LatAm Outlook: Growth Continues
- Brazil and Mexico have both registered growth above expectations during the first half of the year. We expect both economies to decelerate in the upcoming quarters but statistical carry-over will warrant a 3.1% growth for Mexico and a 3.0% for Brazil. Both countries will register lower growth in 2024 mostly due to higher basis of comparison in 2023. Argentina will see a contraction of -2.3% this year followed by a 0% growth in 2024.
- Inflation has fallen significantly in Mexico and Brazil compared to one year ago. In both countries CPI stands at 4.6% (YoY). We expect inflation to show some stickiness in the following months due to wage inflation in Mexico and due to some statistical effects of fuel prices tax cuts in Brazil. We see year end CPI at 4.7% in Brazil and 5.6% in Mexico. In 2024, both countries will see inflation continuing to falling to 3.6% for Brazil and 3.8% for Mexico. Argentina will not control the inflation problem registering a 118% increase in 2023 and 97% in 2024.
- In terms of interest rates, Brazil’s policy rate is projected to finish 2023 at 11.75% following four 50bps cuts while in Mexico we are expecting Banxico to keep interest rates unchanged at 11.25%. In Brazil and Mexico, we expect both central banks to reduce the degree of monetary tightening in 2024 as inflation is controlled but neither country will achieve neutral policy rate levels during that year.
- Forecast changes: From our September outlook we have increased the growth forecast both for Brazil and Mexico reflecting the higher than expected growth seen during the first half and changed the 2024 forecast due to base effects. We have also marginally reduced the inflation forecast both for 2023 and 2024. In Argentina, we have reduced marginally the recession in 2023 to -1.5% and see a 0% growth in 2024.
Our Forecasts
Risks to Our Views
Source: Continuum Economics
Brazil: Brighter than Expected
The Brazilian economy has surpassed expectations in the first half of this year. In the initial quarter, robust growth was predominantly driven by an exceptional surge in the agricultural sector, as soybean producers increased their production by over 30%, propelling a 1.7% quarter-on-quarter (QoQ) growth (Figure 1). Moving into the second quarter, where we observed a 0.9% QoQ growth, the extractive industry and the services sector took the lead in driving growth. Remarkably, these movements have largely offset the effects of the tightening of monetary policy, as they are primarily exogenous to the monetary realm.
However, it's important to note that sustaining this level of growth in the coming quarters is unlikely. The tight monetary policy is expected to have a dampening effect on consumption and investments. Furthermore, the surges in the extractive industry and agriculture are expected to stabilize in the upcoming quarters. Nevertheless, the robust growth experienced in the first half of the year is anticipated to drive the Brazilian economy to a 3.0% growth rate. Over the last three years, the Brazilian economy has outperformed its pre-pandemic levels. Whether this represents a structural shift or is merely a post-pandemic rebound remains to be seen. Our assessment suggests that Brazil will eventually revert to its pre-pandemic growth trajectory. Structural changes in investments have been limited, and the end of the demographic bonus is expected to impede growth. Our growth forecast for 2024 now stands at 1.4%.
Figure 1: Brazil’s GDP by Sectors (2019 = 100, Seasonally Adjusted)
Source: IBGE
Turning our attention to inflation, it is evident that significant progress has been made in this area. Inflation has declined from a peak of 12.1% year-on-year (YoY) to its current level of 4.6% YoY. Notably, food inflation is exhibiting a clear downward trend, driven by increased production and reduced production costs, which are putting downward pressure on domestic food prices. Services are also following suit, albeit at a slower pace. However, it's worth mentioning that the YoY index saw a slight uptick in recent months, largely in response to the fuel tax cuts implemented in the latter half of last year. As the influence of these tax cuts wanes, we anticipate a minor YoY Consumer Price Index (CPI) uptick. We expect the CPI index to exhibit some stability in the final months of the year, ultimately closing the year at an average of 4.6% YoY.
Figure 2: Brazil CPI Inflation (YoY, %)
Source: IBGE
Despite signs of strength in the labor market, there is still evidence of slack (here), as a portion of the decline in the unemployment rate can be attributed to individuals leaving the labor market due to demographic factors. Additionally, wage inflation is not outpacing overall inflation. We anticipate that inflation will resume its downward trajectory at the outset of 2024, reflecting the impacts of the tight monetary policy. However, due to inertia, we expect it to remain above the Central Bank of Brazil's (BCB) target of 3%, closing 2024 at an average of 3.6% YoY but still within the BCB's bands.
