Financial market volatility to continue in Q3

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RATTLING developments at home and abroad sent local financial markets on a downtrend in the second quarter, leading analysts to expect that this will carry over into the next three months.

The domestic financial markets remained in a precarious position in the second quarter, primarily due to rising domestic inflation and inflation expectations, which exerted more pressure for monetary authorities to raise interest rates.

During the quarter, the pace of the increase in consumer prices accelerated beyond market expectations with headline inflation rate at 4.8%, faster compared to the first quarter’s 3.8% and 2.8% in the second quarter of 2017. This brought the average inflation to 4.3% in January to June, breaching the national government’s (NG) 2-4% target band for 2018.

Even as month-on-month inflation showed signs of decelerating, worries among market players remain unabated. The second half of the year opened with July’s inflation rate surging to a multi-year high at 5.7% versus the 5.2% recorded in June and 2.4% in July 2017 according to government data. This was near the midpoint of the 5.1-5.8% estimate range provided by the BSP’s Department of Economic Research and the 5.5% median market forecast for that month.

In an e-mail to BusinessWorld, Bangko Sentral ng Pilipinas (BSP) Governor Nestor A. Espenilla, Jr. said that supply-side factors were mostly to blame, citing the rising food prices caused by adverse weather conditions; the higher excise tax on sweetened beverages; the scheduled increase in excise taxes on tobacco products; the increasing power generation charges and water rates; and the approved provisional increase in minimum jeepney fares in some regions.


However, Mr. Espenilla explained that the central bank does not have control over fixing problems in the supply-side, noting that monetary policy can only influence demand-driven price pressures as well as managing inflation expectations.

Nonetheless, the BSP remains vigilant of supply-side factors and would act against early signs of second-round effects, which include minimum wage adjustments and transport fare hikes. For this reason, the BSP raised policy interest rates by 25 basis points (bp) each in the May and June Monetary Board meetings while another “aggressive” move was made in the August meeting with a 50-bp hike.

Aside from these second-round effects, Mr. Espenilla pointed at potential price pressures from “excessive volatility in the foreign exchange market” that would affect inflation expectations. The peso continued to depreciate at an average P52.43/US$1 during the second quarter, from an average of P51.43/US$1 in the first quarter.

“Sustained pressures on the peso could adversely affect inflation expectations, which would warrant a monetary policy response,” he said.

The BSP Governor clarified that the decision to whether or not raise rates will be dependent on their “comprehensive and rigorous assessment of all relevant data and forecasts.”

Meanwhile, an analyst from a major commercial bank said that the deceleration in inflation would follow an overall economy slowdown “should the BSP opt to continuously address inflation with rate hikes.”

“The BSP would best be served by keeping the powder dry and hike only to address second round effects emanating from cost push inflation on top of anchoring inflation expectations,” the analyst said.

The analyst added: “The real goal of monetary authorities to addressing cost push inflation would be in the realm of containing inflation expectations, which can be done with a mix of policy rate hikes and deft and firm policy statements. As such, reigning in inflation expectations may be more important than actually hitting your target.”

The “faster-than-expected” monetary policy normalization in advanced economies, which includes the policy tightening by the US Federal Reserve (Fed), contributed to the dampening on local market sentiment.

“Monetary policy normalization in advanced economies could generate capital flow volatility and bouts of financial market turbulence. Moreover, faster-than-expected policy normalization in the US and other advanced economies could lead to tighter global liquidity conditions and a re-pricing of risks, resulting in potential reversals in capital flows in emerging markets and depreciation pressures on the peso,” Mr. Espenilla said.

The Fed implemented a series of aggressive monetary policy tightening amid rising inflation expectations due to higher oil and steel prices. In June, the US central bank hiked its policy rates by 25 bps, while pointing to two more hikes — which could bring a total of four increases this year.

Mr. Espenilla noted that while the ongoing trade disputes between the US and China had no significant impact on Philippine exports, these “geopolitical tensions” are still seen as external risks.

“Prolonged trade frictions can still affect overall investment sentiment towards the Philippines and increasing uncertainty in global growth prospects could take a toll on [the local economy]… with effects transmitted through weaker-than-expected trade flows as well as lower demand for overseas Filipino workers and services-related activities,” he said.

