Hungary Outlook Rocky Despite Upgrade

Parliament building in Budapest, Hungary.jpg

Despite Fitch’s recent upgrade of Hungary to investment grade BBB-, we think the country faces growing problems ahead. The Orban government continues to maintain anti-orthodox and anti-EU stances.

POLITICAL OUTLOOK

After winning the general election of April 2014, the ruling coalition led by Fidesz lost its two thirds majority in parliament after a by-election defeat in February 2015. The next general election must be held by May 2018, and indications are that Orban will run again and win handily.

Opponents on the left remain scattered and weak. Instead, Fidesz will have to fight off the right-wing Jobbik. Jobbik is the third largest party in parliament, and seems poised to make even greater gains in the 2018 elections. By taking a strong anti-immigrant stance, Orban is trying to blunt some of Jobbik’s recent success.

Hungary continues to follow a confrontational path with regards to EU relations. Prime Minister Orban has been one of the proponents for halting the influx of refugees into Europe, going so far as to build a fence on its borders with Serbia and Croatia. Parliament recently approved plans for a national referendum this autumn on the EU plan to distribute asylum-seekers amongst EU members.

Hungary has found a long-lost brother in Poland, where the Law and Justice party has tilted quickly away from EU orthodoxy. Much of this is based on the Hungarian model of “illiberal democracy” that Orban favors. Indeed, Orban has said that he will veto any move by the EU to invoke Article 7 (violation of European common values) on Poland.

ECONOMIC OUTLOOK

The economy is likely to slow. GDP growth is forecast by the IMF to slow to around 2.3% in 2016 and 2.5% in 2016 vs. nearly 3% in 2015. Q1 GDP growth came in much weaker than expected at 0.9% y/y. As such, we see downside risks to the forecasts. Senior government statistician noted that in Q1, “Construction plunged by almost 30% as EU funds dried up,” cutting government orders that had buoyed that sector. In addition, car manufacturers cut production in Q1.

Price pressures remain low, with CPI rising 0.2% y/y in April. This remains well below the 2-4% target range. The central bank meets tomorrow and is widely expected to cut rates again by 15 bp to 0.90%. While officials have been downplaying the likelihood of further easing ahead, we think there will be one more 15 bp cut at the June 21 meeting to 0.75% before we see another pause.

Fiscal policy remains a concern. The budget deficit is seen widening to -2.1% of GDP in 2016 and 2.2% in 2017. However, with growth risks to the downside, we think there are risks to these forecasts. Breach of the -3% threshold would trigger an Excessive Deficit Procedure on Hungary.

The external accounts are in good shape. Lower oil prices have helped reduce imports, which have offset downward pressure on exports. Export growth is picking up in 2016, and the current account surplus is seen remaining around 4% of GDP in both 2016 and 2017. Foreign reserves have fallen below $30 bln in April, the lowest since November 2008.

We disagree with Fitch’s recent upgrade of Hungary to investment grade BBB- with stable outlook. Our own sovereign ratings model rates Hungary at BB/Ba2/BB and so an upgrade was not warranted. Hungary lost its investment grade from Fitch back in January 2012. Hungary lost investment grade from S&P back in Dec 2011 and from Moody’s back in Nov 2011.

INVESTMENT OUTLOOK

The forint has performed well within EM. In 2015, HUF was basically flat vs. EUR. This compares to the worst performers ARS (-35% vs. USD), BRL (-33% vs. USD), and ZAR (-25% vs. USD). So far this year, HUF is down -1% YTD vs. EUR, and compares to the worst performers ARS (-8% YTD vs. USD), MXN (-7% YTD vs. USD), and TRY (-2.5% vs. USD YTD). Our EM FX model shows HUF as having STRONG fundamentals.

Still, the forint is likely to succumb to overall EM selling pressures this year. EUR/HUF is nearing the January high near 319. After that is the all-time high near 328 from January 2015.

Hungarian equities have outperformed within EM. Last year, MSCI Hungary rose 50% vs. -17% for MSCI EM. So far in 2016, MSCI Hungary is up 10.5% YTD, and compares to -1.3% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Hungary at a NEUTRAL position.

Hungarian bonds have underperformed this year. The yield on 10-year local currency government bonds is up about 4 bp YTD. This is only behind the worst performers Poland (+17 bp), China (+12 bp), and Bulgaria (+7 bp). With inflation likely to remain low and the central bank likely to ease further, we think Hungarian bonds could start outperforming more. Markets may start looking for another rating upgrade from one of the other agencies.