The BCB has already commenced its interest rate reduction cycle in response to the substantial drop in inflation. Their communications have stressed caution, and the pace of rate cuts has been set at 50 basis points per meeting, at least during this initial phase. Reducing the rate from the peak of 13.75% implies a lengthy path to reach neutral levels, indicating that monetary policy will remain contractionary for an extended period. With four 50bps cuts projected for 2023, the policy rate is projected to conclude the year at 11.75%.
Predicting the interest rate path for the following year is more challenging and contingent upon inflation trends. If inflation rise in the first half of the year, the BCB may choose to temporarily halt the rate-cutting cycle while still maintaining a contractionary stance. However, if inflation continues its decline, as we anticipate, the BCB is likely to persist with 50bps cuts in the first half of 2024 and subsequently reduce the pace to 25bps at some point in the second half. This would bring our forecast to 9.25%, which we believe is still above the neutral level, estimated to be around 7.5%.
There have been concerns regarding Brazil's fiscal situation. The goal of eliminating the primary deficit by 2024 appears increasingly challenging (here). Government expenditures have outpaced revenues significantly, and generating additional revenues in 2024 is expected to be a formidable task. However, we believe this will not render the Debt/GDP ratio unsustainable, as lower interest rates and nominal GDP growth are likely to offset the primary deficit. Consequently, Brazil is not anticipated to face any immediate fiscal problems.
On the political front, Lula's government has enjoyed some success. Opposition forces have not been well-organized and have lost momentum, especially in light of the incidents involving public building invasions (here) that have turned public opinion against them. Furthermore, former President Jair Bolsonaro is already ineligible (here), and significant legal cases may result in his imprisonment during Lula's tenure.
Mexico: On the Nearshoring Road
The Mexican economy has outperformed expectations in recent quarters. Despite a significant tightening of monetary policy, Mexico has achieved a growth rate of 1.1% in Q1 and 0.9% in Q2, exceeding most forecasts. The bulk of this growth has been driven by the services and industrial sectors. We attribute the growth in the services sector to a delayed recovery from the pandemic, given the limited support for small businesses in Mexico, which has prolonged the return to pre-pandemic levels, and is likely to continue to have some effects on growth this year. Conversely, the industrial sector appears to be responding to more structural factors, including robust demand from the United States, with Mexico surpassing China as its primary trading partner.
However, the question remains: is nearshoring truly taking root? Our perspective is that, in terms of U.S. companies establishing new plants on Mexican soil, the evidence suggests otherwise (here). Foreign Direct Investment (FDI) figures do not indicate the expected uptick in this scenario. Although TESLA has announced plans to build a new plant in Mexico, no other major companies have made similar announcements. Instead, it appears that existing plants in Mexico are expanding their production and exporting to the U.S. As the United States seeks to reduce reliance on China and Asian markets, Mexican products are being considered as substitutes. Nevertheless, the development of more sophisticated products and the establishment of new value chains is still an open question.
Figure 3: Mexico GDP (Seasonally Adjusted, Q4-2019 = 100)
Source: INEGI and Continuum Economics
We anticipate a slight deceleration in growth in the coming quarters, with the year expected to end with a 3.1% growth rate. Looking ahead to 2024, the role of nearshoring will remain pivotal. The Mexican government is investing in infrastructure across the country with the goal of attracting new industrial plants. While this will boost demand and guarantee some growth in the next year, the establishment of fresh plants will depend on the development of new value chains. We anticipate that 2024 may not witness as robust growth, with a projected rate of around 2.0%, partly influenced by the lingering effects of a tight monetary policy.
Shifting to inflation, it is undeniable that the Bank of Mexico (Banxico) has been successful in curbing it. Headline inflation has decreased from 8.7% (YoY) in August 2022 to 4.6% one year later. However, this reduction has been primarily driven by non-core components of the Consumer Price Index (CPI), while core CPI exhibits more resilience, currently standing at 6.1%. Furthermore, Mexico's strong labor market has led to wage inflation exceeding headline CPI (here). We anticipate that CPI will demonstrate some persistence in the final months of the year, particularly with Core CPI likely to remain at the 6% (YoY) level. Consequently, our forecast for Mexico's CPI averages around 5.6% (YoY).
