The FBMKLCI plunged 78.81 points or 4.9% to a low of 1,532.24 before closing at 1,536.48 yesterday. It does not appear to be driven by worries about the US entering a recession alone but also fears about a full-scale war in the Middle East after Secretary of State Tony Blinken told his counterparts from the G7 countries on Sunday that an attack by Iran and Hezbollah against Israel could start within the next 24 to 48 hours. The market could have been spooked by the high probability of a full-scale war between Israel and Iran, backed by their respective allies. These negative vibes were compounded further by the unwinding of yen carry trades (post Japan’s decision to tighten its monetary policy and appreciation in yen).

Predictions about the US economy entering a recession are not new and have been around since March 2022, when the 2-year and 10-year treasury yields inverted for the first time in 2019. It has been continuously inverted since July 2022. Historically, recessions tended to lag yield curve inversions by 6 to 18 months, and the current lag is the longest in history, having broken the previous record of 624-day inversion in 1978. Perhaps the onset of another recession indicator has increased the anxiety. Last Friday’s nonfarm payroll data showed the US unemployment rate for July had triggered the “Sahm Rule” and emboldened this earlier view. Sahm Rule indicates that when the unemployment rate over a three-month period averages half a percentage point above the 12-month low, the economy is in recession. This rule was met when the jobless rate rose to 4.3% in July, bringing the three-month average to more than 4.1%, compared to the 12-month low of 3.5%.

However, the Federal Reserve still has the option to quicken the monetary easing pace, if need be, given the high fund target rate of 5.25% to 5.50%. Besides, the US banking system is still healthy, and the US Federal Reserve’s stress tests indicated it is well positioned to survive a severe recession while continuing to lend to households and businesses.

A direct full-scale war between Israel and Iran will escalate tensions in the Middle East and will be detrimental to global economic growth as oil prices will shoot through the roof. We have indicated in our previous report, “Israel-Hamas War – Will the Dark Clouds Engulf the World?”(https://taresearch.taonline.com.my/rrs/files/2023/10/Israel_Hamas_War_20231019.pdf)

dated 19 October 2023, about the possibility of crude oil hitting USD150/barrel if the war escalates and Iran blocks the Straits of Hormuz. Chances of further escalation in tension have increased rapidly after the assassination of Hamas leader Ismail Haniyeh and Senior Hezbollah commander Fouad Shukur by Israel. As a sign of time, the US, which is Israel’s strongest ally, has already ordered additional ballistic missile defence-capable cruisers and destroyers to the Middle East to help defend Israel from possible attacks by Iran and its proxies.

A worsening situation could prompt investors to move into haven assets and away from equities as sell first and decide later attitude will prevail, although defensive and domestic sectors could be less hit by the ongoing turmoil. The scale of the recent sell-down in global and Malaysian equities indicates the correction may continue for a few days until there is more clarity on these adverse developments and the emergence of positive news flows. As such, investors could be better off not catching the falling knife unless the correction has reached attractive levels.

What could be an attractive level? Tracking six major wars since 2001, we noticed, except for the 11 September 2021 attack on the US World Trade Centre and Pentagon, four other major black swan events, which are the attack on Iraq by the US, the annexation of Crimea by Russia, Russia and Ukraine war, and Israel and Hamas war, had less severe and no prolonged impact on the FBMKLCI. Even the current war between Israel and Hamas did not affect the benchmark index when it started on 7 October 2023 (see table).

However, the danger of it ballooning into a full-fledged war between Israel and Iran has raised the stakes, more so if it drags in the US and involves attacks on the US and Iranian soil. So, on a worst-case scenario, presuming the impact on FBMKLCI could mirror the aftermath of the 9/11 attack, where the market corrected by 13.2% in the first two months after the attack before recovering entirely in the fourth month, the 9 June 2023 low of 1,369.41 (at this level it will be 15% correction based on last Friday’s closing of 1,611.05) can act as a solid support. We reckon this is farfetched as the FBMKLCI lagged most regional markets that have hit new highs in recent months, and its current CY25 PER of 13.1x is undemanding compared to the historical average of 16x and 5-year mean of 17.6x. Thus, we believe the correction could be limited to between 5% and 8% (1,480 - 1,530) if the direct confrontation between Iran and Israel can be contained as what transpired last April.

Hence, any further corrections towards the lower band of this level can be a good opportunity to accumulate oversold stocks, especially those related to the domestic sectors like construction and banks, apart from defensive plays in the consumer staples, healthcare, power & utilities sectors and REITs. We are maintaining our end-2024 target of 1,690, which is based on CY25 PER of 14.4x, as the US Fed’s monetary easing cycle is around the corner and believe the global superpowers will be able to contain this carnage from exploding further after an initial rampage if a war broke out. Besides, Malaysia’s diverse economy is largely driven by domestic activities, and the impact of any global economic slowdown can be contained by the ongoing structural reforms and long-term economic plans.

Source: TA Research - 6 Aug 2024