Equity Strategy: Major Chart Damage Suggests Further Losses On The Cards

Following a poor performance in 2013, Chilean equities have seen a substantial sell-off to open 2014, with the benchmark IPSA equity index having broken through support at 3,500 on January 27. We had previously highlighted 3,500 as a key level, and we believe the break lower indicates further losses are likely in the coming months. With the technical picture providing little guidance in the near term, we do not rule out a correction all the way to the 2,250 level, implying a potential 33.6% drop from 3,387, where the index is currently trading. Although valuations on the IPSA are now low by historical comparison, with the price-to-earnings ratio at 15.7x, below the 10-year average of 19.4x, such a sell-off could be warranted on a fundamental level. Indeed, negative sentiment towards Chilean equities has been based on a number of factors, which we believe are likely to see headwinds for company earnings persist in the coming months. First, economic activity expanded by just 2.8% year-on-year (y-o-y) in both October and November 2013, down from an average of 4.5% y-o-y from January to September. As such, we believe there are growing downside risks to our forecast for real GDP to expand by 4.2% in 2014, only a slight slowdown from our estimate of 4.3% in 2013 ( see 'Economic Growth To Cool On Weak Investment', January 10).

Second, Chilean assets remain highly correlated with the price of copper, which has fallen recently and is now testing key trendline support around US$7,055/tonne at time of writing. We maintain our view for a structural deceleration in the Chinese economy to continue in 2014, and have a bearish medium-term metal price outlook - we forecast copper prices to average US$6,800/tonne in 2014, compared to Bloomberg forecasts of US$7,000/tonne. While the IPSA had broadly traded sideways through the first three weeks of the year, it was the release of weak manufacturing data from China on January 22 that sent copper prices and, by extension, a number of Chilean stocks, plunging.

Third, many of the largest Chilean companies have operations throughout Latin America, and are particularly exposed to weakness in the key markets of Argentina and Brazil. With regards to the former, Argentina's recent decision to temporarily lift its currency controls, leading to a 13.7% devaluation of the official exchange rate on January 23, is likely to severely weigh on domestic demand, hurting major Chilean retailers such as Cencosud and Falabella. Meanwhile, in Brazil, the central bank's aggressive hiking cycle to stem inflation will feed through to slower economic growth, informing our forecast for real GDP to expand by 2.4% in 2014, only slightly stronger than our estimate of 2.3% last year.

Next Stop 2,250?
Chile - IPSA Equity Index

Following a poor performance in 2013, Chilean equities have seen a substantial sell-off to open 2014, with the benchmark IPSA equity index having broken through support at 3,500 on January 27. We had previously highlighted 3,500 as a key level, and we believe the break lower indicates further losses are likely in the coming months. With the technical picture providing little guidance in the near term, we do not rule out a correction all the way to the 2,250 level, implying a potential 33.6% drop from 3,387, where the index is currently trading. Although valuations on the IPSA are now low by historical comparison, with the price-to-earnings ratio at 15.7x, below the 10-year average of 19.4x, such a sell-off could be warranted on a fundamental level. Indeed, negative sentiment towards Chilean equities has been based on a number of factors, which we believe are likely to see headwinds for company earnings persist in the coming months. First, economic activity expanded by just 2.8% year-on-year (y-o-y) in both October and November 2013, down from an average of 4.5% y-o-y from January to September. As such, we believe there are growing downside risks to our forecast for real GDP to expand by 4.2% in 2014, only a slight slowdown from our estimate of 4.3% in 2013 ( see 'Economic Growth To Cool On Weak Investment', January 10).

Next Stop 2,250?
Chile - IPSA Equity Index

Second, Chilean assets remain highly correlated with the price of copper, which has fallen recently and is now testing key trendline support around US$7,055/tonne at time of writing. We maintain our view for a structural deceleration in the Chinese economy to continue in 2014, and have a bearish medium-term metal price outlook - we forecast copper prices to average US$6,800/tonne in 2014, compared to Bloomberg forecasts of US$7,000/tonne. While the IPSA had broadly traded sideways through the first three weeks of the year, it was the release of weak manufacturing data from China on January 22 that sent copper prices and, by extension, a number of Chilean stocks, plunging.

More Downside Ahead For Copper Prices
LME Copper Prices, US$/tonne (LHS) & Chile Exchange Rate, CLP/US$ (RHS)

Third, many of the largest Chilean companies have operations throughout Latin America, and are particularly exposed to weakness in the key markets of Argentina and Brazil. With regards to the former, Argentina's recent decision to temporarily lift its currency controls, leading to a 13.7% devaluation of the official exchange rate on January 23, is likely to severely weigh on domestic demand, hurting major Chilean retailers such as Cencosud and Falabella. Meanwhile, in Brazil, the central bank's aggressive hiking cycle to stem inflation will feed through to slower economic growth, informing our forecast for real GDP to expand by 2.4% in 2014, only slightly stronger than our estimate of 2.3% last year.

