In June 2017, the Argentine government issued a 100-year bond. It was a remarkable show of confidence for a country with a history of defaulting. Investors bought $2.75 billion of the century bonds, chasing the 7.9% yield it offered.
“The fact that an issuer such as Argentina, which is not an investment-grade issuer—which is a high-yield issuer—was able to price a bond with a maturity of 100 years tells you a bit about investor sentiment at the time,” said Nishant Upadhyay, head of global emerging markets debt at HSBC.
Just more than a year later, those bonds are trading at around $0.75 on the dollar while investors’ horizons have shrunk accordingly. After a US$50-billion IMF bailout in June, a peso that’s lost half its value this year, and inflation around 34%, the most important date for investors is now the presidential election in December 2019.
President Mauricio Macri will seek a second four-year term with an economy likely in recession and the bitter taste of another IMF intervention in voters’ mouths.
How did it all turn so quickly for Latin America’s third-largest economy? Part of it comes down to “an ill-fated confluence of factors,” as IMF managing director Christine Lagarde put it in a June statement.
Investors had long been aware of the country’s fiscal deficit, low growth expectations and inflation concerns, Upadhyay said. But with interest rates rising in the U.S. and other developed countries, and global trade tensions creating uncertainty, investors started moving into safer debt.
“What’s changed extrinsically is that scrutiny from investors has gone up a lot more in a time when the overall environment for risk assets, especially emerging market risk assets, has been less conducive,” Upadhyay said.
A severe drought at the start of the year damaged Argentina’s corn and soybean crops, hurting top exports. Two interest rate reductions in January led inflation expectations to rise and the peso to lose value.
The government response has been appropriate, Upadhyay said. The central bank raised rates aggressively when faced with a currency run—to 40% in May and to 60% in late August, the highest in the world.
The government approached the IMF for a loan. It said it would slash the number of ministries in half and impose a tax on exports—a tax Macri said was “very bad” but necessary. (Exporters had benefited from the currency devaluation and had more capacity to contribute, he said.)
It’s all part of a plan to balance the budget in 2019 and achieve a 1% surplus in 2020. Under normal circumstances, Upadhyay said, investors would give the government credit.
Instead, Argentina is confronted with the “circular logic” that comes with depending on foreign financing for a current account deficit. “Almost as a corollary, weakness in the currency will translate into inflation creeping higher,” Upadhyay said. “Inflation creeping higher can then lead to further weakness in the currency that leads to that crisis of confidence. Argentina is facing that.”
After growing 3.6% in the first quarter, Argentina’s economy shrank by 4.2% in the second. Many economists are now forecasting a recession and the government’s September budget bill forecast a 2.4% contraction for 2018.
“Rates rising, trying to stop inflation; slow government spending. But how do you make up for that shortfall?” said Anish Chopra, managing director with Portfolio Management Corporation. “It takes time. Generally, a recession is one of the outcomes.”
Nicolas Vaugeois, portfolio manager, global asset allocation at Fiera Capital, said the contraction may be larger than expected. If the soybean season rebounds, though, he said there could be positive numbers by mid-2019.
Upadhyay’s outlook for the next 12 to 18 months is “fairly constructive,” but that depends largely on a base-case scenario of political stability.
2019 presidential election
The biggest risk for investors is a lack of political continuity, Upadhyay said.
Macri was elected in 2015 promising to undo the populist legacy of predecessors Cristina Fernández de Kirchner and Néstor Kirchner.
Investors, including Vaugeois, liked what he was pushing, and so did many Argentines. Until this “ill-fated confluence of factors,” re-election was looking like a safe bet after allies strengthened Macri’s position in congressional elections last year.
The high interest rates and spending cuts have led to labour strikes, and the reappearance of the IMF invokes all the bad memories of the country’s 2001 default. The incumbent faces the prospect of campaigning during a recession.
The good news for Macri is the opposition is at least as fragile. The “notebook scandal”—named for spiral notebooks kept by a driver who described the bags of cash he delivered from businessmen to government officials under the previous administration—exploded this summer. Cristina Fernández de Kirchner, who still sits in the senate and has been rumoured to be considering another run for the presidency, has been called to testify.
