Colombia

Colombia has fallen from grace in terms of its healthy macroeconomic fundamentals, business-friendly government policies, and conservative fiscal stances. The economy is experiencing stagflation, public finances are deteriorating rapidly, and political uncertainty will persist. Underweight Colombia across all financial markets relative to their EM benchmarks, and short Colombian bank stocks and the currency versus their Chilean counterparts.

Despite higher oil prices, Colombian risk assets will underperform their EM peers in the months ahead. The domestic economy is evolving from stagflation into recession, and fiscal and political risks will raise the risk premium of Colombian assets. Take profits on the yield curve inversion trade and stay short COP vs. USD.

Colombian assets are inexpensive, but they are cheap for a reason. The economy is entering a growth recession while inflation will remain sticky and above target. Further, President Gustavo Petro’s policies will lead to lower investment, rising political volatility, and public debt deterioration. Continue underweighting Colombia across all asset classes.

Executive Summary Colombian Stocks Failed To Break Above Technical Resistances Colombian Stocks Failed To Break Above Technical Resistances Colombian Stocks Failed To Break Above Technical Resistances The economy is booming, but capacity constraints are already biting. Structurally, the election of leftist Gustavo Petro will entail a permanent increase in fiscal spending, worsening public debt dynamics, and falling export revenues and FDIs into the oil and coal sectors. The new government’s policies alongside its anti-corporate rhetoric will have the perverse effect of diminishing business confidence and thereby gross investment across the whole economy. On the external front, an already large current account deficit, falling commodity prices, capital flight from wealthy Colombians and falling FDIs will continue to weigh on the peso.   Recommendation Inception Date RETURN Downgrade Colombian Local Bonds and Sovereign Credit to underweight within EM fixed-income portfolios 2022-08-16   Bottom Line: Expect more pain ahead for Colombian markets. We recommend that investors have an underweight allocation relative to EM across all asset classes: equities, currencies, local bonds and sovereign credit. Feature Colombian assets and the economy are facing cyclical and structural headwinds. On the one hand, the economy is experiencing classic overheating: inflation is at a multi-decade high, the labor market is tight, and growth has run into capacity constraints. In response, the central bank (Banrep) has no choice but to continue tightening policy and engineer a major growth slump. On the other hand, as we have been writing since June of last year, Colombia is undergoing an unprecedented social and political shift to the left. This societal change was cemented in June with the election of the country’s first leftist President, Gustavo Petro. His policies will have negative repercussions in the economy in the form of lower business confidence, falling FDIs, higher government intervention, and ballooning public debt. Nevertheless, Petro’s most radical policies will be challenged by his own broad alliance in Congress established with centrist and traditional parties.  All in all, Colombian equities and the currency will continue underperforming versus EM peers, leading us to maintain our underweight stance on stocks and reiterate our short position in the COP versus the US dollar. We are also downgrading our allocation to local bonds and sovereign credit from neutral to underweight. Classic Overheating Colombia is undergoing classic inflationary overheating. Headline and core consumer price inflation have reached a two-decade high, and other core measures of inflation are at similar levels (Chart 1). This implies that rising price pressures are genuine and broad based. Inflation will remain high and persistent going forward, as the Colombian economy has hit capacity constraints and a wage-price spiral is well underway: The labor market is tight, with nominal wages rising rapidly at 13.4% – and quite above core cpi (Chart 2). Further, the unemployment rate has fallen back to reasonably low levels. Chart 1Colombia: Inflation Is High And Broad Based Colombia: Inflation Is High And Broad Based Colombia: Inflation Is High And Broad Based Chart 2Colombia: Nominal Wages Are Outstripping Inflation Colombia: Nominal Wages Are Outstripping Inflation Colombia: Nominal Wages Are Outstripping Inflation   The levels of activity in various segments of the economy have meaningfully surpassed their pre-pandemic levels in volume terms (Chart 3). As a sign of booming domestic demand and hidden inflation, the current account deficit is almost at historic lows, despite sky-high oil prices (Chart 4, top panel). Accordingly, imports of consumer goods are booming (Chart 4, middle panel). Chart 3The Colombian Economy Is Overextend The Colombian Economy Is Overextend The Colombian Economy Is Overextend Chart 4Colombia: Signs of Strong Domestic Demand Colombia: Signs of Strong Domestic Demand Colombia: Signs of Strong Domestic Demand   In addition, real consumer demand has outgrown real capital expenditures (Chart 4, bottom panel). In general, when demand outpaces productive capacity, inflation intensifies. This is what has transpired in Colombia. According to data from Banrep, the country’s output gap is now positive at 1% of potential GDP, entailing the economy is operating above capacity. To add further fuel to the fire, the newly proposed fiscal budget for 2023 is significantly expansive, with total expenditures being 12% higher than the 2022 budget and 43% higher than 2021 expenses. Additionally, the newly elected finance minister, José Antonio Ocampo, wants to revise the 2023 budget even higher. He also plans to delay reducing the fiscal deficit by a year. Consequently, the government balance will remain negative around -5.6% of GDP in 2023. In line with the above, inflation expectations by businesses have skyrocketed (Chart 5). This means they will not only be willing to hike wages but will also raise their selling prices. In short, a wage-price spiral has been put into motion. Given the magnitude of overheating, the central bank has no choice but to continue to hike rates aggressively. Banrep has raised rates by a historic 725 basis points since September 2021 to 9%. However, given headline and core inflation are at 10.2% and 8.4% respectively, monetary policy is not restrictive enough – real interest rates are close to zero. We expect Banrep to continue its rate hiking cycle into the end of the year, particularly in the face of a hawkish Fed and a strong US dollar/local currency depreciation. Given the economy has very strong growth momentum, and the credit impulse is very high, it will not slow down immediately (Chart 6). Chart 5Business Inflation Expectations Are Unhinged Business Inflation