Fundamentals and expectations - Eaglewatch by Dr. Alvin P. Ang

October 17, 2016
A fellow columnist, Henry Ong, responded to a question in his column (Money Matters, PDI, October 12, 2016) on the President and the stock market. I would like to summarize his points before giving my view. He recognized that political noises affect the market, but not necessarily in a direct manner. He points out the people invests in the stock market based on expectations—“that share prices will increase in the long term” as business expands. However, expectations are affected by uncertainties. These uncertainties lead to what is known as equity risk premium. He went on to explain that equity, risk premium is composed of political risk, capital risk and impact risk. Political risk refers to government actions. Capital risk refers to the business environment beyond governance. Impact risk refers to business implications due to changes in policy. Henry summarizes that political risk outweighs the other two when the economy is weak.
 
I tend to agree with Henry that the market is facing various kinds of risks at the moment. As of this writing, the Philippine Stock Exchange index (PSEi) is currently down 1.5 percent. This is happening amid the latest round of pronouncements of the President surrounding foreign policy. Is political risk weighing down on the market? As Henry pointed out, the Philippine economy is currently at its strongest point in decades.
 
The fundamentals or foundations of the economy through growth, employment and prices are reflecting better figures. GDP growth will likely remain above 6 percent this year and next. Unemployment is at its lowest in decades, at 6 percent, and inflation and interest rates also reflecting decades- low figures.

 


 
The budget deficit is manageable at below 2 percent of GDP, while the current-account surplus is 2.5 percent of GDP and savings-to-GDP ratio remains above 20 percent. Thus, fundamentally, there is momentum for growth to continue. Besides, the government has already committed to sustain this by continuing the macroeconomic policies in the last six  years and ensuring public spending by increasing the infrastructure budget to 5 percent of GDP. Therefore, it is not political risk that is challenging the market.
 
So where is the weakness coming from? Two weeks ago we wrote that the PSEi is one of the most expensive in Asia at its prices then of about 22x Price-earnings ratio. This is way above its average of 16.5x.
The market is expensive to begin with. Second, compared to its regional peers, the PSEi at 7,400 actually is not the worst performer in Southeast Asia for the year. Compared to a year ago, it is still up 5.8 percent. This is much better than Thailand’s 1.4 percent and Malaysia’s -2.5 percent.
 
Indonesia and Vietnam have much higher returns of 16.2 percent and 15.8 percent, respectively. Third, the capital risk that Henry was talking about has been taking a significant impact on the market. In here, there are a number of factors at play. The first one is that the US Fed may no longer delay increasing interest rates by another 25 to 50 basis points by December.  According to Bloomberg, a new ruling by the US Securities and Exchange Commission requires that prime money-market funds must have enough liquidity buffers.
 
These funds are short-term source of funding among US banks and firms. With this ruling, it will be costly to keep buffers as these cannot earn, and so funds are moving to US Treasuries. This has already increased interbank borrowing rates in the US. This might be causing funds to move back to the US in anticipation of the full implementation of the ruling this October 14. Another factor is the rising oil prices, which breached $50 per barrel after hitting lows of close to $20 early this year. Higher oil prices could push inflation and interest rates higher.
 
The combination of these external factors, indeed, is affecting the local market today. Politics seem to be more of a contributory rather than the main factor for its weakness. Movement of funds to the US and oil-price hikes will continue to be drags to the regional markets.

 

 

The Philippine market is no excuse. The external perception has increased the equity risk premium requiring listed firms to perform better in the next years. Government is also required to factor in external events in improving and sustaining the fundamentals. Much of the fundamental strength of the country have been generated by foreign funds through overseas Filipino workers remittances, business-process outsourcing  and tourism receipts.
 
The contribution of foreign direct investments is increasing, but is lower compared to other Asean countries. Thus, the domestic economy must be the main engine of growth.
 
Lowering income taxes and increasing government spending is the main approach to sustain the fundamentals. Their full effect will take time to be felt. Thus, in this environment, it is better to lengthen the perspective from short to long term, and from focusing on expectations to fundamentals.