The central bank of Colombia has signaled that the easing cycle is nearing an end. This comes just as political risks are picking up ahead of elections this spring.
The presidential election will be held on May 27. President Juan Manuel Santos cannot run again as he will have served the maximum two terms. Polls now show former left-wing Bogota Mayor Gustavo Petro leading the race with 23% support. Next comes former Medellin Mayor Sergio Fajardo with 18% and former Vice President German Vargas Lleras with 10%.
Obviously, markets would be concerned if Petro were to win. Until recently, Fajardo had been coming out on top of the polls. If no candidate wins in the first round, a runoff vote will be held on June 17 between the top two vote-getters. While we believe that orthodox policies have become institutionalized in Colombia, markets will not take uncertainty well in the near-term.
Before the presidential vote, parliamentary elections will be held on March 11. This is the first time that the rebel group FARC will be fielding candidates. Under the peace agreement, FARC is guaranteed 5 seats each in both the House and Senate.
Yet the peace process has hit a snag. FARC just suspended its election campaign due to safety concerns. The group cited coordinated attacks on its candidates. What this means for the overall peace process remains unknown, though we believe that it is irreversible. Continued implementation of the peace accord should be the priority for any incoming government.
Colombia scores well in the World Bank’s Ease of Doing Business rankings (59 out of 190). The best components are getting credit and protecting minority investors, while the worst are dealing with enforcing contracts and paying taxes. Colombia does worse in Transparency International’s Corruption Perceptions Index (90 out of 176 and tied with Indonesia, Liberia, Morocco, and Macedonia).
The economy is finally picking up from a prolonged slowdown. GDP growth is forecast by the IMF to accelerate to 2.8% in 2018 from an estimated 1.7% in 2017. GDP rose 2.0% y/y in Q3, the strongest rate since Q2 2016. Monthly data in Q4 suggest some deceleration, however, and highlights modest downside risks to the growth forecasts.
The recent drop in oil prices, if sustained, is concerning. Despite candidate Petro’s plans to diversify, the Colombian economy will remain highly dependent on oil and other commodities. WTI oil had trouble sustaining a move above $65 and so perhaps it will trade in a $55-65 range for now.
Price pressures are falling, with CPI inflation decelerating to a lower than expected 3.7% y/y in January from 4.1% in December. This is the lowest since July 2017 and moves back into the 2-4% target range. The policy rate has fallen from 7.75% in November 2016 to 4.5% currently. We believe that the inflation trajectory argues for further easing. Tightening is a 2019 story.
The central bank cut rates 25 bp at the January meeting, as expected. Next policy meeting is March 20, and no move seems likely after the bank signaled steady rates. In minutes from the last meeting, the bank reveals that all members of the board agreed that given all available information, the easing cycle had likely ended. The vote was 4-3 in favor of a 25 bp cut.
The fiscal outlook remains dependent on oil prices. The budget deficit came in at nearly -4% of GDP in 2016, but improved to an estimated -3.6% in 2017 as oil prices recovered. The gap is expected to narrow to -3.1% of GDP in 2018 and -2.7% in 2019, but the trajectory will depend in large part on oil and commodity prices.
The external accounts should improve modestly. Over the past couple of years, low commodity prices hurt exports while the sluggish economy helped reduce imports. Those trends are reversing, with exports growing over 25% y/y in Q4 so far. The current account deficit was an estimated -3.8% of GDP in 2017, and is expected by the IMF to narrow to -3.6% in 2018.
Foreign reserves have continued to recover, helped by higher oil prices. At $47.6 bln in December, reserves are near all-time highs. They cover over 8 months of import and are over 3 times larger than the stock of short-term external debt. Thus, external vulnerabilities are relatively low.
The peso has outperformed after underperforming in 2017. In 2017, COP rose 0.5% vs. USD and was ahead of only the worst performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), and PHP (-0.5%). So far in 2018, COP is +3% YTD and behind only the best performers MXN (+5.5%), THB (+3.5%), ZAR (+3.5%), and CLP (+3.3%).
Our EM FX model shows the peso to have WEAK fundamentals, and so it should start to underperform more. The correlation between WTI oil and COP has strengthened since October, and stands around -0.52 vs. 0.0 last fall. IF WTI oil remains in a $55-65 range, then we suspect USD/COP will remain in a 2750-3000 range.
Colombian equities are outperforming EM after underperforming in 2017. In 2017, MSCI Colombia was up 13.5% vs. 34% for MSCI EM. So far this year, MSCI Colombia is up 3.5% YTD and compares to up 1% YTD for MSCI EM. This outperformance should ebb, as our EM Equity model has Colombia at a VERY UNDERWEIGHT position.
Colombian bonds have performed OK recently. The yield on 10-year local currency government bonds is +6 bp YTD. This is in the middle of the EM pack. The best performers are Peru (-37 bp) and Russia (-34 bp), while the worst are Hungary (+48 bp) and Turkey (+47 bp). With inflation likely to remain low in H1 and the central bank remaining in dovish mode into 2019, we think Colombian bonds can outperform more.
Our own sovereign ratings model showed Colombia’s implied rating falling a notch to BBB-/Baa3/BBB-. This supports S&P’s recent downgrade to BBB-, and suggests downward pressure on Moody’s and Fitch’s ratings of Baa2 and BBB, respectively.