“Tops are processes, not points”
-Keith McCullough, CEO of Hedgeye Risk Management
Conclusion: The Argentinean economy has three key issues that will create significant downward pressure on Argentinean asset values once the global yield-chasing parade comes to an end. Those issues are inflation, declining trade revenue, and overly bullish sentiment. Further, we see the recent appreciation in Argentinean asset values as a sign of a cyclical peak in emerging market asset values.
Plain and simple, if you’re looking for high beta shorts (which you likely should be, given the asymmetric global risk setup) Argentina is very attractive on a lot of fronts. We think the overwhelmingly positive sentiment surrounding the Argentinean economy is a yet another sign of yet another “top” in emerging market asset values.
The Argentinean economy, which has been benefited YTD from a number of tailwinds, has three key issues that will create significant downward pressure on Argentinean asset values once the global yield-chasing parade comes to an end. Those issues, which we dive into below, are inflation, declining trade revenue, and overly bullish sentiment.
Inflation IS a Problem
On the inflation front, many Argentinean economists have gone on record to publicly contest the government’s current reported +11.1% YoY inflation rate, suggesting that consumer prices may actuall be growing at more than twice the rate. The most notable pundit is former Argentine central bank president Alfonso Prat-Gay, who’s proprietary methodology suggests inflation may be running at roughly +25% YoY. Moreover, a September 15th survey by Buenos Aires-based Torcuato Di Tella University showed that consumer prices are expected to rise 25% over the next 12 months, which suggests Argentinean consumers may see through the widely-believed-to-be-faulty CPI data (Argentina’s former president, the late Nestor Kirchner changed the staff at the CPI agency in 2007 – a move many believe he made to hide the extent of inflation).
Currently, Argentine President Fernandez de Kirchner is avoiding selling bonds internationally to service debt despite the lowest yields in two years (~8%). Instead, she and central bank President Mercedes Marco del Pont have elected to finance debt service with FX reserves, which have grown to a record $51.3 billion as a result of dollar purchases and strong export growth. YTD, Argentine has spent $5 billion of reserves this year and plans to use an additional $7.5 billion next year to service debt. Never mind that the fact that former central bank president Martin Redrado was fired for refusing to back the plan because of its inflationary potential.
To sterilize recent sales of the peso, the government is issuing short term local debt that pays about 12 to 14% interest. Effectively, the government is taking a loss on the dollars it is buying which yield ~32bps on 2-year U.S. Treasuries. The total supply of Argentinean central bank debt maturing in one month to three years has grown 77.1% since June ’09 to 60.4 billion pesos. We interpret that as Argentina’s liquidity risk just increased by some fraction/multiple of 77.1% in the last 15 months.
Trade Revenue (and Growth) is Setup to Slow
By now, it’s no secret that Argentine is doing well economically as evidenced by the government’s +9% YoY GDP growth projection for 2010 and the S&P’s Sept. 13th upgrade of Argentina’s debt rating one notch to B (five levels below investment grade). The Argentinean economy has certainly benefitted YTD from record export tax revenue (+92% YoY in September) fueled by a record 55 million ton soybean harvest. Moreover, the Argentine peso is one of few emerging market currencies to decline against the U.S. dollar on a YTD basis – down (-3.9%).
When taken into context of the global commodity reflation we seen over the last few months, we see that the things Argentina is selling (soybeans, oil, corn, wheat, etc.) are all going up in price and, because its currency is depreciating vs. the U.S. dollar, Argentine is receiving incremental dollars on top of price appreciation because of favorable repatriation – a two-pronged tailwind of sorts.
Extremely contrary to consensus belief, we think the cycle is turning negative right here and now, as evidenced by Keith’s decision to go long the U.S. dollar today in our Virtual Portfolio (UUP). To get a sense of what could happen to the prices of Argentina’s top commodity exports see below:
- Corn, up 40.2% YTD, has an inverse correlation to the U.S. dollar of 0.91 on a six-month basis;
- Soybeans, up 18% YTD, has an inverse correlation to the U.S. dollar of 0.90 on a six-month basis;
- Wheat, up 27.5% YTD, has an inverse correlation to the U.S. dollar of 0.80 on a six-month basis; and
- Oil, up 6.7% YTD, has an inverse correlation to the U.S. dollar of .75 on a six-month basis.
Essentially dollar up = Argentinean export revenues down, which will create a drag on Argentinean GDP growth going forward. Similar to company analysis, we callout peak revenue and peak margins on the country level as potential inflection points that are not to be streamlined into future estimates of valuation.
Sentiment is Simply Too Bullish
In our risk management models, whenever bullish/bearish sentiment gets stretched too far in either direction, we take that as a contrarian signal of a market top/bottom. In that regard, we are skeptical of the widespread bullish sentiment among many investors on Argentina. In a recent investor poll by Santander, Argentina recorded the largest positive delta of preferred investment destinations in Latin America, finishing at 36% – up from 3% in July.
Other signs of peak sentiment and trough complacency are abound:
- The Argentine peso recorded the largest drop in volatility in emerging market currencies this year (down -20% YTD);
- The extra yield investors demand to own Argentine bonds instead of U.S. Treasuries narrowed 20bps yesterday to 518 – that spread is down from 846bps on July 1st;
- Argentine CDS (5Y) has declined -579bps since the end of May and are now at levels not seen since its summer 2008 lows (I don’t need to remind you what happened shortly after that); keep in mind that Argentina is a country that has been in a period of default or restructuring for ~56 of the last 210 years!
At the end of the day, we understand that the credit market and bond market are pricing in a potential regime change after former president Nestor Kirchner’s death a few weeks ago. While we agree that a regime change would likely be bullish for Argentinean financial markets, the election is nearly a full year away. There is a great deal of risk to manage between now and then.