Untangling the Economic Enigma that is Argentina

Inflation is still red hot, but it's been cooling. The latest University of Michigan Consumer Sentiment survey showed that longer-term inflation expectations slipped from 3.1% in early June to 2.8% in early July, matching the average rate during the past 20 years before the pandemic. Consumer confidence in the economy is ticking up slightly to early June levels, with 26% of consumers expecting the economy to get better over the next six months, while 57% of consumers expect the economy to get worse. That's down a couple of percentage points. Fair skies? Hardly, but some stabilization as U.S. households come to terms with the realities of the economic slowdown, a potential recession, and a stock market that's kind of going sideways.

This week is huge for earnings results, with some of the largest and most widely held companies reporting results. Traders, though, may be anticipating some nasty results given recent activity in the ETF market. This past Wednesday, inflows into the SQQQ ETF, which is short the triple Q's with three times leverage, hit a new all time high of $460 million. The triple Q's, or the QQQ ETF, holds the top 100 stocks in the Nasdaq, including Apple, Amazon, and Microsoft, and they are all due to report results this week.

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The boleros of the Rio de la Plata had this unforgettable way of making you feel tragedy, joy, triumph, heartache, and the helplessness of falling in love all at the same time. They got to me about 25 years ago when I came down here for the first time, and I did fall in love with a woman, her family, the campo, the food, and the people. I spent most of my time in Montevideo, the capital city of Uruguay, a country known for its beaches, its beef, its football, its pampas, and its wonderful people.

Across the River Plate sits Buenos Aires, Argentina, another wonderful city in a country that has a lot of the same attributes, although it's much bigger, much noisier, and far more complicated, especially its politics and its economy. Argentina is a country ravaged by inflation. You might even say that it has a pathological relationship with inflation that goes all the way back to the middle of the 20th century. Inflation sits at 70% today, and it feels like it climbs every week. In fact, it does, rising at a rate of about 1% every week, typically more than deposit interest rates. That means that money sitting in the bank loses its value every day.

And the current government, that of President Alberto Fernandez and several of the administrations that preceded his are constantly devaluing the peso, the nation's currency, to try to stabilize it, but it never can. For Argentines, that means their money is worth less every day. That's a strong incentive to spend what you've got as soon as you get it. Stimulating consumption and demand, even when most people can barely afford to feed their families. The poverty rate in Argentina is more than 40%. The irony is that Argentina is a country rich in natural resources. It sits atop a massive shale deposit of natural gas known as the Vaca Muerta. It has a strong mining industry with rich deposits of aluminum, lead, copper, zinc, gold, and lithium. It produces some of the best livestock, particularly beef, of any country in the world. It has a strong tourism economy, bustling ports and rail lines, and a fairly robust and educated workforce.

So, how could a country with all of these riches have such a complicated and debilitating relationship with inflation? The answers are interwoven with Argentina's painful political history to try to understand it. I spoke to a few people who know this country well, having grown up here and who are operating their businesses in Argentina.

Juan:

"I think Argentina has a very big problem in their fiscal accounts. Argentines spends much more money than they can afford, and depending on what type of government you have, they resort to different tools."

Caleb:

"Juan Cruz Díaz is the founder and managing director of the Cefeidas Group and the co-director of the Corporate Governance Program at the Universidad de San Andrés. He's a lawyer, not an economist, but his company consults with companies and organizations operating or investing in Latin America."

Juan:

"Center-to-left, or I would say more a state center, governments tends to finance the fiscal deficit, basically through printing more money and through inflation, and that leads eventually to inflation crises that are recurrent in Argentina. Center-to-right governments tend to finance that deficit problem to external debt, and that leads also to the recurrent external debt crisis in Argentina. And if you explore our past decades, we've been going like a pendulum from debt crisis to inflation crisis."

"What we have right now, which is particularly worrisome, is that we are having, at the same time, a debt crisis and an inflation crisis. And we're coming in on a very, very worrisome point in which governments cannot solve the issue because they'e not taking the measures to basically solve the deficits and expenditure problem that we have in Argentina. And what's more worrisome at this point right now is that we have extra pressures which are not only based on monetary issues, but we have also inflationary pressures that are coming from different sources. The war in Ukraine, the post-COVID-19 world, and many other structural problems are putting more inflationary pressures on the world and on Argentina in particular. To add to all of that, we have a credibility problem right now in the government, which is perceived as a weak government."

