Argentine Assets to Underperform as October Elections Approach

The IMF just approved a $10.8 bln tranche of aid to Argentina Friday, yet the peso continues to weaken to record levels. The economic backdrop is worsening even as political risk rises ahead of October elections, and so we believe Argentine assets are likely to continue underperforming this year.

POLITICAL OUTLOOK

The IMF granted a 3-year $50 bln Stand-By Arrangement for Argentina back in June. $15 bln was made available immediately, with the remaining $35 bln to be disbursed quarterly over the life of the program (assuming program targets are met). The IMF just approved a $10.8 bln tranche last Friday. Due to the IMF’s perceived role in Argentina’s last major financial crisis, going to the IMF is likely to hurt Macri’s popularity.

President Mauricio Macri was elected in October 2015 on a reformist campaign. After years of economic mismanagement under Kirchner and Fernandez, voters were ready for a change. Macri won in the run-off 51-49% over Daniel Scioli after the two won 34% and 37% of the first-round vote, respectively. In the 2017 mid-term elections, Macri’s Cambiemos coalition picked up seats in both houses of congress. More importantly, Macri ally Esteban Bullrich defeated former President Cristina Fernandez in Buenos Aires province.

Former President Cristina Fernandez de Kirchner is Macri’s main challenger. Despite presiding over what we view as a failed economic experiment, she still has traction within the populist wing of the Peronists. Having back to back recessions isn’t helping Macri with the voters. either.

Former Economy Minister Roberto Lavagna could mount a challenge as a viable centrist. He last ran for the presidency back in 2007 after holding the post of Economy Minister from 2002-2005. He has been critical of the IMF program, saying it consists of “spending cuts, more cuts and more cuts.”  Lavagna also oversaw the forced debt restructuring that left investors with 25 cents on the dollar, and so he would not be very popular with the markets.

Polls suggest Macri still enjoys decent support despite the economic woes. Most surveys show him winning in a run-off against Fernandez. However, polls suggest Macri would lose to any Peronist except Fernandez. For instance, one pollster shows Macri losing to Lavagna in a run-off vote.

The first-round vote is scheduled for October 27. A run-off would be necessary if the frontrunner receives less than 45% of the vote or receives less than 40% and a margin of ten percentage points over the second-place finisher. We think a win by either Fernandez or Lavagna would not be taken well by the markets.

Press reports suggest the government will freeze prices on some food items for six months, or basically until after the elections. Apparently, up to 100 products could be on the list, and that 40 of them are in Argentina’s basic basket of goods. This is concerning, as price controls never end well. Yes, Macri has an election to worry about but such price controls harken back to the failed policies of the Kirchner/Fernandez era.

 

A BRIEF HISTORY LESSON

Juan Peron first emerged on the political scene in 1943. After the military coup that year, Peron became Vice President as well as the Minister of War and Labor Secretary. During his tenure, Peron united the workers’ movement and enacted several measures designed to help the working class. He believed that the state should take a leading role to ensure cooperation between industry and labor. This became the crux of Peronism.

Peron introduced measures to address severance pay and retirement benefits. While this made him popular with the workers, Peron faced strong opposition from the existing political parties and the business elite. Peron eventually lost the support of President Edelmiro Farrell and was forced to step down and was jailed in 1945. Strikes and protests in support of Peron led to his immediate release.

Peron was elected President in 1946.   Not surprisingly, he won 56% of the vote due to strong support from workers and labor unions. The period 1946-1955 was a turning point in Argentina’s economic development. A reliance on agricultural exports was replaced by an emphasis on developing light industry as part of an import-substitution strategy. Many foreign-owned industries were nationalized, including railways, phone, and power.

The newly expanded role of the state was embodied in a new constitution that was promulgated in 1949. It sought to put social justice and the general welfare of society as the goal of all political and economic activity. In other words, Peronism was enshrined in the Constitution.

Peron was reelected in 1951 with 62% of the vote. Women could vote for the first time, due largely to First Lady Eva Peron (Evita) and her focus on women’s rights. Tragically, Evita died of cancer in mid-1952, just a month after her husband took office again. Evita was highly popular, acting as the glue that helped hold Peronism together. Her death signaled the beginning of the end for that first era of Peronism.

The economic situation had also worsened. A drop in agricultural prices as well as drought conditions from 1949-1952 weighed on the economy. Industry began to desert Peron, and opposition within the military grew. After a failed coup attempt in June 1955, Peron was overthrown that September by the military and was exiled to Paraguay and later Spain.

During Peron’s absence, Peronism continued but it became increasingly fractious. Indeed, one could argue that Peronism had always been made up of many different factions that needed a strong unifying figure at the head. Peronism was outlawed, and the 1949 constitution was annulled. The party was banned from running a candidate in the 1958 elections, when limited democracy was restored.

