Wednesday, 17 August 2011 12:28
Given the high degree of openness of the economy, a global slowdown will be felt strongly in the external trade-related sectors. Deterioration in external demand will affect exports and export-oriented manufacturing. Private investment will take a hit in view of deteriorating business conditions.
When this happens, we can expect large drawdowns of inventory, particularly in the manufacturing and commodity sectors, thus dragging down domestic growth. Deterioration will retard job creation, income growth, businesses and consumer sentiment. We revise downwards 2011 real GDP growth to 4.5% from our base case growth of 5.3% and optimistic scenario of 6.1% on the assumption that world growth will expand by 3.9%, with G3 by 1% and developing Asia by 8.4%.
Considerations for the 2011 downgrade
Exports, the first growth leg, are expected to slow down. Hurting most will be electrical and electronics (E&E), whose exports have been on a negative growth trajectory since March 2011. Slower global growth would mean production will ease in tandem with softer global demand.
We fear manufacturers across the global E&E supply chain would cut back production and drawing down from inventory. A broad contraction of global demand can result in substantial declines in the computer and parts and electrical product segments, especially when corporations decide to delay investing in equipment and software. Electrical products will be influenced by consumer spending.
We also expect some level of dampening of manufacturing in the primary-related cluster. In particular, our concern is over the chemical products industry, which can take a hit if
demand for plastic parts and components used in the E&E and automotive industries gets hurt. Production of the off-estate processing industry can be affected as well by
unfavourable commodity prices, since it will provide less incentive to process off-estate products.
Earnings from commodity exports could drop due to weaker demand and lower prices. After surging through April, commodity prices started to ease in May. We believe the corrections could partly be due to the unwinding of an earlier build-up of non-commercial derivative positions following the increase in general financial volatility and the reaction to recent data on a softer global economy. Prices of crude oil briefly came close to US$120 a barrel in April, fell sharply in May and have stabilised since. Food prices also stabilised since
early 2011 after 2010’s weather-related supply shocks. Our concern will be when both output and prices drop and higher export volume is unable to cushion the fall in prices.
At times when global sentiment towards equity is weak, no market can
claim to have decoupled from Wall Street, the centre of the world's
equity market.
Impact from second growth
leg — private expenditure — may easeWe expect private expenditure to take the lead in driving 2011 economic growth with private consumption being one of the key pillars of growth. While household sentiments are to remain healthy in the near term, our bigger concern is going forward. Households will retrench their spending when the labour market becomes wobbly on employment prospects.
A pessimistic outlook on income expectations as well as falling real wages will force consumers to lower their expenditure binge.
It is possible household income in sectors that are not severely exposed to external demand may not suffer, hence spending patterns may remain relatively unaffected. While this holds true, we are of the view that spending behaviour can be affected by the weak sentiment following the overall weaker economic conditions and uncertainties over income outlook and job security. This will result in a decline in private consumption spending.
This can lead to a decline in capacity expansion. Capital spending will start to decline if business sentiment starts to wane. This will result in businesses deferring or cancelling expansion especially when external demand weakens and a more cautious outlook on domestic economic conditions is perceived. It will affect the inflow of foreign direct investment and domestic investment. Should investment decline we can expect production to slow down, lowering capacity utilisation rate and easing the need for firms to embark on additional capacity expansion.
However, we believe much will depend on how private investment pans out and can lend support to private expenditure (private consumption + private investment) and growth. Much will depend on the magnitude and speed the Economic Transformation Programme (ETP) projects kick in as this will determine the size of the multiplier and its impact on the economy.
Liquidity, the third growth leg, might weigh on the economy
Developing Asia’s inflation is broad based. Headline inflation in developing Asia, including Malaysia, has been on the uptrend driven by larger-than-expected increases in commodity prices. This is due to a higher share of food and fuel in consumption and accelerating demand pressure.
