CEE Economic Outlook Supports Monetary Tightening Sooner, Not Later

new european unionThe European Union raised its 2017 growth forecasts for the eastern members, as export growth and consumer spending boost GDP.

CZECH OUTLOOK

The EU sees the Czech Republic growing 4.3% this year.  The previous forecast was 2.6%.

Price pressures bear watching, with CPI accelerating to 2.9% y/y in October from 2.7% in September.  This is the cycle high and the highest since October 2012, and moves inflation to the top of the 1-3% target range.  Real retail sales remain robust, rising 3.6% y/y in September.

The labor market is tightening.  Wages are rising in both nominal (7.6% y/y) and real (5.3% y/y) terms, which were cycle high readings from Q2.  Unemployment fell to 2.7% in September, the lowest on record, and so we expect wage pressures to intensify.

This supports the case for higher rates, and the central bank has already hiked twice since it started the cycle in August.  The strong koruna will do part of the job, as central bank models show a 1% appreciation is equal to a 25 bp hike.  We think the December meeting will be too soon to hike again, but we look for an early Q1 hike from CNB.

Czech equities are still underperforming EM after an awful 2016.  In 2016, MSCI Czech sank -7% vs. +7% for MSCI EM.  So far this year, MSCI Czech is up 5.5% YTD and compares to 32% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Czech Republic at a VERY OVERWEIGHT position.

Czech bonds have been underperforming this year.  The yield on 10-year local currency government bonds is up 130 bp YTD.  This is the worst in EM and is well above the next worst performers China (+89 bp), Romania (+88 bp), and Turkey (+81 bp).  With inflation likely to continue rising and the central bank likely to tighten further, we think Czech bonds will continue to underperform.

HUNGARY OUTLOOK

The EU sees Hungary growing 3.7% this year.  The previous forecast was 3.6%.

Price pressures bear watching, though CPI decelerated to 2.2% y/y in October from 2.5% in September.  This is below the 3% target and near the bottom of the 2-4% target range.  Real retail sales remain robust, rising 6.0% y/y in September.

The labor market is tightening.  Nominal gross wages rose 13.2% y/y in August, while real gross wages rose 10.6% y/y.  Unemployment fell to 4.1% in September, the lowest on record, and so we expect wage pressures to intensify.

This supports the case for higher rates, and yet the central bank just eased again in September.  The bank has been using unconventional policies to push commercial bank funds out of 3-month deposits at the central bank and into government bonds or lending.  The central bank may lower its limit on 3-month deposits again at the December meeting, but continued easing is risky.

Hungarian equities are outperforming EM after a stellar 2016.  In 2016, MSCI Hungary rose 32% vs. 7% for MSCI EM.  So far this year, MSCI Hungary is up 23.5% YTD and compares to 32% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Hungary at an OVERWEIGHT position.

Hungarian bonds have been outperforming this year.  The yield on 10-year local currency government bonds is -90 bp YTD.  This is amongst the best in EM and behind only the top performers Brazil (-134 bp), Indonesia (-127 bp), Peru (-111 bp), and Argentina (-107 bp).  With inflation likely to resume rising and the central bank eventually forced to tighten, we think Hungarian bonds will start to underperform.  

POLAND OUTLOOK

The EU sees Poland growing 4.2% this year.  The previous forecast was 3.5%.

Price pressures bear watching, though CPI decelerated to 2.2% y/y in October from 2.5% in September.  This is below the 2.5% target and in the bottom half of the 1.5-3.5% target range.  Real retail sales remain robust, rising 7.5% y/y in September.

The labor market is tightening.  Nominal gross wages rose 6.0% y/y in September, while real gross wages rose 3.8% y/y.  Unemployment fell to 6.8% in September, the lowest on record, and so we expect wage pressures to intensify.

This supports the case for higher rates, and yet the central bank just left rates steady at 1.5% this month and reiterated its forward guidance for no hikes through 2018.  There are a handful of hawks on the MPC, but we think their ranks will grow as the recovery deepens.  We see the first hike by mid-2018, if not sooner.

Polish equities are outperforming EM after a weak 2016.  In 2016, MSCI Poland rose 1.5% vs. 7% for MSCI EM.  So far this year, MSCI Poland is up 28% YTD and compares to 32% YTD for MSCI EM.  This modest underperformance should ebb, as our EM Equity model has Poland at a NEUTRAL position.

Polish bonds have been performing in the middle of the pack this year.  The yield on 10-year local currency government bonds is about -20 bp YTD.  With inflation likely to continue rising and the central bank forced to eventually tighten, we think Polish bonds will start underperforming.  

ROMANIA OUTLOOK

The EU sees Romania growing 5.7%, the fastest of all EU members this year. 

Price pressures bear watching, with CPI accelerating to 1.8% y/y in September from 1.2% in August.  October CPI data is due out Friday and is expected to rise 2.2% y/y.  If so, this would be the highest rate since August 2013, and would move inflation closer to the 2.5% target but still within the bottom half of the 1.5-3.5% target range.  Real retail sales remain robust, rising 12.9% y/y in September.

The labor market is tightening.  Nominal gross wages rose 14.0% y/y in September, while real gross wages rose 12.3% y/y.  Unemployment fell to 4.1% in September, the lowest since 2008, and so we expect wage pressures to intensify.

This supports the case for higher rates, and the central bank is already preparing to hike.  The has narrowed the rates corridor around the policy rate for two straight months, in order to improve the monetary transmission mechanism.  Next policy meeting is January 8, and we think the first hike of the cycle is likely then.

Romanian equities are underperforming EM and Frontier after a solid 2016.  In 2016, MSCI Romania rose 7.5% vs. 7% for MSCI EM and -1% for MSCI Frontier.  So far this year, MSCI Romania is up 11% YTD and compares to 32% YTD for MSCI EM and 22% for MSCI Frontier.

Romanian bonds have been underperforming this year.  The yield on 10-year local currency government bonds is +88 bp YTD.  This is amongst the worst in EM and behind only the worst performers Czech (+130 bp) and China (+89 bp).  With inflation likely to continue rising and the central bank likely to tighten soon, we think Romanian bonds will continue underperforming.

CONCLUSIONS

We believe CEE is further ahead of the monetary tightening curve than other regions in EM due to very strong economic growth.  As such, we expect region equity markets and FX to outperform, even as regional bond markets are likely to underperform.