• Imports growth for major trading partners has been softening;this indicates that Malaysia’s exports are likely to slow given the poor external demand
• Domestic consumption and private investments are expected to remain as the only major contributors to economic growth
• Sturdier current income, better outlook for income and employment as well as easing in inflationary pressure are most likely to support the expansion in consumer spending going forward
• The roll-out of projects under the Economic Transformation programme is likely to sustain the private investment
• Putting this all together, Malaysia is expected to grow by 4.0%-4.5% in 2012 after expanding 5.1% in 2011
• Bank Negara Malaysia (BNM) is expected to maintain an accommodative interest environment to support the economic growth with Overnight Policy Rate (OPR) remains unchanged at 3.0% for the remainder of 2012
• We believe that the current level of FBM KLCI has priced in the negative impacts of economic slowdown and lower earnings growth
• With forward PE of 15.3x, 13.8x and 12.7x based on consensus estimated earnings for 2012, 2013 and 2014 (data as at 23 July 2012), the upside potential for 2012 seems to have normalised based on a fair PE of 16x
• In the near term, external headwinds from the European debt crisis as well as the uncertainties that may arise from the 13th General Election could create a short-term consolidation, especially given the strong recent run-up in the Malaysian market
• Our advice to investors: rebalance their portfolio and to consider switching some of their holdings into more attractive markets such as the Greater China region and South Korea

Almost 3 Weeks of Fresh All-Time Highs

After the mild correction in May, the Malaysian equity market (represented by the FBM KLCI) regained its momentum and continued to trend up. The FBM KLCI closed at a fresh all-time high on 3 July 2012 and continued its rally to new record highs for almost every trading day. On 19 July 2012, FBM KLCI climbed to its highest level of 1647.94 points on an intra-day basis (refer to Chart 1).

Chart 1: FBM KLCI and trading volume

As at 23 July 2012, FBM KLCI gained 2.3% on a month-to-date basis and the rally was supported by heavy index weighted telecommunication, plantation and banking sectors. Over the same period, these three sectors gained 5.8%, 3.7% and 3.0% respectively. Year-to-date, telecommunication sector surged 23.3%, while plantation and banking sectors gained 7.8% and 7.1% respectively as compared with a 6.9% gain in FBM KLCI (refer to Chart 2 and 3).

Chart 2: Month-to-Date returns

Chart 3: year-to-Date returns

Does FBM KLCI Have Enough Steam to Go Higher?

We believe that investors’ sentiment has been boosted by the positive headlines of the market making new highs over the past 3 weeks. Again, while market is on the uptrend, we advocate investors to examine the fundamental factors that support the rally before they jump into the market. With this, we examine the economic growth, the direction of monetary policy as well as the healthiness of corporate earnings in supporting the FBM KLCI.

Slower Growth Ahead

Weaker external environment is likely to weight on Malaysia’s exports growth. Imports growth for major trading partners such as Singapore, China, US and Europe has been softening and this indicates that Malaysia’s exports is likely to slowdown given the poor external demand (refer to Chart 4). Given this, the resilient domestic consumption and private investments, particularly in the oil & gas sector, are expected to remain as the only major contributors to economic growth.

Chart 4: Imports growth for major trading partners vs malaysia exports growth

Consumer Sentiments Index in 2Q 2012 is marginally up 0.6 points from last quarter to settle at 114.9 points. The improvement comes from the sturdier current income as well as consumers expecting better outlook for their income and employment. In addition, inflationary pressure is expected to tone down going forward. All these factors are most likely to support the expansion in consumer spending going forward.

On the other hand, Business Conditions Index in 2Q 2012 declined 5 points from last quarter to settle lower at 111.5 points. While the index remains above the 100 threshold, it suggests a slower business expansion in the coming months. The roll-out of projects under the Economic Transformation programme is likely to sustain the private investment. On the supply side, services sector is expected to play an important role in driving the economic growth despite that services activities might slowdown going forward. Manufacturing sector has already taken some hits and is likely to grow slower due to weaker external demands. Putting this all together, Malaysia is expected to grow by 4.0%-4.5% in 2012 after expanding 5.1% in 2011.

Chart 5: business conditions index vs consumer sentiments index

Inflation Remains Benign, OPR Stays at 3.0%

Inflation is expected to remain moderate as oil and commodity prices are likely to be contained given the weak global economic condition. While growth outweighs inflation, Bank Negara Malaysia (BNM) is expected to maintain Overnight Policy Rate (OPR) unchanged at 3.0% for the remainder of 2012. Besides having an accommodative interest environment to support the economic growth, reining in the high household debts could be another concern for BNM when determining the direction of the policy. Household debt to Gross Domestic Product (GDP) in 2011 has surged to 76.6%. To curb the unhealthy level of household debts, maintaining a moderate level of borrowing cost could help to soften the growth in household debts, other than having tighter lending guidelines.

Chart 6: Consumer price index vs overnight policy rate

Fair Valuation with Modest Earnings Growth

Corporate earnings have been revised downward since 4Q 2011 to reflect the negative impacts of slower economic growth. As compared with estimates from 2011, the consensus now expects a lower earnings growth (refer to Table 1).

The recent rally in the telecommunication could be explained by its attractive high dividend yield, but we believe that the current price level for telecommunication stocks has priced in this attractiveness. For plantation sector, the current price rally could be attributed to the improvement in CPO price. For banking sector, although earning growth remains decent based on consensus estimates, but the stock prices are roughly at fair value bearing in mind that there is potential slowdown in economic activities.

Our Advice: Consider Switching to 5 Star Markets

We believe that the current level of FBM KLCI has priced in the negative impacts of economic slowdown and lower earnings growth. With forward PE of 15.3x, 13.8x and 12.7x based on consensus estimated earnings for 2012, 2013 and 2014 (data as at 23 July 2012), the upside potential for 2012 seems to have normalised based on a fair PE of 16x. With a 3-year investment horizon, Malaysian equity market still could provide investor a decent 26.1% upside potential by end of 2014, if the market normalises to its fair level.

Having said that, Malaysia is now one of the markets with lowest 3-year upside potential as compared with the other 16 markets that we cover. As such, Malaysia equity market is rated as “3 stars – Attractive”, the second lowest rating after Indonesia to reflect its lower relative attractiveness as compared with 5 star markets such as China, Hong Kong and South Korea. In the near term, external headwinds from the European debt crisis as well as the uncertainties that may arise from the 13th General Election could create a short-term consolidation, especially given the strong recent run-up in the Malaysian market. We would thus advise investors who are currently invested in Malaysia equity market to rebalance their portfolio and to consider switch some of their holdings into more attractive markets such as the Greater China region and South Korea.