Angelo Taningco
Economist, Treasury Group

Key points

• Leading output indicators portray potential Q3 economic growth moderation for US, China, Japan; acceleration for euro area.

• Inflation rises for G3 economies, China, in August; still below central banks’ targets.

• US monetary policy normalization to remain gradual, another fed funds rate hike in December more likely; quantitative easing in euro area and Japan to continue in near term.

• US tax reform framework unveiled, healthcare reform abandoned; geopolitical risk in Korean peninsula abating.

• Philippine Q3 economic growth likely tempered by dampened sentiment, sluggish manufacturing activity; labor market exhibits mixed trends in July, inflation-unemployment nexus weak.

• Philippine inflation rises in August, forecast for September at 3.1%; domestic liquidity, bank lending growth accelerates in August; BSP’s monetary policy settings to remain unchanged.

• Philippine fiscal balance shifts to surplus in August, unlikely to attain Q3, 2017, deficit targets. 2017 fiscal deficit forecast at 2.0% of GDP.

• Cumulative BOP deficit steady at $1.4 billion in January-August; H1 current account deficit narrows. 2017 BOP deficit forecast at 0.3% of GDP.

• Peso appreciates 0.7% mom in September amid foreign capital inflows. End-2017 USD/PHP forecast at 51.25. GS yields dropped for most tenors, TDF auctions mostly undersubscribed in September.

• First tax reform package endorsed by Senate committee for plenary approval, estimated to generate at least P130 billion, seen to be enacted into law by December and take effect January 2018.

Global Developments

Leading output indicators portray potential Q3 economic growth moderation for US, China, Japan; acceleration for euro area. United States (US) economy has likely remained on expansionary mode, but the disruptions caused by Hurricanes Harvey and Irma are likely to be a bane for its third-quarter (Q3) growth performance.

US economic growth slowed in August according to the Chicago Fed National Activity Index, which fell to −0.31 for the month from +0.03 in the previous month. Likewise, both industrial production and retail sales in the US unexpectedly contracted in August following month-on-month (mom) gains in July (Figure 1). In September, US consumer confidence dipped according to the Conference Board while the country’s overall business expansion was seen by executives as per Markit’s Purchasing Managers’ Index (PMI) recent trends to have slowed.

Figure 1: US Industrial Production & Retail Sales, Jan. 2016 – Aug. 2017
(mom %)

 
In the euro area, year-on-year (yoy) growth of industrial production improved whereas it moderated for retail sales in July. But the region’s manufacturing and services sectors were both observed by business executives to have expanded at a faster clip in September based on monthly increases in their respective PMIs for the month. We foresee the euro area’s gross domestic product (GDP) growth for Q3 to be higher than the second quarter (Q2), which saw its yoy rate revised upward to 2.3% from 2.2%.

Meanwhile, growth of industrial production and retail sales has decelerated in China during August. In Japan, industrial production growth improved but retail sales growth slipped in August. Moreover, the trade surplus positions of China and Japan have narrowed in August. Notably, Japan’s Q2 GDP growth rate was slashed to 2.5% from 4.0%. Meanwhile, S&P Global Ratings has downgraded China’s sovereign ratings amid heightened economic and financial risks induced by prolonged strong credit growth. Given these recent developments, we think both economies will probably register relatively less robust expansion in Q3.

Inflation rises for G3 economies, China in August. Headline consumer price index (CPI) inflation rose in August for both US and euro area partly driven by higher energy inflation, but core CPI inflation was steady for both economies (Figure 2a). In September, euro area’s headline inflation was unchanged while core inflation slipped.

Figure 2a: US and Euro Area Inflation
Jan. 2016 – Aug. 2017
( yoy %)

 
Similarly, as of this writing, US personal consumption expenditures (PCE) inflation is expected by the market to follow the same trend in CPI inflation, with headline PCE inflation seen to post an uptick while core PCE inflation to be steady as well for the same month. Overall, inflationary pressures in both the US and euro area have stayed modest, with core inflation figures still below their respective central banks’ inflation targets of 2% and “close to 2%”, respectively.

Meanwhile, CPI inflation for China accelerated to 1.8% yoy in August from 1.4% yoy in July. Similarly, Japan’s headline and core CPI inflation rates stood at 0.7% yoy apiece in August, higher than their July figures of 0.4% yoy and 0.5% yoy, respectively (Figure 2b). China’s average CPI inflation for January-August stood at 1.5% yoy, well below its government’s inflation target of 3% for 2017. Similarly, Japan’s average headline and core CPI inflation rates for January-August were 0.4% yoy each, below the Bank of Japan’s (BOJ) 2% inflation target.

