Concerns that the weak global environment could hurt Malaysia's external sector did not pan out with consensus expecting real GDP yoy growth to moderate to 4.6% in 2Q from 4.7% in 1Q (which was revised up to 4.9%). Instead, the economy expanded by a faster 5.4% yoy in 2Q, just a tad stronger than our projection of 5.2%, underpinned once again by robust domestic demand. Headline inflation also came in better than expected (consensus: 1.6%; OSK: 1.8%), rising by just 1.4% yoy in Jul, slower than Jun's 1.6% - the ninth consecutive month of moderation.

As in 1Q, the key driver of growth was domestic demand, which contributed a whopping 11.6 ppts to GDP in 2Q. This was largely due to strong investment expenditure, up 26.1% yoy in 2Q from 16.1% in 1Q, underpinned by ETP and infrastructure projects. Also supporting the strong 2Q growth was resilient private consumption, which rose by 8.8% yoy in 2Q vs. 1Q's 7.4%, helped by tight labor market and strong income growth. After a lackluster performance in 1Q, government spending rose by a healthy 9.4% in 2Q (1Q: 7.3%), helped by increased spending on civil servant salaries and generous cash handouts to lower income families. Not surprisingly, the protracted woes in the Eurozone, weak recovery in the US and slowing Chinese economy continued to take their toll on the external sector. Exports slowed to 2.1% yoy in 2Q from 2.8% in 1Q, while imports expanded by a quicker 8.1% yoy in 2Q vs. to 6.8% in 1Q. In short, net exports (exports minus imports) subtracted nearly 5.0% ppts from 2Q GDP. On the supply-side, with the exception of agriculture (which fell 4.7% yoy), manufacturing, construction, services and mining all expanded at a faster pace of 5.6%, 22.2%, 6.3% and 2.3% yoy respectively in 2Q than in 1Q. Given the risks to growth from external headwinds, we expect continued fiscal support for the economy when the 2013 Budget is announced in Sep 28 to drive the economy forward in the uncertain external environment. We maintain our expectation the economy would grow by 5.2% in 2012 (BNM now expects the economy to come in at the upper end of the official forecast of 4-5%).

Contrary to our expectations, food prices rose by a slower 2.6% yoy in Jul (Jun: 1.9%). This together with lower transport costs (Jul: -0.5%, Jun: 0.5%) and stable housing cost (Jul & Jun: 1.5%), helped to restraint inflationary pressures in Jul. In the near term, prices could temporarily re-accelerate as a result of the Muslim fasting month in Jul-Aug. More of a concern though is that both demand-pull and cost-push inflation could re-emerge as a result of the massive government spending and the impact of the minimum wage policy. However, we think that the inflationary pressures are likely to be mitigated by weaker commodity prices and continued government subsidies. We maintain our full-year inflation forecast at 2.3% in 2012. As a result of more moderate inflation amid global headwinds, we do not now expect any hikes to the OPR this year.

Source: OSK