THE LAST THREE MONTHS of 2017 were, for the most part, a good quarter for local financial markets amid strong economic growth, stock market record-highs, and the passage of the first package of the tax reform program.
Last month, the Philippine Statistics Authority reported the Philippine economy expanding in the fourth quarter by 6.6%. While the fourth quarter turnout was slightly lower than market expectations, it was enough to bring the full-year performance to 6.7%, which is within the government’s 6.5-7.5% target range. To compare, the Philippine economy last year was among the fastest-growing economies in Asia after China’s 6.9% and Vietnam’s 6.8%.
Growth in government spending for the year continued to be high at 7.3% albeit slower than 2016’s 8.4% according to the government’s national accounts. Bucking the trend was spending in the fourth quarter, which accelerated to 14.3% compared to 4.5% in the fourth quarter of 2016.
In a separate data by the Department of Budget and Management, infrastructure and capital outlays reached P95.3 billion, which is 28.8% higher than the P74 billion in the 2016’s comparable two months.
Another highlight, and perhaps the most noteworthy, of the quarter was the passage of the first package of the Tax Reform for Acceleration and Inclusion (TRAIN) act. Package 1 of TRAIN reduces the income taxes of almost all of the country’s taxpayers starting this year. On the other hand, additional taxes were raised on products that include sugar-sweetened beverages, tobacco, fuel and cars to make up for the foregone revenue in income tax cuts.
The passage of TRAIN and the “massive” infrastructure program led Fitch Ratings to upgrade the country’s credit rating from BBB- to BBB with a “stable” outlook. The new rating marks the first major upgrade secured under the Duterte administration with the last upgrade being on September 2015.
“The approval of the first package of TRAIN partly improved sentiment on the local financial markets, as lower tax rates for individual taxpayers lead to higher consumer incomes and consumer spending power that could lead to higher sales and income of consumer-related companies,” said Michael L. Ricafort, economist at Rizal Commercial Banking Corp. (RCBC).
In the local bond market, investor demand for local government securities (GS) was robust based on oversubscriptions in the Bureau of the Treasury’s auctions during the quarter. In the primary bond market, the Treasury fully awarded the Treasury bills (T-bills) it offered in the October auctions, while partially awarding those of the 364-day T-bills. Following the P255-billion issuance of the five-year retail treasury bonds, however, the government rejected all bids for the 91-, 182- and 364-day T-bills during the Nov. 27 and Dec. 11 auctions given the weak market appetite and the government already having a healthy cash position. Meanwhile, GS yields at the secondary market were up 54 basis points on the average quarter on quarter.
For equities, the rosy expectations stemming from tax cuts pushed the Philippine Stock Exchange (PSE) index to close the year at 8,558.42 points — then a record-high. The PSE likewise reported an 18% increase in earnings to P825 million with a 3% increase in average turnover to P8.06 billion in 2017.
On the other hand, US interest rates rose during the fourth quarter following the interest rate hike by the US Federal Reserve (US Fed), and the passage of a tax reform bill reducing income taxes for US individuals and corporates.
“The rise in global interest rates as a result of the hawkish hints from these two major central banks pushed domestic yields higher and weakened the peso,” said Guian Angelo S. Dumalagan, market economist at Land Bank of the Philippines (Landbank), referring to the US Fed and the European Central Bank (ECB).
In the fourth quarter, the peso averaged P50.93:$1, depreciating 0.19% from the previous quarter’s average of P50.84:$1, according to data by the Bangko Sentral ng Pilipinas (BSP). In October, the peso averaged P51.34:$1, depreciating by 0.65% from the P51.01:$1 average in September following market expectations of a better third quarter US GDP growth. Also contributing to the pressure was the strengthening of the dollar against the Euro amid the ECB’s decision to prolong its bond-buying program that time. At one point during the month, the peso weakened to an 11-year worst P51.95:$1.
