EM bellwether puzzles investors

In the first week of August, Mexico’s local currency debt was returning –4.53% in US dollar terms – the only country in the JP Morgan GBI-EM index without positive returns. The wider index, by contrast, was returning close to 15%.

Investors and analysts said part of this underperformance could be explained by currency weakness: the Mexican peso has tumbled to record lows against the US dollar this year. Yet the reasons for the peso’s decline are harder to pin down.

“Usually, Mexico trades as a bellwether for emerging market risk appetite, and what’s been surprising this year is that despite having other high-yielding currencies such as the [South African] rand staging a sizeable recovery, Mexico has lagged other key fundamentals, such as when oil has performed,” said Roxana Hulea, an emerging market strategist at Societe Generale. “Mexico is still a puzzle because it doesn’t really correlate with anything right now other than with whatever is the worst performing asset of the day.”

Positioning is one factor that has been weighing on the peso, which is often used by investors as a hedge against broader emerging market risk because of its liquidity. The recovery in Brazil, for instance, has prompted investors to reverse their previous short positions on the Real, and in many cases they have hedged their Brazilian exposure by shorting the peso instead, Hulea said. Brazilian local currency bonds were returning just shy of 50% in dollar terms in early August.

Technical factors have also been weighing on Mexico’s bonds. Around half of the country’s domestic government bonds are in foreign hands, with many investors heading into the year with an overweight position on Mexico. That has left the country on the sidelines as investors piled into previously unfavoured parts of Latin America and other emerging market bonds.

“When the dynamics change dramatically to a more positive outlook for the local currency market, the places you’re going to buy are the likes of South Africa and Brazil and Russia – anywhere that you may have been underweight to the index,” said James Barrineau, co-head of emerging markets debt at Schroders in New York.

“When everything rallies Mexico lags, and when everything sells off Mexico leads because it’s the most widely traded local currency and non-dedicated emerging market investors who want to protect whatever risk assets they have in their portfolio look for the quickest, cheapest, most liquid thing to short – the Mexican peso.”

Performance lacking

Mexico’s economic outlook has not helped performance either. Growth has been relatively sluggish, with the economy expanding by 2.5% in 2015 – well below the lofty 5% growth target President Enrique Pena Nieto outlined as part of his economic reform plan in 2012. Moody’s cut Mexico’s credit outlook to negative earlier this year on the back of weaker growth expectations, forecasting that gross domestic product growth will remain flat in 2016 and 2017. Meantime, Mexican GDP contracted 0.3% in the second quarter, the first quarterly fall in output in three years.

“The worse-than-expected second-quarter GDP maybe offered a clue as to why the peso has been weak,” said Kieran Curtis, investment director for emerging markets at Standard Life Investments. “That is bucking the broad trend in emerging markets, where the second-quarter data has tended to show a recovery from weaker data around the first quarter and the fourth quarter of last year.”

Low oil prices have been a persistent drag on Mexico’s economy at a time when the government is trying to lure foreign investment into the energy sector for the first time in around three-quarters of a century. Efforts to auction oil field exploration and production contracts has met with mixed demand, forcing Mexico to sweeten the terms for potential investors.

In addition, lower revenues at state-owned oil giant Petroleos Mexicanos, or Pemex, means lower tax receipts; Pemex contributes around 20% of the government’s budget. That has prompted spending plans to be trimmed, weighing on growth. And while oil makes up only a small part of Mexico’s overall trade picture, some investors have been less discriminating when wider market sentiment has soured.

“When oil prices are falling, Mexico gets lumped into the oil producers, but then when oil prices rally, Mexico has gotten lumped into non-oil producers – for an investor that is exposed to Mexico, it’s just added to the frustration,” said Jack McIntyre, a fund manager at Brandywine Global.

