Chile Faces Heightened Recession Risks

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Chile is facing heightened recession risks despite the bounce in copper prices.  The central bank is likely to continue easing, but fiscal stimulus will be more difficult to enact. 

POLITICAL OUTLOOK

The ruling center-left coalition Nueva Mayoria’s (NM) losses in the October municipal elections does not bode well for its prospects in the presidential and general elections on November 19th.  President Bachelet’s popularity during her second term has been hurt by several corruption scandals, the weak economy, and a poorly executed structural reform agenda.

It appears that the center-right Chile Vamos could win this fall, likely led by former President Pinera.  Yet one has to wonder why ex-presidents are simply taking turns coming back into power.  Aren’t there any fresh faces?  Possibly.  Polls are showing rising support for leftist independent Senator Guillier.  A former journalist, he is seen as the anti-establishment candidate.

Furthermore, Fernando Atria from the ruling NM is a potential candidate that favors rolling back neo-liberal economic policy of the past few decades.  Whatever happens, it’s clear that Chile is going through an identity crisis that’s perhaps intensified by the end of the commodity boom.  While our base case is policy continuity, the risks of a break with past policy are rising.

A strike at the Escondida copper mine is in its second month.  Last week, BHP increased its wage offer.  This week, BHP is meeting with union leaders for the first time in a month.  However, union officials said the agenda would be limited to three points:  1) maintaining benefits, 2) not increasing hours, and 3) no differentiating between new and existing workers.

ECONOMIC OUTLOOK

The economy is still slowing.  GDP growth is forecast by the IMF to accelerate modestly to 2% in 2017 from 1.7% in 2016.  However, Q4 GDP growth was just reported at 0.5% y/y, which is the slowest rate since Q3 2009.  The central bank is likely to revise down its 1.5-2.5% growth forecast for 2017 in its quarterly monetary policy report out in early April.

Higher copper prices should help boost growth in 2017, but a strike at the Escondida mine (the world’s largest) is limiting output.  There are also growing doubts about the sustainability of this rally, as global copper stockpiles as measured by the LME have risen back to January highs.  For the near month copper contract, a break of the December low near 245 would signal a deeper correction.

Price pressures are falling, with CPI decelerating to 2.7% y/y in February.  This matches the cycle low from December and is below the 3% target.  Inflation has been in the 2-4% target range for seven straight months.  This supports the case for continued easing.

The central bank started the easing cycle a 25 bp rate cut in January to 3.25%.  It stood pat in February and then cut rates 25 bp this month to 3.0%.  The next policy meeting is April 13.  Markets are currently pricing in only one more cut this year, but we think this underestimates the potential easing.  If current trends continue, the policy rate could hit 2% by year-end.

Fiscal policy needs consolidation in light of low commodity prices and 2013-2016 stimulus.  Yet unlike many of the commodity exporters, Chile was relatively well-prepared for the downside of the commodity cycle.  Starting this year, the structural deficit will be narrowed by 0.25 percentage points per annum.  The budget deficit came in at an estimated -3% of GDP in 2016, and is expected to remain steady in 2017 before narrowing to -2.5% in 2018.

The external accounts bear watching.  Lower copper prices have hurt exports, but low energy prices and the sluggish economy have helped reduce imports.  The current account gap was about -1.5% of GDP in 2016, and is expected to widen slightly to -2% in 2017.  Foreign reserves have remained fairly steady and at $39.7 bln in February, they cover nearly 7 months of import and are almost 3 times larger than short-term external debt.

INVESTMENT OUTLOOK

The peso has underperformed after a stellar 2016.  In 2016, CLP rose 5.5% vs. USD and was behind only BRL (+22%), RUB (+20%), ZAR (+12.5%), and COP (+6%).  So far in 2017, CLP is up nearly 2% YTD and is ahead of only MYR (+1%), IDR (+1%), CNY (+1%), PHP (-1%), and TRY (-3%).  Our EM FX model shows the peso to have NEUTRAL fundamentals, so this year’s underperformance should ebb a bit.

Chilean equities have also done well after a strong 2015.  In 2016, MSCI Chile was up 14% vs. 7% for MSCI EM.  So far this year, MSCI Chile is up 13% YTD and compares to 13% YTD for MSCI EM.  This market performance is to be expected, as our EM Equity model has Chile at a NEUTRAL position.

Chilean bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -9 bp YTD, which is in the middle of the EM pack.  With inflation likely to continue falling and the central bank likely to cut rates several times this year, we think Chilean bonds should start outperforming.

Our own sovereign ratings model shows Chile’s implied rating at A-/A3/A-.  The fall in copper prices has taken a toll on the nation, and we believe actual ratings of AA-/Aa3/A+ are facing some downgrade risks.