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April 09, 2019 02:00 AM

Expect 'moderate' economic cycle for Mexico in 2019

Bill Wood
Economics Editor
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    Michael A. Marcotte
    Visitors on the first day of Plastimagen 2019.

    The outlook for Mexico's economy is typically dependent on two dominant factors: the Mexican political cycle and the U.S. economic cycle. That was certainly true in 2018 and it will continue to prevail in 2019.

    These two factors created significant headwinds for the Mexican economy over the past two to three quarters, but much of the struggle is now behind us. It is likely that the political environment in Mexico and the activity levels in the U.S. economy going forward will start to generate tailwinds for the Mexican economy that could provide benefits for years to come.

    During the transition phase of the six-year Mexican political cycle, the economy tends to underperform. The exact reasons for this may vary, but typically there are delays in the execution of large parts of the federal budget as the new administration cancels or changes the projects initiated under the previous administration, and then begins to implement its own plans. This causes uncertainty for both investors and consumers, and such uncertainty restricts economic activity.

    The general election was last July. It was one of the largest in Mexico's history and it followed one of the country's most violent campaign seasons. The subsequent deterioration in investor sentiment and confidence was due to the cancellation of infrastructure projects (most notably a new airport in Mexico City), a cut in the salaries of public workers and a reduction in the federal bureaucracy.

    Along with the federal employees that lost their jobs, there was a large number of private companies that rely on federal contracts, which were also negatively affected. All these cuts were part of a much-needed austerity program intended to reduce rampant federal spending — and the accompanying high levels of inflation — and strengthen the country's balance sheet going forward. But they cause some pain in the near-term.

    The austerity is relatively new, and Mexico is still struggling with a rate of inflation that is persistently higher than the target level. They are attempting to resolve this problem with a policy interest rate that has reached the restrictive level of 8.25 percent. High rates of inflation restrict investment in the long run but using higher interest rates to combat inflation deters investment in the near-term. A combination of time and deft policy decisions is the only solution, but here again, there is pain in the beginning.

    If administered properly, the prescribed political and economic reforms should benefit Mexico's economy in the future. But they impeded economic growth in the second half of last year, and their effects will continue to be felt in the first half of 2019.

    The accompanying chart is a graph of the monthly index of Mexico's total industrial production. As the chart illustrates, the trend in industrial output was rising steadily prior to 2016, but production levels then hit a plateau, and they have been mostly stable for the past three years.

    For the past three months, the trend in the data was moderately downward. The forecast calls for the moderate decline in this data to continue until the middle of 2019, and then the data is expected to exhibit a moderate increase into 2020. The annual total for industrial output in 2019 is forecast to rise 1-2 percent.

    In the second half of this year, the data will improve because the federal budget expenditures will begin to normalize. As soon as consumers and investors become more comfortable with the trend in the government spending, they will gradually increase their levels of activity. This increase will not be large, but it will keep the overall Mexican economy expanding at a pace of 1.3 percent this year.

    Investor and consumer sentiment will also get a lift during the rest of 2019 by the recent change in U.S. monetary policy. The Federal Reserve Board recently announced that it will not raise interest rates for the remainder of 2019. Rising U.S. interest rates tend to lower the value of the peso and increase the volatility in Mexican financial markets. These factors tend to push inflation rates higher and create a level of uncertainty that restricts private investment new jobs, plants, and equipment.

    The good news is that both the general election and the fear of imminent interest rate hikes in the U.S. are now in the past. Further good news will come from a reversion to a more normal rate of economic growth in the United States.

    At the end of 2018, there was burgeoning uncertainty in the U.S. stemming from rising interest rates, deteriorating trade relations with China and a government shutdown. These all had a negative impact on the economy at the end of 2018, and they resulted in economic growth in the first quarter of 2019 that was well below the long-term average. But that is in the past. The pace of growth in the U.S. economy will now accelerate, and total U.S. GDP is forecast to expand by 2.3 percent in 2019. This will provide a significant and much-needed boost in U.S. demand for Mexican imports.

    Taking a longer-term perspective, the future economic growth rates for both Mexico and the United States will be restricted by a chronic trend of underinvestment. Despite the low levels for interest rates during the past 10 years, the pace of business spending has been sluggish. Export levels for both countries are expected to rise in the coming years, and this should encourage more business investment. But a large advance in industrial output will require substantially larger gains in capital expenditures.

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