Caleb:

"Without getting too much into the politics of it all (although it's impossible because Argentina's political history is very complicated), how have past presidents dealt with it, and how is this current administration dealing with it, or not dealing with it, that's exacerbated the problem?"

Juan:

"Well, I'm not going to go too far back, but I have to in order to give some case in point about what I just said. One big inflation crisis we had was in the late '90s after Argentina recovered the democratic system in 1983. President Alfonsín, who was a champion of democracy and all important human rights, wasn't able to solve this issue. And in 1988 and '89 in particular, Argentina had a hyperinflation crisis that extended to 1990. And in '89, President Alfonsín had to resign."

"In the '90s, aligned to the to the political climate of those times, President Menem for the Peronist Party acted counterintuitively in that sense because at that point many expected President Menem to follow no expansionary policies, or more populist policies, if you want. President Menem, aligned to the Washington Consensus, or what it was called by that time, followed a more orthodox path to address the issue and advanced many reforms that cut expenditures and actually went even more aggressive (we had a convertibility law that actually pegged the peso to the dollar), including a big privatization reform process and reform of the states. Argentina was able to contain inflation to zero for a decade."

"During the '90s, Argentina basically eliminated the inflationary process. However, as I said before, a debt crisis was starting to form and exploded in the early 2000s. And in late 2001, the president from a different party, Fernando de la Rúa, wasn't able to deal with this debt crisis, which basically created a huge political and economic crisis that made him resign. And after a messy presidential transition, the convertibility law was basically eliminated, and the inflation that was contained during the '90s was gone."

"So, after the supercycle of commodities that Argentina enjoyed in the early 2000s that helped through it that crisis and have a speedy recovery from those years, I would say by 2007, 2008 we started to see again that expenditure and fiscal problem of Argentina and government. Specifically the Governor Cristina Fernández de Kirchner, under the current vice president, very aggressive expansionary policies that exacerbated the inflationary process in Argentina that President Macri, after... wasn't able to contain."

"And current President Alberto Fernández inherited both at huge external debt prices, a chronic inflationary problem, and then the COVID-19 pandemic came. Most sitting presidents are having a lot of trouble in the region and elsewhere, and for President Fernández it was an impossible problem to solve. I would say at this point we are suffering the situation. The challenge right now that I would say President Fernández has is his electoral base is basically the most poor sectors of the society. So, if we cut social expenditure and social plans, that affects his voters and his base. But at the same time, without doing that, inflation will be impossible to contain. And as we know, especially in Argentina and elsewhere, inflation affects the poor sectors the most."

Caleb:

"Let's talk about day-to-day living in Argentina. I spent some time there recently, and you have to do this mental calculus whenever you spend money. Should I use a credit card? Should I pay cash? But what you find ordinary citizens doing is spending a lot of money and trying to spend their pesos because they don't know if prices are going to go up tomorrow or how much they're going to go up. They just know they're living in a constant cycle of increasing inflation. So, for people on the ground, households, people earning a modest wage, how do they deal on a day to day basis with living in Argentina with this uncertainty?"

Juan:

"It's very challenging. And I will tell you a short story. When I was doing my grad studies here in the United States, all my econ professors, when they started to explain inflation and hyperinflation, asked me to tell this story because I was a teenager in '89, '90 when Argentina had huge hyperinflation by the thousands. And we used to go with my mother to the supermarket, and by then we didn't have barcodes. We had a guy marking prices with a small machine. We had to race and get the stuff before the guy was marking the prices, so we could get the lower prices. The prices were changing second by second. This is not the case right now. We are not in the thousands. We're getting in the 70%, 80% inflation this year."

"But if you go to Buenos Aires, one of our two main cities in Argentina, you will see restaurants, food, you will see people going on vacations because people are spending most of the money because, as you might know, the access to savings is very difficult because the only way to sustain savings in Argentina at this point without the sophisticated capital markets and without other tools is buying dollars and that market is completely controlled. The only way to access dollars in a substantial way is through the black market, and that's what we are seeing right now in Argentina. The dollar at the black market is going up and up and up as the expectations of the economy are not very good."

"So if you don't have the ability to buy dollars, you need to spend the money. So, as you said, people are spending the money. They're buying TVs. And if you can buy stuff in installments, sometimes you can... Shops gives you the chance to pay six, 12, 24, or even more month installments. That's another option that people are taking. But again, that's the people that have some money in excess during the month. But in this situation and in this social and economic crisis, most people, I would say the lower classes and the mid-to-lower classes, probably don't have much excess every month to do this. So, I would say the most worrisome part is that. And the other thing is small businesses, it's very challenging. I think big companies and multinationals, they have options and they have ways and sophisticated tools to protect themselves from this. But this is hurting really bad small and medium businesses, and they have less options."

