The Big Idea
Argentina | Path to recovery
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
After initial gains to start the year, prices on Argentina’s bonds have stalled. This makes sense. Bond prices should follow the trajectory of shock therapy with initial gains on the first successful phase and further gains depending on whether economic stabilization holds. But current prices underestimate the commitment of the Milei administration and the broader public to break with a legacy of policy failure. The legislature has approved economic reform and put a high priority on the first sinking fund payment on the Eurobond ARG’2030s next month. This should retest of former price highs on the bonds and still lower yields towards year end—perhaps not normalized below 10% but around 14%, which seems reasonable if the Milei administration sustains twin surpluses and avoids default.
It’s been so long that maybe we have all forgotten the stages of shock therapy. The markets quickly adjusted to the first stage in response to the immediate successful results. The political commitment and the technocrat team allowed for a quick reversal of twin surpluses for the fiscal and external accounts. This positive cash flow provides immediate liquidity relief. However, it’s still a lengthy process to rebuild the stock of US dollar assets and reduce the stock of US dollar liabilities. It will require several years of positive cash flow to reduce the structural US dollar imbalance, especially if there isn’t a follow-through positive shock that normalizes capital account flows. The social tolerance for the initial stage of shock therapy was impressive; however, it’s unclear if the population will continue to withstand high inflation if the economic recovery disappoints. There is no expectation of a quick normalization on Eurobond yields below 10% under the execution risks of a multi-year adjustment process.
The second phase is more complicated. The quick realignment of prices and the intense fiscal austerity produced the typical stagflation shock with around 20% month-over-month inflation rates into January 2024 as well as a pronounced 5% year-over-year GDP decline in the first quarter this year. The high risk for shock therapy is the social backlash. The Milei administration has been an effective communicator on raising broad awareness and tolerance in this early phases of stagflation. The worst is now over after successfully bringing down inflation to below 5% month-over-month rates and the economy showing signs of bottoming in the second quarter of 2024. However, the second phase is more critical on a broader economic recovery and a slower convergence for lower inflation. The external sector should lead the economic recovery into next year under the benefit of the competitive foreign exchange rate and strong agricultural sector.
However, there are still lingering doubts. Will the broader economy recover under the constraints of a smaller public sector and still cautious investor sentiment? Will the Milei administration continue to manage social tensions and sustain governability heading into midterm elections if the economic recovery disappoints? Is there risk of adjustment fatigue? The declining budget flexibility should also complicate between unwinding distortive taxes while identifying additional spending cutbacks. The IMF assumes lower social subsidies and higher cyclical and social security revenues. Much depends on the approval of fiscal reform. The balancing act should complicate on the tradeoff between inflation/FX competitiveness. There hasn’t yet been a positive shock to sentiment sufficient to reverse the stigma of prior policy mismanagement and escalate FDI or capital inflows. If there isn’t re-entry to capital markets, then the burden will fall on broader access to local markets and a weaker foreign exchange to expand the current account surplus. There is also high vulnerability to the volatility of the agricultural sector. It’s also difficult to allow for broader foreign exchange flexibility, on reducing capital controls, without resolving the structural US dollar imbalance.
Despite these challenges, there is still strong political capital as per the latest surveys. It’s incredible that President Milei benefits from approval ratings above 50% through six months of shock therapy. The government confidence index is still at the highest levels compared to prior administrations over the past 20 years. Much of this optimism is focused on future expectations. The successful decline in inflation now requires progress towards a recovery in employment and broader economic activity. There should be close scrutiny of the high frequency leading indicators to assess the context of the economic recovery. Even if the growth/inflation tradeoff disappoints and social pressures emerge from adjustment fatigue, there is low risk of policy backtracking while the economy has already adjusted to the worst from the stagflation shock.
The strong commitment from the Milei administration to adjust and strong commitment to pay should allow for still lower bond yields, especially on the priority payment of Eurobonds. The first sinking fund payment next month on the ARGENT’30s should reaffirm priority payment through still tight liquidity conditions. There is also optimism on the broader political cooperation for the reform agenda that seeks to de-regulate the economy for higher growth potential and maybe even support for additional fiscal relief. This would lower the execution risks on the multi-year adjustment. The current bond prices have retraced back to multi-year levels that shift from a prior ceiling to now a floor of support. The near-term positive event risks suggests potential to retest recent price highs with further gains a slower process dependent upon the success of the economic recovery and the track record of sustaining twin surpluses while managing social and political pressures. The track record of debt repayment should slowly unwind the still high default risk and reaffirm the commitment to pay. The higher coupons and sinking fund payments will also increase the current yield. The effective liquidity management on the twin surpluses should imply still lower bond yields closer to maybe 14% through year end. We reaffirm an overweight recommendation with a diversification strategy into BOPREAL bonds that reduces the country beta with the central bank counterparty risk, local investor sponsorship and shorter maturities that isolate repayment risk through the policy orthodoxy of the Milei term.
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