Hungarian Outperformance Likely To Ebb

Hungarian assets have largely outperformed this year, backed up by solid fundamentals. However, the economic outlook is set to deteriorate modestly in H2, and supports our call for a more cautious approach for global investors in the coming months.

INTRODUCTION

Hungarian assets have largely outperformed this year, backed up by solid fundamentals. However, the economic outlook is set to deteriorate modestly in H2, and supports our call for a more cautious approach for global investors in the coming months.

POLITICAL OUTLOOK

Prime Minister Orban continues to dominate the political landscape. His ruling party Fidesz and its coalition partner KDNP lost its two thirds majority in parliamentary after losing a by-election earlier this year. However, the next general elections won’t be called until 2018. In the meantime, Orban has used his party’s majority to consolidate power. However, we note that there appears to be a growing split within Fidesz, with some senior officials openly criticizing Orban.

The by-election loss came after a rare popular protest against a proposed internet tax. Polls suggest that Fidesz is losing popular support. Latest one shows undecided voters surging to 44% in June from 39% in April, signifying dissatisfaction with the large parties. Overall Fidesz support fell to 20% from 21%, right wing Jobbik party support fell to 15% from 17%, and Socialist support fell to 9% from 11%. Still, Fidesz leads among decided voters with 38%, trailed by Jobbik with 28% and the Socialists with 15%.

Orban’s rule has been characterized by poor relations with the EU. Indeed, Orban took a significant risk by moving closer to Russia’s orbit and away from Western Europe’s. EU relations won’t be helped by news that Hungary is building a fence on its Serbian border in an effort to keep illegal immigrants out, along with a potentially xenophobic advertising campaign against immigration.

ECONOMIC OUTLOOK

After a protracted easing cycle, official comments suggest it is nearing an end. Hungary central bank meets Tuesday and is expected to cut rates 10 bp to 1.40%. A small handful of analysts look for a 15 bp cut to 1.35%. Central bank minutes from the June meeting showed a 8-0 vote to cut rates 15 bp to 1.5%, but one MPC member wanted to end the easing cycle right then. All 8 also voted to change the forward guidance to further “slight” easing. We think after this meeting, there will be a pause.

The real sector data has been quite robust, so the need for more cuts is limited. The economy is rebounding quite nicely, with GDP growth expected at 2.7% in 2015 and 2.3% in 2016 (according to the IMF). This is a slowdown from 3.6% in 2014, and supports our view that while the easing cycle is likely ending, a tightening cycle is unlikely until 2016.

CPI rose 0.6% y/y in June, the highest rate since November 2013. Low base effects should see the y/y rate explode in H2, and it could approach the 3% target. If the central bank remains on until 2016 as we expect, bondholders could very well get spooked by the lack of concern regarding inflation.

The external accounts have improved, with the current account surplus likely to remain near 5% of GDP in both 2015 and 2016. The budget gap remains under control, but will have to be watched closely for signs of slippage. This is especially true if falling Fidesz popularity encourages Orban to follow more populist policies ahead of the 2018 elections.

The 2016 budget (passed last month) was a positive development. It aims at a reduction of the deficit to -2.0% of GDP from -2.4% this year, and it assumes 2.5% GDP growth. This is more optimistic than the current market consensus (via Bloomberg) of -2.4% of GDP, even though growth expectations are the same at 2.5%. The government will soften the controversial bank tax, in accordance with an agreement between the government and the European Bank for Reconstruction and Development. On the other hand, some revenue raising measures such as a tobacco tax could be disputed by the European Commission.

INVESTMENT OUTLOOK

EUR/HUF has retraced about a third of the April-July rise. The 50% retracement objective from that move comes in near 307, followed by the 62% near 304. Our EM FX model suggests the forint will outperform within EM over the next three months. However, given our overall bearish EM call, we think EUR/HUF will likely test the year’s highs near 318 (from July) and then 327.50 (from January).

Our EM equity model views Hungary at neutral, meaning it should perform along with the wider EM over the next three months. Hungary has outperformed massively, with MSCI Hungary up 40% YTD vs. -2.5% for MSCI EM. Given such outperformance, perhaps it’s time for Hungarian stocks to take a breather. The growth outlook is also softening, which may give bulls a reason to take profits.

Hungarian government bonds have outperformed over the past three months. Local currency 10-year government bond yields have risen 34 bp, according to Bloomberg pricing. The worst performers over the same period are Peru (+124 bp), Czech Republic (+79 bp), and Indonesia (+74 bp). The central bank’s easing cycle and deflationary conditions are the most likely factors behind this outperformance. With inflation set to move higher in H2, this warrants caution on the part of investors.