I believe the iShares MSCI Chile Capped ETF (Bat: ECH) was purchased before September 4th. That same day, Chile voted for or against a new constitution.This political risk has Much of that has been priced in, with stocks trading at a 40% discount to their valuations and currency depreciation over 30%. In my view, a rejection outcome could trigger a 20% to 30% sharp relief rally, while the downside risk to an approval vote could be 10%.
I have lived in Chile for 13 years and have been working as a buy and sell analyst and PM in Latin America since 1995, which has given me a good understanding of the market, macro and political situation in Chile and the region.
Chilean assets under pressure since October 2019
Since the social unrest began in October 2019, Chilean stocks have fallen to 2005 levels in dollar terms, down 46% (excluding Soquimich (SQM)). These mass protests led to a proposal for a new constitution. This creates a high level of political risk and uncertainty, with clear asset value implications.
ECH has fallen 26% since October 2019. However, dissecting this performance, we find that SQM, which now makes up 23% of the ETF, has gained 220% over this time frame. Excluding the impact of SQM sent the ETF down 46%. Going further, the Chilean peso or CLP depreciated by 30%, making the underlying stock contribute -16%.
Political risks far outweigh macro risks
Stock market and CLP results diverged from macro results, highlighting the impact of political risk. Chile’s economy has weathered this political uncertainty and the pandemic well, thanks to massive government stimulus and a nearly 30% reduction in the private pension fund system, which adds up to nearly 20% of GDP . The real estate, consumer and financial sectors reported low interest rates and strong results from a cash-rich economy in 2021.
Until now, there are no signs of stagflation in the macro situation, the CPI is 10%, the unemployment rate has risen to 7.7%, and the 22-year GDP forecast is only 1.2%. At the same time, the country has elected a socialist president who wants to implement a 4% GDP tax hike to fund social spending, reform the pension system into a public “pay-as-you-go” scheme, and stop paying private Pension contribution fund system. All of this happened while the socialist-controlled parliament was drafting a new constitution. Against this backdrop, Chilean assets (equities, debt and foreign exchange) are hardly attractive and the opportunity is here.
Depressed asset valuations, largely a factor in political risk
The market is now clearly in the doldrums, with CLP surging to new all-time highs against the US dollar, depreciating more than 30% since October 2019. Part of this decline is due to the recent drop in copper prices, which account for 50% of exports and impacted dollar inflows. Another part is due to capital flight, selling CLP to buy dollars and move them out of the country ahead of the September 4 referendum.
Stocks are trading at 20-year lows as valuations trade near 9 times earnings or 40% below their 10-year average. However, bond markets are pricing in continued prudent monetary and fiscal policy, with a credit default swap default risk of 1.6% for Chilean sovereign bonds. I believe the foreign exchange and equity markets have largely priced in the political risk.
The September 4 referendum could lead to the rejection of the new constitution
The new constitution was completed on July 5, and on September 4 there will be a referendum to ratify or reject it. It has not been embraced by the public and by many current and past politicians and parties, economists, lawyers, and opinion makers of all political colors. Public discussion bombards amending the new constitution if it gets ratified or better to amend the current constitution. The odds of being rejected are increasing, and while 80 percent of the population voted for the new constitution, the latest polls show that only 30 percent approve of the proposed new constitution.
In the event of a rejection of the new constitution, markets and currencies are likely to see a sharp rebound, perhaps between 20% and 30%. If approved, the knee-jerk drop could be 10%, as most of the risk is already priced into it.
Rejection could lead to a sigh of relief in the domestic and foreign business sectors. This will reduce the power and ambitions of the current government and may lead to a better business and macro environment in the medium term. On the negative side, protests may break out and make headlines, but they may not have popular support and people will vote against extreme changes.
iShares Chile ETF captures referendum gains
ECH consists of 25 stocks and replicates the MSCI Chile Cap Index. All industries and companies (except Vapores) have a negative impact on the new constitution and a stronger socialist government, and will therefore benefit from a rejection vote.
The largest weight (37%) is in the materials/export sector, SQM (lithium and fertilizers), Copec and CMPC (pulp) and Cap (iron ore). Valuations in the sector are more affected by political risk than macro risk. Mining and forestry are at risk of increased taxation, environmental regulation and outright nationalization. SQM, despite its performance, still has a discount compared to Albemarle (ALB) and other lithium startups in the region Livent (LTHM), Lithium Americas (LAC) and Sigma (SGML).
Financials is the second-largest sector, with a weight of 21%, benefiting from government stimulus and now inflation, as most lending is tied to inflation. However, under a more socialist constitution, they may see interest rate controls and/or forced lending, higher loan losses, and lower ROE.
Political risks in the consumer sector are low, but macro risks from lower disposable income and increased foreign exchange depreciation are higher as most consumer goods are imported. However, Fabella has a large financial business that can offset weaker retail sales/margins as well as operations in Latin America. Cencosud has greater exposure in food retail and regional footprint.
Utilities (electricity and water) are politically exposed because they receive returns from regulated tariffs, and increased environmental regulation increases costs and hinders returns. Nationalisation risks are also possible.
Direct equity investments are limited to SQM, Banco de Chile (BCH), Banco Santander de Chile (BSAC), Andina (AKO.B) and CCU (CCU).
I’ve compiled forward-looking consensus estimates for each of the constituents, derived their PE and EV/EBITDA, and compared them to the past 10-year averages. As can be seen, the unweighted average is 40% lower than historical. Part of the reason may be the high interest rates imposed by the central bank, which increased from 0% to 9% in one year. Regardless of the new constitution, however, interest rates are near their peaks and may fall in 2023 due to the need to start stimulating the economy after stagflation.
ECH Offers Solid Risk-Reward Driven by September 4th Referendum
In conclusion, Chilean foreign exchange and stock markets have depreciated significantly (in price) as very real political risks are now about to materialize or disappear on September 4th. In my opinion, the probability of the new constitution being rejected is now over 50% and the power of the current socialist government is weakened. This should lead to a strong rally of 20% to 30%, while confirmation could lead to a 10% decline. Extensive exposure to the trade via the Chilean ETF ECH, while US-listed SQM, CHILE, CCU, AKO and BSAN may outperform the index.