Abrogation of US military agreement suspended
The Visiting Forces Agreement (1999) between the Philippines and the US establishes a legal framework for the presence of US troops and the conduct of joint military exercises. In mid-February 2020, President Duterte gave notice that the agreement would be scrapped in mid-August. On 2 June, Foreign Affairs Secretary Locsin Jr announced the termination would be delayed by six months to a year.
Walking the US-China tightrope
The wider context of this agreement is the re-balancing of foreign relations between the US and China, which has accelerated under President Duterte (at times, against the wishes of his military).
The US has provided security cover since the end of the Second World War (motivated both by its Cold War with the USSR and its imperative to dominate sea transit in the Pacific Ocean).
China has more recently enforced its territorial claims ("9-Dash Line") in the South China Sea which has brought it into conflict with the Philippines among others, largely due to oil and gas resources in disputed waters. In contrast to its disputes with Vietnam and Malaysia, China has agreed to joint drilling with the Philippines (in Reed Bank). Furthermore, China (including Hong Kong) is now almost double the size of the US in terms of Philippines exports.
Along with every other country in Asia, the Philippines is having to walk a tightrope between the US and China and, thus far, it appears to be doing this rather well.
Philippines equities attractive value, but remittance (GCC) and Covid-19 present headwinds
We remain positive on Philippines relative to the global universe of small emerging and frontier markets because of attractive value, low-risk FX rate, established export, remittance and tourist streams, modest structural reform (of infrastructure, security, and tax), and balanced geopolitical relations. Our favourite markets in Asia are still Pakistan (deep structural reform of governance) and Vietnam (diversified exports).
Philippines equities, measured by the local PSEi Index, are down 18% ytd compared to down 9%, 12% and down 17% for MSCI Asia ex-Japan, EM and FM, respectively.
Trailing PB is 1.5x (11% ROE), a 35% discount to the 5-year median, wider than the 10-15% discount for Asia ex-Japan, EM and FM.
Forward PE is 17x (negative 12% aggregate EPS growth), in line with the 5-year median.
The strengths of the Philippines investment case are the following:
Balanced international relations between the US and China.
Multiple sources of FX generation (electrical equipment exports, business process offshoring, diaspora remittances, tourism).
High productivity in manufacturing (higher than China and 10x that of Vietnam).
Structural reform of security, infrastructure and tax under President Duterte.
Cheap equity valuation versus history.
The top-down investment risks are the following:
Real effective exchange rate (REER) implies over a 10% over-valuation and 6% above the last 10-year median.
Deterioration of remittances from the GCC in a lower oil price environment.
Disruption from Covid-19 (to domestic activity, tourist inflows, remittances).
The transition from an era of twin surpluses to (modest) twin deficits (fiscal and current account deficits will average 3.0% and 2.2% over 2020-21, according to IMF forecasts).
Derailment of structural reform of tax and infrastructure as the next election (2022) approaches and the challenges of managing Duterte's succession takes centre-stage.
Indigenous gas production has peaked which makes successful offshore exploration, in conjunction with China, critical for fuel security.
Poor logistics (the worst in the larger ASEAN economies) likely are a constraint on foreign direct and domestic capex in new manufacturing.
Large scale private sector activity is dominated by a relatively small group of family interests (which may reduce incentives for innovation and efficiency and create operating risk should contracts between government and big business become politicised, as seen at the end of 2019).