Chilean Shares Now Merit Market Neutrality in Light of Renewed Economic Weakness

Chile remains a bastion of conscientious economic policymaking owing to its stable polity and responsible leadership.  However, ahead of the election last December and inauguration last March of Michelle Bachelet to a second inconsecutive presidential term, macroeconomic trends in the world’s largest producer of copper had been taking a turn for the worse in the face of inauspicious headwinds from declining global demand stemming from the relapse in Western European and slowdown in emerging market industrial output.  Even though Chile sports the highest credit rating (AA-) in Latin America, both the policymaking and economic atmospheres pose potential near-term challenges for the Bachelet administration that convinces us in Global Markets Intelligence (GMI) to recommend a downgrade to market-weight of the nation’s equity market.

A murky economic outlook is compounding market uncertainty over fiscal policy, thus hampering investor confidence in and debilitating the performance of the nation’s shares market.  Having receded 7.1 percentage points from its peak three and a half years ago to a 2.1 percent annual rate of advance in the second-quarter of 2014, Chilean real GDP growth is unlikely to dip into recession, but will struggle to regain upside momentum through year-end and much of 2015.  An expansion of the budget deficit as a proportion of nominal GDP to two or more percent next year to fund the government’s reform program should be outweighed by further debility in private consumption owing to rising unemployment and declining real wage gains as well as weakening capital formation by businesses despite comparatively accommodative credit conditions.  Merchandise trade too will remain a depressant on the real economy as subsiding exports (especially of copper), irrespective of persistent peso depreciation, engulf decreasing imports to contract the visible trade surplus through next year.

Elected to a second term of office on a platform pledging to narrow socio-economic and educational disparities, President Bachelet is tackling the daunting dual tasks of negotiating and navigating the authorizing legislation through Congress to its ultimate enactment and balancing the cost of her ambitious reform agenda with the expectations of Chile’s creditors and electorate.  In view of the fact that her coalition won majorities in both the lower and upper houses (Chamber of Deputies and Senate, respectively) of the national legislature, Bachelet seems to have limited leeway to maneuver given the constellation of parties and interests comprising the ruling center-left Nueva Mayoria alliance.

Nevertheless, the president is expected to fulfill many, if not most, of her promises via fiscal, educational and constitutional initiatives.  In so doing, foreign investors are concerned as to whether or not their implementation will compromise the country’s reputation for managing the public finances prudently.  Bear in mind, though, Bachelet never put at risk Chile’s credit standing in any annual budget proposed to and enacted by Congress during her prior presidential term.

Public statements of late by President Rodrigo Vergara of the Banco Central de Chile confirm the end of credit relaxation.  Having bottomed at three percent, the monetary policy rate had been cut 225 basis points since January 2012 to recharge domestic investment and demand.  Yet, with the rate of inflation having accelerated to 4.9 percent and likely to surpass five percent in the months to come, the directional bias of monetary policy of the central bank is expected to shift to a tightening stance to abate price pressures within the 2-4 percent target range, entailing further setbacks to consumer and business spending.

From an absolute valuation perspective, the Santiago stock exchange’s positive-adjusted, one-year forward price-earnings multiple (p/e) of 17.8x in US dollar terms is comparatively expensive when measured against that of Brazil (11.1x), Argentina (12.2x), Peru (13.9x) and Colombia (14.9x), but inexpensive vis-à-vis Mexico’s 19.6x forward multiple.  Moreover, while it understates its record high of (29.6x), it is firmly above its historical low (8.8x) and approaching its all-time high (18.2x).  Still, compared with its overall bellwether – the MSCI Latin America index, the IPSA appears 0.51 point undervalued on a relative basis, which normally would favor a multiple expansion were it not for unpromising economic prospects and conflicting policy objectives.

Considering the economic prognosis and policy uncertainty, our rerating of the Chilean stock market to market neutrality conveys our belief that Bachelet’s reform program will not imperil the trust of overseas investors by overstretching fiscal resources for any significant length of time to the long-term disadvantage of its renowned commitment to budgetary discipline.  Nonetheless, mixed financial and credit policy goals and moderating economic activity spell more downside volatility on an equity market that has already lost 7.3 percent in value year-to-date in US dollar terms.  For risk-eager investors desiring a targeted exposure in Chilean equities, they would be well advised to steer clear of the mining sector until a trough is reached in the descending path of copper prices and concentrate their holdings in infrastructure-related and low-beta consumer staples shares.

Subscribe to Insights