The weaker 2Q17 corporate earnings season proved to be a blip as 3Q17 earnings while not spectacular, showed an improvement. Earnings growth was broad-based with banks, O&G and plantations driving 3Q17 earnings. While we have cut our market EPS growth further to -1%, net profit growth remains decent at 2.8% and in tandem with improved macro conditions. We think that the latter is supportive of corporate earnings growth in the coming quarter and we project 8.5% EPS growth in FY18. Maintain Overweight but with a lower 2017 year-end target of 1,770 (based on 17x 2017E earnings).

Stronger GDP Growth, Commodity and Oil Prices Filtering Through

Earnings momentum improved in 3Q17(+6.9% yoy, +1.4% qoq) after the slight blip in 2Q17. Overall, improving macro conditions (stronger than expected GDP growth of 6.2% in 3Q17), higher CPO and oil prices are flowing down to corporate earnings in the banks, plantation and O&G sectors (combined 56% of market earnings) contributing to most of the growth in 3Q17. The other notable sectors (with strong earnings delivery) are rubber products (+46% yoy) and technology (+40% yoy), both of which are seeing demand outstripping supply and strong capex expansion respectively. As opposed to 2Q17 where we saw the large caps earnings performance trumping the broader market, the reverse was true in 3Q17 (Fig 2). We view this positively as earnings delivery is filtering down to the broader market.

A Better 3Q17 Earnings Season

The number of companies with earnings that surprised us increased to 20% of our coverage from 13% in 2Q17. There were also fewer companies that disappointed (36% of coverage in 3Q17 vs 44% in 2Q17). Gaming and Utilities were amongst the disappointers although overall results were pretty much within expectations. Large cap consumer names like BAT and Nestle negatively surprised due to continued loss of market share and higher than expected production cost.

No Changes in 3Q17 Sector Positioning – More Stock Rating Upgrades

No changes to our sector positioning (Fig 17). But, positively there were fewer stock rating downgrades in 3Q17 - 7 downgrades compared to 20 in 2Q17. In addition, there were also more rating upgrades – 13 in 3Q17 vs 7 in 2Q17, which were mostly due to valuation pullback and improved earnings outlook (JTiasa, FGV, UMW-OG and Aeon Credit) (Fig 8).

2017 Market EPS Growth Slows to -1%, Net Profit Growth Still Strong

Despite the better performance, our forecast market EPS growth has slowed to -1.5% from 2.7% after the 2Q17 results season. We nevertheless highlight that market core profit growth is still a positive 2.6% growth in 2017 (0% in 2016), in line with the improved macro backdrop. Moreover, for the FBMKLCI 30 constituents, 2017E EPS growth is even stronger at 5.1% (2018E: 4.9%).

Maintain Overweight. End-2017 KLCI Target Lowered to 1770

We keep our Overweight stance on the KLCI and believe that we should see a broader-based earnings recovery in 2018 as growth shifts from exports to domestic demand. Our 2017 year-end target is lowered to 1,770 based on a 5- year mean PE of 17x (previously 1,813 based on 17.9x or a 3-year mean PE).

Top Call Revisions

Our top call revisions include Maybank, Hong Leong Bank, Top Glove, Inari, Serba Dinamik and Apex Healthcare which replace Allianz, AMMB, Gamuda, Genting Bhd, Perak Transit and Uchi (Fig 12). We nevertheless still have BUY ratings on the six stocks removed as long-term growth drivers remain intact. The sharp price performance of the smaller caps - Perak Transit and Uchi - however leads us in search for other potential candidates that may offer better upside. Our least-preferred names are AirAsiaX, Unisem, Media Prima, WTK and Lafarge. We removed Star due to the limited downside although we still believe that share price is still undergoing a structural de-rating.

Risks

Downside risks: i) decline in commodity prices including CPO and oil prices; ii) further corporate earnings disappointments; iii) Malaysia losing sight of its fiscal consolidation plans and leading to a sovereign rating downgrade; iv) US Fed accelerating its interest rate hike and paring down its balance sheet too fast or ECB tightening its monetary policy too quickly; which combined would lead to an acceleration in capital outflows.

Source: Affin Hwang Research - 5 Dec 2017