Despite solid fundamentals, Philippine assets continue to underperform. Part of the story was an unexpected cut in reserve ratios as well as the central bank’s reluctance to hike in the face of rising inflation. The other part of the story is rising political risk.
President Duterte is nearly a third through his single 6-year term. Recent polls show that President Duterte continues to enjoy very high popularity, near 80%. While he says he will abide by this term limit, Duterte is pushing for changes to the constitution that are raising some eyebrows. He backs a plan to give more power and autonomy to regional governments, while also creating the post of Prime Minister to head the government. The president would still retain control over most institutions, including defense, foreign policy, and national security.
More tellingly, the proposed plan would also change term limits for the president from one 6-year term to two 5-year terms. Though Duterte has pledged to abide by the current one-term limit, the proposed plan would thus allow him to run for two more 5-year terms. This plan would require the first change to the constitution put in place in 1987 after the overthrow of Ferdinand Marcos. Last month, the House started the process by passing a resolution to convene both chambers of Congress to draft changes to the constitution.
Mid-term elections will be held in 2019. Half the Senate and the entire House of Representatives will be up for grabs then. Duterte and his allies claim that greater federalism would address minority Muslim regions’ call for more self-rule. However, critics believe it is a simple power grab. This group includes Vice President Robredo, who was not Duterte’s running mate. We think attempts to change term limits are credit-negative, and could eventually be destabilizing.
The Muslim insurgencies are likely to flare up from time to time. Martial law on the island of Mindanao was extended in December for another year. Both houses of Congress approved the request by an overwhelming margin, and came after renewed attacks in Mindanao were seen last year. Duterte has raised the possibility of widening martial law to the rest of the nation, which would likely be taken negatively by the markets.
The Philippines scores poorly in the World Bank’s Ease of Doing Business rankings (113 out of 190). The best components are getting electricity and resolving insolvency, while the worst are enforcing contracts and starting a business. Philippines does slightly better in Transparency International’s Corruption Perceptions Index (101 out of 176) and tied with Gabon, Niger, Peru, Thailand, Timor-Leste, and Trinidad & Tobago.
The economy remains robust. GDP growth is forecast by the IMF at 6.7% in 2018, steady from 2017. GDP rose 6.6% y/y in Q4, but the recent tax hikes will be a headwind on the economy. As such, we see some modest downside risks to the growth forecasts.
Price pressures are rising, with CPI inflation jumping to 4.0% y/y in January from 3.3% in December. This is the highest since October 2014, and is right at the top of the 2-4% target range. Core inflation rose to 3.9% y/y in January, the highest since August 2012. A major culprit is higher taxes, but a weak peso has also likely fed into higher inflation overall.
The bond market has taken notice. The Bureau of the Treasury was forced to pay an average yield of 6.4% on its 20-year issuance today. This is the highest yield for new 20-year issuance since January 2011, though we note that rates on the secondary market are trading north of 7% and suggest further upward pressure on rates.
The central bank has been on hold since June 2016, when it moved to a new policy regime and cut the policy rate 100 bp to 3.0%. Next policy meeting is March 22, and we see risk of a 25 bp hike then to 3.25%. Bank officials have been reluctant to hike until the impact of the recent tax increases can be better determined, but the market may force its hand. Bloomberg consensus sees two 25 bp hikes this year.
Note that the central bank just cut reserve requirements for commercial banks one percentage point to 19% effective March 2. Monetary Board Member Medalla said the bank will consider another cut after assessing the impact of the first one. The goal is to bring this requirement below 10% by the end of Governor Espenilla’s term in 2023, Medalla added.
We do not think this is the right time to cut reserve requirements. The central bank said the move will free up PHP90 bln in liquidity, but stressed that it will mop up excess liquidity via its term deposit facility.
The fiscal outlook is likely to worsen. The government increased spending sharply. The budget deficit widened to -3.4% of GDP in 2017, and is expected to remain near -3% in both 2018 and 2019. The net impact of the recent tax changes has yet to be felt, but we think they pose upside risks to the deficit forecasts.
The external accounts are also deteriorating. The current account moved into deficit last year. Though it was only an estimated -0.1% of GDP in 2017, it’s the first annual deficit since 2002. The IMF expects a deficit equal to -0.3% of GDP in 2018. Export growth has slowed in recent months, which is disappointing considering solid growth in its three largest export markets (China, US, and Japan).
Foreign reserves have fallen from the record highs seen in 2016. Still, at $81.2 bln in January, reserves cover 9 months of imports and are nearly 4 times larger than the stock of short-term external debt. External vulnerabilities are relatively low, but the current account deficit bears watching.
The peso continues to underperform. In 2017, PHP fell -0.4% vs. USD and was ahead of only the worst EM performers ARS (-14.5%), TRY (-7%), BRL (-2%), and IDR (-1%). So far in 2018, PHP is -4.5% YTD and is ahead of only the worst performers ARS (-6.25%).
Our EM FX model shows the peso to have NEUTRAL fundamentals, and so it should start to see a bit less underperformance. USD/PHP is trading at highs not seen since mid-2006 and is on track to test the February 2004 all-time high near 56.50.
Philippine equities continue to underperform. In 2017, MSCI Philippines was up 23.4% vs. 34.4% for MSCI EM. So far this year, MSCI Philippines is up 1.4% YTD and compares to up 3.7% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has the Philippines at an UNDERWEIGHT position.
Philippine bonds have underperformed. The yield on 10-year local currency government bonds is +113 bp YTD. This is the worst performer in EM and well behind the next worst performers YTD Hungary (+60 bp), and Russia (+50 bp). With inflation likely to continue rising and the central bank on track to tighten soon, we think Philippine bonds will continue to underperform.
Our own sovereign ratings model showed the Philippines’ implied rating steady at BBB+/Baa1/BBB+. There is still some modest upgrade potential to actual ratings of BBB/Baa2/BBB. However, we suspect that the agencies will remain cautious in light of the fiscal changes under the Duterte government.