While 3Q22 GDP should remain strong, this will moderate from 4Q22 onwards given dissipating base effect and weaker external demand. Fed’s aggressive tightening has resulted to a widening FFR-OPR spread and ringgit weakness – both have historically been negative for the KLCI. Although expectations are for an “election budget”, we think it could be rather muted for the market with no major wows or shocks. We lower our end-2022 KLCI target to 1,540 (from 1,560) and introduce our 2023 target at 1,590. Battered valuations at -2SD PB alongside record low foreign shareholding offers some solace for bottom nibbling to tactically ride on the traditional Dec window dressing effect.

Growth moderation ahead. In advanced economies, inflation is trending near its highest levels and far above its target rate of 2.0%, causing most central banks to accelerate monetary tightening – consequently, increasing global recession risk. At home, we expect a strong GDP print for 3Q22, before moderating in 4Q22 following weaker external demand and dissipating base effect (2022f: +6.5% YoY). Looking ahead on this front, we project 2023 GDP to moderate to +4.5% YoY (global recession isn’t our base case, yet) and maintain expectations for BNM to pause in Nov-22 and resume with 2x25bps rate hikes in 1H23, bringing the OPR to 3.0%.

Underperforming. While there was initially some market reprieve from mid-Jul till mid-Aug (KLCI: +7.6%) – on speculation that the Fed would eventually pivot following US’ technical recession – things headed south again after Powell’s reality check at Jackson Hole, alongside another jumbo +75bps FFR hike in Sep. Domestically, KLCI fell -2.9% in 3QTD, bringing the YTD decline to -10.6% or -19.5% currency adjusted, underperforming ASEAN-5’s -15.6%.

Reopening merits but base effect waning. The merits of reopening are showing following Malaysia’s transition to endemicity on 1 Apr: private consumption recovered strongly (2Q22: +18.3% YoY), retail sales surged (Jun/Jul: >31% YoY) and tourist arrivals surpassed expectations. The recent mask mandate removal – while neutral economically – is an important signal that this reopened endemic is here to stay. Still, we are cognisant that some of these robust numbers should diminish in 4Q22 as the base effect wanes; recall that 2-3Q21 was marred by MCO3.0/Phase 1 lockdown. All said, we continue to like the brewers which has visible demand catalysts in 4Q22 from the World Cup (Nov-Dec) and continued tourists recovery.

Fed’s tightening. Based on the Fed’s economic projections post Sep FOMC meeting, they now expect the FFR to hit 4.4% by year end (from 3.4% previously). This could widen the FFR-OPR spread further from the current +63bps to +190bps by end-2022. Typically, periods of FFR-OPR spread widening (or its expectations) have resulted to KLCI weakness – a negative monthly correlation of -58.5% between the two variables (see Figure #5). We believe that market choppiness will persist until the Fed decelerates on its rate hike path – a daunting task to pin down exactly when, given stubbornly high core inflation.

Ringgit weakness. As a result of further FFR-OPR spread widening expectations, ringgit has depreciated (vs USD) to its worst level since the AFC. Given more aggressive Fed tightening than initially envisioned, we now revise our USD-MYR assumption to average 4.44 (from 4.30) in 2022 and end the year at 4.80. Broadly, KLCI has reacted negatively during periods of ringgit depreciation (Figure #6). Despite USD strength, export related sectors have their respective headwinds – oversupply for the gloves and declining US home sales for the furniture/board makers. For exposure to USD strength, we favour tech and O&G upstream.

Market can stomach higher rates. While OPR hikes generally lead to higher bond yields, we note that the current spread between the KLCI’s earnings yield and MGS10 is still relatively generous at 2.57% (+0.6SD above 5Y mean). 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 a 2x25bps OPR hike in 1H23 pans out, this would further narrow the hypothetical spread to 2.07% (-0.1SD), still palatable around its 5Y mean.

Supply chains improving. The global supply chain continues to see improvement as most countries pursue reopening: (i) GSCPI Aug reading of 1.47 has come off significantly from its Dec-21 peak of 4.31 and (ii) ships’ Global Schedule Reliability has been trending up for the most of this year while vessel delays have been reducing. While we expect continued gradual reprieve in supply chains, China’s harsh “zero Covid-19” policy remains a key risk – departing container load from China’s ports has fallen to its lowest level YTD in Sep – alongside the ongoing Russia-Ukraine war which now involves nuclear threats (see Figures #7-10).

Election budget amid a tighter belt. Taking cue from the earlier tabling of Budget 2023 (7 Oct from 28th initially), this points to the likelihood of GE15 happening soon. While expectations are for an “election budget”, its extent could be constrained by the lack of fiscal leeway given record high subsidies (estimated at RM78bn for 2022) alongside economic slowdown risk. We project fiscal deficit to consolidate further to -5.0% to -5.3% of GDP (2022 target: -6.0%). On government revenue, we expect this to increase 2.5% in 2023 with a full reopened year, although new significant taxes (e.g. GST, Prosperity Tax 2.0) are unlikely given the impending polls. For spending, higher BKM cash handouts to the B40 – topping 2022’s RM8.2bn allocation – is a plausible move. While further subsidy rationalisation measures are likely, fuel is a touchy issue which we believe will only materialise post GE15 – some “signalling” though, could happen during the Budget. Expenditure savings should also stem from lower Covid-19 spending, which we expect an allocation of RM11bn (2021/2022: RM38/23bn). To support economic recovery, we think the government will allocate a higher development expenditure (DE) sum of RM80-85bn (2022: RM75.6bn).

Budget expectations. From a market perspective, we expect Budget 2023 to be relatively muted with no major wows or shocks. Broadly, higher cash handouts would be positive for the consumer sector. While construction (traditionally a budget favourite) should benefit from higher DE, the unveiling of new mega projects seems unlikely; focus is likely to be on small to mid-sized basic infra jobs. Initiatives for the property sector will probably be targeted to the B40 and M40 buyer group (e.g. tax relief for first time homebuyers, while not ruling out another HOC). Further expansion/extensions on the benefits accorded to EV car buyers seem probable. For the sins, we believe a tax/excise hike can be averted for casinos (last hike in 2019 and still recovering from the pandemic), NFOs and tobacco (both still face a sizable illegal/illicit market). Though unlikely, a hit on the brewers can’t be discounted entirely (last alcohol excise hike in 2016) given their recovery back to pre-pandemic levels. On the ESG front, we may see (i) details on Carbon Tax (taking cue from the impending VCM launch), (ii) incentives for more RE capacity and (iii) push for higher female board representation.

End-2022 KLCI target at 1,540. We project CY22/23 KLCI earnings growth to chalk in at -8.2%/+6.9%. Our end-2022 KLCI target is revised lower to 1,540 (from 1,560) based on 15.5x (-1SD 5Y) mid-CY23 PE. We also introduce our preliminary 2023 KLCI target of 1,590 derived from 15.5x end-CY23 PE – the modest YoY upside to this reflects rising risk of a possible global recession on the horizon. Granted, PE valuations are rather flimsy given this uncertainty, however we take some solace that (i) PB is at -2SD, which has been a decent gauge of bottomed valuations and (ii) foreign shareholding (end-Aug) is at a record low 20.1%. Expanding further on this, we would tactically bottom nibble on current weakness to ride on the traditional year end window dressing effect – post GFC, KLCI registered positive Dec returns in 11 out of the past 12 years (92% hit rate; Figure #16). Our top picks are Tenaga, RHB, Dialog, MAHB, Sunway, Carlsberg, BIMB, VS, SPToto, DNeX, Armada and FocusP.

Source: Hong Leong Investment Bank Research - 30 Sept 2022