Yesterday BNM raised the OPR by +25bps to 2.25% which was within our expectations. We believe the market can stomach the higher rates, seeing that KLCI’s earnings yield spread to MGS10 is still generous at +1.3SD above 5Y mean. We also believe that current weak ringgit has already reflected expectations of a widening FFR-OPR spread to +90bps by year-end (now: -63bps). Maintain KLCI target at 1,610.

NEWSBREAK

Yesterday, BNM raised the OPR by +25bps to 2.25% which was within our expectations of 2x25bps hikes in 2H22, specifically in Jul and Sep to end the year at 2.50%.

HLIB’s VIEW

Market can stomach higher rates. The current spread between the KLCI’s earnings yield and MGS10 is relatively generous at 3.06% (+1.3SD above 5Y mean; Figure #1). Intuitively, this spread is a measurement of the relative attractiveness of investing in Malaysian equities vs the country’s risk-free rate – a narrower spread makes equities relatively less attractive, vice versa. Assuming our expected +25bps OPR hike in Sep directly narrows the spread by the same quantum, this would bring the spread to 2.81%, which is still +1SD above 5Y mean, suggesting that the market can stomach higher rates.

Weak ringgit has likely priced in expected FFR-OPR spread widening. Figure #2 shows a broad positive correlation between the USD-MYR exchange rate and FFR OPR spread – ringgit weakness tends to happen ahead (i.e. expectations) of a wider spread. Based on the economic projections of the Fed, they expect the FFR to hit 3.40% by year end. Against our 2.50% OPR expectation, this would bring the spread to +90bps by end-2022 from -63bps yesterday. We believe that the current USD-MYR exchange rate has already reflected this expectation, and have an appreciation bias view to the ringgit in 2H22 to average 4.33 (year-end: 4.23). To justify, firstly during the last FFR upcycle from Dec-15 to Dec-18 (3 years), the spread to OPR widened by +225bps. However, ringgit weakness only happened in Year 1 (-4.0%) but recovered in Year 2-3 (+6.9%). Secondly, we flag that the historical FFR-OPR spread has hit a high of +175bps back in June-06 to Aug-07, during which the corresponding USD MYR exchange rate only averaged 3.55, a vast gap from its current standing of >4.40.

Experience from the last OPR upcycle. The last notable OPR upcycle happened in 2010 (coming out of the GFC) where rates were raised by +75bps that year (from 2.00% to 2.75%). Despite the rate upcycle, the KLCI gained +19.3% that year, spearheaded by the index heavyweight banking sector (KLFIN: +25.4%).

Winners and losers. The banking sector (which we are OVERWEIGHT on) is a clear winner from an OPR upcycle as NIM is expected to widen – our banking analyst estimates that every +25bps OPR hike would bump up sector NIM by 5 -6bps and earnings forecast by 4-5% (big gainers are Alliance and BIMB, while small gainers are Affin and Public Bank). Sectors on the losing end are likely to be REITs (narrowed spread between divvy yields and MGS10) and property (our property analyst estimates that a 25/50/75bps rate hike would increase monthly mortgage instalments by 3.2%/6.5%/9.9%).

KLCI target at 1,610. We maintain our KLCI target of 1,610 premised on 15.6x PE (-1SD below 5Y mean) and believe that battered valuations along with bottomed out foreign shareholding offer some solace to nibble.

Source: Hong Leong Investment Bank Research - 7 Jul 2022