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Global Emerging Markets
Research
Taking Stock of Argentina after the Rally: Focus on Carry, Take
Profits on GDP warrants and Stay Long CER and USD Debt
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Argentine assets have rallied impressively since end‐August as the reflation trade and the improvement of relations with international investors has led to a re‐rating of Argentine risk.
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Despite the wide range of returns, credit spreads have been a key common factor for returns across Argentine asset classes.
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At current levels, we remain constructive Argentine assets, but note that the carry will become an increasingly important source of returns and the room for material credit spread compression is materially lower with 5‐year CDS at 550 bps compared with 1000 bps a year ago.
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We believe that FX policy is one in which there is a slow depreciation of the peso and JP Morgan Economics research sees USDARS end‐2011 at 4.20—a 5.2 nominal depreciation.
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Stay long Argentine external debt (Boden 15s) and CER paper (Bogar ‘18s) for carry and Indec optionality.
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We take profits on Argentine GDP warrants as they no longer offer the positive convexity that has made them such an attractive asset.
Argentine assets have rallied impressively throughout the past five months as the introduction and subsequent implementation of QE2 added credibility to the global recovery and reflation trade. Moreover since then the Argentine government has “checked off” many of the outstanding items that were high on the list of investor concerns, namely dealing with the Paris Club debt, an opening of the exchange for Brady bond holdouts, discussions of inflation‐reporting reform at Indec. In addition, the unfortunate death of former President Nestor Kirchner in November has been seen as a catalyst for a potential change in the political landscape. We take stock of the rally in Argentine assets and assess the opportunities going forward.
It should be noted that the rally in Argentine assets since the end of August (indeed over the past two years) has reflected a re‐rating of Argentine assets across the board. The correlation across assets, whether credit, CER paper, GDP warrants and NDFs have all been very high. The common elements have largely been a reduction of the Argentine risk premium and the global economic recovery. Indeed the correlation between prices of ARS Discounts and US Discounts is 92% and the correlation of the level of the S&P and the price of Argentina USD Discounts is 87%. The environment of strong commodity prices has allowed Central Bank reserves to continue to grow despite the paying down of external debt from those reserves and strong growth has buttressed the fiscal accounts at a time when markets globally have paid more attention to the debt sustainability. Moreover, the check list of concerns that has been addressed by the government has further served to improve investor relations at a time when the cyclical backdrop is supportive. As a result Argentine assets have rallied by as much as 68% since August 26th (GDP warrants), CER paper has rallied by 22‐49% and USD external debt has returned between 6‐29%.
Table 1: Asset Returns since Jackson Hole (August 26th) and Since November 3rd
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Source: JP Morgan.
Given the outsized returns that Argentine fixed income has produced, the room for spread compression is by definition more constrained. Although spreads remain well above the lows of 2007, we do not believe those spread levels will be revisited anytime soon particularly ahead of the October Presidential elections when candidates still remain unknown and the macro‐and micro‐economic policies remain unorthodox. Indeed at this point, it is hard to see the catalyst for further material re‐rating of Argentine risk. As a result we believe carry will offer better risk adjusted returns at this point.
ARS Expected to Depreciate 5%, outperforming FX forwards: Stay Long CER paper
JP Morgan’s Argentina economist Vladimir Werning expects the currency to remain very stable and forecasts USDARS at 4.20 at year‐end. The stability of the peso is largely due to government’s and BCRA’s desire to have
a stable currency ahead of the October elections. Indeed, Central Bank head del Pont has also indicated that the peso will end the year at the 4.20 level, as indicated by the budget. A stronger peso on a real basis, remains a viable policy tool to fight domestic inflation and with reserves continuing to grow there is room for support.
Expected returns for Argentine USD and ARS returns comparable in 2011
While in the base case scenario of limited nominal fx depreciation, CER assets offer potentially higher returns than USD assets, primarily due to the fx view. Table 2 below highlights the projected returns on various assets based on scenarios in which there is no further spread compression and one in which spread compression continues and the curve bull steepens. We also assume that USDARS is at 4.20 in a year’s time. Under these assumptions CER paper slightly outperforms USD debt. However, the volatility of CER paper is considerably higher than that of USD debt and on a risk adjusted basis USD debt offers higher ex‐ante risk‐adjusted returns.
The catch is that CER paper still does not price in the optionality that Indec could normalize the reporting of the CER index. However, we note that this is not our expectation. We construct a synthetic breakeven inflation chart (1y NDF+5y CDS, less CER yield) and note that for the most part inflation breakevens are in line (Bogars) or below current year on year CER inflation (Discounts). Another potential factor favoring CER paper is the widening of the “blue chip” fx rate relative to spot. Currently the blue chip rate is 4.04—1.5% premium to spot ARS. As a result we do not have a strong preference for either external debt or CER debt over one another.
GDP Warrants: The time has come to take profits
GDP warrants have been the best performing Argentine asset over the past two years. Indeed many investors remember in Q2 of 2009 when the warrants were trading below the 3.2 December 2009 payment. Since then warrants have increased in value by more than 6 fold. On October 7 (“Argentina: GDP Warrants remain cheap following the rall: favor ARS warrants”), we recommended buying GDP warrants at a price of 12.20 and ARS warrants at an ARS price of 11.47 vs 16.00 and 15.45, respectively. While we do not see warrants as https://mm.jpmorgan.com/stp/t/c.do?i=41FA4-CFD&u=a_p*d_533453.html*h_-2725pk1
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overvalued they have hit our price targets, the USD warrants currently trade at a 27% discount to the 21.82 theoretical value, which is in line with historic valuations and the convexity benefits warrants with respect to spread have largely been priced (See Chart 2 below). In a scenario where Argentine credit spreads tighten a further 150 bps, and we assume the discount to TV of 27%, warrants would be expected to increase to 17.00 from 16.00—a 6% gain. Even if we were to assume that Argentine credit spread is to tighten by 150 bps and warrants only trade at a discount of 20% to TV, then we would expect warrants to trade at 18.60—16% above current valuations. In order for warrants to generate the types of returns possible in external debt or CER assets, growth expectations and/or significant repricing of the discount to theoretical would need to change. Warrants have hit our targets and with the room for further spread compression more limited and the fact that warrants offer no carry, we do not find the risk reward compelling at current valuations given the historic volatility of these assets.
Table 2: Projected Returns and Volatility
Source: JP Morgan.
“Synthetic” Breakeven Inflation
Source: JP Morgan.
Comparison of Argentina GDP Warrants and CDS Spreads
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Source: JP Morgan.
Stuart Sclater-Booth (AC)
(1-212) 834-2152
[email protected]
J.P. Morgan Securities LLC
Carlos J Carranza
(54-11) 4348-3425
[email protected]
JPMorgan Chase Bank Sucursal Buenos Aires
www.morganmarkets.com
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