High inflation erodes consumer confidence; and foreign investor returns!

The main challenge for the Argentine government and the Central Bank is to contain inflation. Inflation is accelerating and domestic prices are rising by 25-30%. The problem is partially structural, as labor unions are powerful and double-digit annual wage adjustments are common (a problem in many Latin American countries). But for 2016 and 2017, there are additional inflation pressures driven by recent government actions via the pass-through effect of the implemented peso devaluation and lower subsidies that drive up the price of electricity and gas. This high level of inflation is problematic as its leads to lower disposable income for household consumption (which represents 2/3 of the country’s GDP and is key for sustainable growth) and pushes the economy in recession for most of 2016.

The combination of high inflation and a lack of economic growth can lead to social unrest and, possibly, to political instability. Mr. Macri was elected by only a small 51% majority of votes and his approval rating has already dropped, after being appointed only a few months ago. On top of that, the new government has support in the Lower House, but the Senate is still dominated by traditional Peronist parties. This leaves limited room to maneuver and shows that the government needs to deliver on a difficult balancing act of managing the fiscal account, inflation, the peso, and domestic growth in order to satisfy both domestic and international (creditors’) expectations.

High inflation is typically passed through in a country’s exchange rate. Foreign investors interested in Argentina should thus take into account that the natural rate of FX depreciation for 2016 is an equivalent 25-30%, which implies a significant erosion of US dollar returns. Year-to-date depreciation stands at 16%, which suggests there is another 10-15% downside to the peso.

Argentina might have a bright future, but it matters when you buy and what you pay for it

We currently see limited investment opportunities in the country. Our cautiousness is driven by demanding valuation levels, a low number of liquid stocks and investable companies, and an expectation that we will get a better entry point at a later stage.

Argentine stocks are not cheap. Most stocks trade above long-term historical averages and the handful of companies that benefit from government policies (such as agricultural exporters) have re-rated significantly. The country is home to several quality banks, but these rank amongst the most expensive across global financials. Other sectors are less attractive as they are not liquid enough for institutional investors or suffer from weak corporate governance.

A new government with the right reform agenda can be a powerful driver of positive equity returns in emerging markets. But reforms are never easy and markets are always impatient. We have seen several examples of ‘reform fatigue’ in other emerging countries, where markets rallied for 3-6 months after the appointment of a new President, only to adjust to more reasonable valuation levels afterwards. Important precedents include Mexico’s market correction in 2013 after the election of Mr. Pena Nieto, and Indonesia’s underperformance during mid-2015.

Within our range of emerging market equity funds, we currently don’t own Argentine stocks. While it might be one of the few future bright spots in emerging markets, we would like to see a better risk/reward profile before becoming constructive.


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