Chilean Underperformance Likely to Continue Until Copper Stabilizes

Chile

Despite strong fundamentals, Chile continues to be buffeted by lower copper prices and generally negative sentiment on EM. We expect Chilean assets to continue underperforming until the outlook for copper stabilizes.

POLITICAL OUTLOOK

President Bachelet remains very unpopular at the halfway point of her second term. Municipal elections in October 2016 will be watched for clues to the next presidential and congressional elections in November 2017. A weak economy and a possible corruption scandal involving her son have taken a toll on Bachelet’s standing. However, she cannot run again and there is speculation that another former president (Pinera) will be a candidate.

Bachelet has tilted more left in her second term, after governing from near the center in her first term from 2006-2010. Her two economic priorities when campaigning were education and fiscal reforms. While many were concerned about her plans to increase corporate taxes, we think that the bearish commodity story is the biggest challenge ahead.

The third area of reform that Bachelet pledged is political. Chile is in the process of drafting a new constitution to replace the 1980 Pinochet-era version. The process begins with a “civic education” phase that will run until March 2016, followed by a public dialogue with citizens whose results will be presented to the executive branch in October 2016. Results will then be used to draw up a draft constitution that will be presented to Congress in H2 2017.

 

ECONOMIC OUTLOOK

Chile reports Q3 GDP Wednesday, and is expected to grow 2.1% y/y vs. 1.9% in Q2. Copper remains a key driver for Chile, and the news here is not good. Copper is making new cycle lows, and is on track to test the 2008 low near 125. With global demand for industrial commodities likely to remain soft due to sluggish growth, that 125 low could be breached on the way to the November 2001 low near 60.

The external accounts have improved, however, as plunging exports have been offset by weaker import demand. The current account gap is expected to narrow to -0.5% of GDP this year from -1.2% in 2014 and the recent peak of -3.7% in 2013. Foreign reserves have remained stable near $38 bln this year, equal to 5 months of imports.

CPI rose 4.0% y/y in October, right at the top of the 2-4% target range but well below the cycle peak of 5.7% y/y from last October. Disinflation should continue, though the weak peso will likely see some pass-through into inflation ahead. The latest central bank survey shows market expectations for inflation to move back to the 3% target over the course of 2016 and 2017.

The central bank last week left rates steady at 3.25%, as expected. Central bank President Vergara said recently that one or two more rate hikes are likely over the next year. The latest central bank survey shows market expectations for 50 bp of tightening by end-2016, followed by one more 25 bp hike to take rates to a likely plateau of 4.0% for the next 23 months. The policy outlook is being complicated by the renewed slide in copper to new cycle lows, which will weigh on growth ahead.

 

INVESTMENT OUTLOOK

The peso is one of the weakest performers in EM, -15% YTD against the dollar. This compares to -30% for BRL, -23% for COP, -20% for MYR, and -19% for both TRY and ZAR. The peso is well correlated with copper, at nearly .65 on a rolling 60-day basis. With copper making new cycle lows and on target to test the 2008 and perhaps even the 2001 lows, USD/CLP is likely to continue making new cycle highs on the way to testing the all-time high near 760 from October 2002. Our EM FX model shows the peso to have some of the weakest fundamentals in EM.

Chilean equities are underperforming slightly within EM. MSCI Chile is down -17% YTD, and compares to -14% YTD for MSCI EM. Our EM Equity model has Chile at a surprising OVERWEIGHT position, up from NEUTRAL the previous quarter despite the underlying weak macro outlook.

Chilean bonds have held up OK this year. The yield on 10-year local currency government bonds is +58 bp YTD. This is in the underperforming camp, and compares to the worst performing group that includes Brazil (+309 bp), Turkey (+184 bp), Peru (+169 bp), and Colombia (+118 bp). With inflation likely to fall and thus keeping the central bank from being too hawkish, we think Chilean bonds could start outperforming.