Colombian Election Likely To Heighten Political Risks

colombia

Colombia holds the run-off vote for president this Sunday.  Center-right candidate Duque is tipped by the polls to win.  The economy is performing solidly, but political risks are likely to rise due to Duque’s opposition to the controversial FARC peace deal. 

POLITICAL OUTLOOK

The first round of the presidential election on May 27 saw Ivan Duque and Gustavo Petro win the most votes.  The conservative Duque led with 39% of the vote while leftist Petro won 25%.  Centrist Sergio Fajardo came in third with 24%, and his supporters likely hold the key for the second round.

The second round will be held this Sunday.  Even though Fajardo has said he won’t vote for either candidate, the most recent polls suggest Duque will win handily.  Some are even calling it a likely landslide.  If so, a Duque victory would be the most market-friendly outcome.

Duque is a candidate for the Democratic Center, formed in 2014 by former President Uribe. Despite its name, the party is widely viewed as center-right.  Petro is leftist, and is running on a platform of higher taxes on the wealthy.

Parliamentary elections on March 11 resulted in a divided Congress.  While the three largest right-wing parties won over 40% of the vote, they failed to secure a majority.  Not surprisingly, the centrist parties that supported outgoing centrist President Santos lost support.  FARC did poorly but is guaranteed five seats in the House and five in the Senate as part of the peace deal.

Given Colombia’s long history of violence between the left and the right (detailed below), it should not be surprising that mistrust remains on both sides.  Also, besides an uneasy peace with the FARC, Colombia is still facing challenges from the National Liberation Army (ELN).  Peace talks with the ELN have been ongoing, but Duque has vowed to end them if elected.

Keeping the peace will remain one of the country’s biggest challenges.  As a protégé of Uribe, it should come as no surprise that Duque opposes the peace deal.  Many on the right believe the deal was too lenient on the former rebels, and Duque favors modification.  On the other hand, Petro has supported the deal and would be unlikely to change it if he were to win.

Colombia scores well in the World Bank’s Ease of Doing Business rankings (59 out of 190).  The worst components are paying taxes and enforcing contracts, while the best are getting credit and protecting minority investors.  It does significantly worse in Transparency International’s Corruption Perceptions Index (96 out of 180 and tied with Brazil, Indonesia, Panama, Peru, Thailand, and Zambia).      

A BRIEF HISTORY LESSON

Colombia experienced a ten-year civil war from 1948-1958 that is now known as “La Violencia.”  The conflict began, as many do, with the 1948 assassination of Liberal Party leader and presidential candidate Jorge Eliecer Gaitan.  The Conservative Party had won the 1946 election, and was thought to have been behind a series of reprisals against members of the Liberal Party ahead of the next election.

The Conservative Party’s Laureano Eleuterio Gomez won the 1949 election uncontested.  Liberal Party candidate Daria Echancia withdrew after an assassination attempt was made on him.  After winning, Gomez extended the state of emergency called by his predecessor Mariano Ospina Perez.  Gomez suffered a heart attack, and the ensuing political uncertainty saw the Army take power with a coup in 1953.  General Gustavo Rojas Pinilla became president and La Violencia intensified.

The civil war finally ended when the Liberals and Conservatives agreed to a power-sharing arrangement in the so-called Declaration of Sitges in 1957.  This National Front government would see alternating presidencies as well as equal shares in ministerial posts for the two parties.  This agreement reliably held until 2002.

Despite the formation of this national unity government, Colombia has had to grapple with rebel violence for the past half century.  The Revolutionary Armed Forces of Colombia (FARC) was the main guerrilla group during this time, formed in 1964 as the military wing of Colombia’s Communist Party.  FARC was a Marxist-Leninist peasant movement that was meant to lead the fight against imperialism.  Over the next several decades, the FARC carried out kidnappings, killings, and pipeline bombings throughout the country.

Conservative Andres Pastrana was elected president in 1998 after pledging to hold peace talks with the FARC.  He tried but failed as the conflict continued across the country.  Pastrana ended peace talks in February 2002 after making little headway.

Alvaro Uribe won the 2002 election and became the first independent president to be elected since the National Front was formed.  Uribe had split from the Liberal party and capitalized on growing public disenchantment, running as an opponent of peace talks.  After changing the constitution to allow him to run for a second consecutive term, Uribe easily won reelection in 2006 with 62% in the first round, thereby avoiding a run-off.  He continued his hardline approach with regards to fighting the rebels.

