OVERVIEW

• 1H17 growth trajectory to remain elevated. 2Q17 growth is projected to expand to 4.8% from 4.4% in 1Q17 as Malaysia is poised to take advantage of improved prospects both domestically and externally despite lingering event risks globally
• Stronger 2017 growth. Surpassing 2016’s 4.2% expansion, growth in 2017 is projected to rise to 4.5% driven by domestic factors with modest upside – relative to 2016 – from net exports.
• Sustained manufacturing and services sector growth. Manufacturing and services sector growth is expected to remain resilient, expanding by 4.5% and 5.6% respectively for 2017 (1Q17F: 4.7% and 5.4% respectively) on E&E, and retail and wholesale trade strength.
• Inflation trending higher in 2017. We expect to see a brief spike of the CPI above the 5.0% mark in 2Q17, largely from cost push factors namely from rising fuel and, to a certain extent, food prices as well as low base effects. However, its impact on broader price levels remains manageable. The average CPI growth is projected to reach 4.4% (2016: 2.1%).
• Oil prices to test USD50/barrel. Crude oil prices will continue to trade within our projection of USD50-55/barrel range though rising US inventories and production means that prices may lean towards the lower range.
• OPR to stay at 3.00% despite sharper inflation. Given the cost-push nature of prevailing inflation, we believe that OPR will likely be maintained amid relatively stable core inflation trends. However, there may be a mild tightening bias if aggregate demand sees sustained strengthening.
• Modest GE14 uptick but fiscal consolidation on track. Despite shakier oil prices, the government’s modest 3.0% fiscal target (as % of GDP) is likely to be realised in 2017 though we expect a mild uptick in expenditure in anticipation of GE14.
• Stabilising capital market flows an upside. Capital flows are expected to stabilise on BNM’s efforts in smothering the offshore ringgit market. We view this as a net positive for reducing ringgit volatility in the short to medium term.
• Ringgit rise on dollar weakness. Dollar weakness from a possible moderation in the reflation trade and less hawkish Fed is likely to provide some room for the ringgit strengthening. We expect the ringgit to be range bound at RM4.40-4.50/USD in the near term, before rounding off the year at RM4.35/USD.
• Slow path to recovery. Despite a stronger growth narrative, medium term risks from the external sector -- which may include the reversal of reflation trade, rising protectionism and strong recovery – will limit the upside to Malaysia’s growth prospects beyond 2017.

Summary

On the path to recovery. Malaysia is likely to enjoy some momentum from 1Q17 along with similar upturn in the global economy. However, despite its recovery momentum, Malaysia must navigate through several key risks area including ringgit weaknesses bearing against competitiveness, moderately elevated inflation from cost push factors and possible volatilities from changes in global policy rates. Consumer sentiments remained somewhat glum (based on MIER survey) though assessments on business sentiments are more varied. Globally, both advanced and emerging market economies are seeing improving economic outlook. While US continue to be among the best performing developed economy, the Euro Area economies have also seen improving economic prospects with firming inflation and growth slightly exceeding that of the US. The recovery narrative is likewise strong in Asia with China seeing 6.7% in 2016 though high indebtedness continues to linger as a key risk area.

Global Outlook

Cautious global growth. Global growth has been notably more upbeat in 1Q17 despite lingering event risks. There have been no sign that the risk factors have deteriorated substantially as it continued to move into 2Q17, even as the global economic outlook improves. IMF and OECD’s forecasts for 2017 global growth remains unchanged at 3.4% and 3.3% respectively (2016 estimates: 3.1% and 3.0% respectively). Furthermore, the Eurozone joins the US as among the recovering advanced market economies (AME) with firming inflation amidst recovering growth and sentiments, though the distribution of growth among the Eurozone members are somewhat uneven. However, lingering event risks (ranging from high-stakes elections in Europe to a more insular US trade policies) meant that these upbeat sentiments in the AME will continue to be capped pending further clarity.

Emerging concerns. Emerging market economies (EME), meanwhile, will see broadly unchanged growth prospects relative to the previous quarter though financial tightening (from slightly higher long term interest rates and higher indebtedness) will bear against growth somewhat. Some EMEs may further have to contend with sharper reversal of capital flows which may see some degree of depreciation to their currencies. This, in turn, may lead to some erosion of purchasing power among some of these EMEs.