Meanwhile, the peso rebounded in November and December, appreciating 0.6% and 1.28% from their previous months’ averages, respectively. At this time, lending support to the peso include, among others, the expectations of a stronger third quarter Philippine GDP growth; the market perception of a more hawkish Fed under Jerome Powell, replacing Janet Yellen as US Fed chair; and the legislation of the TRAIN bill into law.
WHERE DO WE GO FROM HERE?
Even before the passage of the TRAIN bill, analysts were already expecting the BSP to raise key rates to keep inflation in check. A month after the law’s passage, inflation in January increased to its fastest pace in more than three years at 4% — the high-end of the BSP’s 2-4% target band for the year and surpassing market forecasts.
Despite this, the BSP kept policy rates unchanged during its monetary board meeting last Feb. 8. Instead, the central bank announced the reduction of the reserve requirement ratio (RRR) by one percentage point to 19% effective March 2.
“The reduction in ultra-high reserve requirements to a level more comparable with other ASEAN countries, is part of a broader strategy by the BSP to shift towards the use of more market-based monetary instruments for managing liquidity in the financial system,” said BSP Governor Nestor A. Espenilla, Jr., referring to the Association of Southeast Asian Nations.
The BSP requires Philippine banks to set aside a fifth of their total deposit base with the BSP even as they don’t generate any returns. But Mr. Espenilla, who personally wants to see the RRR at single-digit levels, has long suggested of the cut since last year, describing the current 20% level as an “inefficiency to the financial system.”
However, lessening the Philippines’ bank reserve requirements — one of the highest in the world — does not necessarily mean a shift in policy stance, according to the central bank governor.
“[F]orthcoming reductions in RRR should not be mistaken as a change in monetary policy stance,” Mr. Espenilla said earlier this month. “Rather, it should be viewed as part of ambitious financial market reforms that BSP is currently implementing.”
The BSP, along with some of the country’s economic managers, maintained that the fiscal reform’s upside influence on prices is “one-off” and is “not considered as unduly inflationary.”
“The recently approved tax reform program of the NG (National Government) may have some inflationary impact in the short term although a monetary policy response may not necessarily be warranted particularly if there is limited evidence of significant demand-side pressures or a disanchoring of inflation expectations,” Mr. Espenilla said.
For analysts, raising the interest rates this year would not be surprising given market developments.
“While average inflation this year is still expected to fall within the BSP’s target range, the local central bank might take a proactive approach by hiking rates sooner rather than later, considering the natural time lag of monetary policy,” said Landbank’s Mr. Dumalagan.
Mr. Dumalagan added that the BSP, US Fed and the ECB are seen to be less accommodative: “These three central banks are expected to tighten their monetary policy settings this year, potentially hurting stocks and bonds, whose prices move inversely with interest rates,” he said.
“It could also cause volatility in the foreign exchange market, as there might be a push and pull on the peso given that hawkish moves from the BSP are beneficial to the peso while hawkish actions from the Fed serve to reduce the local currency’s attractiveness against the dollar.”
Cheuk Wan Fan, HSBC Private Banking Head of Investment Strategy and Advisory in Asia, shared the same view: “Currently, we only expect one interest rate hike in the Philippines. We expect one 25-basis point interest rate hike in the second quarter of this year.”
For Chidu Narayanan, economist at Standard Chartered, the country’s strong credit growth could prompt the BSP to increase rates this year: “We are a little worried about credit growth. Credit growth has been high among households and corporates.”
For now, the BSP sees inflation hovering slightly higher than expected.
“Taking into account the latest available information, the baseline forecasts of the BSP show that inflation will average slightly above the high end of the target range for 2018 and above the midpoint of the target range for 2019,” noted the central bank governor.
For RCBC’s Mr. Ricafort: “Major catalysts include the second package of the tax reform measures (i.e. reduction in corporate income taxes, rationalization of fiscal incentives), as well as other tax reform measures such as those that pertain to capital market development.”
