Dateline: Far from the windows of Mexico’s Stock Exchange
Whenever I plan a trip to Mexico, or shortly after the start of such a trip, the Mexican peso likes nothing better than to “yank my chain” by staging a rally. In fact, I’ve started to wonder whether I shouldn’t become a currency trader so as to take advantage of this effect. Even when the peso is in a downtrend, the effect seems to hold, and I’m always slightly annoyed that I’m paying more for pesos than I’d have paid a couple of weeks earlier.
But this trip has been entirely different. Now the peso is in full collapse. From Christmas until the Monday before my departure, the peso dropped a swift 9%. For those of you not so familiar with financial markets, this would be a big three-week move for a large-cap stock, a decent sized-move for a mid-cap stock, and within the range of normal for a commodity perhaps. But for a currency? Even for an emerging-market currency, this is nothing short of collapse.
Of course, for those of you not living under a rock, it’s pretty clear that the world’s financial markets are now officially in a state of turmoil. As I write, the S&P 500 is 10.7% off of its December 1st high, and many other markets (US small-cap, Chinese equities, European equities, Japanese equities, emerging market equities, oil, and other things) have sold off even more. While the causes of this are detailed and complex and well beyond this blog post, I’m hoping to provide some color on the peso specifically and to provide something of a framework for how to think about it.
First off, consider that the biggest driver of financial market moves is changes in risk tolerance or risk seeking. Which is another way of saying that when investors of all stripes (equity, bond, commodities, etc.) feel optimistic, they are willing to pay more for the same assets. And when they get pessimistic or scared, they are willing to pay less. And if they get fearful enough, they sell at ridiculous prices. And if they get confident enough, they will buy at ridiculous prices. In commodity markets this applies a bit less as there is actual underlying production and consumption of “stuff” that must be produced, moved, and ultimately consumed. But for the purely financial, not constrained by any underlying reality, moves can remain unmoored from underlying fundamental prospects for long periods.
Where this affects the value of the peso is in a combination of risk tolerance, views on the Mexican economy, and its related financial flows. As an emerging-market, Mexico is viewed (rightly or wrongly) as a relatively risky place to put money. So when investors broadly are risk seeking, they’ll tend to be more willing to invest in Mexico, thus driving the peso higher. And when they get nervous, whether for “good” or “stupid” reasons, they get out of Mexican investments, and then the peso tends to fall. Against this extremely broad (and highly simplified) framework come Mexico-specific concerns like the price of oil, the stability of the government, central bank policies, the trade balance, and other country-specific factors.
From the perspective of risk tolerance and the Mexican peso (MXN), things aren’t going well for Mexico. The continuing collapse in petroleum prices is the most obvious factor. Not only is petroleum a meaningful export earner, but Mexico’s Federal government gets roughly a third of its budget from Pemex. Unlike most large producers, Pemex annually hedges its production, typically in the August/September timeframe. What this means is that Pemex, via financial instruments, effectively fixes the price at which it will sell its output for the next year. So for a year, earnings are unaffected by changes in the oil price. This prevents unpleasant mid-year budget surprises for everyone involved. In 2015, reading the writing on the wall, Pemex hedged its output early, some time in the June/July timeframe. However, if we look at futures contracts for oil, July 2016 oil is only trading at $32.46/bbl, about 10% higher than spot. This means the market believes that Pemex is almost certain to take a big revenue hit in the coming year. And that means either a tighter federal budget or more borrowing, neither good for risk perceptions. So, oil’s persistent decline is bad for the peso and there’s no relief in sight. Barring a Mideast war, oil isn’t likely to rally much even after bottoming. But that’s a whole other argument. If you care about the peso, watch the oil price. For now, it ain’t good.
