OVERVIEW

Exports on the mend – Improving external demand and sustainable domestic growth should be able to keep 1H14 GDP higher at close to 6.0% while in the 2H14 it’s projected to average by 5.2%.

Further fiscal consolidation – both public and private sectors are keeping their belt tight and patiently wading through inflationary pressures as a result of fiscal consolidation. Fiscal deficit is projected to narrow to 3.7% of GDP (-3.9% of GDP).

Inflation above long term average – Inflation remains cost-push and will take a while to normalize. Average CPI rate would remain elevated for much of the 1H14 but should taper off by the 2H14.

Interest rate to stay pat – Current rates are supportive of the economy, inflationary pressures being non pervasive, gives little reason for BNM to raise the OPR for the rest of year.

Ringgit to remain volatile – With ongoing Fed’s QE tapering along with ECB recent rate cuts and possible QE the ringgit is expected remain volatile with a weakening bias vis-à-vis USD.

Some risk remains – Fiscal consolidation may end up hampering domestic growth beyond unwarranted levels whilst risks from the Middle East, Europe, China and Japan may be prolonged, jeopardizing overall growth.

Beyond 2014 – The higher possibility that the Fed would hike interest rates and the impact of the implementation of GST next year would generate an interesting macro environment with a possible downside bias to the economy. On the expectation of further improvement in the global economy and steadier domestic growth traction in the 2H15 we expect GDP may stay above 5.0% next year.

Summary

Rebound in the 2H14. Though the 1H14 global growth is being dragged down the the worse-than-expected 1Q14, it is well on the way to a strong rebound in the following quarters, particularly in the US. Deflationary threats in Europe however remains a prevalent problem and China’s internal restructuring does put a damper on growth, especially in the East. However, Japan’s growth, though currently diminished due to the tax hike in the 2Q14 is expected to recover, aided by additional stimulus. On a whole though, global growth, largely driven by improvements in the US, will help prop up exports in the 2H14, as well as fuel consumption and investment. In Malaysia, growth in the 1Q14 surpassed all expectation and this adds momentum to growth for the rest of the year. Inflationary pressures are slowly normalizing but inflation still remains above the long-term average. There are some volatility on account of QE tapering in the US and interest rate cut in Europe but these remain short term. Though overall growth remains steady, due to a higher base, actual growth rate in the 2H14 is expected to be sligthly more moderate though overall 2014 growth is projected to expand by 5.5%

Global outlook

An upwards but uneven growth. In a nutshell, the global economy is pointing towards a more optimistic second half of the year. However, there are still many portholes and bumps along the road to global economic recovery.

ECB worries. As of late, eyes have been on ECB and their decision to cut the interest rates to a historical low of 0.15% and to lower deposit rates to -0.1% to encourage lending. They’ve also announced a €400b package of cheap funding for banks on the condition it is used to lend money to companies outside the financial sector, and not for mortgages. However, the full impact of its latest monetary measures to the rest of the world is yet to be seen until the bond buying measures or its own version of QE is announced.

Struggling consumption. There are huge disparities in unemployment rates, with countries like Germany posting a 5.2% and Austria by 4.9%, whilst countries like Greece, Spain and France are recording double digit rates of 26.5%, 25.1% and 10.1% each respectively. Inflation continues to fall, latest seen at 0.5 % in June, well below the ECB’s target of 2.0%. Retail sales, as measured by Markit’s PMI index, Eurozone’s PMI could barely remain above the 50-point mark of expansion, and has been contracting more often than not (last seen at 49.9). This points to a higher probabily of some form of QE if things don’t begin to pick up in the near future.

At least yields continue to fall. But there are some positive news from Europe. Ireland, Spain and Portugal have exited their bailout programme and focus has switched from austerity to promoting growth. Having resumed regular auctions of bonds, which have become favourable due to its higher yielding debt, monetary bodies like the IMF and ECB can turn more attention to implementing whatever necessary measure to fighting the threat of deflation in the Euro area as a whole.

So far so good for the USA. Despite the chilly start of the year, which has dragged down the US economy in the 1Q14, leading to a downgrade in overall 2014 forecast by the US Fed, the following quarter is expected to perform substancially better and to add momentum to growth into the second half of the year. Unemployment rates have been on a downtrend (latest at 6.3%) but more importantly, labour participation rate has finally picked up, though at 62.8%, it still remains at over 30-year lows. This led to sentiment, especially consumer confidence to be somewhat mixed. However, general sentiment has been on an uptrend and expecting economic conditions as a whole to further improve.

