Structural reforms could pave way for peso resurgence in 2016

The peso has suffered along with other emerging market (EM) currencies from a shift out of risk assets and into the dollar, ahead of US rate hikes that are almost universally expected sooner rather than later.

However, years of pro-market policies have convinced many analysts the currency can outperform in choppy EM conditions and stage a tentative pick-up around 2015 and 2016 if structural reforms pay off.

In the near-term, the central bank is remaining on the sidelines, having left its interest rates unchanged at 3% at its most recent meeting, despite pressure from some quarters to stimulate the economy. That has left some currency-watchers predicting a period of relative weakness before the economy expands further in Q4, while others insist a strong run is imminent.

Bank of America Merrill Lynch is in the latter camp, advising its clients that the time to buy pesos – which are trading at 13.43 against the dollar – is now, with a bull trend resuming after 15 months of range-trading. “Upside targets are seen to 13.8319 and, potentially, beyond,” says the bank.

Barclays advises a more cautious approach. Marco Oviedo, director of EM research at Barclays, says the peso is likely to depreciate in the months as markets anticipate quantitative easing in the eurozone and a stronger dollar.

“We are expecting the peso to close the year at 13.25 and be at 13.40 in a year from now,” says Oviedo. “In that sense, depreciation pressures will dominate during the next quarter and the first half of 2015.”

Only stronger foreign direct investment (FDI) can provide support to the MXN, he says, and this will likely accelerate until Q3 and Q4 of 2015, with the MXN then appreciating towards 2016.

Nevertheless, in the short term the peso won’t fall against the dollar as much as most other EM currencies, says Oviedo, meaning there is still potential to buy the currency with other LatAm or EM currencies.

“We might see an acceleration of FDI flows on the back of heightened growth expectations and once things stabilize we will see the peso rising again,” he adds.

Fiscal reforms

The general optimism surrounding the longer-term prospects for the Mexican economy and the peso is anchored by the government’s long-standing commitment to a comprehensive fiscal-reforms programme that has seen successive administrations push through a series of measures that should increase FDI flows – the energy-sector in particular – and labour-market productivity.

Barclays is expecting a 2.8% year-on-year growth in H214, which will lead to a 2.3% expansion for the full-year 2014.

The latest stage of the structural reforms has a particular focus on the energy sector and is designed to combat declining oil production. Reforms, which have been passed into law and await implementation, should create new markets in oil, natural gas and electricity, and open up Mexico to foreign investment.

Although previous governments have tried and failed to enact similar reforms, there is an air of confidence that this time will be different, coupled with indications the economy is picking up steam.

However, in the short term, Mexico will be vulnerable to rate rises in the US, which is likely to deter EM flows.

“The Mexican peso has offered little resistance to the dollar’s bull charge,” says Brown Brothers Harriman. The bank says it had expected forthcoming structural domestic reforms and the improved outlook for the US, especially in manufacturing more broadly, to have underpinned the peso.

Gustavo Arteta, EM FX strategist at UBS, adds: “If the US can grow at a reasonable rate, around 2.5%, EM generally will suffer. You have growth slowing in China and Europe, and rates increasing in the US, meaning slowing trade. But it will hurt other EM currencies more than the peso – as long as Mexico’s links to the US remain strong.”

Between 2010 and 2013, that relationship between the economies did weaken, with the lag time between their leading indicators extending from around three months up to around six – but more recently correlations have normalized, says Arteta.

“We calculate the Brazilian real is between 8% and 15% overvalued, whereas the peso is around 3% overvalued,” says Arteta. “If you factor in expected capital inflows from coming reforms, a higher peso could be justified, but an upward correction is more likely than a sustained upward trend.

“We are bearish EM currencies generally, but the peso is better than other EM currencies.”

Fighting inflation

This view is widely shared, with foreigners generally having fewer reservations investing in Mexico than in some other EMs. This is principally because it has been so successful fighting inflation.

“The market is no longer pricing a significant probability of another surprise cut since the economy has shown signs of recovery,” says Morgan Stanley. “Uncertainty about a rising minimum wage and CPI increasing due to higher gasoline prices is warranted, and should also contribute to rising front-end rates, though not the long end as inflation expectations remain well anchored.”

Optimistic predictions about Mexico’s future tend to be predicated on the assumption the central bank will maintain its inflation-fighting credentials.

“The future path of inflation is likely to be decisive for the peso,” says Barclays’ Oviedo. “If inflation remains close to 3% in 2015, no change in interest rates will be implemented until September. It will be that inflation performance and not US monetary policy that is the relevant variable.”

“If there was a big EM sell-off, the peso could hit 14 against the dollar, but this would be a buying opportunity,” says Arteta at UBS. “Otherwise we don’t see it going down significantly. Its resistance level has been 13.47, so it will probably trade in a range to about 13.5 against the dollar until we get more clarity from the Fed and USD stays with a strength bias.”

Arteta predicts Mexico won’t see the benefits of the reforms in the form of inflows until late 2015 or even 2016, but believes the market wants to anticipate the impact of those reforms.

One of the peso’s biggest strengths – liquidity – is also a weakness. EM FX investors remain enamoured with the Mexican currency because it offers vastly better liquidity than most other EM currencies, and even some G10 currencies: according to the Bank for International Settlements, the Mexican peso is the 10th most-traded currency in the world.

However, this liquidity means it can be one of the first positions to be exited when investors are looking to free-up capital in a falling market.

“If someone has a position in another EM currency like the Brazilian real or Turkish lira, they often use the Mexican peso to hedge,” says Oviedo. “That adds to the liquidity of the currency.”

Arteta adds: “Mexico’s close ties to the US mean liquidity is always increasing over time. Investors see the peso as a way to track EM risk; it helps you anticipate what will happen in other EM currencies. And that makes it a great hedge, especially for risk-on/risk-off strategies.

“The liquidity gives investors the comfort of knowing they will be able to exit their position if they need to.”