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Be Aware Of The Downside Risk In Argentina

Summary

Primary elections to be held on August 11th. in a polarized scenario.

Economic indicators are contributing to officialism but at a slow pace.

The market seems to price a re-election consensus.

Downside risk looks larger than upside potential.

Primary presidential elections are to be held on August 11th. An extremely polarized scenario is taken for granted between Mauricio Macri's "Juntos por el Cambio" (JxC) and Alberto Fernandez's "Frente de Todos" (FDT).

The result of the contest will define very much about Argentina's macroeconomic policy in the near future and will show Argentinian's preferred economic model between two well-known poles (a much more structural conclusion).

The market, of course, is not absent from this scenario and, if primary elections do not enable to anticipate the result of general elections (to be held on October 27th.), volatility is around the corner.

Market is anticipation so, with few trading days before the event, we should take a look at it in order to make some inference about upcoming elections and to avoid being surprised by market’s reaction to the result.

First things first. What is happening in Argentina?

For starters, Argentina suffered a couple of huge selloffs against its currency back in 2018 due to a balance of payments crisis. As a result, and in absence of creditors, macroeconomic variables rapidly adjusted to a new equilibrium that eroded confidence on the administration, which already was on a slide due to an attempt of a pension system reform.

Economic instability was the rule from that point onwards. Economic activity hardly fell and inflation spiked to close 50%. Despite that adjustment of variables, it seemed that the real effective exchange rate (OTC:REER) was doing its job, by rapidly cutting a big part of the current account deficit, together with an important support from the IMF.

By January 2019 the picture looked better, inflows to emerging markets contributed and the Central Bank was able to lower the refference rate while the ARS stood stable. At that point, Macri’s administration was confident that the stabilization of the macro would bring a “V-shaped” recovery on activity and that inflation would converge to figures similar to those before the crisis (close 2% MoM). If that was the case, the government had enough time to show some considerable improvement in the economy by the primary elections time.

But this hope tripped with lower ability from the Central Bank to intervene in the FX market (which was limited to a wide non-intervention band), not much a matter of scarcity but more related to responsibility on the use of IMF’s funds. The ARS depreciated again in March (10%), refueling inflation and delaying the reactivation of the economy.

Here is where a turning point comes into play. By end-April IMF gave up its restrictions to intervene in the FX market and, like if it was a spell, the market strongly believed in the Central Bank authorities’ compromise on a nominal anchor. From that point onwards, stabilization worked and was more credible. Some of the macroeconomic results are shown in the following chart.

(see https://www.bloomberg.com/news/articles/2019-04-29/argentine-peso-bounces-back-as-central-bank-overhauls-policy)

What is the market telling us about Argentina's presidential election?

Some say that a bear market is the one where positive news do not boost prices up. Conversely, in this view, a bull market is the one where negative news do not drag prices down.

Given the binary outcome of this election (in which I make the assumption that Macri's re-election would be a bullish and his defeat would be bearish), market's reaction to some news should give us a read on the market sentiment about next week's results.

April’s turning point had effects not only in short-term macroeconomic variables but it also was a turning point in markets, showing the confidence that investors had on this new compromise. Up to this point, some would say that this compromise ensured a smoother transition to another government and some would say that this gave Macri’s administration one last chance.

A couple of weeks later, Cristina Fernandez de Kirchner, the main opposition politician, announced that she would run as Vice President together with Alberto Fernandez (former Chief of Cabinet during Nestor Kirchner’s administration) as President of the formula.

Market’s reaction to this announcement was also ambiguous. Alberto Fernandez would represent a more moderate or “market friendly” government, which would sound good for the ones that believed that. Others would believe that Alberto Fernandez was only there to catch some undecided voters who would not vote for Cristina and that, in practice, he would not have any real decision-making powers.

The real game changer came by early June, when Mauricio Macri picked opposition’s Senator Miguel Angel Pichetto as his candidate for VP. Sovereign risk rallied down 55bps in a single trading day and its down -140bps by today since then.

(See https://www.bloomberg.com/news/articles/2019-06-11/macri-picks-argentina-opposition-leader-pichetto-as-running-mate)

Macri’s pick not only represented the intention to form a government’s coalition with the so called “third force” (Anti Kirchner Peronists & others) but it also polarized the election by diminishing its force. It is useful to remember that Macri won the 2015’s balotaje despite losing general elections due to the fact that most “third force” voters were not willing to vote for Cristina Fernandez.

The thesis of this piece is that this event, combined with improving economic indicators and lower volatility in the FX market are driving the election towards Macri’s victory and that the market is telling that story. This does not mean that Macri needs to win the primary elections, he only needs to get close enough since he will have the self-fulfilling prophesy on his favour as explained later.

