Low Oil Prices Will Continue to Weigh on Colombia

Colombian assets have been pummeled this year, due largely to falling oil prices.  Local currency bonds have outperformed, but we think this will be hard to sustain in light of the plummeting peso, rising inflation, and a widening budget gap.  The peso and the equity market are likely to continue underperforming.

INTRODUCTION

Colombian assets have been pummeled this year, due largely to falling oil prices. Local currency bonds have outperformed, but we think this will be hard to sustain in light of the plummeting peso, rising inflation, and a widening budget gap. The peso and the equity market are likely to continue underperforming.

POLITICAL OUTLOOK

President Santos began his second and final four-year term in August 2014.  At this point, there is no obvious successor to the center-right Santos.  Local and regional elections are scheduled for October, with many focusing on the important mayoral race in Bogota.

Santos is focusing on concluding peace talks with FARC, which is seen as his (potential) lasting legacy.  However, tensions have been rising since May, when FARC ended its unilateral ceasefire.  As a result, the government resumed air strikes on FARC camps.  Most observers believe that an agreement will eventually be reached, despite this flare-up.

Foreign investment may take a hit from an upcoming Isagen ruling.  In May, a Colombian court ordered a halt to the sale of the government’s 57.6% stake in hydropower plant Isagen.  The court will rule on three cases related to the sale, with rulings expected later this month.

ECONOMIC OUTLOOK

The economy is sluggish from the impact of falling oil prices.  GDP rose only 2.8% y/y in Q1, the slowest since Q3 2012.  Monthly data in Q2 suggest potential for a slight pickup, but the headwinds remain in place.   IP and exports are contracting y/y, while retail sales are slowing.  Over half of Colombia’s exports are oil or oil-related.

Yet inflation remains high.  July CPI will be reported late tonight, and is expected to rise 4.36% y/y vs. 4.42% in June.  This would still be above the 2-4% target range, and has been above it since February.  We think the central bank would like to ease, but its hands are tied.  The last move was a 25 bp hike to 4.5% in August 2014.

The external accounts have worsened.  Exports have been contracting for eight straight months, but imports have not contracted as much.  As a result, the 12-month trade deficit has ballooned to record levels.  The current account deficit is expected to widen to around -6% of GDP.  FDI will cover around half, with luck, and so the rest will depend on hot money flows.

Slow growth and low oil prices have taken a toll on the fiscal outlook.  The budget deficit is likely to widen to over -3% of GDP this year, and will likely lead to greater debt issuance at a time when foreign appetite is waning.  The government recently announced added fiscal stimulus, and so we think there are upside risks to the budget gap.

INVESTMENT OUTLOOK

Colombian bonds have held up well compared to the rest of EM, with 10-year local currency government bond yields up only 17 bp YTD.  This compares to the group of worst performers that includes Turkey (+160 bp), Peru (+135 bp), Brazil (+95 bp), and Indonesia (+72 bp).  The US 10-year yield is up 11 bp YTD.  With domestic inflation set to remain high, the long end of Colombia may not hold up as well, especially given rising borrowing needs (greater supply of bonds) due to the fiscal hole from low oil prices.

Lower oil prices and sluggish growth have helped drag Colombian stocks lower.  It’s the worst performer in EM (MSCI Colombia at -29.1% YTD vs. MSCI EM at -6.9%).  We believe the weak growth outlook and low oil prices will keep Colombian equity markets under pressure.  Our EM equity model has Colombia as an underperformer over the next three months.

Given the lack of official concern, we expect USD/COP to continue making new cycle highs in the coming days.  COP is the second worst performers in EM, -19% YTD and ahead of only BRL (-24% YTD).  We are about to test the all-time high for USD/COP near 2980 from January 2003.  After that, we are in uncharted territory and have no obvious targets beyond the obvious round number of 3500.

Government officials seem unfazed by peso weakness, which we think is becoming increasingly reckless in the current environment.  As recently as this week, Finance Minister Cardenas was extolling the benefits of a weak peso, and noting (hoping?) that it wouldn’t threaten the inflation outlook.

Most of the worst currency performers are linked to commodities, and Colombia is no exception.  We note that the correlation between oil and COP (rolling 60-day) is around 0.40, amongst the highest in EM.  Our EM FX model has Colombia as an underperformer over the next three months.