- We are cutting our end-2015’s fair value for the FBM KLCI from 1,880 to 1,650 by lowering the implied PE to 15x – based on the long-term mean. We had previously pegged our fair value to one standard deviation above the mean PE strictly because of liquidity reasons. The market has been trading within one standard deviation above its post-2008 global financial crises mean of 15.7x over the last two years. Despite the recent share price pullbacks, 17 of the 30 FBM KLCI index-linked stocks are still trading above one standard deviation above the mean while 11 of the index-linked stocks are trading within one standard deviation from the mean. Only two index-linked stocks – RHB Cap and Hong Leong Bank – are trading within minus one standard deviation from the mean.

- External liquidity conditions may no longer be supportive of valuations as the passage of time to a hike in the US Fed Funds rate narrows in 2H15. Our view is that the market has not fully priced-in an upcycle in the Fed Funds rate: the expected move in interest rates may lead to a re-pricing of equity markets. Without acceleration in earnings momentum to take over from liquidity as the next share price driver, it is unlikely that the market can still justify its higher PE relative to mean. A positive reversal in the negative earnings cycle may be delayed to 2016, we believe. For a start, consensus earnings growth estimate of 5% (source: Bloomberg) for this year (2016: +8.7%) still looks ambitious, implying that the forward PE bands are actually higher when viewed against the likely cuts in earnings expectations from an anticipated deceleration in economic growth in 2H15.

- There are also other risk factors resurfacing to trigger a PE reversion to the mean. Domestically, there are several macro trends unfolding with the associated repercussions on valuations, the timing of a reversal in the prolonged negative earnings revision cycle, and portfolio de-risking. The domestic macro backdrop for earnings may see further deterioration in 2H15. At the top of our fundamental concerns are the waning domestic macro cycles – particularly private consumption in the face of rising inflationary expectations post-GST, select retrenchments, and staffing cutbacks from big corporates. From our recent round of company visits, we sense that the market may have underestimated the severity of the slowdown in consumption spending and private investments. Same-store sales are contracting while capex as well as working capital financing are being pushed back given a less optimistic economic outlook.

- Furthermore, a high base in 1Q15 – where private consumption grew by 8.8% and investments by 11.7% – makes quarter-onquarter comparison look bad. While some normalisation in spending patterns due to the waning impact of GST implementation is expected in 2H15, the gradient of recovery is flat at best. The weaker private consumption trend casts some downside risk to our GDP estimate of 5.2% for 2015 (government’s estimate: 4.5%-5.5%). Private consumption accounts for a significant 53% of GDP. Given the weakness in private consumption (the single largest component of GDP), there is a growing risk that 2Q GDP to be released in August 2015 may be weaker than expected. Public spending is not expected to offset the slack from private consumption given the government’s focus on fiscal discipline and managing its public debts. The latter stood at 52.7% of GDP as at end-2014, which is just a tad lower than the national ceiling of 55%.

- The weak Ringgit and its associated flipside pressure on inflation may further crimp private consumption, we believe. The surprise move by Fitch Ratings to upgrade the country’s outlook from ‘Negative’ to ‘Stable’ appears to have little impact in boosting ringgit: the post-upgrade currency gains were short-lived. Of late, there have been talk of a twin deficit – fiscal and current accounts – because of the unexpected 8.8% contraction in exports in April 2015. The weak exports numbers were due to the sluggish oil, LNG and palm oil prices, as well as a tough international trade environment namely in China, Malaysia’s major trading partner. Although oil price has rebounded off its low, market view on its sustainability is mixed. There may be some price support for palm oil from El Nino. Exports of electrical and electronics have been fairly robust but a stronger pick-up in global demand is needed for this segment to gain momentum in the 2H15, and offset the slack from oil and commodity exports. The government is projecting a current account surplus of 2% for this year. The delivery of this target is crucial to underpin confidence on the ringgit.

- Foreign ownership in the MGS market remained stubbornly high at 47% (RM158bil) as at end-May 2015. The steady rise of foreign ownership in the MGS market from less than 15% started in 2009 when US interest rates collapsed in the aftermath of the global economic crisis. What has changed now is that the US Federal Reserve is widely expected to start normalising interest rates in 2H15. The flow dynamics may accelerate if the Fed moves faster with more aggression than anticipated, giving the kick to the USD. The timing and magnitude of the reversal in foreign ownership may have significant repercussions on either the Ringgit or MGS yield. This twin challenge poses a policy dilemma because rising MGS yield signifies higher risk free rate, and by extension, higher equity risk premium. Currently, the yield on the benchmark 10-year MGS has already risen above its long-term average of 3.96% – even before the anticipated Fed Funds rate lift.