Fed rates likely to stay pat. Booking for capital goods rose by 0.7% followign a decline of 1.1% previously, services sector at fastest pace in 4 ½ years, as seen in Markit’s flash PMI and new home sales at 6-year high all point to a far more hopeful 2H14. Hence why the Fed still remains optimistic over the overall recovery of the US economy, will stick to gradual QE tapering (currently at US$35b a month). However, on worse than expected 1Q14 results, Fed revised their overall GDP growth to 2.1% to 2.3% from 2.8% to 3.0%. This may prompt them to keep interest rates near zero for a while yet.

ST slowdown in Japan. Here in the East, we saw Japan’s GDP expanding at a rather phenomeal pace prior to the tax hike on the 1st of April. 1Q14 grew by 6.7%, revised from an initial 5.9%, fastest pace seen since 3Q11. This is mainly on higher than expected capital expenditure. This would hopefuly mitigate the downside effect of the tax hike, especially towards consumption. But let it not be said that the Japanese do not take a leaf out of their history book. A tax hike may help reduce their overwhelming debts but it will also be detrimental to growth in the economy.

LT rebound. To hopefully avoid that from happening, the Bank of Japan (BoJ) will provide 4.9 trillion yen (US$48.02b) to banks under a scheme it uses to encourage lending by providing financial institutions with cheap funds. In addition to that, they’ve also revealed plans to cut corporate taxes to below 30%, from the current 36% for large companies, which is currently the highest in the industrialized world. In the Reuters Tankan index, which strongly correlates with the BoJ’s tankan quarterly survey, points to steady confidence amongst Japanese manufacturers and those in the service sector. The upcoming BoJ Tankan is also expected to show a dip in the short term but to be followed by a gradual improvement in the folowing quarter. However, falling exports (-2.7% in May) risks hurting overall economy. Similar to the case of Singapore and South Korea, these countries may not be benefitting yet from a recovery in developed economies.

Moderate China. In China, a moderation is expected in light of their sweeping reforms in all corners of the Middle Kingdom. However, due to the structure of their system, politices and regulations were able to be implemented swiftly and resutls could already be seen. China’s outstanding debt slowed down for nine province and nine cities, growing by 3.70% from the end of June 2013 through to end of March 2014, 7 percentage points slower than the pace in the 1H13. House prices has also fallen, as new homes saw a 0.2% monthly drop in prices, as did property investment (14.7% rise, down from 16.4%) and new construction (fell by 18.6%, fourth consecutive decline).

Hit target. However to ensure that they are still able to hit their GDP target of 7.5%, China’s central bank said that they would keep monetary policy steady in 2014. The total fiscal spending surged nearly 25% (+US$209.6b) in May also highlights the government’s effort to energize the slowing economy. The government has also announced infrastructure plans (building railways, roads and airports), to cut taxes on small firms and encourage banks to lend more to exporters to boost shipments.

Growth Prospects

2Q14 Overview

Moderate pace. After a rather exceptional growth in the 1Q14, we are estimating that the 2Q14 will grow somewhat more moderately, mainly on slight moderation in consumption, with no festivities to give it a boost and an expected winding down from the public side. However, strong momentum from the first quartile of the year along with better-than-expected exports allows us to upgrade our 2Q14 growth estimate to 5.7% from 5.0% previously.

Exports as driver. Overseas shipment is estimated to retain its strong performance throughout the 2Q14. So far, we have seen exports post an impressive 18.9% growth in the month of May, and we expect it to remain at double-digit expansion for the rest of the 2Q14. This will enventually add in to the exports component of the GDP, which we are looking will expand by 13.5%, overtaking 1Q14’s gain of 7.9%.

Subdued domestic demand. Though the manufacturing sector largely gains from overseas demand, we feel that it will grow at a slower pace in the 2Q14, to 5.7% from 6.8% seen in the 1Q14. This is mainly due to a more subdued aggregate demand on the domestic front. With little to churn private consumption (lack of festivites) and a round of penny-pinching following higher costs due to fiscal consolidation, overall consumption is estimated to moderate to 5.4% from 11.2%. Similarly, we also doubt that there will be anymore increased spending on supplies and services in the public sector, which was what helped lift overall consumption in the 1Q14.

