Argentina at the Crossroads

Argentina appears to be at a crossroads. After years of economic mismanagement, the people could finally vote for a change of government but the economic adjustment will be painful. If polls are wrong and the ruling party remains in power, then Argentina will likely face an even tougher road ahead.

POLITICAL OUTLOOK

Recent polls ahead of the Argentine presidential elections on Sunday are moving more in the direction of a change in government. A poll by Elypsis showed the ruling party candidate Scioli trailing by 7.7 percentage points behind opposition candidate Macri, at 39% to 47%, respectively. About 11%of respondents were still undecided. Third candidate Massa has tacitly shown his support for Macri, but some of his votes will likely flow to Scioli since both are Peronists.

Obviously, Macri is the market-friendly candidate, and Argentine bonds and equities have been rallying of late. However, we caution that polls were wrong in the first round vote on October 25, which tipped Scioli to win. And it’s not just Argentina; election polls in the UK and Turkey were dead wrong this year, for instance. Still, even if Scioli were to win, the deteriorating situation may force him to move towards orthodoxy but more pain would likely be involved before his hand is forced.

Whoever leads it, the next government will inherit a messy situation. However, a more market-friendly government could regain quicker access to global capital markets by addressing the holdouts from the 2001 default. Despite the 2012 ruling by US Federal Judge Griesa, Argentina has yet to resolve the matter. Until it does, Argentina will remain locked out of global capital markets at a time when its funding needs are growing. Social tensions are likely to rise as the economic situation worsens.

 

ECONOMIC OUTLOOK

Years of economic mismanagement coupled with low commodity prices have left the economy in a shambles. The IMF expects GDP to grow 0.4% this year, unchanged from last year. Furthermore, the IMF expects -0.7% contraction in 2016. We think there are downside risks to growth, as the next government will have to undertake significant fiscal and monetary tightening.

Despite the weak economy, inflation remains too high. The official CPI reading is 14.3% y/y in October, but unofficial opposition estimates put inflation nearly double that at 26% y/y in September. The IMF has criticized Argentina for its data standards, but the nation has not really responded. The central bank is merely an arm of the government under Kirchner and Fernandez.

High inflation and a slow pace of peso nominal depreciation have led to significant real appreciation (REER) of the peso since mid-2014. Due in part to the strong REER, the external balances have worsened. Low prices for its major exports (soy, wheat, and corn) aren’t helping matters either. After running current account surpluses from 2002 to 2009, Argentina moved back into deficit after 2010. The 2015 gap is expected near -2% of GDP, with risk of further widening next year.

Foreign reserves fell steadily through much of 2014 before stabilizing in 2015, but then plunged over -$6 bln in October. There are growing shortages of dollars, with the official rate of 9.6650 well off the so-called “Blue Chip” parallel rate of 14.78. Indeed, the wedge between the two rates is the biggest on record, nearly a 55% discount. The black market rate is even worse, at around 15.10 currently.

The fiscal accounts are a growing problem. Spending was ramped up ahead of the elections, and the deficit is expected at -6% of GDP this year. Revenues have sagged due to the sluggish economy and low commodity prices. With the international bond market closed off, the government will have to either 1) ramp up domestic debt issuance, 2) run the printing presses, or 3) both. We think it will be 3) both, with clear negative ramifications for bond holders. Note that nominal M3 rose 36% y/y in both September and October.

 

INVESTMENT OUTLOOK

The peso is one of the worst performers in EM, with the official rate -12.4%% YTD against the dollar. Using the unofficial “Blue Chip” rate, the peso is down over -26% YTD and traded at record lows near 15 this week. With the official rate around 9.6650, the Blue Chip is trading at nearly a 55% discount. The only EM currency doing worse than the Blue Chip is BRL (-28% YTD). Compared to the official rate, worse performers also include COP (-22% YTD), MYR (-18% YTD), TRY (-17.5% YTD), ZAR (-17% YTD), and CLP (-15% YTD). We think it’s likely that the next government will have to speed up the pace of nominal depreciation, as the current situation simply cannot be maintained with foreign reserves reaching critical levels.

Argentine equities are outperforming within EM. MSCI Argentina is up 15% YTD, and compares to -12% YTD for MSCI EM. With the growth outlook expected to worsen, we expect Argentine stocks to start underperforming once the election euphoria wears off. The prices of Argentina’s major exports (oil, corn, and soy) all remain soft and near multi-year lows.

Argentine bonds remain a huge gamble, but we think the holdout issue will eventually be resolved by the next government. In 2012, US District Judge Griesa blocked Argentina from making payments to restructured debt until the nation resolved the holdouts from the 2001 default. Since a negotiated settlement has yet to be seen, Argentina moved into technical default on the restructured bonds. A Macri victory would improve the chances of a quick negotiated settlement, while Scioli would likely take longer to come to the table.