Colombia

Highlights Inflation will undershoot, prompting rate cuts by the central bank. The long end of Colombia’s local currency yield curve offers great value. Continue betting on lower 10-year swap rates. The currency is cheap but oil prices are at risk. Colombia's balance of payment is still very leveraged to oil. Dedicated EM managers should overweight Colombia in EM local currency and sovereign credit portfolios and remain neutral in an EM equity portfolio. Feature Restrictive fiscal and monetary policies point to subdued growth and are a downside risk to inflation in Colombia. Such a conservative policy mix suggests that the best investment opportunity is in Colombian fixed-income, particularly long-term local currency bonds. Policymakers in Colombia are known for their macro-economic orthodoxy. Having provided stimulus at the onset of the pandemic, both the government and the central bank (Banrep) are not planning new stimulus measures in 2021. As a result, Colombia is likely to experience major growth disappointments and possibly deflation next year. Colombia’s core inflation measures have fallen to all-time lows and are well below the lower bound of the central bank’s inflation target range (Chart 1). Yet Banrep has recently indicated it will keep the policy rate at current levels, revealing a reluctance to reduce rates further. We believe inflation will continue to drop and monetary authorities will be forced to resume rate cuts. Therefore, we are continuing to recommend receiving 10-year swap rates and overweighting Colombian local currency bonds within an EM domestic bond market portfolio. Colombia’s fiscal thrust in 2021 will be -2.4% of GDP as the pandemic-related stimulus expires (Chart 2). This will represent substantial fiscal tightening, given our expectations that another fiscal stimulus package is unlikely. Chart 1Colombia: Price Deflation Is A Major Risk Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Chart 2Colombia: Fiscal Thrust Will Be -2.4% In 2021 Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Loan growth is decelerating following a short-lived upturn earlier this year when companies drew on their credit lines amid lockdowns. Even if we assume loan growth will stabilize at the current annual rate of 6%, the credit impulse – the second derivative of outstanding loans – will be zero next year. Lower interest rates are unlikely to encourage more borrowing and lending because banks are reeling from the surge in NPLs while the prime lending rate remains very elevated and restrictive at 7.6% in real terms (adjusted for core inflation). Chart 3 shows the aggregate fiscal and credit impulse including our projection for 2021. The post-lockdown recovery will at best be followed by very subdued growth, if not by a relapse. The output gap will remain negative, generating a further drop in the inflation rate. In short, there is a high probability for broad-based deflation. Chart 3A Negative Fiscal Thrust Is A Menace To The Economy Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds As a result, Banrep will be forced to resume rate cuts. Interestingly, the fixed-income market is not pricing in monetary easing. In fact, the yield curve is steep, suggesting that long-term yields offer great value (Chart 4). The long end of the curve will likely drop by another 200-250 basis points. Furthermore, Colombia’s 10-year bond yield in real (inflation-adjusted) terms stands at 3.8% and the nation’s real bond yields are at all-time highs relative to the EM GBI benchmark local currency bond yields (Chart 5). This is an excellent relative value proposition. Chart 4Colombia: The Yield Curve Is Too Steep Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Chart 5Great Value In Colombian Fixed-Income Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Regarding the pandemic, Colombia, like many Latin American countries, might not be out of woods yet. The number of daily new cases of COVID-19 remains stubbornly high and could increase as most social restrictions have been relaxed. Moreover, vaccine deployment will be challenging for Colombia, where the vaccine will only be available by mid-2021. According to public health experts, it will only be by 2022, at best, before its population is fully vaccinated. Given all of this, the business cycle recovery will be very subdued and another relapse in economic activity cannot be ruled out next year. This will cause inflation to undershoot the central bank’s lower bound and prompt rate cuts. Regarding the currency, the peso is quite inexpensive based on two valuation metrics. Its real effective exchange rates, based on the average of consumer and producer prices as well as on unit labor costs, are both very low (Chart 6). The sole risk to the exchange rate is oil prices and the fact