Hungary

Highlights Even though the National Bank of Hungary is set to hike its policy rate, the pace and magnitude of these rate hikes will be insufficient to contain the inflation outbreak. In the meantime, Czech policymakers – both the central bank and a potentially new government – will be decisive in their actions to tackle rising inflation. Rate hikes amid potential fiscal tightening following the October general elections will support koruna appreciation. To sum up, the Czech koruna will outperform the Hungarian forint. We are initiating a long CZK / short HUF trade while closing our long CZK versus an equal-weighted basket of HUF and PLN position. Feature Chart 1The NBH & CNB Will Soon Embark On Rate Hike Cycles An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies Conditions for central bank rate hike cycles are in place in Hungary and the Czech Republic. With brewing inflationary pressures at work in their economies, Hungarian and Czech authorities are likely to embark on a rate hike cycle in the coming weeks (Chart 1). Yet, Czech authorities are following a more conventional policy mix, which entails a positive outlook for the Czech koruna. By contrast, Hungarian authorities will continue with their populist policy cocktail, with QE and large fiscal spending in the cards. We therefore remain negative on the Hungarian forint outlook for the time being. Sooner than later, the Czech koruna will resume its appreciation versus the Hungarian forint. Hungary: The “Inflation Genie” Is Out Of The Bottle The National Bank of Hungary (NBH) is set to hike its policy rate following spikes in headline and core inflation equal to 5.1% and 3.7%, respectively (Chart 2). A couple of rate hikes will likely happen in the second half of this year as inflation accelerates above the target range of 2-4%. Nevertheless, these rate hikes will be too small to halt the inflation outbreak developing in Hungary. Chart 2Hungary: Inflation Will Ovetshoot An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies In short, the central bank will raise the policy rate but will remain behind the inflation curve. This might support the Hungarian forint in the very near term, but the medium-term outlook is negative for this currency. Significantly, expanding government spending ahead of the 2022 elections and ongoing quantitative easing (QE) from the NBH bodes ill for the exchange rate. The QE program will cap the upside in local bond yields, thus limiting the impact of policy rate hikes on aggregate borrowing costs. Critically, the policy rate and long-term government bond yields in real terms (deflated by core CPI) will remain deeply negative, discouraging private investors, including foreign investors, from buying in (Chart 3). Chart 3Hungary: Real Rates Are At Record Lows An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies Ahead of the 2022 general elections, Prime minister Viktor Orbán and his ruling Fidesz party are tied in national polls with the newly formed opposition front. The opposition alliance was set up to challenge both PM Orbán and the Fidesz party’s decade in power. Their 2019 local elections victory in Budapest raises the possibility of a change in government next year. This threat to Viktor Orbán’s power will force his hand in securing easy fiscal and monetary policies to strive for minimum unemployment and higher nominal income growth and with it maintain popular support. These create conditions for the economy to overheat, and inflation to overshoot: First, the government is increasing spending following a period of already sizable fiscal spending in 2020-21. The 2022 revised budget draft is designed to target key voting groups. In particular, the new spending plan entails tax exemptions for workers under 25, increases in support for families, adds extra pension payments to retirees, and reduces tax burdens on businesses. Second, wage growth is already high at 8% and the government is boosting public sector wages and has increased the minimum wage.  Chart 4Hungary: Labor Market Slack Is Small An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies In addition, the number of unemployed people is smaller than in the past outside recessions (Chart 4). As such, labor shortages will persist. This circumstance is conducive to higher wages, and thereby suggests that inflationary pressures are genuine and will be broad-based. Third, the vaccination campaign led by Hungarian authorities is fairly advanced and comparable to developed economies’ efforts. Unleashed, the pent-up demand for consumer goods & services will help overall consumption to expand quickly in the months ahead. Fourth, the National Bank of Hungary (NBH) will further expand its asset purchases (i.e. QE program) to cap government bond yields, enabling more government borrowing at lower cost and more fiscal spending. Chart 5Hungary Has Been Conducting Large Scale QE An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies Inflationary policies, budding economic overheating and the central bank’s QE bond purchases have greatly reduced the attractiveness of local government bonds. Notably, a lack of foreign portfolio inflows into Hungarian government bonds is already forcing the central bank to absorb a third of local government bond issuance (Chart 5). This trend will likely persist and to cap yields the central bank could be forced to increase the size of its QE program.1 When it happens, the currency market will react negatively, and the forint will experience another downleg. Further, the surge in commercial banks’ excess reserves at the central bank due to the QE program creates conditions for commercial banks to expand their local currency assets. This is inflationary and negative for the exchange rate. Chart 6Hungary: BoP Poses A Risk To The Forint An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies Lastly, a lack of foreign portfolio inflows and no current account surplus do not bode well for the forint (Chart 6). Bottom Line: The central bank’s rate hikes will be timid enabling an inflation overshoot. In short, the central bank will fall behind the inflation curve, leading to low real interest rates and a weaker forint beyond the near term (Chart 3 above). Czech’s Central Bank Is Alert To Inflation Chart 7The Czech Republic: Inflation Is Heading Towards CB's Target Range An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies In the Czech Republic, core and headline consume price inflation are breaking above the upper band of the central bank’s target range (Chart 7). Remarkably, core inflation measures have not declined much in the past year even though the