Threat of slower growth looms over corporate earnings

This article first appeared in Capital, The Edge Malaysia Weekly, on July 4, 2022 - July 10, 2022.
Threat of slower growth looms over corporate earnings
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MALAYSIAN stocks were late to the reopening party, with most of the world — especially North America and Europe — reopening for business in varying degrees from as early as the middle of last year.

The S&P 500 rallied 114.38% to a peak of 4,796.56 points on Jan 3, 2022, from March 24, 2020, while the Euro Stoxx 50 climbed 84.49% to a high of 4,401.49 points on Nov 16, 2021, from March 19, 2020.

However, the FBM KLCI had only increased 18.98% since March 19, 2020, to close at 1,455.78 points last Wednesday. The index did not go beyond its three-year high of 1,691 points, which it reached on July 3, 2019.

Then, just as Malaysia’s economic reopening gathered steam, with the country starting its transition to the endemic phase of Covid-19 in April, fears of a global recession are taking hold.

The factors driving these fears are the spectre of a prolonged war in Ukraine as well as higher interest rates in the US to cool inflation but at the risk of sending the world’s largest economy into a recession in early 2023. Then there is China’s zero-Covid policy, which continues to disrupt global supply chains and slow economic activity.

As a trading nation — Malaysia’s trade represents about 120% of its GDP — the external sector has a major influence on the economy. Many local companies, from furniture manufacturers to electrical and electronic (E&E) players, depend on demand from abroad.

A global recession in 2023 is still a toss-up, depending on the outcomes of things such as the war in Ukraine, the reaction to central bank actions and China’s zero-Covid policy. However, if the world is unable to avert a hard landing that leads to a recession, how will the Malaysian corporate sector fare in terms of its earnings?

“If the US economy falls into a recession, it will lead to weaker consumer demand from the US, resulting in slower/declining export growth for Malaysia. This will pose a downside risk for Malaysia’s corporate earnings,” say CGS-CIMB Securities analysts Ivy Ng Lee Fang and Nagulan Ravi in their June 17 trading strategy report.

Last year, Malaysia exported goods worth RM142 billion to the US, representing 12% of its total exports. In the past five market downturns, the earnings of the FBM KLCI fell 1.6% to 9.7% per annum, according to the CGS-CIMB report.

“Our KLCI earnings projection of +0.6%/11% for 2022F/2023F may appear optimistic and could be susceptible to downside risk if the US economy and global economic growth slow down significantly,” say the analysts.

Looking back at previous economic crises that had hit Malaysian shores, they say there is potential earnings downside risk of about 19.7%/17.6% to their current forecast earnings per share growth of 11% for 2023 if the downside risk resembles that of the 2008 global financial crisis (GFC) or the recent pandemic-induced decline.

“During the GFC, the KLCI fell 45% from its peak to 829 points, its lowest point. Earnings fell 8.7% in 2009 and PE (price-earnings) valuations fell to a low of 9.6 times. During the Covid-19 pandemic, the KLCI fell 36% from its peak to 1,220 points, while earnings fell 6.6% in 2020 and PE valuations fell to a low of 14.4 times,” says the report.

“Applying this to our revised target PE of 12.8 times gives us a lower KLCI target of 1,259/1,292 points. If we were to widen the PE discount to 3 standard deviations (SDs) against historical average PE against our existing 2023F earnings projections, we arrive at a KLCI target of 1,489 points.”

CGS-CIMB has cut its end-2022F FBM KLCI target to 1,568 points — which was based on a price-earnings ratio (PER) of 12.8 times or 2.5SD below its three-year average PER on its forecast earnings for 2023 — from 1,647 points, which was based on a PER of 13.5 times to account for additional earnings risk arising from US recession fears.

Sectors that are underperforming

Having tracked the key sectoral indices during previous market downturns, CGS-CIMB says it found that the construction, property, finance and small-cap sectors, which are cyclical industries, tended to underperform the benchmark index.