that excluding oil exports, the current account deficit remains wide at 6% of GDP (Chart 7). We do not believe the current oil price rally will be sustained and any relapse in crude prices is a risk to the peso.1 Chart 6The Colombian Peso Is Inexpensive Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Chart 7The Current Account Is Heavily Reliant On Oil Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds From a secular perspective, Colombia is one of few countries in EM in general, and in Latin America in particular, that has been pursuing structural reforms to boost productivity. This is positive for companies and its long-term growth prospects. However, the caveat for equities is that Colombia’s stock market is dominated by banks and energy producers. Both sectors are facing long-term challenges, not only in Colombia but also worldwide. Our long-term view is that investors should sell/underweight both global banks and energy stocks into the vaccine rally; this strategy is also pertinent for Colombia. In a nutshell, we continue to recommend a neutral allocation to Colombia’s stock market within an EM equity portfolio (Chart 8). Chart 8Colombia: Stock Prices Will Move Sideways Colombia: The Opportunity Is In Bonds Colombia: The Opportunity Is In Bonds Within this bourse, dedicated EM portfolios should favor utilities. The latter are a play on lower bond yields, and we believe domestic bond yields will drop considerably. Finally, we also recommend overweighting Colombia’s sovereign credit within the EM sovereign credit universe. Orthodox macro policies and structural reform efforts will ensure that Colombia remains a low-risk sovereign credit.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Juan Egaña Research Associate juane@bcaresearch.com   Footnotes 1BCA’s Emerging Markets Strategy team believes oil prices will average $40 per barrel in 2021 and $35 in 2022. This differs from BCA’s Commodity and Energy Strategy team’s view.

Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices xTable II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High   Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Go Long HUF / Short PLN Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature We closed our short position in EM equities last week but still maintain our short recommendation on EM currencies. Going forward we will be looking for signs of a durable bottom in risk assets. The clash between forthcoming massive economic stimulus around the world and the unprecedented plunge in global economic activity has generated a great deal of uncertainty over the magnitude and duration of the global recession. In turn, enormous ambiguity continues to produce extreme gyrations in financial markets. The unparalleled drop in the level of business activity and uncertainty over the length of lockdowns make it impossible to determine how much stimulus is required to produce a V-shaped recovery. Notably, all these stimuli will have an effect on the real economy with a lag. In the meantime, the real economy will remain in an air pocket. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Chart 1China: Level Of Business Activity Is Still Lower Than A Year Ago China: Level Of Business Activity Is Still Lower Than A Year Ago China: Level Of Business Activity Is Still Lower Than A Year Ago Even in China, where the authorities have been stimulating and trying hard to restart the economy following lockdowns, the level of business activity remains below last year’s levels. In particular, Chart 1 illustrates that residential floor space sold in Shanghai in the past couple of weeks remains 60% lower than a year ago. This reveals how difficult it is to reboot discretionary consumer spending and business investment following a negative income shock. Overall, financial markets will remain very volatile as they try to recalibrate the magnitude and duration of recession as well as the speed of recovery. Such heightened uncertainty warrants a higher risk premium. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Given financial markets are already discounting a lot of bad news, incoming economic data will be of little use. In our opinion, investors can only rely on various market indicators to gauge the direction of risk assets. Review Of Indicators The following market-based indicators lead us to believe that the selloff is in a late-stage, but not over. Chart 2More Downside In This Risk-On/Safe-Haven Currency Ratio More Downside In This Risk-On/Safe-Haven Currency Ratio More Downside In This Risk-On/Safe-Haven Currency Ratio Our Risk-On/Safe-Haven1 currency ratio is in free fall but has not reached the level that marked its 2011 and 2015 troughs (Chart 2). It is still well above its 2008 level.  