Rejecting The Bear Thesis For Argentina – Global X MSCI Argentina ETF (NYSEARCA:ARGT)

Rejecting The Bear Thesis For Argentina – Global X MSCI Argentina ETF (NYSEARCA:ARGT)

The debate over whether Argentina is changing and becoming a more-friendly environment for foreign investors that offers considerable upside continues to gain considerable momentum on Seeking Alpha. In early February 2018, I penned a piece examining the opportunities that exist for investors concluding that while considerable risks still exist, President Macri’s reforms have given the economy a solid lift. That combined with growing interest in Argentina’s energy patch, reforms to the banking system and growing business, as well as consumer confidence, will all work towards unlocking long-term value for investors.

In the most recent article which takes a very bearish tone towards Argentina’s prospects, author Ian Bezek states:

my overall call is to avoid the Argentine economy, and in particular its banks, which are earning unsustainably high NIMs and are also at risk of serious loan losses during the next recession/political swing.

In my opinion, Bezek is fixated on a small number of concerns and fails to fully understand the transformation that is afoot in Argentina since pro-business Macri took the helm. While the short-term journey will be a bumpy one with plenty of issues arising, along with a raft of deep structural macroeconomic fissures, the economy has finally turned the corner and the longer term outlook is improving.

Reforms are driving a solid growth spurt

Key to Macri’s strategy and the improving economic outlook was to open Argentina’s heavily regulated economy by removing capital controls, winding tariffs and subsidies, eliminating price caps, and devaluing the peso. Inflation has not fallen to the levels projected, stubbornly remaining in the mid-20% range, being reported as 25% for the first quarter of 2018 but this is well below the 47% peak experienced in 2016. Inflation should continue to fall as Macri’s policies gain greater traction.

Unwinding price setting policies including price caps along with the sharp decline in the value of the Argentine peso when it was unpegged from the U.S. dollar all had an adverse impact on inflation, causing prices to rise sharply. Now that those distortionary policies have been removed, inflation should start to fall and it is feasible that the revised 2018 target of 15% can be achieved.

Nevertheless, it will be a lengthy process to reach the ultimate target of 5% inflation annually after almost two decades of distortionary fiscal policy, heavy-handed regulation, capital controls, and price setting.

Another area of significant improvement has been Macri’s ability to reduce the budget deficit to manageable levels. By 2017, the deficit had fallen to 3.9% of GDP well below the expected 4.2% and the 5.4% recorded in 2015 when Macri came to power, and it is forecast to drop even further to 3.2% for 2018. A lower deficit will further help to rein in inflation as well as strengthen the government’s financial position.

These improvements have already been recognized by international rating agency Moody’s which lifted its sovereign debt rating in November 2017 from B3 to B2 with a stable outlook. That has garnered considerable attention from foreign investors adding momentum to the growth of Foreign Direct Investment.

This will all contribute to stronger economic growth with GDP expected to expand by around 3% despite the drought which is impacting the nation’s agricultural sector.

Bezek makes much of the drought and its potential to push Argentina into recession stating:

Argentina is heading for a slowdown in 2018, as 2017 GDP came in at +2.9%. 2018 is heading for just 2.5% and likely more revisions downward as the impact of the drought continues to expand.

While agriculture is responsible for around 10% of Argentina’s GDP and oil-cake, maize, and soya bean products make up its top 5 exports, other sectors are poised to fill at least some of the gap created by the drought. Key among these is Argentina’s energy sector which is on the cusp of massive oil and gas boom which is attracting considerable interest from foreign investors. The overall improving health of the economy will also help to cushion the impact of the drought and forecast decline in agricultural output, supporting the official view that GDP should expand by around 3% this year.

This has all helped drive Argentina stocks higher and given the Global X MSCI Argentina ETF (ARGT) a solid boost, with more to come.

ARGT data by YCharts

That makes now the time for investors to add the ETF to their portfolio with it still possessing considerable potential upside despite gaining 32% over the last year because of the fundamental changes being made by Macri.

The nascent energy boom is an emerging growth driver

For an analyst who hypes the prospects of Colombia’s troubled energy industry, it’s surprising that Bezek heavily discounts the growing contribution of Argentina’s energy patch and mining industry.

He states:

For all the (probably overblown) hype you see around Argentina’s energy industry and gold mining prospects, it’s important to remember that Argentina never managed to develop much beyond basic grain industry along with its competition-sheltered autos business for exports (even cattle make up a shockingly small percent of exports.

