Colombia’s Performance Hinges on Oil

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Colombian assets continue to trade with oil. Last year’s plunge in oil prices dragged Colombia lower, while this year’s rally has pulled it higher.

POLITICAL OUTLOOK

President Santos is nearing the last half of his second 4-year term that ends August 2018. Going forward, it appears that Santos will focus most on completing the peace process that would end several decades of armed conflict with the FARC. The government has also recently started talks with the smaller ELN.

Peace talks have stalled over the government’s insistence that the rebel groups denounce kidnapping and free all hostages. Yet kidnappings and killings continue, albeit nowhere near as bad as the 1990s. Our base case is that a far-reaching peace accord will eventually be reached.

Vice President Vargas Lleras is thought to be a potential frontrunner for the presidency. His right-wing Cambio Radical did well in local and regional elections last October, at the expense of Santos’ Social Party of National Unity and former President Uribe’s Democratic Center party.

ECONOMIC OUTLOOK

The economy is picking up. GDP growth is forecast by the IMF to grow 2.5% in 2016 and 3.0% in 2017. GDP rose 3.3% y/y in Q4 and has accelerated three straight quarters. Add in higher oil prices, and we see upside risks to the growth forecasts.

Price pressures remain high, with CPI rising 7.9% y/y in April. This is just below the 8% peak for this cycle in March, which was the highest rate since October 2001. The central bank meets this Friday and is expected to hike rates by 25 bp to 7.25%. The market is split, however. Of the 29 analysts polled by Bloomberg, 4 see no hike, 22 see a 25 bp hike, and 3 see a 50 bp hike. The central bank hiked the policy rate by 50 bp to 7.0% at its previous meeting in June.

Fiscal policy is a concern. The budget deficit is expected to rise to -3.6% of GDP this year from -3.1% in 2015, and would be the fourth straight year that it has risen. Oil accounts for over 20% of government revenue, and so the recovery in oil prices should help drive some improvement in the fiscal accounts this year.

The external accounts have deteriorated. Low oil prices have hurt exports, while import demand has remained fairly robust. The current account deficit is seen at around -6% of GDP this year vs. -6.7% in 2015. However, it should fall to around -4.5% if oil prices remain firm. Foreign reserves have risen to near record highs around $47.3 bln in April, which represents nearly 10 months of imports.

Our own sovereign rating model gives Colombia an implied rating of BBB/Baa2/BBB. This is line with it actual ratings, and suggests no movement either way by the agencies.

INVESTMENT OUTLOOK

Oil is the number one driver for Colombia. WTI oil has rallied 90% off the February low near $26. The supply-demand dynamic has been distorted by some disruptions, however, such as the wildfires in Canada. OPEC is unlikely to change its current stance at the upcoming June 2 meeting in Vienna. As such, further gains in oil may be difficult to sustain.

The peso has outperformed within EM. In 2015, COP lost -25% vs. USD. This compares to the worst performers ARS (-35%), BRK (-33%), ZAR (-25%), and RUB (-20%). So far this year, COP is up 3.6% YTD, behind only RUB (up 11.6% YTD), BRL (9.9%), and MYR (4.6%). This outperformance is likely to ebb, as our EM FX model shows the peso to have VERY WEAK fundamentals. Retracement objectives for the February-May drop in USD/COP come in near 3060, 3135, and 3210.

The central bank instituted a new FX intervention mechanism back in October. Initially, it offered $500 mln of dollar call options whenever the exchange rate was 7% weaker than its 20-day moving average. The threshold was lower to 5% and then to 3% currently. The options sale was triggered last week for the first time. Governor Uribe noted at that time that the bank could undertake other ways of intervening, such as discretionary dollar sales.

Colombian equities have outperformed within EM. Last year, MSCI Colombia was down -43% vs. -17% for MSCI EM. So far in 2016, MSCI Colombia is up 16.3% YTD, and compares to 0.1% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Colombia at an UNDERWEIGHT position.

Colombian bonds have done well this year. The yield on 10-year local currency government bonds is down -52 bp YTD. Compare this to the worst performers Poland (+13 bp), China (+11 bp), and Hungary (+11 bp), as well as the best performers Brazil (-359 bp), Peru (-100 bp), and Indonesia (-82 bp). With inflation likely to remain high and the central bank still tightening, we think Colombian bonds could start underperforming more.