Odds are that this indicator will drop to 2011 and 2015 levels before staging a major recovery. EM share prices, commodities and global cyclical stocks correlate closely with this ratio. A further drop in Risk-On/Safe-Haven currency ratio will be consistent with more downside in EM equities, resource prices and global cyclicals. The global stock-to-US 30-year bond ratio has crashed but is still above its 2008 trough (Chart 3). Given this global recession is worse than the one in 2008, it is reasonable to expect the ratio to drop to its 2008 level before recovering. The gold-to-US bonds ratio2 has not yet broken out of its rising channel (Chart 4). Only a decisive breakout above the upper boundary of this channel will confirm a sustainable rally in reflation plays. Chart 3Global Stock-To-Bond Ratio: More Downside Is Likely Global Stock-To-Bond Ratio: More Downside Is Likely Global Stock-To-Bond Ratio: More Downside Is Likely Chart 4The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade The Gold-To-Bond Ratio Is Not Yet Confirming The Reflation Trade Meanwhile, the industrial metals-to-gold ratio has plunged below its 2008 and 2015/16 lows (Chart 5). This qualifies as a structural regime change in this indicator. Odds are that this ratio will continue to fall, heralding further weakness in global cyclicals in general and EM risk assets in particular.   The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows The relative performance of non-financial Swiss stocks versus Swedish non-financials seems to have broken below 2002 and 2008 lows (Chart 6). Such a breakdown typically entails additional decline. The latter will be consistent with more weakness in global cyclicals versus defensives. Chart 5A Noteworthy Breakdown A Noteworthy Breakdown A Noteworthy Breakdown Chart 6Cyclicals Vs Defensives Cyclicals Vs Defensives Cyclicals Vs Defensives Interestingly, Chinese equity indexes have dropped less than their global and EM peers. Nevertheless, cyclical sectors within the Chinese equity universe are exhibiting very disturbing chart patterns. Chinese bank stocks appear to be in a genuine downtrend, with no immediate support (Chart 7, top panel). Property developers in the onshore A-share market have hit key resistance levels and appear to be vulnerable to the downside (Chart 7, middle panel). Finally, Chinese investable small-cap stocks have broken down, and their path of least resistance is down (Chart 7, bottom panel). Overall, the relative resilience of Chinese share prices has been due to tech and “new economy” stocks. The rest of Chinese equities have been quite week in absolute terms. Finally, the net aggregate long position in US equity futures by asset managers and leveraged funds as of March 17 was still above its 2011 and 2016 lows (Chart 8).  It is reasonable to expect that the ultimate capitulation in US stocks will be consistent with a lower reading of this indicator. Chart 7Weak Internals Of Chinese Equity Markets Weak Internals Of Chinese Equity Markets Weak Internals Of Chinese Equity Markets Chart 8No Capitulation Among Investors In US Equity Futures No Capitulation Among Investors In US Equity Futures No Capitulation Among Investors In US Equity Futures     Bottom Line: The recent rebound in EM risk assets is unlikely to be sustainable. Several important indicators are not confirming a durable rally in reflation plays. Investment Strategy Even though EM equities have become cheap and very oversold as we discussed last week, odds are that the bear market in EM risk assets and currencies is not yet over. It might be too late to sell EM stocks, but also too risky to buy them aggressively. Chart 9EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction EM Corporate Credit And Domestic Bonds: A Bear Market, Not A Correction Provided the selloff in EM fixed-income markets commenced only a couple of weeks ago, it will likely persist as investors facing losses are forced to further trim their positions (Chart I-9). We continue to recommend staying put on EM fixed-income markets. As EM US dollar and local currency bond yields rise, EM share prices will struggle. Finally, EM currencies remain vulnerable against the greenback. We are maintaining our short in a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, IDR, PHP and KRW. Reshuffling EM Equity Country Allocation We are making the following changes within a dedicated EM equity portfolio: Upgrading Peru from neutral to overweight, and Colombia from underweight to neutral. Both bourses have underperformed substantially and warrant a one-notch upgrade. Peru will - on the margin - benefit from relative resilience in gold and silver prices. The collapse in Colombia’s relative equity performance is advanced. While we are not bullish on oil prices, we are protecting our gains on the underweight Colombian stocks allocation by moving it to neutral. Reiterating our underweight allocations in both Indonesian and Philippine equities. Both bourses are breaking down relative to the EM benchmark (Chart I-10). More downside is in the cards. Readers can click here to access our latest fundamental analysis on financial markets in Indonesia and the Philippines.  