Uribe tried to run for a third term in 2010 but the referendum proposal was rejected by the Constitutional Court.  Instead, Juan Manual Santos became the next president.  His Social Party of Unity was created in 2005 and was basically made up of Uribe supporters.  Santos was Uribe’s Defense Minister, and so enjoyed strong support amongst the populace.

President Santos was reelected in 2014.  He came under criticism by Uribe for reopening peace talks with the FARC during his first term.  During his second term, Santos was able to finally reach an agreement with the FARC, which signed a ceasefire accord in June 2016 and then a laid down its arms in June 2017 after signing a revised peace deal in November 2016.  Yet this deal has proven to be controversial, with many believing it to be too lenient with the rebels.

ECONOMIC OUTLOOK

The economy is picking up modestly.  GDP growth is forecast by the IMF at 2.7% in 2018 and 3.3% in 2019 vs. 1.8% in 2017.  GDP rose only 2.8% y/y in Q1.  With oil prices remaining elevated, we see modest upside risks to the growth forecasts.   However, like most of the other countries in the region, Colombia will continue to struggle with the end of the commodities super-cycle.

Price pressures remain low.  CPI rose 3.2% y/y in May, near the low for the cycle and also near the center of the 2-4% target range.  Core inflation of 3.9% y/y in May is also near the trough, while PPI inflation of 2.8% y/y remains relatively low.  Central bank Co-Director Ocampo said rate cuts won’t depend only on inflation, but also on economic activity which he noted remains subpar.

Thus, we believe central bank is still an easing cycle.  It began the cycle with a 25 bp cut to 7.5% in December 2016.  The last move was a 25 bp cut to 4.25% in April, which represents 350 bp of cumulative easing.  The pace has slowed this year, however, and we do not expect a cut at the next meeting June 29.   Instead, we see a 25 bp cut at the July 27 meeting followed by another 25 bp cut on October 26.

The fiscal outlook remains positive.  The budget deficit was an estimated -2.7% of GDP in 2017.  The OECD expects this gap to narrow to -2.3% in 2018 and -2.2% in 2019.  However, with oil accounting for a large share of government revenues, we believe these forecasts may be too pessimistic.

The external accounts are in solid shape.  The current account deficit was -3.3% of GDP in 2017, and the IMF expects the deficit to narrow slightly to -2.6% in both 2018 and 2019.  Export growth has remained strong due to high oil prices, leading the 12-month trade deficit to narrow to the lowest since late 2014.  Here too, these forecasts may be too pessimistic.

Foreign reserves have remained steady this year.  At $47.4 bln in May, they cover 8 months of imports and are over 3 times the stock of short-term external debt.  On the other hand, foreign ownership of Colombian local currency government bonds is relatively high at around 26%.  Colombia’s Net International Investment Position (NIIP) stands at -48% of GDP, the highest of the major Latin American economies.  Thus, the country is vulnerable to shifts in sentiment and so-called hot money.

INVESTMENT OUTLOOK

The peso is outperforming after a subpar 2017.  In 2017, COP rose 0.5% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), BRL (-2%), IDR (-1%), and PHP (-0.5%).  So far in 2018, COP (+4.5%) is the best EM performer, with CNY (+2%) running a distant second.  Our EM FX model shows the peso to have WEAK fundamentals, and so we expect this outperformance to end.

USD/COP has retraced about half of the December-April drop.  Retracement objectives from that move come in near 2861 (50%) and 2903 (62%).  Break of the 2900 area would set up a test of the December high near 3037.  The 200-day moving average comes in near 2895.

Colombian equities are outperforming after a subpar 2017.  In 2017, MSCI Colombia was up 13.5% vs. 34% for MSCI EM.  So far this year, MSCI Colombia is up 11% YTD and compares to -2.5% YTD for MSCI EM.  Our EM Equity Allocation Model has Colombia at VERY UNDERWEIGHT, and so we expect Colombian equities to start underperforming.

Colombian bonds are outperforming.  The yield on 10-year local currency government bonds is +11 bp YTD.  This is behind only the best EM performers China (-24 bp), Poland (-9 bp), Taiwan (-7 bp), and Russia (+6 bp).  With inflation likely to remain low and the central bank still cutting rates, we think Colombian bonds will continue to outperform.

Our own sovereign ratings model shows Colombia’s implied rating steady at BBB-/Baa3/BBB-.  This supports S&P’s downgrade to BBB- in December, and suggests downward pressure on Moody’s and Fitch’s ratings of Baa2 and BBB, respectively.  However, higher oil prices should help Colombia ultimately retain its investment grade ratings.  Moody’s wrote recently that “Regardless of who wins the elections, Moody’s expects market-friendly policies to continue.”