Global growth is in the middle of a dip dragged by a cocktail of factors. Both global manufacturing and services are currently showing signs of slowing rather than collapsing. Thus, our base case global GDP growth for 2019 remains at 3.2% while for 2020 has been revised down to 2.8% from 3.5% previously. But downside risk global GDP remains high with our worst-case projection at 1.0% for 2020. Bonds markets are already flashing warning signs with yields inversion.

Underpinned by recession concerns, monetary easing will remain. The last time so many central banks cut rates or considered stimulus in unison was during the 2008 financial crisis. Cheap monetary policy is to support growth in an environment of low inflation. But such move comes with a danger — it could tip off a monetary policy race to the bottom.

But with both inflation and interest rates at historically low levels, it leaves less room for the authorities to encourage lending and spending with cheap money. More so, with banks being prudent in driving their lending. Thus, rate cuts could increasingly focus on reducing the value of the currencies that will make exports more attractive and imports expensive which in turn will prop domestic prices.

Thus it will raise the risk of a currency war. Today, the focus is on yuan fixing against the USD. If the trend continues to weaken, it heightens the pace of global interest rate cuts, a move to further weaken their respective currencies to maintain competitiveness. And currency war will do little to boost global growth prospects. It will also be tough for the dollar to weaken due to its dominant presence in global financial markets. What could happen is that governments which are better prepared this time around with healthy foreign exchange reserves will defend their respective currencies or alternatively curb speculative activity in both onshore and offshore markets through tightening of capital controls.

Hence, it could be time to focus on fiscal spending. The risk of cheap monetary policy likely to be less effective in current circumstances remains high. It is not due to some intrinsic weakness, but due to the context in which it is operating seems unhelpful. Consumers and businesses are used to low rates of the past decade to expand their borrowing, and many are now facing leverage limits. Continued restrictions on access to financing will discourage capital investment, research and development and other productivity enhancing expenditures.

On the currency outlook, we foresee the dollar to remain positive though the US economy has become like a rowboat with one oar supported by the services sector with manufacturing losing steam. With the debt ceiling is now suspended for two full years until July 2021, dollar liquidity tightening will emerge as the US Treasury will rebuild its general cash account (GCA) to normal levels by US$280bil–US$350bil for the rest of 2019, a move seen as a form of quantitative tightening and the dollar becomes positive. And continued global rate cuts will still see dollar be on the positive trend.

As we move ahead, we expect dollar strengthening to continue. Uncertainty clouding the Eurozone economy will stress the euro dollar. The UK’s 2Q2019 GDP contraction is a rude awakening and with Brexit, the outlook for pound remains bearish. The BoJ faces tough decision on the next move, and we see yen appreciation is due to its safe haven status. The Chinese yuan faces three-case scenario: (1) a full-blown trade war where the yuan is expected to depreciate by 10% to offset the 10% tariff impact on Chinese goods; (2) a gridlock where the yuan may not weaken or strengthen too much against the dollar but is range-bound, reaching a low of 7.10; and (3) a trade deal that will see the yuan appreciating gradually against the dollar to around the 6.99 level.

On the ringgit, it will be impacted by several factors. Our view of a stronger dollar due to tighter dollar liquidity and its status as safe haven will add downwards pressure on the ringgit. Global interest rates movement will also impact ringgit direction. We believe global monetary easing will continue as countries will use cheap rates to weaken their currencies and maintain comparative advantage. Thus, we expect BNM to follow the trend of the global interest rate cycle than to stay behind the curve.

The direction of the yuan also plays an important role. In our worst-case scenario, the ringgit could fall by 8%– 10% against the dollar should the yuan fall by 10% against the USD. The base case suggests a more range-bound scenario between 4.15–4.20 against the USD. Our base case suggests the ringgit could reach 4.05–4.10 provided there is a trade deal between the US and China that will see the yuan appreciating gradually against the dollar.

