There is downside risk to our 2018 Malaysia GDP forecast of 4.8% coming from the commodity sector. Abroad, the escalating US-China trade war could shave 0.1ppts off Malaysia’s GDP growth but there are opportunities for EMS players. We sense lower government spending propensity with the revelation of GST trust account shortfall and tax refund owing. Given such, we expect the 11MP midterm review (18 Oct) and Budget 2019 (2 Nov) to have a relatively muted market impact. The KLCI’s P/E is -1SD below mean but this is on back of meagre earnings growth of 2% and 5% for 2018-2019, below its post-GFC CAGR of 7%. Our KLCI target of 1,830 is based on 16x P/E tagged to mid-2019 earnings. New additions to our top picks are DRB, Frontken and CCM.

Downside risk domestically. The global economy continues to see ongoing broad based expansion and gradually rising inflation. Despite some moderation following the strong growth performance in 2017, latest economic indicators and survey outcomes confirm broad based growth globally. However, uncertainties relating to rising protectionism and vulnerabilities in emerging markets have gained more traction recently. At home, Malaysia’s economy was negatively affected by the supply disruptions in the commodity sector, namely agriculture and mining sector (-0.4 ppt to GDP) due to temporary factors. Nevertheless, private sector spending grew at a faster pace. Going forward, we anticipate consumption to normalize following the end of consumption tax break period but continue to be underpinned by improved consumer sentiment and income growth. Meanwhile, government spending is expected to weaken as it reprioritises expenditure. On the supply side, there is increasing risk that the temporary factors that weighed on the commodity sector in 2Q18 will continue to be a constraint in 2H18. In the agriculture sector, growth in palm oil production is expected to be slower-than-anticipated due to lower yields while natural gas output is not expected to pick up in the near term due to continued policy uncertainty. Hence, we see downside risks to our 2018 GDP forecast of 4.8% YoY.

Recouping post GE14 losses. 3Q18 started on a weak note with the KLCI falling to its YTD low of 1,664 (6 July) following the selloff by foreigners post GE14. However, much of the post GE14 losses (peak: -9.9%) were recouped during the quarter with the KLCI returns now at -2.6% since the polls (YTD: +0.1%). Against its ASEAN-5 peers currency adjusted, the KLCI was the least impacted YTD (after Thailand’s SET), with the bulk of its negative returns driven by the weaker ringgit (YTD -2.3% vs USD).

Foreigners back to buyers. Back tracking data on Malaysian equity foreign flows indicates that during periods of heavy selling, the outflow generally tends to peak at c.-RM10bn over a 3-month horizon. This was last witnessed in Jun-Aug 2013 (- RM10.6bn) and Jun-Aug 2015 (-RM10.1bn) during the “taper tantrum” and “oil price plunge” respectively. This year, the period from May-July (i.e. post GE14) saw the highest 3-month cumulative outflow (-RM12.2bn) since 2011. With foreign net selling easing to -RM97m in Aug and finally turning to net buying in Sept (+RM77m as of yesterday), (vs -RM5.6bn in May, -RM4.9bn in June and -RM1.7bn in July), we are inclined to believe that the exodus of foreign outflow is over. Nonetheless, we do not envisage a significant pick up in foreign buying, at least for the remainder of the year.

Escalating trade war... Trade tensions continued to escalate in 3Q18 with US recently effecting 10% tariffs (25% by end-2018) on USD200bn worth of Chinese goods (24 Sept), on top of the earlier 25% tariffs on USD50bn (6 July and 23 Aug). China has retaliated with tariffs of 5% and 10% on USD60bn of US goods and previously, by an equal quantum. Earlier this month, President Trump threatened to slap another round of tariffs on USD267bn, effectively taxing all of China’s exports to US (currently: 50%). However, 2 weeks ago, US proposed another round of high level trade talks with China, igniting hope that concessions can be reached.

...not entirely bad for Malaysia. Our “back of envelop” calculations suggest that the USD250bn tariffs implemented by US along with China’s retaliatory sum of USD110bn could potentially shave global GDP by 0.1 ppts (2018 global GDP forecast: 3.8%). Assuming a multiplier of 1x, this may lower Malaysia’s GDP growth by the same magnitude (i.e. 0.1 ppts). Nonetheless, we reckon there are pockets of opportunities for Malaysia as highlighted in our Thematic report (16 Aug) on the US-China trade war. To summarise, the tariffs impacts the E&E sector, causing electronic goods shipped out from China to be uncompetitive. Wages in China have also increased 188% since 2008 and based on estimates, it could be 31-44% cheaper to manufacture in Philippines, Thailand and Malaysia. Malaysian EMS (electronic manufacturing services) players have the expertise and capacity to absorb new orders should giant contract manufacturers (Foxconn, Pegatron, Flextronics, Wistron, USI and Venture) move their operations out of China.

Political climate to remain stable. Despite the unprecedented GE14 outcome, we continue to envisage a stable political climate with the full Pakatan Harapan (PH) Cabinet sworn-in early July. The recent 3 Selangor by-elections (Sg Kandis, Balakong and Seri Setia) also witnessed PH retaining power for all. The next by-election will be for the Port Dickson parliamentary seat which will see Dato Seri Anwar Ibrahim contesting to officially return to active politics. With Tun Mahathir recently reiterating that Anwar will be his successor as Prime Minister, we feel that this should bring some comfort towards Malaysia’s mid-term political outlook. Sentiment indicators such as the Consumer Sentiment Index (CSI) and Business Conditions Index (BCI) have both shown strong readings post GE14 with the former hitting a 21-year high and the latter at its highest in the past 13 quarters.