The multiplier factor. The construction sector will continue its expansion, though at a mode moderate pace largely due to a high base effect. Major projects under the ETP have been running on schedule, and this will continue to add some weight to overall growth. We are looking at the construction sector to expand by 10.1% (1Q14: 18.9%). Overall investment is expected to be further boosted by the private sector, largely on manufacturing and services. We are looking at a investment growth in 2Q14 to expand by 8.7% from 6.3% in the 1Q14.

Outlook 2H14

Hard to keep pace. On account of a stronger 1H14, it will be a bit challenging for the rest of the year to match up. Similarly, it also faces a higher base from the second half of 2013, whence the overall global economy began its road to economic recovery. However, the momentum from the first part of the year should be able to provide just the right amout of push to keep growth steady.

Shipments a boost. Exports will continue to be one of the main drivers in the 3Q14, largely on demand coming from the USA, in light of inventory stock up in anticipation of demand build up in the 4Q14, which has generally seen the strongest consumer demand. We are also optimistic on demand coming from Europe, following the ECB’s cut in interest rates and cheap funding. There’s also the possibility that Draghi may announce a stimilus similar to that of the QE. However, the main driver of exports will be the USA, which also directly improves demand from other exporting nations and emerging Asia, of which Malaysia shares strong trade relations with.

Moderating Asian growth. However, expectation from China and Japan will be somewhat muted and this will restrain growth on the upside. China’s reforms’ will mean economic growth in the Middle Kingdom will be at a more subdued pace for some time. Though Japan’s outlook is rosier, what with Abenomic’s third arrow (US$48b lending scheme, cut in corporate taxes etc.) expected to mitigate downside effects of the tax hike, BoJ is uncertain of its exports sector, which hasn’t been able to take advantage from recovery in developed economies.

Exports’ growth contribution tapers. We are looking at the 3Q14 net exports to grow by 6.7%, a slower pace than our 13.5% estimate in the 2Q14. This is a smaller percentage point (ppt) contirbution of 6.0ppts to overall GDP, compared to 11.9ppts we are estimating for the 2Q13. Into the final quarter of the year, though exports is predicted to improve further, it will be facing an even higher base effect. Therefore, we are looking at value-added exports to grow by 4.0% in the 4Q14 and this will bring about overal 2H14 exports to 5.3%, almost halve of our 1H14 estimate of 10.7%. This is also on the fact that we are estimating a higher imports in the 2H14 (+6.7%), which reduces exports’ contribution to overall growth.

Consumption rebound.The stronger imports will be on the back of improved consumption. If things remain ceteris paribus, the 2H14 ought to see a recovery in consumer demand. With festivities at both ends of the 2H14 (Ramadhan & Eid the 3Q14, year-end holidays and celebrations in the 4Q14), it gives reason to be optimistic on the consumer demand in the 2H14. There is also the expectation of further uptick in consumption in anticipation of the GST implementation in April 2015. Henceforth, we foresee consumption to expand by 5.7% in the 3Q14, and by 6.2% in the 4Q14. This will contribute 3.8ppts and 4.2ppts to GDP respectively. Investment, both public and private is also expected to further gain in the 3Q14, where we’re looking at a 10.9% growth, and 9.1% in the 4Q14.

Manufacturing facing high base. The manufacturing sector also benefits from domestic demand, though at a more sedate pace from the 1H14 due to the higher base. We are looking at the manufcaturing sector to expand by 4.2% in the 3Q14 and to improve slightly in the 3Q14, to 4.9%.

Infrastructure works on schedule. The construction sector will power on, but similar to the situation with manufacturing and exports, it will be at a more moderate pace due to a higher base. Regardles, with major projects steaming ahead on schedule, we anticipate this sector to expand by 8.5% in the 3Q14, followed by 8.0% in the 4Q14.

Lower 2H14 GDP. All in all, we have had to pare down our 2H14 growth to be at a more moderate pace as it will be tougher to keep pace to the stronger growth 1H14. However, we believe that aggregate demand as a whole will remain steady, and we’re looking at an overall expansion of 7.2% in the 3Q14 and 7.1% in the 4Q14. This will help push overall GDP to 5.0% in the 3Q14 and 5.4% in the 4Q14 or 5.2% for the whole 2H14, against 5.9% we are estimating in the 1H14. This will average to overall 2014 GDP at 5.5%.