economy experienced a major pandemic-induced slump. As the economy recovers, inflation will rise to new highs. Yet, policymakers are on the alert: fiscal policy is set to become more restrictive following the October elections and the Czech National Bank (CNB) will hike interest rates continuously over the coming months. It is worth noting that Czech policymakers have pursued much more prudent monetary and fiscal policies than Hungarian authorities. The Czech National Bank (CNB) will normalize nominal and real policy rates sooner than its regional and euro area counterparts. In turn, higher Czech real interest rates will support the currency against both the euro and its central European peers: After strong fiscal spending ahead of the October 2021 general elections, fiscal policy will likely become restrictive in Q4 of this year. Czech prime minister Andrej Babis’ slim chances of reelection had pushed his government to expand fiscal spending as a last resort to gather support. Yet, his ANO party is trailing the center-left coalition of the Pirates Party and the STAN coalition in national polls and is closely followed by the center-right SPOLU party. In any outcome a divided parliament likely entails a return to conservative fiscal policy in the years to come.   Chart 8Czech Economy: Job Market Will Heel Rapidly An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies In addition, labor shortages persist. Job vacancies are high and will rise further as the economy reopens and European tourism picks up. Further, the number of unemployed workers to fill these vacancies is going to fall over the coming months (Chart 8). As employment recovers, competition from local firms to secure labor will bid up wages. The recovery in European manufacturing will continue. This will extend the Czech Republic’s manufacturing expansion. Notably, the nation’s manufacturing production output is back to pre-pandemic levels. This is despite weak production volumes out of the car industry, as auto production has been hampered by a global semiconductor shortage. As these shortages ease, auto production will surge, further increasing Czech industrial output. Historically low corporate and consumer real lending rates will help spur credit growth and incentivize consumption. The current account surplus is at record highs at 3.5% of GDP. Positive dynamics within the BoP is positive for the currency. Chart 9The Czech Koruna Is Not Expensive An Inflationary Brew In The Hungarian & Czech Economies An Inflationary Brew In The Hungarian & Czech Economies Lastly, the koruna is fairly valued according to its real effective exchange rate based on a unit labor costs measure (Chart 9). Bottom Line: The Czech National Bank will hike interest in response to rising inflation. Czech real rates will move above those in central Europe and the euro area. This will continue to support Czech koruna appreciation. Investment Recommendation Odds are that Czech swap rates will rise faster than those in Hungary reflecting the speed of central bank rate hike cycles. Consequently, the Czech koruna will outperform the Hungarian forint We are initiating a long CZK / short HUF trade. We are closing the long CZK versus an equal-weighted basket of HUF and PLN. This trade has produced a 0.8% gain since its recommendation on November 25. We will discuss the outlook for Poland in the coming weeks. In regard to equities, we continue recommending neutral allocation to central European bourses – Polish, Czech and Hungarian equities – within an EM equity portfolio.   Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1In their latest May 25 monetary policy meeting, the NBH stated that it will perform a review of its QE program when purchases amount to HUF 3 trillion. As of May 23, the total stock of purchases amount to HUF 2.23 trillion. In addition, they see government bond purchases as a key tool to smoothing out financial market volatility and avoiding a surge in bond yields.

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Go Long HUF / Short PLN Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights In contrast to the low-inflation experience of the euro area and other developed market countries over the past several years, the structural backdrop has and will continue to favor inflation in central European (CE) economies. Over the coming 6-12 months, this secular rise in inflation will be interrupted. The COVID-19 pandemic has forced policymakers to cause a “sudden stop” in economic activity in most major countries around the world, implying that inflation is set to trend lower this year. At the same time, the crisis is also spurring a policy response that is likely to reinforce the inflationary structural dynamics in these economies over the medium-term. Central European currencies are likely to depreciate further versus the euro and US dollar this year, but will appreciate versus other EM currencies. Regional equity investors should underweight CE stock markets versus the euro area, but overweight them versus an EM equity benchmark. Feature BCA’s Emerging Markets Strategy (EMS) team has written periodically about Central European (CE) economies.1 In these reports, our overreaching theme for CE economies has been that labor shortages are causing strong wage growth, which is exerting inflationary pressures on domestic economies. In this Special Report we briefly review the basis for this theme, and detail how the COVID-19 pandemic is likely to temporarily interrupt structurally rising central European inflation. We conclude with the implications for PLN, CZK, and HUF, versus both emerging market currencies and the euro, as well as the attendant implications for central European fixed-income and equity markets. The Structural Forces Stoking Central European Inflation: A Brief Review In contrast to the low-inflation experience of the euro area and other developed market countries, the structural trend favors inflation in central European (CE) economies. Chart I-1 shows that this trend has already been manifesting itself; various measures of consumer price inflation have been rising in Poland, Czech Republic and Hungary, the three main CEs of focus for BCA’s EMS team. Rising unit labor costs arising from labor shortages have been driving the inflationary backdrop, as evidenced by the following: Chart I-1Inflationary Pressures Are Rising Across Central Europe Inflationary Pressures Are Rising Across Central Europe Inflationary Pressures Are Rising Across Central Europe Chart I-2Scarcity Of Labor In CE ##br##And Germany Scarcity Of Labor In CE And Germany Scarcity Of Labor In CE And Germany     