Figure 2b: China and Japan CPI Inflation
Jan. 2016 – Aug. 2017
( yoy %)

 
Fed’s policy rate unchanged, December rate hike chances now higher; balance sheet normalization to commence in October. Consistent with market expectations, the Federal Open Market Committee (FOMC) following its 19-20 September meeting has decided to keep the target range of the federal funds rate unchanged at 1.00% – 1.25%. It has also announced the start of the Federal Reserve’s balance sheet normalization in October. Market participants were surprised by the Fed’s interest rate path over the medium term. In its latest summary of economic projections, the Fed maintained its upward path for the federal funds rate, signaling another gradual rate hike this coming December and three more in 2018. This was made despite inflation being subdued. However, it adjusted downward its median federal funds rate forecast for 2019 to 2.7% from 2.9%, suggesting that the policy rate may be lower than previously estimated two years from now. In addition, the Fed revised upward its forecasts for 2017 and 2019 US GDP growth; and adjusted downward its projections for 2018 and 2019 US unemployment rate, 2018 US headline PCE inflation, and 2017 and 2018 core PCE inflation (Table 1).

Table 1: Federal Reserve’s Summary of Economic Projections, Sept. and Jun. 2017
(percent)

 
FOMC Chair Janet Yellen, in her 26 September speech said that the FOMC’s outlook is facing “considerable uncertainty”, specifically on factors that are keeping inflation persistently low relative to its target. Along this line, she deems the FOMC’s gradual approach in monetary policy normalization to be “appropriate”. The appropriateness of such gradual removal in monetary accommodation has been echoed by William Dudley (FOMC Vice-Chair and New York Fed president), Charles Evans (FOMC member and Chicago Fed president), and Loretta Mester (FOMC alternate member and Cleveland Fed president) in their recent speeches. Meanwhile, the market is now pricing a higher probability of almost 70% based on fed funds futures for another rate hike in December. Against this backdrop, we reiterate our position of another 25 bps hike in the federal funds rate this year, i.e., to be decided by the FOMC in their 12-13 December meeting.

Monetary policy settings unchanged in euro area and Japan. Monetary policy settings in the euro area and Japan were kept unchanged in September, affirming our expectations since core inflation in the two economies has stayed below the central banks’ targets.  The European Central Bank’s (ECB) Governing Council decided on 7 September to keep its key interest rates and asset purchase program unchanged. In addition, the ECB lowered its 2018 and 2019 inflation forecasts for the euro area by 0.1 percentage points each to 1.2% and 1.5%, respectively. The BOJ’s Policy Board decided on 21 September to retain its yield curve control and asset purchase program in their current form.

US tax reform framework unveiled, healthcare reform abandoned. A unified framework for tax reforms was unveiled by the White House on 27 September, in which it outlines specific areas that the Trump administration together with the House Committee on Ways and Means, and the Senate Committee on Finance are working on to attain a “pro-American, fiscally-responsible tax reform”. Among the salient features of this framework include: i) lowering of tax rates for individuals, families, corporates, and small businesses; ii) allowing firms to write off (“expense”) the cost of new investments in depreciable assets for at least 5 years; iii) attracting offshore profits by exempting them when repatriated to the US; and iv) preventing firms from transferring profits overseas by imposing a lower tax rate on their foreign profits.

Healthcare reforms were abandoned in the Senate as the GOP decided not to put on a vote the Republican-led Graham-Cassidy bill, which aims to “repeal and replace Obamacare”. This was made in light of some Republican senators opposing the bill, making it difficult to muster at least 50 votes needed to get the bill passed in the Senate. Congressional Budget Office (CBO) has estimated that “millions” of people will lose their health insurance over the 2017-2026 period if the bill is enacted into law.

US-North Korea tensions escalate in September on intense rhetoric, sanctions. Various exchanges of heated rhetoric between leaders of the US and North Korea have raised US-North Korea tensions and geopolitical risk in the Korean peninsula. The heated rhetoric emanated from North Korea’s hydrogen bomb test on 2 September. This led the United Nations’ (UN) Security Council to issue a resolution on 11 September that imposes sanctions on North Korea such as a ban on its textile exports, natural gas liquid imports, and work authorizations to its nationals outside the country; restrictions on its crude oil imports and a limit to its petroleum product imports; and additional financial sanctions. North Korea responded belligerently with a missile launch over Japan on 15 September.