- While the risk of a pullback in external portfolio liquidity is a lingering concern, we do not believe that the exit of foreign funds would have a significant impact on the market. This is because foreign ownership is already very low at 23.2% as at end-May 2015. This depressed level of foreign ownership is just slightly higher than its all-time low of 20.4% in December 2009. Furthermore, foreign funds account for less than 25% of the total value traded as compared to more than 40% by the local institutional funds. This breakdown of trading value suggests that overall market direction is largely driven by local institutional funds. To be sure, consider the market’s ascent from the December 2014’s low of 1,673.9 to the recent peak of 1,862.6 in April 2015 as a sustained buying support from local institutional funds had more than offset the selling pressure from foreign funds.

- However, when local buying support abates, the ensuing low trading liquidity would amplify the selling pressure from the foreign funds on the market. This was the case during the last two months when the market retracement was on the back of lower trading liquidity: average daily trading value declined to RM1.95bil, compared with RM2.12bil during the preceding 12 months. While we believe that the market may drift lower due to easing liquidity support and weaker earnings delivery, a significant correction is not expected given the local institutional funds’ domestic orientation in deploying capital.

- In summary, we believe that the market needs to navigate a changing external liquidity landscape and a weaker earnings backdrop which has yet to demonstrate signs of a bottoming. Our cautious prognosis suggests that further market correction from a PE reversion to the mean appears imminent. We are anticipating a recovery to be pushed back to 2016, for which we are assigning a fair value of 1,750 for the FBM KLCI, versus our fair value estimate of 1,650 for this year. Strategy-wise, we believe that there will be a greater premium for earnings certainty, strong corporate management, as well as beneficiaries of a weak ringgit in 2H15. Sectors/stocks that demonstrate these positive attributes are admittedly crowded plays with high valuations but the macro uncertainties ahead suggest that it is too early to turn bearish on them. This is the primary reason for our OVERWEIGHT call on the glove sector with BUYs on Top Glove, Kossan and Hartalega and our oil & gas picks on Yinson and Dialog.

- Thematically, with speculation rife of a Sarawak snap election to be held by year-end, Sarawak stocks will attract attention from an expected acceleration in newsflow momentum. Our top picks are Sarawak Cable (SCable), Hock Seng Lee (HSL) and KKB Engineering. Backed by strong fundamentals, SCable is a stand-out among the beneficiaries as it is the leading integrated transmission line player in the country and an exporter of cables (now at 20% of total production). SCable will benefit from the proposed construction of dams in Sarawak, TNB jobs as well as being directly involved in the construction of small dams in Indonesia. Moving forward, management’s strategy is to focus on cabling jobs with better margins.

- SCable is the country’s sole producer of 275kV underground cables, which may likely be required at the Pengerang Integrated Petroleum Complex. HSL will be a strong contender for works packages of the RM27bil Pan Borneo Highway given its expertise in land reclamation jobs. HSL is also tipped to secure the 2nd phase of the Kuching central sewerage system, which will be worth at least ~RM500mil. For KKB, its earnings profile is expected to be transformed over the next two years, given its foray into the O&G sector via 42%-owned associate and Petronas-licensed services provider Oceanmight. KKB is set to find jobs from government expenditure in rural development, particularly in the supply of steel pipes for water supply.

- We are NEUTRAL on the banking sector. Our sector earnings growth assumption is now 5.4% (previously 11.5%) for calendar year 2015, due mainly to our recent earnings downgrade for CIMB and minor tweaks to our earnings forecasts for Public Bank and Hong Leong Bank. We believe there is still earnings uncertainty on several fronts. Firstly, loans growth is likely to be scaled down in view of the recent muted loan demand trend. Our current loans growth forecast is 8.0% for FY15F, while the latest annualised loans growth rate is only 6% for YTD May 2015. Secondly, the impact from a possible hike in US rates (widely expected to be in Sept 2015) in terms of MGS yield, and consequently costs of funds, is still undeterminable. This implies ongoing uncertainty in terms of NIM compression. While this event has not yet materialised, some banks are now guiding for greater NIM compression due mainly to an already highly competitive environment for deposit, with NIM guidance being brought down to as much as -20bps YoY, from -10bps YoY previously.

