• Election risk is out of the equation with a smooth power transition. Against all odds, Pakatan Harapan (PH) surprisingly won the 14th General Election (GE 14) with a simple majority of 113 seats in parliament (out of 222 seats). With a smooth power transition, Tun Dr Mahathir was sworn in as the the 7th Prime Minister of Malaysia. Meanwhile, the previous ruling government, Barisan Nasional (BN) which was led by Datuk Seri Najib Tun Razak only won 79 seats. PH continued its reign on popular votes, achieving 50% whilst BN garnered 32% and Parti Islam Se-Malaysia (PAS) recorded 18% popular votes. On the state legislative assemblies, BN lost control of the states of Kedah, Perak, Negeri Sembilan, Melaka, Johor and Sabah to PH and Terengganu to PAS. PH continued holding on to power on states such as Penang and Selangor, whilst PAS continued to rule in Kelantan.
• Expecting knee-jerk reaction from the market. We deem the election outcome as a ‘negative surprise’ to the market as the polling results are against investor expectations and the market has yet to factor in any of it. This was evidenced by the drop in Offshore Ringgit, i.e. non-deliverable forward (NDF) and surge in Malaysia credit default swap (CDS). We reckon that equity market, in the short term, will be clouded by uncertainty on some economic policies continuity and public delivery system. Should there be any market selldown, we advise investors to take this opportunity to accumulate the fundamentally sounds stocks especially the blue-chip stocks or index linked counters as we believe the selloff is temporary. In fact, the newly sworn-in PM Tun Dr Mahathir assured that the new government will be business-friendly, and expressed hopes that the stock market will continue to remain active and business community to push up the stock prices after it reopens following the outcome of the polling results. We believe the foreign investors’ interests and confidence on our capital market will be further boosted by The Council of Elders which consists of prominent economist, well-respected business tycoon, highlyexperienced and top-ranked ex-officials who help to advise the government during the first 100 days.
• Potential loser - construction sector; Potential winner - consumer sector. We opine that construction stocks will be bashed down in the short term as Tun Dr Mahathir could review the RM55b East Coast Rail Link (ECRL) project and other infrastructure or building projects related to China investment and/or JV in the likes of Melaka Gateway/Port, Forest City project in Iskandar, Kuantan Industrial Park and Port in Pahang. On the flip side, consumer counters are expected to benefit from the potential scrap of GST, minimum wage hike and other handouts given by the government as well as higher disposable income of the ‘rakyat’ pursuant to abolishment of tolls and re-introduction of petrol subsidy.

• Positive in the long run. We believe that local bourse shall perform positively in the long run as the new ruling government would embark on institutional reform to restore public trust and revamp of economic policies to address the current economic structural woes such as middle income trap, rising cost of living and distortion or misallocations of economic resources. On top of that, the PH government plans to revise current development projects in order to reduce the government debts as well as reducing leakages in the public sector.

• Keep a close eye on fiscal deficit. Malaysia aims to achieve fiscal deficit of 2.8% of GDP in 2018 from an estimated 3.0% in 2017. However, the market is concerned that the government’s focus on fiscal discipline will be distracted with a slew of handouts to be fulfilled. Under PH’s G14 manifesto, it pledges the: 1) abolishment of GST, 2) re-introduction of fuel subsidies for targeted group, 3) introduction of EPF scheme for housewives, 4) hike in minimum wage, 5) postponement of repayment to the National Higher Education Fund Corporation (PTPTN), 6) abolishment of tolls in stages, and 7) scrapping of Felda settlers’ debts. On a positive note, we reckon that the new ruling government could decrease its operating expenditure judging from the smaller size of cabinet of ministers against the previous administration.
• A volatile year. Even with the removal of political risks, we do not foresee the smooth sailing of local bourse for this year. We envisage the market to be choppy mainly affected by a slew of uncertainties in local and external factors.
• GDP growth expected to taper off….. On the local front, GDP growth for this year is likely to slow down to 5.3-5.5% following surprisingly strong economic growth of 5.9% recorded in 2017. This is mainly due to potential slowdown in China economy (Chinese government aims for 6.5% GDP growth this year from 6.9% growth last year) and prevailing trade protectionism advocated by Trump administration. Still, we opine that domestic consumption is resilient enough to cushion the negative impact of slowdown in export.