With volatile global financial market conditions since late May, risk of over-tightening of the policy rate by Bank Negara Malaysia (BNM) to contain inflation can alleviate the speed
of a sharper slowdown. After easing through much of 1H11, markets have become increasingly worried over sovereign risks in the eurozone, the downgrade of the US credit rating to AA+ from AAA by Standard and Poor’s and weakness in the US economic recovery. Insufficient pace of repairing the banking system, notably in Europe, and risks related to re-leverage in various market segments have heightened risks. This is reflected by the rising sovereign credit default swap spreads in some euro economies.
Hence, worries are brewing as to whether there will be a trade-off between growth and inflation. Such concern has started brewing with the US economy still on a weak recovery note. Fear of the US Federal Reserve embarking on another round of monetary easing is growing. Should this happen, it will add additional inflationary pressure and may push up commodity prices. Inflow of short-term funds into developing Asia, including Malaysia, will accelerate, thus making it tougher to control prices.
Can raising policy rates solve the issue? Our answer is “no”. Hiking rates will widen the differential in interest rates, especially with the Fed’s decision to keep the benchmark lending rate near zero till “at least” through mid-2013. Widening interest rate differential will entice more liquidity into developing Asia, given its healthier economy compared to the G3. This will further add inflation into developing Asia, including Malaysia.
On that note, we expect BNM to hold the overnight policy rate (OPR) at 3%. We expect BNM to use macro-prudential measures to tackle inflation should it become less tolerable. We are not ruling out the possibility of the statutory reserve requirement (SRR), now at 4%, to be raised by another 50 to 100bps to absorb liquidity should it become a concern.
Strengthening the ringgit will help ease imported inflationary pressure.
Malaysia’s growth for 2012 looks tricky
Driven by global uncertainties with increasing odds that the US and eurozone could fall into recession and China risk a hard landing, we expect Malaysia to face a challenging 2012. External trade-related sectors are expected to remain weak given the high degree of openness. It can put a lid on the upside growth to exports and export-oriented manufacturing. Private investment will be dampened by the poor business conditions and drawdowns of inventory.
With our global growth projection at 3.5% in 2012 on the assumption that G3 will expand modestly by 2% and developing Asia by 7.9%, our growth outlook for Malaysia is 4.8%. Based on our base case growth projection, we have ruled out a recession for Malaysia.
Nonetheless, we are not ruling out the possibility of the economy registering one or two quarters of negative growth.
In our view, the risk for Malaysia falling into recession will depend much on private expenditure and the regional economic outlook. If the world heads for a recession, dragged by the US, eurozone and a hard landing in China, Malaysia’s risk of falling into recession for the fourth time since Independence will be heightened. Much will depend on how private expenditure will compensate for the shortfall in exports. We do not foresee much
contribution from the public sector. With our odds for a global recession at 40%, the risk is that Malaysia could fall into recession in 2012. Should this happen, we project the
economy to shrink by 0.9%.
Exports could remain weak. Downside risk to E&E remains, but can be contained if:
(i) regional demand stays favourable;
(ii) inventory rebuilding takes place; and
(iii) implementation of stimulus measures partially boosts demand for final electronic products.
The outlook for E&E will also influence manufacturing in the primary-related cluster, especially the chemical products industry. Also of concern to us will be the earnings from commodity exports, which will depend on demand and prices.
Can private expenditure complement any shortfall from weak exports? Erosion in household confidence due to a pessimistic outlook on income expectations and falling real wages can retrench spending. Such behaviour can choke businesses confidence and hence capital spending. Inflow of FDI and domestic investment expansion can take a hit. Any reversal to the negative scenario will depend on the ETP projects and the regional economic outlook.
Thus, implementation will have to be faster than just announcing.
Risk of falling into a ‘liquidity trap’?
While this may not be an issue for now, a U-turn monetary policy may not necessarily provide the desired results. Much will depend on consumer confidence. To ensure confidence remains stable and to ensure a workable U-turn monetary policy it is essential to protect the labour market from worsening and also real wages from falling due to inflation.
Although we have played down this risk for now, this can be a problem going forward.