Maintaining our overweight positions in Korean and Thai equities. Underperformance in both bourses relative to the EM benchmark is at a late stage. We expect the relative performance of these markets versus the overall EM equity index to find a support close to current levels (Chart I-11). Chart 10Continue Underweighting Indonesian And Philippines Equities Continue Underweighting Indonesian And Philippines Equities Continue Underweighting Indonesian And Philippines Equities Chart 11Overweight Korean And Thai Stocks Within The EM Universe Overweight Korean And Thai Stocks Within The EM Universe Overweight Korean And Thai Stocks Within The EM Universe Downgrading UAE from overweight to underweight. We have been bearish on oil prices, but the speed of the collapse in crude prices has wreaked havoc on Gulf equity markets. Similarly, the speed of decline in oil prices has caused considerable tremors in Mexican and Russian financial markets. Our overweight position in Russian equities is now back to its breakeven level, but the one in Mexican stocks is deep under water. We are reiterating our overweight in both bourses but have much lower conviction on Mexican stocks versus Russian ones. We will publish an updated analysis on Mexico in the near term. Finally, we have been and remain neutral on the following equity markets relative to the EM benchmark: China, Taiwan, India, Malaysia, Brazil and Chile. We have been negative on Brazil but have not formally downgraded it to underweight. Among our underweights are also Turkey, South Africa and Hong Kong domestic stocks. The complete list of our equity recommendations is available on page 8. Our fixed-income and currencies recommendations are available on page 9 (all of our recommendations are always enclosed at the end of our Weekly Reports and are available on our Website as well).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Average of CAD, AUD, NZD, BRL, IDR, RUB, CLP, MXN & ZAR total return indices relative to the average of CHF & JPY total returns. 2   It is calculated by dividing gold prices by total return on 10-year US government bonds. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights An analysis on Colombia is available below. If EM share prices hold at current levels, a major rally will likely unfold. If they are unable to hold, a substantial breakdown will likely ensue. The direction of EM US dollar and local currency bond yields will be the key to whether EM share prices break down or not. We expect continuous EM currency depreciation that will likely trigger foreign capital outflows from both EM credit markets and domestic bonds. This leads us to reiterate our short position in EM stocks. We are booking profits on the long implied EM equity volatility and the short Colombian peso/long Russian ruble positions. Feature The Federal Reserve’s intra-meeting rate cut this week might temporarily boost EM risk assets and currencies. However, it is also possible that investors might begin questioning the ability of policymakers in general and the Fed in particular to continuously boost risk assets. In recent years, investors have been operating under the implicit assumption that policymakers in the US, China and Europe have complete control over financial markets and global growth, and will not allow things to get out of hand. Investors have been ignoring contracting global ex-US profits as well as exceedingly high US equity multiples and extremely low corporate spreads worldwide. In the past 12 months, investors have been ignoring contracting global ex-US profits (Chart I-1) as well as exceedingly high US equity multiples. This has been occurring because of the infamous ‘policymakers put’ on risk assets. As doubts about policymakers’ ability to defend global growth and financial markets from COVID-19 heighten, investors will likely throw in the towel and trim risk exposure. A sudden stop in capital flows into EM is a distinct possibility. The Last Line Of Defense EM share prices are at a critical juncture (Chart I-2). If they hold at current levels, a major rally will likely unfold. If they are unable to hold at current levels, a substantial breakdown will likely ensue. Chart I-1Profitless Rally In 2019 Makes Stocks Vulnerable Profitless Rally In 2019 Makes Stocks Vulnerable Profitless Rally In 2019 Makes Stocks Vulnerable Chart I-2EM Share Prices Are At A Critical Juncture EM Share Prices Are At A Critical Juncture EM Share Prices Are At A Critical Juncture   What