A political crisis has erupted in Italy over a dispute between two populist parties and the country’s president on the formation of a new government. Following an inconclusive election outcome in March, a snap election was floated to be held as early as July. Investors are worried that the new government may prefer to exit the euro area. As a consequence, Italian 10-year government bond yields and 5-year credit default swaps (CDS) have both skyrocketed. We think a worsening of Italy’s political environment could spillover unto the euro area, and may slow down the region’s growth momentum and hurt the euro. Also, investors are looking at Spain to determine if its parliament would vote to oust the current prime minister as such change might worsen political risk in the region.

Global oil prices have ascended for the most part of May with prices of Brent and West Texas Intermediate (WTI) breaching $75/bbl and $70/bbl, respectively, before stabilizing at the latter part of the month on expectations that Russia and Saudi Arabia will increase oil production. The oil price upswing was associated with Middle East’s geopolitical tensions, which was partly triggered by US withdrawal from its nuclear agreement with Iran. This stoked concerns over emerging markets (EMs) that depend on imported oil and run current account deficits, and resulted in capital outflows and currency depreciations in most of these EMs.

Among the EMs that were heaviest hit are Argentina and Turkey due to their widening current account deficits and double-digit inflation rates. Central banks of these two EMs have raised sharply their key interest rates in order to thwart the strong depreciation of their respective currencies: Argentina’s policy rate was raised 975bps to 40.00% while Turkey’s was adjusted up 850bps to 16.50% in May. Nevertheless, the Argentine peso and Turkish lira incurred the sharpest rate of depreciation for the month and even since the start of the year.  Meanwhile, the Indonesian rupiah also had a sharp depreciation during the most part of May, but has corrected during the last week of the month as the Indonesian central bank decided to raise its policy rate twice in a row at 25bps each.

Global growth likely moderated in Q1. US Q1 GDP growth was revised down by 0.1 percentage point (pp) to 2.2%, yet the overall growth trend has remained unchanged. The Federal Reserve’s Beige Book has reported that US economic expansion during late April – early May period was moderate and that most of the Fed Districts exhibited “modest to moderate” employment growth, moderate price inflation, and modest wage growth.   Meanwhile, the euro area economy expanded at a softer pace in Q1 compared to previous quarter while the Japanese economy contracted in the same period caused by lower business investment.

Inflation nearing its target in US, drifted farther away in euro area, Japan, China.  Inflation in the US has already moved towards the Federal Open Market Committee’s (FOMC) 2% target; headline and core CPI inflation rates leveled off at 2.5% and 2.1% yoy, respectively, in April while personal consumption expenditures (PCE) inflation in March stood at 2.0% for its headline level and 1.9% for its core. For the month of April, the market expects headline and core PCE inflation to settle at 2.0% and 1.8% yoy, respectively. We noticed though that there appears to be a lack of inflation acceleration despite the new tax law providing for income tax cuts and further tightening of the labor market. For the month of May, we think there might be an inflation uptick on the back of rising global oil prices.

Consumer price inflation in other major economies has waned in April compared to March, and has drifted farther away from central banks’ targets. Euro area’s headline and core inflation rates decreased 0.1pp to 1.2% and 0.3pp to 0.7% yoy; Japan’s headline and core CPI inflation nosedived to 0.6% (from 1.1%) and 0.7% (from 0.9%), respectively; and China’s CPI inflation fell to 1.8% from 2.1% in the same period.

FOMC’s policy rate unchanged in May, likely to be raised in June; no monetary policy adjustments in euro area and Japan. As expected, the Federal Open Market Committee (FOMC) decided to hold off a policy rate hike in May. Minutes from the FOMC’s 1-2 May meeting reveal willingness of participants to raise the target range of the federal funds rate “soon” and to tolerate an inflation overshoot of the FOMC’s 2% target. Together with the market, we are expecting the FOMC to decide during its next meeting scheduled on 12-13 June to initiate another 25bps hike in the policy rate, to enable it to settle at 1.75% – 2.00%.

Meanwhile, we still foresee the FOMC to conduct a 3^rd rate hike this year, and we believe this will likely take place in September. Though some market participants are looking at a 4^th rate hike in December, we still think that such move may lead to a further flattening of the US Treasury (UST) yield curve, and could stoke concerns of an upcoming US economic slowdown or recession.

UST yields backpedaled, yield curve flattened in April. UST yields were initially moving up during the first half of May on some buildup in inflation expectations driven by rising oil prices. The 10yrUST yield was again able to breach 3%. However, Italy’s political turmoil during the last week of the month sparked risk-off sentiment, leading investors to purchase safe-haven assets that led to a precipitous drop in UST yields. As a result, the UST yield curve bear flattened in May with the 2yr-10yr yield spread down to 44bps.

Philippine Developments & Outlook

Robust Q1 GDP growth despite headwinds. Philippine Q1 GDP growth came out at 6.8% yoy, matching the median estimate of analysts surveyed by Bloomberg and BusinessWorld and 0.1pp higher compared to our forecast. We deemed this growth performance as robust even if it missed the government’s target range of 7.0% – 8.0%. We observed certain headwinds such as higher domestic inflation and moderating global growth have suppressed somewhat the economic growth momentum.

Q1 growth drivers on the demand side were capital formation, household consumption, and government spending. Compared to Q4, the growth contributions of capital formation and government spending increased, more than offsetting the reductions in household consumption and net exports.

Services and industrial sectors have again dominated the production side given their relatively large shares in GDP growth. Industrial sector was driven largely by manufacturing while services was bolstered by retail trade. Relative to Q4, growth contributions of both industry and services have outweighed the reduction in agriculture.

We continue to expect GDP growth for the remainder of the year to remain buoyant—to potentially range between 6.5%-7.0%—on the back of the aforementioned factors. Specifically, we think government spending will remain strong due to faster disbursements in and better utilization of funds released by the Department of Budget and Management. The new tax law (TRAIN) and the government’s Build, Build, Build program, we believe, have been instrumental in boosting government spending, specifically on infrastructure projects. In this regard, we maintain our 2018 GDP growth forecast of 6.8%.

Inflation extended its ascent in April, likely to have quickened further in May. Inflation using the 2012-based CPI has again breached the upper end of the government’s inflation target range for the second-consecutive month in April, settling at 4.5% yoy following March’s 4.3%. In comparison, the old CPI that has 2006 as the base year portrayed headline inflation breaking 5% with its 5.1% reading in April from its March rate of 4.8%.

We again expect inflation to climb over the very near term due to TRAIN’s income tax cuts and excise taxes on select products, food supply disruptions, electricity rate hikes, elevated global oil prices, and peso depreciation. For the month of May, our 2012-based CPI inflation forecast is pegged at 5.1% yoy; we think food price inflation has stayed relatively high while both the rising global oil prices and further peso depreciation have exerted upward pressure on import costs.

Policy rate raised in May, another hike for the year looms. The policy rate was raised by the Bangko Sentral ng Pilipinas (BSP) Monetary Board to 3.25% from 3.00% during its 10 May meeting. The 25bps rate hike was widely expected; we think this was necessary to mitigate expectations of higher future inflation given persistently rising inflation. However, we believe there ought to be another policy rate hike of the same magnitude as we foresee inflation expectations to intensify further amid pending petitions for minimum wage and transport fares as well as persistently high import costs. Furthermore, we think another policy rate adjustment may be needed to manage foreign exchange volatility and temper the peso depreciation.  We still maintain our 4.7% inflation forecast for 2018, albeit we recognize its upside risks appear to be gathering steam. We deemed the Monetary Board’s latest monetary policy statement to have signaled a hawkish tone. Thus, our view is that another policy rate hike of 25bps will be made within the year, potentially in Q3.

Domestic liquidity, bank lending growth robust in April; excess liquidity down. TDF auctions in May reveal ample liquidity. BSP reduced RRR, may cut again in H2. Bank lending growth (net of reverse repurchases) accelerated to 19.9% yoy in April from 18.5% in March while M3 money supply growth was little changed at 14.2% versus the previous month’s 14.4%. These trends tell us that both domestic liquidity and bank lending are buoyant, and will continue to support economic growth.

Total funds placed in the reverse repurchase, overnight deposit, and term deposit facilities declined by almost P100b in April to P415b at the end of the month. This was mainly a result of monthly reductions in the funds placed in the reverse repurchase and overnight deposit facilities that combined outweighed the mom uptick in funds placed in the term deposit facility (TDF).

TDF auctions in May have revealed ample demand for the 7-, 14-, and 28-day tenors given relatively high bid coverage ratios. Compared to April, these ratios have increased while the average accepted yields have likewise rose for all tenors. The weekly TDF auction size was lower in May, averaging P92b, compared to April’s P105b. The BSP set the TDF size for its 6 June auction at P100b, lower by P10b from its previous 30 May auction.

The BSP’s Monetary Board has lowered the reserve requirement ratio (RRR) by 1pp to 18%, effective June. This was the second time in the year that an RRR cut was made. We believe such reductions would support domestic liquidity and economic growth. We believe a third RRR cut will likely transpire later in the year, with its chances higher if liquidity would decline.

Fiscal balance shifts to surplus in April, cumulative fiscal deficit narrows. As April is the deadline for the filing of income tax returns, the government’s budgetary balance for the month resulted in a surplus (P46.3b). This allowed the cumulative fiscal deficit to narrow to P105.9b in the first four months of the year; equivalently, we estimated this amount to be at 2.7% of GDP, coinciding with our full-year forecast.

We foresee the fiscal balance to revert to a deficit position throughout the remaining months of the year. We still hold on to our full-year fiscal deficit forecast of P440b (2.7% of GDP).

 Investor appetite strong in 91-, 182-day T-bills and 3- and 5-year T-bonds. BTr auctioned 3-yr RTBs. GS yields fell for most tenors, curve flattened in May. The Bureau of the Treasury’s (BTr) weekly government securities (GS) auctions in May saw ample investor appetite in the 91- and 182-day Treasury bills (T-bills) and in the 3- and 5-year Treasury bonds (T-bonds).

BTr raised a total of P20b from fully awarding all of its 91-day T-bills for the month and P16b from all of its full awards of 182-day T-bills. Meanwhile, BTr was only able to raise P12.2b out of its P30b 364-day T-bill offering for the month.  Average rates for the 91- and 182-day T-bills dropped to 3.3% and 3.7%, respectively, by the end of the month, whereas that for the 364-day T-bill stood was 4.198% on 28 May.    A 3-year retail treasury bond (RTB) with 4.875% coupon was auctioned by the BTr on 30 May, generating P66b in proceeds.

GS yields fell for most tenors in May compared with April with the biggest declines seen at the shorter-end of the curve. The GS yield curve flattened a bit on a monthly basis but is still relatively steep in comparison to last year. We expect GS yields to move along an upward trajectory on rising inflation expectations.

BOP deficit for 4^th-straight month in April; foreign reserves slip below $80b. The balance of payments (BOP) deficit in April was associated with the monthly drop in foreign reserves during the same period. April’s balance of payments (BOP) deficit amounted to $270m, $4m bigger than March, leading the cumulative BOP deficit to expand to $1.5b in January-April. The widening of the BOP deficit occurred despite foreign portfolio investments (FPI) net inflows increasing by $279m in April to $1.0b in Jan-Apr. We suspect that the BOP deficit largely arose from the trade-in-goods deficit, which jumped 42% tot to $8.7b in Q1. Meanwhile, OF cash remittances marginally rose 0.8% yoy to $7b in Q1 and foreign direct investment (FDI) net inflows jumped 52% yoy to $1.5b in the first two months of the year.  As a consequence of the BOP incurring a deficit for 4-straight months, the central bank’s foreign reserves began to slip below $80b at $79.6b by end-April. This level is more than adequate to meet import and short-term external debt requirements: import and short-term external debt covers at 7.8 months and 5.4 times, respectively.

Peso depreciated in May. USD/PHP ended the month at 52.52, the peso weakening vis-à-vis the USS dollar by 1.5% on a mom basis, 4.9% since the start of the year. We adjusted upward our end-2018 USD/PHP forecast by 25 centavos to 52.50.

Table: Philippine Economic Forecasts