Let’s talk about the considerable potential held by Argentina’s energy sector.

The country according to the U.S. EIA possesses the second largest conventional oil reserves in the world and there were claims that the Vaca Muerta shale formation is superior to the Eagle Ford. The Nuequén Basin in the Vaca Muerta play has been compared to the prolific Permian Basin which is the driving force behind the massive growth in U.S. shale oil and gas. Less than 10% of the wells drilled in the play are horizontal demonstrating the ease of drilling.

While the costs of drilling horizontal wells have fallen significantly to $1,390 per lateral foot which is 39% lower than 2016 and less than half of 2015. Those costs can only continue to fall because of improved infrastructure, greater efficiencies, and technological improvements among other factors.

Foreign energy majors have been flocking to Argentina and committing to making considerable investments. Many have stated that they plan to focus on boosting their exposure to shale oil in coming years, including Shell (NYSE:RDS.A) (NYSE:RDS.B), Exxon (NYSE:XOM), and Chevron (NYSE:CVX) all stating that they will make it a driver of growth.

Argentine state-controlled energy company YPF (YPF) has committed to investing a total of $30 billion between now and 2022, with $21.5 billion coming from its own coffers and an additional $8.5 billion from foreign integrated energy majors that will partner with the driller.

To put that in perspective, a single year’s investment in the Vaca Muerta will exceed investment in Colombia’s oil patch for 2018.

It should be considered that global energy majors Chevron, Exxon, and Shell have all committed to boosting their investment in shale oil and gas to make it a major growth lever. They are doing that by investing in the Vaca Muerta because of the attractiveness of the play. Exxon alone has committed $200 million for 2018 and between $10 billion to $20 billion over at least the next 20 years.

Global integrated energy giants would not be making such large investments in the Vaca Muerta if its potential is overhyped.

With the Vaca Muerta slated as one of the best unconventional oil and gas resources globally, it will attract ever greater investment, particularly with Macri focused on making conditions even more attractive for foreign investment in Argentina’s energy industry. The removal of capital controls, unwinding of local content rules, and reduction of labor costs have all boosted its attractiveness.

The effect of that investment can be seen with oil production from the Vaca Muerta in 2018 forecast to grow by 113,000 barrels daily which represents a 43% increase over a year earlier. This marked uptick in output will come from operations only covering 8% of the play’s acreage, underscoring the tremendous potential that exists.

Nonetheless, it is estimated that declining oil production from Argentina’s mature conventional fields will cause overall oil output to remain flat for 2018 but it will grow from 2019 onwards as tempo in the Vaca Muerta rises. The expectation is that Argentina will be producing over 700,000 barrels daily which is 200,000 more than 2017.

With Brent at $65 per barrel, after factoring in the discount applied to Argentine crude, this would add roughly $4 billion-plus to Argentina’s gross domestic product before even factoring an associated increase in natural gas output. That is not a figure to be dismissed for an emerging market that is in the process of stabilizing its economy, boosting growth, and diversifying its gross domestic product. There are also the associated royalties and taxes the government will earn from growing oil production which will help to boost its coffers and further narrow the budget deficit.

Argentina’s banks are in a prime position to grow

Now let’s get into one of my biggest bugbears concerning Bezek’s views. I believe that his logic regarding Argentina’s banks is flawed, which is quite difficult to understand given his repeated claims that Colombian banks will grow by 50% or more in 2018.

Bezek states:

While Argentina does have a high portion of deposits in its banking system at the moment, this is unusually hot money and shouldn’t be seen as trustworthy long-term dependable capital.

Argentina’s banks are in a unique position for banks in a developing economy. They have a high degree of funding from deposits and a low reliance on other forms of more costly funding for their lending activities. Those deposits are not as an unstable source of funding as Bezek would have readers believe.

While bank runs have historically been quite common in Argentina, there are signs that Argentineans are starting to trust banks again. This can be primarily attributed to Macri’s attempts to reduce and stabilize inflation as well as the removal of currency controls.

By the end of 2017, Argentina’s major banks including the two with ADRs listed on the NYSE Banco Macro (BMA) and BBVA Francés (BFR) experienced significant growth in deposits. Interest-bearing liabilities at Argentina’s third largest bank Banco Macro by the end of the fourth quarter 2017 had risen by 34% year over year. It is this money which forms the core of capital that is used to fund Banco Macro’s lending operations. Importantly, much of that growth came from a marked increase in savings accounts which were up by 68%, followed by a 55% increase in corporate bonds, and a 19% expansion in the value of time deposits.

