We  see  the  stabilisation  and  consolidation  of  oil  prices  and  the  reemergence of corporate earnings growth  –  after an absence of nearly three years  –  as re-rating catalysts for the market. The 2H15 recovery in  oil will  banish  fiscal  concerns and help  to  lift  the  MYR.  Improving market  valuations  and  the  rehabilitation  of  the  global  economy  will lead to investors re-examining their underweight positions.

Staying positive on domestic equities. The stabilisation of oil and the recovery  in  corporate  earnings  will  be  key  re-rating  catalysts  for  the local market. The sharp correction in equities since 4Q14 was triggered by the collapse in oil  prices, which  sparked fiscal worries, heightening downside risks for GDP growth from reduced investments in the  oil & gas (O&G)  sector and  causing the MYR to spiral lower. We do not rule out crude oil price volatility throughout the rest of this year and expect equilibrium  to  be  reached  in  2H15,  averaging  the  year  at USD72.50/barrel (bbl), helped by improving global demand conditionsand reduced supply. As Malaysia remains the only net  O&G exporter in ASEAN,  it  will  be  the  sole  beneficiary  of  the  recovery  in  oil  that  will extinguish  lingering  fiscal  concerns.  Our  base  case  assumptions  are that  the global economic recovery will not be derailed and there is no risk  of  significant  tightening  of  monetary  policies  in  developed economies to trigger a rate shock.  Lower oil will  also hasten the global economic  recovery,  driven  mainly  by  the  US  and  UK  economies.  US consumers,  in particular,  will also benefit from a stronger USD, which should increase their purchasing power. The timing of the normalisation of  US  interest  rates  remains  data  dependent,  although  the  latest  US Federal Reserve (Fed)  comments suggest that the first rate increase  is unlikely  until  Sep/Dec  2015. Thereafter,  it  proceed  at  a  more  gradual pace, after recognising that a June  hike could lead to an even stronger USD, which could have negative implications for growth and inflation. In the near term, portfolio flows may move back to emerging markets on the  back  of  increased  appetite  for  riskier  asset  classes.  The  under owned  and  unloved  Malaysian  equities  market  could  enjoy  some spillover. This could help to mitigate the impact of a possible sovereign rating downgrade by Fitch, whih we believe is not yet fully priced in.Better earnings growth this year. We believe corporate Malaysia will be able to show improved bottomline growth this year after lacklustre earnings  over  the  past  three  years.  The  recovery  will  be  driven  by corporates  leveraging  on  their  investments  in  manufacturing  capacity, manpower  and  technology in the last  two  years.  RHB  forecasts  2015 and 2016  FBM KLCI EPS growth of 6.4% and 9.5% from 7% and 7.8% respectively  at  the  end  of  the  preceding  quarter.  2015  FBM  KLCI earnings  growth  will  be  derived  mainly  from  the  banking,  utilities  and healthcare sectors.  Based on an unchanged 16.5x  1-year  forward P/E, our end-2015 target for the index is 1,910 pts (from 1,960 pts).Market strategy. Equities remain our preferred asset class. We have a preference for stocks offering good growth prospects and believe there is a less compelling case for yield stocks. We have 10 sectors (of 22) in which  we  have  OVERWEIGHT  calls  (see  Table  22),  up  from  eight  in the  preceding  quarter,  with  O&G  and  healthcare  the  two  most  recent upgrades.  Our  key  OVERWEIGHT  sectors  include  utilities, construction, ports & shipping, O&G and healthcare.

Market Review

Tepid recovery helped by stabilisation of oil prices
2015 got off to a sombre start, with a renewed sell-off across most markets. This was on the back of concerns that the European Central Bank (ECB) may not meet the market’s expectations for full-scale quantitative easing (QE). This was  coupled with a combination of concerns over global economic growth and  the  possibility of deflation in some countries, which culminated in lower commodity prices and falling financial asset  prices,  particularly  in  emerging  markets.  Most  Asian  markets  gained  amid expectations  that:  i)  most  economies  in  the  region  would  benefit  from  weaker  oil prices,  and  ii)  reduced  inflationary  pressures  allowed  for  more  accommodative central bank monetary policies, which were  positive for their respective markets. The strong  recovery  across  ASEAN  markets  outpaced  the  local  bourse,  with  the exception of Singapore.