IPSA Sell-Off In Line With Regional Trend
IPSA & MSCI Emerging Markets Latin America Index (Normalised, Jan 30 2013=100)

Our caution towards Chilean equities extends across all sectors. In particular, we maintain bearish outlooks for industrial and consumer stocks, where negative fundamentals are likely to persist in the coming months. We note, however, that financial and ICT stocks could begin to look attractive in the coming weeks and months should key support levels hold.

Industrials: Weak Fundamentals To Persist In 2014

Our outlook on industrial equities following what appeared to be a bullish break of short-term trendline resistance on the MSCI Chile Industrials Index in mid-January was well-placed, as the index has suffered substantial losses in recent trading ( see 'Caution Towards Industrial Equities Still Warranted', January 20). Indeed, fundamentally, we continue to believe that lower metals prices and weaker external demand for Chilean mining exports from China will weigh on the mining sector, limiting potential upside for industrial stocks. Profit margins for companies listed on the index have fallen significantly since industrial metals prices hit multi-year highs in early 2011, with average profit margins now negative, indicating that a number of firms are losing money. From a technical perspective, we believe the Industrials index could re-test support around 200 in the coming months, implying some 18.0% losses from 244, where it is currently trading.

False Break Confirms Negative Outlook
MSCI Chile Industrials Index

Consumers: Hurt By Regional FX Weakness

The Chilean peso continues to look weak ( see chart near top of article), underpinning our view that Chilean consumer stocks will underperform the IPSA in the coming months, given a close correlation between the exchange rate and consumer stocks. We forecast real private consumption growth of 4.0% in 2014, marking a slight deceleration from our estimate of 4.7% expansion in 2013, due to our view that exchange rate weakness and higher inflation will weigh on consumers' purchasing power. Moreover, as mentioned above, Chile's two largest retailers, Cencosud and Falabella, generate a substantial portion of their revenues from Argentina, where we recently downgraded our 2014 real GDP growth forecast to 2.2% (from 2.9%), due to our view that runaway inflation stemming from the recent devaluation will weigh on household consumption. In addition, Cencosud's share price has been hit in recent days by a wave of negative sentiment following the dissolution of a widely discussed plan to sell its credit card business to Itau Unibanco Holding S.A. As such, while Cencosud's share price has already been locked in a steep downtrend since early 2013, we see scope for a break of trendline support around CLP1,525 in the coming weeks.

Locked In A Steep Downtrend
Chile - Cencosud Share Price, CLP

ICT: Sonda Approaching Key Levels

As we have previously noted, growth in the Latin American information technology sector has outpaced global IT growth in recent years, and our ICT team's favourable outlook for Latin American IT has led us to become increasingly constructive towards equities in this sector ( see 'Equity Strategy: Financials And ICT Could Offer Upside', October 25 2013). In particular, we continue to watch the Chilean firm Sonda, the largest IT service and platforms provider in Latin America. Sonda has suffered significant losses in recent weeks, following the release of disappointing Q413 earnings on the back of weak results in Brazil and Chile. However, our ICT team sees scope for a rebound in 2014 due to significant growth potential in services, which includes business units like cloud computing and data centres. With the stock approaching key support at CLP1,000, a strong bounce off that level could see us adopt a more positive outlook. We note that valuations look inexpensive, with the PE ratio at 13.8x, well below the 10-year average of 23.1x.

Hit By Weak Earnings Report
Chile - Sonda Share Price, CLP

Financials: Looking Oversold In The Near Term

We continue to believe that financial stocks will outperform the IPSA in 2014, based on solid fundamentals in the Chilean commercial banking sector. Indeed, despite our view for a moderation in the pace of asset and loan growth in Chile's banking sector as economic growth slows, we expect credit demand will be cushioned by lower interest rates, which will help to prevent a sharper deceleration in asset growth. Moreover, we continue to regard the sector in a favourable light overall, given its depth and stability ( see 'Banking Sector: Growth To Moderate In Line With Macro Trend', January 21).

Fallen Too Far?
MSCI Chile Financials Index & RSI (Bottom)

The MSCI Chile Financials Index fell by 4.7% on high volume trading on January 29 after the announcement that Brazilian bank Itaú Unibanco had agreed to purchase Chilean bank CorpBanca under unfavourably viewed terms. However, momentum indicators such as the daily relative strength index (RSI) suggest that the MSCI Chile Financials Index is now oversold. From a technical perspective, we believe that a rally towards trendline resistance around 390 could be on the cards, an 11.1% jump from 351, where the index is currently trading.

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Related sectors of this article: Economy, Finance, Equities
Geography: Chile
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