Vincent Khoo, head of research for Malaysia at UOB Kay Hian, concurs. He says cyclical sectors such as automotive and property will be the most affected in the event that a global recession impacts Malaysia’s economic growth.

“Extending the sales tax exemption would be important, but may not avert industry sales contraction in a deep recession,” he tells , when asked to comment on the extension of the registration period for cars to benefit from the sales tax exemption until March 2023. This applies to cars booked by the June 30, 2022, deadline.

“Meanwhile, we expect auto sales to significantly slow down as car buyers have recently piled in orders to beat the sales tax exemption deadline,” says Khoo, adding that financially sound automotive companies that serve the non-entry-level market will be more insulated from a recession compared with those that serve the entry-level market.

Bermaz Auto Bhd is one of the counters that CGS-CIMB has picked for its high-dividend-yield theme, with an “add” call and target price of RM2.40. The research house expects a dividend yield of 5.4% in 2022 and 6% in 2023.

Sime Darby Bhd is another group with a significant automotive business that has been picked by CGS-CIMB for its high-dividend-yield theme. The research house has a “hold” call on the stock, with a target price of RM2.40 and a dividend yield forecast of 4.8% and 5.3% in 2022 and 2023 respectively.

Meanwhile, sectors that tended to perform better against the FBM KLCI during previous market downturns are consumer, technology, telecommunications, healthcare and utilities, according to CGS-CIMB.

“This leads us to take the view that in a market downturn phase, the best sectors to take shelter in are utilities (Gas Malaysia Bhd, Malakoff Corp Bhd and Tenaga Nasional Bhd), telecoms (Telekom Malaysia Bhd), healthcare (IHH Healthcare Bhd) and consumer (QL Resources Bhd, MR DIY Group Bhd and Genting Malaysia Bhd),” say the analysts in their June 17 report.

“We observe that the technology and transport sectors have gained the most since their Covid-19 lows (+166% to +70%) while the REIT (real estate investment trust) and utilities sectors have gained the least (+3 to +10%). Sectors that gave up most of their gains from previous Covid-19 peaks were the healthcare (glove), energy and construction (-16% to -56%) sectors.”

The research house picked Tenaga before the government decided against a pass through of the higher generation costs that the utility incurred in the first half of the year, into a higher surcharge in the second half, which was announced on June 24. While Tenaga’s electricity generation cost will still be subsidised by the government at the cost of RM5.8 billion, there are concerns that its receivables will continue to increase if the payment for subsidies do not come in on time.

RHB Research Institute analyst Sean Lim downgraded the power sector to “neutral” from “overweight” in a June 30 report, after cutting the research house’s recommendation on Tenaga to “neutral” from “buy”, premised on the rising regulatory risk to uphold the Imbalance Cost Pass-Through (ICPT) framework, which could eventually challenge the incentive-based regulation (IBR) scheme.

When asked, Lim says he has yet to revise the earnings forecast for Tenaga in the event of a recession as RHB Research has not yet revised its 2023 growth outlook for Malaysia.

Hong Leong Investment Bank (HLIB) Research, however, is still positive on Tenaga’s prospects. Its analyst Daniel Wong has maintained his “buy” call on the stock and target price of RM13.40, as the continuation of the ICPT mechanism would allay investors’ concerns about regulatory risks.

Other research houses have reduced their target prices for Tenaga. MIDF Research has revised its target price to RM8.45 from RM9.55 while maintaining a “neutral” call on the counter. Maybank Investment Bank has a target price of RM8.70 (lower than its previous target price of RM9.30) on the stock, with a “hold” call.

Banks to benefit from higher interest rate environment

It is not just a potential recession on the minds of investors but also which stocks to invest in over the next six to 12 months, particularly those that will benefit from a higher interest rate environment.

The rapidly rising interest rates in the US has left other central banks, especially those in Asia, with little choice but to do the same.

Bank Negara Malaysia has embarked on interest rate hikes to ensure the stability of the country’s monetary system. The central bank raised its overnight policy rate (OPR) by 25 basis points (bps) to 2% at its monetary policy committee meeting in May, as it viewed that the transition to endemicity would put the domestic economy on a firmer path.