Weakness in the yuan will put the brakes on other currencies in the region, including the Indian rupee, Singapore dollar, Korean won, Malaysian ringgit and Indonesian rupiah from sliding against the dollar. However, the Korean won will be the biggest loser due to its strong dependence on China and the US where South Korea is closely interlinked in the supply chains between these two countries. Also, the won is being hit by the dispute with Japan, which has spilled into trade between the two Asian neighbours. The most resilient currency in Asia will be the Thai baht. Despite attempts by Thailand’s central bank to weaken it by slashing the policy rate, the baht is being supported by the country’s large trade surplus, low inflation and steady growth.

A. Global growth risks recession

• Global growth is in the middle of a dip despite witnessing a tightness in labour markets in most of the developed economies. Growth is being dragged by a cocktail of factors like trade tension, Brexit, debt crisis, political tension and a much slower-than-expected growth from the US, Eurozone and China.

• Hence, global manufacturing witnessed a slump with declining business confidence. It was reflected by a marked downshift in the global manufacturing PMI which fell for the first time since October 2012 to 49.4 in July and posted a back-to-back sub-50.0 readings for the first time since the 2H2012. It signalled output has stopped growing while inflows of new business shrank, thus impacting business optimism. Conditions will need to recover significantly if manufacturing is to revive later in the year.

• Though there are pockets of extreme weakness in the global economy — particularly in manufacturing — the service sector is holding up relatively well and is expected to support growth. Global services PMI in June was at 51.9, up from May’s 33-month low of 51.6. Though the services PMI may have improved slightly, it requires a revival in business confidence to improve solidly in the coming months.
• Nevertheless, the performance of global manufacturing and services PMI are all consistent with our view that global growth is slowing rather than collapsing. And so, our base case global growth for 2019 remains at 3.2% while for 2020, it has been revised down to 2.8% from 3.5% previously.
• Still, we feel that the downside risk to global growth is high. The bond market that is already flashing warning signs. There are 6 big risks that can derail our growth projection. They are: (1) trade war between China and the US that will continue to hurt overall confidence besides being an open-ended trade war which is unilateral; (2) central banks fail to act causing a negative reaction in financial markets that feeds through to the real economy; (3) a rise in the risk of liquidity trap despite easing interest rates due to lack of fiscal support which in turn drags overall confidence; (4) global services that have been supporting growth start to mirror the downturn seen in manufacturing; (5) the risk of debt crisis emerging; and (6) political tensions in the UK, Eurozone and other regions.

B. Exchange rate becomes target of cheap monetary policy

• Underpinned by recession concerns, 20 central banks around the world have cut interest rates this year. The last time so many central banks cut rates or considered stimulus in unison was during the 2008 financial crisis. The move since the start of 2019 collectively stopped the gradual monetary tightening policy that was carried out with the aim of moving back to normal levels after instituting cheap monetary policy in an effort to recover from the Great Recession.

• The monetary easing in 2019 is a move is to support growth in an environment of low inflation amid rising concerns over slower global growth as a result of a set of downside global risk factors. While such move could help to stave off a painful downturn, there is a danger — this could also tip off a monetary policy race to the bottom.

• Traditional practice by the central banks is to cut rates or buy bonds in order to stoke spending and borrowing at home. But in many places, both inflation and interest rates are at historically low levels. It leaves less room for the authorities to encourage lending and spending with cheap money. Thus, rate cuts could increasingly focus on reducing the value of the currencies that will make exports more attractive and imports expensive which in turn will prop domestic prices.

• So, the current move by the global central banks to lower rates suggests that we are increasingly looking at a world where the exchange rate becomes the objective of monetary policy, of interest rates. With limited if not hardly any growth as well as inflation, the weakening of the currency is to import inflation.

• But most have avoided explicitly tying monetary decisions to foreign exchange out of fear of being called manipulators, which could bring geopolitical risks. Using rates to control currency levels is costly. It can spark devaluation at the direct expense of its trading partners and is likely to be short-lived before other countries cut rates or buy bonds to compete. It risks fueling a full-blown currency war.

C. Currency war can lead to selective controls

• Trade tensions between the US and China is now on the verge of triggering a currency war. From about 2000 to mid- 2014, the PBoC intervened aggressively in foreign exchange markets to prevent the yuan from appreciating fast against the USD. By doing so, China gained competitive advantage over its exports. But since mid-2014, the intervention has been in the opposite direction — to prevent the yuan from depreciating too much or too quickly against the USD, a move to ensure China maintains its comparative advantage.

