Argentina Elections Unlikely to Change Downward Trajectory

Some Thoughts on the Argentine Election

The weekend primary vote in Argentina suggests opposition candidate Fernandez will easily win the presidential vote October 27. Uncertainty in the runup to the vote should keep Argentina under pressure, but we think Fernandez may not be as bad as markets fear. We also downplay contagion risks, as Argentina is too small and isolated to have much impact.

POLITICAL OUTLOOK

Primary elections over the weekend saw a shocking loss for incumbent Mauricio Macri. Opposition candidate Alberto Fernandez won 48% of the vote compared to only 32% for Macri. The primary was designed to narrow the field of candidates for each party. Since the parties only fielded one candidate, the primary ended up being a preview for the October 27 elections.

What’s spooking the markets is that former President Cristina Fernandez de Kirchner is on the Fernandez ticket as Vice President. Despite presiding over what we view as a failed economic experiment, she clearly still has traction within the populist wing of the Peronists. Investors fear the incoming administration will reverse many of the market-friendly policies that Macri has undertaken.

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. That narrow victory was a sign that Macri would have trouble retaining power.

Ahead of this weekend’s primary, most polls had suggested a close contest. This led to a sense of complacency for investors, which was quickly shattered as results rolled out. Perversely, the negative market reaction to the prospects of a Fernandez will probably make it more likely that he will win. Inflation will spike higher, as will interest rates. This will likely choke off the nascent recovery, eating into Macri’s popularity further.

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. The primary vote suggests that Fernandez could win in the first round.

 

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. It appears they may be returning to power after only a brief hiatus.

 

ECONOMIC OUTLOOK

The IMF granted a 3-year $50 bln Stand-By Arrangement to Argentina last 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). Another $5.4 bln tranche was just approved last month, bringing total disbursements up to $44.1 bln. Due to the IMF’s perceived role in Argentina’s last major financial crisis, the IMF deal was likely a factor in Macri’s declining popularity.

The economy is in the second recession during Macri’s first term. That means GDP is set to contract in three of his four years in power, and that’s quite an achievement. The IMF forecasts GDP to contract -1.3% in 2019 vs. -2.5% in 2018, before growing 1.1% in 2020. GDP contracted -5.8% y/y in Q1. While monthly data in Q2 suggest the economy was starting to recover, this latest round of turmoil will make things worse again. 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 54.8% y/y in June, down from the 56.8% high for this cycle in May. While the m/m increases had been tailing off in Q2, they will now rise again due to the renewed slide in the peso. July CPI data will be out Thursday and is expected to rise 2.4% m/m. If so, the y/y rate would ease to 54.2% but this will be the last improvement for some time. This most recent bout of peso weakness will force the bank to reverse course, pushing the LELIQ rate back up above 70% and towards the May high near 75%.

While one might be tempted to think 70-75% rates ought to be high enough to stabilize the peso, that may not be 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 was to be extended several years out. If Fernandez wins, these targets may not mean much anymore. The primary balance (ex-interest payments) is forecast by the IMF to be -0.4% in 2019 and 1.4% in both 2020 and 2021. The nominal deficit was equal to -5.2% of GDP in 2018, and the IMF expects it to narrow to -3.5% in 2019 and -2.1% in 2020. These forecasts seem too 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 -5.2% of GDP in 2018, and the IMF expects the deficit to narrow sharply to -1.8% of GDP in 2019 and -1.6% in 2020.

Foreign reserves have risen as FX intervention has been curtailed and IMF money enters the country. After hitting a trough near $50 bln in May 2018, reserves rose steadily to $71.7 bln in April 2019 before edging lower to $67.9 bln in July. This covers about 120% of the stock of short-term external debt and nearly 9 months of imports. Argentina’s Net International Investment Position is a surprising 13% of GDP.

 

INVESTMENT OUTLOOK

The contrarian in us thinks that perhaps Fernandez won’t be as bad as markets fear. Macri has taken many of the tough steps needed in terms of structural reforms. The populist/statist model that Kirchner and Fernandez followed was simply unsustainable and already unraveling when Macri came to power. Why shouldn’t Fernandez keep Macri’s reforms in place and get all the credit when the economy finally turns? We should know more after the elections. For now, however, we expect Argentine assets to continue underperforming.

Latin America EM FX has underperformed today.  EM weakness has been pretty broad-based this past week, but the Argentina election news certainly focuses negative attention on the region. Believe it or not, BRL should probably be performing a bit better given pension reform movement, but we’re all on board with MXN underperformance.  Some look for Banco de Mexico to cut rates this week but we don’t think they can move given peso weakness.

Yet we downplay contagion risk from Argentina to wider EM.  It’s too small and isolated to have much impact beyond Brazil and Uruguay.  That said, EM remains under pressure and so markets will be looking for any excuse to sell.  The correlation between ARS and MSCI EM FX is currently around -.30, well below the recent peak near -0.40.  That suggests that contagion from ARS to other EM currencies is likely to remain limited.

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 -29% and is still the worst EM performer by far. Next worst is KRW (-8.2%). Our EM FX Model shows the peso to have VERY WEAK fundamentals and so this underperformance should continue. Central bank FX intervention seems unlikely except perhaps to provide limited liquidity. It won’t waste much reserves standing in the way of this freight train.

USD/ARS traded at new all-time highs today before recovering a bit. The pair has gone parabolic and so we simply have no chart points to speak of. Further peso weakness should be seen and some more overshooting seems likely, as both the external and domestic environment remains very negative. At this point, we can’t rule anything out and so see scope for the peso to weaken to the 65-70 area before we see some stability.

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 -19.2% YTD vs. +2.2% 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 +516 bp YTD. This is the worst in EM and well above the next worst performer Pakistan (+33 bp). With inflation likely to spike and the central bank likely to have tighten further, we think Argentine bonds will continue to underperform. Argentina’s hard currency bonds have similarly sold off due to the perception of higher default risk. This may be overdone, but until the uncertainty clears up, bond yields are likely to remain elevated.

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- currently. 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.