Possible outpacing. That being said, we do not discount the fact that there’s every possibilty of 2H14 may even outpace the 1H14 if global rebound picks up faster than initially anticipated. Similarly, if the government decides to postpone any further fiscal consolidation and domestic consumption picks up, we could very well overshoot our 5.5% forecast. For now though, there is still much uncertaintainty surround the global economy and the domestic economy still struggles against belt-tightening.

Fiscal Policy – Continued consolidation

Another round possible. We reckon that there is the possibility of another round of fiscal consolidation in the the 2H14, in the form of another subsidy rationalization for petrol and a hike in the electriity tariff. However, the government seem to almost be dragging their feet in keeping to their supposedly 6-month interval between each hike. Considering the effects of the first round (petrol price hike in September 2013 and the electricity tariff hike at the start of 2014) took quite some time to normalize (inflation rate is still above the long-term average and looks to remain so for a couple of months yet), it is understandable that they are reluctant to do so, especially when the incurred cost towards businesses and consumer demand may have been higher than expected.

External pressures. Pressures of higher global oil prices due to the situation in Iraq doesn’t help matters. Brent has been hoving around the US$110 to US$115 (it hit a 9-month high of US$115 mid-June). The government have already had to request a supplementary budget of RM4.0b, of which RM1.0b was to be used for petrol, liquefied petroleum gas and diesel subsidies. Thankfully, fears have eased over export distruptions from Iraq. The fact that the US has eased oil exports ruling also helps to ease any further rise in oil prises.

Social responsibility. Even if global oil prices continues on its downward trend for the rest of the year, we doubt that there will be a petrol subsidy removal of more than 10 to 20 cents a litre. We reckon the former is more likely, especially when cost-push inflationary pressures remain high and real interest rates remain negative. Any higher, the government will end up dishing out more cash aid and ends up countering any action to narrow deficit. We believe that inflation will average a 3.3% in 2014.

Missing the target. Despite the request for additional budget, we don’t think it’s a level that’ll occur additional costs to the government than what we’re already computed in. We think they’ll slightly overshoot their deficit target of 3.5% of GDP (mainly due to the longer than expected price normalization from the first subsidy rationalization and the rise in oil prices) and hit 3.7% in 2014. Come 2015, implementation of the GST will help narrow their deficit even further, and we’re looking at a fiscal deficit of 3.4% of GDP.

Monetary Policy – at the crossroads

Turning tables. What started off as a year where most economist expected little to no rate hike, after the 8th of May BNM MPC policy meeting, the tables have turned and consensus are looking at up to 50 bps hike in the very near future. We, on the other hand believe otherwise. Based on our heuristic approach, Bank Negara’s decision trend over the last decade, when it comes to the monetary policy over the past decade shows that the probability of a rate hike remains relatively low (Table 2). Any action taken by BNM have been deliberate but extremely decisive, with past hikes being incremental and consecutive and with little to no change for a considerable period afterwards.

Conservative. In the past, BNM was most likely to raise the OPR by 25 bps followed by, more often than not, another 25 bps almost immediately afterwards. This would mean a total of 50 bps rise in the 2H14. But with only a high inflation rate, a better-than-expected in 1Q14 GDP and a seemingly high credit growth as justifcation, we feel that it isn’t compelling enough. The past has shown that BNM had raised the OPR to counter demand-pull inflation and the current inflationary pressure have been mainly of a cost-push nature.

Specific targets via macroprudential measures. There are also other tools that BNM have at their disposal, such as further macroprudential measures and countercyclical regulation. The fall in housing prices is proof that macroprudential measures are more effective at tackling any imblances with surgical accuracy. Raising the OPR will be at the cost of the rakyat, who are already burdened by a higher cost of living as a result of fiscal consolidation.

Social implications. Though a rate hike is eventual, we don’t think the timing is right. Still reeling from subsidy rationalization, anticipating of yet another possibly round soon, and further impact to costs once the GST is implemented in April 2015, an additional hike in interest rate is too much too soon. BNM has to really balance their priorities, whether there is greater weight on output growth or price stability. The past has shown that BNM favours the former, as they should. There is also the social consideration, the need to ease the burden of borrowers especially those in the lower to middle income. Similarly, a rise in interest rates puts current ETP projects at risk of delay from further overruning of costs if the price of borrowing increases even more.

