Introduction
2018 has been a tumultuous year for Argentina. From one of the most severe droughts the country has experienced in decades, to the collapse of the peso and equity markets, to a $50 billion IMF bailout, a series of investor storms have hit Argentina and prompted investors to run for shelter. But while these economic setbacks have caused damage, they have also created a historic opportunity to cheaply buy into an economy which is about to get a significant second wind due to the economic policies of President Mauricio Macri.
We became bullish on Argentina with the election of President Macri in 2015. A pro-business, free market-minded reformer, Macri slashed corporate tax rates, removed export tariffs, deregulated the banking and capital markets sectors and cut government subsidies. As a result, Argentina began firing on (almost) all cylinders. In 2017, the MERVAL Index gained approximately 77 percent, agricultural production soared as it became more profitable, and Argentina quickly established itself as one of the most promising frontier markets.
The Storm Descends
Then began the storm. This year began with a crippling drought, causing big losses in agricultural production, especially corn and soybeans, which together account for nearly 37% of Argentina’s total exports. Crop prices rose as supply shrank, and Argentina was forced to import U.S. soybeans for the first time in 20 years. The economy contracted 2.7% from March to April of 2018, and over $3.4 billion in exports were lost as the agriculture sector’s damage reverberated throughout the economy.
Next came the peso crisis. The sudden strengthening of the dollar in April sent emerging market currencies across the board into a tailspin. With its structural challenges, Argentina’s peso lost over 55% of its value as the Central Bank of Argentina (BCRA) had been expanding the money supply by as much as 30% annually since 2012 in an attempt to improve their fiscal deficit, which only exacerbated inflation. The government also imposed a 5% tax on non-resident holdings of central bank debt, an unexpected move that sent billions worth of foreign investors packing.
Argentina M0 Money Supply 1990-2018:
This perfect storm crushed the equity markets and sent interest rates skyrocketing in Argentina, despite the country’s impending upgrade to the MSCI Emerging Markets Index in June 2018.
A New Growth Season for Crops, Economy
Today, however, the storm clouds have begun to clear, and this fertile land is on sale. Aware of the need to establish credibility for the central bank and value for the peso, President Macri recently appointed Luis Caputo as president of the central bank. Currency creation has slowed considerably, the peso has stopped its slide and Argentinian equities are beginning to make a comeback. Add to that the aforementioned MSCI upgrade, which will drive up to $4 billion in capital inflows over the coming months, and we believe it’s a strong buy.
Meanwhile, recent heavy rainfall during the corn and soybean harvest season (March and April) left ideal planting conditions for wheat, setting up farmers for a record harvest of 20 million tons, up from the previous year’s record of 18.2 million tons. This, coupled with forecasts for normal weather and the USDA’s markedly improved outlook for corn, barley and soybean production in 2018/19 seems likely to lead to a dramatic rebound in Argentina’s agricultural exports. As a result, we are confident economic growth will ignite much like it did after a similar drought in 2009 (see chart below). Even if Argentina’s crop production simply normalizes to pre-drought levels, corn production could rise 30% to 40 million tons, and soybean production could rise 43% to 57 million tons. But with Macri’s production-friendly policies such as the continued decrease of the soybean export tax, we expect production to surpass these prior highs, and economic growth to explode as a result.
Argentina Quarterly GDP Change YoY:
Our thesis is supported by history. Notice in the graph below how, despite a 26% loss of agricultural GDP in 2009 during the drought, production roared back in 2010, overcompensating with a 41.2% increase in agricultural GDP.
Annual change in agriculture as a contribution to Argentina GDP (PIB = GDP):
The benefits of an agriculture rebound go beyond economic growth. Increased exports and production could not only generate necessary tax revenues to improve the country’s fiscal deficit, but also reverse the peso’s fall. Macri’s supply-side economic policy reforms like tax cuts and deregulation reduce the cost of producing goods and services. When the cost of production is reduced, more goods and services are produced, leading to lower prices. Thus, if the government and central bank continue to play their cards correctly, they can steer the nation’s currency back into stronger territory and drive up the real value of Argentinian equities.
An increase in Argentina’s exports is, at its core, an increase in demand for the peso, which should also cause the battered currency to rally. A rising peso will dampen inflation and provide a needed political lift to President Macri. As important as the rain was to the drought and the new central bank leader to the peso, Macri’s survival is critical to Argentina’s continued success.
Plus, the undervalued peso makes Argentina’s exports cheaper and more competitive in the global market. Argentina’s low cost of production is an advantage. Just this week, the president of the Mexican National Farm Council, Bosco de la Vega, announced that Mexico is likely to import an additional 500,000 tons of corn from Argentina as an alternative source to the U.S. while NAFTA is debated.
Conclusion
We strongly believe that investors should view the recent series of unfortunate events in Argentina as a temporary correction in a long-term positive trend of pro-business reform, which will ultimately be the key to unlocking and releasing the potential of the nation’s vast resources. Argentina’s economic storms have taken their toll on the crops and on investor confidence, but Macri’s growth-focused and market-friendly policies will shine on Argentina’s economy and markets.
Written by Thomas Landstreet
Research assistance by Charles M. Grimes
