2014 despite an improving trade balance. Therefore, that Mexico has opted for a limited fiscal response to combat the pandemic should hold MXN in good stead. The average deficit among EM has risen above 10% of GDP, while in Mexico it is still in the 3-4% of GDP range (Chart 3). And the AMLO administration continues following its campaign promises to restrict fiscal spending and stabilize public finances.

However, the lack of fiscal support also means Mexico’s economy now faces one of the region’s largest contractions. This muddies the water for MXN. While the strong fiscal picture is good for the currency, the lack of fiscal support could damage firm and household balance sheets. This could prompt the central bank to ease.

So far, Banxico has been prudent since the start of the pandemic. They cut policy rates by 1.75% to 4.25% but recently announced a pause during their November meeting to gain clarity on the inflation outlook (Chart 4). Meanwhile, the central bank in Brazil cut rates from 6.50% to 2.0% despite the huge fiscal stimulus (the deficit is expected to rise to 16-17%).

On the inflation side, prices increased by 4.09% in October from a year earlier – slightly above the 4% upper limit of Banxico’s target band. In the next 12-24 months, Banxico expects price pressures to remain muted around 3%. The peso depreciation’s impact on inflation has been offset by the drop in commodity prices and the negative output gap. Banxico could yet cut beyond what markets expect, especially if inflation trends lower. But it will likely be very gradual given their cautious stance.

In the end, the overall mix of tight fiscal policy, weak domestic growth and a cautious Banxio could be positive for MXN but negative for Mexican equities (Mexican equities have underperformed MSCI EM by 20%).

Bottom Line

The positive external balance, attractive carry and cautious fiscal/monetary actions all support MXN amid still-low positioning. Moreover, recent news flows (vaccine and Biden election) are positive for Mexico. The impressive recent price action in MXN and a potential slowdown in US activity may be two hurdles for further gains in the short-term. However, if global growth rebounds in 2021, the MXN has room to catch up.