Caleb:

"To understand how businesses try to navigate these rolling waves of inflation and devaluation, I spent some time with Robert Matarazzo, a farmer and a friend of mine who manages 11,000 hectares of land in Santa Fe, a province in Argentina's farm belt in the north central part of the country."

Robert:

"We do agriculture, which would be soy; wheat; corn; rice... that's a little north, the farm further north; and cattle. We breed Hereford and Bradford breeds."

Caleb:

"We're living in a time of hyperinflation, although we're seeing a little bit of that turnover. But when we talk about inflation in the U.S., we're talking about 9% or 6% core inflation. Here in Argentina, you're talking about 70% inflation. Does that translate to what you're doing on the farm to your day to day, to your business?"

Robert:

"Oh, very much so. Mostly our direct costs are dollar linked. So, you are looking at the exchange rate, which of course moves. We have several exchange rates in Argentina, not just one, to add to the complexity, but our business government sets a specific exchange rate by which we can liquidate our grains, by which we get paid (eventually) in pesos, but then indirect costs like salaries, etc., they are left out to the inflation index, and that is 70% as of this year. Looking ahead, a conservative estimate would probably be higher."

Caleb:

"So, it's costing you 70% more for your labor costs?" 

Robert:

"Yes."

Caleb:

"And how about your input costs: fertilizer, water, fuel, all of those costs? How are those set, and how have those impacted your business this year?"

Robert:

"Well, those are more directly linked to international prices. As I was saying, the exchange rate by which we change that into pesos is fixed by the government. So, they keep that pretty slow. There's almost a 90%, 80% difference between the exchange rate we get paid and the, you would say, commercial exchange rate to general numbers, ballpark numbers. The free exchange rate, if there's such a thing in Argentina, is close to 300 pesos, while the farmers, when we sell our grain, we are paid at an exchange rate of 128 pesos. So, you see that gap there is something the government is pocketing themselves."

Caleb:

"We've been seeing hyperinflation across commodities, especially wheat; grains; anything that comes out of the Russia/Ukraine area, obviously; energy costs, obviously. But when we see that type of inflation, how does that translate into what you're able to sell your goods for on the open market, or not even on the open market, to your customers?"

Robert:

"It's a very particular... In Argentina, there's something called an export retention, kind of a similar to a thing they have in Russia for wheat exports. We have it here for soy. It's about 31%, 32%. Wheat is in the 20% retention, and that is gross. So, they're not taxing your profits. This is an export tax that then the exporter will trickle down to the producer, what you get paid eventually. So, Argentine grain in that respect can be cheaper to the world. Actually, there's been issues in the states with dumping or in Europe with biofuel when we export. They consider Argentina to have an unfair advantage, but by hurting its own farmers, which is very ironic. Prices have risen proportionately, but now we are having a little slowdown given the perspective of a global recession that's slowing down."

Caleb:

"So, I know you do a lot of hedging with your input costs, but when you think about that and you think about the possibility of a global slowdown, of a potential recession, how are you hedging today in anticipation of that? Give us an example or two."

Robert:

"I know basically the area I'm going to seed with a different crop. I know my inputs, how much of what I'm going to need. I'm looking at the market, and I have a timeline. Now, in September, I have to plant my corn. So, I'm going to need my seed and my fertilizer for that time. I'm running on that sort of deadline. So, I try to anticipate. We buy from purveyors. As I said, it's dollar quote. We can do... Basically, we will sell grain in exchange for that. Or there is financing also, private financing from banks. Government has special lines that they will subsidize the interest rate. So, it allows you to play favorably against inflation. You might be financing some input in pesos at 40%, 50%, which seems ridiculous. But if you're looking at an inflation of 70% or above, it makes a little sense. And usually a lot of those deals are... you have a net negative interest rate. You end up now with one year of financing."

Caleb:

"What is it that concerns you the most going into the back half of 2022 and into 2023? Is it a recession? Is it climate issues? Is it rising inflation, rampant inflation? Or is it the whole thing? What is it the one thing that sort of keeps you up at night as a farmer."

