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iShares MSCI Chile Capped ETF (NYSE:ECH) is the largest and most liquid Chile country-specific, exchange-traded fund with assets of $340 million. The ETF has been trending lower and underperforming broad global indexes down 5.5% YTD in 2019, and effectively in a bear market down 23% over the past year. The returns are largely a reflection of the weaker Chilean peso currency that has been pressured by falling copper prices. Recent data also suggest softer domestic demand fundamentals in Q1 are weighing on sentiment. This article highlights macro developments in the country and reflects on the direction of the major equities in ECH.
ECH weekly price chart. source: FinViz.com
Macro Update
Latin America is facing a widespread deceleration of economic activity with a combination of country-specific factors and the impact of growing global growth uncertainty. Chile doesn’t have the large fiscal or external account imbalances that are present in some of the other major countries in the region, but nevertheless remains exposed to growing external uncertainties and weaker emerging-market sentiment.
Chile Monthly Activity Indicator. Source: Chile Central Bank/ graph by author
The ‘IMACEC’ monthly activity index posted a 1.9% year-over-year growth in April which has trended lower for the past year since peaking at 5.9% in May of 2018. The softness is related to a decline in mining, down 4.5% y/y in 1Q19, while non-mining activity slowed to 2.5% y/y from 3.7% in Q4 2018. Chile’s annual GDP growth for 2018 was an overall solid 4%. Itau Bank Economics Research has become more pessimistic forecasting a deceleration to 3% in 2019.
Chile CPI and Central Bank Rate. Source: TradingEconomics.com
More domestic-based services sectors and consumption fundamentals have been more resilient this year. Low inflation last reported at an annual rate of 2.0% remains a pillar of stability for the economy and is supporting real wage growth. There appears to be some flexibility for the Central Bank to cut rates to support growth although Central Bank comments suggest that it intends to hold the policy rate steady for the immediate future with a view that longer term inflation forecasts remain anchored at the 3% target level. Meeting minutes showed the Central Bank board is becoming more concerned with potential impacts of external shocks on activity. Given the more recent financial market volatility and weakness in copper prices, which would impact exports and investment demand, the risk is that these forecasts could be revised even lower.
Copper Prices
Copper is the country’s main export and driver of investment activity across multiple sectors. Despite a rebound in the first quarter, futures prices are now down 12% from the high of 2019, approaching the significant $2.50 which has acted as a support since 2017. A conclusion to the U.S.-China trade dispute, one way or another, will likely be necessary for copper to break out of a relatively tight trading range over the past year. Higher prices would be positive for investment demand and mining activity in Chile. The commodity is largely a barometer for the Chinese economy and global trade sentiment in my opinion. Changes in sentiment towards Chile and emerging markets in general going forward will likely be reflected in the direction of copper prices.
Copper Futures Price Chart. Source: Finviz.com
FX
Another important macro theme in Chile is the trend lower of the Chilean peso. Approaching the CLP $700 per USD level, the peso has depreciated about 11% over the past year. The historical record for the exchange rate over CLP $730 was reached in early 2016 amid the deep collapse of commodity prices and poor emerging market sentiment globally. It now appears the peso is trending again towards that level but this time in a more controlled manner for the time being. Note the higher exchange rate here represents a depreciation in the peso.
Chilean Peso per US Dollar. Source: Business Insider
Factors driving this move include below-potential growth, a marginally weaker fiscal position and wider current account deficit in recent years. Chile, traditionally seen as the strongest sovereign credit in Latin America, was downgraded by S&P Ratings in 2017 to A+ and Moody’s to A1 in July of last year with both agencies citing the higher trend of public debt. My view is that there is little to suggest the currency will significantly rebound in the near term given current global conditions. A weaker peso will directly pressure Chilean equity returns denominated in USD and remain a key risk for ECH investors.
ECH Analysis
What I like about the iShares exchange-traded fund for Chile is that it is relatively well-diversified across sectors and offers investors exposure to domestic cyclical themes. Utilities with a 22% weighting followed by financial services at 21% highlight the connection with domestic factors. This is in contrast to some other country-specific ETFs that are highly concentrated on a single stock or overly exposed to commodity exporters. ECH with an expense ratio of 0.59% is a good option for investors to take a bullish or bearish opinion on the economy.
ECH includes a number of holdings including retailers Falabella SA with a weighting of 8.04% and Cencosud SA with a weighting of 3.93% that are not traded on a U.S. exchange, highlighting one of the benefits of this ETF. ECH includes a number of local banks and utilities that will move based in part on cyclical trends in the economy. Among the holdings with actively traded single stock ADRs, the performance over the past year highlights the weakness in Chilean equities’ USD based returns.
- Banco Santander Chile SA (NYSE:BSAC) down 15.5% 1 year
- Banco de-Chile (NYSE:BCH) down 9% 1 year
- Sociedad Quimica y Minera de Chile S.A. (NYSE:SQM) down 42% 1 year
- Enel Chile SA (NYSE:ENIC) down 24% year
- Embotelladora Andina S.A. (AKO.B) down 28% 1 year
Data by YCharts
Conclusion
Investors are reminded that currency risk is a primary factor to consider when investing in foreign stocks. Chile is a structurally strong economy with solid fundamentals. Near term, below-potential economic growth and external uncertainties will continue to weigh on equities. I’m bearish on the ETF because of my view that there is more downside in the Chilean peso, with my expectation of lower copper prices on a deteriorating global growth outlook. A better-than-expected outcome in the U.S.-China trade dispute along with an improvement of emerging market sentiment would be bullish for ECH.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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