Recovery in Mexican peso likely to remain weak in the near term

The Mexican peso has not only weakened markedly through the important USD/MXN 19.00 level last week but is now closer to the uncharted 20.00 level. We see further MXN softening as the 'Trump factor' will remain a key driver in the run-up to the US presidential election on November 8 and beyond if the real estate mogul is elected, which would be a significant long-term negative.

This risk has already claimed a high-profile victim when new finance minister Jose Antonio Meade replaced Luis Videgaray two weeks ago when the latter resigned. Mr Videgaray certainly built up considerable market credibility, not least as the architect of the structural reform push in spite of being criticized for pushing through a tax hike in 2013, and was close to President Pena Nieto but resigned in the political and electoral fallout in the aftermath of Donald Trump's recent visit to Mexico. Then there is the MXN's sensitivity to low oil prices.

Further, in line with recent warnings and outlook downgrades by rating agencies (S&P recently downgraded the outlook on the sovereign BBB+ rating to negative and said that there was a 1-in-3 probability of a rating downgrade in the next two years), several Banxico board members highlighted concerns about the rising debt-to-GDP ratio, as well as its impact on capital flows and the financial situation at Pemex.

Mexico's 2017 budget presented to congress recently has an overall public sector deficit target of 2.9 percent of GDP (the deficit was 4.1 percent of GDP last year) with total revenues rising by 0.4 percent in real terms (to MXN 4.3 trillion, with inflation assumed at 3.0 percent) with an expected 16 percent drop in oil receipts offset by a 10 percent rise in non-oil revenues (the GDP growth assumption is 2.0-3.0 percent).

Meanwhile, the draft budget contains a number of tax simplification measures, particularly for SMEs, but no tax hikes or new taxes. Nonetheless, the budget is not as tight as might appear at first; the government is aiming to cut spending by MXN 239.7 billion next year (1.2 percent of GDP), with Pemex again facing the brunt of the cuts, but MXN 169.4 billion of this has already been announced this year although total budget spending is targeted to decrease by 1.7 percent in real terms from this year.