Colombia to Accelerate Easing Cycle as Economy Slows

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Colombia started what appeared to be a gradual easing cycle, but it is likely to accelerate as the economy is weakening.  The country has made adjustments to lower oil prices, and no longer faces significant downgrade risks.

POLITICAL OUTLOOK

President Santos will complete his second 4-year term in August 2018.  Legislative and presidential elections will be held in March and May 2018, respectively.  Santos cannot run again.  Vice President Vargas is considered the front-runner, as no other candidates have emerged yet.

There have been some recent corruption allegations against Santos.  These are tied to the Odebrecht scandal, which started in Brazil but has spread to other countries in the region.  The firm allegedly made illegal campaign contributions to Santos.  Between this and the unpopular tax hikes passed in December, Santos may be even more of a lame duck as his term winds down.

The peace deal with the FARC guerrillas was successfully completed after first failing the popular referendum last year.  The rebel group this month started phased disarmament under UN supervision.  The deal allocates 10 parliamentary seats for FARC over the next two terms, which is meant to bring the group into the mainstream.  However, some analysts are concerned that organized crime will fill the vacuum left by FARC in illegal mining and the drug trade.

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to accelerate to 2.7% in 2017 and 4.2% in 2018 from 2.0% in 2016.  The World Bank is slightly less optimistic, with forecasts at 2.5% and 3.0%, respectively.  GDP rose only 1.6% y/y in Q4, while Q1 indicators so far (IP, retail sales) suggest further deceleration.  As such, we see downside risks to the growth forecasts.  Higher oil prices should help boost growth in 2017, but the recent correction lower is concerning.

Price pressures are falling, with CPI decelerating to 5.2% y/y in February.  This is the lowest rate since August 2015, but remains above the 2-4% target range.  This supports the case for a an accelerated easing cycle ahead.

Falling inflation and a sluggish economy led to the start of the easing cycle in December.  The bank stood pat in January and cut another 25 bp in February.  This pattern suggests no move at the next meeting on March 24.  However, we think increasing downside growth risks will lead to a 25 bp cut next week.

Fiscal policy is improving.  According to the IMF, the budget deficit came in at an estimated -5.2% of GDP in 2016, down from -6.7% 2015.  With oil providing for a large chunk of its revenues, the government was forced to tighten policy.  Fiscal reform was passed in December that boosted the VAT from 16% to 19%.  The gap is expected to narrow further to -4.2% in 2017 and -4.0% in 2018.

The external accounts bear watching.  Lower oil prices hurt exports, but the sluggish economy has helped reduce imports.  The current account gap fell to -5.2% of GDP in 2016 from nearly -7% in 2015.  It is expected to narrow further to -4.2% in 2017 and -4.0% in 2018.

Foreign reserves have remained fairly steady at around $47 bln since 2014.  They cover over 9 months of imports and are over 4 times larger than its stock of short-term external debt.

INVESTMENT OUTLOOK

The peso has underperformed after a strong 2016.  In 2016, COP rose 6% vs. USD and was behind only BRL (+22%), RUB (+20%), and ZAR (+12.5%).  So far in 2017, COP is flat YTD and is ahead of only the worst performers TRY (-5%) and PHP (-1%).  Our EM FX model shows the peso to have VERY WEAK fundamentals, so this year’s underperformance is to be expected.

Colombian equities have also done worse after a strong 2016.  In 2016, MSCI Colombia was up 23% vs. 7% for MSCI EM.  So far this year, MSCI Colombia is -2% YTD and compares to +10% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Colombia at an UNDERWEIGHT position.

Colombian bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -11 bp YTD.  This compares to the best performers Argentina (-195 bp) and Brazil (-101 bp), as well as the worst performers Hungary (+51 bp) and Czech Republic (+39 bp).  With inflation likely to continue falling and the central bank likely to cut rates several times this year, we think Colombian bonds will start outperforming.

Our own sovereign ratings model shows Colombia’s implied rating improving a notch to BBB/Baa2/BBB in Q1.  The drop in oil prices really took a toll on the fundamental indicators and debt ratios, but they should bounce back now.  Downgrade risks to actual ratings of BBB/Baa2/BBB have dissipated for now, especially after Fitch moved the outlook for Colombia’s BBB rating from negative (since last July) to stable last Friday.