GXG - GXG: The Stars Are Finally Aligning For Colombia

2023-07-17 04:12:33 ET

Summary

• After the steepest set of rate hikes in LatAm over the last two years, Colombia is finally poised for a rate cut cycle.
• Easing inflation and an improving fiscal position bode well for the Colombian cost of capital, along with the Petro government's weakening reform push.
• With equities still very cheaply priced heading into future monetary easing, the risk/reward on MSCI Colombia ETF is looking a lot better.

With Brazil nearing a monetary policy inflection point, Colombia may not be too far behind. The recent decision by the Banco de la República (i.e., 'BanRep' or the Colombian central bank) monetary policy committee to transition to a neutral stance marked a crucial turning point, having hiked at an unprecedented pace to 13.25% (from 1.75% pre-hiking cycle) over the last two years. While inflation remains an issue, the worst has passed; and with the latest print decelerating to ~12%, the policy stance now screens as restrictive vs. the ~2% real neutral rate targeted by the central bank. To be clear, I'm not calling for a pivot within the next month or two, as inflation expectations still need to be managed before a rate cut cycle can begin. But the stars are certainly aligning for a sooner-than-expected pivot.

Not only has the Petro administration's rapidly eroding political capital effectively scuppered his ability to pass populist reforms (a key prior concern, as I discussed here and here ), but Colombia's fundamentals have also stabilized, as highlighted by its narrowing twin deficits (i.e., fiscal and current account). An improved fiscal position bodes well for a strengthening of the Colombian Peso and, by extension, inflationary pressures. It also entails a potential rating upgrade catalyst on the horizon, with Colombian debt lingering below investment grade S&P and Fitch. In the meantime, equity valuations remain cheap, even after the recent rally, at ~6x earnings (~5x fwd) and could re-rate significantly ahead of a BanRep easing cycle. Net, I think it's time to turn more constructive on the Global X MSCI Colombia ETF ( GXG ) here.

Fund Overview - Still a Reasonably Priced Vehicle to Gain Colombian Exposure

The Global X MSCI Colombia ETF, which tracks the performance (pre-expenses) of the MSCI All Colombia Select 25/50 index, remains a reasonably priced Latin American investment vehicle at a total expense ratio of 0.6%. The fund's total net assets have increased in recent months to $31.9m (up from ~$27m prior), benefiting from a combination of investment inflows and strong equity performance.

In line with its historical allocation, the GXG portfolio remains relatively concentrated from a sector perspective. The fund's main exposure remains financials at 39.8% (up from ~36% prior), followed by energy at 22.7% (down from ~25% prior) and utilities at 21.2% (unchanged). With materials and industrials rounding up the top-five sector list, the portfolio composition remains virtually identical to prior reporting periods. At ~96% of the overall portfolio from the top-five sectors, investors will need to be comfortable with GXG's high concentration risk.

The single-stock allocation of the 22-holding portfolio also remains largely unchanged, led by the preferred shares of financial services leader Bancolombia ( CIB ) at 15.4% (up from ~13% prior). The fund also holds 9.0% of its portfolio in Bancolombia common shares, so the total Bancolombia allocation amounts to an outsized 24.3%. State-owned oil & gas company Ecopetrol ( EC ) is still the second-largest holding at 14.1% (up from ~13% prior), followed by power transmission company ISA at 9.5%. The biggest change to the portfolio is the addition of high-end glass and windows manufacturer Tecnoglass ( TGLS ) to the top five. In total, the top five holdings account for an even larger share of the GXG portfolio at ~53%.

Fund Performance - Unimpressive Overall Track Record, but the Distribution Remains Solid

Following a protracted decline through early 2023, GXG has since rebounded strongly and is now up 11.2% for the year. The YTD performance has done little to change the annualized return since the fund's 2009 inception, however, which remains underwhelming at +0.6% in market price and NAV terms. And following a steep drawdown last year, the one-year GXG performance is still in the red at -8.7% (-9.9% in market price terms); similarly, the five and ten-year annualized NAV returns are deeply negative at -8.7% and -8.5%, respectively.

While the distribution was exceptionally strong last year at $2.49/share (~11% trailing yield), this year's payout is tracking significantly lower. To be fair, the sustainability of the 2022 distribution was always in question, given the income largely came from the fund's energy concentration. Still, even if the yield reverts to pre-COVID levels over time, a solid mid-single-digits % yield is likely on the cards. Hence, income investors willing to tolerate the cyclicality will find a lot to like here.

Monetary Policy Pivot Nears as Inflationary Pressures Ease

With the BanRep finally pausing its rate hike cycle, unanimously leaving the policy rate unchanged at 13.25%, Colombia has finally reached the end of a record series of hikes (over eleven full percentage points since 2021). The decision was largely expected, given headline inflation had peaked at over 13% and moderated to ~12% despite fuel subsidies being removed (albeit still substantially above the 3% +/- 1% inflation target range). While the policy statement offered little more than a reiteration of the BanRep's inflation target commitment over the mid-term, it seems clear that the cumulative impact of these rate hikes is already starting to bite. Given monetary policy tends to operate with considerable lags as well, inflationary pressures seem poised to ease further.

Another bullish shift for the Colombian investment case is on the political side. Since the departure of ex-finance minister Ocampo, key members of President Petro's presidential campaign, Armando Benedetti and Chief of Staff Laura Sarabia, have been removed amid concerns about campaign financing irregularities. Alongside the pushback from Colombia's lower house , the Petro government's ability to pass fiscally damaging reforms appears increasingly challenged. In contrast, the country's fiscal position has improved markedly in recent months, aided by prudent spending cuts and fuel subsidy adjustments. A commitment to sustainable fiscal consolidation bodes well for the twin deficit issue, in turn supporting COP appreciation and lower inflationary pressures. Faster-than-expected disinflation also presents upside to BanRep's current expectation for inflation to reach its target band by 2024, so rate cuts could well be on the cards by year-end. Credit implications shouldn't be ignored either - further progress on deleveraging also supports the path toward investment grade, which in combination with a BanRep easing cycle, presents a major boost for Colombian equities via a lower cost of capital.

The Stars are Finally Aligning for Colombia

Easing inflationary pressures in Colombia over the last month has finally pushed its central bank into a neutral stance. From here, the path to a pivot may be shorter than the market thinks. Alongside easing energy and commodity prices globally, stabilizing economic fundamentals should continue to prop up the currency, in turn, capping inflationary pressures. The political hurdle is easing as well, with the Petro administration's deteriorating political capital limiting the passage of market-unfriendly reforms anytime soon. Either way, at an excessively cheap ~6x trailing P/E (especially in the context of a pending rate cut cycle), investors don't need a lot to go right for GXG to work. Potential upside catalysts to watch out for include the October local elections and a potential rating upgrade should the recovery in Colombian fundamentals continue.

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