Sat | Aug 19, 2017

Walter Molano | Mexico: Prepare for volatility

Published:Friday | July 14, 2017 | 7:00 AM
President of Mexico, Enrique Pena Nieto.

The Mexican peso, the MXN, has been one of the best performing currencies of the year. After cresting over 22 at the beginning of 2017, the peso has been on a tear.

Investors piled into the trade when it became evident that United States President Donald Trump would never deliver on any of his punitive promises against Mexico. It was clear that the North American Free Trade Agreement (NAFTA) was designed by the US for the benefit of the US.

Anyone who studied North American history would understand that the United States has never been magnanimous towards its southern neighbour, and would never agree to a trade agreement that would allow Mexico to gain the upper hand.

The US auto industry was the true author of the trade agreement in an attempt to circumvent new environmental and labour regulations that were enacted during the early 1980s. These measures were driving up production costs, while having to simultaneously deal with the competitive encroachment from German and Japanese automakers.

Although Mexico enjoys a sizeable trade surplus with the US, most of the trade benefits accrue to US-owned companies. It is too bad that Banco de Mexico (Banxico) does not provide detail on the corporate dividend payments that are sent from the country. They would probably show that the capital flows to the US are of similar magnitude to the trade deficit.

Likewise, investors realised that Trump's border wall and limitations on remittances would never happen. The construction of the wall raises insurmountable complications. In addition to the high cost, there is the question as to where to put it. It will never be constructed on Mexican territory.

Yet, much of the border is delineated by the Rio Grande. It can't be built in the middle of the river. This means that if the wall is erected on the US side, it would effectively cede control of the river to Mexico. Realising that all of these factors are non-starters, it is no surprised that the MXN rallied.

Still, a new set of risks are coming on the horizon that suggests that the MXN rally may be over. The first risk is macroeconomic. Inflation has been soaring. Consumer prices rose at the fastest pace in more than eight years, reaching 6.16 per cent year-on-year in May. This was more than twice Banxico's annual inflation target of three per cent.

Some commentators and politicians pointed to the sharp rise in gasolene prices, the so-called 'gasolinazo', which occurred at the start of the year. However, a closer look at the breakdown of the May data showed that core inflation, which excludes energy, fresh fruit and vegetables, was up 4.78 per cent year-on-year. This means that the increase in consumer prices may have been heavily influenced by pass-through inflation.

Sadly, pass-through inflation was a phenomenon that had been under control in Mexico for almost two decades. However, it has been some time since the country has suffered such high currency volatility.

Given the sharp rise in consumer prices, the currency will need to adjust to maintain purchasing parity prices, or PPP.

Banxico is very committed to getting inflation back under control, but Governor Agustin Carsten's term is up at the end of the year and we are not sure whether his successor will be as diligent. Moreover, Finance Minister Jose Antonio Mead has been opining that rates should be moving down before the year, adding to the sense of uncertainty in the markets.

The second risk is the upcoming presidential elections. The State of Mexico - EdoMex - along with a handful of other states, held elections last month, but the results were misinterpreted by the market. The incumbent PRI won, but by a very small margin. More important, the data suggests that there may have been fraud.

On the eve of the elections, Morena, the leftwing party led by former Mexico City Mayor Lopez Obrador, was leading in the polls. During the elections, a series of irregularities were reported and the PRI squeaked by in the end.

A defeat for the PRI would have been devastating. The State of Mexico has the biggest population in Mexico, and it has been a PRI bulwark since the Revolution. A defeat would have triggered a chain of events that would have probably thrown the country into the hands of the opposition.

In the aftermath of the election, Morena will double down its efforts and make alliances to avoid a repeat of EdoMex. Furthermore, it will work harder to secure victories in states where the PRI does not have such a strong legacy. These two factors will manifest themselves in the MXN, and we will see it retrace its steps.

The post-Trump volatility phase may have come to an end. Now, we will have to deal with a new phase of volatility that will be tied to higher rates of inflation and the election cycle.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com