Chile
Dear Client, Tomorrow we will publish a debate piece on China shedding more light on the ongoing discussions at BCA on this topic. This report will articulate the conceptual and analytical differences between my colleague, Peter Berezin, and I relating to our respective outlooks on China’s credit cycle. Peter believes that the credit boom in China is a natural outcome of a high household “savings” rate. I maintain that household “savings” have no bearing on credit growth, debt or bank deposit levels. Rather, China’s credit and money excesses are pernicious and will precipitate negative macro outcomes. I hope you will find this report valuable and interesting. Today we are publishing analysis and market strategy updates on Russia and Chile. Best regards, Arthur Budaghyan Chief Emerging Markets Strategist Russia: A Fiscal And Monetary Fortress Underpins A Low-Beta Status Russian financial markets and the ruble have entered a low-beta paradigm. A combination of ultra-conservative fiscal and monetary policies over the past four years will help Russian equities, local bonds as well as sovereign and corporate credit to continue outperforming their respective EM benchmarks. First, both the overall and primary fiscal surpluses now stand at over 3% of GDP (Chart I-1). The authorities have sufficient fiscal leeway to undertake substantial fiscal easing. They have announced a major fiscal spending program, which is planned to be in the order of $390 billion or 25% of GDP, over the next six years. Chart I-1Fiscal Balance Is In Large Surplus Importantly, government non-interest expenditures have dropped to 15.5% of GDP from 18% in 2016. Therefore, it makes perfect sense to ease fiscal policy materially to counteract the impact of lower commodities prices on the economy. What’s more, gross public debt is at 13% of GDP – out of which the foreign component is only 4% of GDP – and remains the lowest in the EM space. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Second, there is scope for the Central Bank of Russia (CBR) to cut interest rates. Both nominal and real interest rates have remained high, particularly lending rates (Chart I-2). Furthermore, growth has been mediocre and inflation is likely to fall again (Chart I-3). Chart I-2Russian Real Interest Rates Are High Chart I-3Russia: Growth Has Been Weakening Prior To Oil Price Decline Although overwhelming evidence warrants lower interest rates in Russia, it is not clear if the ultra-conservative Central Bank Governor Elvira Nabiullina will resort to rate reductions as oil prices and EM assets continue selling off – as we expect. Even if Governor Elvira Nabiullina delivers rate cuts, they will be delayed and small. Hence, real rates will remain high, helping the ruble outperform other EM currencies. Provided the central bank remains behind the curve, odds are that the yield curve will probably invert as long-term bond yields drop below the policy rate (Chart I-4). In short, a conservative central bank will provide a friendly environment for fixed-income and currency investors. Third, the Russian ruble will depreciate only modestly despite the ongoing carnage in oil prices due to high foreign exchange reserves and a positive balance of payments. The current account surplus stands at 7.5% of GDP, or $115 billion. Both the central bank and the Ministry of Finance (MoF) have been buying foreign currency. In particular, based on the fiscal rule, the MoF buys U.S. dollars when oil prices are above $40/barrel and sells U.S. dollars when the oil price is below that level. As such, policymakers have created a counter-cyclical ballast to counteract any negative shocks. A fiscal fortress, as well as the potential for significant fiscal stimulus amid the current EM selloff, will help the Russian currency, local bonds and sovereign and corporate credit markets behave as a lower beta play within the EM universe. Remarkably, the monetary authorities have siphoned out the additional liquidity that has been injected as part of their foreign currency purchases. In fact, the CRB’s net liquidity injections have been negative. This is in contrast to what has been happening in many other EMs. These prudent macro policies will limit the downside in the ruble versus the dollar and the euro. Chart I-4Russia: Yield Curve Will Probably Invert Chart I-5Cash Flow From Operations: Russia Versus EM Finally, rising profits in the non-financial corporate sector and balance sheet improvements justify Russian equity outperformance relative to EM. Specifically, Russian firms’ cash flows from operation have been diverging from EM, suggesting the former is in better financial health than its EM counterparts (Chart I-5). Bottom Line: Even though we expect oil prices to drop further,1 investors should continue to overweight Russian equities, sovereign and corporate credit and local currency bonds relative to their respective EM benchmarks (Chart I-6). Chart I-6Continue Overweighting Russian Stocks And Bonds To express our positive view on the ruble, we have been recommending a long RUB / short COP trade since May 31, 2018. This position has generated a 10.8% gain, and remains intact. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Chile: Heading Into A Recession? Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. Chart II-1Chile's Central Bank Is Behind The Curve The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Chart II-2More Growth Retrenchment In The Next 6 Months Chart II-3Chilean Economy: Certain Segments Are Contracting Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Chart II-5The Chilean Peso Is Not Cheap Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. The main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 1 The Emerging Markets Strategy team’s negative view on oil prices is different from the BCA house view which is bullish on oil. 2 Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3 Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Our recommended strategy2 for Chile has been to (1) receive three-year swap rates, (2) favor local bonds versus stocks for domestic investors, (3) short the peso versus the U.S. dollar, and (4) overweight Chilean equities within an EM equity portfolio. The first three strategies have played out nicely as the economy has slowed, rate expectations have dropped and the peso has plunged (Chart II-1). Yet the Chilean bourse has recently substantially underperformed the EM benchmark, challenging our overweight equity stance. Chart II-1Chile's Central Bank Is Behind The Curve Chart II-2More Growth Retrenchment In The Next 6 Months At the moment, we recommend staying with these recommendations, as the growth slowdown in Chile has much further to run and the central bank will cut rates substantially: Our proxy for marginal propensity to spend among both households and companies – which leads the business cycle by six months – has been falling (Chart II-2). The outcome is that growth conditions will worsen, and a recession is probable. There are already segments of the economy – retail sales volumes, car sales, non-mining exports and mining output, to name a few – that are contracting (Chart II-3). Shockwaves from the global slump in general and China’s slowdown in particular are taking a toll on this open economy. Copper prices are breaking down, and Chile’s industrial pulp and paper prices are falling in dollar terms (Chart II-4). Chart II-3Chilean Economy: Certain Segments Are Contracting Chart II-4Chile: Industrial Paper And Pulp Prices Are Deflating Bank loan growth as well as employment growth have not yet decelerated. The latter are typically lagging indicators in Chile. Therefore, as weakening growth erodes business and consumer confidence, credit growth as well as hiring and wages will retrench. Finally, both core consumer prices and service inflation rates are at the lower end of the central bank’s inflation target band. It is a matter of time before the growth deterioration leads to even lower inflation. We argued in our last analysis on Chile3 that large net immigration has boosted labor supply and is hence disinflationary. This, along with forthcoming hiring cutbacks, will depress wages and lead to lower inflation. Overall, Chile’s central bank is well behind the curve. A major rate reduction cycle is in the cards, as both growth and inflation will undershoot the Chilean central bank’s targets. Lower interest rates, shrinking exports and a large current account deficit will weigh on the exchange rate. In addition, Chilean companies have large amounts of foreign currency debt ($75 billion or 26% of GDP), and peso depreciation is forcing them to hedge their foreign currency liabilities. This will heighten selling pressure on the peso. Notably, the currency is not yet cheap and bear markets usually do not end until valuations become cheap (Chart II-5). Chart II-5The Chilean Peso Is Not Cheap That said, the main reasons to continue overweighting Chilean equities within an EM universe are potential monetary and fiscal easing in Chile that many other EM are not in a position to do amid their own ongoing currency depreciation. Besides, this bourse’s relative equity performance versus the EM benchmark is already very oversold and is likely to rebound as the EM stock index drops more than Chilean share prices. Our recommended strategy remains intact: Fixed-income investors should continue receiving three-year swap rates; Local investors should overweight domestic bonds versus stocks; Currency traders should maintain the short CLP / long U.S. dollar trade; Dedicated EM equity portfolio managers should maintain an overweight in this bourse versus the EM benchmark. One trade we are closing is our short copper / long CLP, which has returned a 1.6% gain since its initiation on September 6, 2017. The original motive for this trade was to express our negative view on copper. While we believe copper prices have more downside, the peso could undershoot, which tips the balances in favor of closing this trade. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña, Research Associate juane@bcaresearch.com Footnotes 2 Please see "Chile: Stay Overweight Equities, Receive Rates," dated May 31, 2018 and "Chile: Favor Bonds Over Stocks," dated February 7, 2019. 3 Please see "Chile: Favor Bonds Over Stocks," dated February 7, 2019.
Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices. There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Chart II-1Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-2Chile: Labor Force Is Expanding At 2% Chart II-3Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices. There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-4Chile: Inflation Is Within Target Range Chart II-5Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade.
We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As...Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside...Bank Shares Have Significant Downside Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Thailand: Stay Overweight Thailand: Stay Overweight Thailand: Stay OverweightThailand: Stay Overweight Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Philippines: Inflation Breakout Philippines: Inflation BreakoutPhilippines: Inflation Breakout Philippines: Inflation Breakout Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold ConditionsPhilippines: Neutral On Equities ##br##Due To Oversold Conditions Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - OverweightCentral Europe: Robust Growth - Overweight Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: No Inflationary Pressures Chile: No Inflationary PressuresChile: No Inflationary PressuresChile: No Inflationary Pressures Chile: No Inflationary Pressures Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - NeutralColombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peruvian Equities - Underweight Peruvian Equities - Underweight Peruvian Equities - UnderweightPeruvian Equities - Underweight
Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown Chart I-10Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com
Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low Chart I-6Chile: Wage Growth Is Tame Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices Chart I-10Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations