GXG: Colombia Risks Reassessed (NYSEARCA:GXG)

Vasily Zyryanov profile picture


In my August note on the Global X MSCI Colombia ETF (NYSEARCH:GXG), I pointed out that playing the global inflation issue with this investment vehicle does not make sense due to the weakness of the Colombian peso amidst political headwinds, even though it is a financially and energy-heavy fund, in theory capable of benefiting from rising oil prices and a decidedly aggressive monetary policy, a combination we have seen in the case of Colombia.

It seemed that he was right, but he did not expect a liquidation of such magnitude. Since then, the fund has fallen ~17.2%, dwarfing inflation, interest rates and the S&P 500’s tech earnings-driven decline of ~5%.

GXG return from coverage

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Today, it is certainly worth providing an update to answer the question of whether the sell-off brought the fund’s price to an attractive level.

As a quick summary of the investment strategy, GXG’s primary objective is to track the MSCI All Colombia Select 25/50 Index as closely as possible. Its closest pair, the iShares MSCI Colombia ETF (traded under an ICOL ticker) closed its doors in August, so GXG remains the only fund targeting the stocks of this Latin American nation, at least I am not aware of one with a similar level of assets or liquidity.

For GXG, nothing has changed tectonically in terms of exposure to the sector, as financials still to dominate the mix, with over 40% of net assets followed by utilities (23.2%) and then energy (21.6%) being the last in the top trio.

Now, the question is what has been the main driver of GXG’s downfall? Unsurprisingly, the completely lackluster performance of the Colombian peso is the main culprit. Since the beginning of the year, the COP has fallen more than 37% against the USD, losing more than 6% in the last month alone. By contrast, the Mexican peso and the Brazilian real are both up in single digits year to date.

And the weakness of the Andean nation’s currency was, in turn, partly engendered by political factors.

Inflation in Colombia has not been willing to relax lately; from August to September, total annual inflation increased from 10.8% to 11.4%, while the target is 3%. This caused the central bank increase the interest rate even higher, by 100 bps at 11% on October 28. For a better context, the September interest rate increase was also 100bps after headline inflation in August rose to 10.8%, exceeding the 9.9% expected.

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There is no denying that the currency’s decline seems totally counter-intuitive due to the fact that Banco de la República has continued to shed excess liquidity to quell unbearable inflation. However, this is one of the cases (see Sweden’s FX/monetary policy paradox) where the ultra-hawkish stance does little to boost national currencies, unable to counter stronger bearish factors in the mix, such as political problems in the case of the peso. .

In addition, it would be pertinent to point out that in the October press release, among other headwinds, the regulator also mentioned “the transfer of the exchange rate to tradable goods,” which is another way of saying that the slow performance of the peso has been causing inflation problem

For GXG’s holdings in the financial sector, the aggressive attitude is a boon. For example, Bancolombia SA (CIB), common and preferred shares that represent 22.4% of GXG’s net assets, said in its Q2 Report that

Net interest income before provisions increased 16.6% and totaled COP 4,315 million in 2Q22.

And “the repricing of the credit portfolio as an effect of the contractionary monetary policy” was one of the main drivers. However, CIB is still down 19.5% YTD in New York with the weak COP being the main detractor.

Data by YGraphics

Importantly, the incumbent strongly opposed the September oversized fee increase. What reported Per Bloomberg, Gustavo Petro, a leftist president who was elected in June, criticized the central bank’s inflation-fighting scheme in a series of tweets and instead proposed a tax on capital outflows, an idea that only helped to the peso’s decline as traders increased their bearish bets. The silver lining here is that Finance Minister José Antonio Ocampo was quick to address investor concerns and clarified that capital controls were not considered. As I said before, the peso still fell more than 6% in October.

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Digging deeper, we find other possible culprits, namely Brazilian hedge funds decidedly bearish view of the COP. Most likely, the Achilles heel they are trying to use in their opportunistic bearish bet is Colombia’s fiscal and current account deficits amid escalating public spending plans that would make the Andean nation more sensitive to headwinds. of the world economy.

Turning to the energy sector, there are also strong risks to both the peso and GXG holdings. For example, Mr. Petro intends to finalize new hydrocarbon exploration projects in Colombia to stimulate a faster ecological transition.

Colombia’s considerable oil production is no secret to investors who closely follow South and Central America. Starting from the BP World Energy Statistical Review 2022, Colombia produced 738 thousand barrels per day in 2021, not the largest in the region, but in the top trio, after Brazil and Venezuela. However, the problem here is that production has been on a downward trend, declining 2.1% in 2011-2021. Furthermore, the issue of natural gas should not be overlooked. The country produced just 12.6 billion cubic meters in 2021, one of the lowest in the region, and consumed exactly the same amount. The problem is that production came from offshore fields that are rapidly depleting, while demand is growing strongly. In a gloomy scenario, with no reserves added due to the suspension of exploration, the country could face shortages and increase expensive LNG imports. Amid the fundamental changes facing natural gas supply chains, and especially its LNG segment, this could send electricity prices soaring and jeopardize energy security in the future. And in this sense, I would say that the sharp downward slide of the peso is partly the consequence of the market slowly pricing in such a prospect.

However, there is something for a “glass half full” scenario. The risk could be exaggerated. Responding to an analyst’s question about the suspension of new exploration contracts during the second quarter earnings call, the president and CEO of Canacol Energy (OTCQX: CNNEF) said that

…we have interests in 11 exploration and production contracts, six in the lower Magdalena valley, which is our main operating area. Five in the middle Magdalena Valley, which is our new high-impact gas exploration area. In those 11 contracts, we have identified about 190 drilling locations, exploration drilling locations, that contain on a gross enriched basis 18 TCF of prospective gas resources. So we have enough inventory to drill those 11 blocks for at least 10 years.

Canacol Energy is an exploration and production company and GXG has a 2.8% stake.

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Another positive here is that the proposed 20% tax on oil and coal exports designed to increase the government’s cash flow needed to cover social spending plans was excluded from the proposed tax reform. And the move was expected to be hailed by the CEO of Ecopetrol (EC), an oil and gas company with a market value of $20.6 billion and GXG’s stake weighing 14.3%. Amid headwinds for Colombian oil companies, EC share price has suffered badly this year, underperforming peers like Petrobras (PBR) and Equinor (EQNR), not to mention Exxon. Mobil (XOM) and ConocoPhillips (COP).

Data by YGraphics

The bottom line

In sum, what scenario has the market priced in the COP/USD rate and GXG’s holding multiples? In short, they probably reflect ideas of increasing government spending that bode ill for the fiscal and current account deficits; reflecting on the end of exploration could jeopardize the country’s energy security, since the shortfall in natural gas production would raise electricity prices in the medium term, contributing to inflation, undermining consumer confidence and would weigh on economic growth. Some risks may be exaggerated, but the situation is highly uncertain.

Meanwhile, there’s no denying that GXG is incredibly cheap, with a diminutive P/E of just 4.69x. according to to AltaVista Research data as of Oct. 27.

Still, my point hasn’t changed. Specifically, I see high risk/high reward here, assuming political concerns subside and the peso and equities trade higher again. However, uncertainty reigns, and I would not attempt to build a bullish case here. I highlight an expected GDP growth rate of 7.9% for 2022 as positive, but insufficient for a strong bullish thesis for the peso and GXG.

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