The  rebound  in  the  FBM  KLCI  benchmark  in  January  was  not  sustained  and  the bellwether index remained stuck in a range-bound pattern thereafter, given the lack of  fresh  leads  and  a  relatively  disappointing  corporate  results  reporting  season. Investor  sentiment  was  largely  driven by  external events  and  profit -taking  activities that  emerged  following  Fitch’s  comments  on  20  Jan  of  a  possible  downgrade  in Malaysia’s  sovereign  rating.  There  was  also  a  series  of  looser  monetary  policies around the world. These included  the: i) Reserve Bank of Australia  (RBA)  surprisinginvestors with an interest rate cut in early January (citing an overvalued currency as a continued headwind to economic growth), ii) People’s Bank of China (PBOC) cuttingbanks’  statutory  reserve  ratio  by  50bps  to  19.5%  to  add  liquidity  to  the  banking system  and  support  lending,  iii)  Monetary  Authority  of  Singapore’s  (MAS) unscheduled meeting  where it decided to adjust its monetary policy to slowdown the appreciation  of  the  SGD  (MAS  said  it  will  reduce  the slope  of  the  band  where  the SGD  fluctuates  but  will  maintain  the  modest  and  gradual  pace  at  which  the  SGD appreciates  against  a  basket  of  other  currencies),  iv)  Reserve  Bank  of  India  (RBI)surprising  markets with a 25bps rate cut to 7.75%  –  the first rate reduction in nearly two  years,  and  v)  Bank  of  Thailand’s  (BOT)  Monetary  Policy  Comitee  (MPC) reducing  the key policy rate (1-day bilateral repurchase rate) by 25bps to 1.75%, the lowest in more than four years.

The PBOC’s timely action allayed growth concerns over weak industrial data, as the HSBC Manufacturing Purchasing Managers’ Index for January fell to 49.7 (A reading below 50 indicates that manufacturing output is contracting). This spurred the local index  higher  to  reach  1,813.25  pts  on  6  Feb.  However,  concerns  over  the  antiausterity  Syriza  party  winning  Greece’s  general  election  –  it  vows  to  reverse  the spending  cuts  and  economic  reforms  demanded  by  the  country’s  international creditors which could  possibly  see Greece  forced out of the Eurozone  –  dampened sentiment. “Grexit,” as a Greek exit has been dubbed, inevitably led to speculation about other debt-laden Eurozone countries leaving the curren cy union  –  potentially sparking a damaging chain reaction across the European continent  – was headed off on  20  Feb  as  a  4-month  bailout  extension  was  approved  by  the  Troika.  The  FBM KLCI was subsequently lifted to a new YTD high of 1,821.21pts on 27 Feb. The MYR –  the worst performing currency in ASEAN  –  continued its descent against the USD, falling 6.7% YTD to MYR3.73 USD on 20 Mar. The weakening of the MYR is largely tied to external factors, namely: i) speculation over the timing of the US interest ratehike  by  the  Fed  and  ii)  concerns  ove  the  implications  of  prolonged  low  crude  oil prices on the country’s fiscal position. This has been exacerbated by weakening CPO prices (Malaysia is also a major exporter), which coincided with the market’s turning point, ie declining 47pts to 1778.16pts on 11 Mar.

The FBM KLCI is up 2.4% YTD but has underperformed most of its  ASEAN  peers, except  for  Singapore and Thailand. The benchmark index still trails the performance of all other major markets in Asia except for Sri Lanka (-3.3%) and – within ASEAN –the Philippines (+8.1%) and Indonesia (+4.1%) (see Table 1). The biggest gainer was China’s  Shenzhen  Composite  Index  (+30.9%),  which  outpaced  the  Shanghai Composite  Index  (+11.8%),  as  Chinese  investors  anticipate  that  the  Hong  KongShenzhen  Connect  programme  will  see  an  influx  of  foreign  investors.  A  similaroccurrence was observed when  the Hong Kong-Shanghai Connect  was  established in Nov 2014.

