Undervalued peso poised to benefit from US recovery

GIVEN the poor state of Mexico&rsquo;s economy, you might think that its currency, the peso, would be suffering. Hit hard by global recession and falling oil prices, the real economy is expected to shrink by 5.5 per cent in 2009 while the country&rsquo;s industrial production is contracting month-on-month. And even the country&rsquo;s growing tourist industry was dealt a harsh blow by the swine flu pandemic.<br /><br />But strategists and currency traders are starting to turn more positive on the peso, as indicated by the latest data from the Commodity Futures Trading Commission (CFTC). In the week ending 4 August, a net 35,931 contracts were long on the peso, compared to 30,207 the previous week. Since May the peso has been range trading between Mex$12.9 and 13.7 but more recently, the pair has been threatening to break out of the bottom of the range as the peso strengthens against the dollar.<br /><br />But with the Mexican economy so mired in recession and fiscal risks remaining relevant, what is supporting the peso so much that analysts are starting to call more upside to the currency?<br /><br />Firstly, it is believed that much of the negative economic outlook has been priced in to the currency &ndash; more so than other emerging market currencies says Barclays Capital &ndash; so any better-than-expected economic data or signs of positive sentiment will fuel the peso higher. And forward-looking indicators of consumer and business confidence are showing the first signs of recovery.<br /><br />Although consumer confidence continued to decline in June, the pace of deterioration is slowing and the consumer confidence index was four points higher in June compared to the previous month. Confidence in the Mexican manufacturing sector is historically weak but is showing initial signs of improvement with many surveys pointing to a more upbeat outlook for future economic and corporate conditions.<br /><br />This means that the Mexican peso has not strengthened in line with other Latin American and cyclical currencies. Since the start of 2009, the peso has only risen 5.42 per cent against the dollar compared to the 20 per cent surge in the Brazilian real over the same period. So the peso has some catching up to do.<br /><br />However, whether the peso manages to break out of its current range depends on two factors. Primarily, the state of global economic recovery will prove crucially important for the currency. Its major trading partner is the US given the geographic proximity, which is enhanced by the North American Free Trade Agreement (NAFTA) bloc. As shown by the top right chart, the US is a net importer of Mexican goods and services &ndash; about 11.4 per cent of America&rsquo;s total imports.<br /><br />&ldquo;A general goodwill feeling will have an impact on Mexico and if there is a continued recovery and momentum building with nothing in the way, then the peso could continue to strengthen,&rdquo; says George Tchetvertakov, head of market research at Alpari UK, adding that anything that boosts the US economy will boost Mexico because of multiplier effects.<br /><br />Secondly, the fears of a debt downgrade have plagued the Mexican outlook for much of 2009, but these are overdone, said Barclays Capital analysts in a recent research note, who also remain relatively constructive on the country&rsquo;s 2010 budget.<br /><br />Fears were also alleviated last week when ratings agency Moody&rsquo;s unexpectedly issued a stable outlook for Mexico&rsquo;s debt, citing &ldquo;resilience&rdquo; in the face of a deep recession, political gridlock and falling oil production. This relieved investors and pushed the peso to 11-month highs against the dollar.<br /><br />Barclays Capital says: &ldquo;In our view, the risk of a downgrade has diminished with Moody&rsquo;s decision to reaffirm Mexico&rsquo;s Baa1 rating &ndash; three notches into investment grade &ndash; and stable outlook. Given this, a downgrade would reflect the view of a particular agency, rather than a widely shared negative perception of the credit. If a downgrade indeed materialises, we do not expect any agency to cut Mexico&rsquo;s rating more than one notch.&rdquo;<br /><br />Moody&rsquo;s rivals Standard &amp; Poor&rsquo;s and Fitch currently have Mexico&rsquo;s debt on negative outlook.<br /><br />However, according to the Economist Intelligence Unit (EIU), the country&rsquo;s public finances continue to &ldquo;hinge exceedingly on volatile oil revenue, scant alternative revenue sources and a high level of inefficiency on the expenditure side&rdquo;. The EIU warns that after an oil hedge agreement expires at the end of 2009, there will be significant concerns about the medium-term fiscal outlook.<br /><br />For foreign exchange traders looking to capitalise on the expected catch-up of the peso, these domestic factors are extremely important to watch. Because the currency is an exotic it is more difficult to find specific research and news about the peso, which can be problematic when placing trades. However, they do exist and for those looking to add a bit of risk and excitement to their currency portfolio, forex traders could look to sell the peso against the dollar targeting the Mex$12.20-12.10 level in the coming months.