iShares MSCI Chile ETF: Still Too Many Risks (BATS:ECH)

With China finally reopening, boosting hopes for a rebound in commodity prices and mining activity, the iShares MSCI Chile ETF (BATS:ECH) has been an outperformer YTD, rallying in the double-digits % (at the time of writing). Yet, investing in Chile still comes with a host of uncertainties, including on the political side, following the rejection of the country’s first constitutional rewrite last year – a resounding defeat for the ruling coalition and the newly elected president. The lack of political support doesn’t bode well for the current administration’s plans to tackle the widening deficit, which will need to be funded at some point.

The risk here is that foreign direct investment also continues to slow, and investor concerns drive more portfolio outflows and a weakening Peso. Amid persistent inflation and worsening external dynamics, this would give the Chilean central bank (Banco Central de Chile or ‘BCCh’) no choice but to continue tightening, further weighing on equity valuations. In sum, investing in ECH comes with too much macro/political noise, and given the potential for two-pronged weakness (equity valuations and FX). Investors may want to hold off on Chilean exposure for now.

Fund Overview – A Low-Cost, Highly Concentrated Play on Chilean Equities

With $576m in net assets and an expense ratio of 0.58%, the iShares MSCI Chile ETF remains one of the cheapest ways for US investors to gain exposure to Chilean equities. The ETF tracks the performance of the MSCI Chile IMI 25/50 Index (before fees), with the largest holding ‘capped’ at a 25% weighting to prevent over-concentration of the portfolio. Overview of the fund per the graphic below:

The ECH portfolio remains dominated by its top holding, Sociedad Quimica Y Minera de Chile SA (SQM), a major chemicals company and the leading global lithium producer, at 20.1%. The second-largest holding is commercial bank Banco de Chile (BCH) at 10.7%, followed by Enel Américas SA (OTCPK:ENIAY) and Banco Santander-Chile (BSAC) at 6.3% and 4.4%, respectively. While the fund has spread out its exposure (note SQM was well over 25% last year), ECH remains a concentrated fund, with the largest ten holdings representing >65% of the portfolio.

On a YTD basis, the ETF has returned 10.9% but has depreciated in value by 40.8% since its inception in 2007, despite the strong 2022 performance (+25.2% market; +24.0% NAV). Relative to the US-listed iShares Latin America 40 ETF (ILF), the fund has underwhelmed on one- and five-year timelines, as well as since inception. The bright spot is the strong distribution (semi-annual basis) yield at 7.1%, reflecting the fund’s concentration in dividend-paying companies across mining and financial services. While the yield will appeal to income investors, it is worth noting that this is on a trailing basis (note 2021/2022 were great years for miners like SQM); depending on the path of commodities prices going forward, the yield could normalize lower.

China Reopening Tailwind Not Enough to Offset Underlying Risks

Given Chile’s dependence on commodities like copper, the prospect of a post-COVID China reopening has provided a welcome tailwind to Chilean equities (and, by extension, ECH) in recent months. That said, investors would do well to keep a keen eye on the various headwinds plaguing the Chilean economy. The big one is inflation running well above the central bank’s target, which likely means no change to the elevated policy rate or to the hawkish forward guidance in a base-case scenario. That’s not all, though – Chile’s deficit (see chart below) is widening amid the worsening terms of trade (i.e., import prices outpacing exports) and slowing growth. The China reopening will help, but the worryingly large deficit will need to be funded without support from foreign direct investments, which has also stagnated over the past year. With the political situation also weighing on investor confidence, it’s hard to see volatile portfolio flows plugging the gap in the meantime; ECH could suffer as a result.

The outsized exposure to financials at ~22% is a concern as well. Inflation in Chile, while still high, is expected to decline from the low-teens % in 2022 (estimated at mid-single-digits % for this year). The key here is that mortgages in Chile are mostly indexed to the UF inflation index, so net interest income is directly tied to inflation outcomes. Thus, a normalization scenario, alongside slower rate hikes, will be a double whammy for the P&L. In addition, the outlook for loan growth in Chile isn’t great given the prospect of slower GDP growth this year, and consumer loans are likely to lead the deceleration. With all signs pointing to a weaker year for Chilean bank earnings, the iShares MSCI Chile ETF’s banking exposure could add to the underperformance relative to a broader LatAm ETF like ILF.

Incremental CLP Weakness Completes the One-Two Punch

In addition to the equity concerns, there is also ample reason for concern for ETF holders on the currency side. For one, Chile’s already-limited FX reserves have been drawn down significantly following efforts last year to insulate the currency against external shocks (recall the intervention program initiated by the Chilean central bank). To shore up the reserve build, the government has tapped the IMF for a two-year flexible credit line. While this will help in the near term, it may not be enough for another substantial intervention effort, given the reserve position (even including IMF funding) has diminished to <$30bn. And the risk of further FX pressure is high, particularly in light of the deteriorating external balance and unstable political/fiscal backdrop in Chile. So even with more tightening on the horizon, the Chilean Peso could still depreciate further amid capital outflows (see graph below), adding to the potential downside for ECH.

Still Too Many Risks

China’s ‘U-turn’ on its zero-COVID restrictions has been a tailwind for commodity-linked plays, and the iShares MSCI Chile ETF has benefited YTD amid hopes for a pickup in demand. The ETF’s outsized exposure to basic materials (mainly via SQM) leaves it well-positioned to benefit, but the elevated risk profile of investing in Chile is hard to ignore. In particular, the outright rejection of leftist leader President Boric’s first constitution draft last year signals a challenging path to implementing his proposed reforms and, by extension, addressing Chile’s growing fiscal deficit. In the meantime, foreign direct investment has slowed, leaving the capital account vulnerable to more portfolio outflows as investor confidence wanes. Thus, depending on how quickly inflation normalizes, all signs point to a longer-than-planned BCCh tightening cycle to support the Peso; equity valuations (and, by extension, ETF holders) will be pressured as a result. Net, I see too much near-term macro and political volatility to be investing in Chilean equities at this juncture.