On  the  local  front,  the  telecom,  technology,  construction,  O&G  (classified  under mining) and consumer sectors were the key outperformers during the period under review  (see  Table  2).  Telecom  stocks  continue  to  be  a  refuge  from  volatility  while tech companies are benefitting from the strong USD. Construction remains in focus ,owing  to  the  maintenance  of  the  Government’s  development  expenditure programme. O&G stocks rebounded off their lows during the quarter,  in line with the stabilisation  of  oil  prices.  Consumer  stocks  benefitted  from  higher  pre-goods  and services  tax  (GST)  spending.  In  contrast,  the  plantation  industry  was  the  worst performing sector. This was  on account of sluggish CPO prices, which  weighed  on the  sector’s  YTD  performance  (-1.1%).  Meanwhile,  the  banking  and  finance,  and property sectors were largely unchanged. Table 3  provides the  list of outperformers and underperformers under our coverage.

Market Outlook

It is not all doom and gloom
The market ended 2014 consumed by fear  over  the implications of collapsing global oil  prices  on  Malaysia's  finances.  Concerns  escalated  on  the:  i)  country's  ability  to meet established fiscal targets,  ii)  knock-on impact of slower economic growth from reduced  investments  in  the  O&G  sector  and  iii)  looming  spectre  of  the  current account  falling  into  a  deficit,  which  could  hasten  a  sovereign  rating  downgrade  by global  rating  agencies.  The  latter  is  expected  to  trigger  a  downward  spiral  in  the MYR,  exacerbated by the high foreign holdings of government bonds, securities and money market instruments.

The  FBM  KLCI  has  managed  to  creep  higher in  2015,  rising  2.4%  YTD.  This  was despite the relatively weak investor sentiment,  with foreign institutional funds mainly underweighting  Malaysia.  We  believe  the  market's  recovery  has  come  in  lockstep with the stabilisation of oil prices during the quarter. This is  very much in line with our expectations  for  our  market  to  be  positively  correlated  to  oil  until  oil  prices  find  a base.  Brent  crude  oil  dipped  below  USD47/bbl  on  13  Jan  2015  before  recovering steeply to over USD62/bbl by end-Feb 2015. The stabilisation of prices was  helped by supply disruptions in Iraq, Libya and Iran, which removed 885,000 barrels per day (bpd) from the global oil market,  as well as the strong winter demand in the  NorthernHemisphere and high refinery throughputs.

Oil to reach equilibrium in 2H15

We reiterate  our view that the decline in oil is more a function of supply-side rather than demand factors. This is because of  the change in the fundamentals in the crude oil supply  dynamics brought about by  the surge in shale O&G production in the US. As  oil  prices  retrace,  high  marginal  cost  producers  will  likely  be  forced  out  of production. According to data from Baker Hughes, the number of active US drilling rigs  fell  to  866  rigs  currently,  down  46%  from  Oct  2014’s  numbers  and  the  lowest since  Mar  2011.  Energy  producers  have  cut  billions  in  spending  and  eliminatedthousands of jobs, threatening to slow down the shale boom. According to the Energy Information Administration (EIA), US oil production seems to be reaching an inflection point where output from shale regions will begin to decline. We expect oil inventories to  increase  at  a  slower  pace  –  or  even  decline  –  as  we  enter  the  peak  demand season  (the  US  summer  driving  season).  There  will  probably  be  crude  oil  price volatility throughout the rest of this year and we expect equilibrium should be reached by  2H15.  Organisation  of  the  Petroleum  Exporting  Countries  (OPC)  secretarygeneral Abdalla El-Badri also believes that the global oil market will return to balance sometime  in  2H15,  as  demand  picks  up  and  high-cost  producers  trim  output  amid lower  prices.  He  added  that  shale  oil  was  not  a  challenge  for  OPEC  and  that  the market  should  be  left  alone  to  determine  prices  that  decide  which  suppliers  will survive.  Over  the  next  25  years,  the  oil  industry  will  need  USD10trn  to  meet  a forecast of a 60% increase in energy demand. Fossil fuel will remain central to the energy mix. According to a senior Saudi Aramco executive, the industry may cancel or delay about USD1trn of planned projects globally over the next couple of years. Although crude oil stocks have been soaring, stocks of refined products have been drawn down since the start of the year, following a normal seasonal pattern.

