CEE Economic Outlook Still Suggests More Monetary Tightening Needed

Central European growth remained robust in Q2, except for Czech Republic. Due rising inflation and tight labor markets, we believe the region’s central banks are behind the curve and will need to tighten policy more.

CZECH OUTLOOK

GDP grew 2.3% y/y in Q2, weaker than expected and down from 4.2% in Q1. The EU now sees the Czech Republic growing 3.4% this year vs. 3.0% previously. Though down from the 4.4% rate posted in 2017, growth would remain strong.

Price pressures remain elevated, though CPI decelerated to 2.3% y/y in July from the cycle high of 2.6% in June. That was the highest since November and remains in the top half of the 1-3% target range. PPI rose 3.4% y/y in July, the highest since February 2012. Retail sales have slowed recently, rising only 1.4% y/y in June.

The labor market is still tight. Wages are rising in both nominal (8.6% y/y) and real (6.6% y/y) terms, which are cycle high readings from Q1. Q2 wage data will be reported September 4. Unemployment fell to 2.9% in June, the lowest on record before rising to 3.1% in July. We expect wage pressures to intensify even more.

This supports the case for higher rates, and the central bank has hiked four more times after it started the tightening cycle last August. The last move was a 25 bp hike this month, and we think another 25 bp hike to 1.5% is likely at the next policy meeting September 26. The real policy rate of -1.3% remains too accommodative.

The exchange rate plays a role in the central bank’s policy outlook. A stronger koruna could do part of the heavy lifting as central bank models suggest that a 1% appreciation is equal to a 25 bp hike. However, the koruna has weakened -2.5% since February, when EUR/CZK made a cycle low near 25.122. We expect EUR/CZK to test the July high near 26.178.

Czech equities are outperforming this year after underperforming in both 2016 and 2017. In 2017, MSCI Czech rose 8% vs. 34% for MSCI EM. So far this year, MSCI Czech is up 4% YTD and compares to -9% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Czech Republic at a VERY OVERWEIGHT position.

Czech bonds have been underperforming this year. The yield on 10-year local currency government bonds is +46 bp YTD. This is behind only the worst performers Turkey (+956 bp), Argentina (+359 bp), Brazil (+208 bp), Indonesia (+151 bp), Hungary (+134 bp), Russia (+101 bp), the Philippines (+85 bp), and Romania (+50 bp). With inflation likely to resume rising and the central bank likely to tighten further, we think Czech bonds will continue underperforming.

 

HUNGARY OUTLOOK

GDP grew 4.6% y/y in Q2, stronger than expected and up from 4.4% in Q1. The EU now sees Hungary growing 4.0% this year vs. 3.6% previously. After the 4.0% rate posted in 2017, growth would remain strong.

Price pressures are rising, with CPI accelerating to 3.4% y/y in July from 3.1% in June. This is the highest since January 2013, above the 3% target but still within the 2-4% target range. PPI rose 7.5% y/y in June, the highest since May 2012. Retail sales remain robust, rising 6.1% y/y in June.

The labor market is tightening. Nominal wages rose 10.9% y/y in June, while real wages rose 7.8% y/y. While slowing from the peak in mid-2017, wage growth remains high. Unemployment fell to 3.6% in June, the lowest on record.   We expect wage pressures to rise again.

This supports the case for higher rates, and yet the central bank has maintained an ultra-loose policy. After cutting rates to a record low 0.90%, the central bank introduced several unconventional policies that are meant to push yields down and flatten the curve. The real policy rate of -2.5% is at the cycle low and remains too accommodative.

The exchange rate started playing a somewhat greater role in the central bank’s policy outlook back in June when EUR/HUF quickly breached the 330 level that month. Until then, the forint was not a concern but weakness then led central bank officials to become less dovish. Deputy Governor Nagy stressed that month that the bank is prepared to tighten monetary conditions if the weak forint endangers its inflation target. Since then, the forint has stabilized and the central bank’s messaging has gotten less hawkish. We expect EUR/HUF to test the July high near 331.

Hungarian equities are getting more traction this year after underperforming last year. In 2017, MSCI Hungary rose 21% vs. 34% for MSCI EM. So far this year, MSCI Hungary is -8.5% YTD and compares to -9% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Hungary at a VERY OVERWEIGHT position.

Hungarian bonds have been underperforming this year. The yield on 10-year local currency government bonds is +134 bp YTD. This is behind only the worst performers Turkey (+956 bp), Argentina (+359 bp), Brazil (+208 bp), and Indonesia (+151 bp). With inflation likely to continue rising and the central bank eventually forced to tighten, we think Hungarian bonds will continue to underperform.

 

POLAND OUTLOOK

GDP grew 5.1% y/y in Q2, stronger than expected and down from 5.2% in Q1. The EU sees Poland growing 4.3% this year vs. 3.8% previously. Though down from the 4.6% rate posted in 2017, growth would remain strong.

Price pressures are rising, with CPI accelerating to 2.0% y/y in both June and July from 1.7% in May. This is the highest since December but still below the 2.5% target and in the bottom half of the 1.5-3.5% target range. PPI inflation remains elevated at 3.4% y/y vs. the cycle peak of 3.7% in June. Real retail sales remain robust, rising 7.1% y/y in June.

The labor market is tightening. Nominal wages rose 7.2% y/y in July, down slightly from 7.5% in June. Real wages rose 5.2% y/y vs. 5.5% in June. Both remain near cycle highs. Unemployment fell to 5.9% in June, the lowest on record. We expect wage pressures to intensify.

This supports the case for higher rates, and yet the central bank has kept rates steady at 1.5% since the last 50 bp cut in March 2015. At its last policy meeting, the bank reiterated its forward guidance for no hikes through 2019. Unofficially, some are talking about steady rates possibly into 2020. We see the first hike by early 2019, if not sooner. The real policy rate of -0.5% remains too accommodative.

The exchange rate does not play much of a role in the central bank’s policy outlook. Governor Glapinski has said this year that he is not concerned about potential zloty weakening. We expect EUR/PLN to test the July high near 4.4140.

Polish equities are outperforming slightly this year after underperforming last year. In 2017, MSCI Poland rose 28% vs. 34% for MSCI EM. So far this year, MSCI Poland is -7% YTD and compares to -9% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Poland at an OVERWEIGHT position.

Polish bonds have been outperforming this year. The yield on 10-year local currency government bonds is -15 bp YTD. This is behind only the best performer China (-26 bp). With inflation likely to continue rising and the central bank forced to eventually tighten sooner than expected, we think Polish bonds will start underperforming.

 

ROMANIA OUTLOOK

GDP grew 4.1% y/y in Q2, stronger than expected and up from 4.0% in Q1. The EU sees Romania growing 4.5%, which would be the fastest of the CEE economies for the third year running. The previous forecast was 4.4%. Though down from the 6.8% rate posted in 2017, growth would remain strong.

Price pressures remain high, though CPI decelerated to 4.56% y/y in July from the 5.41% peak in May. This remains well above the 2.5% target as well as the 1.5-3.5% target range. PPI rose 6.12% y/y in June, the high for the cycle and highest since October 2012. Real retail sales remain robust, rising 7.9% y/y in June.

The labor market is tightening. Nominal net wages rose 14.3% y/y in June, while real net wages rose 8.9% y/y. While slowing from peak growth of 18% in early 2017, nominal wage growth remains high. Unemployment fell to 3.48% in both May and June, the lowest on record. We expect wage pressures to intensify.

This supports the case for higher rates, and the central bank began the tightening cycle in January with a 25 bp hike to 2.0%. It delivered two more 25 bp hikes to take the policy rate up to 2.5% at the May meeting. It delivered a dovish surprise on August 6 by standing pat when markets were looking for another 25 bp hike to 2.75%. Next policy meeting is October 3, and we think the fourth 25 bp hike is likely then. The real policy rate of -2% remains too accommodative.

Romanian equities are outperforming this year after underperforming last year. In 2017, MSCI Romania rose 9.5% vs. 34% for MSCI EM and 28.5% for MSCI Frontier. So far this year, MSCI Romania is up 13% YTD and compares to -9% YTD for MSCI EM and -13% for MSCI Frontier. With growth expected to remain robust, Romanian equities should continue to do well.

Romanian bonds have been underperforming this year. The yield on 10-year local currency government bonds is +50 bp YTD. This is behind only the worst performers Turkey (+956 bp), Argentina (+359 bp), Brazil (+208 bp), Indonesia (+151 bp), Hungary (+134 bp), Russia (+102 bp), and the Philippines (+85 bp). With inflation likely to remain high and the central bank likely to tighten again, we think Romanian bonds will continue to underperform.

 

CONCLUSIONS

Despite the CEE being a bit further ahead of the monetary tightening curve than other regions in EM, more needs to be done. We continue to expect regional equity markets to outperform, even as regional bond markets are likely to underperform.