In its 2H2022 Economics and Strategy report released last Wednesday, HLIB Research analysts Jeremy Goh and Felicia Ling say the research house maintains its expectation of two 25bps hikes at the July and September monetary policy committee meetings, bringing the OPR to 2.5% by end-2022. The sector that will benefit the most from a higher interest rate environment is banking.

“We estimate that every 25bps OPR hike would expand [the banking] sector’s net interest margin (NIM) by 5bps to 6bps which, in turn, bumps up our earnings forecast by 4% to 5% (on a full-year basis, without taking into account potential marked-to-market losses and higher defaults),” say the analysts.

They forecast that Alliance Bank Malaysia Bhd and Bank Islam Malaysia Bhd will be the biggest beneficiaries of a rising OPR, while Affin Bank Bhd and Public Bank Bhd will benefit the least among the banks under their coverage.

However, banks with sizeable operations overseas such as Malayan Banking Bhd (Maybank) and CIMB Group Holdings Bhd could have lower actual gains compared with HLIB Research’s calculations of the increase in NIMs from rising interest rates, say the analysts.

“Typically, banks gain in the short term from a rising interest rate environment. We saw NIM rising 4bps sequentially during the previous 25bps OPR hike (in 1Q2018), but contracted in the following two quarters due to upward repricing in deposits,” they point out.

“Also, any acute CASA (current account savings account) substitution to fixed deposit will limit NIM expansion — sector CASA ratio is elevated at 33% versus pre-pandemic level of 26%. We estimate that every 1% CASA ratio reversal would drag down sector NIM by 1bps to 2bps and earnings by 1%, assuming an FD-CASA spread differential of 150bps.

“From our compilation, Alliance and BIMB saw their CASA ratio shoot up the most (by 11 to 12 percentage points) relative to its peers from 4Q2019 to 1Q2022 while Affin and RHB experienced the least build-up (by 2 to 3 percentage points).

“Nevertheless, if a full CASA reversion scenario played out, it would only neutralise gains from +50bps OPR increase. Recall that Bank Negara has only raised the OPR by +25bps so far versus a total of -125bps cut during the Covid-19 pandemic, suggesting room for more rate hikes and a series of this should support consecutive broadening in NIM.”

HLIB has an “outperform” call on banks. In his report on the banking sector published last Thursday, sector analyst Chan Jit Hoong says HLIB Research is still optimistic about the sector outlook, given its earnings resilience in 2H2022. The research house’s outlook is based on OPR hikes, better loan growth and fee income, along with lower impaired loan allowances.

“Moving into FY2023, the absence of the prosperity tax and continued provision recovery will further boost profit growth (+16.7%) and enhance ROE (return on equity) (+80bps),” Chan says in his report.

He adds that the valuations of Malaysian banks remain undemanding despite the Bursa Malaysia Finance Index (KLFIN) rallying in most of 1H2022 before falling recently. The sector is trading near -0.5 and -1.0SD to both its 5-year and 10-year mean price-to-book ratio of one time.

“On top of that, it is lower versus the GFC bottom of 1.14 times (P/B ratio). Recall that back in the GFC recovery phase, the sector rallied 3SD notches and peaked at +2SD above its 10-year mean P/B (2.07 times) with 15% ROE output (+3 percentage points). Thus, if the current cycle mimics the historical GFC valuation recovery trend, the sector could climb to as high as +1SD above its 5-year mean P/B,” he says in the report.

Meanwhile, REITs will be the most affected by a rising OPR as this will create upward pressure on bond yields and, hence, narrow the spread between the yields of REIT and that of Malaysian Government Securities, says HLIB Research.

The interest rate up cycle will also be negative for the property sector, with HLIB Research’s property analysts estimating that a 25bps, 50bps and 75bps rate hike would increase monthly mortgage instalments by 3.2%, 6.5% and 9.9% respectively.

 

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