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Down 25% Year-To-Date: Buy Chile On Overblown Political Fear

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About: iShares MSCI Chile Capped ETF (ECH), Includes: ARGT, EWH, EWU, NGE, PAK, TUR
by: Ian Bezek
Summary

Chile is the world's worst performing equity market this year.

That's rather surprising given the host of problems other countries have seen in 2019.

Chilean stocks are priced for a major recovery.

If you asked investors what the worst-performing country ETF was this year, I'd bet that few would get the right answer. Surely Argentina (ARGT) would be in the running, given its huge market crash in August, right? Did Brexit throw the UK (EWU) for a loop? Turkey (TUR) comes to mind with its severe political problems earlier this year. If not those, how about Hong Kong (EWH) with its escalating protests and uncertainty around its situation with China, right?

Nope, none of those are 2019's worst-performing dog. While 17 countries have produced gains of just 4% or less for the year, Chile (ECH) has only two serious rivals - Pakistan (PAK) and Nigeria (NGE) for worst country ETF of the year according to Seeking Alpha's country ETF tool:

Source. Data as of November 27th.

Given the huge gains in so many global markets this year, there's definitely good reason to give Chile and these other underperforming markets a look for a potential reversion to the mean trade going forward.

Why Chile Slumped

While the political situation in Chile hasn't garnered the same foreign press as, say, Hong Kong, investors have clearly tuned in. Things kicked off in October, when a proposed metro fare hike led to popular unrest against the unpopular right-wing government there. Things quickly escalated and within days, you started seeing massive demonstrations like this:

Source: Hugo Morales/Wikipedia

During the course of these protests, demonstrators vandalized numerous metro stations and burned down more than a dozen of them. The state responded with a curfew, a declaration of a state of emergency, and the use of the army to quell unrest. Throughout the demonstrations, in total, several thousand protesters were injured, several thousand more were arrested, and 26 people have died.

The president survived calls to step down, and instead reorganized his cabinet, dismissing many of its former members. The government also agreed to a referendum on drafting a new constitution, as the current one has remained in place since the Pinochet dictatorship days.

What's It Mean?

Unlike Argentina and its recent political happenings, it's not so clear what a worst-case scenario for Chile potentially looks like. A country like Argentina has a long history of regularly electing left-wing governments, experiencing hyperinflation, and defaulting on its sovereign debt. So this cycle potentially repeating isn't a bolt out of the blue there. By contrast, Chile has been one of South America's stalwart pro-business countries since the 1970s, so any signs of political unrest shake up investors' outlook much more.

As a result, investors are more uncertain of how far to knock down Chilean valuation multiples. Up until last year, Chile was historically one of the most expensive emerging markets with its stocks often trading at a P/E ratio of 20 and up.

This data source updates once a month; the P/E ratio is now down to ~15 with the subsequent decline in prices since the last data point.

That's with good reason, it has one of the most stable economies from a macro perspective, with sound money, a highly-respected central bank, and a diversified GDP base that counter-cyclically manages its most important resource: copper.

It was hard to get excited about Chilean stocks because their excellence was priced into the market. As such, I've rarely recommended Chilean shares despite my focus on Latin American stocks, and the fact that I've lived in the region for the past six years. In fact, my last big buy recommendation in Chile prior to this fall was on winemaker Concha y Toro back in early 2017.

In any case, though, Chilean stocks are down more than 50% from their 2018 highs, in dollar terms. And that's not because of any particular problems with the economy at present; GDP growth had been generally slow for the past five years or so and has actually improved of late. In any case, Chilean equities haven't tracked GDP growth that directly.

Until recently, you could count on the Chilean Peso to largely follow the price of copper.

Subsequent to this chart's publication, the Peso has fallen to 0.12 (lower is weaker) while copper has not made a major move.

That trend has broken decisively in recent months with all the political uncertainty. Based on the price of copper, the Chilean Peso is now about 20-30% undervalued, and merely returning to its natural linkage to the country's key export would cause large gains for anyone buying Chilean stocks at these prices.

For folks that like the idea of buying inflation protection, owning profitable assets linked to metals prices (such as Chilean banks) is generally a better bet than buying something like a bar of silver that earns no economic profit and pays no dividend. Get the inflation hedge of Chilean gold and copper exports without sacrificing the usual benefits you get from owning equities.

Investors Have Overreacted To Recent Events

Chile has had two left-wing presidencies in recent years, both headed by Michelle Bachelet of Chile's Socialist Party. Despite that, the country's business practices remained distinctly investor-friendly. Like in many Scandinavian countries, Chile has, thus far, demonstrated that it is possible to elect leaders with a different political tilt than the U.S. without giving up the benefits of a free market economy.

The Heritage Institute publishes a ranking of global economic freedom every year. Chile currently ranks in the top 20 in the world, and is one of only three countries in the Americas to get the green light (Canada and the U.S. being the other two):

Source

Other notable South American economies, Peru and Colombia, are #7 and #8 in the region. Meanwhile, Mexico and other large LatAm countries aren't even in the Americas' top 10. Mexico ranks 12th in the region, and poor Argentina and Brazil are way down at 26th and 27th (out of 32) respectively.

All this to say that a modest left turn in Chilean politics would be a minor event and hardly worth an equity bear market, let alone a 50% collapse in the country's main ETF. Chile could veer from its current policies and still be more business-friendly than anywhere else south of the Rio Grande.

The market seems to be pricing in Chile going from the Spanish-speaking world's beacon of unfettered capitalism straight to Argentina or Cuba style governance. Prices are now barely holding 2016 lows - and remember, back then, commodities were in a dismal bear market as compared to now:

Source: Finviz

In any case, Chilean stocks should get a major oversold bounce at a bare minimum, and it's not hard to see a path to a 30-40% recovery as the foreign media turns to other more pressing political situations and forgets about Chile.

It's far from certain that the protests will be more than a one quarter event as far as the economic impact goes. Listen to the conference calls of the Chilean banks, and you'll hear them saying this is a relatively minor disruption thus far. Things would have to get substantially worse to justify the selling we've already seen in Chilean stocks. And if nothing much exciting happens, the mere passage of time should cause Chilean stocks to recover.

For an analogy, remember when everyone in the financial media suddenly became experts on Turkey for about three days this May during their bout of panic selling?

Chart

Data by YCharts

As soon as the spotlight goes elsewhere, prices tend to recover. As it is, Chilean stocks are now selling at just 15x earnings - that's tied for their lowest reading of the past decade (they peaked at 28x earnings to give a sense of potential upside). The Chilean market bottomed at 13x earnings in 2008 during the Financial Crisis for another bit of perspective.

With the economy continuing to perform reasonably well, earnings should be fine, and thus downside is limited. Look at the comparison between Chile and Hong Kong over the past year - I'd argue Hong Kong's political problems are a more serious threat to business as usual, yet its stocks remain unmoved:

Chart
Data by YCharts

One of these reactions is wrong - if Hong Kong stocks are up over the past 12 months despite an existential threat to that island's status quo, how is Chile down 30% on so much less? Long story short: Chilean shares should quickly recover on any whiff of an improvement in the political situation.

Disclosure: I am/we are long ECH. 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.