Mirror Mirror On The Wall…. | Market Strategy
Cheeky title, but apt we think. Most market participants are probably at a loss as to how to call the market right at this point in time. As 2009 gets underway, one which we believe will be wrought with challenges early on, we all lie waiting in hope that the concerted efforts by governments and central banks globally will bear fruit eventually. For if not, and that economies sink deeper into recessions and into a hole too deep to dig itself out of, we are certainly in for much tougher times. The US government and many other nations around the world will be laden with budget deficits so big in these trying times that it will hamper growth for years to come. China’s once mighty growth will fall with a thud which will resonate loud and hard throughout the world.
· Are economies of the world coming to a stall?
There is every reason to believe that efforts will bear fruit. While there are still no clear signs that the housing market in the United States is starting to stabilise, there are signs that the debilitating freeze in the credit market is starting to thaw. We probably have not seen the worse, but we can
possibly say we’re much closer to it today than we were a year ago.
· Or are markets heading for a great big fall?
Deep global recession and worst financial crisis since the Great Depression are the buzz-phrases around town these days, and the farreaching effects it would have on markets worldwide. But has it really been priced-in? In an environment potentially devoid of earnings growth (let alone earnings) in the coming year or so should the worst fears become a reality, current (and hopefully sustainable) book values would be a safer gauge to assess what markets are pricing in.
This is where there is a divergence of thoughts and expectations. While much is said about severe difficulties in the interim, markets globally seem to be pricing themselves otherwise. P/B valuations of markets are hovering around at “neutral” levels, pricing in extreme hope and
expectations that a recovery is at hand in the coming year. What if it doesn’t happen?
· Is it too early to make a call?
We have, since September last year, made our expectation known that we will see a recovery in global economic conditions in 2H09, albeit a weak one. With equity markets taking a lead, we do expect that some form of turnaround in sentiment and increase in risk appetite earliest 2Q09. We continue to maintain our expectation of the KLCI trading towards the 1180 point level at the 2009 year-end, though we must caution that a tight trading band of 910-970 points could be the highlight of the year should conditions and sentiment not recover.
· And be the ones to stand tall?
Capital preservation versus capital appreciation. 3 months in current climes can be a very long time, what with the uncertainties that will continue to abound. For the more risk averse, we suggest “staying indoors”. Companies with earnings derived primarily from domestic sources will be ones we believe to have most visibility and ability to continue paying decent dividends. Many trading opportunities will also present themselves in the coming 6 months, and it is with cyclical sectors like plantations that will offer most gains if the timing is right.
Are the economies of the world coming to a stall?
Malaysia is a small open trading nation. Our fates are in the hands of the major economies of the world. Pump-priming measures can only moderate the present slowdown, but they cannot turn the economy around.
Malaysia is a small open trading nation in the world. What happens in Malaysia will not affect others, but what happens in the major economies in the world will inevitably have an impact on the country. While the government can come up with fiscal and monetary policy measures to pump prime the economy, they can only moderate the slowdown. Ultimately, the domestic economy still has to look to the global economy for turnaround.
The underlying growth of the world economy is generally driven by the United States, China and the Euro Zone. The three countries, which account for a combined total of 48.0% of the world GDP, contributed about 45% to the global growth in 2007. Given their significance to the world economy, it is only natural to expect that the economic growth of Malaysia in 2009 will be in the hands of these three major countries.
The US economy has contracted, China has slowed while the Euro Zone has slipped into a technical recession. Therefore, it is reasonable to expect the economic growth of Malaysia to downshift as well.
The US economy has contracted and is on the brink of a technical recession. The y-o-y real GDP growth of the country dipped from 2.1% in 2Q08 to 0.7% in 3Q08. On a q-o-q annualised basis, its economic growth has fallen from 2.8% in 2Q08 to -0.5% in 3Q08. As for the Euro Zone, its economy has slipped into a technical recession, registering a q-o-q annualised growth rate of -0.2% in both 2Q08 and 3Q08. In terms of y-o-y growth, the fall is from 1.5% in 2Q08 to 0.6% in 3Q08. The Chinese economy, meanwhile, has started to soften since early this year. Its y-o-y real GDP growth has gradually come off from 10.6% in 1Q08 to 10.1% in 2Q08, and 9.0% in 3Q08.
