Policy will be the key to success

Mexico has a track record of prudent macroeconomic and fiscal policies that underpin a certain degree of macroeconomic stability. Despite a surge in Covid-19 infection rates, global supply-chain disruptions and uncertainties stemming from the war in Ukraine, Mexico's economy grew by +3.0% in 2022. The recovery was primarily driven by the vitality of the manufacturing sector and modest improvements in the services sector, with positive changes in domestic spending, especially in investments. In H1 2023, Mexico's economic activity continued to expand, supported by the growth of both services and industrial production, whicb in turn was supported by strong US growth, nearshoring, a tight labor market and rising wages. Nonetheless, activity should lose steam gradually throughout the following quarters, mainly as a result of a weaker US economy as well as lagged effects of tightening monetary policy. We expect economic growth to reach +3.1% in 2023 then decelerate to +1.6% in 2024.

In the medium term, depending on the national policy to be adopted by the next government – elections will take place in June 2024 – the country's growth rates could increase. Mexico stands to benefit greatly from nearshoring policies – in 2023, it will become the top trading partner of the US, overtaking China, and the IDB estimates that the additional gains from exports could reach USD30 bn. However, the current protectionist/state policy towards the energy and mining sectors appears to be a limiting factor as the state is unlikely to be able to cover the high levels of investment required (particularly in lithium extraction).

We expect inflation to substantially come down from a historical perspective. The easing of the shocks resulting from the pandemic and geopolitical tensions (e.g. Russia-Ukraine war), along with the monetary policy stance, have contributed to inflation’s downward trend. However, the trajectory will not be linear: We still note some pressures on the services component in an environment where economic activity is more resilient than previously anticipated. Exchange rates continue to exert downward pressure on inflation as the Mexican peso has appreciated significantly over the year, making it one of the best-performing currencies against the US dollar.

We expect the Bank of Mexico (Banxico) to keep its benchmark interest rate steady at 11.25%. Retaining its hawkish bias, and aiming to achieve an orderly and sustained convergence of headline inflation to the 3% target, Banxico has announced it will maintain the reference rate at its current level for an extended period. Provided that disinflation continues, we expect Banxico to ease the policy rate steadily from Q1 2024, taking it to 7.75% by end-2027.

The Heritage Foundation’s “Index of Economic Freedom 2022” survey assigns Mexico rank 67 out of 177 countries, above the regional and world averages, reflecting strong scores with regard to the tax burden, government spending, tax freedom and investment freedom. However, Mexico scores less favorably regarding property rights, judicial effectiveness and government integrity due to weak rule of law, a bias toward state-owned enterprises and policies that harm the private sector. These factors will continue to weigh on the business climate.

Political risk is moderate. Morena will remain the dominant political force leading up to the next presidential and legislative elections scheduled for June 2024. An opposition alliance that includes the centrist Movimiento Ciudadano (MC, a small but growing minority party) may have a better chance of unseating Morena, but differences in policies and negotiations over power-sharing quotas will pose challenges in forming such a coalition. In the latest poll conducted in October, Morena's representative, Sheinbaum, received 46% support, while her rival garnered 28%. Given this context, we believe that Morena is in a strong position in  the lead up to the 2024 presidential race. Any opposition candidate will face a formidable task in uniting ideologically diverse parties, mobilizing disaffected voters and countering Morena's advantage as the incumbent party.