Bear rally but vicious liquidity cycle may sustain run

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Extended risk appetite-driven rallyEquity markets have rallied since early March. Buying sentiment was underpinned by a sudden reversal in risk appetite that triggered portfolio flows into the region. For Malaysia, the current bounce is now as strong as the previous rally off market low in October 2008 through to early January 2009. The Kuala Lumpur Composite Index has risen 12% from a low of 838 in early March, with cyclicals — select banks, construction, airlines, highly-leveraged small caps, oil and gas companies, and traditional “beta” names; MRCB — leading the way. Key issue is whether the current surge signifies the start of a bull cycle with markets pricing in a recovery in the global economy or is it just another bear market rally that may be approaching its tail-end? Nascent macro signs of stabilisation on external frontUnlike the previous rally in early January, this market upturn, if anything, does have some macro underpinnings, pointing towards a potential stabilisation of the global economy. The US economy appears to be in a relatively better shape given its slower rate of contraction in auto sales, housing and industrial production. China’s PMI (Purchasing Managers’ Index) also recovered to 52 in March — above the 50 threshold for expansion while loan growth data has been very encouraging. In Malaysia, exports contracted by a slower pace of only 16% in February (January: -27%), beating consensus estimate of -28%. The rate of decline in Malaysia’s Industrial Production Index (IPI) also slowed to -15% in February (January: -20%). CPO and crude oil prices have also continued to climb steadily. But other lead indicators still depressedAmid the rejuvenation in trading volume and a rising market set against the backdrop of a growing appetite for risk, it would be easy to ignore if not downplay the still uncertain external landscape despite the tentative signs of stabilisation.Shipping rates point to a double-dip in demand. The Baltic Dry Index continued to slide, down by some 35% off the high this year. Other Organisation for Economic Cooperation and Development (OECD) lead indicators are still weak. Corporate bond yields have not retreated off the highs, implying that credit is still tight.Even though the quantitative easing programme is exerting upward pressure on Treasury prices and compressing yields, corporate bond yields have not fallen significantly. Labour market conditions are still very tough as retrenchment newsflow has yet to abate. Momentum trade; liquidity feeding on itselfFunds have been sitting on lots of cash for some time now. As pointed out in our earlier market strategy report, average cash holding stood at about 50% of net asset value (NAV) until early March. International fund managers’ internal mandates are typically about 80%-90% in equity at least, while thresholds for local funds are less restrictive. From our recent discussions with portfolio clients, we sense funds are buying into the current rally not because they want to but rather that they have to due to performance indexing reasons. Macro fundamentals may not have improved too significantly but as the market continues to rise and momentum builds, sitting on too much cash will surely undermine fund managers’ performance in a rising market.Robust policy newsflow to sustain risk appetiteGovernment policy response worldwide to global recession has been swift and aggressive — demonstrating concerted efforts in using all policy tools to restore financial stability and stem price deflation. Japan has just announced a massive second stimulus programme of US$154 billion (RM554.4 billion) to prop up domestic demand in face of collapsing exports. Strong policy newsflow momentum should continue to underscore the improving balance of risk and accentuate the rising markets, punctuated by intermittent pullbacks on profit taking.Political landscape on the mendIn our opinion, Malaysia’s political landscape has improved significantly with the smooth transition of power to Datuk Seri Najib Razak as the country’s new prime minister. We also witnessed the return of former premier Tun Dr Mahathir Mohamad to Umno, a move widely seen by the market as providing some stability and support for Umno.Najib has formed a new cabinet with new faces and increased participation from other Barisan Nasional component parties to broaden support. He has also released 13 detainees under the Internal Security Act (ISA) while promising to conduct a comprehensive review of the ISA.   