Peronism returned in 1973 under the new name of the Justicialist Nationalist Movement (later the Justicialist Party or PJ), as the military allowed the first elections in ten years. Returning from exile, Peron won the presidency again with 62% of the vote. His second term was cut short by his untimely death in 1974. His widow and third wife Isabel took over as President, but she was then overthrown in 1976 following a chaotic period of intra-Peronist struggles.

Within the Peronist movement, these fissures grew and deepened after the death of Juan Peron. Those fissures can be traced to the current split within the modern Peronist movement. During President Menem’s tenure, several Peronists left the party to form breakaway movements, with each claiming to be the true heir of Juan Peron.

The 2003 election saw Peronist Carlos Menem losing to Peronist Nestor Kirchner. Kirchner and his wife (and successor) Cristina Fernandez both came from the leftist wing of Peronism, which went on to form the Front for Victory. Fernandez’ handpicked successor Daniel Scioli lost to Mauricio Macri in 2015, ending nearly 15 years of Peronist rule.

 

ECONOMIC OUTLOOK

The economy is in the second recession during Macri’s tenure. That’s quite an achievement. The IMF forecasts GDP to contract -1.2% vs. -2.5% in 2018, before growing 2.2% in 2020. GDP contracted -6.2% y/y in Q4, while monthly data in Q1 suggest the recession is still worsening. As such, we see downside risks to the growth forecasts.

Price pressures remain high and likely to rise further due to the weak peso. CPI rose 51.3% y/y in February, the high for this cycle and well above the old 12-17% target range, which has become irrelevant. WPI rose 64.5% y/y in February. While down from the cycle high of 76.6% y/y in October, it still points to potential acceleration in CPI inflation. March CPI data will be reported April 16.

Rate hikes have been effective in stabilizing the peso for only short periods of time, it seems. The new monetary policy framework put into place last fall worked for a bit longer, but the peso has suffered this year after the central bank pushed the LELIQ rate down too much, too fast. This most recent bout of peso weakness has forced the bank to reverse course, pushing the LELIQ rate back up to near 70%. The central bank has pledged to keep policy tight for the time being.

While one might be tempted to think 65-70% rates ought to be high enough to stabilize the peso, that is clearly not the case. The inflation-peso feedback loop remains in play and so we do not know when inflation will peak nor when the peso might stabilize. The situation remains very fluid, but we note that the higher rates go, and the longer rates stay high, the greater the economic costs.

The fiscal outlook bears watching. With the IMF program in place, fiscal tightening will be extended several years out. The primary balance (ex-interest payments) is forecast by the IMF to be zero in 2019 and 1.1% in 2020. The nominal deficit was equal to -5.2% of GDP in 2018, and the IMF expects it to narrow to -2.7% in 2019 and -1.5% in 2020. These forecasts seem way to optimistic, especially in light of the deep recession.

The external accounts should improve. Export growth has slowed but import demand has collapsed due to the recession. The current account deficit was -5.4% of GDP in 2018, and the IMF expects the deficit to narrow sharply to -2.0% of GDP in 2019 before widening modestly to -2.5% in 2020.

Foreign reserves have risen as FX intervention has been curtailed and IMF money enters the country. After peaking at $68 bln in February, reserves have edged lower to around $66.7 bln currently. This covers about 120% of the stock of short-term external debt or nearly 9 months of imports. Argentina’s Net International Investment Position is a surprising 13% of GDP.

 

INVESTMENT OUTLOOK

The peso continues to underperform. Last year, ARS fell -50.5% vs. USD and was the worst EM performer by far. Next worst was TRY (-28.2%). So far in 2019, ARS is -13.2% and is still the worst EM performer. Next worst is again TRY (-7.1%). Our EM FX Model shows the peso to have VERY WEAK fundamentals and so this underperformance should continue.

USD/ARS is trading at all-time highs this week. The pair is trading in an upward sloping channel on the daily charts that dates back to October. The top of that channel comes in near 44.37, but we have little confidence that this channel will hold. Further peso weakness seems likely, as both the external and domestic environment remains very negative.

Argentine equities continue to underperform. In 2018, MSCI Argentina was -54.5% vs. -17.4% for MSCI EM. So far this year, MSCI Argentina is -0.8% YTD vs. +14.8% YTD for MSCI EM. We expect equities to continue underperforming, as our EM Equity Allocation Model has Argentina at VERY UNDERWEIGHT.

Argentine bonds are underperforming. The yield on 10-year local currency government bonds is +59 bp YTD. This is ahead of only the worst EM performer Turkey (+87 bp). With inflation likely to move higher and the central bank likely to have tighten further, we think Argentine bonds will continue to underperform.

Argentina entered our EM model universe last year at an implied rating of B+/B1/B+ but has since dropped two notches before stabilizing at B-/B3/B-. Downgrade risk is seen for all three actual ratings of B/B2/B, but we suspect the agencies will wait until the elections are over to make any moves.