CEE Economic Outlook Suggests More Monetary Tightening Needed

People Under European MapThis spring, the European Union raised its 2018 growth forecasts for its eastern members.  Due to robust growth and tight labor markets, we believe the region’s central banks are behind the curve and will need to tighten policy more.

CZECH OUTLOOK

The EU sees the Czech Republic growing 3.4% this year.  The previous forecast was 3.0%.  Though down from the 4.4% rate posted in 2017, growth remains strong.

Price pressures are rising, with CPI accelerating to 2.2% y/y in May from 1.9% in April.  This is the highest since January and moves inflation into the top half of the 1-3% target range.  Real retail sales remain robust, rising 4.7% y/y in April.

The labor market is tightening.  Wages are rising in both nominal (8.6% y/y) and real (6.6% y/y) terms, which are cycle high readings from Q1.  Unemployment fell to 3.0% in May, the lowest on record, and so we expect wage pressures to intensify even more.

This supports the case for higher rates, and the central bank has hiked two more times after it started the tightening cycle last August.  The last move was a 25 bp hike in February, and we think a long overdue 25 bp hike to 1.0% is likely at the next policy meeting June 27.  The real policy rate of -1.5% 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 show a 1% appreciation is equal to a 25 bp hike.  However, the koruna has steadily weakened since February, when EUR/CZK made a cycle low near 25.122.

Czech equities are outperforming EM 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 3% YTD and compares to -5.5% 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 performing in the middle of the EM pack this year.  The yield on 10-year local currency government bonds is +47 bp YTD.  With inflation likely to continue rising and the central bank likely to tighten further, we think Czech bonds will start underperforming.

HUNGARY OUTLOOK

The EU sees Hungary growing 4.0% this year.  The previous forecast was 3.6%.  After the 4.0% rate posted in 2017, growth remains strong.

Price pressures are rising, with CPI accelerating to 2.8% y/y in May from 2.3% in April.  This is the highest since February 2017 but still below the 3% target and within the 2-4% target range.  Real retail sales remain robust, rising 6.0% y/y in April.

The labor market is tightening.  Nominal net wages rose 11.1% y/y in March, while real net wages rose 9.1% y/y.  While slowing from the peak in mid-2017, wage growth remains high.  Unemployment fell to 3.8% in April, the lowest on record and so 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 has introduced several unconventional policies that are meant to push yields down and flatten the curve.  The real policy rate of -1.9% remains too accommodative.

The exchange rate appears to be playing a somewhat greater role in the central bank’s policy outlook.  Until recently, the forint was not a concern but recent weakness has led central bank officials to become less dovish.  Deputy Governor Nagy recently said the bank is prepared to tighten monetary conditions if the weak forint endangers its inflation target.

Hungarian equities continue to underperform EM.  In 2017, MSCI Hungary rose 21% vs. 34% for MSCI EM.  So far this year, MSCI Hungary is -12% YTD and compares to -5.5% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Hungary at an OVERWEIGHT position.

Hungarian bonds have been underperforming this year.  The yield on 10-year local currency government bonds is +144 bp YTD.  This is behind only the worst performers Turkey (+483 bp), Argentina (+220 bp), and Brazil (+152 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

The EU sees Poland growing 4.3% this year.  The previous forecast was 3.8%.  Though down from the 4.6% rate posted in 2017, growth remains strong.

Price pressures are rising, with CPI accelerating to 1.7% y/y in May from 1.6% in April.  This is the highest since January but still below the 2.5% target and near the bottom of the 1.5-3.5% target range.  Real retail sales remain robust, though slowing to 4.0% y/y in April.

The labor market is tightening.  Nominal wages rose 7.0% y/y in May, while real wages rose 5.3% y/y.  Both are near cycle highs.  Unemployment fell to 6.3% in April, the lowest on record, and so 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 -0.2% remains too accommodative.

The exchange rate does not play much of a role in the central bank’s policy outlook.  Governor Glapinski recently said that he is not concerned about potential zloty weakening.

Polish equities continue to underperform EM.  In 2017, MSCI Poland rose 28% vs. 34% for MSCI EM.  So far this year, MSCI Poland is -13% YTD and compares to -5.5% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Poland at a NEUTRAL position.

Polish bonds have been outperforming this year.  The yield on 10-year local currency government bonds is -13 bp YTD.  This is behind only the best performer China (-29 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

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 remains strong.

Price pressures are rising, with CPI accelerating to 5.4% y/y in May from 5.2% in April.  This is the highest rate since February 2013 and further above the 2.5% target as well as the 1.5-3.5% target range.  Real retail sales remain robust, rising 7.9% y/y in April.

The labor market is tightening.  Nominal wages rose 14.7% y/y in April, while real wages rose 9.4% y/y.  While slowing from the peak in early 2017, wage growth remains high.  Unemployment fell to 3.58% in April, the lowest on record and so 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 has delivered two more 25 bp hikes since then to take the policy rates up to 2.5%, but more is clearly needed.  Next policy meeting is July 4, and we think the fourth 25 bp hike to 2.75% is likely then.  The real policy rate of -2.9% remains too accommodative.

Romanian equities are outperforming EM after underperforming in 2017.  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 7.5% YTD and compares to -5.5% YTD for MSCI EM and -11% for MSCI Frontier.

Romanian bonds have been underperforming this year.  The yield on 10-year local currency government bonds is +64 bp YTD.  This is behind only the worst performers Turkey (+483 bp), Argentina (+220 bp), Brazil (+152 bp), Hungary (+144 bp), Philippines (+126 bp), and Indonesia (+95 bp).  With inflation likely to continue rising and the central bank still tightening, 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.