The second factor relates to Mexico’s auto industry, and manufacturing in general. In recent years, auto manufacturing has been a big success story for Mexico. American manufacturers have expanded production here, and many European and Japanese manufacturers have announced new plants. Both BMW and Mercedes will start manufacturing here in the next year or two as well. And current US auto demand has certainly been good, with 2015 coming in as a record year. But how much better can things get? US manufacturing is already in recession, and it’s early days. You also have to consider that VW, one of Mexico’s larger manufacturing concerns, is facing enormous problems. Mexico’s manufactures also include a heavy dose of electronics, a category which also appears to have peaked for now. So count manufacturing as a second area of concern. No, it’s not in trouble now. In fact, the peso’s weakness is very good for it. But financial markets are forward-looking, and to many, the current state of affairs in manufacturing looks close to a peak.
Third, Mexico runs a persistent trade deficit. Unlike the USA, which does the same, Mexico’s financing options are not nearly as nice, and the government and private companies have a mix of MXN and USD financing. In contrast, the US government and companies can all finance in USD at attractive rates. Obviously USD debt service cost has suddenly gotten a whole lot more expensive for non-US entities, and financial markets are increasingly worried about all USD debt owed by emerging market countries. Rightly or wrongly, Mexico gets “lumped in” with a lot of much dodgier economies such as Brazil (a complete disaster), South Africa (in deep pain), and Turkey (hurting on many fronts). Yes, Mexico has a large, currently-untapped line of credit with the IMF to tide it through any rough spots. But any drawdown on that line will be regarded as highly negative. So let’s hope Mexico doesn’t need to use it.
Fourth, rightly or wrongly (and I refer to the Fed’s recent action), American interest rates are rising. When US rates rise, the USD tends to rally. And in all fairness to the peso, the USD has been in a monster rally against all currencies since August of 2014 when it became clear that the US Federal Reserve was definitely ending its “free-money” policies, while the rest of the world was doubling down on such policies. There’s more to USD strength than this, but it’s too complex for this post. Also, while the USD appears to have stabilized against first world currencies (EUR, JPY, GBP, CHF), emerging market currencies remain in a world of hurt. And given the lack of financial blow-ups to date (which typically mark bottoms), it seems likely that this hurt will continue.
Fifth, and most importantly, is the risk tolerance question we opened with. If you look at the long-term history of the USD/MXN exchange rate, MXN always (always!) gets hit when US investors become nervous and/or when US rates rise or are expected to rise. So the peso, which pre-2008 financial crisis had been trading in a band of 9.5-10.5/USD crashed to more than 15 at the depths of that crisis before recovering over the next 2 years to a point near 11.7/USD, which was far from a full recovery. Then in the summer of 2011, when the US budget debate became contentious and the USA’s debt rating was downgraded, the peso dropped 22% in four months, hitting a low of approximately 14.3/USD. From there it staged a brief rally into early 2012 before re-collapsing during the 2012 global slowdown/Greek crisis. Then from the summer of 2012 into May 2013, the peso staged a rally from 14.6 to close to 12/USD. In May 2013, Ben Bernanke, then Fed Chairman, said in testimony to Congress that the Fed would start to taper Quantitative Easing (QE), which then set the stage for higher US rates. After that, during the so-called “taper tantrum,” the peso dropped from 12 to about 13 and change.
The current bout of peso weakness started, more or less, in the fall of 2014. At that point, crude oil had been in decline for 4-5 months and the US equity rally slowed. High-yield bonds (AKA junk bonds) also began to decline, and to careful observers, the tide of risk-taking began to recede.
So where are we today? Global markets in virtually anything tradeable are in full rout. Equities, commodities, bonds, currencies, you name it, is in full rout. In the short term, I expect this to end within a week or two as this kind of selling is not sustainable without a bounce. And from there, I expect a short term rally, which should then likely boost the peso a bit. However, (and again this is a HIGHLY complex topic) I fully expect global markets to remain in a bearish trend, possibly for the next couple of years. There are many things wrong in the world, financially speaking, and the solutions aren’t easy. China, in particular, is likely facing a financial crisis. In my mind the only questions are when (likely already happening) and how long the government can continue to hide the fact. Pundits who say that China’s economy or financial problems don’t matter obviously don’t remember 1997’s mini-crisis set off by the Thai baht, an irrelevant currency if ever there was one. Make no mistake: China is now incredibly important to the global economy and to global financial markets. Europe is hanging on by its fingernails, and Japan remains stagnant to declining, after an initial burst of optimism about Abenomics, which now appears to be not working. The USA, definitely the strongest of the bunch, still faces problems due to overly high debt levels, questionable sustainability of the housing market, an already-obvious manufacturing recession (likely soon-to-be exacerbated by peak autos), and financial markets still priced for, if not perfection, much better than we’ll likely see. And the US economy appears to be slowing, itself hurt by the strong dollar as US multinationals struggle to turn overseas profits into enough dollars to satisfy investors.