President Trump in his 19 September speech at the UN said the US would “totally destroy North Korea” if forced to defend itself or its allies. He then signed an executive order on 21 September that imposes additional sanctions in connection with North Korea, authorizing the US government to sanction any person, company, or bank that deals with North Korea.

In response to Trump’s speech, North Korea’s Supreme Leader Kim Jong Un said on 22 September that “[he] will surely and definitely tame the mentally deranged US dotard with fire”. North Korea’s Foreign Minister Ri Yong Ho gave a speech at the UN on 23 September, saying that Trump’s insult on his country would make their “rockets’ visit to the entire U.S. mainland inevitable all the more” On the same day, Trump tweeted that “they won’t be around much longer!” This prompted Ri Yong Ho to say on 25 September that the US has declared war on North Korea, but such claim was immediately denied by White House Press Secretary Sarah Sanders.

Since then, the heated rhetoric between the two leaders has waned and the geopolitical risk in the Korean peninsula already abating. However, we will not be surprised if the both leaders in US and North Korea will again engage in another tussle that could again trigger another risk-off episode. We think that the likelihood of a war between North Korea and US is very low, and we deemed diplomatic efforts to prevail in addressing the situation in the peninsula.

Philippine Developments

Q3 economic expansion likely tempered by dampened confidence, weak manufacturing performance. Philippine economic growth in Q3, we posit, may have been tempered by dampened sentiment from both households and firms and sluggish manufacturing performance. Consumer confidence has weakened since its index fell to 10.2% in Q3 from 13.1% in Q2 amid consumers’ concerns over calamities, inflation, peace and order, and little or no change in income, according to the Bangko Sentral ng Pilipinas (BSP) latest Consumer Expectations Survey. Since our empirical model illustrates a strong positive relationship between consumer confidence and household spending growth, we expect the latter to moderate in Q3 (Figure 3). (Household spending is the biggest expenditure type, accounting for 74% of GDP.)

Figure 3: CI for Current Quarter & HFCE Growth
Q1 2007 – Q3 2017
(percent)

 
For the fourth quarter (Q4), the CES reports that consumer confidence is more upbeat on expectations of higher income, more job opportunities, peace and order improvements; if sustained, we think this would translate to a rebound in household spending growth.

Moreover, the sluggish activity of the manufacturing sector-as showcased by the contraction in both value and volume terms during July as well as the downturn in its PMI for August-will likely weigh on Q3 economic growth (Figure 4). Manufacturing gross value added (GVA) has accounted for 19% of H1 GDP.

Figure 4: Manufacturing Indicators

Jan. 2016 – Aug. 2017

 
Labor market exhibits mixed trends in July, inflation-unemployment nexus weak. Unemployment (underemployment) fell (rose) in the previous 3 months through July but increased (decreased) from a year ago, showcasing heterogeneous movements in these two labor market indicators (Figure 5a). The annual increase in unemployment was evident among the relatively young labor force members (15-24 and 25-34 age groups) and among males. In contrast, the annual decline in underemployment was pronounced in the agriculture sector.

Figure 5a: Unemployment & Underemployment
Jan. 2011 – Jul. 2017
(percent)

 
Studies that attempted to establish a link between unemployment and inflation, i.e., to validate the existence of the Phillips curve in the Philippine setting, arrived at ambiguous results. In our case, we portrayed a very weak inverse relationship between unemployment and inflation, i.e., a relatively flat Phillips curve, spanning the 1977-2016 period (Figure 5b)

Figure 5b: Inflation & Unemployment
1977- 2016

 
Inflation climbs in August, September forecast at 3.1% yoy; domestic liquidity growth robust in August; BSP’s monetary policy settings unchanged. Headline CPI inflation rose for the second-consecutive month in August, climbing to 3.1% yoy from its July rate of 2.8% yoy (Figure 6).

Figure 6: Headline and Core CPI Inflation
Jan. 2016 – Aug. 2017
(yoy %)

 
The uptick in headline CPI inflation stems from faster price increases in seven out of eleven commodity groups in the CPI. More specifically, higher food price inflation, higher transport costs, and price hikes in electricity and petroleum products have largely contributed to the increase in headline CPI inflation during the month. Also, core CPI inflation rose to 3.0% yoy in August from the revised July print of 2.8% yoy. The average headline and core CPI inflation rates in the first eight months of the year stood at 3.1% yoy and 2.8% yoy, respectively.