The threat of protectionism and global trade wars which we saw in 4Q16 remain unchanged. With the US reluctant to endorse the free trade dogma during the recent G20 trade, global trade flows will continue to be susceptible to sudden shifts in trade policies, ranging from imposition of tariffs to an outright trade war. We are, however, emboldened somewhat from the broad coalition of major economies reaffirming their commitment on free trade. Overall, on the future of global free trade, we are biased on the downside but slightly positive on willingness of regional economies to pursue a free trade agenda.

Reflation trade takes a hit. The “reflation trade” following the victory of the new US President, Donald Trump, have shown some signs of dissipating as the sentiments-driven rally takes a pause amid policy uncertainties and possible legislative gridlock. The House of Representative’s failure to repeal Obamacare late-March represents a significant blow to the reflation narrative, putting to doubt if Trump’s planned fiscal expansion could make it through Congress amidst rebellion among fiscal conservatives in the Republican Party and moderates who may take exception to excessive cuts in social assistance. Ultimately, however, it is too early to presume the end of the reflation trade and, by extension, the resulting “Trump-rally” (which buoyed market expectations post-US elections). However, we do expect modest dialling down of Trump’s fiscal plan as the administration seeks to reconcile with moderates and fiscal conservatives. This will likely falter as early as 2Q17 as markets temper their expectations on the actual scale of Trump’s fiscal push (i.e. tax cuts and infrastructure spending). This may, in turn, result in significant scaling back of the Trump-induced euphoria or, at worst, risk a speedier reversal of US growth outlook.

Eurozone outlook improving but election brings uncertainties. Across the Atlantic, the outlook for the Eurozone and many of the European AMEs are improving somewhat. Preliminary 1Q17 numbers – improving growth, consumer sentiments and firming inflation, among others – indicate that the recovery narrative for Eurozone remains largely intact. This, in turn, may prompt a slight bias towards monetary tightening by the European Central Bank (ECB). However, we believe that the odds of an ECB tightening remains somewhat remote given uncertainties surrounding several high stakes elections in Europe – France, Germany, Netherlands and Norway – in the wake of rising populism and anti-European sentiments. While the recently concluded Dutch elections saw the incumbent VVD winning the largest number of seats over the populist PVV party, the overall results were somewhat mixed. The PVV gained an additional 5 seats while the

VVD and one of its coalitions partner, PvdA, lost around 8 seats and 29 seats respectively. While the fear is relatively more muted in Norway, a shock victory by the National Front’s Marine le Pen in France is likely to heighten policy uncertainty, though we believe that this may be somewhat tempered by the National Front’s lack of clout in the National Assembly. We are slightly more sanguine in Germany as the key populist battleground arises from the possibility of the anti-immigration AfD gaining some parliamentary representation though insufficient to meaningfully advance its populist agenda. Overall, we are optimistic on mainstream politics prevailing though we retain a measure of caution in the event of a “black swan” which will result in further uncertainties on the European front, akin to volatilities arising from the immediate Brexit aftermath.

Brexit talks to heighten uncertainty. Across the channel, Prime Minister Theresa May formally pulled the trigger on Brexit late March, after a parliamentary vote to pass the Brexit bill. However, more importantly, May’s Parliamentary victory gave her effective carte blanche to negotiate Brexit in her terms. While this will ostensibly allow May to negotiate for the best possible outcome for the UK, this may result in a broad range of outcome ranging from retention of most pre-existing UK-EU trade and investment arrangements to a Brexit sans a deal. We believe that the wider gamut of possibilities will further cloud the economic outlook in UK and by extension, the wider EU.

China takes a breather but indebtedness concerns linger. Closer to home, China, one of the world’s fastest growing major economies, is reining in its growth outlook for 2017 as it seeks to manage concerns of its overheating economy. After a surprising 6.7% growth reported in 2016, it has since lowered its estimates a notch to 6.5% for 2017. However, notwithstanding its revised growth target, high leverage exposes the economy – particularly at the state government and non-financial corporation levels – to rapid increase in global interest rates (as observed in the US) or a possible faltering of global demand. We are encouraged by China’s recent efforts in addressing structural risks, including those arising from rising asset prices (particularly home prices), debt market, among others. However, given the structural nature of these issues, we continue to see medium-to-long term risks in the Chinese economy, compounded by prevailing external risks. However, we believe that growth will remain at the lower end of the 6.5-7.0% considering modest but continued fiscal support in “achieving employment objectives” whilst keeping a tighter leash on monetary policy.

