This time is different. Since the Fed has no roadmap for exiting its experiment primarily because it has never been in this position before, its faces a tough decision. Though we can draw lessons from the failed 1994 episode of Fed tightening the risks is far bigger today. Considering that the U.S. economy is still far from healthy, with unemployment grossly underestimated and the real estate as well as manufacturing recovery vulnerable, we expect the Fed may want to do some backtracking. Apart from having ample opportunity to clarify and dictate its message clearly, we anticipate that Bernanke will ease concerns of a premature shift in policy.

Bad timing. The Fed’s little experiment to gauge the market’s reaction of a possible reversal of QE3 seemed to also coincide with Bank of Japan’s failure to deliver firmer structural reforms. Meanwhile, the strengthening of the U.S. dollar also indicates that it could potentially raise deflationary pressure globally. As a result, it roiled both equity and credit markets triggering capital flight wherever hot money had been flowing.

The Yen connection. The yen strengthening and the correlation with every major equity market and several bond markets (Fig. 3) are becoming increasingly higher. This could also mean that if the yen continues to appreciate, the global financial system may see rise in volatility and downtrend pattern going forward.

A resilient KLCI. In spite of the recent global market rout, the FBMKLCI is still holding up. Since May 22, it only fell by just 0.7% at 1,772.2 as at June 17 close and remained slightly above our year-end target of 1,770. Its resilience could mainly be explained by the more than ample liquidity that can be deployed back into the equity market and the fact that it has been suppressed much earlier due to uncertainty prior to the 13^th General Election (GE). Coupled with its lagging performance against the regional peers, we believe that the local equity market is still in a catch-up mode.

Market outlook. Despite current market concerns, the liquidity backdrop will remain favourable for the emerging market equities for the foreseeable future. Ultimately, it will benefit from improvement in economic conditions that cause the Fed to taper its QE policy. The current rebound of the emerging economies is largely driven by improving structural backdrop and the strengthening global business cycle as opposed to the strong U.S. consumer demand financed by the stronger dollar previously. With the expectation that the global economy would improve in the 2H13, we are looking to revise up our index target especially given that we are in the midst of rolling over our valuation base year for our stock coverage to CY2014. Tentatively, we are pegging our 12-month index target at 1,830, representing 16.4x FY14 PER.

Dollar/ringgit volatility rises. While the equity market appeared to be more resilient, the large outflow of capital seemed to have an adverse affect on the local currency. In tandem with the regional currency downtrend as a result of the large switch towards U.S. dollar asset. We continue to expect the dollar/ringgit to remain volatile in the near term. However, we maintain that the strength of domestic economy along with improvement in the global economic outlook would lend support to the underlying strength of the ringgit. Hence, we retain our year-end dollar/ringgit forecast at 2.97.

Monetary outlook. By now we should be able to conclude that future Fed policy would undertake three distinct phases: tapering, pausing, and tightening. The unknown variable is the length of time between each of the above phases. Nonetheless, Fed tapering is expected to begin later rather than sooner and it would move at a gradual pace to ensure that the economic recovery gathers pace. In other words, the U.S. monetary policy would still be highly accommodative for a long time. Taking the queue from this, it is unlikely that Bank Negara would overreact to immediately adjust its monetary policy to deal with the current flux in the capital market. Hence, our view on BNM’s monetary policy remains unchanged and the Overnight Policy Rate to stay at 3.00% till end of this year. 

Source: Kenanga