FXStreet (Delhi) – Research Team at BBH, suggests that the Mexican peso has underperformed within EM this year and lower oil prices and generally negative EM sentiment are likely to keep pressure on the peso in 2016. Key Quotes “Political outlook President Pena Nieto enters the second half of this 6-year term facing lame duck status. He has come under fire for a possible corruption scandal involving his wife, as well as security concerns after the tragic deaths of the university students and the prison escape by El Chapo. After some early success in opening up the oil sector and undertaking some limited structural reforms, Pena Nieto has not been able to get much traction. There will be local elections next year in 12 states, with all but one governorship up for grabs. The next presidential election will be held in 2018. Early polls suggest Andres Manuel Lopez Obrador (AMLO) of the leftist Morena party is a potential frontrunner. There is no obvious candidate yet for Pena Nieto’s PRI. PAN may nominate former First Lady Zavala, while Governor Valle could be a serious challenge as an independent candidate. The leftist PRD was split when AMLO started Morena, and PRD may not be competitive in 2018 as a result. Economic outlook Mexico finds itself in the familiar position of coming under strong selling pressure when EM sentiment worsens. Lower oil prices are a problem for the economy, but manufactured exports to US have taken up some of the slack. GDP is expected to grow 2.3% this year and 2.8% next year. Domestic consumption remains robust, but has yet to feed into rising price pressures. Indeed, price pressures are still falling, with CPI inflation of only 2.2% y/y in November. This is an all-time low. Core inflation is also falling. This does not make a compelling case for aggressive tightening by Banco de Mexico. Bloomberg consensus is for 75 bp of tightening over the course of 2016, with another 25 bp seen in Q1 2017. There was a split in the market over whether Mexico would follow the Fed with a 25 bp hike of its own. We think that the weak peso ultimately pushed the central bank into starting the tightening cycle with a hike. While there has not yet been any inflationary pass-through from a weak peso, the bank decided to be cautious and tried to anchor inflation expectations. The central bank had been on hold since March, when it cut the policy rate by 50 bp to 6.0%. Fiscal policy is a concern given still-falling oil prices. While PEMEX is quite active in hedging oil price risk, falling oil prices will still add to the budget deficit. It is expected at -3.5% of GDP this year and -3% in 2016. The external accounts are in decent shape. Lower oil prices have hurt exports, but the non-oil sector has picked up some of the slack. Foreign reserves have fallen to $172 bln in November, the lowest since August 2013, which was one reason that the FX Commission tweaked its intervention program last month. The current account deficit is seen at around -2.5% of GDP in both 2015 and 2016, which is largely covered by FDI. Investment outlook The peso made a new all-time low against the dollar last week. Lower oil prices are a factor, but more important may be generalized EM sentiment since the peso typically suffers in bad times due to its role as a proxy for wider EM. The peso is freely tradable (and shortable), and so investors that are negative on Brazil or Russia can more easily express their views via the peso. MXN is in the underperforming camp, -14% YTD vs. USD. We believe the peso will make new all-time lows past 17.50 in the coming weeks. Mexican equities have outperformed slightly within Emerging Markets. MSCI Mexico is -14.8% YTD, and compares to -17.4% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Mexico at an UNDERWEIGHT position. Tighter monetary policy and sluggish growth could be the triggers. Mexican bonds have done all right this year. The yield on 10-year local currency government bonds is up about 31 bp YTD. This is in the middle of the pack. Compare this to the worst performers Brazil (+401 bp), Turkey (+245 bp), Peru (+179 bp), and Colombia (+170 bp). Inflation is likely to remain low, and with the tightening cycle likely to be very modest, we think Mexican bonds can still outperform a bit.” For more information, read our latest forex news.