Oil prices to trade range-bound. As in our previous report, we believe that crude oil prices will continue to trade within the USD50-55/barrel range with a slight upward bias from OPEC’s ability to rally both its members and non-members alike. However, in view of rising inventories – specifically, in the US – and increased US production, we are less optimistic on oil prices sustaining itself on the upper end of the USD50-55 range but instead it may lean towards the lower end of the price range of our Brent crude oil price forecast.

Overview 1Q17

Brighter outlook but room for improvement. Preliminary 1Q17 data suggests that Malaysia is making steady progress along its recovery trajectory though with some caveats. Inflation has trended sharply higher moving into 1Q17, though largely from the cost-push factors rather than marked upturn in aggregate domestic demand. External demands have firmed up as evidenced by improving export numbers though trade surplus continued to narrow from faster expansion in imports, partially attributed to weaknesses in the ringgit. On the industrial front, Malaysia’s manufacturing sector continues to sustain modest growth, driven by its electrical and electronic sector (E&E) and Petroleum, Chemical, Rubber and Plastic product, among others, though moderation in the mining sector was a drag on the headline industrial production index.

Private consumption resilience moving into 1Q17. We expect growth to take a breather in 1Q17, expanding 4.4% from a 4.5% growth in 4Q16 though we expect growth to pick up somewhat in 2Q17 and 3Q17. Despite weak consumer and business sentiments, we anticipate continued resilience in private expenditure as a driver of growth with private consumption growing at a slightly faster 6.5% YoY in 1Q17 (4Q16: 6.2%) while private fixed capital investments expand at 5.3% (4Q16: 4.9%). Public expenditure, on the other hand, is likely to remain somewhat subdued in 1Q17 on the government’s continued fiscal consolidation efforts, with public consumption contracting by 0.5% (4Q16: -4.2%). However, public fixed capital investments is expected rebound to 2.0% (4Q16: -0.3%) as the government starts implementing its various key infrastructure projects. Overall, we expect domestic demand to contribute approximately 4.5 ppts to growth (4Q16: 3.1 ppts).

1Q17 net exports disappoint. On improving global economic prospects, we see some upside in external demand in supporting exports recovery. This is, in part, supported by the relatively weaker ringgit which helped boost export competitiveness. However, on the flipside, the weaker ringgit has also meant that dearer imports will likely outpace improvements on exports. As such, we expect exports to expand 2.6% (4Q16: 1.3%), overshadowed by a sharper 2.9% growth in imports (4Q16: 0.7%). Combined, we believe that external sector contribution to 1Q17 GDP will be negligible but remain positive. (4Q16: +0.5 ppts)

Manufacturing and services sector growth sustained. The manufacturing sector is expected to see continued recovery moving into 2017. This theme is further reinforced by the trends observed in the manufacturing PMI trajectory which saw the index declining at a slower pace moving into 2017, though still remaining below the 50 points threshold. This is supportive of our modest growth trajectory for the manufacturing sector which we estimate a growth rate of 4.7%, just slightly lower than 4Q16’s 4.8%. The services sector will likewise see sustained growth at 5.4% (4Q16: 5.5%).

The construction sector will strengthen somewhat to 6.0%, partly from public sector infrastructure spending (4Q16: 5.1%) though it is worth noting that 4Q16’s growth was among the lowest since mid-2011. Mining and quarrying, however, will be subdued with crude oil production seeing slower growth from Malaysia’s fulfilment of its OPEC production curbs. Overall, services is poised to be the largest contributor to GDP growth, projected at 2.9 ppts while other major contributors being manufacturing (1.1 ppts), construction (0.3 ppts), mining (0.2 ppts) and agriculture (-0.1 ppts).