Of far greater importance than the black stuff is Mexico’s trade relations with the US, and that is entering an uncertain phase ahead of the US presidential election in November. Republican party candidate Donald Trump has repeatedly made clear his disdain for current relations, promising to build a border wall and threatening to slap a 35% tariff on Mexican goods. A Trump victory could potentially destabilise Mexico’s economy.

“The relationship is absolutely vital for Mexico,” said Dan Raghoonundon, an emerging market equities analyst at Janus Capital in London. “Remittances from Mexicans working in the US sending money back home to Mexico is worth about US$26bn a year. Some 80% of Mexican exports go to the US. And, since 2010, the US is responsible for 40% of all foreign direct investment in Mexico. Suffice to say these numbers are pretty outstanding, and if we have any change in that relationship, Mexico will suffer greatly.”

So far, the Trump factor has left a varied impression on asset prices. Amit Agrawal, an emerging market strategist at Societe Generale, said Trump’s rhetoric on Mexico and initial polling data have been hurting the peso.

But other asset classes are holding up. Raghoonundon pointed out that Mexican equities are near record highs, while Gorky Urquieta, a fund manager at Neuberger Berman in Atlanta, said US election uncertainty has not made a huge dent on Mexico’s foreign currency-denominated bonds. That has ensured demand for Mexican-flavoured non-peso debt has remained robust. Mexican companies including Pemex have issued roughly US$15.3bn of foreign currency bonds this year, about half a billion more than at the same stage last year, according to Dealogic.

“A lot of the demand is coming from the general appetite for credit in fixed income markets at the moment,” said Curtis. “We really like Cemex, which is going through a big deleveraging programme, and they have been buying back debt this year, so spread performance there has been quite spectacular.”

Appetite for Mexico’s local currency debt among investors outside of the country has not weakened substantially either despite the toll the falling peso has wrought on dollar returns (returns in peso terms, by contrast, were 4.4% by the first week in August – still the lowest in the Latin America region). Many investors expect foreign demand to remain sturdy given that Mexico has shrugged off previous bouts of turmoil, such as the ‘taper tantrum’ in 2013, when emerging market bonds sold off heavily after the US Federal Reserve said it would slow the pace of its economic stimulus programme.

Sticky money

“Foreign ownership [of Mexican domestic debt] was stable during that period, so that suggests this is very sticky money,” said Stuart Ritson, a fund manager at Aviva Investors. “Concerns about a large unwind of foreign holders is slightly overblown.”

Even so, a brace of unexpected interest rate hikes by Mexico’s central bank in the first half of the year, as it took action to bolster the peso, has added an extra layer of uncertainty. That defensive stance is a pivot away from the path many investors had expected the bank to pursue by raising rates in step with the Fed. Yet, given the proportion of Mexico’s domestic debt that is owned offshore, the central bank is unlikely to hike excessively in case it rattles investors.

“The bank has probably had one eye on what the rate hikes have done to the shape of the yield curve, just to make sure they’re not taking away the punch bowl too quickly from foreign investors, many of whom have been reliant on the steep yield curve to hedge their peso exposure and still pick up a sensible yield,” said Curtis.

Mexico’s relatively low inflation rate – 2.1% in 2015, down from 4.1% in 2014, according to Moody’s – is another reason some investors are comfortable sticking with their positions.

“The Mexican bond market has exceptionally high yields when adjusted for inflation compared to the rest of the emerging market universe,” said Ritson. “In this sort of world, ultimately the demand for yield will support this market.”

Investors including Urquieta and McIntyre also pointed out the peso is undervalued by a number of key measures, such as the real effective exchange rate and from a terms-of-trade perspective. That hints at potential for a turnaround once the uncertainty of the US election is out of the way.

“There are a lot of issues still plaguing Mexico, but there is a point where technicals and valuations stand out, and that can make Mexico the next big emerging market story,” said Hulea. “It’s a currency that people love to hate this year but it can become the next big thing next year, just as Brazil is this year versus last year and the rouble before that.”