Colombia

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

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

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

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