Inflation manageable but trending higher. We reckon that inflation may be on the higher end, potentially breaching the 4.0% mark during 1Q17 on higher fuel prices and sustained food price inflation. With January’s and February’s inflation already at 3.2% and 4.5% YoY respectively, we expect inflation to round of the quarter above 5.0% in March, bringing the 1Q17 forecast to an estimated 4.4%.

Risks from household indebtedness receding. Based on BNM’s latest Financial Stability and Payment Systems Report, household indebtedness has moderated somewhat in 2016, receding to 88.4% of GDP (2015:89.1% of GDP). This reinforces our previous assertion that medium-to-long term risks arising from household indebtedness are limited. This is especially so, given slower growth in household debt at 5.4% (2015: 7.3%) supported mainly by residential property financing.

Outlook 2Q17 and 2017

Riding on recovery momentum. We expect the recovery momentum to continue buoying Malaysia’s growth moving into 2Q17, expanding 4.8% from our 4.4% 1Q17 estimates. This momentum may well be extended into 3Q17, on the possibility of pre-election buzz. However, we are tempering our expectations somewhat with a more staid trajectory moving into 4Q17, assuming that the election takes place in 3Q17. Our forecast projects 2Q17 GDP growth of 4.8% on further final total consumption strength which our model estimates to be at 6.0% (1Q17E: 5.2%). This will bring 1H17 growth to 4.6%. For the 2H17 forecast though, we expect

growth to be slightly lower at 4.5% from tapering growth momentum in 4Q17 (4.2%). This brings our full year growth to 4.5%, which is right smack in the midpoint of the Ministry of Finance’s 4.0-5.0% forecast and slightly below the midpoint of Bank Negara’s 4.3-4.8% forecast.

Broad-based pickup for 2Q17. Growth in 2Q17 will likely step up relative to 1Q17. Our model puts private consumption growth at 7.3% (1Q17E: 6.5%) while public consumption growth rebounded slightly to 0.7% (1Q17E: -0.5%) on expectations of a General Election boost. Furthermore, fixed investments growth will also enjoy a mild improvement, with private and public fixed investment expanding 5.5% and 2.1% respectively (1Q17E: 5.3% and 2.0%). On the external front, net exports may provide some measure of support to growth with exports surpassing imports at 3.5% and 3.3% respectively (1Q17E: 2.6% and 2.9% respectively) as the external sector starts seeing some gains in competitiveness from ringgit weakness.

Manufacturing and services sector driving 2017 growth. On improved external sector demand observed in 1Q17, we see some additional support for the manufacturing sector, particularly for the E&E subsector which we expect to expand at a faster 7.2% (1Q17E: 6.5%). This will ultimately see manufacturing sector growth picking up to 5.1% in 2Q17 (1Q17E: 4.7%). In line with our narrative of higher 2Q17 private consumption growth, we expect a modest push in wholesale and retail trade, which we expect to be a major player in service sector expansion, along with the information and communication subsector. This will culminate in a faster expansion in the services sector growth at 5.9% from 5.4% in 1Q17.

Elsewhere mixed growth prospects in 2017. Elsewhere, the agriculture sector will likely see a marginal 0.2% contraction in 2017 though this would represent a bottoming out of agriculture sector deterioration (2016: -5.1%) as we expect a gradual turnaround in the oil palm subsector. The growth of mining and quarrying, meanwhile, is expected to moderate to 2.0% (2016: 2.7%), in part from Malaysia’s fulfilment of its OPEC commitments though there is a mild upside for the sector should we see a further strengthening of the commodity rally. Construction sector growth, meanwhile, is expected to decelerate to 6.3% growth for 2017 from 7.4% in 2016 in line with the fiscal consolidation and the completion of major transportation projects like the MRT1.

GE14 play a wild card. While details remain sketchy, we believe that the odds of a General Election in September to be a distinct possibility. Overall, we believe that GE14 is likely to have a mild-to-moderate feel-good impact on the economy, buoying consumption and investments, especially during 2Q17 as the pre-election hype kicks in.