First, our labor shortage proxy – calculated as number of job vacancies divided by the number of unemployed people – remains elevated in all CE and continues rising in the Czech Republic and Hungary, while slightly rolling over in Poland (Chart I-2). Meanwhile, Germany’s labor shortage proxy also is elevated and rising (see discussion below). A breakdown of this proxy’s components reveals that the number of job vacancies continues to climb, while the number of unemployed people continues falling (Chart I-3A & I-3B). Chart I-3AA Breakdown Of Our Labor Shortage Proxy A Breakdown Of Our Labor Shortage Proxy A Breakdown Of Our Labor Shortage Proxy Chart I-3BA Breakdown Of Our Labor Shortage Proxy A Breakdown Of Our Labor Shortage Proxy A Breakdown Of Our Labor Shortage Proxy Second, wage growth, overall and manufacturing, has been rising faster than productivity growth. This implies that unit labor costs have been rising acutely in these economies (Chart I-4). Third, firms are more like to pass on cost increases to consumers when profit margins are lower, meaning that rising wages have been likely been stoking consumer price inflation over the past 5 years. Fourth, German outsourcing has anecdotally been noted as being an important driver of high demand for labor in the manufacturing hubs of Poland, Hungary and Czech Republic, which is consistent with the elevated labor shortage proxy for Germany noted above. While it is difficult to approximate the exact amount of outsourcing activity that is occurring between Germany and CE economies, we offer a few perspectives below: Intra-European trade between Germany and CE has swelled over the past two decades. Rising bilateral trade is consistent with outsourcing, in that it reflects intermediate goods being exported to CE for production and subsequently imported back into Germany for final assembly. Low labor costs in CE appear to have led firms to outsource their production from Germany to CE economies. Chart I-5, top panel, shows that production volumes have been rising at much quicker pace in CE than in Germany over the past decade, in response to a large CE labor cost advantage over Germany (Chart I-5, bottom panel). Chart I-4Labor Shortages = Rising Unit Labor Costs Labor Shortages = Rising Unit Labor Costs Labor Shortages = Rising Unit Labor Costs Chart I-5Cheap Labor = Job Outsourcing Cheap Labor = Job Outsourcing Cheap Labor = Job Outsourcing Manufacturing employment over the past decade has also grown considerably quicker in CE economies than in Germany, which signifies that increased CE production volumes are being driven by rising labor inputs, not just increased capital. Finally, CE withstood quite well the manufacturing recession in Germany in 2019. Bottom Line: Employment and income growth across the CE had been robust until now. COVID-19: A Near-Term Deflationary Event While the secular outlook for CE economies is inflationary, the opposite is true for the coming 6-12 months. The COVID-19 pandemic has caused a “sudden stop” in economic activity in most major countries around the world, as policymakers implement strict physical distancing measures to try and slow the spread of the disease and avoid a collapse in their respective health care systems. Aggressive and swift measures have been taken across CE, and more quickly than in some euro area countries. This is positive in the sense that it should shorten the period of time that aggressive control measures should be required, but negative in the sense that it will also lead to a more acute domestic shock to the economy in the near term. This, in turn, implies that inflation is set to trend lower for a time, as Chart I-6 underscores that core inflation in CE economies is fairly reliably correlated with lagged growth in final demand. In addition, Chart I-7 highlights that core inflation in CE economies is also fairly correlated with the German manufacturing PMI, underscoring that the deflationary shock in the euro area economy from physical distancing measures is also likely to reverberate back to central Europe. Chart I-6COVID-19 Shock Will Hit Final Demand And Inflation COVID-19 Shock Will Hit Final Demand And Inflation COVID-19 Shock Will Hit Final Demand And Inflation Chart I-7German Manufacturing Versus ##br##CE Inflation German Manufacturing Versus CE Inflation German Manufacturing Versus CE Inflation However, over the medium-term, the COVID-19 pandemic has also spurred a policy response that is likely to reinforce the inflationary structural dynamics in these economies. It also occurred at a moment of relative cyclical strength, which should limit the duration of the disinflation/deflationary episode for CE economies: Monetary policy in CE economies has been ultra-loose over the past few years, and is set to remain so for the coming 6-12 months (at a minimum). This ultra-loose policy has depressed lending and mortgage rates (Chart I-8), and had already aggressively stimulated manufacturing and construction activity. Owing to the severity of the shock, policymakers are likely to lag a recovery in economic activity once physical distancing measures are removed, suggesting that interest rates will create incentives to bring forward aggregate demand even more intensely than before the pandemic. Chart I-8Policy In CE is Ultra Accommodative Policy In CE is Ultra Accommodative Policy In CE is Ultra Accommodative On the fiscal front, public debt dynamics in CE countries are not precarious. Namely, interest rates at below nominal growth, which satisfies a pre-condition of public debt sustainability. This leeway will allow policymakers to expand fiscal spending aggressively. Critically, the average household credit to GDP within CE is amongst the lowest in EM and DM economies (Chart I-9). As such, household debt deflation is not a risk, meaning that CE likely faces an “income statement” rather than a “balance sheet” recession. This implies that aggregate demand will recover faster in central Europe than in other, debt-laden economies. Economic momentum was stronger in CE economies going into the crisis, as evidenced by elevated final demand in the region. This is corroborated by strong money and credit growth in the region, as well as positive and rising output gaps (Chart I-10). Chart I-9Household Leverage is Low... Household Leverage is Low... Household Leverage is Low... Chart I-10...Which Entices Strong Credit Growth ...Which Entices Strong Credit Growth ...Which Entices Strong Credit Growth Bottom Line: Despite the imminent deflationary risk, ultra-accommodative polices alongside labor shortages will keep final demand more resilient in