The slide took investors by surprise, although many stuck to bets that the central bank will keep interest rates on hold as it watches for the withdrawal of U.S. economic stimulus measures and forecasts a pickup in growth in the second half of 2013.
The economy shrank by 0.74 percent in the second quarter compared with the first quarter, the national statistics agency said on Tuesday, well below forecasts in a Reuters poll for a 0.21 percent expansion.
The government on Tuesday cut its 2013 growth forecast to 1.8 percent from a prior outlook for 3.1 percent growth in Latin America's No.2 economy.
Lower government spending after a change in administration has slowed the roll-out of major infrastructure projects, in turn hitting companies such as Cemex (>> Cemex SAB de CV), one of the world's biggest cement makers.
Separate economic activity data also published on Tuesday showed construction plunged 6.8 percent in June from a year earlier, again the biggest drop since 2009, when the country was in the midst of a deep recession.
President Enrique Pena Nieto took office in December, and government spending typically falls in the first few months after a change of administration.
"That's a horrible number," said Alberto Bernal, head of research at Bulltick Capital Markets. "It clearly shows that the risk is that growth for the full year is going to be close to 2 percent."
The weak figures prompted Barclays to revise down its 2013 growth estimate for Mexico to a feeble 1.4 percent, from 2.5 percent previously.
Pena Nieto is betting on a wide-ranging package of economic reforms to boost growth, but those measures are still in the pipeline and it will be months, at best, before they translate into gains.
Mexico has lagged the growth rates of emerging market peers like Brazil over the past decade and suffered from its deep ties with the U.S. economy, which has been slow to regain its footing after the 2007-2009 financial crisis.
LITTLE ROOM FOR MANEUVER
While poor growth data would normally give a central bank reason to cut interest rates, Mexican policymakers' room for manoeuvre is limited by expectations the U.S. Federal Reserve will soon start to pull back its economic stimulus program.
The Banco de Mexico, which has also cut its growth outlook for 2013 to between 2 and 3 percent, is confident growth will pick up in the second half. Some analysts agree.
"We suspect that Q2 will mark the low point for the economy and that growth will accelerate from here," London-based Capital Economics said in a client note.
Second-quarter growth compared with a year earlier was 1.5 percent, well short of expectations for 2.32 percent growth in a Reuters poll.
The central bank cut interest rates to a historic low of 4 percent in March, but most expect it will not take advantage of cooling inflation to cut rates further this year.
Fears of a tapering of the Fed's bond-buying program, which has supported appetite for risky assets, hit Mexico's peso hard in June but the currency has since steadied. The peso pared gains just after the data, but then recovered.
The disappointing quarter-on-quarter figure was pulled down by a 1.1 percent contraction in industrial output, which showed its biggest dip since the first three months of 2009.
Services also shrank by the most in four years, confirming negative sentiment among some retail companies.
Aurelio Adan, the chief financial officer at Mexico's no. 2 retailer Soriana (>> Organizacion Soriana S.A.B. de C.V.), said last month that slower growth, a dip in the money Mexicans abroad send home and a slowdown in consumer confidence weighed on second-quarter sales.
"All of these factors combined translate into a negative environment for consumption in our stores and in general in the economy," he said, although he added that he was still optimistic for the rest of 2013 due to an expected increase in federal government investment.
Economic growth in the United States, Mexico's closest trading partner, unexpectedly accelerated in the last quarter, but the cheery data could bring the Federal Reserve a step closer to cutting back its stimulus.
The figures were calculated with a new methodology that uses 2008 as a base year. On that basis, Mexico's annual growth in the first quarter was assessed at 0.6 percent, from the original 0.8 percent.
The statistics agency said economic growth in 2012 was 3.8 percent, down from the previously announced 3.9 percent, based on that methodology. It also revised down first-quarter growth on a quarterly basis.
(With reporting by Jean Luis Arce; editing by Krista Hughes, Kieran Murray, John Wallace and Leslie Gevirtz)
By Alexandra Alper and Simon Gardner