A weakening economic outlook and deepening political risk have kept Malaysian assets on the defensive. We see both of these drivers remaining intact in H2 2016.
Political risk remains high due to the ongoing 1MDB scandal. Even though the domestic authorities have closed the book on the matter, other countries continue their investigations. Singapore recently shut down BSI SA’s local unit even as Swiss authorities began criminal proceedings against the parent bank due to questionable money flows related to 1MDB. Authorities from the US, UAE, and Luxembourg are also reportedly looking into 1MDB and so there is risk of further negative developments.
Due to the lack of a credible alternative, the ruling Nation Front coalition is likely to remain in power for the time being. Indeed, the ruling coalition recently won big in the state of Sarawak, winning 72 out of 82 seats in the state assembly. The next general elections are due in 2018.
Prime Minister Najib has basically purged the ruling UMNO party of any rivals at all levels of government. Casualties include former Prime Minister Mahathir’s son Mukhriz, a Najib critic who was ousted from his post as Chief Minister of Kedah state back in February.
Gerrymandering has basically made it impossible to mount a credible challenge, however. In the last election in 2013, the opposition won only 47% of the vote (the lowest ever) but this translated into 60% of the parliamentary seats (133 out of the total 222 seats). This was the first time that the opposition won a bigger share of the popular vote than the ruling coalition did.
The economy remains sluggish. GDP growth is forecast to slow modestly from 5% in 2015 to around 4.3% in 2016 before recovering modestly to 4.5% in 2016. GDP rose 4.2% y/y in Q1, slower than expected and the weakest since Q3 2009. As such, we see downside risks to the growth forecasts.
Price pressures are easing, with CPI up only 2.1% y/y in April. This is the lowest rate since May 2015. Although the central bank does not have an explicit inflation target, we think it will tilt more dovish in H2 if the slowdown continues. The central bank has been on hold since July 2014, when it hiked the policy rate by 25 bp to 3.25%. Next policy meeting is July 13, but no changes expected then.
Fiscal policy has remained prudent. Despite lower oil prices cutting into government revenues, the budget deficit remained near -3% of GDP in 2015. It is expected to remain steady around -3% in 2016 and 2017. However, there are risks as the 2018 election approaches, as the government will most likely open up the spigots in an attempt to buy support.
The external accounts are in decent shape. Lower oil prices have reduced exports, but this has been offset by downward pressure on imports due to sluggish growth. The current account surplus is expected to be around 2% of GDP in 2016 and 2.5% in 2017. Foreign reserves have rebounded to around $97 bln in May after falling as low as $93.3 bln back in September.
We see downgrade risks ahead. Our own sovereign rating model rates Malaysia at BBB+/Baa1/BBB+, which is below its actual ratings. Moody’s cut the outlook on its A3 rating on Malaysia from positive to stable back in January. Fitch moved the outlook on its A- rating on Malaysia from negative to stable last June. Lastly, S&P affirmed the stable outlook on its A- rating back in March.
Of note, troubled 1MDB just made a scheduled payment of MYR143.8 mln on its Islamic debt. This was important, as 1MDB had technically defaulted on two payments due to a dispute with its guarantor, Abu Dhabi’s IPIC. 1MDB President Kanda said ““1MDB has ample liquidity to make interest payments and service its current debt obligations. 1MDB reiterates that, notwithstanding the dispute with IPIC, it will continue to honor current debt obligations.”
The ringgit has outperformed within EM in 2016. In 2015, MYR lost -18.5% vs. USD. This was one of the worst performers, behind only ARS (-35%), BRL (-33%), ZAR (-25%), COP (-25%), RUB (-20%), and TRY (-20%). So far this year, MYR is up 4% YTD, behind only RUB (10% YTD) and BRL (9.5% YTD). This outperformance could ebb a bit, as our EM FX model shows the ringgit to have NEUTRAL fundamentals.
USD/MYR has retraced nearly half of the January-April drop. The 50% retracement objective comes in near 4.1430, while the 62% level comes in near 4.2130. Break above that is needed to set up a test of the January high near 4.4415.
Malaysian equities have underperformed within EM. Last year, MSCI Malaysia was -5.5% vs. -16.6% for MSCI EM. So far in 2016, MSCI Malaysia is -2.5% YTD, and compares to +0.9% YTD for MSCI EM. This underperformance should continue, as our EM Equity model has Malaysia at an UNDERWEIGHT position, down from NEUTRAL the previous quarter.
Malaysian bonds have done all right this year. The yield on 10-year local currency government bonds is about -25 bp YTD. This is in the middle of the pack. Compare this to the best performers Brazil (-352 bp), Peru (-99 bp), and Indonesia (-85 bp), as well as the worst performers Poland (+17 bp), China (+15 bp), and Hungary (+15 bp). With inflation likely to remain low and an easing cycle potentially starting in H2, we think Malaysian bonds could start outperforming more.