CE. This will lead most likely to a faster recovery in domestic growth indicators. Investment Implications On the currency front, there are several important factors to consider concerning the performance of CE currencies versus the euro and EM currencies respectively. Judging the likely direction of CE currencies is crucial, as that assessment heavily influences our fixed-income and equity recommendations. First, it is noteworthy that CE currencies have been breaking down versus the euro since the COVID-19 outbreak (Chart I-11). We see the following factors driving CE currency pairs versus the euro in the near term: European and foreign investor ownership of CE local currency bonds and equities is high, especially in Poland and Hungary (Chart I-12). As such, these markets are at risk of foreign outflows from European and foreign investors. Chart I-11CE Currencies Are Breaking ##br##Down CE Currencies Are Breaking Down CE Currencies Are Breaking Down Chart I-12Foreign Holding Of Polish And Hungarian Assets Foreign Holding Of Polish And Hungarian Assets Foreign Holding Of Polish And Hungarian Assets The global risk-off environment makes these local markets unfavorable to foreign investors. External debt levels are high across the region, particularly for non-financial corporates and banks (Chart I-13). Even though intra EU exports cover more than half of CE external debt, collapsing exports over the next few months will temporarily put a strain on foreign debtors. As of December 2019, exports of Poland, Hungary and Czech Republic to EU member were contracting. Chart I-13External Debt Is High In CE External Debt Is High In CE External Debt Is High In CE Finally, CE foreign exchange valuations based on unit labor costs are not cheap (Chart I-14). On the other hand, the euro is comparably cheap and will contribute to a faster recovery in German exports. In hand, demand for German goods are artificially supported by ultra-accommodative monetary policy from the ECB. Chart I-14CE Currencies Are Not Cheap CE Currencies Are Not Cheap CE Currencies Are Not Cheap Second, CE economies are still viewed by many investors as developing economies, and thus their currencies have been dragged down by the sharp selloff in EM FX over the past few weeks. Relative to other EM currencies, however, the downside risk facing CE currencies over the coming 6-12 months is much lower: Chart I-15CE Currencies Have Low Correlation With Commodities CE Currencies Have Low Correlation With Commodities CE Currencies Have Low Correlation With Commodities CE currencies exhibit lower correlation with commodity prices (Chart I-15). The risk of an outright deflationary spiral in CE is much less likely than in other EMs, especially in Poland and Hungary (see discussion above). Balance of payment dynamics remain supportive for CE currencies relative to other EMs. In particular, positive trade balances have historically been an important supporting factor for these crosses against both the US dollar and euro in the medium term. More importantly, foreign portfolio flows have been weak over the past few years, especially in Poland and Hungary. Also, ownership of local currency government bonds in both countries has been lower than in many other EM markets. Considering the above, and BCA’s EMS team’s existing positioning, we recommend the following over the coming 6-12 months: Currencies and Fixed Income Markets: Portfolio outflows and a comparatively cheap euro warrant CE currency depreciation versus both the euro and US dollar. Yet, better balance of payments dynamics and strong domestic fundamentals warrant CE currencies to appreciate versus EM currencies. Within CE, we continue to favor the CZK versus the PLN and HUF. Czech rates have risen above both Polish and Hungarian rates, which will support the CZK. Further, Polish and Hungarian policies have been behind the curve relative to Czech ones in regard to inflation. That said, we recommend overweighting CE local currency government versus EM GBI local currency bond benchmark due to favorable currency movements in CE versus EM. For fixed income investors, Polish and Hungarian local currency government spreads versus German bunds are at risk of widening (Chart I-16). Meanwhile, Czech rates have widened already considerably versus German bunds. Equity Markets: BCA’s Emerging Markets Strategy team continues to recommend that investors underweight CE equities relative to a euro area equity benchmark. Historically, CE equities have underperformed the euro area whenever EM equities underperformed DM equities (Chart I-17). Chart I-16Government Bond ##br##Spreads Government Bond Spreads Government Bond Spreads Chart I-17Continue To Underweight CE Equities Vs. Euro Area Continue To Underweight CE Equities Vs. Euro Area Continue To Underweight CE Equities Vs. Euro Area Within an EM equity portfolio, we recommend overweighting CE equities relative to the EM benchmark. Currency trends are critical for relative performance of equities. We expect CE currencies to appreciate versus EMs currencies, even though they will depreciate versus the euro. Over the medium to longer run, the structurally inflationary forces in CE economies that we have noted will return, arguing from a valuation perspective that the long-term risk to CE currencies is to the downside versus DM currencies. However, over the coming 6-12 months the pandemic, the response of policymakers, and its aftermath will be the primary driver of CE currencies. We will update investors on changes to our outlook for central Europe as the situation evolves, and as the structural forces that we have described draw nearer. Stay tuned!   Andrija Vesic, Associate Editor Emerging Markets Strategy andrijav@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, Weekly Report "Country Insights: Malaysia, Mexico & Central Europe" dated October 31, 2019, Weekly Report "The RMB: Depreciation Time?" May 23, 2019, available at ems.bcaresearch.com