Optimism on growth tempered by Inflation and event risks. However, with elevated inflation levels expected to continue into 2Q17 and likely to persist for the rest of 2017, consumer spending may be somewhat dampened despite BNM’s narrative that the fuel-induced inflation will only have a modest impact on overall price trends. However, this may be partially offset by the Government’s measures on improving disposable income including BR1M hand-outs and optional reduction of statutory contribution towards the EPF. This, along with external uncertainties – including deflated optimism of Trump’s reflation trade, European election uncertainties, and deceleration of China’s growth, among others – meant that our forecast for the rest of 2017 will be more muted with our projected 4.5% full year growth only slightly higher than 4.2% in 2016.

2017 growth driven by domestic factors. Despite our milder projection of 2017 growth relative to 2Q17, the underlying sources of growth remain largely unchanged. We continue to see private sector expenditure expansion of 6.1% in 2017 (2016: 5.7%) on the back of a 6.5% and 4.8% expansion in private consumption and fixed investments respectively (2016: 6.1% and 4.4% respectively). Our model also forecasts a mild boost in public expenditure growth from the GE14 boost which may result in a minor fiscal push. This implies a 4.0 ppts and 0.3 ppts growth contribution from private and public expenditure respectively (2016: 3.9 ppts and 0.1 ppts respectively). Net exports contribution to headline growth will be modest at 0.1 ppts (2016: -0.2 ppts), largely from gains in external demand competitiveness in 2Q17 and 3Q17.

Fiscal Policy

On track to fiscal consolidation. The government’s 3.0% of GDP target remains within reach given greater fiscal space afforded by an uptick in oil prices – relative to the Ministry of Finance’s conservative oil price assumption of USD45/barrel. Given our house forecast of oil trading at USD50-55/barrel, we do see some upside on oil-related revenues, including Petroleum Income Tax (PITA) and royalties. This, along with improved tax collection and successive implementation of budget rationalisation, will contribute towards a narrower fiscal deficit.

Upside from income tax and GST revenue collection. The Inland Revenue Board, in January, announced a tax collection target of RM127b in direct taxes from a weaker RM114b collection in 2016 (2015: RM117b). Royal Customs also targets GST collection of RM42b, slightly higher than the MoF 2017 estimates of RM40b. We believe that these projections are subject to some upside, especially given a faster GDP growth (MoF 2017 forecast: 4.0-5.0% vs. 2016: 4.2%). This, in turn, will give further wriggle room for the fiscal target.

Loosening purse-strings for GE14? Despite likely improvements in the fiscal space, implying room for further lowering the fiscal target, we do not rule out a higher-than-expected uptick in government expenditure in 2Q17-3Q17 (assuming a September election). However, broadly speaking, we believe that the expenditure uptick will only be mildly expansionary with the 3.0% fiscal target in sight.

Monetary Policy

Global Interest rate divergence. Monetary policy trajectory has been relatively fluid across the globe. As mentioned, we believe that the ECB is holding back on raising its interest rates in consideration of possible threats to growth from the high stakes elections to be held across Europe. With the last of these elections concluding at beginning of 3Q17, this suggests a possible rate hike for the Eurozone in its late-October meeting, at the earliest, assuming that inflation remains manageable.

Fed hike rates with caution. The US, meanwhile, appears on target to raise rates thrice in 2017 after its March rate hike, possibly during its June and December meeting. However, as mentioned in our March FOMC commentary, the Trump administrations’ failure to dismantle Obamacare, portents further legislative gridlock which would dial the reflationary trade down a notch, potentially reversing some of the Fed’s consumption and inflation barometer. We are inclined to believe that the FOMC will likely raise interest rates three times in 2017 though a reversal of the reflationary trade may hobble the rate hike timetable to just two rate hikes for 2017.

Mixed rate direction. Overall, the interest rate trajectory is a mixed bag with some EMEs adopting a looser monetary policy stance to nudge recovery along while others may be prompted to adopt a neutral-to-tightening bias for managing capital outflows. However, given increasing integration of financial channels between EMEs and AMEs, the divergent monetary policies of the AMEs is likely to be a source of greater financial market turbulences, increasing currency volatility and disrupting portfolio flows in the EMEs.

Diminished odds of rate cut; inflation in focus. Given improving growth prospects, rising inflationary trend (albeit on costpush factors), and to a lesser extent, capital outflows, we believe that the odds for a rate cut has greatly receded. At the same time, however, we do not see a compelling justification for a rate rise despite an uptick of February’s core inflation levels at 2.5% (January: 2.3%). This is especially so, given relatively stable demand and general price trends. However, we do note that this may be a starting point for a mild tightening bias, especially when demand-induced inflation starts kicking in when aggregate demand strengthens.

