In a post-pandemic world in which supply chains are being overhauled and inventory security is paramount, rising geopolitical tensions are driving companies to explore nearshoring. This involves outsourcing the production of goods, services, and materials to firms that are closer to end markets.

Helped by its proximity to the US and the United States-Mexico-Canada Agreement (USMCA), Mexico is set to be the biggest beneficiary of US companies' nearshoring efforts. Its rich natural resources, labor market advantages and lower manufacturing costs have proved enticing for many US companies. Nonetheless, some skeptical investors question whether we're seeing genuine nearshoring rather than a cyclical trend related to the strength of the US economy – which could fade if recession bites in the US.

Mexico's next big investment cycle

Mexico has enjoyed stronger economic links with the US since it signed the North American Free Trade Agreement (NAFTA) in 1992. Indeed, as shown in Chart 1, the US accounted for over 56% of all foreign direct investment (FDI) into Mexico. Notably, data in June of this year showed Mexico at the top of the list of US imports by country of origin.1

Chart 1. FDI in Mexico by country in 2022

Source: Statista 2023

In particular, Northern Mexico has benefited from its proximity to the US. The region already enjoys strong economic links with US border states, and these ties will only strengthen if the US ramp up nearshoring. Investments data of companies planning to shift their supply chains to Mexico suggest this is already happening.

Chart 2. Announced investments ($m)

Source: JP Morgan, June 2023

Growth for all

A clear beneficiary of higher FDI in Mexico is the industrial property sector. Companies in this space are reporting strong demand for industrial space from prospective tenants looking to expand their operations. The property market is currently tight as a result, particularly in the northern states. This is pushing up rents and creating new growth opportunities for developers.

On a recent investment trip, we spoke to many banking representatives. They believe Mexico has already benefited from the nearshoring trend and attribute it to the expansion of NAFTA and its renewal under the USMCA framework. One bank in the north explained that it's indirectly exposed to the supply chain via small- and medium-sized enterprises (SMEs). Many are profiting from the growing manufacturing base in the region, while other larger banks are looking to expand their presence there.

Chart 3. Industrial real estate vacancy rates

Source: JP Morgan, June 2023

More broadly, Mexican companies in all sectors are optimistic about the opportunities from nearshoring. Many think additional investment and more dynamic growth will lead to higher employment, increased disposable incomes and, consequently, higher consumption. Consumer companies make up a large proportion of the Mexican stock market. And, while the consumer sector is not an obvious beneficiary of higher foreign direct investment (FDI), these companies are currently seeing a relatively resilient consumer environment. A stronger economy should boost consumption further.

The political landscape

Regulatory shake-ups and political noise are key risks for companies based in Mexico or those looking to nearshore their supply chains. In a recent case involving a Spanish renewable energy firm, the Mexican government acquired 13 power plants on behalf of the state-owned electric utility Federal Electricity Commission. At first, the news framed the government as attempting to expropriate private assets, generating significant controversy among the business community. Ultimately, though, Iberdrola received a generous $6 billion valuation package, with the company's board unanimously agreeing to the deal.

Regional politics can be volatile. The current administration's implementation of policies has raised the perception of political risk, especially in more regulated sectors. Despite this, Mexican institutions have held up well, preventing unorthodox reforms from derailing critical sectors. An example is Congress's decision to dilute the Mining Law which would have impeded the sector's development. The Supreme Court has also expressed its views on the unconstitutionality of some proposed bills, which is another example of the proper functioning of checks and balances.

A growing market

The Mexican stock market still has ample room to grow. At present, however, Mexican companies often choose to fund business activity via the debt market, which has left the stock market underdeveloped. The lack of a strong development bank and a still-nascent financial market ecosystem, including the role of pension funds in equity investing, have also contributed to this. But the situation is gradually improving. The government is attempting to modernize the Stock Exchange Act to encourage more companies to join capital markets. At the same time, it's taking steps to increase compulsory contributions to pension funds. This should drive increases in pension funds' assets under management, resulting in greater allocation to domestic equities.

Final thoughts

Only time will tell whether the increased investment in Mexico is here to stay or merely a side-effect of a strong US economy. Either way, companies on the ground are benefiting from the optimism and dynamism of the Mexican economy. Next year, political risks and uncertainties could arise from the US and Mexican elections. Whoever wins in Mexico will have to work hard to capitalize on the opportunity that nearshoring presents.

Article adapted from a recent episode of our Emerging Markets Equities Podcast, “New path along the Cordillera: Mexico and nearshoring", hosted by Nick Robinson.