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IPE special report May 2018

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Mexican peso: No good deed goes unpunished

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The Mexican peso has suffered as investors have sold the formerly favoured currency following concerns about China and the global community slump, writes Christopher O’Dea  

At a glance

• Investors are concerned about the China slowdown and falling commodity prices have been selling the Mexican peso.
• Mexico has one of the biggest bond markets among emerging economies as well as the most liquid currency.
• Some managers see the peso’s decline as a source of opportunity in the corporate debt markets.
• Rising rates in the US will have a particularly acute effect on its southern neighbour.

Imagine an emerging market nation that has tamed inflation, implemented fundamental economic reforms that are just starting to bear fruit and developed a local capital market so deep and liquid that foreign investors own nearly half of its local-currency sovereign debt. The country could justifiably expect to be viewed as an attractive destination for global financial transactions.

Mexico has achieved all that and more. But success breeds its own problems and in the past year the country has discovered the unintended consequences of becoming the most robust capital and foreign exchange market among developing countries. Investors concerned that the slowdown in China and the global commodity slump will cause lasting damage to growth in emerging markets needed to protect themselves against losses. They have found a solution – selling the Mexican peso. While that has helped some investors hedge, peso sales during the summer pushed the currency below 15 to the dollar in intraday trading – its lowest point since the 1993 revaluation – sparking tricky questions more often posed to the central banks of developed nations.

That is because the peso has become a proxy for investors’ views on emerging markets. The peso’s decline did not stem from a weak Mexican economy. If Mexican economic prospects were the only factor to consider the peso would likely be doing quite well. But global investors have turned to the peso to hedge against weakness in emerging nations where bond and currency markets cannot accommodate the total volume and large transactions they require to protect their portfolios.

Investment Performance Survey of Emerging Market Debt (top quartile actual ranking) return in $US (before fees) over 3 mths, 1 yr, 3 yrs, 5 yrs to 15 June

The peso crisis shows how new risks can arise in emerging market investing at a time when some major investors argue the volume of bonds, credit quality and valuations weigh in favour of increased allocations to the asset class. Underlying the more favourable view are long-term drivers such as the growth of a new middle class in many emerging markets, which the commodity slump is expected to slow, but not derail. Some investors are even moving beyond the traditional distinction between local-currency and hard-currency bonds, adopting a strategy akin to unconstrained fixed-income mandates that have gained favour in recent years. 

Such broad approaches reduce exposure to benchmark bonds and deploy capital into the spectrum of emerging market debt instruments, including off-benchmark sovereign and quasi sovereign bonds, dollar corporate bonds, local-currency debt and emerging market currencies. At times, some managers will tactically hedge a portion of emerging market currency exposure back into dollars, although seeking to maintain the emerging market currency exposure to maximise the higher yields on local bond weightings.

Mexico stands at the crossroads of this reassessment. With a comparatively robust financial market and sound legal system, the country is grappling to balance the benefits of success with the challenges that arise when investors use that safer, more efficient market to protect against losses in less robust markets.

While all emerging currencies have depreciated against the dollar in the past several years, the Mexican peso occupies a unique perch. Mexico “has the foremost, most liquid currency, as well as the biggest bond market among emerging economies,” says Andrew Keirle, a portfolio manager of the T Rowe Price Emerging Local Markets Bond fund. “The peso is highly accessibl e and tends to have a high correlation with other EM [emerging market] currencies,” he says. “So it has been used, as far as we can see, as a form of hedging instrument against generalised EM weakness.”

That is a function of the size and functionality of the Mexican currency and bond markets, says Keirle. “Mexico is one of the biggest bond markets in the emerging markets,” he says. “It’s also one where international investors have one of the largest percentages of ownership, north of 50%.” Because of the advancements made in macroeconomic policy, the quality of the Mexican institutional framework and the country’s proximity to the US market, Mexico has enjoyed significant inflows of foreign investor money into its bond market, Keirle adds.

The peso is also the most liquid EM currency, with an average daily volume of about $11bn (€10bn), with an average order size of $20m to $25m, Keirle adds. “Bigger tickets can be relatively easily processed, and that’s probably about double the next nearest EM currency – Brazil’s real. Brazil is very large, but it’s not as liquid and not as 24-hour as Mexico,” he says. “Mexico really does stand on its own in terms of market structure.”

For bond investors, the steep Mexican yield curve continues to offer value, Keirle continues. Local-currency Mexican five-year debt due in 2021 pays a 5.5% yield, and investors can lock in a yield premium of 2.5-3% over US Treasuries by selling the peso forward at an implied yield of approximately 3%, he says. 

A weaker peso

While the peso’s dive has focused attention on the possibility that Mexican government bonds, or bonos, might get caught in the downdraft if portfolio managers trim their holdings, some managers see the peso’s decline as a sign of opportunity in the corporate debt market. While holding some high-quality peso-denominated corporate debt, “the bulk of our exposure is through dollar-denominated corporate bonds”, says Todd Crescenzo, director of research of LM Capital Group, a San Diego-based firm founded in 1984 by Mexico City native Luis Maizel, that manages $5.2bn in fixed income assets for US pension funds and institutions. The firm began investing in emerging market debt as the ‘plus’ component of a core-plus debt strategy in the early 1990s and in March launched a stand-alone EM debt strategy that has been attracting capital from US state and city pension plans. 

“We’re playing the other side of the peso depreciation, and trying to find the companies that benefit from the depreciation – namely, the exporters,” says Crescenzo. “We’ve always had a bias toward corporate credits, where often the relative values to US comparables are pretty interesting.”

While the potential impact of a US Federal Reserve move to raise rates would challenge all EM debt, it would have added resonance for Mexican bonds, says Marcin Adamczyk, senior portfolio manager for emerging market debt, local currency and local bonds, at NN Investment Partners in the Netherlands. Mexico’s business cycle and monetary policy are closely geared to its northern neighbour. In July the Mexican central bank, known for its hands-off policy towards the peso, reduced the daily volatility level at which it would intervene to support the peso’s value. This was a signal that Mexican policymakers are not comfortable with the currency’s weakness, after losing about 10% of its value in 2015 and almost 20% in the past 12 months, according to  Adamczyk.

The Mexican central bank, Banxico, has established strong credibility with financial market participants, Adamczyk believes, and the peso firmed in the wake of Banxico’s policy move to support the currency. But ultimately the prospects for emerging market debt hinge on economic growth, and with the International Monetary Fund projecting that EM growth will be less than two percentage points better than developed market growth in the year ahead, there is no sign yet of a relative economic improvement that would support emerging debt markets overall. 

While emerging market debt investors may take shelter in hard-currency assets as the Fed starts its tightening cycle, Mexico’s peso and bond market will continue to act as bellwhethers for investor sentiment. “The Mexican peso is probably the most liquid currency in the EM universe, so its relative attractiveness as a hedge from both trading and carry costs perspectives is important,” says Adamczyk. 

“Mexico’s broad local fixed-income market has been a favourite among international investors due to supportive fundamental picture, credible institutional framework and the positive reform story,” he adds. “With rising headwinds facing emerging markets, the demand for hedging long bond positions has only increased.”

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