Hungary Nears End of Easing Cycle

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Hungary is poised to extend the easing cycle next week.  However, with inflation rising, we think this is likely to be the last move.POLITICAL OUTLOOK

The ruling coalition led by the Fidesz party is firmly in control.  Prime Minister Orban led his party to a landslide win in 2014 election.  However, the loss of a by-election in 2015 led to a loss of its two thirds majority in parliament.

General elections are due by April 2018.  Fidesz appears likely to win a third consecutive term.  The center-left opposition parties remain weak and divided, and so the biggest threat to Fidesz will likely come from the far right Jobbik party.  All signs point to continuity in Hungary’s economic policies.

Relations with the EU are likely to remain strained.  Orban has bristled at the EU’s refugee policies, while the EU has been very critical of the authoritarian tilt in Hungary.  For now, there is an uneasy truce.

ECONOMIC OUTLOOK

The economy is likely to pick up.  GDP growth is forecast to accelerate modestly to around 3% in both 2017 and 2018 from 2% in 2016.  GDP rose 1.6% y/y in Q4, while monthly data so far in Q1 suggest some acceleration will be seen.

Price pressures are rising, with CPI accelerating to 2.9% y/y in January.  This is the highest rate since January 2013, but remains within the 2-4% target range.  Despite central bank forecasts for lower inflation ahead, we believe low base effects could see inflation approach the top of the target range this year.

The central bank last cut rates 15 bp to 0.90% in May 2016.  However, it has since been easing by unconventional measures.  Most recently, the central bank has capped the amount commercial banks can keep at its 3-month deposit facility.  This pushes funds out of the central bank’s deposit facility and into government bonds and the interbank market.  The end result has been lower government borrowing costs and lending rates.

The current cap on 3-month deposits was set at HUF750 bln at the December policy meeting.  This will run to end-Q1.  The central bank will set its end-Q2 cap at its next policy meeting March 28.  Recently, the central bank warned that “Monetary policy has reached its limit.”  We look for one more symbolic cut in the cap next week.  We also think the statement could be adjusted to remove the potential for further easing.  Tightening, however, is unlikely until 2018.

Fiscal policy has remained prudent.  Perhaps too prudent.  The central bank recently called for a more expansionary fiscal policy, warning that the better than expected budget stance is likely to weigh on growth.  The budget deficit came in at an estimated -1.8% of GDP in 2016, little changed from 2015.  It is expected to widen slightly to -2.4% in 2017 and -2.3% in 2018.

The external accounts remain in good shape.  Low energy prices and the sluggish economy have helped reduce imports, but that should ebb as the year progresses.  The current account surplus was 3.6% of GDP in 2016, and is expected to narrow slightly to 3% in 2017 and 2.5% in 2018.

Foreign reserves have remained fairly steady this past year after steadily dropping in 2014 and 2015.  At $40.5 bln in December, they cover less than 2.5 months of import and are a little more than 1.5 times larger than its stock of short-term external debt.

INVESTMENT OUTLOOK

The forint has traded in a very narrow range against the euro since mid- 2015.  The pair has rarely traded below 305 or above 320 during this period.  Our EM FX model shows the forint to have NEUTRAL fundamentals.

Hungarian equities have underperformed after a stellar 2016.  In 2016, MSCI Hungary was up 32% vs. 7% for MSCI EM.  So far this year, MSCI Hungary is up 1% YTD and compares to 13% YTD for MSCI EM.  This underperformance should ebb a bit, as our EM Equity model has Hungary at a NEUTRAL position.

Hungarian bonds have underperformed recently.  The yield on 10-year local currency government bonds is +44 bp YTD.  This is behind only the worst performers Czech Republic (+46 bp) and Romania (+55 bp).  With inflation likely to continue rising and the central bank retaining a dovish stance, we think Hungarian bonds will continue underperforming.

Our own sovereign ratings model shows Hungary’s implied rating at BBB-/Baa3/BBB-.  This is right at actual ratings, as Hungary finally regained its investment grade rating from all three agencies.  Further upgrades are unlikely for now.