MXN: three factors behind the recent underperformance - BBVA

Analysts at BBVA Research highlighted the three main reasons behind the underperformance of the Mexican Peso (MXN) by about 17% in 2016: reduced expectations of US growth, weakening economic fundamentals and the Trump factor.

Key Quotes:

"i) Reduced expectations of US growth. Part of the MXN underperformance, we think, can be attributed to the significant slowdown in the US economy over the past two years. As Chart 12 shows, if we consider the 3-month moving average (3mma) of the Citi Economic Surprise Index daily data, US activity indicators have on balance been consistently below consensus expectations. In fact, the index has remained negative (on a 3mma basis) since early March 2015. It seems to have taken a toll on the peso (see Chart 12). The Mexican economy is most closely tied to the US manufacturing sector (see Chart 13). The sharp slowdown in the US manufacturing sector began in 4Q14, matching the time that the MXN started to underperform (see Chart 14). All in all, the slide in the US economy broadly resembles the MXN’s plunge (see Chart 15). However, Charts 14 & 15 show that before August (when the US economy seems to have turned for the worse once again), from April to July 2016, the MXN seems to have lagged behind the recovery path of the US economy. The MXN did not recover, but weakened further. Is there scope for a catch-up in the MXN’s relative performance? Not so fast! There are other factors in play."

"ii) Weakening economic fundamentals, particularly related to the external balance. The major slide in oil prices has taken a toll on both public finances and the external balance. With respect to the first, one can sum up what has happened in one phrase: tragedy strikes us when we least expect it. The energy reform was supposed to bring major investments to the oil sector within a few years that would not only boost oil production but also lead to a higher potential rate of growth for the Mexican economy. Although we still think the reform is likely to bring at least some of the expected benefits to the Mexican economy, tragedy struck and public finances have taken a hit from the combination of lower oil prices and falling oil production (see Chart 16). Before the major slide in oil prices, oil represented around one third of fiscal revenues and it was the country´s second source of foreign exchange. That said, in our opinion the government should probably have taken a more conservative approach to public finances and should not have relied on something that was uncertain. Hope is an unsafe friend and economic growth forecasts have been largely biased on the optimistic side over the past few years."

"iii) The Trump factor. The third factor that seems to be affecting the MXN is the possibility of a Trump presidency. Hillary Clinton is leading Trump in opinion polls, though her edge has narrowed (see Chart 22). As if the backdrop for the MXN were not already challenging enough, the potential negative implications for Mexico of a Trump presidency seem to be an additional factor contributing to the MXN’s weakness and underperformance. Although whether Mr. Trump will ever turn his rhetoric on Mexico into action is uncertain, the potential consequences are not by any means small and the markets seem to have taken note. What if Trump is elected? On the one side, he has insisted on building a wall on the border with Mexico and has pledged that Mexico is going to pay for it, arguing that if Mexico refuses to do so, he will impose taxes on remittances sent to Mexico (which are key to avoiding a further widening of the current account deficit). On the other side, although the US President cannot renegotiate NAFTA (it is a prerogative of Congress) he can withdraw from it with a six month notice. It seems that the stakes of the US election for Mexico have never been higher. Considering that, it is unsurprising that the peso seems to fare better whenever Hillary Clinton’s lead is widening and seems to weaken whenever Mr. Trump narrows Clinton’s lead (see Chart 23). Also, it is reasonable to consider that the MXN will increasingly be used as a hedge against a Trump victory as Election Day approaches."