Expectations Are Unhinged Business Inflation Expectations Are Unhinged Chart 6The Colombian Economy Will Not Slow Down Yet The Colombian Economy Will Not Slow Down Yet The Colombian Economy Will Not Slow Down Yet Chart 7Prepare For Further Yield Curve Inversion Prepare For Further Yield Curve Inversion Prepare For Further Yield Curve Inversion This and easing fiscal policy will give the central bank strong reasons to continue raising rates in large increments in the months ahead. Eventually, this will produce a major growth slump sometime in 2023. Bottom Line: The economy is booming but capacity constraints are already biting. Surging inflation means the expansion is unsustainable. The upshot is continuous central bank tightening until domestic demand slumps considerably. For now, an overheating economy, runaway inflation, continuous rate hikes and growing prospects of an economic downturn in 2023 warrant a more drastic yield curve inversion (Chart 7). The currency remains at risk of a widening current account deficit and a potential US dollar overshoot. Petro’s Policies Hinder Long-Term Growth The election of leftist outsider Gustavo Petro is consistent with the average voter’s tilt towards the left, as well as the rejection of traditional centrist and right-wing policies. With this historic societal political shift, it is clear the new government will move away from a tradition of small budgets and orthodox fiscal policy towards significant state spending on social programs, particularly on education, health and pensions. Below we analyze Petro’s proposals and relationship with Congress, as well as the implications for businesses and Colombia’s structural outlook. First, Petro’s most radical reforms will be watered down in Congress, but do not expect traditional parties to fully block his proposals. On the one hand, Petro’s original left-wing coalition (the Historic Pact) has only 15% of seats in Congress and 19% in the Senate. This has forced the President to form a broad alliance with traditional centrist parties (such as the Liberal Party and the Union Party). This new alliance holds a small majority of 56% and 58% in Congress and the Senate, respectively. However, many of its individual members are centrists and right wing and might not always support Petro’s government. Therefore, we can expect the traditional political class to push back on Petro’s intentions to overhaul Colombia’s socio-economic model. On the other hand, moderate and right-wing parties have an incentive to support a permanent increase in fiscal spending to not distance themselves even further from the median voter – who has taken a leftward shift. This is evident even within right-wing ex-President Iván Duque’s government, which has submitted an expansionary budget for 2023.1 All in all, we expect Petro and Congress will work together to meaningfully increase government spending, but more radical reforms will be watered down and implemented gradually but not eliminated entirely. While Congress will probably support Pero’s tax reform to increase collection and raise income and wealth taxes on high-earning Colombians, the finance minister has already stated it will be implemented in a gradual manner, reducing the collection target from 5% to 1.7% of GDP in 2023. This suggests the significant increase in government spending will not be offset by higher revenues. Second, fiscal largesse will worsen public debt dynamics. Colombia’s fiscal accounts are already in a precarious position: the fiscal deficit is the widest in history (excluding the peak of the pandemic), and public debt has risen to 71% of GDP (Chart 8, top and middle panels). To make matters worse, 40% of gross public debt is nominated in foreign currency. Going forward, gross public debt will rise meaningfully due to (1) persistent and large fiscal deficits; (2) continuous currency depreciation; and (3) local bond yields hovering significantly above the nominal GDP growth rate (Chart 8, bottom panel). As long as these three conditions remain, the public debt-to-GDP ratio will continue spiking. Further, falling oil prices will negatively impact fiscal accounts, as oil revenues account for 15% of total government revenues. BCA’s Emerging Markets Strategy service believes oil prices have formed a major top and will average well below $100 per barrel in the years to come (Chart 9).  Chart 8Colombia: Public Debt Dynamics Will Go From Bad To Worse Colombia: Public Debt Dynamics Will Go From Bad To Worse Colombia: Public Debt Dynamics Will Go From Bad To Worse Chart 9Global Oil Prices And Energy Stocks Are Heading For A Downturn Global Oil Prices And Energy Stocks Are Heading For A Downturn Global Oil Prices And Energy Stocks Are Heading For A Downturn   Third, Petro’s environmental proposal of banning new oil explorations and new open pit mining projects will reduce FDIs into the energy and mining sectors, and ultimately curtail export revenues. Colombia’s oil and coal exports account for a massive 34% and a 17% share of total exports, respectively. Worryingly, oil and coal output have not recovered in the past two years (Chart 10). A lack of new investment will accelerate the fall in production and, hence, export revenues. In short, all these will have a perverse effect on the balance of payments. Even if Congress is able to persuade the government to water down the outright ban on new projects, and instead opt for increased regulation and red tape for extractive industries, the economy will experience declining domestic and foreign investment in these sectors. The new finance minister has already proposed imposing a 10% tax on oil and coal exports if their prices exceed $48 per barrel and $87 per ton, respectively. Fourth, there are a myriad of other economic policies in the new government’s wish list which will hurt the nation’s productivity in the long term. The ones that stand out are raising import barriers and re-establishing diplomatic relations with Venezuela. The last one is particularly worrisome because it may undermine the trust and cooperation Colombia has with the US government and multinationals, which have diplomatically and economically shunned the Venezuelan government. Being the most important regional ally with the US, Colombia could miss out on a golden opportunity as an international manufacturing hub for nearshoring efforts away from China and Emerging Asian countries. Finally, all these policies will serve to meaningfully worsen business confidence. As we have seen in Mexico, rising state intervention in the energy sector and anti-corporate rhetoric can hurt business confidence and investment across the entire economy (Chart 11). Chart 10Colombian Commodity Production Has And Will Not Recover Colombian Commodity Production Has And Will Not Recover Colombian Commodity Production Has And Will Not Recover Chart 11Poor Business Confidence Will Hurt Gross Investment Across The Whole Economy Poor Business Confidence Will Hurt Gross Investment