should investors be looking at to determine whether EM share prices will find a bottom close to current levels, or whether another major down-leg is in the cards? In our opinion, the direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Chart I-3 illustrates that EM equity prices move in tandem with EM corporate US dollar bond yields as well as EM local currency bond yields (bond yields are shown inverted on both panels). Falling EM fixed income yields have helped EM share prices tremendously in the past year. Chart I-3EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM Equities Drop When EM US Dollar & Domestic Bond Yields Are Rising EM corporate US dollar bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when EM credit spreads are widening more than Treasury yields are falling; or (3) when both US government bond yields and EM credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for US government bonds, presently EM corporate US dollar bond yields can only rise if their credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently rests with EM corporate spreads. EM corporate and sovereign credit spreads are breaking above a major technical resistance (Chart I-4). The direction of these credit spreads is contingent on EM exchange rates and commodities prices as demonstrated in Chart I-5. Credit spreads are shown inverted in both panels of this chart. Chart I-4A Breakout In EM Sovereign And Corporate Credit Spreads? A Breakout In EM Sovereign And Corporate Credit Spreads? A Breakout In EM Sovereign And Corporate Credit Spreads? Chart I-5Falling EM Currencies And Commodities Herald Wider EM Credit Spreads Falling EM Currencies And Commodities Herald Wider EM Credit Spreads Falling EM Currencies And Commodities Herald Wider EM Credit Spreads   EM exchange rates are also crucial for foreign investors’ in EM domestic bonds. The top panel of Chart I-6 demonstrates that even though the total return on the JP Morgan EM GBI domestic bond index has been surging in local currency terms, the same measure in US dollar terms is still below its 2012 level. The gap is due to EM exchange rates. EM local currency bond yields are at all-time lows (Chart I-6, bottom panel), reflecting very subdued nominal income growth and low inflation in many developing economies (Chart I-7). Chart I-6EM Currencies Are Key To EM Domestic Bonds Total Returns EM Currencies Are Key To EM Domestic Bonds Total Returns EM Currencies Are Key To EM Domestic Bonds Total Returns Chart I-7Inflation Is Undershooting In EM Ex-China Inflation Is Undershooting In EM Ex-China Inflation Is Undershooting In EM Ex-China   Hence, low EM domestic bond yields are justified by their fundamentals. Yet foreign investors are very large players in EM local bonds, and their willingness to hold these instruments is contingent on EM exchange rates’ outlook. The sensitivity of international capital flows into EM US dollar and local currency bonds to EM exchange rates has diminished in recent years because of global investors’ unrelenting search for yield. As QE policies by DM central banks have removed some $9 trillion in high-quality securities from circulation, the volume of fixed-income securities available in the markets has shrunk. This has led to unrelenting capital inflows into EM fixed-income markets, despite lingering weakness in their exchange rates. Nonetheless, sensitivity of fund flows into EM fixed-income markets to EM exchange rates has diminished but has not yet outright vanished. If EM currencies depreciate further, odds are that there will be a sudden stop in capital flows into EM fixed-income markets. Outside of some basket cases, we do not expect the majority of EM governments or corporations to default on their debt. Yet, we foresee further meaningful EM currency depreciation which will simply raise the cost of servicing foreign currency debt. It would be natural for sovereign and corporate credit spreads to widen as they begin pricing in diminished creditworthiness among EM debtors in foreign currency terms.     Bottom Line: Unlike EM equities, EM fixed-income markets are a crowded trade and are overbought. Hence, any selloff in these markets could trigger an exodus of capital pushing up their yields. Rising yields will in turn push EM equities over the cliff. EM Currencies: More Downside We expect EM currencies to continue depreciating. EM ex-China currencies’ total return index (including carry) versus the US dollar is breaking down (Chart I-8, top panel). This is occurring despite the plunge in US interest rates. Notably, as illustrated in the bottom panel of Chart I-8, EM ex-China currencies have not been correlated with US bond yields. The breakdown in correlation between EM exchange rates and US interest rates is not new. This means that the Fed's easing will