• ……..coupled with lukewarm corporate earnings. We foresee some downside risks on corporate earnings growth on the back of escalating costs with the implementation of few policies and rulings starting this year – higher finance costs following rate hike in January this year; rising operating costs in relation to higher gas and fuel prices as a result of increase in power/gas tariffs, higher raw material costs following rebound of crude oil and commodity prices; higher labour costs with the hike in minimum wages and adoption of employment insurance scheme (EIS) early this year. This is detrimental to industrial sector especially small-and-mid cap manufacturing companies whilst index-linked or large-cap counters are relatively immune from that. Furthermore, the earlier strengthening of MYR against USD also aggravates the bottom lines of those export-oriented counters. However, we believe the large cap or index-linked counters could immune from this relatively well as compared to the small-and-mid cap stocks.

• Lingering concerns on the end-of-cycle of low interest rate…… On the external front, the prelude of normalisation of interest rate from developed markets to emerging markets would put pressure on asset values. The US Federal Reserve signalled another 2~3 more rate hikes in 2018 following the recent hike in March this year. ECB indicated that it would halve its bond buying programme from Euro 60b to 30b per month, which started early this year and eventually stop the quantitative easing (QE) in end-September 18. Back to the region, South Korea and China had raised their interest rates in 2H17 whilst Malaysia lifted its overnight policy rate (OPR) early this year. Market speculates that the Philippines, Thailand, and Taiwan could follow suit. Recent soaring of US 10-year Treasury yield, now closes to 3.0%, which is above its average of 2.6% for the past 10 years, also exacerbates the volatility of asset values. Risky asset such as equity might look unappealing to investors with the rising bond yield. US Treasury yield is expected to inch up in the near term pursuant to Fed tightening, i.e. unwinding its balance sheet and issuance of more Treasury notes and government bonds for funding Trump’s tax cut, infrastructure spending could further weigh on the bond prices and lift the yields.

• ……as well as escalating trade tensions. Besides, heightening trade tensions between China and the US coupled with the US’ ban on China’s ZTE for chip supply and prevailing investigations on Huawei in relation to US’ sanctions on Iran also aggravated the situation. This could further escalate trade tensions between the largest and second largest economies in the world, triggering full-blown trade war and disrupt the global supply chains for technological and industrial products.

• We reckon that asset rerating is underway for the local bourse on the back of rising bond yields. Following the recent spike in US 10-year Treasury (which surpassed 3% at one time), the premium between the earnings yield of the market and 10-year MGS is narrowing. The rising yields could alter the value proposition for equities versus fixed income for years to come. Should the US employment data and inflation figure perform above market expectations, we could see higher and faster-than-expected rate hike and surge of bond yield which triggers fresh round of outflows of foreign funds from the emerging markets.
• Fundamental analysis wise, current market valuation is fairly priced with the FBM KLCI currently trading at 16-17x 2018 PE, which is at the range of +0.5~+1.0 standard deviation above its historical mean PE of 15.2x. At this junction, we deem the current valuation as fully valued in the absence of any strong positive catalyst whilst immediate market outlook remains uncertain.
• On a technical outlook, our technical indicators are mixed with the RSI hovering above the oversold zone while the MACD crossed below its signal line. The selldown since last month came after failing to test the psychological 1900 points. Last Tuesday’s rebound climbed above the 100-day moving average of 1834 points but remains in the downtrend channel as it still below its 50-day moving average of 1859 points.

• We recommend investors to start looking at small-and-mid cap stocks as political risk is out of the equation and following the broad-based slump of these stocks since early this year with limited downside at this junction. We believe the second and third liners could play catch up to the large caps.

• Maintain NEUTRAL on the local bourse with our 2018 FBM KLCI year-end target of 1860 points. Our 2018 KLCI target is based on our market EPS growth forecast of +5.9% for 2018 with target 2018 PER of 16.9x (+1 standard deviation above mean). Whilst we maintain our neutral with positive bias view on the market outlook for this year, we are mindful that market could exhibit another choppy year in 2018 under prevailing mature bull market.

• Our top picks under coverage are: Hai-O (Target Price: RM6.41), Kim Loong Resources (Target Price: RM1.52), LBS (Target Price: RM1.30) and Tasco (Target Price: RM2.49).

Source: JF Apex Securities Research - 14 May 2018