Ugly inflation data and an upgrade from S&P
Over the past month, bad news came along with good news, none of them completely unexpected. On the dark side, adjusted core inflation continued its upward march and reached the trigger point at which the MNB formerly said would consider monetary tightening. Given this event, and especially the stable upward trend of core inflation, the MNB can do little else than to actually start tightening. The real question is when, exactly how and how much they will move.
On the bright side, the government was finally upgraded to BBB/Stable by S&P, after staying in BBB- with a positive outlook since August 2017. This is likely to strengthen the forint in short term, particularly if Fitch Ratings decides to follow S&P’s example on a similar Hungarian rating at its upcoming revision date on February 22.
GDP grew by close to 5% in full-year 2018, its yoy growth being pretty much evenly distributed among quarters. In Q4, the key drivers of growth continued to be domestic wages and consumption, booming fixed investment and construction activity, and also the industrial sector. Industrial output appeared to be positively decoupled from its cyclically weakening European counterpart, probably because of the strength of domestic demand and the endeavors by European companies to shift production into low-cost areas like Hungary.
In a state-of-the-nation speech on February 10, PM Orbán set a multi-year target to reach GDP growth of the average of growth in the EU plus 2 percentage points. Should the EU Commission be right on EU growth, this would require 3.5% growth for Hungary in 2019. We see the difference between 5% current growth and the new target as the MNB’s flexibility, and the statement itself as a political go-ahead for cautious and gradual monetary tightening.
The negative side of the same speech was Mr. Orbán’s announcement of new policy measures. Contrary to officially encouraged expectations, he once again missed the really important measures to raise competitiveness, and came forward with a politically motivated demography program, which at best can add to the domestic labor supply over a very long time period. This leaves the economy with the existing labor shortages and heavy upward wage pressures, as suggested by the labor actions and wage agreements seen in the private sector in the early part of this year.
Preliminary Q4 BOP data reflected further deterioration. The net financing balance, which we regard as the key fundamental variable, ran more into the red during this period, pulling down the annual surplus essentially to ‘positive zero’. This negative trend was driven by the speedy deterioration of the merchandise trade balance. Reliance on the current account and the external income balance as the main BOP indicators would be misleading because of the existence of a large and increasing errors and omissions deficit.
Fiscal performance continues to be a bright spot. The central government started the year with a big cash surplus in January. The annual cash deficit and the government’s net financing requirement may get significantly smaller in 2019, in part because of EU development transfers, and in part because the government sticks to its thrifty policy on a number of areas, even at the expense of taking political risks in the current election year. Mr. Orbán’s new spending program does not look very expensive at second glance. The reduction of the central government’s debt ratio in 2018 looks impressive, especially if we take the ratio net of the government’s bank deposits.
In view of all this, the MNB is likely to start tightening in March, together with its new quarterly inflation report. As a first step, we expect the elimination of the negative interest rate on O/N deposits, but the hike could be bigger if core inflation turns out nasty in February and March. Given the threats of an excessively strong currency, we would only expect any net withdrawals from FX swaps if the forint previously retreats to north of EURHUF 320. Finally, we do not expect the MNB to touch its credit rate until BUBOR gets reasonably close to the base rate, which may be the situation at some point in H2 2019 the earliest.
We apologize for the unusually lengthy explanation of political issues in this paper. On foreign politics, PM Orbán has continued to break pepper under the nose of the EU, but no material political decision against him seems possible before the European election in late May. However, his course in EU diplomacy could only prove sustainable if a landslide shift takes place at the election in favor of populist parties, which we believe to be less likely.
The US government also has concerns about Hungary, but they appear to be preoccupied much more with strategic and military issues than with Hungary’s performance with regard to democracy and civil rights. A recent visit to Budapest by secretary of state Pompeo seemed to have taken care of most of their immediate concerns, even though it did not result in a complete success for the US government.
Finally, a series of political conflicts is seen to be building up on the domestic political scene, mainly because of Fidesz’ aggressive behavior regarding power concentration and fiscal matters. For now, however, PM Orbán seems to be strong enough to weather out those and even win this year’s European and local government elections.
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