not prevent EM currency depreciation. EM currencies correlate with commodities prices generally and industrial metals prices in particular (Chart I-9, top panel). The latter has formed a head-and-shoulders pattern and has broken down (Chart I-9, bottom panel). The path of least resistance for industrial metal prices is down. Chart I-8More downside In EM Ex-China Currencies More downside In EM Ex-China Currencies More downside In EM Ex-China Currencies Chart I-9A Breakdown In Commodities Points To A Relapse In EM Currencies A Breakdown In Commodities Points To A Relapse In EM Currencies A Breakdown In Commodities Points To A Relapse In EM Currencies Chart I-10Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies EM currencies’ cyclical fluctuations occur in-sync with global trade and Chinese imports (Chart I-10). Both will stay very weak for now. Finally, China is stimulating, and we believe the pace of stimulus will accelerate. However, the measures announced by the authorities so far are insufficient to project a rapid and lasting growth recovery. In particular, the most prominent measure announced in China is the PBoC’s special re-lending quota of RMB 300 billion to enterprises fighting the coronavirus outbreak. However, this amount should be put into perspective. In 2019, private and public net credit flows were RMB 23.8 trillion, and net new broad money (M2) creation was RMB 16 trillion. Thus, this re-lending quota will boost aggregate public and private credit flow by only 1.2% and broad money flow by mere 2%. This is simply not sufficient to meaningfully boost growth in China. Notably, daily, commodities prices in China do not yet confirm any growth recovery (Chart I-11). Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Bottom Line: The selloff in EM exchange rates will persist. As discussed above, this will likely lead to outflows from both EM credit markets and domestic bonds. Reading Markets’ Tea Leaves It is impossible to forecast the pace and scope of the spread of COVID-19 as well as the precautionary actions taken by consumers and businesses around the world. In brief, it is unfeasible to assess the COVID-19’s impact on the global economy. The direction of EM sovereign and corporate US dollar bond yields as well as EM local currency government bond yields will be the key to whether EM share prices break down or not. Rather than throwing darts with our eyes closed, we examine profiles of various financial markets with the goal of detecting subtle messages that financial markets often send: Aggregate EM small-cap and Chinese investable small-cap stocks seem to be breaking down (Chart I-12). Chart I-11Daily Commodities Prices In China: No Sign Of Revival Daily Commodities Prices In China: No Sign Of Revival Daily Commodities Prices In China: No Sign Of Revival Chart I-12Investable Small Cap Stocks Seem To Be Breaking Down Investable Small Cap Stocks Seem To Be Breaking Down Investable Small Cap Stocks Seem To Be Breaking Down   The technical profiles of various EM currencies versus the US dollar on a total return basis (including the carry) are consistent with a genuine bear market (Chart I-13). Hence, their weakness has further to go. Global industrial stocks’ relative performance against the global equity benchmark has broken below its previous technical support (Chart I-14). This is a bad omen for global growth. Chart I-13EM Currencies Are In A Genuine Bear Market EM Currencies Are In A Genuine Bear Market EM Currencies Are In A Genuine Bear Market Chart I-14A Breakdown In Global Industrials Relative Performance A Breakdown In Global Industrials Relative Performance A Breakdown In Global Industrials Relative Performance   Finally, Korean tech stocks as well as the Nikkei index seem to have formed a major top (Chart I-15). This technical configuration suggests that their relapse will very likely last longer and go further. Chart I-15A Major Top in Korean And Japanese Stocks? A Major Top in Korean And Japanese Stocks? A Major Top in Korean And Japanese Stocks? All these signposts relay a downbeat message on global growth and, consequently, EM risk assets and currencies. A pertinent question to ask is whether the currently extremely high level of the VIX is a contrarian signal to buy stocks? Investors often buy the VIX to hedge their underlying equity portfolios from short-term downside. However, when and as they begin to view the equity selloff as enduring, they close their long VIX positions and simultaneously sell stocks. In brief, the VIX’s current elevated levels are likely to be a sign that many investors are still long stocks. When investors trim their equity holdings, they will likely also liquidate their long VIX positions. Thereby, share prices could drop alongside a falling VIX. Therefore, we are using the recent