We maintain our 2019 GDP growth forecast at 4.5% and expect a 25bps OPR cut within the next 6 months amid external uncertainties. Despite KLCI falling 5.3% in 3Q, we are hopeful for positive 4Q returns given a mildly expansionary Budget 2020 (unlike its austerity sounding predecessor) and year end window dressing (90% probability of positive Dec returns). Risk of WGBI exclusion has also abated, at least for the next 6 months. Maintain KLCI target at 1,670 (16.6x PE; -1SD). Bottom nibble at current levels as P/B at -1SD has in the past, been quite a gauge of bottomed valuations.

Central banks to stay expansionary. Economic prospects are deteriorating for both advanced and emerging economies. Escalating trade tensions and Brexit uncertainty are taking a toll on business confidence, weakening investment prospects and endangering financial markets. In addition, new risks have emerged as geopolitical tensions rise in the Middle East with the disruption of Saudi’s oil production. In view of weaker economic outlook and prominent downside risks, global central banks including the Fed and ECB, are expected to remain expansionary.

Malaysia’s growth resilient thus far... In 1H19, growth remained strong at +4.7% YoY (2H18: +4.6% YoY), partly driven by pickup in commodity sectors after temporary weakness in 2018. Growth in 2H19 is anticipated to be more moderate as private consumption normalises following high base effect due to GST holiday in Jun-Sep 2018 while increased economic uncertainty is expected to keep investment weak. Exports are also anticipated to remain subdued, consistent with weaker global growth and decline in the global manufacturing PMI (Aug: 49.5; Jul: 49.3). We maintain our 2019 GDP forecast at 4.5%.

…but OPR cut expected amid external risks. In the recent Sept MPC meeting, BNM maintained the OPR at 3.00% and kept its 2019 growth projection unchanged at 4.3%-4.8%, but said it was subject to further downside risks from worsening trade tensions and other global uncertainties. This suggests that BNM may prefer to hold off from easing and wait for stronger evidence of domestic slowdown before acting. Nevertheless, against this environment of worsening trade tension with negative implication on global demand and commodity prices, we maintain our expectation for BNM to have an easing bias and cut the OPR by 25bps within the next 6 months.

Sliding down in 3Q. On a currency adjusted basis, the KLCI declined -6.5% (absolute: -5.3%) in 3Q19, the 2nd worst performer within ASEAN-5 after STI (-8%). The index heavyweight banking sector was sold down on (i) expectations of another OPR cut and (ii) higher-than-usual proportion of results disappointment (3/8 within HLIB coverage). Despite Malaysia reporting sequentially stronger 2Q19 GDP (4.9% vs 1Q19: 4.5%), bucking the regional trend, this was overshadowed by external headwinds. These include: (i) trade tensions heating up between Japan and South Korea, (ii) US-China trade tensions escalating to a full blown trade war; all Chinese imports will be tariffed and existing rates raised and (iii) Brexit status remains in limbo.

We are hopeful for Malaysian equities to chart positive returns in 4Q19 (amid a lower base) driven by a mildly expansionary Budget 2020 (unlike its austerity sounding predecessor) and traditional year-end window dressing. Risk of Malaysia dropping out of the WGBI has also abated, at least for the next 6 months.

Malaysia stays in WGBI, for now. Last Fri, FTSE Russell announced that Malaysia will be retained on its watch list for a potential downgrade from its current Market Accessibility level of 2 and consequently removed from the WGBI. Recall that Malaysia was put on the watch list back in Apr 2019; next review in Mar 2020. FTSE Russel also stated that it will continue to engage with market participants to understand the practical impact of BNM’s recent initiatives (announced in May and Aug) to improve market liquidity and accessibility. We feel that this watch list extension is neutral from an equity market perspective; a firm inclusion would be positive while a firm exclusion is negative. In the latter case, this could possibly lead to a USD7.8bn outflow (RM32.6bn) or 8% of total outstanding MGS (as at Aug).