For me, this is a mixed blessing, at least peso-wise. It’s almost incomprehensible how cheap things are here on this visit. I’m regularly eating meals in restaurants for less than or very close to $10USD. ATMs now offer the preset option of taking out 7,000 pesos at a time, but that’s still running less than $400 USD. Investment-wise, I’m fully prepared for whatever might come. But I cannot buy a Mexican house under such circumstances. Why would I plunk down several hundred thousand USD in a house only to see a good chunk of the value summarily vaporized by the foreign exchange markets? And who knows what this exchange rate will do to the Mexican economy and the peso value of real estate? Even if I believed that a Mexican house would be my last one, why not wait to get something nicer for the same money in USD?
I fully believe that the likelihood of some crisis in the next two years is fairly high. (As opposed to the so-far fairly orderly selloff in financial markets.) And if that belief is correct, then expect the peso to get to 20 or more to the dollar. Heck, at this point, 20 isn’t that far away, as it’s trading at 18.27 this very minute. Yet part of me can’t believe I’m still this bearish on the peso, as I’d only recently started to consider 17 an extremely favorable exchange rate. But this morning the peso is already down 1.5% and falling fast. And investors have got to be wondering how much longer the Bank of Mexico can afford to support this falling rock. (They step in whenever the peso moves down by more than 1%.) That perception by itself is likely to add fuel to the fire.
So, what would I do given the circumstances? First, if I lived in Mexico, I would not put off purchases of internationally-traded goods. So if I needed a car, I’d buy it soon. The peso price is probably going to go up a big chunk. Add to that list things like tires, home appliances, imported medicine, imported wines, olive oil, cheese, prosciutto, whatever. Barring a miraculous rally in the peso, peso prices of all that stuff have got to go up; it’s only a matter of time. Two, I’d maintain low peso balances, either cash, or bank deposits. While we could see a short-term rally in the next couple of weeks, my best guess is that this will be short lived. (By the way, don’t sweat the change in the value of the pesos you have; if you live here you’ll pretty much get full value for them in terms of living expenses, etc. Just don’t buy too many pesos at once.) Three, given my thinking (albeit for a *LONG* time) of retiring here, I wouldn’t buy property. I’d be patient. For me, this is the hardest part, but I feel I have no alternative. And finally, if I already lived here, with USD income, well, I’d just enjoy the ride! While I feel sorry for Mexico’s predicament, that’s no reason to not go out and enjoy the benefits. And any USD that we convert to MXN and spend here will only benefit Mexico. So enjoy it while it lasts. Saludos!
By the way, I’ll do my best to answer questions in the comment section. Please note the disclaimer below.
What’s my background to write such a post? I spent my twenty-something year career in equities investing and trading. No, I’ve never been a currency trader. However, I am a keen student of the financial markets, hold an MBA in finance, and am currently an independent trader. Though I’m confident in my outlook, I am also fully cognizant that this is the type of article that tends to come out just about the time that the market in question bottoms. And it’s acknowledged in the post above.
The above blog post should not be construed as specific financial advice as I cannot possibly know your personal financial situation or objectives. Though I have a high degree of conviction in my thesis, the timing is the hardest part to get right. By many metrics, the MXN is already substantially undervalued. Most importantly, I disavow any responsibility for consequences of your acting on any of the above. I will attempt to answer questions, but I cannot give specific financial advice. If you’d like to talk off-line, that could be arranged.