Across The Whole Economy Poor Business Confidence Will Hurt Gross Investment Across The Whole Economy   Bottom Line: Petro’s policies will have negative repercussions for fiscal accounts and meaningfully hinder the country’s productivity and long-term potential growth. This calls for a structural derating in Colombian risk assets. Balance Of Payments Dynamics Will Only Get Worse Colombia’s external environment is also set to deteriorate over the medium- and long-term horizons. Cyclically, falling oil and coal prices resulting from a global slowdown will weigh heavily on the Colombian peso. Additionally, currency depreciation will be aggravated by short-term capital flight from wealthy Colombians as they seek to protect their incomes from tax hikes. Structurally, Petro’s environmental policies against new oil exploration and open pit mining projects will constrict future exports of oil and coal. This will also weigh on FDIs, of which 11% and 8% are destined towards oil and mining projects, respectively. We believe investment in current oil and mining projects will also be curtailed as domestic and foreign investors see less future growth in these industries. Bottom Line: Colombia’s balance of payment dynamics will go from bad to worse (Chart 12). Investment Recommendations Given the bleak cyclical and structural outlook for the Colombian economy, our recommendations are as follows: Equities: A combination of high and persistent inflation, rising interest rates and a troubling structural outlook lead us to maintain an underweight position in Colombian equities within an EM equity portfolio. As a bearish signal, Colombian stocks have nosedived below long-term moving averages in absolute and relative terms (Chart 13). Chart 12Colombia's Current Account Deficit Is The Country's Achille's Heel Colombia's Current Account Deficit Is The Country's Achille's Heel Colombia's Current Account Deficit Is The Country's Achille's Heel Chart 13Colombian Stocks Failed To Break Above Technical Resistances Colombian Stocks Failed To Break Above Technical Resistances Colombian Stocks Failed To Break Above Technical Resistances   Currency: High inflation, falling oil prices and an already large current account deficit make for a dangerous cocktail for the Colombian peso. Stay short versus the US dollar. Fixed Income: Regarding local bonds, the risks of further currency depreciation and worsening fiscal accounts lead us to downgrade their allocation to underweight relative to the EM benchmark. Further, foreigners own 25% of local bonds, so the risk of capital flight can further weigh on domestic bond and currency performance. Rising short-term interest rates and an imminent growth slump in 2023 favor further yield curve inversion. Therefore, we continue to recommend our yield curve flattening trade (Chart 7 above). Concerning sovereign credit, we are also downgrading our allocation to underweight within an EM credit portfolio. While sovereign spreads are the highest in LATAM, expansive fiscal policy and a mushrooming public debt-to-GDP ratio will weigh on their performance. Juan Egaña Associate Editor juane@bcaresearch.com Footnotes 1     Under Colombian law, the departing government must submit the fiscal budget for the first year of the newly elected government. This budget is then debated and revised in Congress. 

Executive Summary The Economy Will Enter A Slowdown The Economy Will Enter A Slowdown The Economy Will Enter A Slowdown Colombian stock prices and the peso rallied earlier this year, but the rebound is over. Hawkish monetary and tight fiscal policies will slow down domestic demand considerably. Despite high oil prices, the current account deficit will remain wide. This will weigh on the peso. Political risks will rise ahead of the presidential elections which will prove to be a very tight race. Odds of far-left candidate Gustavo Petro winning are not low. His victory would present institutional risks to Colombia’s market-friendly economic model.         Recommendation Inception Date Return A New Trade: Receive 10-Year / Pay 6-Month Swap Rates 2022-05-04    Bottom Line: Colombian financial markets will be buffeted by ongoing monetary tightening, an impending growth slowdown and rising political volatility. Remain underweight Colombian stocks within an EM equity portfolio and continue shorting the currency versus the US dollar. Maintain a neutral allocation to Colombia in both EM domestic bond and sovereign credit portfolios. We are also initiating a new trade: Bet on substantial yield curve inversion. Feature Chart 1Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices This year’s rally in Colombian stocks and the peso has largely been the result of strong domestic demand and a catch up to sky-high oil prices (Chart 1). In the past month, however, alongside other commodity producers such as Brazil and Chile, Colombian risk assets have been buffeted. This is because the outlook for commodity prices has become more uncertain with an ongoing slowdown in the Chinese economy and an impending slump in DM domestic demand for goods. Going forward, Colombian markets will trade on oil price fluctuation, the local business cycle and the presidential elections. The global commodity trade appears to be struggling at present. The business cycle outlook is negative as hawkish monetary and fiscal policies will slow down growth decisively. The political risks have not yet materialized but they could pose a serious menace to financial markets as frontrunner Gustavo Petro presents institutional risks with his plans to upend Colombia’s market-friendly economic model. All in all, we recommend that investors maintain an underweight stance on Colombian stocks and a short position in the currency, while keeping a neutral allocation to domestic bonds and sovereign credit within their respective EM portfolios. We also recommend betting on yield curve inversion by receiving 10-year and paying 6-month swap rates. Cyclical Forces: Growth Slowdown The Colombian economy is overheating: core measures of inflation are reaching their highest point in two decades (Chart 2). Particularly, hairdresser inflation – which we view as a signpost of genuine inflation given that costs are mainly labor and rent – is high and accelerating (Chart 2, bottom panel). Further, nominal wages are rising at 11% in annual terms, the unemployment rate has fallen almost to pre-pandemic levels, and business inflation expectations remain above the central bank’s (Banrep) target of 3% +/- 1% (Chart 3). These are signs that inflation is genuine and broad based in Colombia. Hence, monetary tightening will continue. Chart 2Colombia: Inflation Is Reaching Historic Highs! Colombia: Inflation Is Reaching Historic Highs! Colombia: Inflation Is Reaching Historic Highs! Chart 3Inflationary Pressures Are Genuine And Broad Inflationary Pressures Are Genuine And Broad Inflationary Pressures Are Genuine And Broad Just last week, the central bank raised the policy