A slowdown in the economy may force the policy makers to delay their fiscal deficit consolidation, especially in 2012. Should there be a delay in reducing the budget deficit in 2012, it could mean a possible delay in relaxing the subsidies. Compensating the subsidystrain would be the implementation of GST by end-2012 and trimming of public consumption expenditure, especially in the area of operating expenditure. We continue to reiterate our view that the budget deficit in 2011 would be trimmed to 5.4% of GDP in 2011 from 5.6% of GDP in 2010. Looking ahead into 2012, we expect the budget reduction would be around 5.2% of GDP, still staying above the 5% threshold.
The severe retracement in the local market recently was not unexpected and is clearly a contagion effect from the turmoil on Wall Street. At times when global sentiment towards equity is weak, no market can claim to have decoupled from Wall Street, the centre of the world’s equity market.
How the equity market has behaved recently shed some light on what the price trend will be until the end of the year. Judging by the intensity of the market pullback, what transpired was surely not a one-day fluke, unlike the “flash” crash of the previous year. We reckon that the market is hurriedly pricing in more severe headwinds than earlier expected. While there could be a technical rebound, selling pressure on the equity market is expected to persist for a while. The market is likely to remain volatile, with prices on a correction path until it reaches equilibrium.
We believe investors are bracing for the prospect of either a global double-dip recession or marked slower-than-expected growth. The Fed pictured a subdued outlook for the US economy, so much so that it expects to keep the key overnight rate near zero through mid-2013. GDP growth announced for 2Q11 thus far has been lacklustre, with the US figure coming in lower than expected at 1.3% against market consensus of 1.9%. The economic report card for Asia-Pacific countries has also been equally lacklustre.
In addition, the sovereign debt situation in the eurozone is far from settling with “too big to bail” countries such as Italy and Spain beginning to show signs of distress as evident by soaring spreads in the credit default swap (CDS) market. Moreover, S&P’s downgrade of US credit ratings to AA+ from AAA, with room for further downgrading to AA if the US fails to reduce spending to the agreed upon level by 2013, certainly does not help market sentiment.
A death cross is crossover resulting from an index’s short-term moving average or support level falling below the long-term moving average. As long-term indicators carry more weight, this trend indicates a bear market on the horizon and is reinforced by high trading volumes. Additionally, the long-term moving average becomes the new resistance level in the rising market. The “short-term” popularly refers to the 50-day moving average (50dma) while
the “long-term” refers to the 200-day moving average (200dma). When the 50dma crosses from below the 200dma, it is called the “golden cross”. When the 50dma crosses from above to below the 200dma it is called the “death cross”.
Our simulation of the FBM KLCI shows that we can expect a death cross on Sept 15. This assumes that the market consolidates at the 1,500 level from now onwards. While the market may stage a rebound after a death cross, the 200dma will be a strong resistance. This resistance should be in the region of 1,530. Thereafter, expect a secular (long-lasting) downtrend. In 2008, it lasted for more than six months.
Based on empirical observations, the FBM KLCI’s present year price-earnings ratio (PER) generally ranged between 14 and 18 times during “peace” time and it slumped to as low as nine times at the depth of a “crisis” period. As we enter into a period of heightened uncertainty, we surmise that the market PER valuation shall accordingly be reflective of the situation. Hence we can expect the FBM KLCI to end the year at the lower end of its peace time PER band of 14 times. Revised FBM KLCI 2011 target to 1,430 points.
At 14 times PER, our FBM KLCI year-end 2011 target is thereby revised downward to 1,430 points. The new target is 13.3% lower than our previous target of 1,650 points.
The table lists a total of 13 stocks that we believe will not only outperform the broader market but will also continue to maintain its dividend payments in the event of a secular bear market. The 13 stocks met all our established yardsticks except for Axiata Bhd, Maxis Bhd and MSM Malaysia Holdings Bhd as they lack price history due to their relatively recent listings.
Nevertheless, we believe they are in good stead to outperform the broader market in the event of a bear market due to the defensive nature of their businesses. Furthermore their strong financial standing leaves little doubt about their ability to maintain dividend payments even during an economic downturn.
