Argentina’s woes show that faith alone will no longer prop up markets

Before we get started today, I just wanted to let you know about a conference I think you'll probably be interested in attending.

Regular MoneyWeek contributor David Stevenson has put together an event focused on dividends a topic which I know is close to many a MoneyWeek reader's heart. There are lots of the very best active fund managers going along including Gervais Williams of Miton as well as some top strategists, plus many of the biggest ETF issuers.

It's on the morning of 15 May (9am kickoff) at Schroders in the City of London and you can find out more here.

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Better yet, David has arranged for some free tickets for MoneyWeek readers. If you're interested in coming along, then contact events@etfstream.com and tell them John at MoneyWeek sent you.

I'll be there on the day too, so hopefully see you there!

Turning to today's story we look at the rapidly escalating collapse of the Argentinian peso, and what lessons we can learn from the country's woes...

How Argentina fell from grace

In June last year, despite having a patchy long-term credit record, Argentina managed to borrow $2.75bn over 100 years, promising to pay the creditors around 8% a year in interest.

This raised plenty of eyebrows at the time. However, under new centrist president Mauricio Macri, elected in 2015, the country was reforming, and risk-hungry investors looking for potential investments were quite happy to lap up Argentinian assets.

Just quickly re-reading an article from the FT last summer, we learn that few investors "are expecting any major upsets in Argentina." Indeed, the worst-case scenario, apparently, was that Macri would fail to win a second term.

That's not quite how things have panned out. The elections don't roll around until next year, and yet the price of those bonds has now slid by more than 15%, and the Argentinian currency the peso is collapsing.

Last week, the central bank lifted interest rates from (brace yourself) 27.25% to 30.35%. That didn't arrest the decline. So yesterday it hiked them to 33.25%. That hasn't worked either. The peso is now at an all-time low against the US dollar, having lost a quarter of its value in the past year.

What's gone wrong? To be fair to Argentina, there's nothing happening that is particularly out-of-the-ordinary for an emerging market. Argentina has a big fiscal deficit (it spends too much). But everyone knew that, and the point of borrowing more money now was to try to push through economic reforms to deal with it in the long term.

Those reforms have moved too slowly for investors' liking. But since when have politicians been good at getting things done quickly?

The central bank looked as though it was coming under pressure from the government to go too easy on inflation targeting earlier in the year, which rattled markets. But clearly they've learned from that mistake.

Meanwhile, the economy has been hit hard by a severe drought, which is set to batter soybean and corn harvests (which also plays into currency strength, as commodities are a key export).

That's all par for the course for developing markets. Harvests fail; governments even reforming ones move slowly and screw up every so often.

The real problem is that expectations were too high. This time last year, most things were priced for perfection. In 2017, the market ocean was as flat and as placid as a boating pond on a sunny day. So when investors thought about buying a 100-year Argentinian bond, they didn't think: "Wait, this is Argentina." They thought: "Wow, that yields 8%!"

That's changed. Suddenly investors are focusing on the risk again. And they don't like what they see.

Four lessons from Argentina's woes

It's an interesting story if a depressing one but is there much of a lesson here for the majority of investors, who probably haven't ever owned any Argentina-based asset in their lifetimes?

Yes. Firstly, it's a very clear and valuable reminder that narratives are often nonsense. Stories sometimes have an element of truth in them, but many are essentially made up or skewed in order to make sense of what's happened.

"Look investors snapped up Argentina's debt. It must be good! The turnaround story must be true!" It's all backward-looking justification, not to be relied upon.

Secondly, and related to that first point, markets can turn on a sixpence. One minute it's all about how you only have to hold that Argentinian century bond for 12 years to make your money back. The next it's "how fast can you get me out of here?"

Thirdly, it's a reminder that tighter money and declining risk appetite tend to squeeze the weakest areas first. A stronger dollar is bad news for emerging markets in general. Argentina might be the most egregious example of that right now, but it's hardly the only one that looks vulnerable to capital outflows.

Finally, when it comes to borrowing either as an individual or if you're looking at a company or a country it's always much safer to have your liabilities denominated in the same currency as your income.

A big problem for Argentina right now is that this debt is dollar-denominated. So as the peso falls in value, it becomes ever more expensive for the country to service the debt. As Edward Glossop of Capital Economics puts it: "FX reserve coverage is currently high. But the central bank is burning through them to support the peso at an alarming rate. And the markets seem to be calling its bluff."

That spells more interest rate hikes or at worst, a full-scale repeat of the hyper-inflationary era, which would be extremely bad news.

Overall, this is a sign that the highly-forgiving environment of the last decade or so is starting to fray at the edges.

It's like Elon Musk's temper tantrum at analysts over Tesla earlier this week. Flaky business models and fragile economies that once won the benefit of the doubt from investors are no longer having that benefit extended to them.

And a lot of the time, we're going to find out that it was only faith that kept them afloat in the first place.