Figure 4: Mexico CPI (YoY, %)
Source: INEGI
For 2024, we expect CPI to remain somewhat sticky in the early months, primarily due to wage inflation, before beginning to decline more significantly in the second half of the year. The stabilization of food inflation is contingent on avoiding further inflationary shocks, such as spikes in oil and commodity prices. We project that inflation will approach Banxico's target of 3.0% and close 2024 with an average of 3.8% (YoY).
Regarding interest rates, Mexico has reached the end of its tightening cycle, with rates at 11.25%. While the recent drop in inflation has led some analysts to anticipate rate cuts in 2023, Banxico's communications suggest otherwise. Banxico has emphasized its intention to maintain interest rates at this level for an extended period, with no discussions of cuts. Additionally, concerns surrounding wage inflation are expected to deter any premature cuts by Banxico. We anticipate that the first rate cut will only commence at the end of the first quarter of 2024, likely a 50 basis points reduction, and this pace will continue throughout the year. This would result in an interest rate of 9.0% at the end of 2024, significantly above the neutral rate.
One of the major events for Mexico in 2024 is the general elections. Incumbent President Lopez-Obrador will not be eligible for re-election due to Mexican constitutional restrictions. The opposition party PAN and PRI have already announced they will have a unified candidate. Lopez-Obrador party, MORENA, will also appoint one candidate. The favorites at the moment to represent those two forces are: Claudia Sheimbaum for MORENA; and Xochitl Galvez for the Unified front of PAN and PRI. This means Mexico will have its first female President. At the moment, Lopez-Obrador popularity puts Claudia Sheimbaum as the favorite to win the Presidential chair and no major changes of policy.
Argentina: Breathless Elections
The Argentine economy is currently navigating through challenging waters. Prolonged droughts in rural areas have significantly hampered the country's grain production, thereby diminishing its primary source of exports. Consequently, the Central Bank of Argentina has seen a sharp reduction in its ability to accumulate foreign reserves, resulting in historically low FX reserve levels. The IMF, recognizing the severity of the situation, has exhibited some flexibility by reducing the quantitative reserve accumulation target and accelerating disbursements, even though neither target was met.
Meanwhile, Argentina's economic woes have deepened, with a 2.8% quarter-on-quarter contraction during the second quarter of the year. We anticipate that import restrictions, coupled with soaring inflation eroding real wages, will drive the nation into a recession this year. Our projection is a contraction of 2.3 % for Argentina in 2023. Inflation continues to surge unabated, with the government allowing the official peso to devalue by over 14% in a single day following the Primaries, only to freeze it until the general election in October. This has created expectations of a similar devaluation after the general elections, causing prices to react. Additionally, a portion of the fiscal deficit is being financed through monetary emissions, further exacerbating inflationary pressures. We anticipate inflation reaching a staggering 118% (YoY average) by the end of 2023, ranking among the highest in the world.
Meanwhile, the Central Bank of Argentina (BCAR) appears to be following IMF directives, maintaining the policy rate (BADLAR) at a slightly positive real level without being overly restrictive. We anticipate this stance to persist, with the year ending at 118%.
The outlook for 2024 hinges on the elections scheduled for October 22 2023, with a potential run-off on November 29. During the national primaries, the far-right candidate, Javier, garnered the most votes. He will contend against Minister of the Economy Sergio Massa, representing the left-wing ruling coalition, and the center-right Patricia Bulrich, representing the main opposition forces. We believe that all three candidates have similar chances of reaching the run-off, with the outcome dependent on the composition of votes. If Patricia Bulrich faces off against Javier Milei, some moderate votes from Massa may swing in Bulrich's favor. In other scenarios, Massa is likely to lose to either Milei or Bulrich.
Consequently, we anticipate that either Bulrich or Milei will lead Argentina in the coming year, with both candidates needing to present a stabilization plan to address the fiscal deficit and curb inflation. This is expected to lead to a gradual improvement in inflation, with a reduction to 97% in 2024, and a corresponding decrease in the policy rate to 70% (approximately 100% in effective terms, accumulated over 12 months). Nevertheless, we anticipate economic growth to remain stagnant at 0% in 2024, as the lingering effects of droughts, high inflation, and fiscal adjustments continue to weigh on growth. It's worth noting that many of the radical ideas proposed by Javier Milei, such as dollarization and closing the Central Bank, may not be feasible, and he is likely to moderate his stance if elected.