Statistically, the economic growth of Malaysia has the strongest correlation with that of China. During the period 1Q00-3Q08, both countries registered a reasonably high correlation of 0.63. It is higher compared to that between Malaysia and the United States. The economic growth of the two countries registered a correlation of 0.54 from 1Q00 to 3Q08. Given that the Chinese economy is currently undergoing a soft-landing (though a somewhat severe one), there is every reason to expect that the Malaysian economy would not slow too significantly over the near term. Interestingly, we find that the yo-y real GDP growth of Malaysia has not correlated positively with that of the Euro Zone over the years. This indicates that the economic impact of a technical recession in the Euro Zone on Malaysia may not be great, immediate and direct.
If the China economy continues to slow orderly and gradually, the International Monetary Fund forecasts that its y-o-y real GDP growth would soften from 9.7% in 2008 to 8.5% in 2009. Our estimation shows that every 1.0 percentage point decline in the y-o-y real GDP growth of China has a tendency to lower that of Malaysia by 0.6 percentage point. Strictly going by the regression test and based on our y-o-y real GDP growth forecast for Malaysia in 2008, the country’s economy for 2009 is likely to expand by about 4.1-4.3% in theory. Depending on how effective the projects outlined in the Economic Stabilisation Plan would be implemented, attaining a y-o-y real GDP growth rate of about 4% next year is still a real possibility for Malaysia, albeit challenging.
The world economy, including Malaysia, is now at a crossroads. In the best-case scenario, we may see the economies of the United States, the Euro Zone, China and Malaysia to stage a strong and steady recovery in 2009. The economic growth of China would climb back to 10%, while that of Malaysia may significantly surpass the 5% mark in 2H09. Realistically, one can expect the United States economy to reach the trough only in 1Q09, and make a gradual and bumpy recovery in 2H09. In the base-case scenario, the economic growth of China is expected to stabilise at around 9% in 2H09, while that of Malaysia would climb above 5% in 2H09. In the worst-case scenario, the world economy would slip into a technical recession and grow significantly below 3%. If that happens, the economies of the United States, the Euro Zone and Malaysia are very likely to slip into a technical recession. As for China, its economic growth would significantly slump below 8% in 2H09.
The present slowdown in the world economy is not entirely due to global credit crunch. High inflationary pressure plays a significant part in choking the growth of the major economies as well. As the consumer price indices of most countries have generally come off, it has removed one of the hurdles to recovery. The sub-prime crisis has past the halfway point and it is likely to be over by the middle of 2009. Undoubtedly, the sub-prime crisis in the United States has spread to real sectors and thereby weakened the fundamentals of the world economy. Nevertheless, one cannot entirely attribute the present slowdown in the global economy to the credit crunch alone.
Prior to August 08, global inflationary pressure had heightened to the critical level that almost choked off private consumption expenditure in many countries to death. The consumer price index of the United States rose to a 17-year high of 5.6% in July 08, while that of the Euro Zone increased to an all-time high of 4.0% in June 08. In the case of China, its consumer price index jumped to a 12-year high of 8.7% in February 08.
Thankfully, global inflationary pressure has eased off over the past few months. In October 08, the consumer price index of the United States had fallen to 3.7%, while that of the Euro Zone had dropped to 3.2%. As for China, its consumer price index had come off to 4.0% in October 08. Given that the global market prices of mining and agriculture commodities continue to slide, there is every reason to expect that inflation in many countries would continue to be in a downward trend into next year.
This will lift a heavy financial burden from the shoulders of the general public at large. Needless to say, global consumer spending will perk up again and this will thus remove one of the hurdles to recovery. Especially for the major economies in the world, where private consumption expenditure generally accounts for over 70% of their GDPs, an upsurge in consumer spending can certainly give a much-needed shot in the arms to their economic growth.