A tighter fiscal belt. Looking ahead into 4Q18, we believe investors will be focused on the upcoming 11MP mid-term review (18 Oct) and Budget 2019 (2 Nov). However, unlike previous announcements which managed to stir up some market excitement in anticipation of “goodies” being thrown, we are inclined to believe the impact would be rather muted this time around. This follows from the revelation by FM Lim Guan Eng that (i) the government faces a RM19.3bn shortfall in its GST refund trust account and (ii) there are RM16bn in unpaid refunds for income tax, corporate tax and RPGT with some being owned for the past 6 years. FM Lim mentioned that the government will try to repay these refunds via (i) waiving of penalties for companies that are unable to pay SST due to tight cash flow resulting from outstanding GST refunds and (ii) allowing those with outstanding tax refunds to apply to offset tax payable in the current year (subjected to approval and the overall fiscal position). In any case, we view these revelations as a signalling on the government’s lower propensity to spend as it embarks on greater fiscal prudence going forward, necessitating short term pain but long term gains. Overall, we reckon there may be some downside risk to the fiscal target being met (2018: 2.8% of GDP).

Development expenditure scale back? The initial development expenditure (DE) allocation for the 11MP (2016-2020) was set at RM260bn (10MP: RM230bn). As of 2Q18 (mid-point of the 11MP), DE spent amounted to RM107bn or 41% of the 11MP’s budgeted sum. As previously elaborated, given the fiscal constraints faced, we do not discount the possibility of a cut in the 11MP’s overall DE allocation during the mid term review. Assuming DE spent in 2H of 11MP (i.e. 3Q18 to 4Q20) mirrors that of its 1H, this would imply an 18% reduction to RM214bn (from RM260bn initially). Sectorial wise, construction would be negatively impacted by this possible DE cut given the strong correlation (71%) between nominal construction GDP and DE. Nevertheless, Economic Minister, Datuk Seri Azmin Ali mentioned that the 11MP mid-term review will focus on increasing income of the B40 segment.

New taxes possible but… While we are still a month away from the unveiling of Budget 2019 (2 Nov), we attempt to draw some possibilities on what it may look like. To broaden its revenue base, we do not discount the possibility of new taxes being implemented such soda tax (on sugary soft drinks), inheritance tax (deliberated by the previous administration for Budget 2018) and digital tax (recently proposed by Deputy Finance Minister). On the breweries and tobacco, we do not expect an increase in excise duties as this would only worsen the incidence of illicit trade which is estimated at 40-50% for the former and 63% for the latter. Instead, we believe the government will try to clamp down on illicits to boost excise duty collection. Likewise, we also do not foresee a gaming tax hike for both the NFOs (high illegal operators) and casinos (heavy capex incurred for GITP). We do not envisage an increase in corporate tax (cut from 25% to 24% in Budget 2015) as this may prompt upward price pressure from producers which would be counterintuitive to why GST was abolished in the first place.

...some goodies may still be given. Taxes aside, we reckon that the new administration will also throw in a fair share of goodies for the rakyat. While it is hard to pinpoint at this juncture what this may entail, it is possible that some of its unfulfilled (or “work in progress”) manifesto pledges could take shape. Based on PH’s “10 promises in 100 days”, this may include (i) targeted fuel subsidies, (ii) assistance for FELDA settlers’ debts, (iii) postponement of PTPTN repayment and (iv) Skim Peduli Sihat (basic healthcare treatment for B40). Broadly speaking, we reckon that most of the goodies for Budget 2019 will be for the B40 segment.

Fairly valued. We continue to project meagre earnings growth for 2018 at 2% but fine-tune our 2019 forecast to 5% (from 5.7%). While the KLCI’s P/E (1 year forward rolling earnings) seems compelling at -1SD below its 5-year mean, we argue that this may be warranted given the subpar earnings growth for 2018 and 2019, which in both cases, are still below its historical post-GFC CAGR of 7%. From a risk premium perspective, the KLCI’s earnings yield spread against the 10-year MGS yield is now at 2.07%, hovering close to the mean of 1.98%, suggesting relatively fair valuations on this front. Valuations aside, our expectations for a muted 11MP mid-term review and Budget 2019 prompts us to believe that market upside could be capped in the near term. Our KLCI target of 1,830 is derived from 16x P/E (roughly -0.5SD below mean) tagged to mid-2019 earnings.

Top picks. The list of our top picks remains largely unchanged but we remove Public Bank as share price has increased by c.10% (since our inclusion to our top pick list during mid-year). Apart from that, Heineken and Rohas are also removed given their results shortfall during the 2Q18 reporting season (in Aug). In replacement, we add DRB (disposal of Alam Flora and launch of its SUV (based on Geely Boyue) towards year-end) along with our recent initiations being CCM (successful turnaround play) and Frontken (multiyear earnings growth from semiconductor upcycle and O&G recovery).

Source: Hong Leong Investment Bank Research - 28 Sep 2018