OVERVIEW

The Nikkei Malaysia Manufacturing Purchasing Managers’ Index (PMI) showed an early sign of improvement in operating condition for the manufacturing sector, raising hopes for a slow recovery ahead. Despite remaining in the contraction zone, the headline PMI reading rose to a 4-month high of 48.1 in July from 47.1 in June. Both production and new orders fell in July, but at a slowest pace in months. Meanwhile, employment decreased in July after holding firm in the previous month and new export orders fell for the second month. The recent Bank Negara Malaysia (BNM) decision to cut OPR by 25 bps in July could potentially help to lift up consumer spending and cushion the impact of weak domestic demand on the manufacturing sector. However, we see limited upside for Malaysia’s manufacturing sector in 2016 on rising uncertainties on both the domestic and external front.

The PMI reading rose to 48.1 in July from 47.1 in June. The July index marked the highest reading in four months. However, the index has stubbornly remained in the contraction mode for sixteenth consecutive month as indicated by the sub-50.0 reading. The sluggish domestic economy, weak domestic demand and volatile global markets remained the factors that weigh down on the manufacturing indicator.

Across the board, the sub-groups of new orders, output, employment and stocks of purchases all deteriorated in July. Although all the sub-groups besides employment experienced a softer contraction, the overall weakness has resulted in the weak PMI reading in July which remains well under the 50.0 reading separating expansion from contraction.

New orders in July stayed on its downward trend that started in March 2015. However, we see positive sign as the fall of new orders is the least since March, partly thanks to a smaller decline in new export orders. This provided a breather after export orders have been tumbling for two consecutive months, providing an indicator that demand may soon recover.

Following a decline in new orders and international demand, production in July extended its dismal performance that has lasted for more than a year. On a positive note, the fall of production is the mildest in six months. Overall, this suggests a long road ahead for production to return to a level indicative of a healthy manufacturing sector growth.

The employment index slipped in July after holding firm in the previous month. Employment declined as manufacturers adopted cost saving measures amid tough operating conditions and falling sales. As a result, volume of unfinished work increased, exerting additional pressure on manufacturing capacities. This can, however, help reducing spare capacity in the industry, which can possibly pose a threat to the already fragile industry.

Stocks of purchases decreased in July but at a slower rate compared to the previous month. The drop in stocks of purchases is not surprising considering the lower demand and production, signaling lower capacity utilization ahead. The rising input cost is largely due to higher sales tax and weak exchange rate. Subsequently, manufacturers increased their charges in July but at a milder pace.

Meanwhile, the Markit Global PMI was higher at 51.0 in July from 50.4 in June. The PMI among world major economies suggests an improved outlook for the global manufacturing sector. Eurozone held to its robust performance with a PMI reading of 52.0 in July. The Caixin China Manufacturing PMI returned to expansion territory for the first time in 17 months, registering an impressive 50.6 reading, as the Chinese economy appears to benefit from the government’s fiscal stimulus programmes. Furthermore, Japan moved closer to the expansion territory with its July PMI reading of 49.3, compared to 48.1 registered in June.

On a closely related trend, the Baltic Dry Index (BDI) stayed stable in July. The Baltic Dry Index, which measures the transportation cost of raw materials, like the PMI, is a leading indicator of global trade. It started its downtrend around November 2014, when Malaysia’s manufacturing sector was beginning to slow. The BDI inched lower at 656 in July from a reading of 660 in June. We suspect it is taking a breather before resuming a slow and long recovery process. Still, we need to closely monitor the BDI reading in the coming months before a more credible trend of recovery can be confirmed.

Outlook

The July PMI performance kicked off 3Q16 on a weak note, suggesting a slow and painful recovery in the months ahead. Sluggish domestic demand may present a high hurdle for a full recovery this year. The weak growth of narrow money supply in June seems to imply tepid consumer spending as well, dimming prospects of near term recovery in local manufacturing output.

We believe the recent Bank Negara Malaysia (BNM) decision to cut OPR by 25 bps in July could potentially help to lift up consumer spending and cushion the impact of weak domestic demand on the manufacturing sector. However, the impact of the OPR cut on domestic manufacturing sector in the near term is likely to be small, due to the tepid consumer sentiment in the face of rising uncertainties on both the domestic and external front. As such, we see limited upside for Malaysia’s manufacturing sector for the remainder of the year.

Meanwhile, we see the recent UK’s vote to leave the European Union to have a limited impact on local manufacturing due to the relatively small bilateral trade volume between UK and Malaysia. However, we believe the referendum result will likely exert downward pressure on global manufacturing performance. In view of the still weak manufacturing sector performance in major economies, we expect heightened uncertainties in local manufacturing performance in at least the next six months.

As manufacturing production makes up two-thirds of the Industrial Production Index (IPI), the prolonged weakness in local manufacturing activities is a sign that the IPI would settle at a more moderate pace this year. The weak PMI readings reaffirm our view that industrial production is to grow at a slower rate of 4.3% in 2016 from 4.5% in 2015.

The continued state of weak performance of the manufacturing sector as indicated by the PMI could further exert downward pressure to the country’s GDP growth for the whole of 2016. Meanwhile, the weak global manufacturing performance may also adversely affect Malaysia’s trade performance. Combined with negative consumer sentiment and rising uncertainties in the global economic outlook, we have revised our 2016 GDP forecast to 4.0%-4.5% from 4.5%.

Source: Kenanga Research - 2 Aug 2016