Dr Mahathir’s return to Umno hints of major infrastructure spending getting under way soon, centring on high-impact projects under the 9th Malaysia Plan, the mini-budget and resolution of deadlock on water asset migration. More importantly, the new administration must now deliver to ensure continuity of power. Steep re-rating of IJM, Gamuda and WCT The shares of these construction companies have risen significantly in the past month despite depressed construction margins. Gamuda’s construction margin in the previous quarter was only 1%, from a peak of more than 10%. Even though order book risk remains a lingering concern, market is buying into these stocks on expectations that new contracts flow will soon pick up, given the need to pump-prime the economy. This would be via government-led spending on cornerstone infrastructure projects — Second Penang Bridge, LRT upgrades, Inter-State Water Transfer project — as well as smoother execution of the double-tracking railway project. Despite execution delays in the past, we believe the new administration under Najib would now ensure speeding rollout of the projects. Risk factorsWhile rate of contraction in exports slowed significantly in February (-16%), domestic demand trends are weakening. From our company visits, we note that Malaysian property and auto companies are still guiding for continued declines in sales despite attractive buying incentives. Residential property demand would have been worse if not for low interest rates, aggressive downpayment schemes (5/95 plan) and waiver of legal fees, among others. Developers are holding back new pre-sales, focusing instead on liquidating inventory. Auto sales contracted for the fifth consecutive month in February, declining by some 5% year-on-year (y-o-y) to 36,675 units. We expect total industry volume (TIV) to fall by 23% to 423,000 units in 2009. Property landlord IGB is also expecting to offer higher rebates to sustain tenancy at The Gardens Mall, The Garden. Banks are expecting subdued loan growth, circa 5%-6%, this year. Market and sector strategy: Navigating the liquidity rallyMarket’s year-end fair value was lifted from 800 to 1,050. Fundamentally, the market is entering an extended bear rally where liquidity feeds on itself from a “forced” shift in asset allocation away from cash in a rising market and falling bond yields. Near-term strength should continue but further out, a sustained re-rating will hinge on inflexion of macro cycles. Real economy is now deteriorating at a slower pace, and some tentative macro signs of stabilisation are already evident. Cyclical transition, however, towards economic recovery will be a fragile progression in the coming quarters. Nonetheless, government policy response to the global recession has been swift and impressive. If the recent spate of policy initiatives was to be a guide, it shows that governments worldwide will not hesitate to deploy all policy tools to stabilise the global economy and financial markets. Risk appetite should continue to improve, we believe. We are upgrading our year-end fair value from 800 to 1,050,  based on forward price earnings (PE) of 15 times 2009 earnings — at the midpoint of its post-Asian crisis’ valuation band of between 10 and 20 times. Continued normalisation in risk appetite and easing balance sheet concern should trigger a PE valuation reversion to the mean, before positive earnings revisions kick in. The latter may not be so soon as profit cycles are still turning down. We are forecasting corporate earnings to contract by -7% for 2009 before rebounding by a robust 14% in 2010.  Gravitating towards reflation themes — plantation, oil & gas, construction and building materials. Given our revised fair value for the market, we are revamping our sector strategy and stock picks, gravitating towards reflation themes. 1. With US dollar weakening and commodity plays rebounding, reflation trade will gain further traction, we believe. Plantation sector is our high-conviction overweight. We have revised our CPO (crude palm oil) price assumption further to RM2,500/tonne for 2009, rising to RM2,700/tonne in 2010 on sustained pricing cycle from robust demand/supply dynamics. IOI and KLK are buys but smaller players — Asiatic, IJM Plantations and SOP — may offer deeper value.  2. We are turning more constructive on the oil & gas sector given depressed valuations, reduced bias against small caps, and recovering new order flow. We are buyers of SapuraCrest, fabricators Kencana, BHIC and Coastal, as well as Wah Seong.  3. Construction stocks have had a good run. We are retaining our buy rating on WCT. IJM and Gamuda remain a hold for now. We expect buying interests to rotate towards laggard building material players: Ann Joo is now a buy, as well as construction laggard Naim Cendera. 4. We expect renewed consolidation talks to fuel buying interests on the water stocks, Puncak and KPS. New administration appears committed to resolving the pricing deadlock, pointing towards a return of KPS to spearhead consolidation in Selangor. Proton and Axiata attractiveOn the GLC front, we expect Proton to be the prime beneficiary of the government’s likely efforts to revitalise the ailing automaker. While earnings cyclicality risk is still high, Proton’s strategic importance may propel certain policy changes to its advantage. Incremental newsflow is getting stronger too: rollout of electric cars. At P/B of just 0.3x, valuation is overly depressed. Valuation-wise, Axiata appears “bombed-out”, trading at a forward PE of only 10x. Balance sheet should no longer be a concern. The completion of its rights issue should improve net gearing to 0.3x, from 1.1x. Tenaga remains a buy. RHB Cap our top pick in banking sectorIt has underperformed the rising market and from a valuation standpoint, RHB appears significantly undervalued, trading at just 1x P/B — despite its status as the fourth-largest banking group in the country. We are buyers of Public Bank given its above-industry loan growth and attractive dividend yield in excess of 7%.