The Mexican Peso has weakened ~10% following Trump’s presidential election victory given fears of a shift towards a more protectionist trade position by the Trump administration. However, in truth, the Peso has been trending weaker since June 2013 (USDMXN bottomed at ~12 in 2013), and had weakened >30% before Trump’s appointment had become a realistic prospect. No doubt the broad trend stronger in the US dollar has helped push USDMXN higher, but in an environment of US economic outperformance which might be expected to benefit Mexico, it is notable that the Peso ranks towards the bottom of the rankings of emerging market currency performance over the last few years.
So where to from here? There are a number of reasons to be positive on the Peso at current levels, along with a big, but uncertain potential reason to be negative.
On the positive side:
1) The Mexican Peso is now undervalued when viewed from a long-term purchasing power parity (PPP) perspective and towards the lower end of valuation ranges observed over past decades.
2) Banxico has now hiked rates a cumulative 2.25% in response to rising inflation, as a result of pass-through from currency weakness. As such, the positive carry on short USDMXN positions is the most favourable it has been in over ten years (excluding the financial crisis). Even with the current elevated volatility in USDMXN, Sharpe ratios on long MXN positions are towards the upper end of observations seen in recent years.
3) Linked to the Banxico rate hike cycle, along with the negative confidence hit Trump’s policies seem to be generating in Mexico, we anticipate a further improvement in Mexico’s balance of payments position. Developments in Brazil may be instructive here. The severe recession in Brazil during 2015 and 2016 led to a significant retrenchment in domestic demand, which facilitated a rapid improvement in the trade balance as import demand withered.
Our concern regarding the Mexico Peso over recent years had been that although the currency had weakened, until recently Mexico’s balance of payments provided little evidence that the Peso was undervalued, i.e., we had not observed an improvement in the balance of payments that would be expected to be associated with a ‘cheap’ currency. This is now changing as the Mexican non-oil trade balance has now moved into surplus on a 12-month rolling basis, and further domestic demand weakness should see this improve further. We have also seen some positive developments in terms of investment in Mexico’s oil sector, which also suggests that the worst of the deterioration in the non-oil trade balance could be behind us.
The big potential negative for the Peso in the coming months remains what the Trump administration chooses to do on its trade policies, either directly by the imposition of tariffs, or indirectly via a border adjustment tax. Some market commentators believe that the enactment of either could still push USDMXN to new highs. This is of course possible, although we’d note that fiscal reforms seem likely to take longer than was hoped for a few months ago, and price-action in the Peso has proved robust despite last week’s comments from President Trump that an announcement on tax reform would come in the next few weeks, suggesting much is already incorporated in the Peso’s current valuations.
We therefore remain cautiously optimistic on the outlook for the Mexican Peso, although we recognise the road ahead will likely be bumpy.