- Thirdly, we believe that credit costs have yet to peak, as there is usually a time lag effect from the initial slowdown, to the materialisation of impaired loans. Sector credit cost is estimated at 30bps in 1Q15, not much changed from 4Q14’s 33bps. In terms of calendar year forecasts, our sector credit costs assumption is 25bps for 2015F and 30bps for 2016F. The recent change in guidelines on rescheduled and restructured loans requiring these to be presumably impaired, rather than non-impaired, is also likely to give rise to higher credit costs ahead. As a gauge, sector credit costs came in at 70bps in 2008. In addition, we believe there is likely negative feedback loop from the recent macro slowdown. In our recent company visits, banks have generally set a more cautious tone. For exposure to the banking sector, we advocate Maybank and Public Bank. We expect both to be relatively more resilient than peers.

- We recently upgraded the plantation sector to OVERWEIGHT. We believe that the risk-reward trade-off is turning attractive after the pullback in share prices of plantation companies. The improvement in soybean prices resulting from delays in planting is expected to support CPO prices. Plantings of soybeans in the US are behind schedule due to heavy rains. Excess moisture is also expected to affect soybean yields, which may result in weaker-than-expected production in the US. Additionally after two years of growth, global soybean production is expected to be flat at 317.6mil tonnes in 2015/2016 versus 318.3mil tonnes in 2014/2015. Soybean output in the US is envisaged to decline by 3% to 104.78mil tonnes in 2015/2016 on the back of lower yields. Soybean production in Brazil, Argentina and Peru is forecast at 162.8mil tonnes this year compared with 162.5mil tonnes last year.

- CPO production in Indonesia could fall short of expectations in 2H2015 due to the lag impact of the dry weather, which took place in Kalimantan and certain parts of Sumatra in October 2014. As such, peak output season in Indonesia in 2H2015 may not be as strong as previous years. Currently, the country’s CPO production is forecast to increase by 6.5% from 31mil tonnes to 33mil tonnes in 2015. In the coming few years, there is a possibility that Indonesia’s CPO production could be lower than estimated not only because of the decline in new plantings but also due to unfavourable weather patterns. The weather has been erratic as reflected in the bouts of dry weather and floods in Malaysia and Indonesia. This had resulted in FFB yields being affected every six months, 12 months and 24 months. Presently, industry experts expect Malaysia’s CPO production to be at 19.7mil tonnes-20.1mil tonnes in 2015 compared with 19.7mil tonnes in 2014. Our top picks are KL Kepong and IJM Plantations.

- After a lull in 1H15, we expect the imminent roll-out of infrastructure spending under the 11th Malaysia Plan (11MP) to trigger renewed orderbook expectations for Malaysian contractors. Under the 11MP, development expenditure is projected to increase by 13% (RM26.bil) vs. that of 10MP – implying a c.10% growth for the construction sector over the next five-year period (2016-2020). Notably, we expect the PDP awards of two big-ticket jobs – the RM27bil Penang Transport Master Plan (PTMP) and RM28bil Klang Valley MRT 2 (MRT 2) – to materialise by 3Q15. For both jobs, Gamuda is a clear favourite given its track record and status as the PDP for both the MRT1 and MRT2 lines. Some of the other major job opportunities in the offing include:- (i) Klang Valley LRT 3 (RM9bil); (ii) RM27bil Pan Borneo Highway; and (iii) Gemas-JB double tracking project. Downside risk to construction margins is low as building material prices remain benign.

- Construction sector’s valuations are undemanding at CY15F and CY16F PEs of 13x and 11x on healthy earnings growth of 12% and 9%, respectively. Within our construction universe, Gamuda remains our top pick ahead of three key event catalysts coming up in 3Q15:- (i) MRT2; (ii) PTMP; and (iii) resolution to Selangor’s water impasse (water assets account for 9% or RM0.59/share of NAV). Just by including the PDP contract for MRT2, we estimate a 3% enhancement (RM0.17/share) to Gamuda’s NAV. If Gamuda successfully clinches a 50% stake each in the tunnelling contract and PDP works for the PMTP, its NAV will rise further to RM7.72/share (+RM1.26/share; +19%).

