-- Surprise no. 1: Amid overwhelming growth pessimism, growth of a few could surprise positively - India, Philippines and Vietnam are the top candidates.
Our oil price forecast has been significantly revised downward vs. our baseline scenario when our 2015 Outlook was published - i.e. brent crude is now forecast to average $63/bbl (vs. $80) in 2015F and $70/bbl (vs. $85) in 2016F - but recent price action had even bigger drop.
Moreover, our commodity team is emphasizing supply side factors as the bigger driver of the oil price slump than demand. Despite what should be seen as a more positive supply-shock, we have not upgraded any growth forecast in Asia, except Vietnam, and instead, downgraded the growth forecast of the sole commodity-vulnerable country in Asia - Malaysia (to 5% vs 5.3% in 2015F). However, price action on interest rates and bond markets would suggest that market is not factoring in any growth upside from lower oil.
But could market be surprised? A supply driven oil shock is well known to redistribute income from oil-producers to consumers, the latter characterizing most Asian economies and many major advanced economies that constitute important export markets for Asia, namely the US (a major growth upgrade to 3.6% from 3.0%), and to a lesser extent, more modest growth upgrades in Euro Area and Japan. The growth upside in a number of EM Asian countries should theoretically be even larger than the US given that Asian economies are much more energy intensive, and thus, among the net importers, the income/profit effect should be larger, not to mention that US is also an increasing oil producer. Oxford Economics macro forecasting model suggests the GDP impact should be particularly large in Philippines, Thailand, China and India (we would add Vietnam here though it is not included in the OEF).
We think India, Philippines and Vietnam appear best positioned for positive oil-related growth surprises. All three are net oil importers (though Philippines and India much more than Vietnam), and unlike China and Thailand (two other large oil beneficiaries), India and Philippines don't have leverage issues that would drag domestic demand. Philippines gets support from persistently accommodative monetary conditions, which is getting a longer lifeline, thanks to commodity-led disinflation. There is also upside from a more supportive fiscal stance following the huge drag last year. The Philippines' 2015F budget is calling for almost 15% increase in spending vs. the 2014 plan, or about a 30% increase vs. 2014 actual. Though the spending goal will likely be missed, the low base and pre-election motivations could still see a positive surprise to the fiscal impulse, on top of the windfall from oil. Meanwhile, Vietnam's debt overhang is now 6-8 years old, and while its legacy lingers, the drag to the economy is gradually abating amid ample liquidity, very competitive manufacturing sector (see Figure 9), buoyed further by landmark trade deals, and the positive spillovers this creates to the rest of the economy (e.g. services and construction sectors). It doesn't hurt that Vietnam's exports are the most directly exposed to the US market, and is up 25-30% YoY.
We also think India's growth is poised for a positive surprise (in fact, our longheld growth forecast is of 6.5% in FY16 is still a tad above consensus) from a pick up in reform momentum, improving business sentiment that is now driving up new project announcements and a favorable turn in domestic funding conditions through more accommodative policy. India's tight monetary conditions should progressively ease as RBI has started to cut rates and external liquidity position has improved significantly. With oil prices now much lower than expected, we expect
India's CA deficit in FY16E and FY17E CAD will fall sharply to only about 0.2% and 0.8% of GDP vs. > 1% of GDP previously. Coupled with net FDI flows, India is now forecast to run a "basic balance" surplus for the first time in seven years, making it increasingly less vulnerable to shocks in global capital flows.
Meanwhile, despite the oil windfall, we think it seems less plausible to see much positive growth surprise out of China. There are too many offsetting drags, especially in the heavily levered SOE, property/construction and other "overcapacity" sectors (e.g. coal, cement, iron). China's property investment YoY growth has now turned negative with funding being a constraint, and forward looking indicators such as land sales and building starts are falling sharply YoY. The latter would further impair local government finances and weigh on infrastructure investment. Faced with risks from tighter funding, possible defaults, and fx risks, positive surprise from oil is balanced by negative surprise elsewhere.
We are also less sure about Thailand, as it is undergoing a deeper malaise that may not be sufficiently lifted by the oil windfall. First, household debt remains historically high, such that fuel windfall may be used to service debt;
Second, Thailand is also a net agricultural exporter, and the collapse of oil has some negative spillovers to biofuel demand and agri prices, which could impact rural consumption (65% of Thai population are rural); Third, even if energy intensive industries incur gains, it's unclear how much of that will translate to domestic investment given still significant underutilization, lack of fiscal support, eroding manufacturing competitiveness and unresolved political uncertainties;
Lastly, tourism spending accounts for 9.5% of Thai GDP, not to mention spillovers to retail spending and property investment. A significant casualty of lower oil (and sanctions) have been Russia with the rouble losing almost 40% of its value vs. the USD since Sep 14. Next to the Chinese, Russians are the fastest growing source of visitor arrivals to Thailand in the last few years (up an average of > 53% YoY in 2010-13), and despite distance, is remarkably the third largest source of visitors to Thailand (after China and Malaysia), with average spend per person that is higher than the two (Russians account for about 10% of Thailand's tourism revenues). Thus, the sharp collapse of Russian visitors to Thailand is a negative offset from what should be a positive impact of the oil price slump.
Market implications: Positive growth surprises in these countries would anchor their relative FX performance and growth-sensitive assets (such as equities) and supportive of PHP, INR and VND. In the Philippines case, where growth momentum is the strongest, it may yield PHP bond relative underperformance(we are neutral at the moment).