• The recent US-China trade tension saw the yuan-dollar peg surpassing the thin line of 7.00, its lowest level since 2008 and it has not dipped back below the 7.00 since then. As a result, several central banks like New Zealand, Thailand and India acted aggressively by cutting their policy rates sharply in a defensive move to protect themselves from the collateral damage resulting from rising global trade tensions amid weakening domestic growth. Major advanced economies’ central banks like the Bank of England, Bank of Japan and European Central Bank are likely to loosen monetary policy in the coming months to deal with the travails of their own economies. A further rate cut by the US Fed is also on the table.
• Today, the focus is on yuan fixing, where it could reach 7.05–7.10 against the USD. Thus, we expect more countries globally to cut their policy rates to weaken their respective currencies in order to support growth and maintain comparative advantage in an environment where the world economy is slowing down.
• Currency devaluation is seen as a policy tool for economies suffering from slowing growth or dealing with trade disputes. It carries a huge risk on those countries and for the global economy. A cheaper currency is seen as an easy and convenient way to boost domestic growth and retaliate against trade sanctions imposed by other countries. But the actual benefits are likely to be brief while the costs in disrupted trade and lost growth could be huge.

• Currency war will do little to boost US growth prospects. It will be tough for the dollar to weaken due to its dominant presence in global financial markets. It will be hard for the US to engage in a unilateral intervention on a scale large enough to influence the dollar against other major currencies, especially if the US Fed stays on the sidelines on its policy rate. And a move by the US will incite a broader currency war, with other countries stepping up their own retaliatory intervention. The resulting turmoil in financial markets could actually firm up the USD if investors turn to it for safety.

• Meanwhile, China may want to prevent any further devaluation in order to curb capital flight. In 2015–16, Beijing witnessed some US$1 trillion of its US$4 trillion foreign-exchange reserves used to defend the yuan due to capital flight. Besides, a deep depreciation of the yuan will trigger a debt crisis as the borrowers’ risk struggling to repay foreigncurrency debts in a devalued yuan. Non-financial companies owe US$800 billion in dollar debt or 6% of its GDP, while Chinese banks’ exposure of USD debts is around US$670 billion or 5% of GDP.

• Property developers have issued USD bonds worth billions to exploit the very cheap US interest rates even as their profits decline at home. Capital flows through Hong Kong and elsewhere make it difficult to detect all of China’s foreign indebtedness. Thus, a sudden wave of defaults of USD and other currency debts triggered by exchange-rate stress would kneecap China’s economy, perhaps raising the risk of falling into its first recession post-Mao reform era.

• There are other costs for the world economy. A stronger USD would end up creating collateral damage in some emerging market economies, on account of balance-of-payments pressures caused by large amounts of dollar-denominated debt as a result of weakening currencies.

• All these tremors in currency markets will add to the uncertainty already caused by global trade tensions. This uncertainty, in addition to the exchange rate volatility triggered by currency wars, will keep business investment weak and continue hurting productivity and employment growth around the world.

• What could happen is that governments which are better prepared this time around with healthy foreign exchange reserves will defend their respective currencies from such a destructive spiral much earlier. Alternatively, the governments might shut down speculative activity in both onshore and offshore markets. Any tightening of capital controls to reduce capital flow volatility would spook foreign investors.

D. Time to focus on expansionary fiscal policy

• The risk of cheap monetary policy likely to be less effective in current circumstances remains high. It is not due to some intrinsic weakness, but due to the context in which it is operating seems unhelpful. Lowering interest rates may not be powerful enough. Consumers and businesses are used to low rates of the past decade to expand their borrowing, and many are now facing leverage limits. Continued restrictions on access to financing will discourage capital investment, research and development and other productivity enhancing expenditures.

• Thus, active macro-prudential policy is needed to avoid a situation leading to financial instability. Countries with fiscal space can use the fiscal policy to support growth. There is a need to look at expansionary fiscal policy, where government spending rises and risks leaving its fiscal deficit higher than earlier projected.

