On 4th Dec, Fitch Ratings downgraded Malaysia’s sovereign credit rating to ‘BBB+’ from ‘A-’, with a stable outlook. This marks the rating agency’s first downgrade for the country since the 1997/98 Asian Financial Crisis. We opine that knee-jerk reaction to Fitch’s downgrade could lead to capital outflows and some depreciation pressure on the ringgit. Sectorial wise, we continue to advocate a concoction of recovery plays (Tenaga, AMMB, MBM, Media Prima and Focus Point), volatility (Bursa), defensives (TM, MQREIT), value (IJM, Sunway and Armada) and sold down pandemic beneficiaries (Top Glove). Maintain end-2020 KLCI target at 1,620 and end-2021 at 1,690 (18.5x PE at +0.5SD above 5Y mean).

NEWSBREAK

Fitch Ratings downgraded Malaysia’s sovereign credit rating to ‘BBB+’ from ‘A-’, with an improved outlook from negative to stable, as the depth and duration of the Covid-19 crisis have weakened several of Malaysia's key credit metrics.

Persistent high public debt. Fitch expects general government debt, which includes committed government guarantees to jump to 76.0% of GDP in 2020 from 65.2% of GDP in 2019. On this basis, the debt burden is significantly higher than the medians of 59.2% and 52.7% for the 'A' and 'BBB' rating categories, respectively. Fitch expects the fiscal deficit to remain higher than pre-pandemic levels, given a continuation of support measures and political pressure for higher spending.

Prolonged political uncertainty and weaker governance. After a significant improvement in 2019, Malaysia's World Bank governance score weakened slightly in 2020, and is closer to the 'BBB' median than the 'A' median. Deterioration in governance and continued political uncertainty could dampen investor sentiment, constraining economic growth.

MOF has since responded to the downgrade, stating that Fitch did not give due credit to Malaysia’s swift response (RM305bn; 20% of GDP) to the Covid-19 crisis and the country’s strong economic fundamentals. The Government rationalises that the targeted and temporary nature of the stimulus measures limit the impact on the fiscal deficit. In the medium to longer term, the Government remains committed to fiscal consolidation and sustainability, guided by Medium-Term Fiscal Framework which Fitch did acknowledge. Malaysia’s credit standing is also supported by its robust external position as the country holds a sizeable net foreign currency external asset position of RM1tn or 71.8% of GDP. Compared to the Asian Financial Crisis period, Malaysian banks are significantly more resilient to shocks. Notably, banks’ excess capital buffers currently stand at RM123.7bn, more than three times the levels seen during the 2008/09 Global Financial Crisis. The government also rationalises its strong institutional setup will continue to ensure the effective implementation.

HLIB’s VIEW: ECONOMICS

A bond is considered investment grade if its credit rating is BBB- or higher, which indicates Malaysia’s current credit rating of BBB+ is an investment grade bond. Nevertheless, knee-jerk reaction to Fitch’s downgrade could still lead to capital outflows. Non-residents currently hold 24.6% of Malaysia’s government bonds (RM202.1bn). Out of which, long-term holders (central bank and pension fund holders) account for 51% of total. The rest are held by foreign banks, insurance companies, asset management companies and others. In addition, Malaysia’s position in FTSE Russell Watchlist for a possible exclusion from World Government Bond Index (WGBI) and its upcoming update in March 2021 may add another layer of uncertainty on capital flows. On a YTD basis, while the ringgit has averaged at USD/MYR4.21, stronger than our forecast of USD/MYR4.23-4.28, this announcement may lead to some initial depreciation pressure.

Currently, Moody’s credit rating is A3 with a stable outlook (next review expected to be in 1Q21) while S&P Global Ratings has a A- with a negative outlook for Malaysia (next review expected to be in 2Q21).

HLIB’s VIEW: MARKET

We believe this unfortunate downgrade news will inevitably result to negative repercussion towards the domestic market. While Fitch’s forecast of Malaysia’s GDP contraction of -6.1% is worse than our internally tabulated -5.5%, we note that their growth projection of +6.7% for 2021 is higher than our +6.5%. In any case, a further exit of foreigners from Malaysian equities seems like the reasonable assumption. Nonetheless, we highlight that foreign shareholding levels on Bursa (Nov: 20.8%) is close to the GFC trough of 20.7%. As such, while a near term sell-down is naturally expected from this rating downgrade, its downside may be less profound than thought to be.

Market support is likely to stem from retail investors whose participation rate has been robust at 34.4% for 11M20 (vs 2019: 24.7% and 10Y mean: 24%). In addition, market support could also come from the traditional the “window dressed” Dec; KLCI ended higher MoM in 9 of the 10 past years with an average MoM return of 2%.

The index heavy weight banking sector is likely to take a hit, but we would take this as an opportune time to accumulate, riding on an eventual vaccine driven recovery play to the broader economy (AMMB is a laggard in this regard; Maybank for an eventual sold down beta rebound). We continue to advocate a concoction of recovery plays (Tenaga, AMMB, MBM, Media Prima and Focus Point), volatility (Bursa), defensives (TM, MQREIT), value (IJM, Sunway and Armada) and sold down pandemic beneficiaries (Top Glove). Maintain end-2020 KLCI target at 1,620 and end-2021 at 1,690 (18.5x PE at +0.5SD above 5Y mean; reflecting a slight “recovery premium”).

Source: Hong Leong Investment Bank Research - 7 Dec 2020