Argentina – the reforming frontier-market economy
Background
This frontier market is unloved by fixed income investors, having defaulted twice in the last two decades. Yet a recent change in political leadership has triggered an unexpectedly positive shift for the economy.
In November, the country’s voters faced a choice between left-wing candidate Sergio Massa or radical libertarian Javier Milei, as we wrote here. Milei defied the polls to take victory. Since then, he has dealt a positive surprise to the market, given both the speed at which he has forged ahead with his promised radical economic rehaul and the experience and credibility of the team he has chosen. We recently reported that these measures were starting to bear fruit. Crucially, they have stoked hopes of a more sustainable economic future and more favourable outlook for investors in the country’s debt. Yet Milei’s proposed reform bill – which seeks to modify around 300 laws and deregulate key sectors of the economy – has political hurdles to clear as it needs to gain the support of Argentina’s powerful provinces.
The path to economic strength and stability
The path to a sustainable economic future will be bumpy, but some key elements point to a country that is heading in the right direction.
A revision to the country’s pension formula is a key element to ensure a sustainable fiscal adjustment. The political will seems to be there, with Milei determined to turn around the fiscal deficit. Progress on this front is already in evidence – in February, Argentina logged a primary fiscal surplus for a second consecutive month, after years of regular deficits.
The outlook for inflation appears encouraging, and the peso looks set to continue to weaken (in nominal terms) in a controlled manner. Since the currency devaluation of over 100% in December, the 2% crawling peg (the mechanism for devaluing the peso) should continue over the short-term as Milei wants to prove credibility, and various macro data points are moving in the right direction. However, the path is likely to be bumpy. The peso is rapidly appreciating in real terms, potentially deterring exporters from converting their (US dollar) harvest proceeds. And while inflation figures have come in better than feared – slowing month-on-month to 13.2% in February and broadly expected to slow to 4% by year end – it remains very elevated. There is a long road ahead for this economy. That said, foreign exchange controls on exports are likely to be lifted in the summer, which could coincide with another deal with the IMF. If Milei can achieve this key goal, it would be an early win for his radical policies and pave the way for an economic recovery.
Trip takeaways
When I arrived in Buenos Aires, Milei was struggling to win the support of the lower house – where his coalition (La Libertad Avanza – LLA) controls less than 15% of seats – for his reform bill. Despite clunky handling of negotiations by this relatively inexperienced politician, I was cautiously optimistic around the likelihood of a political agreement being reached, given signs of agreement on some key issues. My various meetings with political analysts, legislators, policymakers, economists, and energy experts strengthened this view.
There seems to be some willingness by the provinces to negotiate as they are heavily dependent on central government funding, and with Milei holding the power to potentially ease their local fiscal burdens the government appears to have the upper hand in the short term. With an opposition in disarray, the general view is that Milei needs to take decisive action now and build relations with the key provinces while his popularity remains high.
Presidential Palace (Casa Rosada)
Source: Ninety One.
Central bank
Source: Ninety One.
Implications for debt investors
The wide-sweeping proposed reform agenda is a potential gamechanger for investors in Argentina’s hard currency sovereign and corporate debt, drawing a line under a chequered past and ultimately facilitating a move from frontier to emerging market economy status. However, short-to-medium-term political machinations mean the path ahead should remain bumpy and significant market volatility is likely to accompany this. Associated mispricing in the market could present significant alpha capture opportunities for investors who can see past the headlines and keep a firm eye on the fundamentals.
To illustrate this, newsflow since my trip – both positive and negative – has continued to impact the market. On the positive side, Argentina has refinanced the equivalent of around US$50 billion in peso-denominated sovereign debt in a record bond swap. By extending maturities, the deal aims to relieve pressure on public accounts, which could ease the path for Milei to lift currency controls later this year. However, a separate development served to highlight the political difficulties Milei is facing – the Senate rejected his emergency decree to deregulate the economy in his attempt to deliver much-needed reforms, meaning he can only progress by introducing changes by law if the rejection is confirmed by the lower house as well, although that seems unlikely for now.
Room for improvement on sustainability
While economic reforms are a key step forward for the Argentine economy, broader sustainability trends are disappointing. In this regard, Argentina’s policymakers could take note from their counterparts in Brazil, as outlined below.