• The feeling of a higher budget deficit is bad and budget surplus is good since the government needs to go into more debt to cover its expenses and subsequently drags markets down may not be true. This is especially so should the government plan to operate under a higher deficit supported by strong governance and transparency as well as well targeted and temporary. It will not exert a strong pressure on the ability to service the debt.

• Hence, the fiscal space should not be determined by merely focusing on the level of public debt. In fact, public debt-toGDP ratio can improve over time and create additional fiscal space. It is a dynamic concept that varies with market and economic conditions, sometimes quite quickly and substantially.

• Thus, the government should rely on a multi-faceted approach using various other indicators and tools like the composition and path of public debt; financing needs; assets that can be drawn upon; future spending commitments; effectiveness of fiscal policy; and the strength of fiscal institutions and fiscal rules to boost credibility and market access.

• In our view, a well-executed fiscal stimulus will boost the dynamics of the economic activity and outweigh the initial deterioration in its fiscal position. It could potentially lower the public debt-to-GDP ratio and create more fiscal space. Government spending can increase the velocity of money — the rate at which money circulates in the economy — and even more if used well. A higher velocity of money is good as it shows the robustness of the economic activity, with companies and individuals feeling confident and spending accordingly.

• Regardless of why or when the next slowdown or recession will be, it is important to use every effective tool available to end a potential slowdown as soon as possible, and steer the economy back on a growth path. The tools will need to boost the spending of households, businesses and governments to relieve the aggregate demand shortfall that is the fundamental cause of a potential slowdown or recession.

• Hence, the fiscal spending must be large enough, temporary and targeted, and focus on key trends reshaping the global economy i.e. shifting demographics, rapid technological progress and deepening global economic integration. Those with limited budgetary room should adopt inclusive and growth-friendly strategies.

• And to avoid fiscal stimulus from raising interest rate and crowding out private investment, the monetary policy will play an important role by creating more liquidity and keep interest rates low to support private expenditure. Also, it needs to create and facilitate better credit growth in targeted areas, synchronizing with the fiscal policy.

E. Forex Outlook – Positive On Dollar

1. Though US economy has become like a rowboat with one oar, we foresee positive trend on USD

• US economy has become like a rowboat with one oar. The services sector is propelling the economy forward and keeping it above the water where most are employed while the manufacturing sector basically pulled its oar out of the water. The services sector recorded the strongest rise in business activity since April to 52.2 in July offsetting a downturn in manufacturing output which reported at 50, a 118-month low. The slowdown in the US manufacturing dovetails with weakness in Europe and Asia that is weighing on the global economy, though the US is doing better by comparison.

• Overall, we foresee a modest growth that conceals a two-speed economy, with a steady service sector growth masking a deepening downturn in the manufacturing sector affected by the increasing rate of loss of export sales. With manufacturers shedding workers at the fastest rate since 2009, services sector job creation is now down to its lowest since April 2017.

• Besides, the economy is expected to experience a collision between two policies. With the US president having signed the new debt-ceiling bill on 2 August, it means that the debt ceiling is now suspended for two full years until July 2021. Thus, it should open the door for higher spending. However, this will be less attractive, especially the Democrats will be less supportive of further fiscal stimulus measures with the US presidential election in November 2020.

• Besides, the US is seen to be looking like Japan with its fiscal deficit to stay above 4% for a period. Budget balance/GDP is projected to be around -4.6% in 2019 from -4.3% in 2018. Thus, chances of additional stimulus is limited. Hence, the pressure is on the Fed to loosen its policy. We expect a loose monetary policy in 2019 and 2020. But the risk is that it may fall into liquidity trap due to lack of fiscal support given that the loose fiscal policy used by the US president is fading away. Also, both businesses and consumers have already been enjoying the low interest rates from the 2008 crisis.

• With the debt ceiling now suspended for two full years until July 2021, it will impact dollar liquidity. If the debt ceiling is not suspended, the US Treasury will not be able to borrow by October and this will force the US Treasury to draw down its general cash account (GCA) at the Fed to pay its bills. Such a move will raise liquidity in the banking system and increase the amount of bank reserves. It is a form of quantitative easing.