- We remain NEUTRAL on the oil and gas sector, as contract flows remain scarce given the capex/opex cuts by oil majors amid the recent plunge of crude oil prices. This could be seen in Petronas’ indication of a capex cut by as much as 15%-20%, while it is looking at reducing opex by 25%-30% for 2015 given the current oil price levels. Consequently, we expect earnings delivery to remain weak for companies within certain segments of the sector in the coming quarters. Impact on the pure-play fabricators would be most felt as order book replenishment continues to be challenging given the slowdown in E&P activities and intense competition from foreign yards. Rig and OSV operators also face downward pressure on dayrates and utilisation rates due to request for contract renegotiations and rate discounts by their clients.

- We prefer established companies that are exposed to the production phase with long-term service contracts and recurring income. We like Dialog Group (BUY; FV: RM1.95/share) for its execution track record; it is supported by the tank terminal business, which will remain relatively insulated from the fluctuation of oil prices. We also like FPSO players for the good earnings visibility underpinned by the long-term nature of FPSO contracts. We prefer Yinson Holdings (BUY; FV: RM3.60/share) as the group’s execution and counterparty risks appear somewhat lower and it is well protected by the contract terms with its customers.

- The latest 1Q15 earnings season suggests rising competitive pressure and a significant shift in prepaid share between Celcom and Digi/Maxis. Overall industry mobile revenue turned in positive growth (+0.5% YoY) compared to the past five quarters of contraction but competition intensity is on the rise – price adjustments seem to be concentrated on the voice segment in 1Q15, in particular the prepaid youth and migrant segments (estimated to account ~20% of revenues) while Maxis is striving to regain subscriber share, but of late, it is spreading towards entry level data as well, where Celcom is making a comeback in postpaid.

- Despite positive revenue growth trends, margin trends are generally still showing a contraction and rising competition suggests possible margin pressure in the near term, especially with Celcom returning to the market from 2Q15 and the initial impact of GST implementation on 1 April 2015. Overall, earnings revision cycle has been on the downtrend while dividends too have fallen in line with weaker earnings and peaking net-debt to EBITDA levels for select telcos. Axiata remains our top sector pick for:- (1) a turnaround in Celcom performance in 2H15 after having resolved its network issues and it is at the tail end of its IT revamp; (2) a structurally improved XL from 2H15 once it is through its transition to a value-driven business model; and (3) best potential for a dividend surprise given the low net debt to EBITDA of 1.2x vs. typical ceiling of 2x-2.5x, and it being one of the better-positioned GLCs to increase dividend upflow to Khazanah.

- We have a contrarian OVERWEIGHT call on the property sector. Admittedly, newsflow momentum is weak – slowing new residential presales, a lull in the secondary transactions, and select policy restrictions at the state levels. Nonetheless, at an average discount of close to 50% to NAVs, we believe that valuations are approaching the trough levels. The residential pricing cycle has somewhat softened but we do not expect to see any significant price correction to trigger downgrades to NAVs. More importantly, developers are taking advantage of the slow presales market to replenish their landbank. Thus far, land prices have not eased. We are also seeing selective strengths in the purchases of residential properties, which are primarily driven by location. The recent strong demand for launches at Malton’s Pavillion II and Desa ParkCity are good cases in point.

- Mah Sing is a BUY on account of its attractive valuations – 10x-11x PEs and a 45% discount to our estimated NAV of RM2.79/share and its high locked-in unbilled sales of RM5.2bil. We remain committed to our investment thesis on Eastern & Oriental despite the steep order-driven selldown after its acquisition of properties in London. Sentiment may improve if E&O successfully lists its London assets in 4Q15. More importantly, the imminent award reclamation works for its ‘jewel-in-the-crown’ Sri Tanjung Pinang II (STP II) should renew buying interests on the stock. STP II is a very lucrative development because of its low breakeven cost (estimated to be about RM135/psf), excellent sea-fronting location, and rising land values in Penang due to scarcity of big tracts of development land with immediate development potential.

- We recommend BUY for AirAsia. We believe the market has substantially discounted the risks associated with AirAsia’s exposure to a few troubled associates and risk-reward leans more to the upside at the current share price levels (share price has dropped >40% YTD). FY15F PE of 7x is undemanding and the stock is now trading below FY15F’s BV of RM1.70/share. Key catalysts are:- (1) MAS’ restructuring is gradually taking shape after announcing several route cuts, which will impact AirAsia’s regional operations positively against a depressed earnings base in FY14; (2) successful asset monetisation to address balance sheet risk; (3) pre-IPO fund raising for Indonesia AirAsia and AirAsia Philippines to partially recoup amounts owing to AirAsia; and (4) sustained low jet fuel prices to better reflect earnings over the next three quarters.

Source: AmeSecurities Research - 8 Jul 2015