surge in equity volatility to close our long position in implied EM equity volatility. Even though risks to EM share prices are still skewed to the downside, their selloff may not be accompanied by substantially higher EM equity volatility. However, we continue to recommend betting on higher implied volatility in EM currencies. The latter still remains very low. Investment Conclusions We reinstated our short position on the EM equity index on January 30, and this trade remains intact. For global equity portfolios, we continue to recommend underweighting EM versus DM. Within the EM equity universe, our overweights are Korea, Thailand, Russia, central Europe, Mexico, Vietnam, Pakistan and the UAE. Our underweights are Indonesia, the Philippines, South Africa, Turkey and Colombia. We are contemplating downgrading Brazilian equities from neutral to underweight. The change is primarily driven by our downbeat view on banks (Chart I-16). This is in addition to our existing bearish view on commodities. We will publish a Special Report on Brazilian banks in the coming weeks. Barring an irrigation-type of credit and fiscal stimulus, the mainland economy will disappoint. Among the EM equity sectors, we continue to recommend a long EM consumer staples/short banks trade (Chart I-17, top panel) as well as a short both EM and Chinese banks versus their US peers positions (Chart I-17, middle and bottom panels). Chart I-16Brazilian Bank Stocks Are Breaking Down? Brazilian Bank Stocks Are Breaking Down? Brazilian Bank Stocks Are Breaking Down? Chart I-17Our Favored EM Equity Sector Bets Our Favored EM Equity Sector Bets Our Favored EM Equity Sector Bets   We continue to recommend a short position in a basket of the following currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. We are also structurally bearish on the RMB. Today we are booking profits on the short Colombian peso / long Russian ruble trade (please refer to section on Colombia on pages 13-17). With respect to EM local currency bonds and EM sovereign credit, our overweights are Mexico, Russia, Colombia, Thailand, Malaysia and Korea. Our underweights are South Africa, Turkey, Indonesia, and the Philippines. The remaining markets warrant a neutral allocation. As always, the list of recommendations is available at end of each week’s report and on our web page. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Colombia: Upgrade Domestic Bonds; Take Profits On Short Peso Trade Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked The Business Cycle Has Peaked The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South Investment Expenditures Heading South Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Hawkish Fiscal Policy Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums The Economy Is In The Doldrums The Economy Is In The Doldrums Chart II-6Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart II-1Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Oil Makes A Huge Difference To Colombia's Current Account Today we recommend upgrading local currency bonds and booking profits on the short Colombian peso / long Russian ruble trade. The reason is tight fiscal and monetary policies are positive for bonds and the currency. Although we are structurally bullish on Colombia’s economy, we remain underweight this bourse relative the EM equity benchmark. The primary reason is the high sensitivity of Colombia’s balance of payments to oil prices. In particular, oil accounts for a large share (40%) of Colombia’s exports. As of Q4 2019, the current account deficit was $14 billion or 4% of GDP with oil, and $25 billion or 7.5% of GDP excluding oil (Chart II-1). In short, each dollar drop in oil prices substantially widens the nation’s current account deficit and weighs on the exchange rate. Besides, the current hawkish monetary stance and overly tight fiscal policy will produce a growth downtrend. The Colombian economy has reached a top in its business cycle: The flattening yield curve is foreshadowing a major economic slowdown (Chart II-2, top panel). Our proxy for the marginal propensity to spend for businesses and households leads the business cycle by about six months and is presently indicating that growth will roll over soon (Chart II-2, bottom panel). Moreover, the corporate loan impulse has already relapsed, weighing on companies’ capital expenditures (Chart II-3).  