iShares MSCI Peru ETF: A Hazy Outlook

Summary

• It is difficult to say if the Peruvian president Castillo will be influenced by the hardcore leftist PM or the more moderate FM.
• EPU’s top two holdings that jointly account for almost half the portfolio remain particularly vulnerable under the current regulatory regime.
• Valuations of EPU are quite reasonable and the risk-reward looks attractive, but the charts are yet to show any signs of bottoming out.

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Brief profile of iShares MSCI Peru ETF

Investors looking for access to one of the fastest-growing markets in Latin America may consider the iShares MSCI Peru ETF (NYSEARCA:EPU) that covers 24 Peruvian equities. Unlike most regional-focussed ETFs that typically only offer exposure to heavyweights, EPU's portfolio is tilted towards mid-caps (~46%). Besides, it also makes plenty of room for small and mid-caps that account for 21% and 9% of the portfolio respectively; large-caps make up for the rest of the portfolio. EPU’s expense ratio of 0.59% is in line with the other LatAm-focussed ETFs. Peru’s resource-rich credentials are well captured in this ETF as the materials sector accounts for the bulk of the portfolio with a ~52% share, twice as much as the next largest segment - financials.

Continent-leading growth prospects could be stymied by the recent political shift

Prima facie, the Peruvian landscape is one of the most attractive regions to be exposed to; it is one of the few if not, the only LatAm economy that will post double-digit GDP growth this year. It is also expected to lead the LatAm region in terms of growth for each of the next four years.

Source: S&P Global ratings

That said, given some of the political developments that are currently unraveling in Peru, I suppose you'd have to be a consummate lionheart to dive into Peruvian equities at this juncture. EPU is dominated by two stocks in particular - Southern Copper Corp (SCCO) which accounts for ~25% of the portfolio and Credicorp (BAP) which accounts for ~21% of the portfolio. Both these stocks are currently grappling with the risk of heightened regulatory pressures that could stymie the merits of their core operations.

Basically, Peru is in something of a divided state and this was reflected in the recent elections where the Marxist candidate and former union leader - Pedro Castillo only managed to win the Presidential ballot by a margin of 44000 votes! During his victory speech, Castillo has reportedly been stating that he would like to nationalize some of the resource assets, boost socialist spending and redraft its free-trade deals. Castillo’s ensuing cabinet selection too has been rather curious and doesn’t provide any clear indication as to how his administration plans to govern. He first appointed a hardcore leftist - Guido Bellido as his prime minister which would have to be construed as severely negative for the Peruvian industry. But he then followed this up by appointing a former World Bank economist who is more of a moderate - Pedro Francke as his finance minister. The latter has been noted to follow a more conciliatory tone with the Peruvian industry and there are some suggestions that the regime under Castillo may not be as draconian as initially thought. Yet there are doubts over whether Castillo, Bellido, and Francke can present a unified front with regards to their policies.

To push through his socialist agenda, and focus on aspects such as education and health, Castillo had previously threatened to hike taxes on Peruvian mining companies (Peru is the second-largest supplier of copper in the world). He has also suggested that he would reassess contracts with mining companies that locked in favorable tax rates for the longer term. This could dent the allure of EPU’s top holding - SCCO who recently delivered solid Q2 results. SCCO is poised to be one of the key beneficiaries of the multi-year demand/supply mismatch in the global copper markets as it is one of the leading integrated copper producers of the world and owns total copper reserves that account for nearly 70 MMT. Results so far have primarily been driven by healthy prices for metals such as copper, zinc, and silver, but if Castillo has his way, any windfall from higher prices would need to be diverted to the country’s socialistic priorities.

One also does wonder what the country’s future investment climate looks like under the new regime. Already this year, SCCO has committed to invest around $7.9bn for projects in and around Peru but there are doubts over whether they could get the requisite permits to proceed (Source: Q2 call). On the Q2 call, management stated that they are trying to project an image of not just a capitalistic driven company but also a socially conscious one, one that also wants to stimulate the employment situation in the country. For instance, they believe that their latest Tia Maria project in Peru could potentially offer employment to 9000 local Peruvians in the construction stage and a further 4800 jobs (both directly and indirectly) once the operation gets running (Source: Q2 earnings call).

It’s important for Peru to have a government that doesn’t put the brakes on projects such as this, as the country, like most of its Latin American peers, already suffers from weak real fixed investment growth compared to the EMEA or Asia regions. You also have to wonder what a socialistic fabric could do to productivity levels which already remain suppressed and are not showing any signs of bridging the gap with developed nations such as the US. As you can see from the chart below, in PPP terms, Peru's real GDP "per capita" relative to the US remains the weakest out of all the notable LatAm countries.