rate by 100 basis points to 6%, while three of the seven board members voted for a larger increase of 150 basis points. Rapidly raising the policy rate from a historical low of 1.75% comes at a cost, however, and it will result in a notable growth slowdown. The top panel of Chart 4 shows that banking credit has been strong but is set to roll over as Banrep raises interest rates significantly. Our marginal propensity to consume proxy and the narrow money impulse are also foreshadowing a growth slowdown in domestic demand (Chart 4, bottom two panels) Regarding fiscal policy, the fiscal thrust is going to be negative this year (Chart 5). Chart 4The Economy Will Enter A Slowdown... The Economy Will Enter A Slowdown... The Economy Will Enter A Slowdown... Chart 5... And Fiscal Stimulus Will Not Save The Boat ... And Fiscal Stimulus Will Not Save The Boat ... And Fiscal Stimulus Will Not Save The Boat   A combination of tight fiscal and monetary policies also presents a notable risk to the credit cycle and to banking profitability. Banks’ EPS in local currency terms has reached a historic high, and their share of non-performing loans (NPLs) and provisions has fallen drastically in the past months. As interest rates rise further and the economy slows down, financial stocks – which make up 47% and 54% of the nation’s COLCAP stock index or the MSCI index, respectively – will experience a soft spot. Banks will have to lift their NPL provisions on the back of rising lending rates and a slowdown in growth (Chart 6, top panel). Any time NPL provisions rise (shown inverted in the top and bottom panels of Chart 6), bank share prices drop. As a result, banks will tighten credit standards and reduce loan origination. This will be a hurdle to both economic growth and banks’ profitability. Chart 6Banks' Share Prices And NPLs Banks' Share Prices And NPLs Banks' Share Prices And NPLs Bottom Line: The Colombian economy is facing strong domestic headwinds, which will result in a growth slowdown. The Current Account Deficit: Colombia’s Achilles’ Heel Despite very high oil prices and the rally in commodity plays around the world early this year, the Colombian peso has appreciated only mildly and has given up most of its gains in the past month (Chart 1 above, bottom panel). Odds are the currency will weaken further in the near term (next 3 months), so we are reiterating our recommendation to stay short the peso versus the US dollar: First, it is not certain whether commodity prices will rise significantly in the coming months. While commodity supply constraints remain acute, global demand is deteriorating. In a nutshell, high crude prices are causing oil demand destruction. We elaborated on the outlook for Chinese overall growth and DM domestic demand for goods in our April 21 Strategy Report. This analysis is more pertinent for industrial commodities, less so for oil and has little relevance for agricultural commodities. Second, the chronic massive current account deficit will continue exerting downward pressure on the exchange rate. The current account deficit remains large at $18 billion or 6.2% of GDP as of Q4 2021. Further, even if we assume oil prices will average US $120 per barrel in 2022, the current account deficit will be large in 2022 (Chart 7, top and middle panels). Excluding oil, the current account deficit is also wide. Third, FDI inflows have been meager both in the oil sector and the rest of the economy (Chart 7, bottom panel). There is little chance that FDI will be strong in the coming months given election uncertainty. The front-runner in this year’s presidential elections, Gustavo Petro, has a hardline stance against oil exploration, which would disincentivize foreign investment in the sector. In general, his left-wing policies are not conducive for overall FDI inflows. We elaborate on this topic below. Finally, foreign portfolio flows into local bonds have been a large source of funding for the current account deficit. With the currency depreciating and elevated political risks, net portfolio inflows into domestic bonds could dry up in the near term (Chart 8). Chart 7The Current Account Will Remain In Deficit Despite High Oil Prices The Current Account Will Remain In Deficit Despite High Oil Prices The Current Account Will Remain In Deficit Despite High Oil Prices Chart 8Colombian Local Bonds Will Underperform Colombian Local Bonds Will Underperform Colombian Local Bonds Will Underperform Bottom Line: The current account deficit remains wide. Even a marginal decline in foreign net portfolio inflows will lead to currency depreciation. In turn, given the tight correlation between the exchange rate and headline inflation, the central bank will respond by raising interest rates more to curb inflation. Political Risks: Will Colombia Elect A Left-Wing Government? Since June of last year, we have been arguing that Colombian politics would take a left-ward shift given the massive demonstrations demanding higher government expenditures on social programs. In that report, we also flagged the growing popularity of veteran left-wing candidate Gustavo Petro. Presently, Colombia has never been closer to electing a far-left president. Going forward, we expect Colombian markets will trade on two factors: (1) the possibility of Petro winning the election, and (2) his potential to undermine Colombian institutions if he is elected president. Both will insert volatility in Colombian markets from today till the outcome of the second round is known on June 19. First, we believe the contest between the far-left Gustavo Petro and the conservative Federico “Fico” Gutiérrez will be a very close race. While Petro is set to dominate the first round on May 29 (Chart 9), Fico has had a meteoric rise in popularity since last year, which suggests he can possibly bridge the remaining 7% gap between the contenders before the second round on June 19 (Chart 10). Chart 9Petro Will Dominate In The First Round… Colombia: Market Turbulence Ahead Colombia: Market Turbulence Ahead Chart 10… But The Race Will Be Tight In The Second Round Colombia: Market Turbulence Ahead Colombia: Market Turbulence Ahead The result of the election largely depends on both candidates’ ability to attract moderate voters, which Fico has been more successful in doing. While Petro has doubled down on his left-wing base by choosing progressive environmentalist Francia Márquez as his running mate, Fico has made conscious steps to separate himself from rightwing leaders (particularly ex-president Álvaro Uribe), in line with the leftward shift in Colombian voters. He has done this by campaigning on a more centrist platform, which includes increasing government spending on infrastructure, pensions, primary education and housing. Further, he has secured the support of the centrist Liberal party, which has a large voter base and holds 17% of seats in congress. So far, we believe the election will be largely a toss-up between Petro and Fico. Second, if Petro does manage to win, investors have reasons to worry. Among his policy proposals, some of the most alarming to the business and financial communities include bypassing congress and legislating freely for the first 30 days, forcing private landowners to dedicate land for agriculture, stripping the central bank’s independence and partly nationalizing funds of private pensions. Further, Petro has promised to outright ban new oil explorations due to environmental concerns, which would largely deter domestic and foreign investment into the sector. This would severely reduce dollar inflows and hurt productivity and oil production in the long run, thereby negating the short-term positive effects of high oil prices.   