For the month of September, we forecast headline CPI inflation to level off at 3.1% yoy on the back of food price inflation, electricity rate hikes, and increases in petroleum products. If this occurs, the average inflation on a year-to-date basis would still be 3.1% yoy. We are still maintaining our full-year 2017 headline CPI inflation forecast of 3.0%.

Meanwhile, domestic liquidity (M3 money supply) growth accelerated to 15.4% yoy in August from 13.5% yoy in July on the back continued strong credit growth. Bank lending growth climbed to 20.4% yoy from 19.7% yoy in the same period.

The BSP’s Monetary Board decided on 21 September to keep its monetary policy settings-key interest rates and reserve requirement ratios-unchanged on the basis of its assessment that inflation environment has continued to be manageable. We foresee the central bank to hold on to its current monetary policy settings over the remaining months of the year since we do not think inflation will rise sharply to breach the upper limit of the government’s inflation target range.

Cumulative fiscal deficit narrows on August surplus, unlikely to meet Q3, 2017 targets. The month of August has witnessed consecutive fiscal surplus positions since 2010, though this year’s August surplus of P28.8 billion was 12% lower yoy amid stronger government expenditure growth (14% yoy) versus government revenue growth (10% yoy); compared to July, however, revenue growth was positive but expenditure growth negative (Figure 7). We surmise public infrastructure spending may have weakened in August compared to July, thus, potentially contributing to the lower government expenditures.

Figure 7: Fiscal Indicators
Jan. 2016 – Aug. 2017
(P billion)

 
The surplus in August led the cumulative fiscal deficit covering the January-August period to narrow to P176.2 billion, which is less than half of the government’s revised 2017 fiscal deficit target of P482.1 billion-equivalent to 3.0% of GDP. Our view of a lower-than-targeted fiscal deficit for 2017 still holds, with our current year fiscal deficit forecast of 2.0% of GDP still maintained.

BOP deficit narrows in August but steady year-to-date, 2017 forecast at 0.3% of GDP; H1 current account deficit narrows. The balance of payments (BOP) was again in a deficit position in August, albeit a very small size of $7 million that barely nudged the cumulative BOP deficit of $1.4 billion. The small BOP deficit in August was recorded despite the gross international reserves (GIR)/net international reserves (NIR) expanding more, i.e., by $448 million, in the same month as the latter’s relatively huge increase was largely driven by a sharp revaluation adjustment in gold reserves amid a spike in gold prices; netting out the gold revaluation adjustment from the change in the NIR shows a closer positive correlation with the BOP (Figure 8a).

As a share of GDP, the BOP deficit widened to 0.5% in the first half (H1) of the year from 0.1% in 2016. This was largely driven by the current account shifting to a deficit of 0.2% in H1 from a surplus of 0.2% in 2016 (Figure 8b).

Figure 8a: BOP & Foreign Reserves
Jan. 2016 – Aug. 2017
($ million)

Figure 8b: BOP & Current Account
2010 – H1 2017
(% of GDP)

 
We believe the cumulative BOP deficit will shrink in the near term, especially when the current account deficit and net outflows from the financial account will both narrow. We think the current account deficit will drop if the trade-in-goods deficit would continue to fall and if strong growth in both business process outsourcing (BPO) export proceeds and overseas Filipinos (OF) remittances will be sustained. The trade-in-goods deficit accounted for 12.9% of GDP in H1; in July, it narrowed 17% mom and 20% yoy. BPO’s export earnings expanded 8.5% yoy and non-resident OF worker remittances grew 5.5% yoy in H1. OF personal remittance growth accelerated in July, climbing to 8.7% yoy from 6.8% yoy in June.

Net outflows from the BOP’s financial account totaled $135 million in H1 and this was a result of net outflows in foreign portfolio investments (FPIs) and other investments that combined outweighed the foreign direct investment (FDI) net inflows.

Meanwhile, external liquidity buffers have continued to be more than adequate on the basis of the end-August import cover and short-term external debt at 8.7 months and 560.5%, respectively, both higher than their minimum thresholds. We firmly believe that adequacy of the country’s foreign reserves will stay relatively high.

Peso appreciates mom in September, year-to-date rate of depreciation weakens; end-2017 USD/PHP forecast at 51.25. The Philippine peso has appreciated by 0.7% mom in September largely due to foreign fund inflows, a chunk of which were related to the purchase of Energy Development Corporation (EDC) shares and Japan Tobacco Inc. (JTI) acquisition of Mighty Corporation’s assets (Figure 9). On a year-to-date basis, the peso’s rate of depreciation fell to 2.2% in January-September from 2.5% in January-August.

