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Argentina: What Was Old Is New Again

May 12, 2016

My firm has consistently taken the position that emerging market investors should consider a blended emerging and frontier market exposure when investing in developing markets.

Our arguments are predicated on the observation that the designation of whether a country is frontier or emerging is a relatively arbitrary one made by the index providers, and that having a broader palette of strategic holdings allows investors to potentially benefit from the low correlation and unpredictable occurrences of outsized returns characteristic of these markets.

In the case of frontier market countries, a material part of the appreciation in a country’s stock market can take place prior to its reaching emerging status, due to the slow-moving nature of the index-maker’s internal process. The recent events in Argentina provide a vivid illustration of these arguments.

Argentina has had a fraught history, with multiple bouts of economic collapse, military dictatorships, and social turmoil. Even in the last 15 years, what was once one of the largest Latin American equity markets has shriveled dramatically due to numerous self-inflicted wounds.

These include two defaults on its sovereign debt, the nationalization of a number of its largest private companies, and, in the late 2000’s, instituting a restrictive regime of capital and currency controls. This last move proved to be the last straw for indexing firm MSCI, which downgraded Argentina’s status from emerging to frontier in 2009 – effectively removing it from most emerging market portfolios.

Since the downgrade, the government has continued its retreat from the global capital markets, including a particularly contentious battle with owners of its defaulted sovereign bonds. The country’s onerous capital controls (investors were required to deposit 30% of incoming funds in an interest-free bank account for one year) made foreign ownership of its equities all but impossible, and those investors still interested in gaining Argentine exposure were consigned to the ADR market.

Despite these challenges, those who continued to hold exposure to Argentina benefited, with index returns of 66.0%, 19.0% and -0.50% for calendar years 2013, 2014, and 2015 respectively.

For context, these returns handily outpaced the MSCI Emerging Markets Index for each of these calendar years.

Matters changed unexpectedly – and quickly – at the end of 2015.

Argentina's long-time ruling party was unexpectedly voted out of office and the new government moved swiftly to reach an accommodation with its creditors, resolving a series of court challenges in quick order to close out this chapter in its financial history.

The country also began to aggressively unwind its capital and currency controls, signaling a deep desire to re-ignite trade and allow foreign ownership of its stocks. Investor reaction has been equally swift, with Argentina’s most recent bond issuance oversubscribed (with press reports that the $15bn issuance currently has investor demand to the tune of $70bn), and Argentine equity markets outpacing both emerging and frontier market indexes on a year-to-date basis.

With all this positive news came speculation that MSCI was to consider changing Argentina from frontier back to emerging market status. However, due to the intricacies of the index-provider’s process, this graduation will most likely not happen until 2018, by which time, arguably, any outsized returns from Argentina’s economic liberalization measures will be priced into the market.

Given the delay in emerging status being conferred by the index providers, as well as the observation that returns were not overly punishing for those who stuck with Argentina, it can be argued that a better choice for emerging market investors may be to invest in a strategy that includes a relatively static allocation to a diversified set of frontier market countries.

The motivation for investment in both markets is the same: seeking to capture the growth opportunities present in the less-developed economies of the world. The size distinction between frontier and emerging is in many ways artificial with regards to this thesis, further reinforcing the argument to include an allocation to both classes in emerging markets portfolios. Finally, the long process in moving a country from frontier to emerging allows much of the gains from this positive news to be realized prior to graduation, as was the case in 2014 for Qatar and UAE, and appears will be the case for Argentina.