Source: S&P Global Ratings

Like SCCO, EPU's second-largest holding - BAP too is finding it difficult to flourish under the current regulatory environment which has already curtailed fee income for financial companies and has now set up interest rate caps of 83.4% for small consumers and small and micro business loans. The most recent restriction was for the period May-Oct 2021 and this is something that will be reviewed and dictated by the Peruvian central bank every 6 months.

One ought to question the merits of something like this where banks such as BAP have their hands tied and are not able to price their loans effectively according to the risk involved. Admittedly the BAP management stated that they don't believe it will have a profound impact on their bottom line, but I feel it could affect long-term sentiment for Peruvian banks as a whole, given that they could now be less effective in serving as agents of financial inclusion. Because banks know that their ROIs for these SME and retail loan products will effectively be capped, they would rather divert their excess liquidity to other lucrative areas where the loans can be priced according to the market dynamics. If institutional funding remains low, these borrowers will eventually have to go to the unofficial and informal avenues where lending rates can often prove to be crippling, resulting in the pernicious debt trap; this defeats the whole objective of the socialist government.

Interestingly Peru has some history with implementing similar rate caps back in the 80s and it didn’t end well; from 1979-1990 when rates were curbed in the country, the credit share of GDP dropped to mid-single digits from 14% previously. This then reverted back to more normalized levels once the caps were removed in the 1990s.

Source: S&P Global Ratings

All in all the situation doesn’t look good for BAP which has already been reeling under a difficult credit environment and also decided to postpone its dividend plans until there is further clarity on the government’s stance.

Unsurprisingly valuations of BAP have plummeted of late. This is a well-diversified and well-capitalized bank that has most often enjoyed a P/BV above 2x (the 5-year average is 2.2x). Currently, you can pick this up for an astronomical discount of ~45% with the stock trading at 1.2x book value.

Source: YCharts

Closing thoughts

From a valuation angle, EPU is somewhere in the middle of the broad Latin American universe. On a forward P/E basis, the ETF currently trades at a multiple of 11x. It is more expensive than the flagship Latin American ETF (ILF) which only trades at 9.6x P/E but do consider that ILF is heavily skewed by the influence of Brazil equities which account for over 60% of its portfolio and are currently one of the cheapest options within LatAm.

Source: Prepared by the writer using data from YCharts

The income component of EPU too looks rather tasty at around the 4% mark and should provide some useful insurance during this phase of selling, but I do wonder if there's a downside surprise to EPU’s outflows this year considering that a key component of EPU-BAP has not shown any inclination to reinstate the dividend in H2-21 (something which it had cut in Feb-2021).

Source: Prepared by the writer using data from YCharts

Moving to the technicals, it is pretty evident that the momentum is in favor of the bears with the ETF trading well below all three key moving averages (50,100, 200DMA) on the daily charts.

Source: ETF.com

We can see the bearish sentiment reiterated in the fund flow data as well; until the last week of July-2021, on a YTD basis, EPU had witnessed net total inflows to the tune of $14bn, but the tables have turned and such has been the ferocity of the selling since 23rd July that the current net fund flow position stands at -$32bn (implying over $45m worth of sales over the last week or so).

Source: StockCharts.com

This selling has obviously made Peruvian assets look a lot more attractive compared to other pockets within LatAm. We can see get a sense of this by looking at the relative strength chart of Peruvian equities vs the whole of LatAm; this ratio has tended to trend upwards in the shape of a quasi-ascending channel for much of its lifetime reflecting Peru's growing popularity over the years. At the start of Q2, we saw this ratio collapse below the lower channel boundary, and it is currently trading at its lowest point in over 7 years. The glass-half-full cohort will now be hoping it can retest and reclaim the previous channel, if and when political uncertainty dissipates.

Source: TradingView

Shifting the focus to the price action on EPU’s standalone long-term chart, we can see that for two years (from 2018-2020) it had been forming something akin to a descending broadening wedge pattern. In December, there was a breakout beyond the upper boundary of this wedge, but it proved to be a failed breakout with the sellers gaining confidence by February. Over the last few months, we’ve not only seen that breakout getting negated, but also a much deeper collapse back into the wedge. Currently, there are no indications of a pause in selling or any sort of base formation at lower levels, so I wouldn’t encourage any long positions until perhaps around the $22.5-$24 levels which looks like a prospective support area where it could build some sort of floor. If you find that the political dynamics with the Peruvian industry haven't worsened even further, a long position may be considered at those levels. For now, it would be prudent to wait on the sidelines.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.