Chile faces challenges ahead due to the end of the commodity boom. While macro policies have remained prudent, the nation nevertheless is struggling with the aftershocks.
President Bachelet’s popularity remains low. She has been hurt by corruption scandals as well as the economic slowdown. However, the blame seems to be evenly spread, as public confidence in both main coalition groups (center-left Nueva Mayoria and center-right Chile Vamos) has fallen to multi-decade lows.
Municipal elections will be held in October. The results should provide some clues to the national elections in November 2017. At this point, the main contenders are likely to be former presidents. Nueva Mayoria could nominate Ricardo Lagos, while Chile Vamos could nominate Sebastian Pinera. Senator Isabel Allende, daughter of former president Salvador Allende, has expressed interest in running as the Nueva Mayoria candidate.
Bachelet is likely to focus in the last part of her term on completing promised reforms in education and labor. Her tax reforms have so far not proven to be disastrous, as many predicted. However, spending plans have clearly been curtailed by the reality of low copper prices.
The economy remains sluggish. GDP growth is forecast at 1.5% in 2016 and 2% in 2017 vs. 2.1% in 2015. GDP rose 2% y/y in Q1, but is tracking around 1.5% in Q2 so far. For now, the growth forecasts seem realistic but much will depend on copper prices. So far this year, the price is averaging $2.13/lb and compares to $2.50/lb in 2015.
Cochilco recently maintained its price forecasts for 2016 and 2017 at $2.15/lb and $2.20/lb, respectively. However, it cut its global copper demand growth forecasts to 1.1% and 1.8% from 1.8% and 2.1% previously. It sees global copper supply rising 3.5% this year and 3.2% next year. There is a lot of supply coming on line this year from Peru, which has a better cost structure for producing copper than Chile. China is by far Chile’s largest trading partner and export destination. Growth there continues to slow, and so demand for copper is likely to remain subdued.
Price pressures are easing, with CPI rising 4.2% y/y in June. July CPI will be reported Monday, and inflation is expected to fall to 3.9% y/y. This would be the lowest rate since November and would signify a return to the 2-4% target range. We believe interest rates have peaked, and that the next move is likely to be a rate cut near year-end or perhaps early 2017. The central bank next meets August 11, and no change is expected then. The central bank has been on hold since the last 25 bp hike back in December took the policy rate to the current 3.5%.
Fiscal policy has remained prudent. Unlike many of the commodity exporters, Chile was well-prepared for the downside of the commodity cycle. Bachelet’s tax reform raised the corporate tax rate to 22.5% (it will rise to 25% in 2017) , and the added revenue will help fund promised improvements to education, health and infrastructure. The budget deficit came in around -3% of GDP in 2015. It is expected to narrow slightly this year this year to -2.8% and -2.5% in 2017. Here too, much will depend on copper prices. The government has already enacted several rounds of spending cuts in response to the loss of revenue from lower copper prices.
The external accounts bear watching. Lower copper prices have hurt exports, but low oil and energy prices have helped reduce imports. The current account gap was about -2% of GDP in 2015, and is expected to remain near that in both 2016 and 2017. Foreign reserves have risen modestly from the lows. At $39.7 bln in June, they cover nearly 7 months of import and are about 2 times larger than short-term external debt. Chile has very low external vulnerabilities compared to other EM commodity exporters.
The peso has outperformed this year after a weak 2015. In 2015, CLP lost -14% vs. USD. This was only slightly better than the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), TRY (-20%), and RUB (-20%). So far this year, CLP is up 8% YTD and is trailing only the best performers BRL (+23.5%), ZAR (+13%), and RUB (+12%). Our EM FX model shows the peso to have WEAK fundamentals, so this year’s outperformance should ebb a bit.
Much of last year’s weakness was driven by plunging copper prices, which have recovered a bit this year after hitting a low in January. The correlation between CLP and copper prices stands at around -0.55, down from the March peak near -0.70. If copper prices continue to weaken, then the peso should also come under some pressure.
Chilean equities have outperformed this year after underperforming slightly in 2015. Last year, MSCI Chile was -19% while MSCI EM was -17%. So far in 2016, MSCI Chile is up 17% YTD, and compares to 10% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Chile at an OVERWEIGHT position, up from NEUTRAL in Q2.
Chilean bonds have underperformed this year. The yield on 10-year local currency government bonds is about -29 bp YTD. This is ahead of only China (-6 bp), Czech (-20 bp), Poland (-22 bp), and Mexico (-26 bp). With inflation likely to continue falling and the central bank’s next likely move to be a cut, we think Chilean bonds will start outperforming.
Our own sovereign ratings model gives Chile an implied rating of A-/A3/A-. As such, we see downgrade risk to actual ratings of AA-/Aa3/A+.