While the sub-prime crisis is not expected to end anytime soon, it has past the halfway point and is likely to be over by the middle of 2009. The International Monetary Fund estimates that there is about US$1.4trn of potential aggregate write-downs on global holdings of United States-originated and securitised mortgage, consumer and corporate debt. An approximate total of US$760bn was reported to have been written down by the end of September 08, of which US$580bn or 76.3% were incurred by banks. At the time of writing, a total of US$980bn was reported to have been written down. We estimate that it would take about half a year more to write down the remaining potential losses.
Actually, the impact of global credit crunch on the Asian economies is relatively insignificant and indirect. Bank write-downs on global holdings of United States originated and securitised mortgage, consumer and corporate debt in the Asian region as at September 08 were unimportantly small. This is actually in line with our estimation that high inflationary pressure plays quite a significant part in choking the growth of many Asian economies as well. Be that as it may, the United States sub-prime crisis has admittedly spread to real sectors and this indirectly affects the economic growth of many export-led countries in the region. Given ample liquidity in Asia as a whole, credit crunch in the region is more of a confidence issue than a real shortage of capital, if ever there was one.
After careful assessment of all the underlying impediments and potential catalysts, we estimate that the Malaysian economy would expand by 4.1-4.3% in 2009. The growth is expected to be largely underpinned by the domestic-based services sector and private consumption expenditure. The export-oriented manufacturing sector is expected to gradually emerge from the doldrums in 2H09.
While there are impediments that could crimp the growth of the Malaysian economy in 2009, there are also catalysts that would potentially boost the domestic economy next year. A deeper than expected recession in the United States economy and a sharper than expected slowdown in the China economy may send the Malaysian economy into a tailspin. On the contrary, a gradual recovery in the United States economy in 2H09 and a continued softlanding in the China economy would provide support for the Malaysian economy.
Actually, there is every reason to believe that a substantial easing of global inflationary pressure, a significant cut in policy interest rates worldwide, a massive injection of capital into the global banking system, a series of tax and non-tax stimulus packages can help lift the US economy out of the doldrums. Further, it is reasonable to expect that the domesticbased services sector in China would continue to support the growth of the economy, while the export-oriented manufacturing sector slows.
After careful assessment of all statistics available, we estimate that the real economy of Malaysia would grow by 4.1-4.3% y-o-y in 2009 (see Figures 14 and 15). It is one percentage point lower than our earlier forecast, which was 5.2% y-o-y, for two reasons. First, the growth of the local manufacturing sector is expected to dip more than expected, as almost half of the global economy is now in a recession. Second, due to a sticky price movement in the domestic economy, the easing of inflationary pressure is expected to take longer than expected. While an economic expansion rate of 4.1-4.3% is obviously below the trend-growth of Malaysia, it is by no means a concern. After all, it is in line with the International Monetary Fund’s projection that the growth of the world economy would slow from 3.7% in 2008 to 2.2% in 2009.
For 2009, the economic growth of Malaysia is expected to be largely supported by the domestic-based services sector, which accounts for about 54% of the country’s economy. As consumers in Malaysia now have a lower inflation expectation, they will turn less cautious about spending. In particular, this will give a shot in the arm to the wholesale and retail trade, accommodation and restaurant industries, which account for a combined total of about 27% of the services sector in Malaysia. Coupled with the fact that interest rates in the country are conducive to mortgage purchases and the local employment market continues to be healthy, both the banking and real estate industries are expected to grow encouragingly. The two industries account for over 20% of the local services sector. All things considered, we expect that the services sector would grow by a y-o-y rate of 5.5% in 2009. As the services sector is expected to grow at a softer rate next year, we expect that the growth of the domestic private consumption expenditure would slow from 9.1% in 2008 to 4.5% in 2009.