For Guian Angelo S. Dumalagan, market economist at the Land Bank of the Philippines (LANDBANK), the trade war has caused foreign investors to dump Philippine assets.

“Fundamentally, the trade war between the US and China has not yet crippled the Philippine economy. Our fundamentals are strong enough to help us weather the initial onslaught of the tit-for-tat tariff imposition between the world’s two largest economies,” he said.

“However, even as the Philippines’ economic core remains solid, its outer surface has received some battering due to constant foreign portfolio outflows as a result of increased geopolitical risk. Local financial markets have been quite volatile as well because of the never-ending political noise from the US and China.”

For Ruben Carlo O. Asuncion, economist at the Union Bank of the Philippines (UnionBank), the immediate impact of the trade war may have manifested in the weakening of currencies through the “deteriorating of prospects on trade growth and the strengthening of the US dollar as investors flock to more stable assets.”

The domestic financial markets will continue to react on key local and external developments, BSP’s Mr. Espenilla said.

“In the domestic front, markets are looking at inflation outturns, trajectory for growth, fiscal performance and borrowing activity of NG, corporate earnings results and portfolio investments, as well as progress on infrastructure spending of the NG,” he said.

“On the external side, the unwinding of accommodative monetary policy in advanced economies as well as trade and geopolitical tensions could affect market sentiment,” he added.

For LANDBANK’s Mr. Dumalagan, domestic inflation is expected to “taper back” to the central bank’s inflation target by 2019, but that the weakness of the peso and possible second-round effects are expected to exert “upside price pressures,” which could reduce growth in domestic demand.

“Secondly, the progress of the government’s infrastructure program needs to be monitored as well. This program of the government is highly correlated with the present administration’s tax reform initiative, which is currently experiencing some delays. If funds cannot be sustained due to delays in the tax reform program, investors may begin to recalibrate their highly optimistic view of an infrastructure-led growth,” he added.

As far as monetary policy is concerned, economists expect the BSP to raise policy rates further, on expectations of continued peso depreciation and inflation remaining elevated.

“[The] BSP is expected to aggressively respond to inflation pressures and to re-anchor inflation expectations,” ING Bank N.V. Manila senior economist Jose Mario I. Cuyegkeng said, adding the possibility of another 25-bp rate hike later in the year.

For UnionBank’s Mr. Asuncion, there might be another 25-bp hike in the third quarter, followed by another by the end of the year.

“Even if the inflation starts to ease at the end of the year, inflation expectations will take longer to adjust. We expect inflation to average at 5.1% this year, hence another policy rate hike necessary. The BSP’s decision to hike rates by 100 bps in 3 months indicate their intention of bringing inflation back within 2-4%,” he said.

The country’s stock market took a beating in the second quarter as the benchmark Philippine Stock Exchange index (PSEi) plunged 11.1% quarter-on-quarter to average 7,618.99 points.

The local bourse opened the second quarter on a positive note, up 0.74% or 59.62 points to close at 8,039.45 on April 2. This rally, however, was short-lived when the PSEi dropped below the 8,000 level within the same week.

In May, the local bourse recovered, as optimism lured investors back to buy local index stocks at low prices after the BSP’s decision to raise rates for the first time in nearly four years. At that time, local stocks surged to close above the 7,700 levels.

The rate hike in June was another story. In June 21, local equities entered the bear market territory with the PSEi down 21.6% from its January peak to close at 7,098.15.

The index sank further to an 18-month low in June 25 to close 6,986.88 while ending the quarter at 7,193.68 on the back of window dressing alongside gains made in international markets.

Michael L. Ricafort, head of Rizal Commercial Banking Corp.’s (RCBC’s) Economic and Industry Research Division, expects the benchmark index to retest the 8,000-level in the third quarter: “PSEi could go up… amid healthy upward correction from the [intraday] low of 6,923.67 posted on June 22, 2018, especially if bargain-hunting/net foreign buying is sustained.”

Meanwhile, the rising domestic inflation, the US Fed rate hikes, and geopolitical concerns abroad, may cause local stocks “to show indecisive moves,” LANDBANK’s Mr. Dumalagan said.

On the other hand, UnionBank’s Mr. Asuncion expects a recovery in the equities market “in a short amount of time.”

