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If the Mexican peso fails, the loonie could be next Add to ...

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For emerging markets assets, the rout is on. The only question now is how far the damage will spread.

For investors, the Mexican peso represents a line in the sand. A failing peso puts the loonie and the Australian dollar firmly in global investors’ crosshairs.

The currency-related carnage has so far been focused on countries with similar characteristics, namely slow growth, inflation and large current account deficits.

EM Currency in USD: Value of $100 Invested

SOURCE: Scott Barlow/Bloomberg

A rising U.S. dollar has diverted investors from emerging markets debt to U.S. Treasury bonds. The problem became so acute for the developing world that Brazilian central bank governor Alexandre Tombini compared U.S. bond markets to a “vacuum cleaner” sucking money out of his country.

Because deficit countries must raise funds, they have been forced to jack interest rates higher in an attempt to attract buyers to their bonds. At this point, any country requiring foreign investment is going to have to pay bond buyers rates approaching double digits, whether it suits their rate of economic growth or not.

The Mexican peso is an important bellweather. Mexico does run a current account deficit, but at 1.8 per cent of its GDP, it’s less than a third of Turkey’s. Mexico’s proximity to the United States is also a positive factor. Exports to the United States – notably from an auto sector that is expected to export more cars to the U.S. than Japan in 2014 – provide a steady stream of U.S. dollars that supports the peso.

For these reasons and others, emerging markets bond fund managers have been moving assets into Mexican debt issues. The peso is, if not the last hombre standing, among the most stable in the asset class.

Recent data out of Mexico City, however, hasn’t been all that terrific. Industrial production for November was reported 1.4 per cent lower year over year, more than a full percentage point below consensus estimates.

Gross domestic product growth in Mexico has also seen a sharp slide, from over four per cent per year in 2012 to 1.3 per cent according to most recent data.

The danger is that Mexico’s economy, and its current account deficit, could deteriorate just when global asset managers are moving assets there to hide out from the volatility in India, Brazil, Turkey and the other beleaguered currencies. With China’s growth increasingly uncertain, there would be few options left for emerging markets investors.

If the currency and bond market selling extends beyond emerging markets, this will become a problem for Canada and Australia. The domestic current account deficit is running at a disturbing 3.2-per-cent-of-GDP pace and Australia’s is slightly worse at 3.3 per cent. The loonie and the Australian dollar, already weak because of depressed commodity prices, would bear the brunt of a potential developed market bond meltdown.

There is cause for concern, but it’s more likely that the peso will hold up. The signs of U.S. economic growth should prevent a major slide for the Mexican economy.

But investors should pay close attention to the peso in the days ahead. The longer it stays stable, the closer a market recovery will be.

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