Robert:

"Weather it has to be... the classical farmers answer. We're in a Nina cycle that is dry for this part of the world. There's nothing you can do against a drought. Secondly would be world recession. Very little we can do about that. And inflation, we know it's really bad, but we know how to deal with that. We're accustomed to that. So, that would be the least of my concerns."

Caleb:

"To one's point, big businesses and even medium-sized businesses like the one my friend Robert runs know how to navigate inflation. They've been living with it for decades. Agricultural exports are key to Argentina's economy, accounting for about 17% of its GDP. So, as Robert said, there are incentives for farmers and exports are priced in dollars. Still, the mathematical gymnastics that farmers, business operators, and consumers have to deal with in this country on a day-to-day basis are mind bending. Imagine planning your weekly shopping trip to the grocery store in the United States and not knowing if a gallon of milk will be $5, $8, or even $12. Yet Argentines are used to it. It's part of their everyday life, as frustrating as it is. Here's Juan again."

Juan

"It's a very challenging situation. Having said that, as you said before, this is not new for Argentina. Most citizens are preparing themselves. We have memories of how to do this. So, most people are protecting themselves in any way they can. Keeping dollars not in bank accounts but at home or in safes or looking for different ways. I think people, especially the middle classes, are way better prepared right now than other times. But the most worrisome part, I would say, is that the lower sectors are the poor sectors of our society."

Caleb:

"It's obvious when you're walking around Buenos Aires that people are spending money, those that can spend money. But it's also pretty obvious that the lower classes are not doing well at all, and they haven't been doing well for decades, in fact. So, let's talk a little bit about how the government deals with rampant inflation. There's a constant devaluing of the peso going on. And then at the same time, workers are demanding higher wages to deal with inflation. How does the government balance these two things out? And then we're going to get to imports and exports, which is a whole nother set of calculus that people need to think about in operating in Argentina. But let's talk about, first of all, the devaluation of the peso. How does that work and how can that work, since they seem to be doing it so often?"

Juan:

"The most complicated part is, in Argentina, we don't have one exchange rate, we have several exchange rates. So, there's one official exchange rate that has... although we have seen some constant devaluation, it has been relatively stable because it's controlled by the government, but it's a fictitious exchange rate because it's virtually impossible for people or for companies to access dollars at that price. And then you have several types of exchanges. Some of them are official. Some of them are created basically by the financial sector with some creativity, using different tools on the market. And then you have the different unofficial exchange rates. We call that the blue dollar, which is the unofficial exchange rate versus the Bitcoin dollar. I mean, there's a tourist board and there's several exchange rate. So, it's very complicated at this point to deal with that."

"So, depending on who is a stakeholder depends on who will talk about the valuation. But that's the pressure that the market is put in right now... and the market and the unofficial dollar, right now, as we speak today, it's reaching 340 pesos and the official dollar is 140 pesos. There's like a 170%, 180% difference between the two exchange rates. So, there's a lot of pressure on the government to devaluate, to bring down those those values to a more equilibrium. Of course, in the middle of this inflationary process, the government is quite concerned that if they devaluate, this situation will impact prices as well. And of course, workers earn less money and will become more poor."

"So, on the other element of your question that it's important to understand is we have the formal workers, most of them are unionized, and the unions are very strong in Argentina, and they have strong links with the government. And the unionized workers have been able to negotiate that their salaries are updated at least at the rate of inflation. So, they are relatively protected in this context. But the big problem is that almost 50% of the workers in Argentina, and it's the same for the many other countries in the region, are not formal worker in the informal sector, and those workers are not unionized, and those workers are not protected by these negotiations. Of course, they not only have less worker rights and social institutes rights, but their salaries are not keeping up with inflation. So, as we said before, these informal workers are losing strongly with the inflation. This, as you know, worsens the social situation that we were discussing before."

"The interesting part right now is unemployment is not that high. After the pandemic, we've seen a recovery in economic activity. There are several sectors that have been recovering. The services sector, tourism, the oil and gas sector is doing very well. As you know, Argentina has become more... and we're seeing records and production on gas and oil. We've seen this year records in the agricultural exports in Argentina. So, that there are fundamentals that are working in the country. And I would say that problem right now is mainly political, in which the political elites haven't been able to agree on how to address this inflation. And they created a lot of uncertainty."

Caleb:

"So, let's talk about small businesses. You said they have a lot of trouble, especially those that export. When the inflation rate is constantly rising or constantly on the move, the currency is constantly being devalued, there's multiple exchange rates, and a lot of uncertainty, how does an exporter operate and how can those that are importing from that exporter and other countries—call it the U.S., Europe, China—depend on prices and price stability from small businesses in Argentina?"

