Hungary Imbalances Growing

new hungaryThe ruling Fidesz is likely to win another term, as the opposition remains weak and divided.  While the economy is robust, we think imbalances are growing and warrant caution. 

POLITICAL OUTLOOK

Fidesz remains firmly in control.  Even though it lost its two thirds majority in parliament after a 2015 by-election, Prime Minister Orban has been able to advance his vision of a so-called illiberal democracy.  He shows no signs of backing off, and along with Polish leaders has pushed back against EU criticism.

Tensions with the EU have ebbed but remain on a slow simmer.  Similar to the current EU-Poland tensions, so too has Hungary locked horns with Brussels.  The biggest disagreement was with the EU’s refugee policy and its quota system for member countries.  Then, it was legislation that sought to crack down on NGOs such as Transparency International, as well as foreign-run universities.

The next national elections are due by April 2018.  Polls suggest Fidesz and its junior coalition partner KDNP are likely to win a third consecutive 4-year term.  A September poll shows Fidesz winning 55% of the vote, which would be up from 45% in 2014.

The opposition in Hungary remains in disarray six months ahead of elections.  Socialist candidate Laszlo Botka just quit the race after failing to unite the opposition.  Polls show support for the Socialists dropping to less than 10%, a fall from grace for the party that ruled in the 1990s and 2000s.

With such poor polling numbers, Botka was unable to gain the backing of the other opposition parties.  Several of these parties recently announced plans to run their own candidates for prime minister.  The right-wing Jobbik party is polling second with 16%, which is around where it polled in the 2014 elections.

Hungary scores well in the World Bank’s Ease of Doing Business rankings (41 out of 190).  The best components are trading across borders and enforcing contracts, while the worst are getting electricity and protecting minority investors.  Hungary does slightly less well in Transparency International’s Corruption Perceptions Index (57 out of 176 and tied with Jordan and Romania).

ECONOMIC OUTLOOK

The economy remains robust.  GDP growth is forecast by the IMF to accelerate to around 3% in both 2017 and 2018 from 1.9% in 2016.  Private sector forecasts are more optimistic, as are the central bank’s forecasts of nearly 4% in both years.  GDP rose 3.2% y/y in Q2, down from the Q1 rate of 4.2% (the strongest rate since Q2 2014).

Price pressures bear watching, with CPI accelerating to 2.6% y/y in August from 2.1% in July.  This was the highest since March.  September CPI data is due out October 10 and is expected to rise 2.7% y/y.  If so, it would be near the cycle highs but still within the 2-4% target range.

Yet the central bank eased again last month.  It kept the main policy rate steady at 0.9%, but cut the overnight deposit rate deeper into negative territory to -0.15% and lowered the cap on 3-month deposits to HUF75 bln at the end of Q4 vs. HUF300 bln at the end of Q3.  The bank has been loosening policy every quarter, and so the December meeting will offer the next opportunity to ease.  With price pressures rising, it seems risky to remain so dovish.

Fiscal policy is deteriorating.  The budget deficit came in at an estimated -1.8% of GDP in 2016, up from -1.6% 2015.  Expenditures are picking up ahead of the elections.  The deficit is expected by the OECD to widen to around -2.5% of GDP in 2017 and nearly -3% in 2018.  After the elections, Fidesz should focus on limiting the deficit in order to avoid EU sanctions.

The external accounts should remain solid.  Export growth has picked up, but so have imports.  The current account has been in surplus since 2010.  It was about 6% of GDP in 2016, and is expected to narrow to around 4% in 2017 and 3% in 2018.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At EUR21.7 bln ($25.8 bln) in August, they are the lowest since 2008.  Reserves cover barely 2 months of import but are almost 2 times larger than the stock of short-term external debt.

INVESTMENT OUTLOOK

The forint has traded in a narrow 302-314 range all year.  The pair is on track to test the April high near 314 and then the December high near 315.50.  After that is the June 2016 high near 322.  We maintain a negative bias on the currency, as one of the desired effects of Hungary’s unconventional easing is a weaker forint.  Our EM FX model shows the forint to have WEAK fundamentals, another reason for our negative bias.

Hungarian equities are underperforming EM after a stellar 2016.  In 2016, MSCI Hungary jumped 32% vs. 7% for MSCI EM.  So far this year, MSCI Hungary is up 18% YTD and compares to 29% YTD for MSCI EM.  This modest underperformance should ebb, as our EM Equity model has Hungary at a NEUTRAL position.

Hungarian bonds have outperformed this year.  Lowering the 3-molnth deposit cap pushes more money into government bonds, thereby lowering borrowing rates.  The yield on 10-year local currency government bonds is -48 bp YTD.  This is one of the best performers in EM, behind only Brazil (-155 bp), Indonesia (-142 bp), Peru (-109 bp), Russia (-79 bp), and Colombia (-60 bp).  With inflation likely to continue rising and the central bank still dovish, we think Hungarian bonds will start underperforming more.

Our own sovereign ratings model shows Hungary’s implied rating steady at BBB-/Baa3/BBB-.  This matches its actual ratings, and suggests upgrades are unlikely for now after it regained investment grade status from all three agencies in 2016.