Figure 9: USD/PHP, end-of-period
Jan. 2016 – Sep. 2017

 
However, we expect the cumulative rate of peso depreciation to gradually rise in the remaining months of the year on account of another US interest rate hike in December. We maintain our end-2017 USD/PHP forecast of 51.25.

GS yields fall for most tenors, TDF auctions mostly undersubscribed in September. Government securities (GS) yields fell for most tenors in September. Strong market demand was evident for treasury bills auctioned on the 11th and 25th of September and for the re-issued 7-year and 10-year treasury bonds auctioned on 5 September and 19 September, respectively. Meanwhile, the Q4 offerings for treasury bills and treasury bonds amount to P75 billion apiece or P150 billion in total, according to the Bureau of the Treasury.

The term deposit facility (TDF) auctions in September were mostly undersubscribed, as the bid coverage ratios for both the 7-day and 28-day tenors were less than 1.0, on average. For the 4 October auction, the offer volume has been lowered by P10 billion to P140 billion.

First tax reform package endorsed by Senate committee for plenary approval; expected to be approved late this year, to take effect next year and to generate P134 billion additional tax revenues. On 20 September, the Senate ways and means committee endorsed for plenary approval Senate Bill (SB) No. 1592, a.k.a., “Tax Reform for Acceleration and Inclusion (TRAIN)”. According to the committee’s chair, Senator Sonny Angara, SB No. 1592 aims to lower personal income taxes of “99% of taxpayers”, raise the people’s purchasing power, and develop the country’s physical and human infrastructures, among others.

This Senate version of TRAIN, similar to House Bill (HB) No. 5636, which was approved by the House of Representatives on 31 May, provides for a reduction in personal income tax rates; a widening of the value-added tax (VAT) base; greater efficiency in the transfer tax system; and imposition of excise taxes on automobiles, petroleum products, and sweetened beverages, among others. Both bills are seen to generate at least P130 billion in additional tax revenues during the first year of implementation.

On income taxes, the Senate version provides tax exemption to the first P150,000 annual income of compensation earners as well as those who are self-employed and professionals. For the self-employed/professionals, the bill offers an alternative option of a flat 8% tax on their annual income.

On value-added tax (VAT) exemptions, SB 1592 provides a higher VAT-exempt threshold on the sale or lease of goods and services amounting to P3 million compared to P1.9 million; this can provide relief to owners of small businesses. The bill also provides VAT exemptions to certain sectors/groups, such as BPOs, cooperatives, healthcare, food, socialized housing, persons with disabilities, and senior citizens. In addition, SB 1592 aims to promote an efficient transfer tax system by setting a flat 6% tax on the net estate’s value and a 6% donor’s tax.

Among the salient provisions of SB 1592 that differ from HB 5636 would include:

i. Lower personal income tax-exempt threshold of P150,000 in SB 1592 versus P250,000 in HB 5636;

ii. A two-phased approach on sweetened beverage tax compared with HB 5636’s P10/liter on beverages with pure locally-made sugar-P20/liter on other sweetened beverages. i.e., SB 1592 calls for the first two years imposing taxes of P3/liter on beverages using non-caloric sweeteners, P5/liter on those using caloric sweeteners, and P10/liter on those using high fructose corn syrup. After the second year, a tax of P0.05/gram of sugar on beverages using purely caloric sweeteners will be implemented;

iii. Adds “instant soluble coffee” and “pre-packaged powdered coffee products” (ex. “3-1” coffee) to the list of beverages-which include milk, natural fruit and vegetable juices, meal replacement/medically indicated beverages, ground coffee, unsweetened tea-that are excluded from the scope of the sugar tax;

iv. Different excise tax schedule for yearly incremental increase on petroleum products

v. P1.75-P2.00-P2.25/liter over 2018-2020 period versus HB 5636’s P3-P2-P1/liter;

vi. Higher excise taxes on automobiles in first year compared to House version, which proposes for a two-year implementation period;

vii. Higher tax of 20% on foreign currency deposits (from 7.5%), cash/property dividends (from 10%), and capital gains from sale of unlisted stocks (from 5%-10%);

viii. Higher coal tax of P20/metric ton (from P10); &

ix. Excise tax of 20% on “cosmetic procedures, surgeries, and body enhancements undertaken for aesthetic reasons.”

We expect TRAIN to be approved by the Senate plenary in October; deliberated and approved at Congress’ bicameral conference in November; signed into law by the Philippine president in December; and take effect at the start of 2018.

Table: Philippine Economic Forecast Summary

Disclosures Appendix
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