Chile Outlook Improves But Copper Rally Overdone

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The Chilean peso has been on a tear, boosted by rising copper prices.  We think the copper rally is overdone, but the growth outlook has improved while political uncertainty may pick up as November elections approach.

POLITICAL OUTLOOK

President Bachelet is in the final year of her second 4-year term.  Despite ending her first term (2006-2010) with record high approval ratings, Bachelet has struggled in her second term.  Sluggish growth is one factor, but so apparently is voter discontent with the status quo.

Her 32% approval rating in July is up from lows near 20% last year, but she is still fighting lame duck status.  The government recently introduced a bill to legalize gay marriage.  The government has also proposed changes to the national pension system.  The reforms include boosting the mandatory contribution to 15% from 10% currently.

Elections will be held on November 19.  A run-off between the top two candidates will be held on December 17 if no one wins a majority in the first round.  Polls suggest former President Sebastian Pinera (2010-2014) is the frontrunner.  Yet we see risks that voters opt for a non-traditional candidate.  The center-left (Nueva Mayoria) and center-right (Chile Vamos) coalitions have been taking turns ruling the country since the end of the dictatorship, and voters may truly want a change.

The main non-traditional candidates are Alejandro Guillier and Beatriz Sanchez.  Guillier is a former journalist and is currently an independent senator.  Sanchez is also a former journalist and is backed by the left-wing Frente Amplio coalition.   Both are polling behind Pinera, but a lot can still happen between now and November.

Chile scores well in the World Bank’s Ease of Doing Business rankings (57 out of 190 but down from 55 in 2016).  Its best categories are dealing with construction permits and protecting minority investors, while the worst are paying taxes and getting credit.  Chile does even better in Transparency International’s Corruption Perceptions Index (24 out of 176 and tied with the Bahamas and UAE).

ECONOMIC OUTLOOK

After a protracted slowdown, the economy is finally picking up.  GDP growth is forecast by the IMF to accelerate modestly to 1.7% in 2017 from 1.6% in 2016, before picking up to 2.3% in 2018.  GDP rose 0.9% y/y in Q2, the strongest rate since Q3 2016.  Monthly data so far in Q3 suggest further improvement, so we see modest upside risks to the growth forecasts.

Price pressures remain low, with CPI rising only 1.7% y/y in both June and July.  This is the lowest rate since October 2013, and is below the 2-4% target range.  However, PPI rose a cycle high 10% y/y in July and points to rising pipeline price pressures that warrant caution on the part of policymakers.  August CPI will be reported next Friday and is expected to accelerate to 1.9% y/y.

This supports the case for steady rates, and we believe the central bank will remain on hold for the time being.  The next policy meeting is September 14, and no change is expected then.  Indeed, the central bank signaled an end to the easing cycle after its last 25 bp cut to 2.5% back in May.

Fiscal policy has deteriorated due to low copper prices.  The budget deficit came in at an estimated -3.0% of GDP in 2016, and it is expected to remain around -3% in both 2017 and 2018.  However, much will depend on copper prices.

Chile ran a budget surplus from 2004-2008.  The commodity windfall was used to modify the Copper Stabilization Fund in 2006 by splitting it into the Pension Reserve Fund and the Economic and Social Stabilization Fund.  The string of surpluses was interrupted by the global financial crisis, but the budget returned to surplus in 2011 and 2012.  Since then, Chile has run deficits every year.

The external accounts should remain in solid shape.  Low copper prices have hurt exports, but the sluggish economy helped reduce imports.  Those trends are reversing.  The current account deficit was about -1.4% of GDP in 2016, and is expected by the IMF to remain there in 2017 before widening to -1.7% in 2018.

China is by far Chile’s largest export market, followed by the US and Japan.  Data suggest the mainland economy is stabilizing, but probably not by enough to justify the 27% rally in copper since late December (49% since late October).

Foreign reserves remain steady.  At $38 bln in July, they cover nearly 6 months of import and are over twice as large as the stock of short-term external debt.

INVESTMENT OUTLOOK

The peso has done well even after a strong 2016.  In 2016, CLP rose 5.5% vs. USD and was behind only the best performers BRL (22%), RUB (20%), ZAR (13%), and COP (6%).  So far in 2017, CLP is up 7% YTD and is amongst the top EM performers.  Ahead of it are MXN (16.5%), THB, (8%), and KRW (7%).  Our EM FX model shows the peso to have WEAK fundamentals, so this year’s outperformance is likely to ebb.

Earlier this week, USD/CLP had dropped to 623, the lowest since June 2015.  After a modest corrective bounce, the pair seems poised to test the May 2015 low near 593.  After that is the October 2014 low near 574.

Chilean equities are outperforming EM after a strong 2016.  In 2016, MSCI Chile rose 14% vs. +7% for MSCI EM.  So far this year, MSCI Chile is up 28% YTD and compares to 27% YTD for MSCI EM.  This modest outperformance should ebb, as our EM Equity model has Chile at an UNDERWEIGHT position.

Chilean bonds have underperformed.  The yield on 10-year local currency government bonds is -1 bp YTD.  This is near the bottom of the EM pack, ahead of only the worst performers China (+64 bp), Czech Republic (+53 bp), Korea (+20 bp), the Philippines (+4 bp), and India (+2 bp).  With inflation likely to start rising and the central bank eventually forced to tighten, we think Chilean bonds will continue underperforming.

Our own sovereign ratings model showed Chile’s implied rating falling a notch this quarter to BBB+/Baa1/BBB+.  The fall in copper prices has taken a toll and actual ratings of A+/Aa3/A are still facing downgrade risks.  Indeed, Fitch recently cut Chile one notch to A while Moody’s moved the outlook on its Aa3 rating from stable to negative.  This comes after S&P cut Chile one notch to A+ back in July.