Surprise Colombia Rate Cut Could Trigger Underperformance

Colombia oil

The Colombian central bank surprised markets with a 25 bp cut Friday. This is a risky move in the current global environment. Soft fundamentals and an aggressive easing cycle are likely to keep the peso under pressure.POLITICAL OUTLOOK

President Santos was able to quickly negotiate a new peace agreement last month after the old one was rejected by popular referendum in October. Congress quickly ratified it, and the new deal does not have to be passed by a referendum again. Using the FARC agreement as a template, the government will reportedly start peace talks with the smaller ELN rebel group in January.

Santos’ second and final term ends August 2018. Congressional (March) and presidential (May) elections will be held in H1 2018. Vice President Vargas Lleras is an early frontrunner to replace Santos. No other candidate on the right has significant traction yet, but it’s still early. On the left, possible candidates include Bogota Mayor Gustavo Petro.

ECONOMIC OUTLOOK

The economy continues to slow. GDP growth is forecast to accelerate modestly to around 2.5% in 2017 and 3% in 2018 from an estimated 2.1%% in 2016. GDP rose 1.2% y/y in Q3. This was weaker than expected and the slowest since Q2 2009. As such, we see downside risks to the growth forecasts.

Price pressures are still easing, with CPI rising 6.0% y/y in November. This was the lowest rate since October 2015 but still above the 2-4% target range. PPI may be accelerating now, due in part to the weak peso. As such, the central bank will have to be careful in managing this easing cycle.

Yet the central bank cut started the easing cycle with a 25 bp cut to 7.5% on Friday. The last move was a 25 bp hike back in July. Minutes from this meeting will be released December 30. New Governor Echavarria will take over from Uribe next month, and is likely to be even more dovish given his close ties to President Santos. The central bank is thus likely to continue the easing cycle then with another 25 bp cut.

Low oil prices have taken a toll on fiscal policy. Oil revenues account for nearly a fifth of government revenue. The IMF estimates that the budget deficit came in around-3% of GDP in 2015. It is expected to widen slightly to around -4% this year before narrowing to -3.3% in 2017. Congress is expected to vote soon on a proposed fiscal reform bill, which seeks to widen the tax base whilst reducing income tax rates. Other key elements include a hike in the VAT and a new tax on dividends.

The external accounts have improved. Lower oil prices have hurt exports, but slow growth has helped reduce imports. The current account gap was almost -7% of GDP in 2015, but is expected to narrow slightly to -5% in 2016 and -4% in 2017. Foreign reserves have fallen modestly, but at $46.75 bln in November, they cover more than 9 months of imports and are about 4 times larger than short-term external debt.

INVESTMENT OUTLOOK

The peso has outperformed this year after a poor 2015. In 2015, COP lost -25% vs. USD. This compares to the worst performers ARS (-35%), BRL (-33%), and ZAR (-25%). So far this year, COP is +5.5% YTD and is lagging only the best performers RUB (+19%), BRL (+17.5%), and ZAR (+10%). Our EM FX model shows the peso to have VERY WEAK fundamentals, so this year’s outperformance does not seem warranted. Retracement objectives for the November-December drop in USD/COP come in near 3052 (38%), 3082 (50%), and 3111 (62%).

Colombian equities have outperformed this year after a poor 2015. Last year, MSCI Colombia was -43% while MSCI EM was -17%. So far in 2016, MSCI Colombia is +21% YTD, and compares to +7% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Colombia at an UNDERWEIGHT position.

Colombian bonds have outperformed this year. The yield on 10-year local currency government bonds is about -130 bp YTD. This is behind only Brazil (-446 bp) and ahead of India (-125bp) and Russia (-102 bp). With inflation likely to continue falling and the central bank likely to continue cutting, we think Colombian bonds will continue outperforming.

Our own sovereign ratings model shows Colombia to have an implied rating of BBB-/Baa3/BBB-. Fitch recently moved the outlook on its BBB rating from stable to negative, and the agency noted that tax reforms are key for addressing the deteriorating fiscal outlook. We think Fitch’s move was warranted, and believe that all three ratings are subject to downgrade risks.