On the other hand, we doubt Petro will be able to fully implement his left-wing agenda. Congress is fragmented between left, right and centrist parties, but the right and center right faction still holds a majority of 51%. Petro will therefore have to negotiate and water down his most radical proposals. Nevertheless, he can still enact presidential decrees, and his intentions to bypass congress to legislate freely for 30 days and his plan to revoke the central bank’s independence are worrying signs for Colombia’s institutions. All in all, the tight race in the second round and the possibility of Petro winning present large risks that we believe financial markets have not fully priced in. Now that domestic demand is set to decelerate and the outlook for oil prices has become muddled, investors will shift their focus to the presidential race. Petro remains the favorite candidate albeit his lead over Fico has narrowed substantially. While Petro may not be able to fully implement his government plan, Colombian risk assets will trade on the loss of business and investor confidence and institutional risks if he wins the election. Further, while conservative candidate Fico’s rise in the polls has been impressive and could get more votes in the final round as other right-wing and centrist candidates drop out of the race after May 29, his victory in the second round is not assured. Expect more political and financial volatility until then. Investment Recommendations We have the following investment recommendations: Equities: maintain an underweight stance within an EM-equity portfolio. A combination of slowing growth, rising interest rates and political risks will be negative for share prices. We will consider upgrading this bourse to neutral when election risks are priced in and if the right-wing candidate Fico secures the presidential victory. Currency: keep shorting the Colombian peso versus the US dollar. Domestic Bonds: maintain a neutral allocation relative to the respective EM benchmark. Local yields offer value (the 10-year bond yield stands at 10.5%), and the macro policy mix remains fairly orthodox. Nevertheless, given that foreign investors hold 25% of the local bond market, the risk of Petro’s victory would entail large outflows from this asset class. We are initiating a yield curve flattening trade: Receive 10-year and pay 6-month swap rates (Chart 11). As Banrep hikes rates and the economy slows down, chances are high that the yield curve will invert considerably. Sovereign Credit: maintain a neutral allocation within an EM-dedicated credit portfolio. Colombia’s sovereign spreads offer a lot of value: credit spreads are above mainstream Latin American countries (Chart 12). However, the possible election of Petro presents a risk to this asset class. Chart 11Colombia: Prepare For A Yield Curve Inversion Colombia: Prepare For A Yield Curve Inversion Colombia: Prepare For A Yield Curve Inversion Chart 12Colombian Sovereign Credit Is Cheap! Colombian Sovereign Credit Is Cheap! Colombian Sovereign Credit Is Cheap!   Juan Egaña Associate Editor juane@bcaresearch.com

Executive Summary Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  Petrocurrencies have lagged the surge in crude prices. This has been specific to the currency space since energy stocks have been in an epic bull market.Both cyclical and structural factors explain this conundrum.Cyclically, rising interest rate expectations in the US have dwarfed the terms-of-trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy (Feature Chart).Structurally, the US is now the biggest oil producer in the world (and a net exporter of natural gas). This has permanently shifted the relationship between the foreign exchange of traditional oil producers and the US dollar.Oil prices are overbought and vulnerable tactically to any resolution in the Russo-Ukrainian conflict. That said, they are likely to remain well bid over a medium-term horizon, ultimately supporting petrocurrencies.Petrocurrencies also offer a significant valuation cushion and carry relative to the US dollar, making them attractive for longer-term investors.Tactically, the currencies of oil producers relative to consumers could mean revert. It also suggests the Japanese yen, which is under pressure from rising energy imports, could find some footing, even as oil prices remain volatile.RECOMMENDATIONINCEPTION LEVELINCEPTION DATERETURNShort NOK/SEK1.112022-03-24-Bottom Line: Given our thesis of lower oil prices in the near term, but firmer prices in the medium term, we will be selling a basket of oil producers relative to oil consumers, with the aim of reversing that trade from lower levels.FeatureOil price volatility is once again dominating global market action. After hitting a low of close to $96/barrel on March 16th, Brent crude is once again at $120 as we go to press. Over the last two years, Brent crude has been as cheap as $16, and as expensive as $140. Energy stocks (and their respective bourses) have been the proximate winner from rising oil prices (Chart 1).Related ReportForeign Exchange StrategyWhat Next For The RMB?In foreign exchange markets, the currencies of commodity-producing countries have surprisingly lagged the improvement in oil prices (Chart 2). Historically, higher oil prices have had a profound impact on the external balance of oil producing versus consuming countries in general and petrocurrencies in particular. Chart 1Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices   Chart 2Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices  Based on the observation above, this report addresses three key questions:Are there cyclical factors depressing the performance of petrocurrencies?Are there structural factors that have changed the relationship of these currencies with the US dollar?What is the outlook for oil, and the impact on short term versus longer-term currency strategy?We will begin our discussion with the outlook for oil.Russia, Oil, And PetrocurrenciesA high-level forecast from our Commodity & Energy Strategy colleagues calls for oil prices to average $93 per barrel this year and next.1 The deduction from this forecast is that we could see spot prices head lower from current levels this year but remain firm in 2023. From our