Chart II-2The Business Cycle Has Peaked The Business Cycle Has Peaked The Business Cycle Has Peaked Chart II-3Investment Expenditures Heading South Investment Expenditures Heading South Investment Expenditures Heading South   The government considerably tightened fiscal policy in the past year and will continue to do so in 2020. The primary fiscal balance has surged to above 1% of GDP as primary fiscal expenditures have stagnated in nominal terms and shrunk in real terms last year (Chart II-4). In regards to monetary policy, the prime lending rate is 12% in nominal and 8.5-9% in real (inflation-adjusted) terms. Such high borrowing costs are restrictive as evidenced by several business cycle indicators that are in a full-fledged downtrend: manufacturing production, imports of consumer and capital goods, vehicle sales and housing starts (Chart II-5). Chart II-4Hawkish Fiscal Policy Hawkish Fiscal Policy Hawkish Fiscal Policy Chart II-5The Economy Is In The Doldrums The Economy Is In The Doldrums The Economy Is In The Doldrums   Overall, economic growth has been held up solely by very robust household spending, which accounts for 65% of GDP. Critically, consumer borrowing has financed such buoyant consumer expenditures (Chart II-6). However, the pace of household borrowing is unsustainable with consumer lending rates at 18%. Chart II-6Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Consumer Spending Has Been Supported By Borrowing Moreover, nominal and real (deflated by core CPI) wage growth are decelerating markedly and hiring will slow down in line with reduced capital spending.  Besides, disinflationary dynamics in this country will be amplified due to the massive influx of immigration from Venezuela in the past two years. Currently, the number of immigrants from the neighboring country stands at 1.4 million people, or 5% of Colombia’s labor force. Such an enormous increase in labor supply introduces deflationary pressures in the Colombian economy by depressing wage growth. Therefore, despite the depreciating currency, core measures of inflation will likely drop to the lower end of the central bank’s target range in next 18-24 months. Investment Recommendations The economy is heading into a cyclical slump but monetary and fiscal policies will remain restrictive. Such a backdrop is bullish for the domestic bond market and structurally, albeit not cyclically, positive for the currency. We have been recommending fixed-income investors to bet on a yield curve flattening by receiving 10-year and paying 1-year swap rates. This trade has returned 77 basis points since its initiation on January 17, 2019. Given the central bank will stay behind the curve, this strategy remains intact. Today we recommend upgrading Colombian local currency bonds from neutral to overweight. Further currency depreciation and an exodus by foreign investors remain a risk. However, on a relative basis – versus its EM peers – this market is attractive. The share of foreign ownership of local currency government bonds in Colombia is 25%, smaller than in many other EMs. Additionally, Colombian bond yields are 80 basis points above the J.P. Morgan EM GBI domestic bonds benchmark and its currency is one standard deviation below its fair value (Chart II-7). We are also overweighting Colombian sovereign credit within an EM credit portfolio. Fiscal policy is very tight and government debt is at a manageable 50% of GDP. Continue to underweight Colombian equities relative to the emerging markets benchmark. We will be looking for a final capitulation in the oil market to upgrade this bourse. Finally, we are booking profits on our short COP versus RUB trade, which has returned a 19% gain since May 31, 2018 (Chart II-8). As mentioned earlier, the peso has already cheapened a lot according to the real effective exchange rate based on unit labor costs (Chart II-7). Meanwhile, Colombia’s macro policy mix is positive for the currency. Chart II-7The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially The Colombian Peso Has Depreciated Substantially Chart II-8Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade Taking Profits On Our Short COP / Long RUB Trade   In contrast, Russia is relaxing its fiscal policy – which is marginally negative for the ruble – and the currency has become a crowded trade. Juan Egaña Research Associate juane@bcaresearch.com  

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth bca.ems_wr_2019_08_22_s1_c3 bca.ems_wr_2019_08_22_s1_c3 Chart I-4China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. Chart I- The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract Philippine Exports Will Contract Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Philippine Equities Are Expensive Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation The Exchange Rate And Inflation The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? A Top In The Business Cycle? A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Severe Fiscal Tightening Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking The Business Cycle Is Peaking The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Things Could Get Worse Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations