Angelo Taningco
Economist, Treasury Group

Key points

• US GDP growth could ease in Q3 on Hurricane Harvey; Q2 growth rate revised upward to 3.0%.

• GDP growth accelerates in the euro area and Japan in Q2, likely sustainable (unsustainable) for the former (latter) in Q3. China’s Q3 GDP growth potentially moderate.

• Inflation low and stable for G3 economies, China in July, likely missed central banks’ inflation targets in August.

• Fed’s balance sheet normalization announcement expected in September, December fed funds rate hike still on the table despite low market probability. Monetary policy settings likely unchanged for the euro area and Japan in September.

• Geopolitical and US government shutdown risks became pronounced in August, US tax reform uncertainty lingers.

• Philippine GDP growth may be less robust in Q3 vis-à-vis Q2 on drop in business confidence.

• Philippine headline inflation at 2.8% in July, forecasted to rise to 3.0% in August. Monetary policy settings to remain unchanged in September.

• Philippine fiscal deficit size modest in July, widens in January-July; likely to fall short of full-year 3% government target.

• BOP deficit rises to $1.4 billion in Jan-July given trade-in-goods deficit and FPI net outflows, outweighing OF remittances and FDI inflows.

• Peso depreciated 1.4% in August, 2.8% year-to-date. End-2017 USD/PHP forecast revised upward to 51.25.

• GS yields dropped for most tenors in August amid geopolitical risks. TDF volume lowered to P150 billion for 6 September auction.

Global Developments

US GDP growth could ease in Q3 on Hurricane Harvey; Q2 growth rate revised upward to 3.0%. The United States (US) economy grew at a faster pace than previously estimated in the second quarter (Q2), as its gross domestic product (GDP) growth rate was revised upward to an annual rate of 3.0% from its advance estimate of 2.6% (Figure 1). This was more than the market’s median forecast of 2.7% and the highest since the first quarter (Q1) of 2015. The upward revision was brought about by bigger-than-previously estimated increases in personal consumption expenditures (PCE) and in nonresidential fixed investment.

Figure 1: Real GDP Growth of US, euro area, and Japan, Q1 2015 – Q2 2017

Following its relatively strong Q2 expansion, the US economy might exhibit a moderate growth in the third quarter (Q3) given the adverse effects of Hurricane Harvey. Preliminary cost estimates on the hurricane impact vary ranging from $30 billion to at least $100 billion. Initial calculations by some market participants show a potential reduction in the US Q3 GDP growth rate by around 0.2 to 0.3 percentage points. Hurricane Harvey first struck Texas on 26 August; Texas is the second-largest state economy in the US, accounting for about 9% of the country’s GDP and the fastest-growing across all US states since the fourth quarter (Q4) of 2016. A few days later, on 30 August, the hurricane made landfall in Louisiana, which contributes 1.3% to GDP.

Meanwhile, US leading output indicators gave mixed signals during the first month of Q3. On one hand, business expansion and industrial production have eased in July. The Institute for Supply Management’s (ISM) Purchasing Managers’ Index (PMI) for manufacturing fell to 56.3 in July from 57.8 in June while its non-manufacturing index (NMI) plunged to 53.9 from 57.4 in the same period; these downturns were caused by slower growth in production, new orders, new export orders, and employment. Moreover, US industrial production growth slowed to 0.2% mom in July from 0.4% mom in June largely due to a contraction in manufacturing activity. On the other hand, US retail sales performance improved in July, as its growth advanced to 0.6% mom and 4.2% yoy for the month from 0.5% mom and 3.4% yoy in June.

PCE will remain the main GDP growth driver coming from the demand side of the economy for Q3. This is supported by elevating consumer confidence levels especially in August based on the Conference Board and the University of Michigan’s indices. We conjecture that PCE growth will likely be steady in Q3.

GDP growth quickens for euro area and Japan in Q2, likely sustainable (unsustainable) for the former (latter) in Q3. The euro area’s GDP growth accelerated to 0.6% quarter-on-quarter (qoq) and 2.2% yoy in Q2 from 0.5% qoq and 1.9% yoy in Q1 (see again Figure 1). We think this growth trend in the euro area will likely be sustained in Q3, especially that economic sentiment in the region has become more optimistic and business expansion continually accelerating. Economic confidence in the region saw its index up 0.6 points mom at 111.9 in August, while Markit’s composite PMI for the region edged up to 55.8 in August from 55.7 in July.

Japan’s GDP growth jumped to an annual rate of 4.0% in Q2 from 1.5% in Q1 (see again Figure 1). This was more than the market’s forecast of 2.5%, and the highest since Q1 2015. The acceleration in Q2 GDP growth was fueled by stronger household spending and business investment. However, we expect this trend to be unsustainable, with the GDP growth rate likely to be lower in Q3. Preliminary signs of growth moderation are evident in industrial production growth, which eased to below-than-expected 4.7% yoy in July (market forecast: 5.2% yoy) from 5.5% yoy in June. Also, retail trade growth decelerated to 1.9% yoy in July from 2.2% yoy in June.

China’s GDP growth could moderate in Q3 on growth slowdown in industrial production and retail sales. We gauge that China’s GDP growth will again range between 6.0% and 7.0% in Q3 but may fall short from its impressive first-half (H1) growth of 6.9% yoy. Though the manufacturing sector continues to expand at a slightly faster clip in recent months, the non-manufacturing sector’s expansion has been slowing down. Specifically, the country’s PMI manufacturing stood at 51.7 in August and 51.4 in July, quite similar to its H1 average of 51.5. In contrast, the PMI for non-manufacturing fell to 53.4 in August from 54.5 in July, with both figures below the H1 average of 54.6. Moreover, industrial production growth fell to 6.4% yoy in July from 7.6% yoy in June; industrial profit growth fell to 16.5% yoy in July from 19.1% yoy in June; and retail sales growth decelerated to 10.4% yoy from 11.0% yoy in the same period.

Inflation low and stable for G3 economies, China in July, likely to miss central banks’ inflation targets in August. Latest consumer price index (CPI) inflation trends in the US and the euro area showcased relatively low levels and little changes in both headline and core CPI inflation rates (Figure 2a).

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

For the US, headline CPI inflation inched up to 1.7% yoy in July from 1.6% yoy in June but core CPI inflation stood at 1.7% yoy for both months. Similarly, US PCE inflation, which is highly positively correlated to CPI inflation, is expected to be stable in July, with market median forecasts for headline and core PCE inflation rates penciled in at 1.4% yoy apiece. We think core PCE inflation, which is the main inflation barometer of the Federal Reserve, will likely remain below the central bank’s inflation target of 2% for August.

In the euro area, headline inflation stood at 1.3% yoy in July, unchanged from June, whereas core inflation edged up to 1.3% yoy in July from 1.2% yoy in June (see again Figure 2a). For the month of August, the market is expecting headline inflation to inch up to 1.4% yoy but core inflation to remain unchanged at 1.2% yoy, and thereby miss the European Central Bank’s (ECB) inflation target of close to 2%.

Consumer price inflation trends in China and Japan exhibited low and little movements as well (Figure 2b). For China, CPI inflation was unaltered at 1.5% yoy in July. We expect August inflation to fall short of the government’s 3% inflation objective. For Japan, headline CPI inflation was unchanged at 0.4% yoy in July and core CPI inflation edged up to 0.5% yoy in July from 0.4% yoy in June. As expected, this was again distant from the Bank of Japan’s (BOJ) 2% inflation target, which we think will remain elusive for August and for the rest of the year.

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

Fed’s balance sheet normalization announcement expected in September, December federal funds rate hike still on table despite low market probability. Minutes of the 25-26 July Federal Open Market Committee (FOMC) monetary policy meeting have documented the committee members’ consensus of further gradual hikes in the federal funds rate and the Federal Reserve’s balance sheet normalization to commence “relatively soon”. These have also been echoed by several FOMC members in August. In this regard, we think the FOMC will decide during its 19-20 September monetary policy meeting to initiate the balance sheet tapering by October. The same minutes portrayed the FOMC’s willingness for more gradual hikes in the federal funds rate. Our view is that the FOMC will again raise the federal funds rate by 25 basis points (bps) in December, especially if US economic expansion and labor market strengthening will be sustained. However, the market is pricing in only a 33% probability of a December rate hike. Nevertheless, this leads us to project a 2.4% yield for 10-year US Treasuries by the end of this year.

Monetary policy settings to remain unchanged for the euro area and for Japan in September. We expect the ECB’s Governing Council and the BOJ’s Policy Board to decide to keep their key interest rates and asset purchase programs unchanged in their upcoming monetary policy meetings scheduled on 7 September and 19-20 September, respectively. This is in line with our view that core inflation in both economies will likely remain below their central banks’ 2% inflation targets

Geopolitical risks, US government shutdown risks rose in August, US tax reform uncertainty lingers. Geopolitical risks in the Korean peninsula elevated in August, triggered by North Korea’s missile launch and US President Trump’s anti-North Korea rhetoric. Moreover, Trump’s political support waned with the disbandment of his two advisory councils comprising of chief executive officers. Trump’s remarks on tax reform held on 30 August only provided its principles in terms of making the tax code simpler, fairer, and more competitive, but still lack important details. Also, threats made in August of a government shutdown by October have spooked market sentiment. We surmise the chances of a tax reform and government shutdown occurring this year are low.

Philippine Developments

Economic growth robust in Q2 and H1, may ease in Q3 on drop in business confidence. Real GDP growth edged up to 6.5% yoy in Q2 from 6.4% yoy in Q1. On the demand side, stronger growth in household consumption and government spending lifted GDP growth (Figure 3a).

Figure 3a: Real GDP by Expenditure Type
Q1 2015 – Q2 2017
(yoy %)

On the supply side, faster Q2 growth in agriculture, hunting, forestry, fishing and in industry sector stimulated economic expansion (Figure 3b).

Figure 3b: Real GDP by Industrial Origin
Q1 2015 – Q2 2017
(yoy %)

H1 GDP growth, which stood at 6.4% yoy, was buttressed by healthy domestic demand, production, and exports. For Q3, GDP growth might moderate as business sentiment weakened, potentially dampening capital formation. Business confidence became less optimistic for Q3, with its index down to 37.9% from 43% in Q2, on concerns over seasonal business activity and demand slowdown, peso depreciation, inflation, the war in Marawi city and martial law extension in Mindanao (Figure 4).

Figure 4: Business Confidence Indicator
Q1 2015 – Q3 2017
(%)

Moreover, the manufacturing sector was seen to have grown at a slower pace in July as its PMI slipped on a mom basis, partly due to manufacturers’ concerns on Mindanao’s martial law (Figure 5).

Figure 5: Nikkei Philippines Manufacturing Purchasing Managers’ Index (PMI)
Jan. 2016 – Jul. 2017

 
Headline inflation edges up, core inflation plunges in July; headline inflation projected to have risen to 3.0% in August. Headline consumer price index (CPI) inflation edged up to 2.8% yoy in July from 2.7% yoy in June on the back of faster annual price hikes in four out of the eleven commodity groups in the CPI led by transport. However, core CPI inflation plunged to 2.1% yoy in July from 2.6% yoy in June, implying a more modest inflation trend and outlook (Figure 6).

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

 
Our headline inflation forecast for the month of August is 3.0% yoy, which we think will be largely driven by food price inflation, electricity and fuel price hikes, and higher transport costs. For 2017, we maintain our headline inflation forecast of 3.0% yoy.

Last 10 August, the Bangko Sentral ng Pilipinas (BSP) Monetary Board decided to keep its key interest rates and reserve requirement ratios unchanged amid manageable inflation. The BSP also revised upward by 0.1 percentage points its inflation forecasts for 2017 and 2018 to 3.2% yoy and 3.1% yoy, respectively. Meanwhile, we think the BSP’s monetary policy settings will again be kept unchanged to be decided in the next Monetary Board meeting scheduled on 21 September. We think this decision will be based on the inflation trends and outlook depicting a manageable inflation environment, with future inflation likely to remain within the BSP’s inflation target range of 2% – 4%.

Fiscal deficit widens in January-July, likely to fall short of its full-year target. The fiscal deficit stood at P50.5 billion in July, little lower than its P50.7 billion total twelve months prior as the government’s revenue growth of 14% yoy has exceeded expenditure growth of 11% yoy (Figure 7). This was also lower compared to its P90.9 billion deficit posted in June. Meanwhile, the cumulative fiscal deficit widened 20% yoy to P205 billion in January-July as expenditure growth (9% yoy) outpaced revenue growth (8% yoy); however, this is still below the government’s 2017 fiscal deficit target of P478.1 billion (3.0% of GDP). For the current year, we believe the fiscal deficit will miss the government’s target, with our forecast pegged at 2.0% of GDP.

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

 
Merchandise trade deficit narrows in June, widens in H1, to persist in July. The trade-in-goods deficit narrowed 9.4% yoy to $2.1 billion in June as merchandise exports rose 0.8% yoy while importable items fell 2.5% yoy (Figure 8). However, the cumulative merchandise trade deficit edged up 1.3% yoy to $13.2 billion in H1 despite export growth of 13.6% yoy being faster than import growth of 9.6% yoy. We believe a deficit position in the merchandise trade balance was again registered for the month of July and for January-July. This may have likely contributed to the balance of payments (BOP) deficit in the first seven months of the year, which in turn would have exerted downward pressure on the value of the peso.

Figure 8: Merchandise Trade
Jan. 2016 – Jun. 2017

OFs remittances climb in June, Q2, H1; growth to accelerate in July. Overseas Filipinos (OFs) personal remittances jumped 6.8% yoy to $2.8 billion in June, leading its cumulative level to climb 5.5% yoy to $15.4 billion in H1. Likewise, OFs cash remittances were up 5.7% yoy to $2.5 billion in June, 1.8% yoy to $6.9 billion in Q2, and 4.7% yoy to $13.8 billion in H1 (Figure 9). We think both the peso depreciation and stable external labor demand were responsible for the remittance growth. We expect OFs remittances to grow in July, and to accelerate in upcoming months. We maintain our OFs cash remittance growth forecast of 6.5% yoy for the current year.

Figure 9: OFs Cash Remittances
Q1 2015 – Q2 2017
($ million)

FPI net inflows down in July, FDI net inflows surge in May. Foreign portfolio investment (FPI) net inflows plunged 81% yoy to $206 million in July as its gross inflows fell 37% yoy to $1.4 billion and gross outflows inched up 2% to $1.2 billion (Figure 10). Meanwhile, FPI was in a net outflow level of $261 million in January-July, a reversal from its $1.6 billion net inflow in the first seven months of last year. We think FPI net inflows will be sustained in August and in the remaining months of the year on the back of positive investor sentiment towards the equity market, modest inflation, and low interest rates. Against this backdrop, we expect FPI to shift to a net inflow position for the full year, and thereby support the BOP’s financial account.

Figure 10: FPI Flows
Jan. 2016 – Jul. 2017
($ million)

Foreign direct investment (FDI) net inflows surged 57% yoy to $572 million in May, propelled by a 108% yoy jump in nonresidents’ net debt investments that outweighed the 21% yoy drop in net equity investments (Figure 11). This led the cumulative FDI net inflow amount to reach $3.0 billion, which is 24% lower on a yoy basis due to a negative change in nonresidents’ equity capital placements. Nevertheless, we believe that FDI net inflows will be sustained in June and for the rest of the year on the back of the country’s healthy macroeconomic conditions; this would, in turn, support the BOP’s financial account.

Figure 11: FDI Net Flows
Jan. 2016 – May 2017
($ million)

BOP deficit widens in July, reaches $1.4 billion in January-July; GIR falls in July, remains adequate at $80.8 billion. The BOP was in a deficit of $678 million in July, the largest deficit for the year, thus far, leading the gross international reserves (GIR) to incur a monthly decline of $535 million (Figure 12).

Figure 12: BOP and ∆GIR
Jan. 2016 – Jul. 2017
($ million)

As a result, the cumulative BOP deficit increased to $1.4 billion in January-July. As regards the GIR, it slipped to $80.8 billion by the end of July. Nevertheless, external liquidity buffers remain adequate with the import cover and short-term external debt cover at 8.6 months and 550%, respectively, well above their minimum requirements of 3.0 months and 100% (Figure 13).

Figure 13: GIR, Import Cover, and Short-term External Debt Cover
Jan. 2016 – Jul. 2017

Peso depreciation induced by BOP deficit, geopolitical risks; end-2017 USD/PHP forecast revised upward. The peso has depreciated by 1.4% mom in August and 2.8% on a year-to-date basis largely due to the BOP deficit and heightened geopolitical risk in the Korean peninsula. We revised upward our USD/PHP forecasts to 51.25 for end-2017 and 51.50 for end-2018.

GS yields fell for most tenors in August amid geopolitical risks, TDF volume lowered to P150 billion for 6 September auction. Geopolitical risks in the Korean peninsula have partly contributed to the drop in yields for most government securities (GS). We, however, expect GS yields to tread an upward trajectory in the near term. Meanwhile, the term deposit facility (TDF) total volume has been lowered to P150 billion from P180 billion for the 6 September auction as the 28-day tenor volume offering was cut by P30 billion to P110 billion while the 7-day tenor volume remained unchanged at P40 billion.

Table: Philippine Economic Forecast Summary

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