To test the thesis, I can mention some negative news that had almost no effect. Those least relevant are:

- FdT reaching an alliance with Sergio Massa the very next day (See Macri's key rivals in Argentina presidential election strike...)

-Moody’s putting Argentina into negative outlook on July 12th. (See https://www.bloomberg.com/news/articles/2019-07-12/moody-s-puts-argentina-on-negative-outlook-on-policy-uncertainty)

-The Province of Chubut seeking for a reprofiling of debt on July 24th. (See https://www.bloomberg.com/news/articles/2019-07-24/argentina-s-chubut-seeks-debt-reprofiling-to-extend-maturities)

But the most relevant, without any doubt was on the night of Sunday, July 28th. when FdT’s candidate Alberto Fernandez announced in an interview that if he was elected, he would rise pensions by 20% (a cost of close 0.2% of GDP) by lowering Leliq’s (Monetary policy instrument) interests payments (at the time was not clear if he intended to say defaulting or lowering, but was later clarified). Furthermore, he assured that the FX rate was not competitive at the current price of the USD/ARS “was not the price”. He also said imports policy was not “intelligent” that electric and gas supply tariffs were overpriced and that they had to be linked to purchasing power.

(See "Voy a aumentar las jubilaciones un 20%" Alberto con Navarro | El Destape)

These words were like shooting a mosquito (small market) with a nuclear missile (big announcements). Not only he was not clear about defaulting or not, but it was meant that monetary policy would be discretionary on the hands of the Executive branch. Even more, if that 20% in pensions was risen by lower CB’s interest payments, that also meant the comeback of monetary funding of the fiscal deficit. If that wasn’t too much, he announced that the ARS was trading rich.

¿Market’s reaction to this event? Sovereign risk fell -1.3%, S&P Merval Index rose 1.9% and USD/ARS went up 1,1%.

Of course, the FX market got volatile and would probably continue so until the primary election. Portfolio decisions have to be taken, and big moves easily shake small markets like equity or FX markets in Argentina. The best signal is to look at the fixed income market, which is not that much affected by volatility of undeveloped markets; when looking to sovereign risk, we see volatility off the table for almost a month.

(See https://www.bloomberg.com/news/articles/2019-07-26/volatility-is-back-in-argentina-as-election-jitters-take-toll)

All in all, it seems that the market is revealing something: FdT’s potential measures don’t affect since it is becoming unlikely that they would be able to defeat JxC.

Is there anything supporting this view?

Surveys for primary elections show that Mauricio Macri is cutting distance. July polls are showing improvements in JxC’s numbers and most evidence a technical tie within the margin of error. In the following chart, publicly known polls from June 22th onwards are shown, so it is likely that new polls added to this survey will show tighter results. As we always say, “trend is your friend”.

Polls sources:

Market Still Thinks Argentina's President Macri Has A Chance At Reelection

https://www.bloomberg.com/news/articles/2019-07-08/macri-s-odds-of-winning-argentina-race-are-rising-pollster-says

Recent polls show a notorious parity between Macri and Fernández

Opinion polling for the 2019 Argentine general election

Nuevas encuestas: mejoró Mauricio Macri y la diferencia a favor de Alberto Fernández promedia sólo 3 puntos

Other indicators suggest that Macri’s chances are increasing. Both UTDT’s Consumer Confidence Index and Confidence in Government improved significantly since May (after the mentioned turning point), returning to levels similar to those before the last ARS selloff.

(See: Centro de Investigación en Finanzas | Universidad Torcuato Di Tella)

(See: ICG)

The self-fulfilling prophecy and the downward risk

It has to be taken into account that there are close to 2 ½ months in between both elections, enough time for the FX market's reaction to elections to hit on real variables like inflation, wages, consumption and so on.

If Fernandez's FdT earns a comfortable win in the primary elections (let's say for the sake of the argument, an unexpected win over 5pp), it could activate a self-fulfilling prophesy mechanism that could drive macroeconomic variables to a bad equilibrium, hitting confidence in the current administration and providing and edge to FdT for the general elections.

A narrower result or a close tie would not trigger that much, given that this result seems to be priced, according to the view developed in this piece. The market seems to be reading this result for the current administration while sentiment indicators and polls show a trend in line with the argument. But what is really driving this improvement in JxC's numbers? My answer is FX stability and inflation deceleration. Thus, a narrow result would probably bring a more stable FX market, giving an additional 2 ½ months for showing improved economic indicators, the self-fulfilling prophecy boosts also JxC’s results.

Conclusion

The conclusion should be to be aware of the downward risk in fixed income and equity markets and not to expect that much from the upside (in the short term) since the bullish event seems already priced. You could expect more volatility, even to the upside in FX markets, due to the previously explained reasons. If JxC wins by a wide edge, that's another story, since it would foster governability through greater participation at least in the Chamber of Deputies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.