perspective, there are a few factors that support this view:Forward prices tend to move in tandem with the spot fixing (Chart 3), but recently have also been a fair predictor of where current prices will settle over the medium term. Forward oil prices are trading at a significant discount to spot, suggesting some measure of mean reversion (Chart 4). Chart 3Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together   Chart 4The Oil Curve And Spot Prices The Oil Curve And Spot Prices The Oil Curve And Spot Prices  There is a significant geopolitical risk premium embedded in oil prices. According to the New York Federal Reserve model, the demand/supply balance would have caused oil prices to fall between February 11 and February 25 this year. They however rose. This geopolitical risk premium has surely increased since then (Chart 5).Chart 5Oil Prices Embed A Significant Geopolitical Risk Premium The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Russian crude is trading at a sizeable discount compared to other benchmarks. This means that the incentive for substitution has risen significantly. Our Chief Commodity expert, Robert Ryan, noted on BLU today that intake from India is rising. This is helping put a floor on the Russian URAL/Brent discount blend at around $30 (Chart 6). Oil is fungible, and seaborne crude can be rerouted from unwilling buyers to satiate demand in starved markets.A fortnight ago, we noted how the US sanctions on Russia could shift the foreign exchange landscape, especially vis-à-vis the RMB. Specifically, RMB-denominated trade in oil is likely to increase significantly going forward. China has massively increased the number of bilateral swap lines it has with foreign countries, while stabilizing the RMB versus the US dollar.2Finally, smaller open economies such as Canada, Norway and even Mexico are opening the oil spigots (Chart 7). While individually these countries cannot fill any potential gap in Russian production, collectively they could help in the redistribution of oil supplies. Chart 6Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount   Chart 7Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices  The observations above suggest that the currencies of small oil-producing nations are likely to benefit in the medium term from a redistribution in oil demand. Remarkably, there has been little demand destruction yet from the rise in prices, according to the New York Fed. This suggests that as the global economy reopens, and the demand/supply balance tightens, longer-term oil prices will remain well bid.The key risk in the short term is the geopolitical risk premium embedded in oil prices fades, especially given the potential that Europe, China, and India continue to buy Russian supplies. We have been playing this very volatile theme via a short NOK/SEK position. We are stopped out this week for a modest profit and are reinitiating the trade if NOK/SEK hits 1.11.On The Underperformance Of Petrocurrencies? Chart 8Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  The more important question is why the currencies of oil producers like the CAD, NOK, MXN or even BRL have not kept pace with oil prices as they historically have. As our feature chart shows (Chart 8), petrocurrencies have severely lagged the improvement in their terms of trade. This has been driven by both cyclical and structural factors.Cyclically, the underlying driver of FX in recent quarters has been the nominal interest rate spread between the US and its G10 counterparts. We have written at length on this topic, and on why we think there is a big mispricing in market behavior in our report – “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant.” In a nutshell, two-year yields in the G10 have been lagging US rates, despite other central banks being ahead of the curve in hiking interest rates. This means that rising interest rate expectations in the US have dwarfed the terms of trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy.Structurally, the US is now the biggest oil producer in the world (Chart 9). This means the CAD/USD and NOK/USD exchange rates are experiencing a tectonic shift on a terms-of-trade basis. In 2010, the US accounted for only about 6% of global crude output. Collectively, Canada, Norway, and Mexico shared about 10% of global oil production. The elephant in the room was OPEC, with a market share just north of 40%. Today, the US produces over 14%, with Russia and Saudi Arabia around 13% each, the US having grabbed market share from many other countries. Chart 9The US Dominates Oil Production The US Dominates Oil Production The US Dominates Oil Production   Chart 10The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil  As a result of this shift, the positive correlation between petrocurrencies and oil has gradually eroded. Measured statistically, the dollar had a near-perfect negative correlation with oil around the time US production was about to take off. Since then, that correlation has risen from around -0.9 to around -0.2 (Chart 10).A Few Trade IdeasThe analysis above suggests a few trade ideas are likely to generate alpha over the medium term:Long Oil Producers Versus Oil Consumers: This trade will suffer in the near term as oil prices correct but benefit from a relatively tighter market over a longer horizon. It will also benefit from the positive carry that many oil producers provide (Chart 11). We will go long a currency basket of the CAD, NOK, MXN, BRL, and COP versus the euro at 5% below current levels.Chart 11Real Rates Are High Amongst Petrocurrencies The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Sell CAD/NOK As A Trade: Norway is at the epicenter of the likely redistribution that will occur with a Russian blockade of crude, while Canada is further away from it. Terms of trade in Norway are doing much better than a relative measure in Canada (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate. Chart 12CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade  Follow The Money: Oil now trades above the cash costs for many oil-producing countries. This means the incentive to boost production, especially when demand recovers, is quite high. This incentivizes players with strong balance sheets to keep the taps open. This could be a particular longer-term boon for the Canadian dollar which is seeing massive portfolio inflows (Chart 13). Chart 13Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows  On The Yen (And Euro): Rising oil prices have been a death knell for the yen which is trading in lockstep with spot prices. Ditto for the euro. However, the yen benefits from very cheap valuations and extremely depressed sentiment. Any temporary reversal in oil prices will boost the yen (Chart 14). In our trading book, we were stopped out of a short CHF/JPY position last Friday, and we will look to reinitiate this trade in the coming days.  Chart 14The Yen And Oil Prices The Yen And Oil Prices The Yen And Oil Prices   Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comFootnotes1 Please see Commodity & Energy Strategy Weekly Report, “Uncertainty Tightens Oil Supply”, dated March 17, 2022.2 Please see Foreign Exchange Strategy Special Report, “What Next For The RMB?”, dated March 11, 2022.Trades & ForecastsStrategic ViewTactical Holdings (0-6 months)Limit OrdersForecast Summary