This healthy demand for refined products in the US has ensured that the oversupply is  confined  to  the  crude  oil  market.  The  US  refineries  will  ramp  up  throughput  in preparation  for  peak  demand  –  the  summer  driving  season  –  where  crude  stocksshould start to rise more slowly or even fall.

The USD hit a 12-year high  –  jacking up the cost of oil and other USD-denominated commodities.  In  summary,  on  the  supply  side,  there  are  some  signs  the  surge  in crude  from  the  US  shale  plays  is  beginning  to  level  out  as  drilling  activities  fall. Demand  for  gasoline  in  the  US  is  rising  at  its  fastest  rate  since  2010,  as  cheaper prices  encourage  motorists  to  use  their  cars  more.  Demand  from  Japan  could  be lower due to a  switch to liquefied natural gas (LNG) for power generation, and the impending  start-up  of  two  Sendai  nuclear  reactors  in  Japan.  Our  house  average crude  oil  price  forecast  is  USD72.50/bbl  and  USD80/bbl  for  2015  and  2016 respectively.

Revised 2015 Budget
The Government revised the 2015 Budget on 20 Jan to factor in the rapid collapse in crude oil prices in late 2014. It also increased flood-related expenditure. The oil price assumption  was  revised  to  USD55/bbl  for  2015,  from  the  Government’s  earlier assumption of USD100/bbl in the original budget tabled in Oct 2014. This will result in a revenue shortfall of MYR13.8bn, caused by a fall in oil revenue as a result of lower oil prices.

Budget shortfall not as negative as feared
However, the shortfall is not as severe as Petronas' earlier forecast. The national oil company had earlier stated  that its contribution to  government coffers would fall by about  MYR25bn,  including a cut in  dividends  by  MYR12bn  and  drop in petroleum income tax by MYR9bn.

This implied  that Petronas could be paying almost the same quantum of dividend in 2015. This is because the dividend payment is   based on the financial performance of  Petronas  for  the  2014  calendar  year,  which  was  not  as  badly  affected  by  thesharp fall in crude oil prices towards  the end of the year. While oil revenue could decline  23.5%  from  the  initial  forecast,  this  is  offset  by  the  abolishment  of  fuel subsidies  and  implementation  of  the  managed  float  mechanism  for  retail  fuel  and diesel  prices,  which  is  expected  to  help  the  Government  save  MYR10.7bn  in  fuel subsidies, leaving the shortfall of MYR3.1bn.

The  Government  also  announced  new  expenditures  (mostly  flood-related expenditure)  and  fiscal measures  to  mitigate  the  impact  of  lower  oil  prices  on the economy.  Costing  about  MYR5.2bn,  this  will  widen  the  shortfall  to  MYR8.3bn.  If nothing is done, the MYR8.3bn shortfall would worsen the fiscal deficit to 3.9% of GDP.  Finally,  a  cut  in  opex  by  MYR5.5bn  was  budgeted,  helping  to  narrow  the shortfall  to  MYR2.8bn  or  0.2%  of  GDP.  On  balance,  the  Government  revised  its fiscal deficit target to 3.2% in 2015, wider than its earlier target of 3% and down from 3.5%  of  GDP  estimated  for  2014.  We  highlight  that  the  revised  budget  does  not negatively  impact  gross  development  expenditure  for  2015,  amounting  to MYR48.5bn.  This  should  provide  support  to  the  economy,  stimulating  private investment  and  consumer  spending  in  2015.  While  the  new  fiscal  deficit  target misses the previous one, we are encouraged by the fact  that the trend continues to improve in the right direction.