Eye on the Fed. We think that BNM should only raised the OPR in the 2H15, once any glitches with GST implementation has been smoothen out. At the same time, this is also the point where we think the Fed may raise their interest rates, if the US economy continues on its current trajectory. A rise in the Fed fund rate would be one of the signals for other central banks to act. Alongside what we hope that by then, there will be a switch to demandpull inflation rather the current cost-push, making it the right time for OPR to be raised 25 to 50 bps.

Ringgit outlook – To remain volatile but fundamentally strong Continued volatility. The American side of the Atlantic is heading for strong rebound in economic growth and QE tapering continues as planned whilst the European side saw a cut interest rates and introduction to a stimulus package aginst the threat of deflation. This has led to a rather volatile forex market, especially amongst emerging economies. Though EM currencies’ selloff has somewhat abated it is likely to continue intermittently over the next 6 to 12 months.

Strong fundamentals. When it comes to the Ringgit, there is still fundamental strength behind the currency, keeping it proped up. Based on the trade weighted Ringgit, the currency is still undervalued but this is just as well, as it will further help with exports. However, it does post a slight pressure towards imports but we do not think it is a level that is worth worrying. Given that the Fed’s QE tapering is on track to stop by end of the year with scant indication of tighthening anytime soon, our year-end 2014 target for the USD/MYR to 3.21 (average: 3.25). This also takes into account on Ringgit favourability on account to a stronger GDP growth this year and a better-than expected current account surplus. With volatility to remain relatively high the USD/MYR level is expected to trade in the range of 3.20 to 3.30.

Risk to growth European woes. There is every possibility that the situation in Europe may worsen and that cutting the interest rates, imposing a negative deposit rate or supplying cheap loans to banks is insufficient to boost the economy upwards. Even if the ECB announces a form of QE, it may be too late. This could very well be the price of such severe austerity in the last couple of years and the ECB’s slow reaction towards policy decisions to encourage growth. Another recession is not impossible, and quite probable. Germany alone will not be enough to bolster the rest of Europe.

Geopolitical concerns. Though oil prices have begun to come off, there is still much uncertainty surrounding the Middle East region that could very well fuel worries on oil supplies and put pressure on prices once again. Despite the US’ relax on oil exports regulations and constant supply for other oil producing coutries, it may not be enough to mitigate the risk that is still very much prevalent surrounding the geopolitical crises in the Middle East region. For now, our oil forecast remains at US$110.23/barrel by year-end (US$107.47/barrel average) for 2014, if the situation escalates and global prices keep increasing, we may have to revise our oil forecast.

Tough reforms. In Asia, Abenomics’ third arrow alone may not be enough to counter the tax hike. There are still problems with trying to increase wages faster to counter the higher inflation rate, which many businesses are reluctant to do. There are also difficulty in implementing social policies such as encouraging more women into the workforce. China’s reforms could take longer before the economy begins to pick up again and that China may not be able to hit their GDP target of 7.5%. This implicates the rest of Asia, which has very strong ties to China.

Domestic struggles. Here in Malaysia, inflationary pressure may end up dampening consumption longer than anticipated, and even more so if the government decides further subsidy rationalization before prices could normalize. Purchasing power may dwindle even further, permeating and bleeding throughout the whole economy, threatening growth of the overall economy.

Beyond 2014

Look to the US. If the current US economic trajectory is anything to go by, there is every chance of a rate hike by the Fed in the later part of 2015. This will be the pivotal signal to central banks worldwide, who will have to keep in mind the implications of mentioned hike. We reckon the impact will be similar to whence the former Fed chairman, Bernanke, announced the start of the QE taper. However, we feel that BNM is well prepared to such eventuality and well equipped with the tools to handle the situation.

GST fears. In Malaysia, the main issue will be the impact of the Goods & Services tax, the only developing country in the region that has not adopted it with the exception of Myanmar. It is difficult to guage how exactly the market and the economy will react to it, and it is honestly, anybody’s guess. However, based on our research on other countries who have implemented similar tax sytems, we will be looking at a more moderate pace in growth for at least two quarters following the implementation of the GST. Once glitches (we don’t doubt that there will be glitches) have been smoothen out and businesses and consumers adjust, we should see a rebound (albeit a gradual one) by the end of 2015. Maintaining our cautiously optimistic view on the long-term economic outlook, Malaysia’s GDP growth may still remain slightly above 5.0% in 2015.

Source: Kenanga