• FBM KLCI has weaken over the past 2 months in tandem with outflows from the region and Emerging Markets on a whole. Further fund outflows may however be contained supported by a wide interest-rate differential between US and Malaysia, stronger RM, absence of political overhang and investors’ confidence on a more transparent new government.
• Investors could attain an 8%-9% upside based on lower projection for the index of 1,845 at end-2018 based on 18.4x 2018E KLCI EPS (previously 1,923 at 18.6x PE)
• Risks include escalating trade tensions between US and China, faster pace of US rate hikes, disappointing corporate earnings, sovereign rating downgrade, geopolitical risks and bond market sell-down

The Fund and Its Objective

The Net Asset Value (NAV) per Unit was RM1.7468 as of 9th July 2018, declining by 6.1% since our initiation on 5th June 2018 which was in line with the 4.7% decline in the FBM KLCI. The Fund’s NAV was RM2.9057m as of 9th July 2018 which is 4.3% lower compared to the start of the year compared to a 5.5% decline over the same period for the benchmark.

Recall that the FBM KLCI etf aims to achieve a price and yield performance, before fees, expenses and tax, that is similar to that of the FTSE Bursa Malaysia Large 30 Index. The Fund manager, AmFunds Management Berhad, aims to achieve a performance, over time, with a correlation of 95% or better between the Fund’s NAV and the Benchmark. The 3-year tracking error is 0.3% while the management fee is 0.5%.

Performance in 1H2018

In the first half of 2018, the FBMKLCI tumbled by 5.9% to 1691.50 following nearly two consecutive months of net capital outflows in May and June amounting to RM10.5bn which had erased the RM3.5bn net inflow recorded earlier from January to April 2018. Pakatan Harapan’s initial cancellation announcements of major projects such as the Kuala Lumpur-Singapore High Speed Rail (HSR) and MRT 3 in a bid to reduce the Government’s debt of RM1.087 trillion or 80.3% of GDP as of 31st December 2017 led to the sell-off of notable construction and infrastructure names as well as those politically linked to the previous government. On the external front, the FBMKLCI performance was pulled down by the stronger US$ which appreciated by 2.5% in 1H2018, Italian election jitters, slowdown in economic growth in Europe and Japan as well as increasing trade tensions between the US and China. Despite this, the FBMKLCI performance was in line with the declines seen in other Asian markets in the first half of the year.

FBMKLCI Outlook in 2018

In the second half of the year, real GDP is estimated to slow to around 5% compared to 5.5% estimated in 1H18. As Malaysia is a highly open and trade dependent economy, with strong exposure to the semiconductor industry, the steady growth in the global economic development and semiconductor demand will support Malaysia’s exports. Domestic demand is expected to gain some momentum from higher private consumption as households increase their purchases following the reduction of the Goods and Services Tax (GST) to 0% effective 1 June 2018.

Furthermore, the Government has recently stated that HSR could be scaled down instead to RM20bn from RM60bn while the East Coast Rail Link (ECRL) will be suspended as the Government looks to the reduce the cost of the project. The revenue loss from cancelled construction projects is only estimated to have a negative impact of RM3bn or 0.3% of GDP. Moreover, the construction sector earnings account for only 3% of market earnings. Therefore, for the full year, the Malaysian economy is still anticipated to grow at 5.3% yoy compared to 5.9% in 2017.

Going forward, sharp outflows from the KLCI could be limited by the country’s ample domestic liquidity. Based on our estimates, private and quasi government funds combined account for more than RM1.6trn and accounts for 52% of the Malaysian capital market. Secondly, the interest rate differential between the US and Malaysia remains wide at 125bps compared to most of its peers. Even with US Federal Reserve raising its Fed Funds rate twice so far this year to 1.75-2.00%, while some regional central banks (Bank Indonesia and Bangko Sentral ng Pilipinas) have also raised policy rates, we believe BNM will likely wait until late 2H18 to gauge the state of the Malaysian economy before deciding on whether to raise OPR further by 25bps to 3.5% (3.25% currently).

Thirdly, the Ringgit, which appreciated to its strongest of RM3.86 against the US$ on 2nd April 2018, has weakened by 4.6% at the end of the 2Q18 due to uncertainties over the global trade war and international investors’ expectations of a sharper appreciation of the US dollar. This had led to some unwinding of holdings of emerging market assets by foreign investors back to US denominated assets. Despite this, the Ringgit is still anticipated to appreciate to RM3.80/US$ by end-2018, supported by Malaysia’s healthy economic fundamentals, large current account surplus which is anticipated to be substantial at RM39bn in 2018 or 2-3% of gross national income (GNI) (2017: RM40.3bn or 3.1% of GNI), as well as ample foreign exchange reserves which is currently at US$104.7bn as of end June (US$108.5bn as at end May). Lastly, the absence of a political overhang and a more transparent new government will bolster confidence in Malaysia.

The recent decline of the FBMKLCI led to the drop in the PE valuation to 1SD below its 5-year historical mean, and is currently trading at an attractive 16.9x 2018E earnings (16.1x 2019E earnings). Hence, the inhouse KLCI 2018 year-end target has been lowered to 1,845 (previously 1,923) based on a lower PE of 18.4x (previously PE of 18.6x) after taking into account a revised time horizon (still on a 5-year basis) and lower corporate earnings growth.

Downside Risks to KLCI Outlook

Firstly, the escalating trade tensions between US and China. Secondly, US Fed accelerating its interest rate cycle in response to a rise in US inflation levels. Thirdly, disappointing corporate earnings. Fourthly, sovereign rating downgrade if the Government loses sight of its fiscal consolidation plans or contractionary fiscal measures which could weigh on GDP. Lastly, the risk of heightened geopolitical risks in North Korea and/or the Middle East may disrupt financial markets. Lastly, a selldown in the bond market.

Source: Affin Hwang Research - 10 Jul 2018