Current account to remain in surplus
The Government expects the current account to narrow in 2015,  but to  remain firmly in  surplus.  Falling  commodity  prices,  crude  oil  and  LNG  will  be  offset  by  higher manufactured exports from stronger global demand. This helps to rebut concerns that Malaysia  could  suffer  from  a  "twin  deficit".  Overall,  we  expect  the  current  account surplus of the balance of payments to narrow significantly to MYR26bn,  or 2.3%  of GDP in 2015  vs  a surplus of RM49.5bn,  or 4.6%  of GDP,  in 2014. We estimate that the  current  account  is  only  likely  to  fall  into  a  deficit  position  if:  i)  Brent  crude  oil languishes below USD40/bbl,  ii)  LNG prices decline by more than  40%,  and iii) CPO prices decline by more than 20% – all for a sustained period.

A downgrade by Fitch remains a distinct possibility
On  21  Jan, Fitch  Ratings  maintained  a  “Negative”  outlook on  Malaysia's long-term issuer default ratings ad indicated that  it is  more likely than not to downgrade the ratings  within  the  next  12-18  months.  Fitch  said  the  upward  revision  to  Malaysia's 2015  fiscal  deficit  target  –  amid  sharply  falling  crude  oil  prices  –  shows  that  the country's dependence on petroleum-linked revenues remains a key sovereign credit weakness. The rating agency expects to conduct a full review of Malaysia's ratings before the end of July. Fitch has said before that slippage in the  Government's fiscal targets would be credit negative for the country.

These revisions underscore the vulnerability of Malaysia's economy and credit profile to  sharp  movements  in  commodity  prices,  ie  the  high  share  of  revenues  linked  to O&G-linked revenues is a structural weakness. The sharp decline  in energy prices  is also likely to have an impact on Malaysia's external accounts. The emergence of twin fiscal and current account deficits will remain a rating sensitivity for Malaysia. Such a scenario would risk greater volatility in capital flows to a  degree that could become disruptive for the economy. Although the Government revised upward the 2015 deficit target, Fitch maintains that further consolidation measures might be required to meet the  country’s  target  of  achieving  a  balanced  budget  by  2020.  Malaysia's  rising contingent  sovereign  liabilities  are  also  likely  to  remain  a  credit  weakness.  The financial position of 1Malaysia Development Bhd (1MDB) – a state-owned investment company  –  has  become  a  source  of  uncertainty.  Fitch  views  1MDB  as  a  close contingent  sovereign  liability because of the nature of its operations and leadership, as  well  as  the  explicit  sovereign  guarantees  of  some  MYR5.8bn  of  the  entity's MYR41.9bn debt (as at end-Mar 2014).

As  a  whole,  Fitch  appears  to  have  made  up  its  mind  to  downgrade  Malaysia's sovereign  rating  in  late  May/early  June  unless  there  is  more  convincing  fiscal measures being introduced between now and  May. Thissuggests that the sovereign rating will  have a more than 50% probability of being downgraded, as it  has  to make a  decision  within  20 months after  putting  the country's  rating  on a negative  watch. Key reasons put forward by Fitch  are  the lack of convincing fiscal reforms  and  the Government’s overdependence on oil revenue.

lf downgraded, there will likely  be some negative impact on: i)  Malaysia's investmentrisk premiums,  ii)  the MYR,  and iii)  the market,  though it will  still be cushioned by the two  other  rating  agencies,  which  have  maintained  their  calls  on  the  country’s sovereign credit ratings.

Standard & Poor's maintains  their stable outlook. ..
Standard & Poor's Financial Services LLC (S&P) has affirmed Malaysia's short-term foreign currency sovereign credit rating at “A-2” and its long-term rating at “A-”, with a stable outlook on the long-term rating on 10 Feb. This is because it expects the fall in oil prices to not disrupt the country’s  long-term fiscal consolidation.  It also affirmed its long-term “A”  and short-term  “A-1”  local currency ratings on Malaysia, as well as its “axAAA/axA-1+” ASEAN regional scale rating on the country.

.. . while  Moody's has a  positive outlook
Moody's Investors Service  (Moody’s)  also affirmed the government bond and issuerratings of the  Malaysian Government  at  “A3”  on 30 Jan with a positive outlook. This was  on  account  of  the  Government's  intention  to  adhere  to  its  policy  of  deficit reduction,  driven  by  fiscal  reforms  that  have  already  bolstered  the  administration's resilience to cyclical commodity price shock

Source: RHB