“This corruption scandal is kind of a gift for Macri,” Vaugeois said.
Investing in Argentina
For Vaugeois, who is a subadvisor for the Horizons Active Emerging Markets Bond ETF, the crisis has made Argentine bonds attractive. “We think at over 700 basis points over the U.S. Treasury in the 10-year, it makes an appealing investment in the current environment,” he said.
Upadhyay’s outlook on dollar-denominated debt is also mostly sanguine, as long as a far-left government doesn’t take power next year. Bonds won’t rally back to a big spread in a matter of weeks, “but over the course of a year or 18 months, you will get paid at fairly attractive valuations,” he said.
The outlook on locally denominated debt is less clear, Upadhyay said, as inflation continues to cause volatility. The trade-off for investors is between that volatility and a generous yield, but the peso’s sell-off may not be over. The currency was hovering around 39 pesos to the dollar in early September.
The notebook scandal has also affected some large companies, and interest rates are causing pain.
“For companies that are refinancing in the current rate environment, it’s very punitive,” Chopra said.
The situation is leading some investors to remain on the sidelines. Chopra recommends a conservative capital allocation given the uncertainty about how the economy will fare over the next few years.
“What you don’t want to do is overspend your cash on the current stock price where the economy deteriorates on you or on a company or a particular area over the next number of years,” he said.
The Buenos Aires Stock Exchange Merval Index was up slightly year to date in late September.
Official name: Argentine Republic
Capital: Buenos Aires
Chief of state: President Mauricio Macri (since December 2015)
Government type: presidential republic
Population: 44.3 million (2017 est.)
GDP (purchasing power parity): US$920.2 billion (2017)
GDP per capita: US$20,900 (2017)
GDP growth: -2.4% (2018 est.)
Unemployment rate: 9.6%
Inflation rate: 34%
GDP by sector
Source: CIA World Factbook
Argentina has a tax treaty with Canada.
Companies incorporated in Argentina and branches of foreign companies are deemed to be tax resident. Corporations are taxed on worldwide income.
Income and branch tax: 35%
Capital gains tax: 35% in most cases. For non-residents, gains from the sale of Argentine shares are taxed at 15%. Dividends paid to a non-resident are exempt from withholding tax.
Income tax: 5% to 35% for residents; 24.5% for non-residents
Capital gains tax: 0% to 15%. Most Argentine- source financial income is exempt from taxation, including interest from bonds, dividends and other profits. Gains from securities not listed on a stock exchange or authorized for public offering are taxed at 15%.
Source: Deloitte’s “Taxation and Investment in Argentina 2017”
Emerging market contagion
Argentina isn’t alone in its debt crisis. Turkey’s currency crisis has led to dramatic inflation, leading some observers to worry about emerging market debt contagion.
For markets dependent on global trade and external financing, the tightening monetary policy in developed markets and the threat of a U.S.-China trade war have raised investor scrutiny about risk assets, HSBC’s Nishant Upadhyay said.
“Emerging markets are not growing at a significantly slower rate than they were growing three months ago. What’s changed is the sentiment,” he said in early September. “It’s always hard to know when things will start reversing.”
Argentina and Turkey represent perhaps the most dramatic examples of what Chopra describes as a common dilemma. “A big chunk of the problem in emerging market countries is the fact that they can’t pay their external creditors back in the currency of the country,” he said. They generally pay it in U.S. dollars—which gets harder as the dollar strengthens and their own currencies suffer.
More than 70% of Argentina’s total sovereign debt is dollar-denominated.
“External shock,” such as a faster-than-expected Fed hike or a global economic slowdown, remain the greatest threats to emerging markets, Fiera’s Nicolas Vaugeois said, but he thinks the spillover effect from Turkey is “overdone.”
“We think it’s a good moment to invest in EM debt as spreads widen across the board because of Turkey, when Turkey doesn’t actually have that big of a weight in the global economy,” he said.