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BY DR ARUP RAHA, CHIEF ECONOMIST OF RHB
Navigating in the new Malaysia

There is an old saying that goes, "The more things change, the more they stay the same". For Malaysia’s economy and financial markets, this aphorism has probably never been truer.

After 61 years of successive Barisan Nasional (BN)/Alliance governments, GE14 resulted in the first ever win by an opposition party, in this case Pakatan Harapan (PH), an alliance of four parties. It was a major change indeed and essentially meant that the capital markets were headed for uncharted waters.

As we all know, and were reminded numerous times during the post-election weekend, markets dislike uncertainty. Market participants were therefore prepared for a down and volatile day on May 14 when financial markets opened for the first time after the election results. Yet, after an opening sell-off, equity markets rebounded and ended the day modestly higher. Bond yields and the ringgit ended the day close to flat, signalling that the markets were far from nervous, indeed hopeful.

The initial apprehension aside, a closer look tells us that the management of the economy is in very safe and experienced hands. The Prime Minister Dr Mahathir Mohamad has a long history of successful policy making, including a masterful and, some would say, unorthodox navigation through the Asian Financial Crisis of 1997/98 where Malaysia escaped with minimal damage.

The PM has also appointed a “Team of Eminent Persons” who will help guide the economy during the first 100 days. This council is as distinguished a group as one could possibly put together: Former Finance Minister Daim Zainuddin; former Bank Negara Governor Dr Zeti Akhtar Aziz, who was widely regarded as one of the best in the world during her time; Tan Sri Hassan Marican; Tan Sri Robert Kuok; and Dr Jomo KS. Each is a stalwart in his or her own field. Add to that the newly appointed Finance Minister, Lim Guan Eng, who has a successful track record as Chief Minister of Penang.

other words, as far as economic management is concerned, markets do not need to have any fears on account of the change in the government. To be sure, there are challenges ahead, both political and economic, but for now, markets were willing to give the government the benefit of the doubt. While the leadership has changed, the economy still looks the same. And that is good news.

starters, the economy is on a firm footing. GDP growth was 5.9% in 2017, a strong showing based on robust export growth which, in turn, was aided by a resurgent global economy. In the first quarter of this year, the economy slowed to 5.4% growth but that was to be expected as global growth was unlikely to keep up its 2017 pace. On the domestic side, there appears to have been some postponement of investment activity in the lead-up to the elections and we expect a pick-up with the uncertainty gone. Consumer spending is robust at close to 7% and with wages rising, we expect that to stay unchanged.

there are challenges, though most of them are external. Growth appears to have peaked in the EU and Japan, though it remains strong in the US and China. The continued divergence in growth rates between the US and the EU and Japan has led to enhanced expectations of rising interest rates in the US and consequently, a stronger US dollar. We continue to expect the US Federal Reserve to raise rates three more times this year and the US dollar to remain under appreciation pressure.

We believe the current market dynamics can be leveraged by adopting a trading strategy. With the market still adapting to the implications of the PH government, portfolio rebalancing initiatives remain underway and will offer trading opportunities created by possibly overzealous selling.

The global environment means that emerging markets are likely to be under pressure of capital outflows. Some emerging markets such as Argentina and Turkey have come under extreme pressure, so some people are starting to worry about a crisis. We think that is unlikely in an Asian country, but nonetheless, ever since the US dollar started strengthening this year, ASEAN economies, in particular Indonesia and the Philippines, have also been under pressure. Malaysia had been the recipient of inflows — US$937.8 million went into the equity market for the year until the end of April — but that reversed with outflows totalling US$1.4 billion in May. Managing the exchange rate and domestic interest rates will be a challenge if outflows persist.

As the US Fed raises rates and the US dollar strengthens, Bank Negara will face a choice between raising rates and letting the MYR weaken. Most likely, it will do a bit of both, but the bias will be to hold rates steady. A weaker currency, as long as the process is orderly, imposes a lower cost on the economy.

Recent prints of the Consumer Price Index have been in the order of 1.3%-1.4% and with the government planning to fix the domestic price of oil, there is some slack on the inflation front. Also, a weaker MYR versus the US dollar will increase the ringgit value of US dollar debt. With short-term external debt at about 28% of GDP, the sovereign balance sheet should be able to handle some MYR weakness. On the other hand, with household debt at 84% of GDP and government debt possibly at 65% of GDP, the economy is probably more sensitive to interest rate increases.

The other challenge is domestic — the management of the fiscal accounts. With the Goods and Services Tax (GST) now at 0% and the Sales and Service Tax (SST) set to be implemented on September 1, there is likely to be a loss of fiscal revenue. Add to that, the reintroduction of fuel subsidies and a pay rise for civil servants, the loss of revenue could be substantial. To be sure, some benefit will come from higher oil prices, as government revenue increases by about RM300 million with every US$1 increase in oil prices. The budget had assumed that oil prices would average US$52 a barrel for this fiscal year but year to date, they are averaging close to US$70 a barrel.

By our calculations, there will still be a revenue shortfall of close to 1%-1.5% of GDP that will need to be made up on the expenditure side if the fiscal deficit is to be kept as its projected level. The government has indicated it will take initiatives to reduce waste and rethink some projects. We believe that market participants should watch these developments closely.

So, what does all this mean for financial markets? Since the beginning of the year, we have believed that markets are being too complacent about the outlook of the US interest rate and that the Fed Funds rate and long-term bond yields would rise more than expected. That, in turn, meant that the US dollar would strengthen against most currencies, including the ringgit. That view remains unchanged. That said, nearly all emerging market currencies and yields are currently under pressure as US bond yields have risen. Malaysia is in a relatively strong position, supported by a current account surplus, modest domestic inflation and higher oil prices.

Our view pre-election fundamental view of the equity market remains largely unchanged, but there are challenges in the short term. As highlighted above, most of the risks are external, from the state of the world economy, possible trade friction and geopolitical uncertainties in the Korean peninsula and the Middle East. Moreover, we remain hawkish on US interest rates. Domestically, there is uncertainty too, mostly on how policies will be executed.

We believe the current market dynamics can be leveraged by adopting a trading strategy. With the market still adapting to the implications of the PH government, portfolio rebalancing initiatives remain underway and will offer trading opportunities created by possibly overzealous selling. This year, until the end of April, there had been strong foreign inflows into large-cap stocks but in about 11 days of trading after the elections, the inflows reversed.

The construction sector is moving into a state of flux, gripped by uncertainty over which projects are going to be subject to review. There are differing views on how quickly this process can be concluded. Anecdotal evidence suggests that we could see an uptick in consumer confidence as inflation abates with the cessation of the GST and the new government puts in place populist measures.

Evolving developments and steady foreign selling could keep the benchmark index volatile in the near term. We retain our end-2018 FBM KLCI target of 1,850 points (16x forward earnings). Key OVERWEIGHT sectors include banks, gaming, oil and gas, rubber products, healthcare, basic materials and utilities.

Attributed to the French critic and novelist, Jean-Baptiste Alphonse Karr, who wrote plus ça change, plus c’est la même chose in Les Guêpes, January 1849
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