USDMXN way out of line with fundamentals

I am far from being an expert on Mexico, but I am aware of the basic story behind the weakness of the MXN in the last few years. General USD strength, concerns about protectionism under Trump and weakness in the oil price have all contributed, while related NAFTA negotiations and the election this year are helping to prevent a major recovery. But the extent of MXN weakness just looks way out of line with the available evidence. Of course, it is possible that trade arrangements with the US become more problematic, but the MXN is around 25% weaker than you would expect relative to “normal” valuation. That is, USD/MXN has typically traded around 70% above PPP in the last 20 years. With PPP currently around 8.90, this suggests the “normal” level would be around 15.15. The current price near 19 just seems to price in all but the very worst bad news, so that the risks from here lie overwhelmingly on the upside for the MXN.

The chart below illustrates just how far away from normal the MXN is. The only time in the last 30 years that we saw the MXN as weak as this was during the “Tequila crisis” of 1994/1995. This was a proper crisis. The current account started off with a deficit of nearly 6% of GDP and the liberalisation of markets led to a devaluation of the peso, a loss of confidence in the economy, a balance of payments crisis, a 6% decline in GDP in 1995 and ultimately a US led bailout. The current situation is comparatively benign. While the current account deficit has increased, it is not in worrying territory, and growth, though a little weaker than desirable, is reasonable. GDP per capita is around 30% higher relative to the US now than it was then. There are of course concerns surrounding the relationship with the US, but markets in general are no longer expecting Trump to carry through his more aggressive threats.

I’m not going to predict the outcomes of NAFTA negotiations, or the Mexican elections. As I say, I’m no expert on these issues. But valuations say that the MXN is substantially undervalued unless we get a replay of the Tequila Crisis, and even the pessimists aren’t forecasting that.

 

usdmxn

Source: OECD

Mexico current account

Source: World Bank, OECD

 

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