The Philippines: Is this a good starting point?

As a domestically-oriented and consumption-driven economy, the Philippine archipelago is heavily dependent on imported goods. The associated capital outflows should lead to large current account deficits. However, huge remittance inflows from overseas Filipino workers (OFWs) and revenues from business process outsourcing (BPO) have seen the Philippines accumulate a sizeable current account surplus from 2004 to 2015. Even though the government shifted to a more aggressive fiscal stimulus in 2016, the resulting current account deficit position has only been a modest 0.3-2.6% of gross domestic product (GDP)¹.

These accumulated surpluses have enabled the Philippines to reduce its external debt levels (from 69% of GDP in 2003 to 24% in Q2 2019)², thereby becoming less dependent on external funding. In April 2019, in recognition of improved financial conditions and solvency, the international credit rating agency Standard & Poor’s raised the country’s sovereign rating by another notch to BBB+³. This investment grade rating speaks to the nation’s enhanced ability to meet its debt payment obligations.

A stable currency, coupled with lower oil prices and a slower increase in domestic food and non-alcohol beverage prices, has helped ease inflation, a nagging worry in 2018, to within the Philippine central bank’s (BSP) target of 2-4% (see Fig. 1). Benign inflation has in turn created more room for monetary easing to revive the economic slowdown stemming from the US-China trade war, global recession fears, and other domestic factors.

Fig 1: The Philippines macro forecasts⁴

*A negative balance represents a ‘deficit’ whilst a positive balance represents a ‘surplus’.

In a decisive move, in 2019, BSP reversed the rate hike cycle and reduced policy interest rates by 75 basis points to alleviate borrowing costs. To ensure ample domestic liquidity supply, the central bank also lowered the required reserve requirement ratios (RRR)⁵.

As interest rates have fallen, the national government has also pledged to increase its fiscal spending again after a budget delay (when the economy was overheating in 2018). At the forefront is a comprehensive tax reform programme, which aims to relieve the burden of low-income groups yet broaden the tax base to fund an extensive infrastructure overhaul.

Greater fiscal spending and monetary easing have helped economic growth to rebound (from 5.5% in Q2 2018 to 6.2% in Q3 2019⁶); domestic liquidity to improve, and the equity markets to recover (see Fig. 2).

Fig 2: Recovery in Philippine equities in 2019⁷

The aggregate earnings for the companies in the Philippine Stock Exchange Composite (PSEI) index are expected to grow by nearly 20% in 2019, after the profit growth slowed to sub 5% in 2018. While the profit growth appears on track, the price has trailed, making the equity market more attractive. The PSEI is currently trading at a forward price-to-earnings (P/E) ratio of 13.6, much lower than the last 10-year average of nearly 15.5x⁸. Beyond the PSEI index universe there are more attractive opportunities

We are finding undervalued opportunities in smaller companies, which also happens to be an under-owned market. The forward P/E ratios of small- and mid-cap stocks (a total of 96 stocks listed on the Philippine stock exchange are in a ‘very attractive’ range, more than one standard deviation below their 10-year average levels (refer to Fig. 3). Such stocks present attractive opportunities in a market where the chasing liquidity shored up the valuations of large-cap counterparts.

Fig 3: Small- and mid-cap equity valuations in attractive territory by historical standards⁹

*The ‘Z’ valuation is a measure of the deviation of forward price earnings ratios. Retail Con. Disc. refers to retail consumer discretionary. Number of stocks is stated in brackets.

At the same time, there are also ‘undervalued’ stocks with strong fundamentals that exist within less glamorous industries. Utility stocks, for example, with their high dividend yields (~3.9%), defensive nature and compelling valuations (an 8.9x forward P/E ratio), make an attractive investment case.

We are also finding mispriced opportunities in the real estate sector, which is an obvious beneficiary of favourable demographics, rising income levels and demand for office space from the BPOs. Select real estate stocks are not only trading at attractive P/E ratios compared to history (see Fig. 3), but also at a deep discount to their revalued net asset values (RNAV).

As policymakers embark on easing measures to mitigate downside growth risks, the current account will likely remain in deficit in 2020 (see Fig. 1). Nevertheless, we take comfort that the deficit remains less than 3%. The market seems to have adjusted to the new normal of a current account deficit; therefore, the rapid depreciation of the Philippine Peso – as seen over the last few years – may not be repeated.

Other factors to monitor are the government’s clampdown on Philippine Offshore Gaming Operators (POGOs) and its dispute with two of the country’s largest water providers in Manila.

In August 2019, the government suspended the issuance of new POGO licenses. Since 2016, 60 POGOs have been set up to provide online gambling services to foreigners. The industry currently employs 470,000 workers, representing roughly 3.3% of the Philippines’ GDP¹⁰. The current suspension appears to be temporary and will end in December 2019. Nevertheless, the social costs and economic benefits of the online casino industry are likely to continue to be debated.

In December 2019, the country’s water regulator repealed an extension of the water concession deals with two of its largest water utilities¹¹.The Duterte administration has attributed the country’s water shortages to water providers which “inefficiently delivered water to households”. If this is the case, and one sees the revocation as a move to address the problem, the long-term development is important to watch.

All in all, as the Duterte administration enters the second half of its six-year term, key economic reforms should have a better chance of obtaining approval from both houses of the legislature. If executed consistently, the structural reforms will enable the building of fiscal space to fund infrastructure spending, enhance external competitiveness, and reduce micro economic inefficiencies. That said, the policymakers must also consider the practical and legal consequences before making any decisions on what measures to undertake next.

The Philippines macro is finding its feet again with cooling inflation, favourable monetary conditions, a manageable current account deficit and the expected recovery in earnings growth. Perhaps the equity market too will find its legs, especially with the aggregate valuations falling into the ‘fair to attractive’ zone compared to history.

We continue to believe in the Philippines structural story; patient and disciplined investors will continue to get rewarded over longer time frame.