This article first appeared in Capital, The Edge Malaysia Weekly on November 27, 2017 - December 3, 2017

THE Malaysian economy is growing at its fastest pace in three years, expanding 6.2% year on year. The ringgit recovered to its strongest level against the US dollar in 15 months last week. To top it all, the emerging-market equity bull run is now in full swing, riding the broadly positive economic data coming out worldwide.

So, why are Malaysian equities lagging behind?

This year, local benchmark the FBM KLCI only managed a 4.6% gain, closing at 1,717.23 points last week. While still in positive territory, its performance is pathetic compared with that of other emerging-market indices (see accompanying story).

In fact, it appears that many of the blue chips that drove the index up in the first three quarters of the year made a U-turn in mid-September (see above). Take CIMB Group Holdings Bhd — a 57% increase in the company’s share price accounted for 32% of the FBM KLCI’s stellar performance until Sept 12, but an 8% decline in it has accounted for 18% of the index’s fall since then.

Did CIMB’s fundamentals deteriorate substantially? No. The same can be said for the other 21 constituent stocks that have lost ground in the past 2½ months.

It is also interesting that blue chips appear to be the most affected. The FTSE Bursa Malaysia EMAS Index has lost only 2.88% in value since Sept 12, closing at 12,393.24 points last week, while the FTSE Bursa Malaysia Small Cap Index has only traded sideways, losing a mere 0.48% in the same period.

Understanding the reasons for the lacklustre performance of the FBM KLCI is crucial. If the index’s component stocks have in fact become undervalued, this could present an investment opportunity. However, investors should be cautious if the opposite is true, as the market is (accurately) pricing in negative expectations that have not yet been reflected in the broader economic data.

Thus far, a myriad of reasons have been given for the divergence between market sentiment and company fundamentals, ranging from local institutional profit-taking and a slowdown in foreign investment to persisting pessimism about corporate earnings.

“It is not just Malaysia. Asean markets have lagged in the emerging-market rally due to relative earnings growth, and in Malaysia’s case, a defensive low Beta market. Over the last year, our ‘Green Shoots’ reflationary thesis for Malaysia is gaining traction macro-wise, but has yet to deliver significant upwards EPS (earnings per share) revision,” JP Morgan’s head of Malaysian equities research, Mak Hoy Kit, tells The Edge.

He argues that nominal GDP growth has not been proportionately reflected in corporate earnings.

For perspective, nominal GDP (not adjusted for inflation) grew 11.6%, 10.2% and 9.9%, or an average of 10.6%, year on year in the first three quarters of 2017 respectively. Looking at Bloomberg data, the aggregate earnings of the FBM KLCI’s constituent stocks grew only 6.7% year on year to RM105.76 per share.

The difference of about 3.9 percentage points is huge with the corporate earnings growth of blue chips lagging GDP by more than one-third.

One reason for the poor corporate earnings could stem from higher input costs, caused, among other things, by the weaker ringgit.

Against this backdrop, Mak adds, Malaysian equities are not particularly cheap at this juncture, “averaging at the mid-15 times [price-earnings multiple]”.

Any upside will have to be driven by a jump in corporate earnings. However, there is room for scepticism as not all economic data has been positive. The latest Malaysian Institute of Economic Research Consumer Sentiment Index (CSI) and Business Conditions Index (BCI) fell in the third quarter of the year.

The CSI slipped 3.6 points quarter on quarter to 77.1 points on a softer income growth outlook and ongoing inflation concerns (values below 100 are considered negative) while the BCI fell sharply to 103.1 points from 114.1 points previously. While still in positive territory (above 100), the index decelerated on weaker manufacturing sales and a slowdown in production.

Nikkei’s forward-looking Purchasing Managers’ Index (PMI) has also remained relatively depressed despite the strong GDP numbers, largely hovering below the 50-point mark, indicating contractionary conditions. In October, Malaysia’s PMI fell to 48.6 from 49.9 the previous month.

That said, the negative sentiment is perplexing because one of the keener barometers of broader market sentiment — the ringgit’s value — has strengthened substantially this year.

Last week, the ringgit breached the 4.10 mark against the US dollar, touching 4.0965 last Tuesday — its strongest level in 15 months.

“Of late, we have seen strong foreign inflow into the MGS (Malaysian government securities) market. Interestingly, this has not been matched by an inflow into the equity market, which is more typical,” notes a fund manager who declined to be identified.

Money could be waiting on the sidelines, he says, “to see how the third-quarter results season (that ends this month) plays out”.

“Thus far, we have seen some relatively positive earnings at index heavyweights like Axiata (whose revenue rebounded 15% year on year, although net profit fell 7%). I think the worst is over for the telcos, which should help lift the index. Other than that, we will be keeping a close eye on the banks’ results.”

That said, satisfying expectations is a tricky matter. Positive economic data has been inflating earnings expectations, which, thus far, have not been met.

“There is a disconnect between the macroeconomic data and corporate earnings in the sense that results largely meet expectations instead of exceeding them. That could be the reason for the profit-taking,” Bernard Ching, who heads research at Alliance DBS, tells The Edge.

“I think some funds are locking in profit, especially from small and mid-caps, after a good year despite the underperforming regional markets.”

Banks the key to growth

Looking ahead, investors should keep a close eye on banks and liquidity in credit to get a sense of the market’s prospects, going forward.

“Another aspect that has been holding the market back has been liquidity. While we have seen a recovery in the current account, M2 money supply growth has not caught up  and has been slower than nominal GDP growth. This divergence can be pinned on the hoarding of foreign currencies like the US dollar,” says one analyst.

M2 is a broader measure of money supply. It includes M1 (cash and chequing deposits) as well as other near-money elements like savings, money market securities and mutual funds.

“However, the money supply situation could improve with the central bank’s measures. An expansion of the money supply would stimulate a recovery in the credit cycle, which bodes well for a broader recovery in earnings next year,” he adds.

Bank Negara Malaysia data does not show M2 money supply but M1 money expanded at an average rate of 9.3% year on year while M3 money increased only 4.6%.

“Of course, attention will be largely on banks that make up 30% of the market. If there is an earnings recovery next year, it will be bank-led. This could be driven by better-than-expected NIM and credit growth,” says Mak.

JP Morgan’s base case anticipates Malaysian corporate earnings to grow 5.2% next year for the MSCI Malaysia index.

However, in a bull case scenario, growth would be three percentage points higher, “driven by improved liquidity, better NIM, a 5% strengthening of the ringgit from current levels, as well as an increase in crude oil prices to between US$65 and US$70 per barrel”.

On the flip side, the bear case for Malaysia anticipates a 10% drop in earnings  with key downside risks, including non-performing loans turning systemic, a sharper-than-expected decline in oil prices and the ringgit, and a selldown in MGS by foreigners.

Against this backdrop, Mak brushes off talk that the impending 14th general election may be dampening sentiment. “Volatility is near an all-time low, suggesting that the equity market is pricing in the status-quo” he says.

In short, it all comes back to corporate earnings. There may be some growth at the moment but if investors are to wager more money on Malaysian stocks, earnings needs to improve substantially, especially in the face of robust growth in other markets.

That said, the divergence could be an opportunity for those willing to bet against the market. After all, the domestic funds locking in profits to pay dividends this year will have to reposition themselves next year. “[This] should be an opportunity to accumulate now to position for next year,” says Ching.

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