• However, with a debt ceiling deal having settled, it will now reduce liquidity from the banking system from 3Q2019 since the US Treasury will now have to rebuild its GCA to normal levels by US$280bil–US$350bil for the rest of 2019. It is seen as a form of quantitative tightening that will tighten dollar liquidity and the dollar becomes positive.

• Taking into account of the debt ceiling being settled and global central banks lowering their policy rates in order to weaken their respective currency value against the dollar to maintain their comparative advantage since yuan fixing will remain above 7 going forward, the dollar will stay on a positive trend.

2. Uncertainty clouding Eurozone economy stresses euro dollar

• Softening global growth and trade will continue to weigh on the Eurozone’s outlook. Despite showing some signs of resilience, economic sentiment is low, especially in the manufacturing sector due to a prolonged period of uncertainties, political factors, protectionism threat and vulnerabilities in emerging markets.
• Following a +0.4% q/q 1Q2019 GDP growth, recent data suggests a slower Eurozone GDP outlook in 2Q2019. PMI manufacturing from Germany tumbled to its lowest level in seven years to 43.1 from 45.0 in June while French PMI manufacturing slowed unexpectedly to 5.19 in July from 52.7 in June. Meanwhile, the headline Italy’s manufacturing PMI remained below the 50 mark for the 10th month running in July, reading at 48.5 from 48.4 in June.
• More importantly, 2Q2019 German GDP dropped by 0.1% q/q from +0.4% q/q in 1Q2019, marking the end of a decade of expansion where the economy grew on average by 0.5% q/q since the end of the 2008/9 recession, expanding in 35 of the last 40 quarters. Manufacturing and construction bore the brunt of trade conflicts and Brexit uncertainty.

• It shows that the German economy is teetering into recession though domestic demand demonstrated resilience due to the services sector offsetting much of its trade-related industrial weakness. Resilience in disposable income and private consumption can be at risk should the downturn in the industrial sector spread into services. Industrial output posted a quarterly fall by 1.9% q/q – the steepest fall since the last technical recession following the Eurozone debt crisis in 2012/13.

• With the economic slowdown, there are growing possibilities for the ECB to loosen its monetary policy, a move that is expected to weaken the euro dollar. It is likely to take place as early as September which includes the resumption of QE measures in an attempt to rescue the Eurozone economy.

• Meanwhile, there is no authority like the ECB that can tax and spend on behalf of the euro region. Individual members lack the flexibility to print their own currency. The fiscal policy is expected to limp in the Eurozone.

• However, there is some room for fiscal policy to be loosened for the first time although the scenario varies between France, Germany and Italy. For instance, France has embarked on fiscal stimulus while Germany’s focus is on balance budget and Italy will want fiscal stimulus but is not allowed.

• France is injecting stimulus measures of tax cuts and changes in tax credits that will give a “one-off” boost to investments. Its budget deficit should reach 3.6% of GDP in 2019 from -2.6% of GDP in 2018. France plans to reduce the deficit to 2.1% of GDP in 2020. However, it is not the obvious credit for belt-loosening given its debt nearing 100% of GDP.

• Germany could run fiscal deficits of some 1.5% of GDP and the debt/GDP ratio would still stabilize at 60%. While running deficits instead of surpluses is currently still more than one bridge too far for the German government, some fiscal loosening looks more likely than many might think. Without this, the outlook for the German economy will be beholden to external factors. The budget surplus/GDP in 2018 is 1.7% and for 2019 is 1.1%.

• Should Germany abandon its balanced budget policy to reflate the economy, the focus is on higher "green" expenditure plus heavy tax to partially fund it. It is unlikely to be a "business-friendly" one. It will also be the impact from slower economy and additional tariffs risk.