Mildly expansionary Budget... Budget 2020 will be tabled in Parliament on 11 Oct. While the Government targeted a deficit-to-GDP ratio of 3.0% for 2020 (2019: 3.4%) in its medium term fiscal framework (MTFF), Finance Minister Lim Guan Eng (FM Lim) has stated that this will be challenging to meet given the uncertainties from the USChina trade war. With the onslaught of the US-China trade war possibly taking a greater impact in 2020, we opine that some “belt loosening” is necessary as a counter cyclical measure. Taking this into consideration, we expect the deficit-to-GDP ratio for 2020 to be set at 3.2%, higher than the MTFF target of 3.0% but lower than 2019’s 3.4%. On an absolute basis, this entails a deficit balance of RM52.5bn for 2020 (2019: RM52.1bn) which is mildly expansionary.

...with a contingency plan. With heightened risks to growth emanating from the USChina trade war and slowing global growth, we opine that Budget 2020 will include a contingency plan. During the GFC, 2 stimulus packages were rolled out in Nov 2008 (RM7bn) and Mar 2009 (RM60bn). This time around, we think a contingency plan amounting to RM4bn could be in the offing, likely in the form of additional development expenditure and tax benefits. If utilised, this would lift the overall deficit balance to RM56.5bn or 3.5% of GDP for 2020. The additional allocation will likely be used for projects with high multiplier effect, including construction projects (affordable housing, public transport) and possible tax cuts.

A change of tone. Rewinding back the clock, the KLCI fell 4.7% over a 1 month period prior to the tabling of Budget 2019 on the PH administration’s “signalling” that it would be a challenging one. A slew of taxes (perhaps T20 targeted) such as RPGT, higher stamp duty, soda tax, departure levy, digital tax (by 2020) and higher gaming tax were introduced. We sense a different tone this time around and do not expect the similar “austerity belt tightening” sentiment à la Budget 2019; this should be positive for Malaysian equities. Last month, FM Lim said there will be no new tax measures for Budget 2020.

Possible sector impact. Visit Malaysia Year 2020 (VMY2020) is expected to be a key focus area in Budget 2020; this should be positive for aviation, REITs with prime malls (KLCCSS, Pavillion REIT, IGBREIT and SunREIT) and healthcare tourism. Higher development expenditure (DE) will be positive for construction given the 70% correlation between DE and nominal construction GDP. For property, we expect measures to boost first home ownership (e.g. continuation of NHOC), but the devil is in the details. We project subsidies and social assistance to increase 10.8% in Budget 2020 which should be broadly positive for the consumer sector. On sin taxes, we do not expect a hike for tobacco (further worsen an already chronic illicit trade) and gaming (casinos were hit by higher gaming tax last year while illegal NFOs remain rampant). For brewers, the possibility of an excise duty hike (last in 2016) cannot be entirely discounted; although this would be detrimental to clamping contraband beers.

Window dressed ending? While it may still be too premature to speculate about year-end window dressing, we note that the KLCI ended in positive territory for Dec in 9 out of the past 10 years (2014 was the exception) with returns ranging between 1.1% and 4.8% (see Figure #2).

Maintain KLCI target of 1,670. With the 6.3% decline YTD, the KLCI’s valuations are at (i) 16x 1-year forward PE; -1SD from 5-year mean and (ii) spread between earnings yield and 10-year MGS at 2.68%; +2SD above 5-year mean. Against ASEAN-5, KLCI’s PE is 1.7x multiple higher; slightly above its mean premium of 1.5x. We continue to advocate bottom nibbling at current levels, justified by P/B valuations at - 1.5SD from long term (10-year) mean, which has in the past been quite a credible gauge of bottomed valuations. Our 1-year KLCI target of 1,670 (end-2019: 1,630) is premised on 16.6x PE (-0.5SD) tagged to 2020 EPS. We continue to favour high divvy yielders (defensive and low MGS yield) and exporters (depreciation bias to ringgit). Our top picks are largely unchanged but we replace Axis REIT and Frontken with KLCCSS and TM.

Source: Hong Leong Investment Bank Research - 7 Oct 2019