Recent Developments Are MXN-Positive

(from my colleague Dr. Win Thin)

INTRODUCTION
Banco de Mexico announced a new FX program to help support the peso without draining its foreign reserves.  While this should help lower FX volatility near-term, the peso is benefiting more from a more benign EM backdrop and signs of thawing US-Mexico relations. 

POLITICAL OUTLOOK
Tensions remain high as President Pena Nieto and his government has said they refuse to accept unilateral US actions on immigration.  

Mexican Foreign Minister Videgaray said the government will fight President Trump’s most recent immigration order, which allows the US to deport any illegal immigrants to Mexico, even if they are not Mexican nationals. 

Secretary of State Tillerson and Secretary of Homeland Security Kelly are currently in Mexico.  The team is meeting with their Mexican counterparts to discuss immigration and security issues.  The meetings come after Pena Nieto last month cancelled a visit to the US, and so perhaps there is a thaw in relations.  White House press secretary Spicer played down the rifts, instead calling US-Mexico relations as “phenomenal.”

Indeed, comments today from US Treasury Secretary Mnuchin regarding Mexico should be viewed as constructive.  This stance would support the view that a less confrontational stance will be seen, despite President Trump’s inflammatory campaign promises.  Mnuchin said that he was not worried about US-Mexico trade relations, calling it a “win-win” result for both countries.  He added that we shouldn’t expect action on US-Mexico trade in the short-term. 

ECONOMIC OUTLOOK
The economy is still sluggish.  GDP growth is forecast to decelerate modestly to 1.6% in 2017 from 2.3%% in 2016.  GDP rose 2.4% y/y in Q4 vs. 2.1% in Q3, so there are upside risks to the forecasts.  Indeed, higher oil prices should help boost growth in 2017.  On the other hand, fiscal and monetary tightening will act as headwinds.

Price pressures are rising, with CPI accelerating to 4.7% y/y in January.  This is the highest rate since September 2012, and has moved above the 2-4% target range.  Core inflation accelerated to 3.8% y/y in January, as did PPI to 12.3% y/y.  

Higher inflation would seem to support the case for further tightening.  However, the bank will likely wait to see if the firmer peso will have a beneficial impact on inflation before hiking again.  Next policy meeting is March 30.  Our early call is for no change, but this will depend in large part on external factors.  The central bank last hiked rates 50 bp to 6.25% earlier this month.

Fiscal policy has remained prudent.  Unlike many of the commodity exporters, Mexico was relatively well-prepared for the downside of the commodity cycle.  The Finance Ministry enacted several rounds of fiscal tightening last year.  The budget deficit came in at an estimated -2.6% of GDP in 2016, down from -3.5% 2015.  The gap is expected to narrow slightly to -2.5% in 2017 and -2.1% in 2018. 

The external accounts should improve.  Higher oil prices should help exports, while the sluggish economy will help reduce imports.  The current account gap was -3.3% of GDP in 2016, and is expected by the IMF to narrow to -2.8% in 2017 and -2.4% in 2018.  FDI continues to cover a large portion of the current account deficit.

After falling modestly in 2015, foreign reserves have remained fairly steady for much of 2016.  At $174.8 bln in January, they cover more than 5 months of imports and are almost 3 times larger than its short-term external debt stock.  The recently announced FX hedging program and higher oil prices should help the bank replenish reserves.

INVESTMENT OUTLOOK
The peso has done better after a poor 2016.  In 2016, MXN fell -16% vs. USD and was ahead of only TRY (-17%) and ARS (-18%).  So far in 2017, MXN is up 5.25% YTD and is behind only ZAR (+7%), KRW (+6%), BRL (+6%), and RUB (+5.5%).  Our EM FX model shows the peso to have NEUTRAL fundamentals, so this year’s outperformance should ebb a bit.

Banco de Mexico just announced a new $20 bln FX hedging facility.  Long story short, this is very much like the swaps program used by Brazil.  This should allow Banxico to limit the impact of hedging demand on deliverable FX.  The central bank takes on FX risk but pays out in local currency so there is no drain on its FX reserves.  Any FX losses will be absorbed by Banxico, but it has been profitable over the last several years.  

A key level for USD/MXN comes in near 19.6435.  This is the 62% retracement objective of the big November-January move higher.  A break below would target the November 9 low near 18.1635.  The 200-day Moving Average comes in near 19.5140.

Mexican equities are still underperforming after a poor 2016.  In 2016, MSCI Mexico was -12% vs. +7% for MSCI EM.  So far this year, MSCI Mexico is up 7% YTD and compares to 11% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Mexico at an UNDWERWEIGHT position.  

Mexican bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -19 bp YTD.  This is in the middle of the EM pack compared to the best performers Argentina (-241 bp) and Brazil (-119 bp) as well as the worst India (+38 bp) and China (+30 bp).  If inflation rises and the central bank has to continue hiking rates, we think Mexican bonds may start to underperform more. 

Our own sovereign ratings model shows Mexico’s implied rating at BBB+/Baa1/BBB+.  Both S&P and Fitch appear to be on target with their BBB+ rating.  However, we note that Moody’s decision to move the outlook on Mexico’s rating from stable to negative last March could presage an eventual cut to Baa1, as our model suggests.    

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