• With a long stagnant economy, Italy would want to kick-start growth by widening its deficit. However, it will run up the EU rules. Nonetheless, Italy may delay the implementation of a sales tax hike in 2020, while expediting the process of cutting income and corporate tax rates as well as leave the income support and early retirement programmes intact. Its balance deficit/GDP in 2018 is 2.1% and for 2019 is a deficit of 2.7%.
• Finally, the region is also burdened by political uncertainties. Britain's withdrawal from the EU due at the end of October remains an enigma. The Italian government is on the brink of collapse. It is on the verge of another general election after a dispute between the ruling League and M5S parties over an infrastructure project came to a head. Deputy Prime Minister Matteo Salvini, who is the leader of Italy's largest political party and victor from the prior election, is seeking the dissolution of parliament and a fresh national ballot. Thus, Italy will remain the weak link in the Eurozone.
• Thus, the current market environment will see the EUR/USD likely to be under stress. Until the ECB meeting, and probably beyond that, the EUR/USD will remain under pressure. Besides, the positive outlook on the dollar as a result of tightening dollar liquidity will impact the single currency.

3. UK’s 2Q2019 GDP contraction a rude awakening with bearish outlook on pound

• The economy contracted for the first time in nearly seven years with 2Q2019 GDP down 0.2% q/q. Persistent concerns and uncertainty over Brexit will continue to have a huge repercussion on the economy. Besides a no-deal Brexit, there is mounting speculation for a fresh general election. Global economy is facing huge challenges due to trade war, weak investment and faltering global supply chains. Thus, the contraction in 2Q2019 is a rude awakening.

• Macro data like inflation is still subdued, down 2% y/y in June. It has been on a sliding trend from 3.1% y/y in November 2017. Although the current inflation is in line with the BoE's target of 2%, concern still persists. Business investment continues to trend downwards with manufacturing PMI down to 48 in June which is in the contraction region. Industrial production and retail sales are passive and remains unclear if they will improve as companies pump more resources into planning for a messy Brexit. And the often-dominant services sector reported no growth at all. While consumers kept the economy afloat, it is becoming increasingly worrying whether the underlying growth is largely absent.

• On the policy front, authorities have successfully lowered their fiscal deficit/GDP from 10% in 2010 to 1.4% in 2018 which is the lowest level in 17 years. The fiscal deficit/GDP is projected to drop further to 1.3% in 2019. But after being in a long period of austerity, the tide is expected to change.

• The new PM has pushed for tax cuts worth £20bil which is about 1% of GDP and a series of pledges. It should lift the GDP by about 0.3%. We feel that delivering those promises will be tough, especially if Brexit turns out to be a no-deal. In a situation of a no-deal Brexit, it could potential make a hole of around pound £30bil in its public finances.

• We foresee a sharp and instantaneous contraction from a no-deal Brexit plus slower global growth and challenges in Europe. The downside risk to GDP growth in 2020 is a contraction by 2.0%–2.5% in 2020 while 2019 growth will be lowered from 1.4% to 1.2%. We expect a 5%–10% drop in the stock market and the pound to depreciate by 10% against the US dollar and 5% against the euro.

• Hence, there is lot of pressure on the BoE to ease monetary policy to support the economy. The pressure on the BoE is rising as counterparts like the US Fed, ECB and Bank of Japan have also indicated an easing to their monetary policies. Although the BoE left the policy rate unchanged on the 1 August policy meeting, we believe the central bank will likely reduce the policy rate later in the year if the economy trends towards recession by early next year.

• We now see three likely scenarios over the coming months. The first which is the most unlikely is where Ireland agrees to relax some of its demand and the UK agrees to a deal and leaves the EU on 31 October into a transition while a trade deal is negotiated. The second, which is what we are looking at is that PM Boris Johnson pursues a no-deal Brexit. The final scenario is for a vote of no confidence and trigger a general election which is also possible.

• Should a vote of no confidence trigger a general election, the arrival of Labour leader Jeremy Corbyn would not pacify the economy. In fact, it will worsen the situation, especially if the Corbyn-led Labour government wins the election. His high tax, low-profit policies and anti-business rhetoric will deliver a hammer blow to the already struggling economy. It will add uncertainty for the pound and GDP.

• Hence, due to growing political and economic uncertainties, the outlook for the pound is bearish. By looking at a ‘nodeal’ scenario, we expect the GBP/EUR to reach 1.01–1.03 while the GBP/USD to touch 1.08–1.10 by the end the year. This suggests a 5.0% decline in the pound against the euro from current levels of around 1.08 and a sizeable near-10% decline against the US dollar from the current levels at 1.21.