Below are analysts’ outlooks for each of the key markets:
Gov. Espenilla, BSP: “The planned integration of the fixed income exchange and equities market, a step to make domestic capital market more efficient and cost effective, is expected to make the local bourse more robust and attractive to both foreign and local investors.”
Mr. Dumalagan, Landbank: “Equities are expected to remain strong, assuming that the Build, Build, Build program and the tax reform of the government would unfold as planned, without unexpected delays. Else, we could see a downward correction in the local index, especially since higher interest rates are generally bad for stocks.”
Mr. Ricafort, RCBC: “Consumer-related companies/industries that benefit from higher consumer incomes and spending in terms of higher incomes and sales could lead to higher valuations. However, companies/industries whose costs will significantly increase as a result of higher taxes on oil/petroleum, sweetened beverages, tobacco, vehicles, coal, mining, local oil/petroleum exploration may be adversely affected in terms of narrower margins, lower sales/net income, and valuations.”
Ms. Fan, HSBC: “Within Asia, Philippine stock market is relatively expensive as compared with the regional average. Currently, the 12-month forward P/E (price-to-earnings ratio) of the Philippine stock market is around 19 times as compared with the regional average of 13 times. This underpinned our relatively neutral view on the upside potential of the Philippine market as compared with its regional peers.”
Gov. Espenilla, BSP: “The Philippine government is expected to source 80% of its 2018 borrowing program domestically while the remaining 20% will be from external sources. Moreover, to support the funding requirements of the administration’s infrastructure push, the NG is planning to increase gross domestic borrowings by 30% in 2018.”
Mr. Dumalagan, Landbank: “Yields are expected to rise due to inflationary pressures and tighter policy settings domestically and abroad. Higher yields would mean lower bond prices. In relation to US monetary policy, it is also critical to monitor the progress of the US tax reform, as it could potentially defer or accelerate the pace of US interest rate normalization. Political noise concerning the exit of Britain from the Euro zone and the North Korean missile program need to be observed as well, as it could potentially result in some volatility in the financial markets.”
Mr. Ricafort, RCBC: “Local interest rates could continue its gradual upward trend, fundamentally supported by higher inflation, stronger Philippine economic growth, weaker peso exchange rate, and the rising trend in US/global interest rates. The US Federal Reserve is widely expected to continue raising its key short-term interest rates in 2018 (three to four Fed rate hikes of +0.25 each), as well as the tapering of the Fed’s balance sheet.”
Gov. Espenilla, BSP: “The Philippine peso relative to the US dollar is expected to remain broadly stable. The expected growth in foreign exchange inflows from overseas Filipino remittances and BPO (business outsourcing processing) revenues (in 2018 by 4% and 10%, respectively); and sustained inflows from foreign investments, tourism receipts, as well as the ample level of the country’s gross international reserves, are expected to support the peso.”
Mr. Dumalagan, Landbank: “The peso is still expected to remain weak, at least for this year, primarily because of the continuous rate hike of the US Federal Reserve, which is pulling foreign portfolio investments outside of the country. The local currency’s depreciation, however, might be tempered by the country’s improving macroeconomic fundamentals.”
Mr. Ricafort, RCBC: “Record high trade deficits have led to some weakness in the peso exchange rate vs. the US dollar. However, relatively weaker US dollar vs. global/Asian currencies since 2017 could mitigate/limit this.”
Divya Devesh, Asia FX Strategist at Standard Chartered Bank: “We expect the dollar to be broadly weaker in 2018. Inflation expectations in the US still remain quite low. Global growth has become synchronized, which means that US assets on a relative basis are not as attractive.”
“We expect dollar peso to be largely range-bound for most part of 2018. We’re looking dollar peso at P50.5 by the end of this year. I think it is important to note that we are expecting dollar peso to remain relatively stable even in a weaker dollar environment. That should mean that the Philippine peso will continue to underperform relative to its peers in [emerging markets] and in Asia.” — J.B. Gonzales