At the start of 2019, we said that we were bullish on the stock market but that there were numerous risks that would cap the PSE index’s upside to 8,600.

While the arguments for why we were bullish proved to be correct, the impact of the risks that we highlighted (plus some more) proved to be much worse than expected, hurting foreign fund flows and sentiment for Philippine equities. As a result, the PSEi ended 2019 higher by only 4.7% to close at 7,815.26.

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Here are some of the positive developments that should have pushed the Philippine stock market much higher in 2019:

Falling inflation: After peaking at 6.7 percent in October of 2018, inflation has been on a downtrend in 2019, thanks to lower rice prices, lower oil prices and tightening measures implemented by the central bank in the second half of 2018. In the first eleven months of 2019, the average inflation rate was 2.5 percent, much lower than the 5.2 percent average inflation rate for 2018.

Falling interest rates: Largely due to falling inflation, interest rates declined sharply. The 10-year bond rate fell to 4.5 percent as of end 2019, which is even lower than its end 2017 level of 5.1 percent. Moreover, the BSP loosened its monetary policy by cutting its benchmark rate by 75 basis points and reducing banks’ reserve requirement ratio by a total of 400 basis points.

Strong economic growth: After averaging only 5.5 percent in in the fist half, GDP growth recovered in the third quarter, reaching 6.2 percent. Growth picked up due to the recovery of consumer spending (which suffered from poor consumer confidence in the first half) and the rebound of government spending (which suffered from the delayed passage of the budget and election spending ban in the first half).

Cheap valuations: At the start of 2019, the PSEi was trading at only 15.6X P/E, well below its historical average of 17.6X. At the said level, the implied earnings yield was 6.4 percent, higher than the 10-year bond yield of 5.1 percent.

Stronger peso: Finally, the peso strengthened instead of weakening, much to everyone’s surprise. Recall that the peso depreciated sharply in 2018 because of the government’s aggressive infrastructure spending program which led to a higher budget deficit and the current account deficit. Given the government’s plan to continuously increase infrastructure spending in 2019, everyone was bracing for the peso to depreciate. However, because of the government’s underspending caused by the delayed passage of the budget and the surprise drop of interest rates globally, the peso strengthened to end the year at 50.84 to $1 from 52.59 to $1 as of end-2018.

On the other hand, here are the negative developments that hurt the performance of the Philippine stock market in 2019.

Worsening US-China trade war: At the start of the year, the consensus view was that the US and China would come up with a trade deal in 2019. However, in May, the US surprisingly announced that it would resume with tariff increases and impose even more tariffs on Chinese goods. China retaliated by imposing more tariffs on American goods. The heightened uncertainty brought about by the worsening trade tension between the two countries hurt business confidence, prompting a lot of companies to hold back on their investments, negatively affecting global economic growth. Appetite for riskier assets such as emerging market stocks (including the Philippines) was also negatively affected, prompting most investors to shift to safe haven assets such as US sovereign bonds and gold.

Heightened regulatory risk: The Philippine government’s recent decision to revoke the extension of Manila Water and Maynilad’s water concession from 2022 to 2037 highlights the increasing level of regulatory risk in the country. As a result, even though our economic growth prospect is very attractive and valuations of stocks are cheap, concerns that the government can change regulations and provisions of contracts anytime is causing investors to stay away, especially from buying shares of companies that belong to highly regulated industries. Consequently, although several emerging markets already started to go up during the past few weeks, the PSEi has decoupled and continues to lag.

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Next year should be better for the Philippine stock market given favorable domestic economic conditions, attractive valuations of stocks, and the signing of the first phase of the trade deal between the U.S. and China. However, it remains to be seen whether investors will choose to ignore the heightened regulatory risk given everything else that is working in favor of the Philippines.

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