As for the export-oriented manufacturing sector, its growth is expected to continue to be discouraging, especially during 1H09. This is based on our expectation that the United States economy would remain sluggish and the China economy would continue to soften over the near term, thereby dampening the production growth of electronics and electrical products. Nevertheless, we expect the global electronics industry to slowly perk up in 2H09, as the United States economy makes a bumpy recovery then. All in all, it is estimated that the manufacturing sector would grow by 2.3% in 2009. In line with the moderate performance of the industrial sector, we expect the Malaysian exports to grow by only 3.3% next year.
Given global economic uncertainties over the near term, many Malaysian companies are expected to be cautious about capital spending, at least during the first half next year. Most of the local businesses, especially those in the export-oriented manufacturing sector, are expected to invest minimally. Even if there would be some improvement in the world economic conditions in 2H09, we expect that most of the manufacturing firms in the country would positively respond to it only in early 2010. Therefore, we estimate that the local private investment expenditure would merely increase by 4.2% in 2009.
As for the construction sector, its growth in 2009 would be mainly hobbled by the delay in the implementation of the government infrastructure projects. Reportedly, many of them will either be downsized or cancelled due to the government fiscal constraints. Nevertheless, we expect that private housing projects would still grow moderately and civil engineering activities in the oil and gas industry would keep the construction sector expanding. Thus, the growth of the construction sector is expected to remain at about 3% in 2009.
Both the mining and agricultural sectors are expected to expand by 2.9% and 2.6% in 2009, respectively. The growth of the former would be mainly underpinned by the production of crude oil and natural gas, while that of the latter would be largely supported by the production of industrial crops and food crops. While the prices of mining and agriculture commodities have dipped substantially of late, it is still profitable to gradually increase the production capacity. After all, we expect that the prices of the two commodities would slowly climb, as the global economic conditions stabilise in the second half next year.
The Key Underlying Assumptions of the 4.1-4.3% Y-o-Y Real GDP Growth Forecast for
Malaysia in 2009 ;
1. The United States economy would not slip into a deep and prolonged recession.
2. The China economy would not undergo a hard-landing.
3. The United States economy would recover gradually in 2H09.
Are markets heading for a great big fall?
Can the biggest economy and market in the world pull itself out of this one? What started as a country and sector-specific problem has spread so far and wide, governments and central banks worldwide are at their wits end in trying to fix the damage it has done. Why the importance of the US economy? Because it is the world’s largest consuming economy, and the fate of the rest of the manufacturing economies like China and Malaysia are very much dependent on its recovery.
Taking a look at the last few decades in American history, with particular attention to 3 “dark” periods (the Great Depression in the 1930s, the Oil Shock in the 1970s, and the bust of the dotcom bubble in the 2000s), we can see that the economy is strewn with various periods of recession, with markets seeming to react ahead. The questions that are upon us now – how long more will the US economy be mired in its current problems, and has the market priced it in?
There is no clear indication as to how prolonged this problem will drag on but we can see that in the last few decades since WW2, no recession in the US has lasted more than 24 months (16 months to be more specific). Each era would have had their specific sets of issues, though it is widely accepted that the current set is the worst that has been during the period in mention. By 2H09, the recession in the US would have run a course of at least 18 months, making it the longest ever (the Great Depression years aside).
Deep global recession and worst financial crisis since the Great Depression are the buzzphrases
around town these days, and the far-reaching effects it would have on markets worldwide. But has it really been priced-in? In an environment potentially devoid of earnings growth (let alone earnings) in the coming year or so should the worst fears become a reality, current (and hopefully sustainable) book values would be a safer gauge to assess what markets are pricing in.
This is where there is a divergence of thoughts and expectations. While much is said about severe difficulties in the interim, markets globally seem to be pricing themselves otherwise. P/B valuations of markets are hovering around “neutral” levels, pricing in extreme hope and expectations that a recovery is at hand in the coming year. What if it doesn’t happen?