4. BoJ faces tough decision on next move with yen appreciation

• The economy is caught in the crossfire of the trade war between the US and China, added with slowing global economy. Thus, a resurgence in yen threatens to sap profits and complicate the economic outlook as investor appetite for risk reduces, boosting assets perceived to be safer bets, such as gold and the yen.

• Macro data like exports dropped for an eighth straight month in July by 1.6% y/y as shipments of chip-making machines and automobile parts declined, reflecting the slowdown in China and other Asian economies. Manufacturers’ confidence slid for a third straight month to -4 in August from the prior month's +3. It was the weakest sentiment reading since April 2013, dragged down by electric machinery, metals, food processors and transport equipment.

• Though services sector activity remains firm in Japan, simmering international trade tensions pose risks for the exportreliant economy, causing manufacturers’ sentiment to worsen. Confidence in the services sector also plunged, to +13 from +25 in July, due to big drops at wholesalers and retailers.

• It now raises the question over how much longer domestic demand can remain resilient enough to offset rising external pressures with a rise in the domestic sales tax set for October. Private consumption constitutes about 60% of the economy. Besides, we expect the US-China trade war, Japan's export curbs to South Korea and the recent yen rises will form a bottleneck for sale.

• Thus, the next policy-setting meeting of the Bank of Japan (BoJ) set to be held 18–19 Sept is crucial as fresh monetary easing is likely to take place following the yen’s recent spike against other major currencies. The yen’s appreciation, which has been attributed to monetary easing by central banks including in emerging economies, fuelled concerns about earnings at Japanese companies and raised the possibility of pre-emptive easing by the BoJ.

• And if the ECB and the Fed decide to carry out further easing, and the BoJ stops short of taking any fresh measures such as increased exchange-traded fund purchases or a further expansion of its negative interest rate policy, the yen may strengthen further.

• The BoJ will face a tough decision on its next move as there are also significant concerns about side effects from further easing measures under its already ultra-easy monetary policy. Besides, the economy has been tightening its fiscal policy to a deficit of 3.2% of GDP in 2018 and projected to reach -2.8% of GDP in 2019. With the plan to raise sales tax in October and withdrawing fiscal stimulus, the economy risk tipping back into recession.

• There is a lot of doom and gloom across the globe. Yield curves are suggesting a potential slowdown or recession in the US, Germany, Italy and the UK. Chinese data are not exciting. Thus appetite for safe-haven assets like the yen will remain strong.

5. Chinese yuan faces three-case scenario

• Fears of a spiraling economic slowdown in Europe and Asia rose following Germany’s poor 2Q2019 GDP and China reporting a raft of weak data. Industrial production — an important indicator for the economy — grew just 4.8% y/y in July, the worst growth in 17 years. Retail sales climbed 7.6% in July. Meanwhile, the labour market worsened in July. The jobless rate in urban areas increased to 5.3%, compared with 5.1% in June.

• The broad-based slowdown in activity and spending suggest that after holding up reasonably well in the first half of the year, economic growth now faces renewed downward pressure. This kind of slowing growth might give China a greater incentive to support growth.

• Anticipation is growing that China will have to deploy additional stimulus measures to keep the economy growing by its 6–6.5% target. Beijing has already stepped up on fiscal stimulus by cutting taxes and other measures. And it remains to be seen how effective these will be. Infrastructure spending is still low.

• The central bank would come under pressure to cut interest rates as other global central banks have done. The PBoC unveiled a plan to improve and reform its loan prime rate (LPR) mechanism in its latest effort to reduce its financing costs for the real economy. It will benefit private, micro and small players. To free up funds for lending and to accommodate local government project financing, we still expect the PBoC to cut banks’ reserve requirement ratios (RRR) further in the coming months, on top of six reductions since early 2018.

• On the yuan, it is unlikely to fall below 7 against the dollar unless the trade talks between the US and China turns positive and stays that way. Thus, our base case is for the yuan to stay above 7 against the dollar after having protected the currency since the global financial crisis.