Climate Action Tracker now rates Argentina’s climate targets and policies as ‘Critically Insufficient’. With the immediate focus on fixing the economy, the climate agenda is regrettably taking a back seat. In addition, to deliver on his promise to achieve a fiscal balance, Milei has axed a number of social programmes as well as cutting funding to antidiscrimination agencies, for instance, so that the social agenda is also unfortunately taking a step backwards. This contrasts with the positive dynamics we see around rule-of-law, accountability and institutional capacity under the new administration, helping to lift our overall score for the country within our ESG trends framework.
Brazil – embracing a more stable path
Background
Accounting for 10% of the JP Morgan GBI-EM local currency debt index and carrying a significant country weight in the EMBI (hard currency) and CEMBI (corporate credit) indices, Brazil is a much more familiar – and comfortable – name for investors.
While there is less drama around this economy, thanks to its more solid fiscal footing of late, recent political developments have kept investors on their toes. Since being sworn into office at the start of 2023, President Lula da Silva’s (commonly referred to as ‘Lula’) fiscal stance has at times alarmed markets. A revised fiscal rule was unveiled last spring (setting limits on the primary fiscal deficit while also capping the country’s expenditure growth). Tax reforms and rating upgrades followed, against a backdrop of credible and orthodox monetary policymaking (allowing Brazil to embark on a rate-cutting cycle before most global peers). But in October, Lula’s comments around potentially reducing the primary fiscal target deficit to below 0% met with investor concern over fiscal risks in the country.
Presidential building (Planalto)
Source: Ninety One.
Congress
Source: Ninety One.
Trip takeaways
In almost every meeting I attended over the course of three days in the country, I heard that Brazil has become “boring”. Let’s be clear: boring is good for debt investors.
The economic outlook seems bright, and it is widely acknowledged that Brazil is benefiting from another “lucky Lula” moment. Lula is reaping the benefits of a structural growth uplift thanks to offshore oil production, which is still forecast to increase nicely over the coming years. Growth should also benefit from improved credit conditions. However, the harvest, which was at record levels in 2023, is likely to come in at lower levels, largely driven by the impact of El Niño. Stronger growth is reflecting in better-than-expected tax revenues for January – the ambitious 0% primary balance target for this year may prove a reality.
While Brazil’s fiscal adjustment has relied on a lot of “one-offs” and there is a cyclical element at play, I heard from several independent sources that the administration is doing a good job at looking for new “one-offs” and closing loopholes. Furthermore, the minister of finance Fernando Haddad was universally praised for being a safe pair of hands on economic policy.
Implications for debt investors
The trip served to strengthen my positive outlook for Brazilian assets and, for the main part, lift concerns over potential negative fiscal noise. The affordability of Lula’s political agenda to address low growth, inequality and a growing hunger crisis posed questions. However, I left thinking Brazil could beat somewhat pessimistic market expectations on the fiscal front this year given the improved oil-related growth opportunities, and as minister of finance Haddad remains in control of the public purse. This should provide a supportive backstop for Brazilian assets. That said, investors should be aware of the cyclical tailwinds currently at play, the increased sensitivity of revenues to commodity prices, and risks that if the economy falters, a stimulus push ahead of the next general elections due in October 2026 could materialise (this is not my base-case view).
Some of those I met see the potential for more rate cuts than are priced in by rates markets, although a tight labour market, minimum wage policy and sticky services inflation pose a risk to the benign inflation dynamics.
Market consensus is largely bullish on Brazilian assets so much of the above is already in the price, but it serves to confirm that the largest country in South America, and the fifth largest nation in the world, is on a robust trajectory.
Forging a sustainable path
In a turnaround from recent years, Brazil is leading on sustainability. In November, Brazil’s National Treasury announced the issuance of the country’s first-ever sustainable bond on international markets, marking a positive shift towards more sustainable practices.
Politically, now that big economic reforms have been approved, the focus is shifting to the green agenda, with the speaker of the house keen to establish a cap-and-trade system and green taxonomy. Related developments include collaboration between the Ministry of Economy and the central bank with the Inter-American Development Bank to develop an FX hedging facility for green FDI in Brazil, as currency volatility is one of the impediments to real long-term investment in the sector. I got a real sense of potential for things to start happening on this front. Banco do Brasil already has an impressive portfolio of sustainable loans (BRL300 billion out of total portfolio of BRL1 trillion), which it will continue to grow. There could be significant potential for fixed income investors to tap into transition-related opportunities in the months and years ahead.
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Specific risks. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