Notably, contrary to Bezek’s implied claims that deposits are an unreliable source of funding for Argentina’s banks, time deposits make up 57% of Banco Macro’s deposit base. This highlights just how stable the bank’s source of funding is, especially when it is considered that time deposits by the end of 2017 had grown by almost 20% year over year.

The same phenomenon becomes apparent when reviewing BBVA Francés’ 2017 results. By the end of 2017, private sector deposits and other funding had grown by an impressive 37% compared to 2016. The largest contributor to this increase in deposits was a staggering 86% spike in the value of savings accounts, followed by a 26% increase in time deposits. That growth now sees time deposits making up 29% of BBVA Francés total deposit funding, which is significantly lower than Banco Macro.

While the minimum amount of time for a time deposit is 30 days, the substantial growth in both savings accounts and time deposits indicates that there is a significant pool of cheap funding available to Argentine banks.

If we then compare these results to other Latin American banks including Bezek’s ongoing comparison to Colombian banks, there are many important observations that can be made. Funds growth at Colombia’s two largest financial institutions Bancolombia (CIB) and Grupo Aval (AVAL) is increasing a far slower pace with total funds growing by 2.5% and 7.6% respectively for the same period.

Meanwhile, time deposits grew by 2.4% year over year at Bancolombia and 7.9% for Grupo Aval which is significantly lower, somewhere between a tenth and a third of the rate of growth at Banco Macro and BBVA Francés.

Furthermore, time deposits only make up 32% and 40% of those bank’s total deposits which is significantly lower than Banco Macro, although higher than BBVA Francés.

Just like in Argentina, the shortest term for a time deposit is 30 days and that means Colombian banks like Argentine and other regional banks are at risk of rapidly losing a considerable portion of that funding. Because Colombian households are essentially tapped out because of a massive boom in consumer credit in recent years along with wages remaining low, it is difficult to see Colombian banks growing their deposit base at anywhere near that being experienced by Argentina’s banks.

I also expect deposits in Argentina to continue rising at a rapid clip for the foreseeable future because lower inflation, the removal of capital controls, and an increasingly stable financial system has made it more attractive for Argentinean’s to deposit their money in a financial institution than stash it under the mattress or ship it offshore as they had previously done.

This creates a reliable steadily growing low-cost source of funding for Banco Macro and BBVA Francés. When this is coupled with low credit penetration and high net-interest-margins creates a powerful tailwind for growth. Even more so in an environment where business and consumer confidence are rising, the economy is stabilizing and excessive regulation such as price caps as well as tariffs are being unwound.

Despite the optimistic outlook, there is still risk

While there is considerable opportunity emerging in Argentina, risks still do abound. Key among these is whether Macri can maintain the required political mandate to continue with his reforms.

Clearly, if Macri is replaced at the next presidential election by a Peronist politician with a populist focus, it is likely that not only would his reforms be discontinued but many of his policies would be unwound. That could see Argentina slipping back to where it was under the Kirchners.

Nevertheless, surprisingly, Macri’s political party emerged from the October 2017 midterm elections with a major political victory, indicating that Peronists may have finally lost their political sway in Argentina.

The next presidential election is to be held in 2019 and Macri is eligible to run again for the top job but his popularity has waned significantly since the midterm elections last year.

According to Bloomberg, Macri’s approval rating by January of this year had plunged from 71% after the midterms to a personal low of 49% while his disapproval rating had risen to a record 48%. Much of the can be attributed to the toxic nature of Argentine politics and the particularly divisive pension and wage reform being undertaken by Macri to reduce the government deficit which came in at 3.9% of GDP for 2017, well below expectations.

Takeaway for investors

Argentina is becoming an increasingly attractive destination for investors. Macri’s reforms have already triggered considerable growth, but while the risks remain high, there is considerable growth ahead. The overall sentiment is, despite Bezek’s claims that this is just another repeat of the past and that Argentina is nothing more than a momentum play, that this time it is different.

The significant growth in deposits being experienced by Argentina’s banks indicates that confidence is returning and that along with renewed foreign investment as well sounder fiscal policy will drive greater rates of growth. It can be argued that Argentina has yet to enjoy the full fruits of entering the catch-up phase of economic growth and that there is considerable upside on the horizon for Banco Macro, oil company YPF, and the Global X MSCI Argentina ETF.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BMA over 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.

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