Current Account Position

Firmer external demand supportive of CA surplus. Based on the strong recent external trade data flowing from the region and globally, we are somewhat bullish on the prospects of firming external demand in the coming quarters. Furthermore, continued weaknesses in the ringgit will likely be supportive of further gains in trade competitiveness, hence sustaining the current account surplus, at least in the 1H17. To reflect this relatively better outlook, for the whole of 2017, we are revising our current account surplus projection to 1.7% of GNI (1.6% of GDP) from 1.5% (1.4% of GDP), slightly on the higher end of BNM’s forecast of 1.0-2.0% of GNI. However, this projection is contingent on the absence of significant policy risks, particularly anti-trade sentiments stemming from the new US President Trump.

External uncertainties further weighs against financial flows. Over the medium to long term, however, we are cautious on the rising levels of external uncertainties, stemming from the highly volatile policies under US President Trump and other antitrade sentiments. Furthermore, we believe that these uncertainties will continue to weigh against financial flows, potentially resulting in further financial account outflow, particularly from portfolio investments. We do, however, believe that the BNM’s initiatives to soothe ringgit volatility will result in some long-term upsides, likely to stem the ringgit volatility by the 2Q17. This, in turn, will help ease some of the concerns on the forex-adjusted returns of Malaysia, potentially reversing some of the portfolio outflows seen during 4Q16.

Capital Flows and Ringgit Outlook

Stabilising capital outflows. BNM noted continued improvements to capital market flows post-FMC intervention in restricting the offshore ringgit market, particularly for nondeliverable forwards (NDF), while developing the onshore ringgit market. As such, BNM expects capital outflows to be less susceptible to speculative pressures moving forward, hence reducing ringgit volatility. This, in turn, implies a more stable ringgit trajectory.

Return of foreign inflows? The relatively sharp spike in foreign liquidity in the equity markets, shortly in the week ended 17 March is largely in line with strong foreign purchases in regional equity markets. This, along with the subsequent inflow of foreign liquidity in the succeeding week, is likely indicative of the less hawkish overtones of the Fed FOMC press release. Foreign investors have been net buyers on a weekly basis since the week ended 10 February. While we are encouraged by higher foreign liquidity, we remain cautious given the relatively short term nature of these flows, especially as sentiments turn south.

Range bound ringgit. The ringgit has seen some upside of late against the USD, largely from US dollar weakness following the failure of Trump in repealing Obamacare. Furthermore, measured optimism by Federal Reserve over the Fed Fund Rate trajectory rather than hawkish overtones, placated further depreciation pressures against the ringgit. We believe that this may justify a narrower ringgit range of 4.40-4.50 in the near term. Moving forward, the Fed Fund futures implied probability suggests that a May rate hike is relatively remote (around a 13% odds). Implied probability for a June rate hike remains slightly better than a toss-up at just above 50.2% as at 28 March 2017. Indeed, the implied probability for a June rate hike plunged sharply from its peak of 59.7% just before the FOMC meeting, largely from the lack of a hawkish overtone in the March FOMC press release and the subsequent failure of Trump in repealing Obamacare. Assuming modest dialling back of Trump’s reflationary agenda, we expect the dollar to be on the downside, hence, by implication resulting in modest ringgit strengthening. However, at present, we do not see a strong catalyst to justify widening our Ringgit range to account for a sharper ringgit improvement beyond MYR4.40/USD though our year-end Ringgit forecast remains at MYR4.35/USD on odds of improving Malaysian fundamentals.

Beyond 2017

Cautious on 2018. Despite our upbeat tone for 2017, medium term risks from external sector – including a possible reversal of the reflation trade, rising protectionist tendencies and stalled recovery. While we do see some upside to 2018 growth, we are cautious on the overall prospects, hence our initial 2018 growth forecast range at approximately 4.5-5.0%. Our revised forecast will be highly influenced by the aforementioned external events along with the sustainability of Malaysia’s domestic demand growth.

Source: Kenanga Research - 31 Mar 2017