Headwinds Building for Chilean Economy

Chile inflation is running at its highest since April 2017. The central bank is likely to start the tightening cycle in Q4, but the economy may face other headwinds from lower copper prices. We are neutral on the peso but negative on Chilean bonds and equities.

POLITICAL OUTLOOK

Sebastian Pinera took office this March after being elected to a second non-consecutive 4-year term in December. He won with 54.6% of the vote in the second round after failing to win a majority in the first round with 36.6%. Pinera beat Alejandro Guillier of outgoing President Bachelet’s New Majority coalition.

In between Pinera’s two terms, former President Michelle Bachelet served her second term. While very popular in her first term, her second one was marred by several controversies, including a corruption case linked to her son. To make matters worse for Bachelet, the economy was sluggish, with growth averaging only 1.8% during that term.

The next elections are scheduled for 2021. Much ink has been spilled on the rightward shift politically in Latin America. The center-left dominated Chile for much of the post-Pinochet period, and so we think it’s too early to write them off now. However, it will have to work hard to recover the popularity lost under Bachelet’s second term.

During Pinera’s first term (2010-2013), the commodity boom was going full force. Copper prices peaked at more than twice the subsequent lows seen in 2016. Growth averaged 5.3% during this term. Pinera (like Rousseff and Lula in Brazil along with many others) was 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.

Indeed, President Pinera recently dropped his proposal to cut the corporate tax rate. Whilst this was one of his major campaign promises, Pinera said that the funds were needed for a broad set of education, health care, and pension reforms. His first state-of-the-nation address of this second term focused on spreading the wealth to more citizens, including women and pensioners. This sounds like a page right out of the center-left playbook.

Chile scores well in the World Bank’s Ease of Doing Business rankings (55 out of 190). The best components are getting electricity and dealing with construction permits, while the worst are getting credit and paying taxes. Chile does even better in Transparency International’s Corruption Perceptions Index (26 out of 180 and tied with Bhutan).

 

A BRIEF HISTORY LESSON

President Salvador Allende was elected by a plurality in 1970. The vote was split between Allende (36%), former right-wing president Jorge Alessandri (35%), and left-wing Radomiro Tomic. Under the prevailing rules, Congress conducted a run-off race between the top two candidates, and Allende won handily by a 153-35 vote.

Allende was a Marxist and belonged to the Socialist Party as part of the Popular Unity. He ran unsuccessfully for president in 1952, 1958, and 1964. His coalition also included the Communist, Radical, Social Democratic, and several smaller parties. Allende embarked on a campaign of expropriating and nationalizing many sectors of the economy, including the important banking and mining industries.

After some initial success under Allende, the economy quickly deteriorated. A bad situation was made worse by US efforts to undermine and destabilize the Allende government. President Nixon reportedly ordered the CIA to “make the economy scream” in order to prevent Allende’s election. Furthermore, declassified documents show post-election correspondence between the US and outgoing Chilean President Frei on how to block Allende’s inauguration, as well as outlining US efforts to promote a military coup and destabilize the economy under Allende.

In September 1973, a military coup ended Allende’s presidency and his life. Whilst many had believed that Allende was assassinated, a forensic analysis conducted in 2011 on his remains concluded that he had committed suicide. The CIA later acknowledged that it was aware of the coup plot but denied any involvement. A senior CIA agent that was stationed in Chile at that time has said the decision not to stop the coup was made by the White House, not by the CIA.

General Augusto Pinochet was then commander of the army and established himself as the head of a four-man military junta. He carried out a brutal campaign of murder, imprisonment, and torture. Indeed, his regime even went so far as to initiate a program to eliminate its political enemies outside of the country. One of the most brazen was the car-bomb assassination in 1976 of former Ambassador Orlando Letelier in Washington, DC. Letelier had served in the Allende government and was imprisoned by the junta but eventually freed on the condition he leave Chile.

Pinochet inherited an economy in crisis. Hyperinflation took hold even as the economy contracted. As such, the regime undertook a radical restructuring that included large-scale deregulation and privatization. These reforms were drafted by a group of US-educated technocrats that became known as “the Chicago Boys.” Chile became one of the first countries in Latin America to embrace free market principles.

Despite human rights abuses too numerous and gruesome to recount here, the economy thrived under Pinochet. It was the very first in the region to win a coveted investment grade rating in 1992 with a BBB from S&P. Pinochet lost his last bid for the presidency in 1988, losing a plebiscite where 56% voted against him. The transition to democracy thus began with the 1990 election, when Patricio Aylwin led the center-left Concertacion coalition to victory. Pinera’s first victory in the 2009 election was the first to break the Concertacion’s post-Pinochet stranglehold on Chilean politics.