As can be noted from the table above, quite a number of markets still trade significantly higher than their recent historical low P/B valuations, which may be a destination for most markets should our worst fears be realized when global economies sip into points of no return, not until 2010 at the very earliest. Right this moment, we find it quite improbable but can’t quite rule out the possibility that it could happen.
On the flipside however, we find that most of these markets are also trading below their “long term” P/B averages, thereby leaving room for some decent upside when sentiments do recover somewhat.
Is it too early to make a call?
We are truly at a cross road today, economy and market-wise. We need to see positive effects of all concerted efforts by governments and central banks by March/April 2009, otherwise we will be in for some serious time of pain and gloom. Economic data being released currently paint a grim picture and gives a despairing outlook. We choose to see the positives however, taking comfort that these multi-year lows are coming out now rather than later and are still hopeful of a recovery in 2H09, albeit a weak one.
There is every reason to believe that the initiatives will work, and that the world will be able to pull ourselves out of this mess. While there are still no clear signs that the housing market in the United States is starting to stabilise, there are signs that the debilitating freeze in the credit market is starting to thaw. We probably have not seen the worse, but we can possibly say we’re much closer to it today than we were a year ago.
As early as September last year, we were one of only a very small number of people making our expectation known that we saw a mild recovery in global conditions in 2H09, much to the general disbelief of all. Today however, we hear of and read many more reports stating the same.
We also hypothesized (in our strategy note dated 12 September) that a possible floor of the index could be 909 on a fundamental basis when the Index was hovering at the 1050 level, and saw that coming to pass though over-shooting it on the downside a little.
The only thing we didn’t see was the KLCI perhaps getting close to our year-end expectation of 1020 points as sentiment had taken a more severe beating than we had anticipated post the writing of our target downgrade. We are nevertheless optimistic that the 2009 target of 1180 points is within reach.
Foreign participation in the domestic market has been waning over the last few months however, and we know the importance they play in upward and downward movements in the local bourse. In the current times when de-leveraging is still on-going, it is not a surprise that there have been more outflows in the recent months.
Net flow of funds post the Asian Financial Crisis in 1997 paints an even more grim picture. Assuming we take the 1998 period to be when most foreign funds that had wanted to get out of the market had gotten out just before the capital control measures instituted in 3Q98, there has been a net outflow of RM14.5bn from the transaction of shares and corporate securities (assuming 4Q98 as the starting point).
Almost every quarter’s net outflow of funds has corresponded with a decline in the Composite Index and a rise when there have been net inflows (with the exceptions of 4Q98, 4Q01, 4Q02, 2Q03, 1Q05, 1Q06, 3Q06, 4Q07), and the importance of foreign participation in our market cannot be more than stressed on this documentary evidence. Question is – when will it start to turn into inflows again?
While there is no direct correlation nor concrete data to state convincingly that what we are highlighting in the following table is an indication of entry and exit of foreign funds, it does however show a pattern of expectation and realization between GDP growth and net flow of
funds with a 2 quarter lag. The data starts from 2000 given the adjustment of prices in GDP
to the year.
The net outflow of funds in a particular quarter (numbers boxed up) seems to be in expectation of weaker economic conditions two quarters on. Conversely, inflows (highlighted in black) are generally followed by stronger economic numbers in a similar two quarter lag. Given our expectation of a recovery only in 2H09, we do expect market weakness to prevail in the near term as investors attempt to find a firmer footing in currently fluid situation in the market. Re-entry into the markets, 2Q09 would seem the safest best.
Annual numbers, as highlighted in the following table, doesn’t make for great reading either.
Expectation of stronger economic numbers for a particular year is met with net inflows and vice versa. On this score, and our expectation that GDP for 2009 will be at a weaker 4.1- 4.3%, can we expect to see another year of net outflows, and a correspondingly subdued performance in the KLCI? It would probably be so, but there is cause for optimism though. By 2H09, we expect to be coming off one of the worst financial and economic crises in the last few decades, and see it as the inflection point for out-performance in equities going into 2010.
What will make us all stand tall?