Analysis on Mexico and Central Europe is available on pages 6 and 10, respectively. Highlights Deflationary pressures have been intensifying in Malaysia and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. In Mexico, pieces are falling into place for stocks to outperform the EM equity benchmark on a sustainable basis. We are also keeping an overweight allocation on Mexican sovereign credit and local currency bonds. In Central Europe (CE), inflation will continue to rise as both labor shortages and ultra-accommodative monetary and fiscal policies promote strong domestic demand. We are downgrading our allocation of CE local currency bonds from overweight to neutral. Malaysia: Besieged By Deflationary Pressures Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. The Malaysian economy continues to face strong deflationary pressures. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Chart I-1The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Chart I-3Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-5Malaysian Households Are Retrenching Malaysian Households Are Retrenching Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Mexico: Raising Our Conviction On Equity Outperformance Mexican local currency bonds, as well as sovereign and corporate credit, have been one of our highest conviction overweights for some time. These positions have played out very well (Chart II-1). Presently, pieces are falling into place for Mexican stocks to outperform the EM equity benchmark on a sustainable basis. First, long-lasting outperformance by Mexican local currency bonds and corporate credit will lead to the stock market’s outperformance relative to the EM benchmark. Chart II-2 shows that when Mexican local currency bond and corporate dollar bond yields fall relative to their EM peers, the Bolsa tends to outperform. In brief, a relative decline in the cost of capital will eventually translate into relative equity outperformance. Chart II-1Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Chart II-2Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Second – as discussed in detail in our previous Special Report – market worries about Mexico’s fiscal position are overblown, especially relative to other developing nations such as Brazil and South Africa. Orthodox fiscal and monetary policies, as well as low public debt, warrant a lower risk premium in Mexico, both in absolute terms and relative to other EM countries. Moreover, market participants and credit agencies have overstated the precariousness of Pemex’s debt and financing requirements. Pemex U.S. dollar bond yields have been falling steadily compared to EM aggregate corporate bond yields since the announcements of policies aimed at supporting the company’s debt sustainability. We have discussed Pemex’s financial sustainability and its effect on public finances in past reports.1  Third, having cut rates twice since September, the Central Bank of Mexico (Banxico) has embarked on a rate cutting cycle. This is positive for stock prices, as it implies higher equity valuations and will eventually put a floor under the economy.  Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. Banxico members have been vocal about their desire to cut rates further, which is being foreshadowed by the swap market (Chart II-3, top panel). Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. The slowdown in the domestic economy and Andrés Manuel López Obrador’ (AMLO) administration’s tight fiscal policy will enable and encourage Banxico to further ease monetary policy (Chart II-3, bottom panel). Fourth, another positive market catalyst for Mexican equities is the ongoing outperformance of EM consumer staples versus the overall EM index. Consumer staples have a large 35% share of the overall Mexico MSCI stock index, while this sector in the EM MSCI benchmark accounts for only 7%. Therefore, durable outperformance by consumer staples often hints at a relative cyclical outperformance for the Mexican bourse (Chart II-4). Chart II-3Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Chart II-4Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Chart II-5Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Finally, Mexican equities are not expensive. Chart II-5 illustrates that according to our cyclically-adjusted P/E ratios, Mexican stocks offer good value in both absolute terms and relative to EM overall. We continue to believe AMLO’s administration is proving to be a pragmatic government with the aim of reducing rent-seeking activities and addressing structural issues such as poverty, corruption and crime. These policies will be positive for the economy over the long run and share prices will move higher in anticipation. Bottom Line: We are reiterating our overweight allocation on Mexican sovereign credit and domestic local currency bonds within their respective EM benchmarks. With further rate cuts on the horizon, yet upside risks to EM local currency bond yields, we continue to recommend a curve steepening trade in Mexico: receiving 2-year and paying 10-year swap rates.  We now have high conviction that Mexican share prices will stage a cyclical outperformance relative to their EM peers. The bottom panel of Chart II-4 on page 8 illustrates that Mexican stocks seem to have formed a major bottom and are about to begin outperforming the EM equity benchmark. Dedicated EM equity managers should have a large overweight allocation to Mexican stocks. Our recommendation of favoring small-caps over large-cap companies in Mexico has been very profitable since we argued for this trade last November. We are taking a 12.9% profit on this position and recommend keeping an overweight allocation to both Mexican large- and small-caps within an EM equity portfolio.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Central Europe: An Inflationary Enclave In Deflationary Europe Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. CE economies have stood out as an inflationary enclave in Europe. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Chart III-3Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Chart III-4Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Chart III-5Strong Domestic Demand In CE… bca.ems_wr_2019_10_31_s3_c5 bca.ems_wr_2019_10_31_s3_c5 Chart III-6...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Chart III-7Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating Investment Implications Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Anddrija Vesic Research Analyst andrija@bcaresearch.com     Footnotes 1. Please see Emerging Markets Strategy, "Mexico: The Best Value In EM Fixed Income," dated April 23, 2019 and "Mexico: Crying Out For Policy Easing," dated September 5, 2019, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights In the Philippines, inflation is breaking out while the central bank is well behind the curve. Financials markets remain at risk. As a play on surging interest rates: Go short Philippine property stocks. We appraise and modify our investment strategy across all central European markets in general and Hungary in particular - where a monetary policy shift is in the making. A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area. Feature The Philippines: Short Real Estate Stocks Philippine stocks are on the verge