Note: An update on Peru is available on page 10. Highlights The longer it takes the Colombian government to drastically expand fiscal policy and increase social benefits, the higher the risk that next year’s presidential election will result in a win for the left. The government will be slow or reluctant to act and, hence, odds of a left-wing government in one year’s time is increasing. We are not forecasting that radical left-wing candidate Gustavo Petro will win next year’s presidential elections. Our point is that rising odds of a victory will be sufficient to undermine Colombia’s financial markets as the nation’s macro risk premium widens. We are downgrading Colombian equities from neutral to underweight and local currency bonds and sovereign credit from overweight to neutral relative to their respective EM benchmarks. Short the Colombian peso versus the US dollar. Feature Colombia has entered a critical moment in its history. The country was once seen as a beacon of political stability, fiscal orthodoxy, and market friendly policies. However, recent large-scale protests have raised the question as to whether Colombia will move toward the left, as has occurred in Mexico, Argentina and more recently in Peru with the election of Pedro Castillo. The nationwide protests in Colombia were triggered by the government’s attempt to raise taxes amidst a recession. What’s more, these protests are a manifestation of deep-rooted popular anger about poor social security benefits, income inequality and unaffordability of education and health care for a large chunk of the population. Further, angst relating to organized crime and government corruption has boiled over as the government has failed to address these systemic issues. In a nutshell, years of market-friendly conservative policies have widened the gap between “haves” and “have nots”. The recent recession has only exaggerated this income disparity and has unleashed public anger toward the government. Critically, social transfers in Colombia amid the pandemic were among the lowest in the world (Chart 1). Chart 1Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? The main risk to the nation’s financial markets is not that President Duque drastically increases fiscal spending to calm down protests, but rather the rising odds of a left-wing victory in the May 2022 presidential elections. Unfortunately, the current government’s reluctance to let go of traditional economic conservatism could eventually backfire and inadvertently swing the country to the far left.  As a result, we are downgrading our stance on Colombian equities from neutral to underweight and are downgrading local and sovereign bonds from overweight to neutral in their respective EM portfolios. Underlying Motives For Popular Discontent There are fundamental grounds for Colombia’s popular discontent. This year’s protests against President Duque echo the sentiment of previous demonstrations that occurred in 2019 and 2020: weak income growth, high income inequality, low government support for social programs, and unsuccessful policies to reduce corruption and organized crime. These issues have not been resolved even as Colombia emerged as one of the most successful economies in the region. In essence, wealth and development have not been felt by the entire population. According to the Gini coefficient, Colombia is the most unequal country among Latin American and OECD nations, even after accounting for taxes and transfers (Chart 2). Colombia suffers from a stubbornly high official unemployment rate which has seldom fallen below double-digit levels in the past two decades (Chart 3). Chart 2Colombia Is One Of The Most Unequal Countries In The World Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 3Colombia’s Unemployment: High And No Improvement Yet Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Government cash transfers and spending on pensions and education remain among the lowest of developed and developing nations (Chart 4). Voters are frustrated with the government’s failure to tackle crime and insurgent paramilitary groups, especially given that Duque ran on an anti-crime platform. According to data from Transparency International, Colombian’s perception of government corruption has risen dramatically since 2018 (Chart 5). Chart 4The Government’s Social Spending In Colombia Is Small Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 5Corruption Perception Has Been Rising Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Bottom Line: Even though Colombia’s GDP growth has been solid, especially relative to its Latin American peers, the benefits have not been widely distributed across all social groups. The severe recession has highlighted Colombia’s challenges and unleashed popular anger toward the government. When Too Much Economic Orthodoxy Backfires Colombia’s right-wing government has provoked massive public discontent due to its insistence on tightening fiscal policy during the worst recession in the country’s history. In essence, the government tried to pass a tax reform bill which would raise taxes on utilities, consumer goods, and business income at the height of the second wave of the COVID-19 pandemic and amid a massive nominal and real GDP contraction (Chart 6). Chart 6Colombia: The First Nominal GDP Contraction On Record Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? What followed were not only protests but also a broad-based backlash against the government from all corners, including political parties. President Duque has become isolated and is quickly turning into a lame duck president. Duque’s economic policies, his failure to reduce violence from insurgent paramilitary groups in recent years, and his own militant response to protests have made him lose the confidence of voters. Moreover , his failure to control the political upheaval from the outset has made him lose the confidence of international investors. Going forward, the major risk to financial markets will be rising odds that a left-wing candidate might win next year’s presidential elections. Chart 7 illustrates that leftist Gustavo Petro leads other potential contenders by a wide margin. Petro is a former member of a guerilla organization and was the frontrunner in the 2018 presidential election. Chart 7Growing Risks Of A Left-Wing Presidency In 2022 Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? If he were to win, it would mark a major pivot from an orthodox/conservative approach to a considerably leftist model of economic policy. Some of his proposals include nationalizing mining companies, de-investing from fossil fuels, government confiscation of land for agriculture, reducing central bank independence, and import substitution policies for the industrial sector.  