“Economic growth of the Philippines remains strong despite the inflationary pressures. The market will be advanced by the strong earnings of domestic companies and the strength of US and Chinese corporations,” he said.

To recall, the Philippine economy grew by 6% in the second quarter — its slowest in three years. This compares to the 6.6% growth posted in the same period in 2017.

Investor demand for government securities (GS) stayed strong based on oversubscriptions in the Bureau of the Treasury’s auctions during the quarter. For the April-June period, total demand reached P321.4 billion, almost twice the P195.0 billion total offered amount. The oversubscribed amount of P126.4 billion was higher compared to the P59.2-billion figure in the first quarter.

Meanwhile in the secondary market, GS yields rose save for the seven-year debt papers. On the average, yields were 52.2 bps higher with a range of 48.9 bps for the seven-year Treasury bonds to 139.9 bps for the one-year T-bills compared to rates in the first quarter. Compared to rates in end-June 2017, average yields were up by 145.02 bps.

The higher yields were primarily attributed to investors remaining on the sidelines amid hawkish comments made by the BSP governor, which fueled expectations of another rate hike in the works.

Economists expect domestic yields to remain higher.

ING’s Mr. Cuyegkeng: “Yields would likely move sideways to higher depending on inflation, inflation expectations, monetary policy and [the] government’s financing requirement for the rest of 2018 and for 2019.”

Angelo B. Taningco, economist at Security Bank Corp.: “For the third quarter, I expect local fixed income yields to move up due to expectations of another US rate hike, BSP’s rate hike in August, and higher Philippine inflation.”

RCBC’s Mr. Ricafort: “Yields could go up slightly in 3Q 2018 amid expectations of further local policy rate hike due to elevated inflation beyond the inflation target and on possible further Fed rate hike. However, inflation is expected to reach the peak around August and could start to ease due to higher base effects after [this month].”

LANDBANK’s Mr. Dumalagan: “Domestic yields are still expected to trend higher in the third quarter, especially since the US Federal Reserve remains on track to hike rates again in September and December this year. The rise in local inflation may also contribute to higher domestic interest rates.”

Unionbank’s Mr. Asuncion: “The upward pressure on yields is mainly due to inflation expectations by the market. The level of prices is expected to remain elevated and will consequently keep upward pressure on yields.”

The same three months brought the value of the peso down 1.91% with the currency averaging P52.43-to-a-dollar in the second quarter compared to the previous quarter’s P51.43/$1, according to BSP data.

The second-quarter average also depreciated by 4.91% from P49.86/US$1 average in the same period in 2017.

Mr. Espenilla noted that while the country’s economic fundamentals remain solid, “sustained pressures” on the peso could add up to inflation expectations, warranting a policy response.

“Over the policy horizon, the peso is expected to be broadly stable and reasonably flexible to reflect changing demand and supply conditions in the foreign exchange market,” said Mr. Espenilla.

ING’s Mr. Cuyegkeng: “We would likely see fresh 12-yr lows for [the peso] as imports continue to increase and the trade gap remains unfunded from structural inflows. An aggressive monetary tightening cycle would moderate such weakness.”

Security Bank’s Mr. Taningco: “I expect peso-dollar exchange rate to move up to around 53.50 by the end of the [third] quarter.”

RCBC’s Mr. Ricafort: “The US dollar/peso exchange rate could correct lower in 3Q 2018 due to stronger signals to further tighten policy rates. Resumption of net foreign buying at the Philippine stock market for the final week of July 2018 (after 25 straight weeks of net foreign selling) could also support the healthy downward correction in the US dollar/peso exchange rate.”

LANDBANK’s Mr. Dumalagan: “The peso may also show sideways movement above the P53/$1 level, as geopolitical tensions could reduce the local currency’s attractive versus the safer greenback. The gradual rate hike of the US Federal Reserve could limit the possibility of a strong peso correction.

Rajiv Biswas, APAC chief economist at IHS Markit: “The PHP has already depreciated from around P50 per USD at the beginning of 2018 to around P53.4 by mid-August. Further PHP depreciation to P54.5 per USD is expected by the end of 2018.”

UnionBank’s Mr. Asuncion: “The peso is expected to depreciate due to widening trade deficit, more capital investments and the massive infrastructure development program of the Duterte administration.” — Carmina Angelica V. Olano