of a major breakdown (Chart I-1, top panel). Meanwhile, local currency bond yields are surging (Chart I-1, bottom panel). Chart I-1Philippine Stocks Are On The Edge Of A Breakdown Philippine Stocks Are On The Edge Of A Breakdown Philippine Stocks Are On The Edge Of A Breakdown The Philippine economy continues to overheat, and the Bangko Sentral ng Pilipinas (BSP) has fallen well behind the curve. The top panel of Chart I-2 shows that both headline and core inflation measures are rising precipitously and have breached the central bank's upper target of 4% by a wide margin. Chart I-2The Central Bank Is Far Behind The Curve The Central Bank Is Far Behind The Curve The Central Bank Is Far Behind The Curve Odds are that inflation will continue to climb higher. Overall domestic demand remains reasonably strong. Noticeably, both the current and fiscal accounts are in deficit and widening (Chart I-3). A current account deficit is a form of hidden inflation. The basis is that it gauges the degree of excess domestic demand relative to the productive capacity of the economy. Chart I-3The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit The roots of these macro problems stem from ultra-easy monetary and fiscal policies pursued by Filipino authorities. The BSP has kept borrowing costs low and for much longer than was warranted, and has been slow to hike rates. As a result, credit has been booming relentlessly (Chart I-4). Chart I-4Bank Loans Have Boomed... Bank Loans Have Boomed... Bank Loans Have Boomed... The fiscal authorities, on the other hand, have vigorously pursued growth-at-all-costs programs. Government spending is now growing at an annual rate of 22% (Chart I-5). Chart I-5...So Have Government Expenditures ...So Have Government Expenditures ...So Have Government Expenditures Consequently, these populist policies have created excessive domestic demand that has stoked an inflation breakout. Given Philippine President Rodrigo Duterte's reluctance to cut back on fiscal expenditures, it will be up to the monetary authorities to tighten sufficiently enough to curb inflation.1 The currency was depreciating against the U.S. dollar in 2017, even as its EM peers rallied. A falling currency amid strong economic growth is generally a symptom of an overheating economy; it signals that real interest rates are low and the central bank is behind the curve. Today, the monetary authorities need to hike borrowing rates aggressively, otherwise the currency will plunge much further. The country's financial markets are quickly approaching a riot point, and local currency bond yields are already selling off as creditors are rebelling (see bottom panel of Chart I-1 on page 1). Another option the BSP could take to defend the peso without hiking rates much is to sell foreign exchange reserves. Doing so, nevertheless, will still lead to higher domestic interest rates - especially at the short end of the curve. When a central bank sells its dollar reserves, it absorbs local currency liquidity - i.e. commercial banks' excess reserves at the central bank decline. Interbank rates then rise, which pushes up short-term rates and potentially long-term ones too. This is how financial markets naturally force macro adjustments on an overheating economy when policymakers are reluctant to act. As such, Filipino share prices are now facing a major risk. Higher domestic rates amid strong loan growth will cause the economy to decelerate significantly. Certain interest rate-sensitive sectors such as vehicle sales are already shrinking. The property sector - the segment of the economy that has benefited the most from the credit binge - will be the next shoe to drop: The supply of residential real estate buildings has been booming - floor space built has risen 2.4-fold since 2003. As interest rates continue to rise, real estate and construction loans - which are still growing at a 19% annual rate - will slump. Higher borrowing costs will hurt real estate prices. Meanwhile, rent growth will decline as the economy decelerates. The slowdown in the property sector will take a heavy toll on real estate development and management companies: First, these firms' revenues and income - property sales, rental and other types of income - will decelerate significantly (Chart I-6, top panel). Chart I-6Listed Real Estate Companies Will Face Major Headwinds Listed Real Estate Companies Will Face Major Headwinds Listed Real Estate Companies Will Face Major Headwinds Second, higher interest rates will raise their interest expenses (Chart I-6, bottom panel). Remarkably, Philippine real estate stocks have remained quite resilient, despite the broad selloff in financial markets. While the former are down by 18% in dollar terms from their early 2018 peak, Chart I-7 suggests rising interest rates herald a much more pronounced drop in their prices. Chart I-7Filipino Property Stocks Are On A Cliff Filipino Real Estate Stocks Have Been Quite Resilient Filipino Real Estate Stocks Have Been Quite Resilient Besides, these property companies are also still expensive. Their price-to-book value (PBV) currently stands at 2.9. Between the years 2000 and 2005, their PBV averaged 1.6. We are therefore initiating a new trade: Short Philippine real estate stocks in absolute U.S. dollar terms. Crucially, the real estate sector makes up 27% of the Philippines MSCI index, and will therefore have a significant impact on the Philippine stock market. As to bank stocks - the other large segment of the equity market - a couple of points are in order. Commercial banks in the Philippines are exposed to the real estate sector. Hence, a slowdown in the property sector will culminate in the form of higher NPLs and provisions for bad loans on banks' balance sheets. Real estate and construction loans account for 25% of total bank loans. Crucially, NPLs and provision levels - at 1.3% and 1.9%, respectively - are very low, and have so far not risen. This is unsustainable given the magnitude of the ongoing credit boom and rising interest rates. Higher provisions will cause banks' profits and share prices to suffer materially. This will come on top of plunging net interest margins (Chart I-8). Chart I-8Philippines Commercial Bank Profits Are Getting Squeezed Philippines Commercial Bank Profits Are Getting Squeezed Philippines Commercial Bank Profits Are Getting Squeezed As to equity valuations, this bourse is not cheap, neither in absolute terms nor relative to the EM equity benchmark - both valuation measures are neutral (Chart I-9). Chart I-9Equity Valuations Are Not Attractive Equity Valuations Are Not Attractive Equity Valuations Are