Fundamentals Improve in Colombia While Political Uncertainty Rises

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The fundamentals in Colombia are improving just as political uncertainty is rising.  We remain cautious on Colombia, as we expect further central bank easing to erode the peso’s attractiveness.   

POLITICAL OUTLOOK

The next parliamentary election will be held in March 2018, with the presidential vote following shortly in May.  If no candidate wins a majority, then the top two go to a run-off vote in June.  President Santos is in the final year of his second 4-year term.  Vice President Vargas Llera resigned earlier this year, setting up a likely run for the presidency.

Polls show former Bogata Mayor Gustavo Petro as the current frontrunner.  He is a former guerrilla and an avowed leftist, which would make investors nervous.  However, it’s early and there’s still a crowded field.  Back in June, former Presidents Uribe and Pastrana announced that their two parties would join forces for a “great coalition” of the center right, but they have yet to name a candidate.

The FARC peace agreement has been successfully implemented.  FARC is now a political party and will stand in the 2018 elections for the first time ever.  The peace agreement allocates a minimum of 5 seats in both the house and senate to FARC.  Elsewhere, a ceasefire was recently negotiated with the ELN, the second-biggest rebel group.

Colombia scores very well in the World Bank’s Ease of Doing Business rankings (53 out of 190).  The best components are getting credit and protecting minority investors, while the worst are enforcing contracts and paying taxes.  Colombia does less well in Transparency International’s Corruption Perceptions Index (90 out of 176 and tied with Indonesia, Liberia, Morocco, and Macedonia).

 

ECONOMIC OUTLOOK

The economy is still sluggish.  GDP growth is forecast by the IMF to accelerate modestly to 2.3% in 2017 from 2.0% in 2016, before picking up to 3% in 2018.  GDP rose 1.3% y/y in Q2, but monthly data so far in Q3 suggest some modest acceleration.

Price pressures bear watching, with CPI accelerating to 3.9% y/y in August from 3.4% in July.  This is just within the 2-4% target range, but had been decelerating since the July 2016 peak of 9% y/y.  Minutes from the August policy meeting show that the majority voted for a 25 bp cut, while two voted for a 50 bp cut and one voted not to cut at all.

We believe the data support the case for lower rates, and that the central bank will cut 25 bp again when it meets September 29.  It has cut seven straight months and eight of the past nine.  Yet the latest central bank survey of analysts sees steady rates until December, when the next 25 bp cut to 5.0% is expected.  After that, consensus sees a 25 bp cut to 4.75% in March 2018 and another 25 bp cut to 4.5% in May 2018.

Fiscal policy has worsened due to low oil prices.  Oil revenues account for a large share of government revenue.  As such, the drop in oil prices necessitates fiscal tightening.  The budget deficit came in at an estimated -3.8% of GDP in 2016, up from -3.1% 2015.  Bloomberg consensus expects the gap at around -3.1% of GDP in 2017 and -3.3% in 2018, but much will depend on oil prices.

The government seems too optimistic on the economic outlook.  The most recent government projections from June assume that oil prices will rise to $60 per barrel next year and about $70 from 2020, compared to $50 currently.  In addition, those projections assume GDP growth of at least 4% per annum from 2019 to 2025.

The external accounts should improve.  Low oil prices have hurt exports, but the sluggish economy has helped reduce imports.  The current account deficit was about -4.2% of GDP in 2016, and is expected to narrow slightly to -3.7% in 2017 and -3.5% in 2018.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $47.6 bln in August, they cover nearly 8 months of import and are over 4 times larger than the 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 the best performers BRL (22%), RUB (+20%), and ZAR (+13%).  So far in 2017, COP is up 3% YTD and is ahead of only the worst EM performers ARS (-7%), PHP (-3%), HKD (-1%), TRY (+1%), and IDR (+1.5%).  Our EM FX model shows the peso to have NEUTRAL fundamentals, so this year’s underperformance is likely to ebb a bit.  Still, further rate cuts in Colombia are likely to erode the peso’s attractiveness.

Friday’s drop below 2900 took USD/COP to levels not seen since June 7.  Now, the pair is moving higher along with the rest of EM FX.  Levels to look for on the downside are the June low near 2885 and then the April low near 2831.  Levels to look for on the upside are the 200-day moving average near 2945 and then 3000.

Colombian equities are underperforming EM after a strong 2016.  In 2016, MSCI Colombia rose 23% vs. 7% for MSCI EM.  So far this year, MSCI Colombia is up 15% YTD and compares to 29% YTD for MSCI EM.  This underperformance should continue, as our EM Equity model has Colombia at a VERY UNDERWEIGHT position.

Colombian bonds have outperformed recently.  The yield on 10-year local currency government bonds is about -60 bp YTD.  This is behind only the best performers Argentina (-192 bp), Brazil (-162 bp), Indonesia (-143 bp), Peru (-102 bp), Russia (-76 bp), and Mexico (-60 bp).  With inflation likely to resume falling and the central bank still in easing mode, we think Colombian bonds will continue outperforming.

Our own sovereign ratings model shows Colombia’s implied rating steady at BBB/Baa2/BBB.  The drop in oil prices took a toll on the economy, but growth should bounce back now that prices have recovered and the central bank is in the midst of an aggressive easing cycle.  Downgrade risks to actual ratings of BBB/Baa2/BBB have dissipated for now.  However, Moody’s recently warned that rising debt levels are clearly negative for Colombia’s creditworthiness.