Investors Shouldn’t Get Too Negative on Chile

new ChileWeekend elections in Chile offered up a negative surprise.  Former President Pinera won, but his margin of victory was small and he goes to the second round in a weakened state.  Still, we caution investors not to get too negative as a result of the elections.

POLITICAL OUTLOOK

Polls suggested former President Sebastian Pinera would handily win this weekend’s election.  Instead, he won only 36.6% of the vote.  Alejandro Guillier, an independent running with the support of Bachelet’s Nueva Mayoria coalition, came in second with 22.7%, and will face Pinera in the second-round vote December 17.  Turnout was 46.7%, the lowest since the return of democracy in 1990.

Beatriz Sanchez of the new center-left Frente Amplio alliance was a big surprise, winning 20.3% of the vote.  Before the vote, the polls showed her winning only 8.5% vs. 44.4% for Pinera.  Sanchez now becomes the kingmaker, as Guillier will try to draw support from the other center-left parties.  He has already gotten the support of independent Marco Enriquez-Ominami, who won 5.7% of the first-round vote.

We caution investors not to get too negative on Chile as a result of the elections.  The difference in center-left and center-right policies is not that great, though we note that Bachelet did tilt more leftish in her second term, raising corporate taxes and boosting social spending.  Pinera has promised to cut taxes and boost investment, while Guillier said he would continue Bachelet’s policies.

Rather than politics, we think that copper prices will probably be the major determinant of Chilean asset prices.  During Pinera’s first term (2010-2014), the commodity boom was going full force, with copper prices peaking at more than twice the subsequent lows seen in 2016.  Pinera (like Rousseff and many others) lucky enough to catch the tail end of that boom, and investors should realize that Pinera will not be a panacea for Chile’s woes.

Chile scores highly in the World Bank’s Ease of Doing Business rankings (55 out of 190).  The best components are dealing with construction permits and getting electricity, while the worst are getting credit and paying taxes.  Chile does even better in Transparency International’s Corruption Perceptions Index (24 out of 176 and tied with the Bahamas and UAE).

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to decelerate modestly to 1.4% in 2017 from 1.6% in 2016, before picking up to 2.5% in 2018.  GDP rose 2.8% y/y in Q1, the strongest rate since Q3 2015.  Monthly data so far in Q3 suggest some modest improvement, and highlights some upside risks to the growth forecasts.

Price pressures remain low, though CPI accelerated to 1.9% y/y in October from the cycle low of 1.4% in September.  Inflation has remained below the 2-4% target range since June.  However, core inflation is edging higher even as PPI inflation has spiked to double digits.  Nominal wage growth has been limited, but falling unemployment suggests upward pressure on wages will intensify.

This supports the case for steady rates, and we believe the central bank will keep rates steady when it next meets December 14.  The bank has signaled that the easing cycle is over, and we think it will tilt more hawkish if price pressures continue to rise.  The latest central bank survey shows that the market expects one hike in 2018, one in 2019, and one in 2020.

Fiscal policy has remained prudent despite the end of the copper boom.  Copper revenues account for around a quarter of government revenue.  As such, the drop in prices necessitated several rounds of fiscal tightening.  The budget deficit came in at an estimated -2.7% of GDP in 2016.  The OECD expects the deficit to widen to -3.1% of GDP in 2017 before narrowing to -2.7% in 2018.

The external accounts are likely to worsen.  Low copper prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was -1.4% of GDP in 2016, and the IMF expects it to widen to -2.3% in 2017 and -2.8% in 2018.

Foreign reserves have risen to near record highs.  At $39.3 bln in October, they cover nearly 6 months of import and are nearly 2 ½ times larger than the stock of short-term external debt.  Higher copper prices should see reserves rise further.

INVESTMENT OUTLOOK

The peso has held up well after a good 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 5% YTD and is in the middle of the EM pack.  The best performers are KRW (10%), THB (9%), MXN (9%), and MYR (8%).  Our EM FX model shows the peso to have NEUTRAL fundamentals, so this year’s so-so performance is likely to continue.

USD/CLP has traded largely in the 615-640 range since August.  Now, the pair is poised to test the October 2 high near 642.  Retracement objectives from the July-September drop come in near 641 (50%) and 647 (62%).  The 200-day moving average comes in near 650.

The correlation between copper and CLP is currently around 0.47, down from over 0.60 back in October.  After flirting with the 200 level in 2016, the near month copper futures contract has rallied to 309, nearly 60% from the lows.  The rally has faltered recently, as global copper stockpiles are rising.

Chilean equities are underperforming EM after a strong 2016.  In 2016, MSCI Chile rose 14% vs. 7% for MSCI EM.  So far this year, MSCI Chile is up 26.3% YTD and compares to 32.5% YTD for MSCI EM.  This modest underperformance should continue, as our EM Equity model has Chile at an UNDERWEIGHT position.

Chilean bonds have performed OK recently.  The yield on 10-year local currency government bonds is about +13 bp YTD.  This is in the middle of the EM pack.  The worst performers are Czech Republic (+148 bp), Turkey (+144 bp), and China (+94 bp), while the best are Indonesia (-129 bp), Brazil (-120 bp), and Peru (-101 bp).  With inflation likely to continue rising and the central bank eventually likely to tighten, we think Chilean bonds will start underperforming more.

Our own sovereign ratings model showed Chile’s implied rating steady at BBB+/Baa1/BBB+ after falling a notch last quarter.  The fall in copper prices has taken a toll and actual ratings of A+/Aa3/A are still facing downgrade risks, as Fitch’s recent downgrade suggests.