• We now look at three alternative scenarios on the yuan’s direction. Our worst-case scenario suggests a full-blown trade war where the yuan is expected to depreciate by 10% to offset the 10% tariff impact on Chinese goods. This will spark a currency war and we foresee selective controls imposed by affected countries. In our base case, it is a gridlock where the yuan may not weaken or strengthen too much against the dollar. The yuan will be in range-bound, reaching a low of 7.10. The best case is where there is a trade deal that will see the yuan appreciating gradually against the dollar to around the 6.99 level.

6. Malaysia

• GDP in 2Q2019 of 4.9% y/y expanded faster than 1Q2019 GDP’s of 4.5% y/y. It mainly came from private consumption which grew by 7.8% y/y (+7.6% y/y in 1Q2019) on the back of sustained income growth and the festive season i.e. Hari Raya. Capital spending in the services and manufacturing sectors lifted private investment which grew by 1.8%y/y in 2Q2019 (+0.4%y/y in 1Q2019). Net exports rose 22.9% y/y in 2Q2019 from 10.9% y/y in 1Q2019 due to sharper drop in imports. Exports grew at the same pace as in 1Q2019 by 0.1% y/y but imports fell by 2.1% y/y (-1.4% y/y in 1Q2019).

• Despite a stronger 2Q2019 GDP growth, downside risk to growth remains, arising from external headwinds and domestic challenges. The economy has yet to feel the full impact from tariff implementations due to lagged effects. The manufacturing PMI has been in the contraction region since October 2018. In July, it fell to a four month-low of 47.6 in from 47.8 in June. Industrial production rose by 3.9% y/y in June 2019 from 4% y/y in May, the smallest gain since March.

• Manufacturing output grew softer by 3.8% y/y from 4.2% y/y in May. The Leading Economic Index fell 1.7% m/m in May 2019 from +2.5% m/m in May, the first monthly decline since February. Loans growth will remain tight as banks will remain prudent and cautious on their lending policies. Also, commodity prices will be range-bound with more downside risk due to slower global growth. Besides the global semiconductor cycle will remain on the downcycle.

• For the full year of 2019, GDP is more likely to stay around 4.5% with our global GDP projected at 3.2%. The challenge will be in 2020 where we foresee slower global growth. Our base case global GDP growth is 2.8%. We project Malaysia’s GDP to grow at 4.0% in 2020. But the downside risk is high for both the global GDP and Malaysia’s growth.

• Thus, we foresee some immediate short-term measures to support the domestic economic growth. Targeting specific policies to boost business activities and investment are vital. At the same time, the monetary policy will need to play its role in supporting business and investment. Hence, funds need to be freed up for lending and to accommodate local business and investment financing.

• On the ringgit, it will be impacted by several factors. Our view of a stronger dollar due to tighter dollar liquidity and its status as safe have will add downwards pressure on the ringgit. Global interest rates movement will also impact the ringgit’s direction. We believe global monetary easing will continue as countries will use cheap rates to weaken their currencies and maintain comparative advantage. Thus, we expect BNM to follow the trend of the global interest rate cycle rather than to stay behind the curve.

• The direction of the yuan also plays an important role. In our worst-case scenario, the ringgit could fall by 8%–10% against the dollar should the yuan fall by 10% against the dollar. The base case suggests a more range bound scenario between 4.15–4.20 against the dollar. Our base case suggests the ringgit could reach 4.05–4.10 provided there is a trade deal between the US and China that will see the yuan appreciating gradually against the dollar.

• Weakness in the yuan will put the brakes on other currencies in the region, including the Indian rupee, Singapore dollar, Korean won, Malaysian ringgit and Indonesian rupiah from sliding against the dollar. However, the Korean won will be the biggest loser due to its strong dependence on China and the US where South Korea is closely interlinked in the supply chains between these two countries. Also, the won is being hit by the dispute with Japan, which has spilled into trade between the two Asian neighbours. The most resilient currency in Asia will be the Thai baht. Despite attempts by Thailand’s central bank to weaken it by slashing the policy rate, the baht is being supported by the country’s large trade surplus, low inflation and steady growth.

Source: AmInvest Research - 20 Aug 2019