Investors are falling in love with Mexico while Brazil loses its ‘darling’ status

After a period of broad gains in most Latin American currencies on the back of remarkable economic growth and fiscal discipline in the past couple of years, the region’s foreign exchange market is showing signs of divergence.

While the Mexican peso has been getting stronger in the past year, the Brazilian Real and the Argentine Peso have stayed weak. In Chile, where the currency appreciated 12% since January, investors are increasingly worried about possible central bank intervention.

The divergence is more visible through analysts and investors’ outlook for two of the most heavily traded currencies in the region, the Mexican Peso and the Brazilian Real.

With foreign investors chasing higher yielding assets throughout the globe, bets in Mexico’s local debt markets have increased as the pace of purchases of Brazilian assets has slowed.

The shift in investor preference is also being compounded as expectations for economic growth in Mexico surpass that of Brazil in 2013. Moreover, Mexico’s central bank has traditionally avoided interference in the foreign exchange markets, unlike its Brazilian counterpart.

“It seems everybody loves to love Mexico these days, while Brazil has lost some of its ‘darling’ status to foreign investors” says Marjorie Hernandez, a foreign exchange strategist at HSBC.

“But focusing on fundamentals, what we have in Brazil now is a case of slower growth, lower rates, higher taxes and a very active central bank. Meanwhile, the economic background is stronger in Mexico and the central bank is being more market friendly.”

That combination, alongside Mexico’s ties with the US economy – which has performed relatively better throughout 2012 than other developed nations – has contributed to an increase of foreign investment into Mexican bonds.

According to data from Banxico, the country’s central bank, and compiled by HSBC, since the beginning of 2010 foreign holders of domestic Mexican bonds have nearly tripled to stand at 65 billion dollars in August.

Some of the demand, HSBC explains, came from Mexico being included in Citigroup’s World Government Bond Index in 2010, which alerted a larger pool of investors to the country’s positive dynamics.

But Ms. Hernandez warns that the bulk of the move in favour of the Mexican peso versus the Brazilian real may have already been completed and at this stage, a straight sell-Brazil and buy-Mexico strategy would offer limited returns.

“It may be a bit too late for investors to try and catch that move as it is mostly behind us,” she says.

Indeed, the Mexican Peso has appreciated almost 9% this year. In contrast, the Brazilian Real has declined more than 20% since hitting a cyclical high in late July 2011, in part as a result of a series of benchmark rate cuts by the central bank to stimulate growth.

In addition to the cuts, Brazil’s central bank has introduced several taxes on international financial transactions in recent years seeking to slow speculative inflows and damp rapid currency gains. Moves included a levy on foreign exchange derivatives to discourage long bets on the Real.

One group hit by the tighter capital control measures was Japanese investors, who have traditionally supported the Brazilian Real via so-called Toshin funds. As a result, Brazil-related investments now account for 60% of Japanese holdings in emerging markets, down from 68% at the end of 2009, data from JPMorgan Chase & Co. show.

Another challenge for the Brazilian real is the country’s stronger ties with China. While China’s voracious appetite for commodities and other goods in the past decade helped fuel an economic boom in Brazil, now that the world’s second-largest economy is growing at a slower pace, pressure on the Real is mounting.

The Chilean Peso also faces a similar threat, given almost a third of its total exports are destined for the Asian nation, compared with a 22% share in Brazil. In addition, the two currencies display a high correlation with copper prices, one of the most widely used indicators of future economic prospects in China, which render the currencies vulnerable to the metal’s price fluctuations.

“Brazil is more linked to the China story,” says Jose Wynne, head of North America foreign-exchange strategy at Barclays. “When you examine the performance of the Brazilian and Mexican stock markets in dollar terms, you notice the correlation between the moves in Brazil and markets like Shanghai and Taiwan, are stronger.”

Mr. Wynne says that investors should not completely disregard the Brazilian Real as the country’s economic fundamentals remain solid and Mexico’s ties with the US also make it vulnerable to potential headwinds in the world’s largest economy. The looming “fiscal cliff” in the US at the start of 2013, for example, may hurt the US economy and weigh on the Mexican Peso story.

“There’s no doubt Brazil is going through a soft patch and it’s growing below potential,” he says. “But while we are a bit more optimistic that the Mexican Peso will appreciate in the near term, it is not a complete risk-free proposition”.