Juan:

"That's very challenging. I would say the external sector in Argentina, it's one of the most challenging sectors right now. If you are an importer, for example, if you need to import goods, even to produce... I mean, there's a lot of sectors of the industry in Argentina that are very efficient, but they need to import equipment, parts, some raw materials to be able to export. But the red tape and the restrictions and the regulations are so, so, so hard. And the bureaucracy is so hard at this point because of this because every dollar is controlled in Argentina at this point, every dollar that goes out. So, it's been a nightmare for many businesses."

"And as I said before, big businesses or big companies or big multinationals, although they have problems, some sectors have specific benefits. In the mining sector; in the oil and gas sector; in the auto parts sector; or the big, big industrial sector, some of them are receiving some benefits or some flexibilities in order to... the imports. But for smaller companies that have less, I would say, force to negotiate with the government for these type of exceptions, it's been at points virtually impossible to import the materials that they need. And this has been a nightmare in terms of sometimes the production hasn't been stable. There are some small companies that had to lay off people or break some commitments that they had, even closing the door."

"So, it has been a strong problem in terms of the import. And in terms of the exports, that's a sector that the government is much more interested in because that means that some of those dollars are coming to Argentina. But again, it's a headache for many of them because the dollars that they receive are official. So when they export, they will receive in Argentina those dollars in pesos at the official rate discounting... sometimes you have export taxes, like in the case of the agricultural industry, for example, on these certain cases, in the mining sector in particular. So, it's quite a headache for many of these companies."

Caleb:

"How do you see things playing out over the next year or to 15 months in Argentina?"

Juan:

"Well, it's a very, very challenging situation for President Fernández, and his chances or his expectations for a potential reelection, at this point, it's very hard to think that President Fernandez could win or could even be a candidate for the next presidential election in 2023 and even beyond that. If we look at the polls today, it looks extremely challenging, virtually impossible for the Peronist Party, which is actually running the country right now, to win the presidential elections next year."

"We see a country with strong economic credentials. The Supreme Court in Argentina is very independent and actually very opposed to the government. The government does not control fully the Congress. We have the media and the press is very independent and mostly very critical with the government. And the actual chances of the opposition to win the elections are very high. So, despite this economic uncertainty and an economic inflationary crisis, we still have solid institutions working so far, which is good news because this will help Argentina go through this crisis in a potentially orderly way."

Caleb:

"That's the paradox of Argentina. Inflation, political instability, and economic uncertainty are just part of life. And the people I met here and the millions of people you see throughout the bustling streets of Buenos Aires live life to its fullest. Tragedy, joy, triumph, heartache, and the helplessness of falling in love are all part of the tango that is Argentina."

Term of the Week: Capitulation

It's terminology time. Time for us to get smart with the investing term we need to know this week. And this week's term comes to us from Michael in British Columbia, Canada. Lovely up there in the BC. Michael suggests capitulation this week and we love that term given recent trends in the stock market. We've sold off a lot, with the S&P 500 down a little over 17% from its highs of 2021, climbing out of a bear market in the last couple of weeks. According to Investopedia, capitulation describes the dramatic surge of selling pressure in a declining market or security that marks a mass surrender by investors. The resulting drop in market prices can mark the end of a decline, since those who didn't sell during a panic are likely to do so soon after. Capitulation typically follows significant downturns in price, which can take place even as investors remain bullish. As the downturn accelerates, it reaches a point where the selling by the investors unwilling to suffer further losses snowballs, leading to a dramatic plunge in price.

Despite all the selling this year, it kind of feels like we haven't quite seen capitulation, at least just yet. On the other hand, the research team at JPMorgan just pointed out that a record 12% of U.S. companies were trading beneath their cash and short-term investments. That's the highest level we've seen going all the way back to 1990, which tells us that even a sizable chunk of companies are not even being credited with the assets on their books. That kind of does feel like capitulation. But if you remember what Dan Niles told us last week, he thinks we could see another drop of 20 to 30% in the S&P 500 as companies report results that could underwhelm investors. We'll see this week, but maybe we are standing on the precipice. Capitulation on one side, a return to buying on the other. Or maybe we're just going to hang out here for a while until investors are compelled to keep selling or start buying. Good suggestion, Michael. A pair of Investopedia's sweetest socks are coming your way.