-- Surprise no. 2: Despite persistent negative inflation surprises, some Central Banks could surprise in their resistance to ease policy at the onset
The sharply lower oil prices, and benign food inflation across most countries, are likely to deliver significant negative inflation surprises. If our oil price forecasts are correct and barring any weather shock - these negative surprises will likely persists at least into 3Q15 (see Figure 15). This will likely elevate market expectations for rate easing in a few - market is pricing in 25bps cut in Korea, 100bps rate cut in China and India over the next 12M. We think there may be some built-in expectation of a cut in Thailand even though the FX linked IRS curve isn't pricing in anything, and that the market is partly positioning for a SGD NEER easing move by the MAS. However, we think there are TWO considerations that could constrain appetite for monetary easing at the onset (NOT our base case in China and Thai) - and thus, there is risk that CBs may disappoint the market:
First, If the CPI disinflation is seen more of a "supply" than demand-driven - this would be the case if output gap isn't too large (or close to zero/positive) such that disinflation shock is less likely to feed into expectations - then CBs could more likely view a commodity led-disinflation as "transitory", and be reluctant to act for now. Based on our output gap estimates, we would argue that China, Korea and Singapore could be at risk here of being more prudent than market expectations. India and Thailand have sufficiently large output gap that make this argument less compelling (Figure 16). We discuss the three:
-- China: While growth has slowed significantly led by investment, consumption has been far more resilient. Thus, while overall output gap estimates would suggest there is considerable slack, our "private consumption expenditure" (PCE) gap estimate suggests it is still running slightly above potential, and could explain why both consumer survey price expectations and core inflation remain sticky. This could be a risk factor that delays PBoC's decision to cut rates (not our base case, but a plausible risk nonetheless).
-- Korea: BoK now believes potential growth is lower at 3.4% and sees very low risk of deflation. However, with Korea inflation expectations already heading south, if growth surprises to the downside and currency war escalates, BoK conservativeness could be challenged later on (though financial stability considerations could be their line of defense; see next section).
-- Singapore: Growth could surprise on the downside, but MAS may also be slower to formally ease policy given political sensitivities on inflation perceptions close to elections, its view that labor market is still tight, plus some demand offset with an expansionary pre-election budget on Feb 23rd. Second, financial stability considerations will also constrain willingness to use monetary easing in countries where there is significant buildup of leverage in a number of countries, and thus, a bias to "lean against the wind".
Financial stability considerations will be a bigger issue when level of debt is high, credit is expanding at a relatively rapid pace and where asset price performance (real estate being particularly important) encourages further credit exuberance even as they approach very elevated levels. We cited in previous work that India (and Indonesia) doesn't need to worry about this given very muted pace of leverage build up, but China on the corporate side, and Korea, Malaysia and Thailand (and Singapore) on the household debt side, have all seen a buildup of leverage. Recent data suggest household debt ratios are still rising in Thailand and Korea, though are coming off in China (from a very high level).
Market implications: Resistance to rate easing in these markets doesn't change the subpar growth/lowflation dynamics of their economies, and if anything, could be conducive to a flattening of their yield curve as market prices in later easing. There is also risk that when there is crowded received positions in both China and Korea, we could see pullbacks as CBs disappoint.
-- Surprise no. 3: RBI surprises with the speed/magnitude of rate cuts; Could BI surprise too? - Sharper-than-expected commodity-led disinflation, receding inflation expectations, disappearing external imbalances, lack of financial stability concerns and a credible fiscal consolidation plan are factors that set the stage for RBI to surprise in its delivery of rate cuts. We think it's harder for Indonesia to do the same as external imbalances and a much more aggressive inflation target will constrain BI policy (prudence should support Indonesia credit, anchor IDR and drive down IDR bond yields, but then growth less likely to surprise positively).
Market implications: In India, faster than expected rate easing that is more growth supportive is likely to be supportive of INR (though capped by RBI's reserve accumulation). With OIS already pricing in 125bps of rate cuts, we see more room for INR bonds than swaps to rally. In Indonesia's case, we think a more prudent central bank on top of fiscal prudence, is very bullish for bonds and for the credit, but likely more neutral on IDR as we expect Bank Indonesia will be incentivized to shore up FX reserves - even more so than India.
-- Surprise no. 4: A sharper-than-expected tightening of global funding conditions from a sustained USD strength.
Aside from the vulnerabilities in large CAD countries (Mongolia, Sri Lanka, and to a lesser extent, Indonesia), we think even surplus countries like China, Malaysia could be vulnerable given the sizeable external borrowing that coincided with the rise in leverage that could reverse. For Singapore tight funding is an issue even ahead of US rate rise.
Market implications: We would be cautious on MYR or bonds on the back of this risk (though the impact on the latter could be offset by efforts to repatriate Malaysia's foreign assets held by GLCs to support domestic finanicng).Despite its CA surplus, Malaysia is more exposed to shift in global funding than what markets may realize, on top of commodity concerns having negative spillovers to its fiscal position. Thus, while currency mismatch isn't a risk and weaker ringgit should eventually help exporters, the unwinding of capital flows can adjust much faster than trade flows, and BNM has very limited reserve backstop to anchor the currency. While China is also exposed, it has a much strong FX reserve backstop and a more closed capital account - at the margin, this leads us to remain more neutral on both CNY and rates as fundamentals would argue that, if anything, China's monetary policy should ease (that is not the case in Malaysia). We also think that Singapore economy is very vulnerable as its ability to capitalize on US recovery amid eroding manufacturing competitiveness is offset by pressures on domestic de-leveraging. SGD should remain the preferred funding currency.
-- Surprise No. 5: China widens RMB trading band, leading to more depreciation - While not our base case, it is a plausible risk underappreciated by the market. More flexible exchange rate is part of China's financial market reform agenda. There could be an argument to be made that it is better to do it sooner rather than later, and such a move would likely lead to larger-than-expected RMB depreciation.
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This is an extract from a longer Asia Macro and Strategy Outlook report by Johanna Chua, Chief Asia Economist at Citi.
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