Since the end of the global recession, global stock markets have seen strong returns. So far throughout 2014, Argentina leads the way. The Argentina benchmark exchange, "Mercado de Valores De Buenos Aires", also known as Merval, has surged 60% year-to-date, putting the exchange at the top of the list of 40 global markets for 2014.
(Source: Investing.com Merval Overview)
Key components of the Merval Exchange are stocks like Petrobras, Banco Marco, and Telecom Argentina. Top performers for 2014 are EDENOR, Pampa Energia, and Frances. ENDENOR, up 205% YTD and 756% in the past 12 months, is an electric utility company that distributes power to several municipalities in the Greater Buenos Aires metropolitan area.
The reason that the market has surged is not due to any sort of fundamental changes in the economy. Actually, strong fundamentals have nothing to do with the rise in stock prices and the surge in the overall Merval exchange. Instead, it's the lack of strong fundamentals and the draw of high-risk, high-returns that come with a country that offers high bond yields. The stock market has enjoyed huge inflows of cash that look to buy high-yielding companies, especially those companies that are backed by the Argentinian government.
The chief international strategist for Wells Fargo discussed the reason that investors are pushing so much cash into the Merval Exchange:
"There's been a general rotation out of safety and into risk," said Paul Christopher, chief international strategist. In particular, the countries that had most attractive valuations have been the most bought this year."
The strong performance proves that investors have had a mental recovery from the 2012 U.S. and European Union crisis, which caused a surge in bond yields as countries such as Spain and Greece toed the line of defaulting on debts. The fact that investors are willing to invest in high-risk areas shows that the conservative methods have already run their course. Those who have invested are now under pressure, especially bond holders, as the country flirts with defaulting. Investors went headlong into the Merval, using the possibilities of high returns to justify the use of risk and leverage. Now the investors and banks alike are looking for a way to mitigate what should be huge losses to the bottom line.
The index's surge isn't being driven by improving fundamentals. Asha Mehta, portfolio manager at Acadian Asset Management, describes the move as a contrarian play:
"Argentina's market was one of the worst frontier markets in 2012. Prices became so depressed that bargain hunters began to see value and have started to come back in."
Mehta warns investors that risks are high as the economy deals with pressing issues. Argentine president, Cristina Fernández de Kirchner, a controversial politician who nationalized Argentina's largest oil company last year, has come under pressure due to her economic policies. However, the president's inability to turn the economy around has been the biggest issue that citizens struggle with. More than a million protesters took to the streets to express their discontent.
Today, all investors, citizens, and the global economy are looking at the U.S. Appeals court ruling that could push Argentina to the brink of default. A panel of judges is deciding how to settle a case between the Argentine government and holdout creditors who claim they are owed nearly $1.5 billion on their defaulted bonds.
Argentina defaulted on its debt in 2001, and recent events with the U.S. have pushed more risk of default into the Argentina Merval Exchange. The Argentina government reported statistics that show an inflation rate of 15%, while at the same time, the economy is contracting. This shows a huge disconnect between the economy and the stock market. High rates of inflation in a contracting economy means consumers are losing purchasing power on the Argentina Peso. In turn, goods such as gasoline and groceries cost more.
Argentina's Debt Talks on Bonds With The U.S.
Argentina is potentially on the verge of default as it tries to meet creditors and pay bondholders who have refused to work with the Argentina government to reduce payments. The country has shown that it cannot meet current payments on it bonds owned by U.S. banks and international holdings. The U.S. Supreme Court backed the ruling which is called the "pari passu clause" in which Argentina must pay all bondholders, including those who have refused to restructure the yields owed to them. What is interesting is that Argentina has already missed a payment to U.S. banks that was due June 30th. However, the country has a "grace period" of 30 days, which means we are coming up on the technical default rate, unless Argentina can restructure or find a way to pay creditors.
Argentina's president Kirchner has tried to explain to investors that the $15 billion owed is equal to half of the entire central bank foreign exchange reserves, which would cripple its economy and further cause triggers to other high-risk countries around the world. The situation is somewhat similar to the 2012 issues that caused erratic moves in global stock markets.
If Argentina Defaults
The entire strategy of the International Monetary Fund, IMF, is one in which it rescues countries close to defaulting by advising on debt restructuring in cases that involve payments that are too large to be paid by the host country. With the U.S. ruling pari passu clause, creditors can challenge any attempt to reduce payments, and further, sue the country that has defaulted.
Argentina markets would potentially lose all of the gains in the Merval Exchange if the country defaults on debt payments. Chief business correspondent for the BBC further explains the consequences to the global market,
"For instance, the IMF is considering extending the time to repay for debt to try and avoid debt write-downs. A multi-tiered bond market could result. So, bonds issued under New York or English law with such equal treatment clauses may be viewed as more secure and command a higher price than bonds which don't. For bonds, the higher the price, the lower the yield, which translates into cheaper borrowing costs for those countries. It would be an unintended consequence of their attempt to make future debt restructuring easier after the drawn-out process with Greece."
Argentina may rely on what the eurozone dictates, Collective Action Clauses (CAC), to bond holders, forcing them to accept a restructured deal. Argentina, in turn, would change the global landscape, making future bonds much more expensive to issue. Investors must keep an eye on the potential restructuring over the next few months, in which more payments are due. If the country defaults, then the market will plunge. Bond yields will sky-rocket as a vast sell-off resumes. Argentina is already suffering a stagnating economy. A government default would drive unemployment rates higher, increase the country's rates of inflation, and more importantly, could cause a ripple effect around international markets.
However, if Argentina can come to an agreement with U.S. officials through a mediator to avert a default, both the Merval and the bond market will continue to move higher. Cash would start to flow back into the exchange. Bonds will have a more interesting reaction, though. If a deal is struck, yields will still remain high. The burden of the restructuring will fall back onto the Argentinian government for issuing debt in the future. Also some government integrated companies, such as the oil giant Petrobras, would be impacted, as both bonds and preferred shares will face higher yields as the company indirectly ties itself to its host government. Investors should stay clear of the Merval. Locking in gains and waiting the issue out may be the best strategy at play for the moment.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.