? Fed’s dovish tone to induce foreign fund inflows. With the US Federal Reserve appearing to be less committed to raise rates anytime soon amidst growing signs of a weak economy and a dissipating Trump reflation trade, more funds are expected to switch into higher yielding assets and the emerging markets. This could raise the flow of foreign funds into Malaysian debt securities in the short to medium term.

? Short term funds in focus. Given the lingering risk in the global economy, we expect foreign portfolio inflows to be inclined towards shorter government bond tenures. Meanwhile, we expect the long-term government securities to still attract some interest mainly from institutional investors, i.e. central banks, as well as pension and insurance funds.

? Strong fundamentals to mitigate risks of funds outflows. Malaysia’s strong fundamentals including improving GDP outlook, strong exports growth, a gradual build-up of foreign reserves, and expectations of a stronger ringgit will help to mitigate risks of foreign funds outflows. Barring unforeseen external or domestic shocks in the short to medium term, it may also help sustain funds inflows.

Dovish Fed, a catalyst for funds inflows. The market was somewhat surprised when the Fed’s tone was more dovish than the market had expected in its latest monetary announcement on July 27. The Fed acknowledged that inflation have been on a moderating trend and expected to remain below its 2.0% target. With low energy prices and weak wage growth, signs of a weakening economy, along with the dissipating Trump reflation trade, the markets have started to factor in a higher possibility of a delay in Fed’s rate normalization schedule. Because of this, one of the most notable impacts would be another major shift of funds towards higher yielding assets mainly in the emerging debt markets.

Minimal impact from Fed’s dovish stance. While the market continues to digest the Fed’s dovish statement, Malaysia’s debt market could see a rebound in net foreign holdings of debt securities from July onwards. While the implied probability of a Fed funds rate hike at the FOMC meeting in December has receded to 41.8% (as of July 28) from as high as 55.3% prior to the 27th July Fed meeting, the market would soon turn its focus on the timing of Fed’s first balance sheet normalization, in which the Fed has signaled to be “relatively soon”. As such, from a longer period perspective, we see minimal impact of Fed’s latest announcement on domestic bonds flows and yield, though it may provide some form of defense for the domestic debt market in terms of funds retention. Meanwhile, the benchmark 10-year Malaysia Government Securities (MGS) yield continued to remain stable at 3.988% (as of July 28), marginally lower than 3.990% yield registered the day before the Fed latest rate decision (July 27).

Short term funds in focus. Given the lingering risk in the global economy, we expect foreign portfolio inflows to prefer shorter government bond tenures. Cautiously waiting for the Fed’s next course of tightening action, which include the muchanticipated unwinding of its USD4.5t balance sheet, could however limit the purchasing upside of ST securities by foreign funds. Meanwhile, we expect the long-term government securities to still attract some interest mostly from institutional investors, i.e. central banks, pension and insurance funds. Combined, this group of government bond holders owned nearly half of the total debt issued.

Dollar knee-jerk reaction. The U.S. dollar index took a hit and fell 93.152, a 13-month low after the Fed’s announcement. The dollar could stay relatively weaker in the near term as the market factors in the possibility of a slower pace of Fed’s rate normalization. This in turn would provide an upside to the Ringgit. However, we believe the dollar selldown is largely a kneejerk reaction and the “Dovish Fed” factor that weighed down on the dollar. Meanwhile, Malaysia’s strengthening macro fundamentals would likely become more significant in driving the ringgit trend in the coming months along with the increasing demand of domestic debt and equities as foreign inflows picks up pace.

Mild outflows in June. Foreign holdings of Malaysia’s government debt securities experienced a mild outflow in June following two consecutive months of capital inflows. Foreign net selling of government debt securities was just RM0.4b for the month following a net inflow of RM9.9b in May. It is noteworthy that the year-to-date (end-June) capital outflows still stood at RM21.9b, the largest outflows in recent years. MGS turned out to be the only government securities that saw net selling by foreign funds in June. Total foreign ownership of MGS declined by RM0.9b in June (May: +RM8.9b). As a result, share of foreign holdings of MGS moderated slightly to 41.2% from 41.8% in May. In contrast, foreign holdings of all other government debt instruments saw a stable and positive net increase: Government Investment Issues (GII) (RM0.09b); Malaysia treasury bills (RM0.3b); BNM Bills (RM0.03b).

Equity inflows uninterrupted. Meanwhile, the Malaysian equity market continued to enjoy steady foreign capital inflows in 2Q17 on the back of improved corporate earnings as exports and economic growth rebounded strongly. The domestic equities saw a second consecutive quarter of net foreign funds inflows of RM4.4b in 2Q17 (1Q17: +RM5.7b). However, the monthly net inflows have tapered off to RM0.3b in June from RM1.5b and RM2.6b in May and April respectively. The FBMKLCI has gained 1.4% or 23.58 points to 1,763.67 in 2Q17.

High foreign holdings posed outflow risk. While an influx of foreign funds can be beneficial to domestic financial market by improving liquidity, it can pose a shock to the market in view of a major reversal of foreign funds, especially when a large portion of those funds are speculative or short term in nature. BNM Governor Datuk Muhammad Ibrahim has raised concern of the rising risk of financial instability due to the large ownership of foreign holdings in Malaysia securities. Nevertheless, we believe the bond market is currently well shielded from the risk of major outflow due to Malaysia’s improving macroeconomic fundamentals.

Ringgit strength to provide buffer. In view of improving growth outlook, we see a stronger albeit volatile ringgit by the end of the year. The ongoing political turmoil and uncertainty in the Trump administration, if continually unresolved, could weigh on the dollar strength. By default, this would lift up the ringgit value vis-à-vis the dollar. Hence, we expect the USDMYR to gravitate towards 4.15 by end of this year. (Refer to “Ringgit Outlook 3Q17’’ for details). A potentially stronger ringgit provides some buffer to the local debt market and alleviates the adverse impact of potential capital outflow. Furthermore, the MGS also holds a comfortable yield spread over similar U.S. securities, with a 5-year and 10-year bond yield spread of around 180 basis points (bps) and 170 bps respectively (as of July 28).

Solid fundamentals outweigh external risks. While it seems plausible to see a certain degree of foreign withdrawal from local bond market in tandem with U.S. tightening cycle, we expect the probability would be relatively low. This is largely based on our assessment of Malaysia’s strong fundamentals. Malaysia’s exports registered an exceptional 23.3% YoY growth in 5M17 (1.7% in 5M16) and it is expected to maintain a solid momentum for the remainder of the year. Meanwhile, slow and steady rise of Malaysia’s foreign reserves is well underway, which saw it climb to a two-year high of USD99.1b in mid-July. These bullish factors combined with improving domestic demand have led to recent upward revision of Malaysia’s 2017 GDP outlook by major multilateral organizations including the World Bank and the IMF. This will effectively strengthen foreign investor’s confidence and help to retain foreign funds in the local debt market. While Malaysia’s strong fundamentals may help mitigate funds outflows it may also help sustain funds inflows barring unforeseen external and domestic shocks in the short to medium term.

Source: Kenanga Research - 31 Jul 2017