OVERVIEW

• Foreign funds return. Net foreign holdings of Malaysian debt securities jumped in September, totalling RM9.3b (Aug: -RM0.7b). The inflows were broad-based, led by MGS (RM5.8b); GII (RM2.1b); and MTB (RM2.1b). Consequently, foreign holdings of MGS rose to 42.8% from 40.3% in August.
• Fed tightening to induce outflows. The Fed’s balance sheet normalization, Fed hawkish tone, and strong US economic data have pushed up US dollar and Treasury yield. We thus see an increasing risk of foreign outflows.
• Higher government financing costs. Rising government bond yield might add to the challenge for the government to finance its fiscal deficit, though we believe this will not materially affect the government ability to reach its goal of reducing the fiscal deficit. Thus we believe the government’s fiscal deficit target of 3.0% of GDP this year is achievable.
• Fundamentals as a shield. The foreign holders of Malaysia government bonds are mostly institutional investors who mainly focus on the fundamentals. Thus, we see fund flows into domestic debt market to remain steady and fluid on the back of Malaysia’s strong fundamentals.

Foreign funds return. The foreign holdings of Malaysian debt securities saw a solid increase in September after three consecutive months of net selling. Net foreign purchase of Malaysian debt securities totaled RM9.3b, offsetting a cumulative outflow of RM3.3b in the previous three months. On a quarterly basis, domestic debt market registered lower net foreign inflows of RM6.3b in 3Q17 compared to RM16.5 in 2Q17.

Broad-based increase in holdings. The local debt market received a broad based foreign purchase of its various securities in September, led by a RM5.8b jump in Malaysian Government Securities (MGS) (Aug: +RM2.1b); +RM2.1b in Government Investment Issues (GII); and +RM2.1b in Malaysian Treasury Bills (MTB). Consequently, foreign holdings of MGS rose to 42.8% from 40.3% in August; while GII increased to 7.0% from 6.3% in August. The foreign inflows in September reflects the general view that most investors remained fickle and are likely to switch their portfolio holdings into higher yielding assets in the emerging markets following uncertainty of the US Fed monetary policy triggering a risk off mode.

Equity outflows continue. On the other hand, the monthly capital outflows in local equity market extended for the second month in September. Rising geopolitical risks, particularly the tensions between U.S. and North Korea over its nuclear programme had raised much uncertainty and jittered investors. Foreign net selling of local equity totaled RM0.7b in September (August: -RM0.2b). Nonetheless we remain positive that equity market would likely see a renewed interest from foreign investors in the near term due to the resilient economic and improving business conditions.

Uninterrupted rise in reserves. On a positive note, the foreign reserves grew for the ninth straight month in September. This could partly be attributable to the steady exports growth and the subsequent repatriation of export earnings. Malaysia’s foreign reserves rose a further USD0.7b to USD101.2b at end-September, after breaking the USD100.0b psychological level for the first time in August. This is sufficient to finance 7.6 months of retained imports and 1.1 times of short-term external debt. The BNM’s ongoing efforts to build a larger buffer of reserves could prove to be crucial in establishing Malaysia’s financial stability and driving investor’s interest to invest in Malaysian debt securities.

Fed tightening induced funds outflow? Despite the brief period of foreign funds flowing into emerging markets including Malaysia debts market as seen for the month, the most recent market developments seem to suggest the inflows could be short-lived. In a significant move, the Fed has announced its decision to start normalizing its USD4.5 trillion balance sheet in October. The increasingly hawkish tone from the Fed has also lifted the market expectations of another rate hike before the year end. Indeed, the series of strong US economic data would lend a case for a hawkish Fed. Despite the latest US payroll number showing a decline due to Hurricanes Harvey and Irma, the Fed will likely opt to overlook the seasonal factor and acknowledge the tightening labor market.

We have seen the US dollar strengthening against ringgit, with the USDMYR pair gravitating back towards the 4.25- 4.30 range after dipping below 4.20 level. The U.S. 10- year Treasury yield has risen to as high as 2.359% last week from an average of 2.193% in September. As such, we remain wary of the increasing risks of foreign funds flowing out of Malaysian debt market in search of higher yields and returns.

Rising bond yield, higher financing cost. Along the Fed’s monetary normalization cycle, a rising US debt yield would inevitably push up yields on Malaysian government securities in order to maintain competitive interest rate differentials. We reckon this might potentially increase the financing cost of the government and serve as additional burden for the government to finance its fiscal deficit. The rising government bond yield might also have a spillover effects on the corporate financing costs. Nevertheless, we believe this will not materially affect the government ability to reach its goal of reducing the fiscal deficit, in view of the government’s ongoing cost rationalization initiatives and broadening sources of revenue. We maintain our estimate for a 3.0% fiscal deficit in 2017 (2016: -3.1%) and a narrower fiscal deficit of 2.9% next year.

Fundamentals as a shield. In spite of the rising risks of foreign capital outflows, we reiterate our view that Malaysia’s sound fundamentals will play the main role in dictating the foreign investors’ investment decisions and foreign fund flow movement. Most of the foreign holders of Malaysia government bonds are comprised of institutional investors including central banks, pension funds and insurance companies, which usually place a greater emphasis on the fundamentals of the destination country. Malaysia has enjoyed an improving economic outlook partly thanks to its strategic position in the global supply chain link and the robust recovery of global trade. The World Bank was among the latest major institutions to upgrade Malaysia’s economic outlook (to 5.2% in 2017 from 4.9% previously). As such, we see fund flows in domestic debt market to remain steady and fluid. This would prompt BNM to maintain its overnight policy rate (OPR) for this year and likely next year as well.

Source: Kenanga Research - 10 Oct 2017