In the past, Chile was considered a rare economic success story in emerging markets, in the same vein as the high-growth “Tigers” of East Asia. After the neo-liberal reforms introduced by the “Chicago Boys” of the military dictatorship (1973-1990), Chile enjoyed high GDP growth and significant improvements in social indicators. However, in recent years progress has stalled and Chile has started to look a lot more like its regional neighbors than like an East Asia tiger. Moreover, this process of convergence with the region is expected to accelerate in the near term as a constitutional assembly approves a new progressive constitution that is expected to greatly increase social rights and benefits and undo much of the neoliberal economic framework imposed during the military regime. Undoubtedly, these important changes will impact growth and the investment environment. Investors would be negligent to not incorporate this new reality into their analysis of business opportunities.
Chile’s growth path has been on a steady decline. Following about a decade of spectacular growth (1986-1997) the economy has gradually lost its dynamism. Even during the commodity super-cycle of (2003-2012), growth levels were a step below the previous trend. Like in the rest of commodity-producing Latin America, the commodity boom was more a curse than a blessing, leaving behind high debt levels, an overvalued currency and deteriorated governance. Since the commodity bust in 2012, the country has entered a low growth path and faces increasing social instability resulting from the unmet high expectations generated during the boom years. The chart below shows Chile’s GDP growth path since 1980 and the IMF World Economic Outlook projections through 2026. The IMF now sees Chile’s sustainable GDP growth path to be around 2.5%, which is only slightly above the regional average and a fraction of previous growth. Moreover, the IMF’s numbers do not yet take into account the considerable economic disruption that will probably result from the upcoming constitutional reform.
The marked reduction in growth prospects for Chile will mean lower corporate profit growth and impact stock market valuations. We can look at history to put this in context.
The first chart below shows the performance of stocks on the Santiago exchange for the very long term (1894-2021). We can see a long decline from the 1890s through 1960, and then a more precipitous decline caused by the political agitation of the 1960s and the rise to power in 1970 of the socialist, Salvador Allende. The concurrence of the military coup in 1973 and a boom in commodity prices led to a huge stock market rally in the 1970s, with the index rising by 125 times (a dollar invested in 1970 would have appreciated to 125 dollars in 1980). Then came the collapse in commodity prices and the Latin American debt crisis, and the market lost 86% of its value before stabilizing in December 1984. From that low point the market would rally 33.5x before topping in July 1995. In retrospect, we can say that 1995 was the glorious peak for Chilean stocks. The stock market provided dollarized annualized returns of 39.6% between 1973 and 1994. Between 1994 and today annualized returns have been a measly 1.9% (These numbers are before dividends which increase returns by about 2% per year). About 70% of contributors to the Chilean Pension fund system joined after 1994 and therefore have experienced low returns on their investments in Chilean stocks.
The following chart shows the more recent performance in greater detail. We can see that the 1994 peak was built on a period of rising earnings and rising PE multiples, with the PE reaching 26.4, the highest ever for Santiago. The commodity boom bull market (2002-2012) was built essentially on USD earnings growth, a combination of corporate earnings and a strengthening peso. Since the commodity bust in 2012, USD earnings have fallen by half because of a combination of lower corporate earnings and a weakening peso. Nominal USD earnings today are at the same level as 14 years ago.
We can shed more light on valuations by considering cyclically-adjusted Price-Earnings ratios (CAPE) for the Chilean market. What we see here is that Chilean stocks have had two “bubbles” over the past 30 years: first in 1994, based on the extrapolation of the “miracle” economy and optimism on the transition to democracy; second in 2007-2010, when the commodity super-cycle drove up both USD earnings and multiples.
What do these numbers tell us about future returns? First, we can see that current CAPE earnings are about 20% below trend. Second, we see that the cape ratio is well below the trend-line which is also in sync with the historical median CAPE for Chile of 17.9. Assuming a return to earnings trend in several years and the historical median CAPE ratio, Chilean stocks would have nearly 80% upside from current levels.
This is the normal analysis done with CAPE. Fraught as it is with problems, it does generally provide a reasonable indicator of return potential. But perhaps the case of Chile does not fit into this easy analysis.
First, the historical median cape may be distorted by two periods of extraordinarily high CAPEs over the 30-year period, during the 1994 and the 2007-2012 bubbles. What if current CAPE ratios reflect more realistically Chile’s current prospects of low growth? Second, perhaps the earnings trendline should be sloping downwards to take into consideration these diminishing growth expectations. No one believes that Chile can return to the kind of growth it saw in the 1990s. On the contrary, the low GDP growth expected by the IMF is in line with consensus and may even be optimistic if the constitutional reform is as anti-business as many observers now fear.
The fact is that a return to normalcy is a low probability scenario. Investors have the difficult task of evaluating what the new Chilean growth model will look like and project expected returns on that basis.
The case of Chile illustrates one of the characteristic traps of emerging market investing. Sudden and radical changes in political and regulatory environments can completely undermine an investor’s valuation framework. We are currently seeing this in China where regulators have suddenly put in question the financial models of most of the prominent tech firms. In Chile, the protests of recent years and the prospects of constitutional reform have signaled the end of the pro-business neo-liberal regime, meaning that the high valuation multiples of the past are probably irrelevant.