This article first appeared in The Edge Financial Daily on May 7, 2018

KUALA LUMPUR: With two days left to the 14th general election (GE14), the stock market remains on a downtrend ahead of what is expected to be the most fiercely contested election in Malaysia’s history.

What is at stake?

On Wednesday (May 9), the incumbent Barisan Nasional (BN) government led by Prime Minister Datuk Seri Najib Razak, will take on opposition coalition Pakatan Harapan, led by former PM Tun Dr Mahathir Mohamad.

Dr Mahathir, Malaysia’s longest serving PM, is bent on ousting Najib owing to 1Malaysia Development Bhd’s (1MDB) financial scandal which has reverberated worldwide and tarnished the country’s reputation. If his coalition wins, Dr Mahathir has promised a thorough investigation into the state-owned development fund’s dealings and to charge those found complicit in any wrongdoing.

Ahead of the “mother of all elections”, investors have been watching closely as the tension builds up, with many of them sitting on the sidelines. Consequently, the FBM KLCI has only gained a marginal 3.4% year to date (YTD) while the FBM Small Cap Index has fallen 14.1% over the same period.

RHB Research Institute head of research Alexander Chia pointed to the perceived political risk as a key factor contributing to the divergence in the stock market performance for small- and big-cap stocks.

Rakuten Trade vice-president of research Vincent Lau is of the view that the selldown in the small-cap space has created a buying opportunity for investors and traders. “I think it’s impossible to time the market accurately and say that the market will run up once the election is over or vice versa.

“But fundamentally, some of these companies have strong growth prospects, but their share prices have been on a downtrend since the beginning of the year as the market is cautious,” Lau said, adding that valuations are attractive.

Regardless of who wins, the market will rebound if the fundamentals and earnings growth remain intact, he said, especially when the incumbent prevails, ensuring a status quo.

The most likely outcome: BN to retain a simple majority win

This view is in line with surveys conducted by independent pollster Merdeka Centre, which expects the incumbent to maintain power although Pakatan has made gains and will likely win the popular vote.Likewise, most investment analysts and fund managers take a simple majority win by BN as the base case.

AllianceDBS Research head Bernard Ching said in his market report last Friday that investors will refocus on fundamentals again post-GE14 if the incumbent remains in power, and that there is a potential for a 6% gain should the benchmark index hit 1,950 points by year end.

“Without predicting the election outcome, our base case assumes that the status quo will be maintained which will see the election overhang ease post-GE14 as investors focus on fundamentals again. Against the backdrop of sustained economic growth, we expect the Malaysian equity market to resume its upward trajectory and reiterate our end-2018 [FBM] KLCI target of 1,950,” Ching said. He added that laggard mid- and small-cap stocks will likely be rerated given attractive valuations (below one standard deviation of its price-to-book of 0.8 times) and when investors regain their risk appetite.

In the event the incumbent performs better in GE14 than in GE13, the stock market could see a stronger rally as political risk would subside.

However, FXTM global head of currency strategy and market research Jameel Ahmad believes there will be some risk aversion heading into election day.

Notably, while most market observers are expecting a base-case scenario, concerns about whether the Malay votes would swing to Pakatan remain. A “Malay tsunami” could see an unprecedented win by the opposition.

The worst-case scenario: a hung parliament

In March, The Edge Malaysia weekly raised four possible scenarios: BN to retain its simple majority, a bigger majority win for BN (presumably two-thirds), a hung parliament and a surprise Pakatan victory. Of these possibilities, most analysts agree that the worst case would be a hung parliament as most investors would pull their money out of the market to wait out the uncertainties.

Ching said the “election is expected to be fiercely contested with [a] status quo being the base case while the worst case is a hung parliament leading to protracted uncertainty and risk aversion”.

An analyst declining to be named said a hung parliament could see the FBM KLCI drop by 200 to 300 points or 10% to 16% from the current levels. “Investors will want to stay on the sidelines to see how the events will turn out as there are too many possibilities. PAS’ (Islamic party) kingmaker gambit will be a possibility if that happens and we could even see defections to other parties. There will be concerns about the effectiveness of the government to function if that happens,” he added.

Thus far, neither Invoke nor Merdeka Centre anticipate a hung parliament although Invoke predicts Negeri Sembilan and Melaka will be hung states with equal representation from BN and Pakatan in the state assemblies.

Beyond the general election

While GE14’s outcome could influence the stock market, Jameel observes that the election is but one event that could impact the stock market. “Investors across the globe will be monitoring the recent commencement of trade talks between the US and China with a very close eye. It is not thought that these negotiations will be straightforward and any suggestions that there will be a breakdown in talks between two of the largest economies in the world can impact risk appetite. If investors are less attracted towards taking on risk, there would also be less attraction towards the Malaysian stock market as a result of less risk appetite,” he said.

Other than the external environment, there are also key domestic events which could affect the stock market even if GE14 pans out as expected.

In a report, Maybank Investment Bank (Maybank IB) director and head of research for Malaysia equity markets Wong Chew Hann highlights two key macro decisions in May following GE14 — Bank Negara Malaysia’s (BNM) monetary policy statement on Thursday and the release of the gross domestic product (GDP) numbers for the first quarter of the year. She has projected the overnight policy rate would remain at 3.25% for the rest of 2018 and that GDP growth at 5.3% this year. In March, BNM raised its GDP growth forecast to between 5.5% and 6% from an initial 5% to 5.5%.Wong also noted the peak of first-quarter corporate results to be released in the last two weeks of May.

Maybank IB Research has a 2018 FBM KLCI target of 1,880 based on 16 times, 12-month forward price-earnings ratio.

DBS Bank senior economist Irvin Seah also believes that beyond the election and political uncertainties, Malaysia has made significant progress over the year in ensuring growth stability and fiscal sustainability. “The implementation of economic transformation strategies as well as continuity of many of its more progressive policies will be crucial to its longer-term outlook. Both internal and external stakeholders will be looking to the next government in this respect,” he said in a report last Friday.