 

ECONOMIC OUTLOOK

The economy remains robust. GDP growth is forecast by the OECD at 3.6% in both 2018 and 2019 vs. 1.5% in 2017. GDP rose 5.3% y/y in Q2, the strongest since Q3 2012, and so we see upside risks to the growth forecasts. Last month, Finance Minister Felipe Larrain raised his growth forecast for 2018 from 3.5% to 3.8% and for 2019 from 4.1% to 4.2%.

Price pressures are rising. CPI rose 2.7% y/y in July, the highest since April 2017. However, inflation remains below the 3% target and in the bottom half of the 2-4% target range. PPI inflation has accelerated to 10.1% y/y in June, the highest since October 2017. This points to some acceleration in CPI inflation. In its quarterly monetary policy report in June, the central bank raised its 2018 inflation forecast from 2.3% to 2.8% whilst leaving its 2019 and 2020 forecasts steady at 3%.

The central bank has signaled a likely rate hike in Q4. It has been on hold at 2.5% since the last 25 bp cut back in May 2017. Bloomberg consensus sees the first rate hike in Q4 2018 followed by 25 bp per quarter in 2019. We concur and see no move at the next meeting on September 4.

The fiscal outlook bears watching. Copper accounts for a large share of government revenues, and its recent swoon is worrisome. Larrain is forecasting that copper will average $3.12 this year, but this seems too optimistic given that it is currently trading near $2.65 and barely above the year’s low near $2.55. The budget deficit came in at -2.7% of GDP in 2017, and the OECD forecasts it to narrow to -1.9% in 2018 and -1.6% in 2019. This may be too optimistic.

The external accounts remain in solid shape. The current account deficit was -1.5% of GDP in 2017, and the IMF expects the surplus to widen modestly to -1.8% of GDP in 2018 and -1.9% in 2019. Export growth is solid, but trade tensions and lower copper prices pose some downside risks here. Also, imports are likely to be elevated by high oil and energy prices, putting further pressure on the external accounts.

Foreign reserves have dropped from their peak but remain high. In July, reserves stood at $37.6 bln vs. $39 bln in December. They cover nearly 5 months of imports and are equivalent to almost 2 times the stock of short-term external debt. Lastly, Chile’s Net International Investment Position (NIIP) is around -20% of GDP. Overall, Chile’s external vulnerabilities are low.

 

INVESTMENT OUTLOOK

The peso is underperforming after a middling performance last year. In 2017, CLP rose 8% vs. USD and was in the middle of the EM pack. Compare this to the worst EM performer ARS (-14.5%) and TRY (-7%) as well as the best ones KRW (+13%) and MYR (+11%). So far in 2018, CLP is -8% and is ahead of only the worst performers ARS (-38%), TRY (-38%), BRL (-19%), RUB (-15.5%), ZAR (-13.5%), and INR (-9%). Our EM FX model shows the peso to have NEUTRAL fundamentals, and so we expect underperformance to ebb.

USD/CLP traded at a cycle high on August 20 around 672 before falling slightly. With pressure on EM expected to continue, we see this pair moving even higher. The May 2017 high near 682 Is the next target followed by the May 2016 high near 700. Break of 677 would set up a test of the January 2016 high near 733.

Chilean equities are underperforming after a stellar 2017. In 2017, MSCI Chile was up 39% vs. 34% for MSCI EM. So far this year, MSCI Chile is -14% YTD and compares to -9% YTD for MSCI EM. Our EM Equity Allocation Model puts Chile at UNDERWEIGHT, and so we expect Chilean equities to continue underperforming.

Chilean bonds have outperformed. The yield on 10-year local currency government bonds is +18 bp YTD. This is behind only the best EM performers China (-27 bp), Taiwan (-13 bp), Poland (-11 bp), Korea (-9 bp), Malaysia (+12 bp), and Mexico (+16 bp). With inflation likely to continue rising and the central bank signaling a rate hike in Q4, we think Chilean bonds will underperform more ahead.

Our own sovereign ratings model Chile’s implied rating steady at BBB+/Baa1/BBB+. The fall in copper prices has taken a toll and actual ratings of A+/A1/A are still facing some downgrade risk. Last month, Moody’s downgraded Chile by a notch to A1, citing “the gradual but broad-based deterioration in Chile’s credit profile.” Indeed, all three agencies have downgraded Chile since last July.