Stay defensive and “indoors”, focusing on stocks that derive income primarily from domestic sources with a fair amount of visibility. Stay large and liquid, focusing on stocks that will allow ease of entry and exit should conditions take a serious and unforeseen turn for the worse and markets head south in a hurry.
Taking a look across all sectors on the Exchange, it is difficult to find one that is not bogged with one issue or another. Our overweight call on the plantation sector is primarily due to our view of values at current share prices amid an expected recovery in average CPO prices in the medium term. Our overweight call on the consumer sector is primarily due to government’s current initiatives in putting money back in the hand of the general populace to spur spending and ultimately economic growth.
There is lack of clarity in the other sectors however, with bellwether names most likely to come out less scathed than smaller capitalized companies owing to the strengths of their balance sheets and earnings qualities.
How fast the favourite fall from grace. Oil and gas related companies were the darlings of the investment community in the early part of the year, but have subsequently made up 3 of the worst 10 performing stocks in the Composite Index for 2008, with KNM Group having lost the most value over 12 months.
The fact that ¾ of the top 10 performing stocks in 2008 are ones that have never set pulses racing in terms of share price performances over the years highlight the level of risk aversion and fear that has gripped the market.
For the immediate term, we see no signs of this abating and would suggest staying defensive and “indoors”, continuing to pay attention to dividend-yielding companies that derive a large portion of income primarily from domestic sources and with a fair amount of earnings visibility. Stay large and liquid as well, focusing on stocks that will allow ease of entry and exit should economic conditions take a serious and unforeseen turn for the worse and markets head south in a hurry.
Tracking the net flow of foreign funds into or out of the market against the performance of the KL Composite Index and the corresponding quarterly share price performances of the companies highlighted, we have noticed a greater level of out-performance vis-à-vis the Index over the years. It is by no means a measure of how the stocks will perform in the coming quarters, but we believe it does indicate some form of resilience of the stocks to weather adverse economic and market conditions.
The various other stocks that we have under coverage, while providing some opportunities for cherry-picking at relatively distressed valuations vis-à-vis their fair values, need to be done with extreme caution and with a certainly much longer investment horizon in view. A similar exercise as that carried out with the larger-capitalized companies, but this time on the lesser capitalized ones with BUY calls, reveals general under-performance by almost all of the stocks in question from the periods 2000-current.
WHERE ARE THE MARKETS HEADED TO IN 2009?
Though we still have not seen any turnarounds economically, we believe the trough is evernearer.
Unfortunately, we do not expect to see a significant amount of growth in earnings in 2009 as companies recover from a year of weakening earnings (starting 3QCY08 and into 2QCY09). Our estimation of a 3.5% earnings growth for CY09 is premised upon a higher assumption for plantation and banking earnings, versus consensus estimates of a general contraction in earnings (c. -2.6) in 2009.
On that score, and on the assumption that sentiments do not recover significantly in the coming year, we could expect to see the market trading sideways for the entire year, oscillating between 910 and 980 points. The 980 point estimate is derived from the entire Index component stocks trading to their average fair values as estimated by the market, loosely based on the expected close for the current calendar year.
Our earlier expectation of a year-end 2009 close of 1180 points however is premised upon a recovery in sentiment, and PE expectations of the market expanding despite tepid growth for CY09. We are inclined to maintain that forecast for now given our expectation of a slow, but
nonetheless a recovery in 2H09. 1180 points is also achievable should share prices trade to
the upper-end of consensus average fair values.
Entry filed under: Business, Finance, Stock Market. Tags: bear fruit, budget deficits, buzz-phrases, Capital preservation versus capital appreciation, central banks, Cheeky title, credit market, devoid of earnings growth, divergence of thoughts and expectations, Economic Stabilisation Plan, equity markets, financial crisis, global recession, Great Depression, housing market in the United States, International Monetary Fund, KLCI trading, Market Strategy, mighty growth, Mirror On The Wall, open trading nation, P/B valuations of markets, Pump-priming measures, recessions, staying indoors, technical recession, US government.