EFTA01386034.pdf

16 October 2017 Special Report: Argentina - Position for the upturn Argentina: Position for the upturn the incumbents would still need the economic Introduction momentum to continue with the reforms needed to eventually balance the budget and stabilize external Upside surprises - lackluster market response. indebtedness after all. These are the pre-conditions for Argentina's FX and fixed income markets have had a another round of re-pricing - eventually. muted response to the recent upside surprises in both domestic activity and better-than-expected primary results / electoral polls since the PASO. Rather than a 'Aihere do policies point to in terms of asset allocation' sign of market skepticism we find this consistent with The political and policy mix means elevated primary the new stage of the cycle the economy finds itself in, deficits (likely to post 3.2% in 2018 and 3.8% without where the growth is accelerating but amid a very one-off revenues) and still a slight positive impulse vs. gradual improvement in fiscal accounts, a widening 2017 - when the primary deficit is likely reaching 5% current account deficit and persistent inflation. without extraordinary measures. This combined with investment growth - concentrated in public and (less Asset selection becomes more important. The so) private consumption (at 4.1%) - and rising real improvement in growth outlook is more clearly wages (over 3% up in real terms) point to excess reflected in the 40%+ returns in equity markets and absorption. outperformance of Argentina's external debt. Meanwhile, inflation inertia and the still high pace of 'Therefore. we expect price pressures to remain issuance have underpinned the lackluster performance concentrated in non-tradables, which means further of the peso and local fixed income in recent months. real currency appreciation pressures. According to our The gradual improvement in macro conditions we fundamental-based valuation framework the ARS is foresee slows re-pricing and highlights the importance about 15% overvalued and this will probably increase of relative value at this stage in the business cycle. in the coming quarters. An economy running hot to secure political support and an overvalued currency are In this report, we review recent macro developments consistent with a widening current account deficit. and outlook, and discuss how to position for this stage in the cycle. Funding this wider gap and fighting inflation will require high - and possibly temporarily higher - real rates for long. The central bank suggested that real Politics and policy mix support (tactical) rates of 4% are consistent with disinflation. Persistent carry in local markets and duration in inflation and the increase in 2018 inflation expectations to 15.8% (vs. 14% of early O2) suggest that policy rates hard currency may have to increase a little further still before easing could resume early next year The October mid-term elections will likely confirm the expected gains by Mach's coalition. The race in the key What could be the market implications? (and normally a leading indicator) BA province shows the incumbent's candidate leading by almost 5 points. Also, the main Cambiemos leaders still enjoy favorable Local rates: Focus on "safer" carry ratings - especially Governor Vidal (near historical highs) - while Cristina Kirchner's rejection rate is on the In our view. the need to fund widening current account rise. Local polls also suggest - despite limitations - that deficits and anchor disinflation will support additional Cambiemos may win in the province of Buenos Aires, (mild) real peso appreciation. We expect the peso to the city of Buenos Aires, Cordoba, Mendoza and Santa depreciate in nominal terms but to lag inflation and Fe - the five largest electoral districts. The government forwards. In other words, without fiscal tightening would still lack majority in congress but such an monetary policy (including the exchange rate) will outcome would fragment the opposition further and continue to bear the brunt of disinflation. We target the increase the government's leverage with governors and USD/ARS at 18.0 at the end of 2017 and 19.8 at the thus legislators. end of 2018 vs. forwards of 18.3 and 21.0. respectively. With the forwards likely overestimating the pace of This is essential to pass various reforms (especially tax. ARS depreciation the backdrop is supportive of carry co-participation, and de-regulation), keep growth oriented positions. momentum sustainable. and pave the way to reelection. The administration has revealed its preference for a Monetizing carry wi€l not be straightforward. however gradual policy rebalancing and growth recovery, but It is important to bear in mind that - in contrast with Page 2 Deutsche Bank Securities Inc. CONFIDENTIAL - PURSUANT TO FED. R. CRIM. P. 6(e) DB-SDNY-0087561 CONFIDENTIAL SDNY_GM_00233745 EFTA01386034