Not Attractive Overall, the outlook for Philippine equities as a whole remains unattractive both in absolute terms, as well as relative to the EM benchmark. Bottom Line: EM equity portfolios should continue underweighting this bourse. We are also initiating a new trade: Going short Philippine real estate stocks in absolute U.S. dollar terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Strategy For Central European Markets Our presiding macroeconomic theme for central Europe - which we first elaborated on in a Special Report titled, Central Europe: Beware Of An Inflation Outbreak2 - has been as follows: An accommodative policy stance in the context of strong growth and tight labor markets warrants higher inflation. Our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - is continuing to surge across all central European countries as well as in Germany. This foreshadows higher wage growth ahead (Chart II-1). Chart II-1Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Tight Labor Markets Means Higher Wage Growth Furthermore, monetary policy in central European countries remains accommodative - policy rates are negative in real (inflation-adjusted) terms. Consistently, private credit (bank loan) growth and domestic demand remain robust. Today, we appraise and modify our investment strategy across all central European markets in general and Hungary in particular, where a policy shift is in the making. Hungary: Moving Away From Ultra-Accommodative Monetary Policy? Last month, the NBH (National Bank of Hungary) modified its monetary policy statement to include a new paragraph explaining that the council is prepared for the gradual normalization of monetary policy, depending on the outlook for inflation.3 Given our view that inflation in Hungary will continue to rise, the NBH is likely to move away from ultra-accommodative monetary policy sooner rather than later. Besides mounting inflationary pressures, several factors lead us to believe that the NBH is more comfortable normalizing policy today than in the past: First, after seven years of deleveraging, private credit is finally on the rise, and money supply growth is booming (Chart II-2, top and middle panel). Chart II-2Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Hungary: Easy Monetary Conditions Will Lift Inflation Second, capital expenditures are recovering and business confidence is making new highs (Chart II-3, top and middle panel). Furthermore, construction is firing on all cylinders (Chart II-3, bottom panel). Chart II-3Hungary: Capex Is Robust Hungary: Capex Is Robust Hungary: Capex Is Robust Lastly, core consumer inflation is rising and the real deposit rates is at -2%, the lowest in 20 years (Chart II-2, bottom panel). Given the genuine need for rate normalization in Hungary and the central bank's readiness to do so, we are adjusting our strategy: We are taking profits of 72 basis points on our Hungarian yield curve steepening trade that we initiated on June 21, 2017. Hungary's yield curve is already the steepest yield curve in Europe. The slope of the 10/1-year yield curve is 320 basis points in Hungary, versus 200 in Poland, 100 in the Czech Republic and 105 in Germany. We are closing our long PLN / short HUF trade with a 7.7% gain since its initiation on September 28, 2016 (Chart II-4). The cross rate is close to an all-time high and will likely reverse. Chart II-4Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF Book Profits On Long PLN / Short HUF A new trade: We recommend paying 3-year swap rates in Hungary and receiving 3-year swap rates in the euro area (Chart II-5). Chart II-5A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates A New Trade: Pay Hungarian / Receive Euro Area 3-year Swap Rates First, not only is final domestic demand in Hungary much more robust than in the euro area, but Hungary's output gap is positive while the euro area's is still negative (Chart II-6,top and middle panel). This foreshadows a widening gap in inflation between Hungary and the euro area (Chart II-6, bottom panel). As this transpires, policy rate expectations will rise faster and by more in Hungary than in the euro area. Chart II-6Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Hungarian Economy Will Overheat Faster Than Euro Area's Second, ultra-accommodative monetary policy in Hungary has served its purpose and has generated an overflow of liquidity. In effect, with broad money supply in Hungary now growing considerably faster than in the euro area, the NBH will likely tighten its policy at a faster pace and by more than the ECB (Chart II-7). This warrants a widening 3-year swap rate differential between Hungary and the euro area. Chart II-7Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Hungary Vs. Euro Area: Money Growth And Swap Rates Third, as global trade continues to slump, affecting German manufacturing, the European Central Bank will be fast to reiterate its readiness to keep policy accommodative longer than expected. This could push back expectations of the first ECB rate hike. Finally, Italy remains a risk and European banks are exposed to weakening developing countries. With euro area bank share prices plunging close to their 2008 and 2012 lows, the ECB will be both slow and cautious in signaling rate normalization in the immediate future. While Hungary is a very open economy and will feel the pinch from a slowdown in European manufacturing, its currency may depreciate further against the euro as it typically does amid global risk-off periods. A cheap currency will reduce the NBH's worries about the pass-through of a global slowdown and disinflation into its domestic economy. In short, given that both economies have different inflationary backdrops, Hungarian interest rate expectations will increasingly diverge from those of the euro area. As such, fixed-income investors should bet on a rising 3-year swap rate differential between Hungary and the euro area. Our Other Positions In Central European Markets Within the fixed income and currency space: Stay overweight CE3 within EM dedicated fixed-income portfolios. Predicated on our view that the epicenter of the ongoing global growth slowdown is China, emerging Asian and commodity leveraged markets are at much bigger risk than their Central European counterparts. Consistent with this theme, stay short IDR versus PLN. Book profits of 109 basis points on the following trade initiated on July 26, 2017: Pay Czech / receive Polish 10-year swap rates (Chart II-8). In line with our expectations,4 the Czech National Bank has been responding to rising domestic inflationary pressures and has been tightening