All Aboard the Peso-Coaster

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1 JAN All Aboard the Peso-Coaster Richard Lawrence» Few currencies have garnered more press over the past 18 months than the Mexican peso. The peso has experienced a rollercoaster ride courtesy of the always interesting tweet flow from Washington D.C. along with some challenging domestic developments. As one may recall, the peso drifted lower in 2016, falling roughly in line with now-president Trump s rising popularity in the opinion polls. A post-election collapse followed, with the peso bottoming at almost 22 a year ago. A spectacular rally then ensued before another late-year swoon as NAFTA negotiations hit some road blocks and domestic politics came to the forefront (see Chart 1). So what are the prospects for the peso in 2018? As investors in Mexico, we weigh some specific questions. What concerns are priced in already and what risks are not being adequately discounted? First, let us recap the primary stress points pressuring the country and the currency: NAFTA The biggest headlines for Mexico seem to be around the topic of NAFTA, yet the actual economic impact of an end to the trade agreement may be limited. About half of current U.S.-Mexico trade does not use NAFTA preferential tariffs. A good portion of NAFTA exports would revert to World Trade Organization (WTO) rules, meaning average tariffs of 3.5%

2 on Mexican exports to and 7.1% on Mexican imports from the U.S. Furthermore, any unwinding of the significant supply chain integration between Mexico and the U.S. could have dire consequences for U.S. manufacturing employment. Politics Mexico will have a presidential election in July. The incumbent PRI party selected José Meade as its candidate as he was believed to be a clean politician. However, a recent corruption scandal has embroiled several party members, including Meade. This development has further boosted the election prospects for Andrés Manuel López Obrador (AMLO), the firebrand, populist, left-wing candidate. His anti-trump rhetoric combined with his commitment to more social spending and higher gasoline subsidies have boosted his popularity in the polls. During Brazil s political crisis in 2016, we used to joke that Brazil needed to decide whether it wanted to be more like Mexico or Argentina. How the tables have turned. We now wonder whether Mexico threatens to revert to old-style Latin American populist politics. AMLO s candidacy certainly represents a threat to the fiscal discipline Mexico has experienced under Enrique Peña Nieto s presidency. However, we believe his ability to roll back reforms, particularly in the energy sector, may be limited by his lack of support in Congress. Inflation and the Economy In response to rising inflation pressure from a weaker currency and the removal of some administered price controls, the Bank of Mexico (Banxico) hiked rates 150bps in 2017 which followed 275bps of hikes in the prior 13 months. The rate increases impacted real incomes and private consumption, helping to slow growth to the sub 2% level. So What s the Good News? We believe that most of this news is priced in. The currency remains cheap on many measures, which keeps Mexico competitive on the global stage (see Chart 2). Mexican inflation is also forecast to abate in 2018 (see Chart 3).

3 Based on inflation forecasts, Mexico should enjoy some of the highest real yields available (see Chart 4). We believe that Banxico is done with its rate-hiking cycle and should be able to start reducing rates in the second half of These expected favorable dynamics should help improve growth prospects later this year. Growth via exports should

4 also be supported by a better U.S. economy in 2018, although subject to the NAFTA risks discussed earlier. As demonstrated by the chart below, better prospects for the U.S. economy tend to be a positive for Mexican exports (see Chart 5). Conclusion In summary, we expect 2018 to be another year of volatility for the Mexican peso. However, with most of the negative factors already priced into a cheap currency and attractive yields on local currency bonds, we believe that there is still a role for Mexican assets in our portfolios. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

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