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By Joseph Hogue, CFA

The Chilean economy has long been the model for Latin America and maintains the region’s highest credit ratings with Aa3 from Moody’s and A+ from Standard & Poor’s and Fitch.

Image courtesy of Individuo: http://www.everystockphoto.com/photographer.php?photographer_id=18122
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The Andes tower over Santiago, Chile

The Chilean economy reported its fastest growth in three quarters with 5.6% in the first quarter. Moderating pricing pressures and global risks have allowed the central bank to keep from raising rates.

Despite a fairly strong Chilean economy, the country has not been immune to global headline risks. The market has gained about 1.9% year-to-date but underperformed the S&P500 by 1.7%. While it has underperformed the broad U.S. index, it has outperformed the iShares S&P Latin America Index (NYSEARCA:ILF) and its loss of 6.8% since the beginning of the year.

The sell-off is more an aversion to risk than a valuation perspective on Chilean equities and should rebound once global markets calm. Given its credit rating and stability, the country is a core holding in regional allocations providing high risk-adjusted returns. The outlook for the Chilean economy is for moderate growth, outperforming Brazil and Argentina but below that of regional peers Colombia, Mexico, and Peru on a risk-adjusted basis.

Economic outlook

The International Monetary Fund forecasts growth for the Chilean economy in 2012 at 4.3%, just above the regional average of 3.7%. The country has strong economic ties to the growing Asian economies which should help it to withstand weakness in Europe through the first half of the year.

Reuters reports manufacturing output surged by 13.3% in March, but largely due to seasonal factors and widespread vacationing holding down February data. Domestic demand, normally a strength within the region, advanced at its slowest pace since 2009 in the first quarter. Rapid growth in manufacturing risks an inventory overhang if exports remain weak and consumer demand cannot fill the void. An increase in the unemployment rate in March to 6.6% and a 2.6% reduction in copper production is driving fears of a second half slowdown for the Chilean economy, but this is tempered by the considerable resources available to the government for stimulus measures.

Productivity growth rates in Chile, a systemic problem in the region, are comparable to those in developed markets at an average of 5.8% per year. The country is also the first in the region to successfully establish counter-cyclical economic policies and a sovereign wealth fund. This helps the Chilean economy break from the traditional boom and bust cycle that keeps Latin America from moving forward relative to other regions.

In the event of a further slide in global growth, the government may tap its $14.9 billion sovereign wealth fund to protect the Chilean economy. This helps put a floor under asset prices and would help companies in the domestic space outperform exporters.

Risks

The Chilean economy, like Brazil’s, stands to bear the brunt of globally-induced volatility as the country is relatively more dependent on commodity exports. Copper prices have fallen almost 20% from a year earlier and account for approximately 45% of the country’s export revenues [pdf]. The windfall from copper represents about 20% of fiscal revenues and 4% of GDP.

While China has recently announced a program to speed up infrastructure and construction projects which should help support copper prices, significant short-term risks remain from headlines out of Europe.

The government has recently buckled to student protests and promised an increase in corporate taxes to offset more spending in education. Also proposed are cuts to personal income taxes and fuel surcharges partially paid for by an increase in taxes on hard alcohol.

The government of neighboring Peru has recently declared a state of emergency as mining protests threaten output, and the risk remains that the labor unrest will spread to Chile. Civil unrest over worker rights and inequality are common in the region and usually end in some form of arbitration between the corporate and public sector. While specific events may scare investors and drive asset prices in the short-term, they often provide a good entry point on a valuation basis.

Investment options

Sociedad Quimica Y Minera de Chile (NYSE:SQM) is a Chilean Chemicals manufacturer operating in four segments: specialty plant nutrients and fertilizers, iodine derivatives, lithium, and industrial chemicals. The company has operations in every continent and is distributed in more than 110 countries. Though its current price-to-earnings ratio of 26 times makes it fairly expensive from a valuation standpoint, the company controls its expenses better than its peers and has a net profit margin of 22.5% and a return on equity of 26.7%. The company is a leader in fertilizers and industrial chemicals and should benefit from the strong growth in agricultural products going forward.

The iShares MSCI Chile ETF (NYSEARCA:ECH) holds equity in 38 companies and seeks to replicate the equity market performance of stocks traded in the Chilean market. The top four sector holdings of the fund make up more than 75% with utilities (25.5%), materials (19.7%), industrials (16.3%), and consumer staples (13.8%).

Individual shares and sectors include:
Company Name
Symbol
Sector
CIA CERVECERIAS UNIDAS SA
Consumer Non-Durables
EMBOTELLADORA ANDINA SA
Consumer Non-Durables
VINA CONCHA Y TORO SA
Consumer Non-Durables
AFP PROVIDA SA
Finance
BANCO DE CHILE
Finance
BANCO SANTANDER CHILE SA
Finance
CORPBANCA
Finance
SOCIEDAD QUIMICA Y MINERA DE CHILE SA
Process Industries
LAN AIRLINES SA
Transportation
EMPRESA NACIONAL DE ELECTRICIDAD SA/CHILE
Utilities
ENERSIS SA/CHILE
Utilities
Source: Analysis: The Chilean Economy In 2012