monetary policy faster than the National Bank of Poland. There now remains little upside in Czech rates relative to Polish ones, so we are booking profits. Chart II-8Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Book Profits On Pay Czech / Receive Polish 10-year Swap Rates Stay long CZK against the EUR. Widening growth and inflation gaps between the Czech Republic and the euro area justify higher rates and a stronger currency in the former relative to the latter. Regarding the equity space: Stay long CE3 banks / short euro area banks. CE3 banks are less leveraged and have a higher return on assets than euro area banks. Continue overweighting CE3 within EM dedicated equity portfolios. CE3 stocks have staged a double bottom relative to their emerging market peers, both in common and local currency terms (Chart II-9). Given emerging markets are saddled with credit excesses, unresolved economic imbalances and looming currency weakness, central Europe is likely to continue outperforming. Chart II-9CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM CE3 Equities Will Outperform EM A summary of all our trades and asset allocations can be found on page 14 and 15. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see Emerging Markets Strategy/Geopolitical Strategy Special Report, "The Philippines: Duterte's Money Illusion," dated April 25, 2018, available at ems.bcaresearch.com 2 Please see Emerging Markets Strategy Special Report "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, available at ems.bcaresearch.com. 3 http://www.mnb.hu/en/monetary-policy/the-monetary-council/press-releases/2018/press-release-on-the-monetary-council-meeting-of-18-september-2018 4 Please see Emerging Markets Strategy Weekly Report "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 bca.ems_wr_2018_08_16_s1_c1 bca.ems_wr_2018_08_16_s1_c1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... CHART 2 CHART 2 Malaysia: Keep Underweight For Now As... CHART 3 CHART 3 Malaysia: Keep Underweight For Now As... CHART 4 CHART 4 ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside CHART 5 CHART 5 ...Bank Shares Have Significant Downside CHART 6 CHART 6 ...Bank Shares Have Significant Downside CHART 7 CHART 7 Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds CHART 8 CHART 8 Indonesia: Underweight Equities & Bonds CHART 9 CHART 9 Indonesia: Underweight Equities & Bonds CHART 10 CHART 10 Indonesia: Underweight Equities & Bonds CHART 11 CHART 11 Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 As Banks' NPL Provisions Rise, Bank Stocks Could Fall CHART 12 Indonesia: The Sell-Off Is Not Over Yet CHART 14 CHART 14 Indonesia: The Sell-Off Is Not Over Yet CHART 16 CHART 16 Indonesia: The Sell-Off Is Not Over Yet CHART 13 CHART 13 Thailand: Stay Overweight Thailand: Stay Overweight CHART 19 CHART 19 Thailand: Stay Overweight CHART 17 CHART 17 Thailand: Stay Overweight CHART 20 CHART 20 Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm CHART 15 CHART 15 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 21 CHART 21 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 18 CHART 18 Thailand: Better Positioned ##br##To Weather The EM Storm CHART 22 CHART 22 Philippines: Inflation Breakout Philippines: Inflation Breakout CHART 28 CHART 28 Philippines: Inflation Breakout CHART 27 CHART 27 Philippines: Inflation Breakout CHART 26 CHART 26 Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 25 CHART 25 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 24 CHART 24 Philippines: Neutral On Equities ##br##Due To Oversold Conditions CHART 23 CHART 23 Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation CHART 29 CHART 29 Central Europe: Labor Shortages & Wage Inflation CHART 30 CHART 30 Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight CHART 31 CHART 31 Central Europe: Robust Growth - Overweight CHART 32 CHART 32 Central Europe: Robust Growth - Overweight CHART 33 CHART 33 Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities CHART 34 CHART 34 Chile: Robust Growth - Overweight Equities CHART 35 CHART 35 Chile: No Inflationary Pressures Chile: No Inflationary Pressures CHART 36 CHART 36 Chile: No Inflationary Pressures CHART 37 CHART 37 Chile: No Inflationary Pressures CHART 38 CHART 38 Chile: No Inflationary Pressures CHART 39 CHART 39 Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve CHART 40 CHART 40 Colombia: Currency Will Be A Release Valve CHART 41 CHART 41 Colombia: Currency Will Be A Release Valve CHART 42 CHART 42 Colombia: Currency Will Be A Release Valve CHART 43 CHART 43 Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 44 CHART 44 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral CHART 45 CHART 45 Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral bca.ems_wr_2018_08_16_s1_c46 bca.ems_wr_2018_08_16_s1_c46 Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments CHART 47 CHART 47 Peru: Vulnerable To External Developments CHART 48 CHART 48 Peru: Vulnerable To External Developments CHART 49 CHART 49 Peru: Vulnerable To External Developments CHART 50 CHART 50 Peruvian Equities - Underweight Peruvian Equities - Underweight CHART 51 CHART 51 Peruvian Equities - Underweight CHART 52 CHART 52 Peruvian Equities - Underweight CHART 53 CHART 53

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Inflation Is Rising In CE3 Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Labor Shortages = Higher Wages Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports ECB Policies Have Been A Boon For German Exports ECB Policies Have Been A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted German Wage Inflation Is Muted German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity ...Even After Adjusting For Productivity ...Even After Adjusting For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Bet On Yield Curve Steepening In Hungary Bet On Yield Curve Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Investors stand to benefit from Czech koruna revaluation versus the euro and also from positive carry, while waiting for the central bank to remove the exchange rate floor. Go long CZK / short euro. Economic fundamentals and policy divergence between Poland and Hungary point to a stronger zloty versus the forint. Go long PLN / short HUF.

Gold seems to be leading global share prices. Gold prices have rolled over since March 10. Hence, odds are that the U.S. dollar is about to bottom, and that global and EM stocks, as well as commodities prices, are about to relapse. We recommend two new trades in central Europe: Go long central European banks / short euro area banks and buy 10-year Polish domestic bonds.