Argentina: From Frontier To Emerging Market

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Summary

MSCI is expected to review the classification of Argentina on June 20th, which may be beneficial for the country’s equity and debt.

The Argentinean economy is recovering from the recession with a healthy positive outlook for 2017-2018.

The primary risk is political and will determine the recovery and growth of the economy into the future.

With a strong growth forecast, taking into account potential risks, good performance can be expected.

Since the beginning of the year and after the post-election sell-off, emerging markets have been posting significantly higher returns than developed markets. Nevertheless, with higher yields, investors should expect higher risks in the form of additional political instability, currency risk, and higher illiquidity.

Frontier markets are a category of emerging markets in countries that don't qualify as emerging markets because of their smaller size. Frontier markets are even riskier and more illiquid than emerging markets. Technically, emerging and frontier markets can be compared to large-cap and small-cap companies respectively. MSCI classifies the following countries as frontier markets: Argentina, Croatia, Estonia, Lithuania, Kazakstan, Romania, Serbia, Slovenia, Kenya, Mauritius, Morocco, Nigeria, Tunisia, Bahrain, Jordan, Kuwait, Lebanon, Oman, Bangladesh, Sri Lanka and Vietnam.

In addition to higher returns, emerging and frontier markets provide diversification opportunities and are reasonable to include as a small allocation in a portfolio.

Investors looking to invest in frontier markets can consider diversified ETFs such as the Guggenheim Frontier Markets ETF (TICKER: FRN) and the iShares MSCI Frontier Markets (TICKER: FM) which have had significant returns since the beginning of the year.

As another approach, investors can choose the most opportunistic countries and invest directly into a single name ETF. I believe that Argentina provides an excellent investment opportunity and, in this article, I will explain why.

  • MSCI Promotion from Frontier to Emerging Market

MSCI has classified Argentina as a Frontier Market country and is expected to review the classification in June. MSCI will announce the decision on the 20th of June. What does this mean to investors?

With the reclassification of the country, Argentina will be added to the Emerging Markets indexes. If the promotion happens, investors can expect the inclusion of 16 stocks that are listed on the U.S. stock exchange in the indexes. The expected inflows will have an upward pressure on the overall equity markets.

  • Political Risk

EIU Political risk for Argentina for the last five years

Source: Bloomberg Terminal

After President Macri had taken office in the December of 2015, the political risk in Argentina decreased significantly. From the first days in office, Macri focused on fiscal deficit reduction, fighting inflation, resuming economic growth, and easing capital and exchange controls to access the international capital markets. The success of these efforts will depend on the strength of future economic growth.

One of the significant political risks will be parliament elections in 2017. Macri's party needs to win extra seats in parliament to push the needed reforms and overturn populist policies, left over from the previous government. Without a congressional majority, it will be hard to push the changes, which will ultimately affect future growth and investor confidence.

Central Bank is still building credibility in the environment of inflation targeting and the floating exchange rate regime. Central Bank set up an inflation target of 12%-17%, which is below the analyst consensus of 21%. To fight inflation, Central Bank hiked short-term interest rates to 26.25% for the first time in April 2017.

  • Economy overview

IMF Economic forecasts

Source: Bloomberg Terminal

The economy of Argentina started to recover from the recession in 2016 and IMF has a positive outlook with expected GDP growth of 2.2% in 2017 and 2.3% in 2018.

The recovery was driven by strong exports in the agriculture sector and supported by the elimination of export taxes and improvement in technologies. Moreover, for 2017/2018, Argentina expects higher wheat production (20mm tons) compared to 18.4 in 2016/2017.

Argentina's position as an export-oriented country brings another risk: lower commodity prices in the future which could slow down the economy and depreciate the currency.

One of the major concerns for investors is a high inflation rate of roughly 36% at the end of 2016 that is forecasted to decrease to a more reasonable rate of 25.6% at the end of 2017 and 18.7% at the end of 2018.

Reduction in the fiscal deficit is one of the primary goals of President Mauricio Macri. The Treasury target is a budget deficit of 5.6% in 2016, down to 4.2% in 2017 and 3.2% in 2018.

1. Current Account Deficit

The current account deficit is projected to be -2.9% in 2017 and -3.4% in 2018. The primary trading partner of Argentina is Brazil, an economy which is still in recession and subject to ongoing political scandals. Significant dependency on the Brazilian economy is one of the primary risks for the Argentinean economy.

Source: Bloomberg Terminal

2. Foreign Direct Investments

Source: Bloomberg Terminal

From 2014 to the Q3 2016, foreign direct investments increased significantly. As a result of positive foreign direct investment inflows offsetting the current account deficit, the exchange rate was stable over the year.

The Argentinean peso was one of the best-performing currencies for the last year relative to that of other frontier/emerging markets countries.

Total return of emerging/frontier markets currencies for the last year

Source: Bloomberg Terminal

3. Credit Risk

Argentina has low leverage - 53.8% of the GDP. Rating agencies have the following ratings: Moody's - B3 (positive outlook), S&P - B (stable outlook), Fitch - B (stable outlook).

Argentina Debt-To-GDP ratio for the last ten years

Source: Bloomberg Terminal

Compared to the other emerging/frontier markets, Argentina's yields on sovereign debt are significantly higher than Mexico, Indonesia, Brazil, Russia, Chile, Colombia, and Turkey.

Interest rates term structure of the Emerging Markets countries

Source: Bloomberg Terminal

For the last year, reserves increased substantially from 25,000 mm to 45,597. The higher reserves imply the ability of the government to repay debt and maintain solvency.

Foreign currency reserves for the last ten years

Source: Bloomberg Terminal

Taking into account low debt-to-GDP ratio, current GDP growth, political risks, and currency reserves, the probability of default is not too high - 6.12%. Argentina has default experience; the country defaulted in 2001, only 15 years after the country settled the debt for $4.65bn.

Source: Bloomberg Terminal

In the next section, I will demonstrate the opportunity of investment in Argentinean equity or debt.

  • Equity investments

One investment option is to purchase the Global X MSCI Argentina ETF (TICKER: ARGT), which fully replicates the MSCI All Argentina 25/50 index.

Global X MSCI Argentina ETF provides full exposure to Argentinean equity. The fund will benefit significantly from Argentina's promotion to the emerging market classification as the largest holdings are listed on the U.S. exchange. The fund has 179 mm AUM with average 0.20% bid-ask spread.

  • While the fund is riskier than S&P 500 Index (beta 1.11), it's less risky than the MSCI Emerging Markets Index (beta 0.93).
  • The volatility of the fund is 18.11%, which is above 16.62% of the Vanguard FTSE Emerging Markets ETF (TICKER: VWO) and 9.55% of the SPDR S&P 500 Index ETF (TICKER: SPY).
  • Nevertheless, the Global X MSCI Argentina ETF has a higher Sharpe ratio - 2.53% relative to the SPDR 500 Index ETF 1.78% and the Vanguard FTSE Emerging Markets ETF 1.39%. Higher Sharpe Ration means higher return per unit of risk.

Compared to the Vanguard FTSE Emerging Markets ETF, the Global X MSCI Argentina ETF has significantly lower concentration in the energy sector, which implies lower volatility and less downside potential due to the global underperformance of the sector.

Source: Bloomberg Terminal

The Global X MSCI Argentina ETF has a higher concentration in the financial sector. The financial sector looks strong compared to the financial sector of the Vanguard FTSE Emerging Markets ETF:

Source: Bloomberg Terminal

  • Lower percentage of non-performing loans (0.25% vs. 2.95%)
  • Higher funding of existing loans (91.74% vs. 73.44%)
  • Higher return on equity (18.45% vs. 15.90%), which was achieved due to higher leverage and asset turnover based on the DuPont analysis.
  • Profitability of the financial sector is lower than the Vanguard FTSE Emerging Markets ETF, however, but with a recovery of the economy, improvement in profitability and ROE can be expected.

For the last year, the Global X MSCI Argentina ETF significantly outperformed emerging markets ETF.

Performance of the Global X MSCI Argentina ETF compared to the Vanguard FTSE Emerging Markets ETF and iShares Emerging Markets Index ETF (NYSEARCA:EEM)

Source: Bloomberg Terminal

The other option for investing in Argentinean equity is to buy diversified funds such as the iShares Frontier Markets ETF (Argentina comprises 18.61% of the ETF and is the second largest country) or the Guggenheim Frontier Markets ETF (TICKER: FRM) (14.56% of the ETF and the largest country).

For the last year, ARGT significantly outperformed diversified frontier markets ETFs.

Performance of the Global X MSCI Argentina ETF compared to the iShares Frontier Markets and Guggenheim Frontier Markets ETF (NYSEARCA:FRN)

Source: Bloomberg Terminal

  • Debt Investments

Progress on inflation and expectations of decreasing inflation in the future will drive up bond prices.

Taking into account expected decline in inflation, relatively low emerging markets leverage, increasing currency reserves, foreign direct investments, moderate political risk, and economic recovery, sovereign bonds can be attractive investments.

Argentinean sovereign debt is included in most of the emerging markets bond ETFs. However, the percentage of Argentinean debt in the portfolios is not significant - around 4%. With the inclusion of Argentina in emerging market indexes, a higher concentration can be expected.

The funds usually invest in local and USD currency sovereign debt. One of the largest ETFs holding Argentinean sovereign debt in USD is the Vanguard Emerging Markets Bond ETF (TICKER: VWOB) and iShares JPMorgan Emerging Markets ETF (TICKER: EMB). The funds that invest in domestic denominated sovereign debt include the iShares JP Morgan EM Local Currency Bond ETF (TICKER: LEMB) and VanEck Vectors Emerging Markets Local Currecny ETF (NYSEARCA:EMLC).

Disclosure: I am/we are long ARGT, EMB, EEM, VWO, EMLC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.