In order to reduce Petro’s odds of winning the election, the current government must splurge on public spending and dramatically reform the country’s social security policies to appease a wide portion of the population. Nevertheless, we believe the government’s response will be too little, too late. Not only is the government reluctant to open the fiscal taps, but it also has no intention of revamping social security, health care and education policies. In fact, talks with protesters have yet to go anywhere after more than a month of a national strike. The current government’s failure to address Colombians’ concerns may boost the popularity of left-wing politicians. As a result, the market could soon start pricing in rising odds of a left-wing presidency in Colombia. This is negative for financial assets. Bottom Line: Investors will soon start realizing that there is a risk that a left-wing government could upend Colombia’s structural backdrop in a year’s time. To reiterate, we are not forecasting that radical left-wing presidential candidate Gustavo Petro will win next year’s presidential elections. Rather, our point is that rising odds of his victory will be sufficient to undermine Colombia’s financial markets as the nation’s macro risk premium widens. Implications For Financial Markets 1. Downgrade equities from neutral to underweight within an EM equity portfolio. A lingering pandemic, dwindling consumer and business confidence, and a broken monetary policy transmission mechanism are major headwinds for the economy and for corporate profits: Various sectors of the economy are struggling to recover, and our proxy for the marginal propensity to spend is suggesting that the economy will underwhelm (Chart 8). Nominal income growth is very weak. One of the reasons is very low inflation – core CPI measures remain below the central bank’s target range (Chart 9). Chart 8Growth Will Surprise To The Downside Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 9Colombia: Inflation Is Nowhere To Be Seen Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Commercial banks are not expanding credit and will not do so any time soon. Credit growth is negative, and provisions and non-performing loans will continue rising, reaching historical highs (Chart 10). Given that banks make up a large part of Colombia’s bourse, this will weigh heavily on Colombian equity indexes. Notably, lending rates are higher than warranted by economic conditions. This will make it very difficult for borrowers to service debt. While the central bank (Banrep) has cut rates to a historical low of 1.75%, the nominal prime lending rate is at 8.1% and real (deflated by core inflation) lending rates remain elevated at 6% (Chart 11).  Rolling economic lockdowns will impede the economic normalization process. Colombia is still suffering from a deadly second wave of COVID-19 infections. New daily cases and deaths are at all-time highs, and the country’s vaccination drive is falling behind most DM countries and large regional peers. This will further cap economic growth. Chart 10Bank Credit Is Very Weak Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 11Colombian Lending Rates Are Elevated Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?     2. Short the Colombian peso versus the US dollar. The basis is that the current account deficit remains wide at 3.8% of GDP while foreign capital inflows – both FDI and portfolio flows – will wane due to political volatility and rising odds of a left-wing government next year (Chart 12).  3. Downgrade Local Currency Bonds and Sovereign Credit to Neutral Domestic Bonds: While local yields seem quite attractive, currency depreciation risks are too high. The yield curve is incredibly steep and swap rates are pricing in about 75 basis points in rate hikes over the next 12 months (Chart 13). Yet, economic conditions warrant lower not higher interest rates. This makes long-term bond yields attractive, barring the election of a left-wing government next year. Chart 12Balance Of Payments Will Weigh On The Currency Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 13Colombian Local Bonds: Value Or A Value Trap? Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Despite very attractive yields and low inflation, the risk-reward tradeoff of overweighting Colombian local bonds is no longer attractive. We are also closing the position of receiving 10-year swap rates. Sovereign credit: The nation’s sovereign credit spreads will widen if and as international agencies downgrade Colombia’s rating. The nation’s sovereign credit spreads are tight because its governments have been known for orthodox macroeconomic policies and prudent debt management. With political pressures for more social spending, sharply rising public debt and growing odds of a left-wing victory in the next presidential elections, sovereign credit might be repriced.  We will monitor the situation and if the government fails to appease protesters with higher fiscal spending, we will downgrade our allocation to local currency bonds and sovereign credit further to underweight within their respective EM benchmarks. A Word On The Peruvian Elections The election of left-wing candidate Pedro Castillo in Peru is all but confirmed. While right-wing presidential candidate Keiko Fujimori is alleging signs of fraud and is demanding a recount of hundreds of thousands of votes, it is unlikely that this will change the outcome of the election. Fujimori lost the popular vote by an even smaller margin in 2016 but conceded victory after days of uncertainty. Chart 14Peruvian Stocks Are On The Edge Of A Breakdown Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Nevertheless, next week will prove to be volatile as the electoral tribunal makes a decision on Fujimori’s appeal. We expect uprisings from voters on both sides: Castillo supporters will defend his triumph and Fujimori supporters will voice their anger at what they perceive to be an unfair election. We continue to recommend an underweight allocation on Peruvian equities within an EM-dedicated equity portfolio. In the short term, Peruvian share prices will suffer from socio-political volatility. In the medium to long term, Castillo’s populist and anti-market policies will undermine business and investor confidence. Chart 14 shows that Peruvian equities have reached critical levels, displaying a tapering wedge technical profile. If they relapse further, it would qualify as a major breakdown. A significant gap down is likely to follow. We also recommend investors maintain a neutral allocation to Peruvian local bonds and downgrade sovereign credit to underweight. While public debt remains low at 22.6% of GDP, an overhaul of orthodox macroeconomic policies requires a re-rating of Peruvian sovereign credit. Juan Egaña Research Analyst juane@bcaresearch.com