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The outlook for Argentina

6 September 2018

Michael Biggs, Investment Manager, Emerging Markets Fixed Income, takes a look at the macroeconomic challenges currently faced by Argentina, what policymakers are doing to address them and why the medium-term outlook for the country looks positive.

Argentina faces a number of challenges at present. But in our view, the extremely high yields, the orthodox policy response and the IMF involvement in the crisis there make us positive on the medium-term outlook for the country. As a result we favour an overweight position in Argentina. However, the risks of further near-term volatility remain high, and we re-evaluate our views continuously given these pressures.

The economic and market outlook in Argentina

How we got here:

In 2017 credit growth in Argentina surged, the credit impulse turned positive and private demand growth strengthened.

Chart 1: Credit growth vs nominal GDP growth

Chart 1 
Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

Chart 2: Credit impulse vs private sector demand

Chart 2 
Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

Strong demand boosted imports and the trade balance widened, but the current account was easily financed by capital inflows.

Chart 3: Monthly trade balance

Chart 3

Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

Investors became concerned when the central bank changed its inflation target and cut interest rates in early 2018, and this set off some weakness in the Argentine peso.

The response

In our view, inflation is likely to surge on the back of FX weakness, but the central bank has responded aggressively. Last week the central bank increased the policy rate to 60%. By any measure, real interest rates are now strongly positive. Even if inflation were to rise to 45%, real policy rates would still be 15%.

In addition, the Argentine government had secured a USD 50 billion loan from the IMF that was to be released over three years. However, the IMF has agreed to review the phasing of the loan and to collaborate with Argentina on a plan to bolster the economy.

Chart 4: Policy rate vs CPI inflation

Chart 4 

Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

We believe the strong policy response was necessary, but equally it has resulted in a sharp collapse in GDP growth. This could put political pressure on the government.

Since early 2017 Argentina had made excellent progress on reducing the size of its budget deficit. However, we believe the fiscal improvements will be hard to maintain as GDP falls.

Chart 5: Budget deficit as a percentage of GDP

Chart 5 

Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

Things to watch:

We expect to see a substantial improvement in the trade balance in the coming months as growth slows. However, this could be offset partly by softer exports due to weaker global food prices. In our view, the improvement in the budget balance is likely to be reversed at least in part. The challenge will be for the Argentine government to keep a lid on the fiscal deterioration in the face of falling growth and next year’s election.

If some of the fiscal response takes place via reduced spending, then political risks could rise as we approach the Argentine election in October 2019.

Valuations

The chart below shows real effective exchange rates of a range of EM economies over the past 25 years (around an average of 100). Based on this chart, the Argentine peso was about 12% overvalued from 2015 to 2017, but it is now 33% undervalued. In general, real effective exchange rates tend to appreciate from these levels.

In our view, the valuation metrics on exchanges rates are useful, but perhaps a more relevant measure of the combination of FX valuation and the policy stance is the current account balance. After three years of an overvalued exchange rate, Argentina’s current account deficit had widened to over 5% of GDP.

The deficit likely widened a little in Q2. However, if our expectations are correct, the current account deficit should narrow sharply in Q3 and Q4.

We think the Argentine peso is cheap at current levels, and our conviction will strengthen if we see the current account deficit narrow as we anticipate it may.

Chart 6: Real effective exchange rate (average = 100)

Chart 6 

Source: Bloomberg, as at 31 August 2018.

Past performance is not indicative of future performance.

 

Chart 7: Current account as a percentage of GDP

Chart 7 
Source: Haver Analytics, as at 31 August 2018.

Past performance is not indicative of future performance.

 

On the interest rate size, valuations are made more difficult by the range of instruments Argentina has on offer. However, these instruments are underpinned by the policy rate.

The Argentine central bank (BCRA) has now raised the policy interest rate to 60%. Inflation expectations for the next 12 months (in the latest survey) were 35%. Risks to this estimate must be to the upside given recent FX weakness but, even if inflation rises to 45%, the real policy rate will be 15%.

In our view valuations are extremely favourable for any outcome that does not involve a collapse in the economic policy-making framework.

Outlook for Argentina assets

Our baseline expectation is that Argentina’s trade balance narrows sharply on weak growth, the fiscal deterioration is contained, and the downside risks from the growth weakness are mitigated by IMF support. If the Argentinian peso shows any signs of stabilisation, then these yields should be extremely attractive to the market, and capital inflows are likely to easily finance the narrowing current account deficit. If our baseline view is correct and any sort of stabilisation is achieved, we would expect Argentina government bonds to yield excellent returns. The probability of a positive outcome would be improved if the US dollar stabilised and the global risk environment improved.

From an outlook perspective, it is really the downside scenarios that are arguably more important. The first risk is that in the near term, the currency continues to weaken despite the high yields and the IMF assistance. We think the current measures and the orthodox policy response to date should prevent this happening, but the near-term outlook remains uncertain.

The second, more fundamental, risk is that the steps taken to limit fiscal deterioration in Argentina, which could include spending cuts, put political pressure on the incumbent government before the October 2019 election. If a more populist government appears likely to into power, or if the current administration is forced onto a more populist path, then the policy framework could come under threat. In this scenario even the current valuations might prove insufficient to shield the investors from losses.

Outlook for EM market

Our aggregate positioning remains largely unchanged. We are long EM in general, underweight / short Turkey.

We remain overweight / long Argentina, and we outlined above the variables we will be watching to reduce or increase this exposure.

For EM as a whole, we believe 1) the DM growth outlook remains solid, 2) China is stimulating which reduces downside growth risks, and 3) EM growth is likely to strengthen in Q3 after a weaker Q2. In this environment, we expect EM local currency assets to do well.

Apart from US dollar strength, the two main risks are 1) an escalation in the trade wars, and 2) a tightening in domestic monetary conditions due to recent asset price weakness. We plan to reduce our exposure to EM if these risks become our baseline forecast.

 
Important legal information
 
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of future performance and current or future trends.
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