Malaysia

Investors should not count on buoyant growth in the ASEAN and Indian economies because of manufacturing relocation away from China in the next couple of years.

In this chartbook, we look at the balance of payments across DM and EM countries. The US does not fare well, but neither do a few other countries.

The ongoing rally in ASEAN currencies will fizzle sooner rather than later as they are not supported by fundamentals. The ringgit and the baht, however, will fare better than the peso and the rupiah during the coming global risk-off period. This report explains why.

ASEAN stocks and currencies will weaken further as these economies face multiple headwinds. Raising policy rates did not stop a sliding currency in the past, it is unlikely to do so now.

The geopolitical backdrop remains negative despite some marginally less negative news. China’s stimulus is not yet large or fast enough to prevent a market riot. Two of our preferred equity regions, ASEAN and Europe, are struggling to outperform. Investors should stay defensive overall.

Malaysian central bank raised policy rates last month. What will it do to Malaysian bank stocks and the overall share market? How about fixed income market?

Executive Summary Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness Malaysian stocks’ continued weakness despite the country’s surging trade surplus is symptomatic of a structural malaise. That malaise is loss of manufacturing competitiveness due to a decade of meagre capital investments and vanishing FDI. Diminishing competitiveness has led to erosion in manufacturing pricing power and, with it, profitability. An impending contraction in exports will hurt income growth and, hence, domestic demand. A negative fiscal impulse will be an additional headwind for the economy. Inflation will soon give way to disinflation. Corporate profits will contract anew. Bottom Line: Fixed-income investors should stay overweight Malaysian domestic bonds and sovereign credit in their respective EM baskets. Dedicated EM and Asian equity investors should stay neutral on this bourse for now. The reason is that the larger EM stock universe is also vulnerable. Feature Chart 1Even A Massive Trade Bonanza Couldn't Propel Malaysian Stocks Even A Massive Trade Bonanza Couldn't Propel Malaysian Stocks Even A Massive Trade Bonanza Couldn't Propel Malaysian Stocks Malaysian share prices continue drifting lower. Even a massive surge in the country’s exports and trade surplus could not give a boost to this market (Chart 1). This is a sharp departure from the past: strong exports have traditionally benefitted this small, open economy, and in turn, its stock market. So, what changed? And, what happens to the Malaysian economy and its financial markets as the export windfall begins to fade? What has changed is Malaysian producers’ competitiveness, which has eroded steadily over the years. The result is a sharp decline in profitability.  Indeed, despite the trade bonanza, Malaysian firms’ profits (EPS) in USD terms have fallen in absolute terms over the past year. The root cause of this apparent dichotomy is hidden in the country’s structural shortcomings. A decade of meagre capital investments has crippled Malaysian manufacturing competitiveness, and thereby their firms’ profitability. Periods of sporadic export windfalls can now only boost economic growth for a short while, but are unable to usher in a sustainable bull market in Malaysian stocks. In the months to come, shrinking global trade means that Malaysian export revenues are set to contract. Which in turn will weigh on income and domestic private consumption. As such, equity investors with an absolute-return mandate should stay away from this bourse. Dedicated EM and Emerging Asian equity portfolios should maintain a neutral stance on the Malaysian bourse. EM domestic bond and sovereign credit portfolios, however, should keep their respective overweight exposures to Malaysia. Poor Pricing Power  Chart 2Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness Profits Collapsed As Sliding Capex Decimated Manufacturing Competitiveness The real malaise that is plaguing Malaysian firms is their poor pricing power, which, by extension, is hurting their earnings: Malaysian companies’ EPS in US dollar terms have fallen by half over the past 10 years. It all began with a secular decline in the country’s capital expenditure. From a decent rate of 26% of GDP back in 2012, the capex has steadily fallen to 19% currently (Chart 2, top panel). Investments in machinery and equipment too have followed a similar path (Chart 2, bottom panel). The past decade also saw FDI inflows into the country’s manufacturing sector dry up dramatically (Chart 3). This not only deprived local companies of capital, but also the latest know-how and technology that often accompanies FDI inflows.   This caused Malaysian firms to fall behind in the race for producing high-quality, technologically superior products that could fetch a premium price. Instead, they were gradually relegated to producing commoditized products where they have little pricing power: The unit export prices of Malaysia’s manufactured goods, and machinery and equipment have gone nowhere over the past 10 years in USD terms (Chart 4). Chart 3Vanishing FDI Meant Neither Capital Nor New Technology For Manufacturing Vanishing FDI Meant Neither Capital Nor New Technology For Manufacturing Vanishing FDI Meant Neither Capital Nor New Technology For Manufacturing Chart 4Manufacturing Sector Can't Produce High-End Products, And So Has Little Pricing Power Manufacturing Sector Can't Produce High-End Products, And So Has Little Pricing Power Manufacturing Sector Can't Produce High-End Products, And So Has Little Pricing Power Chart 5Loss Of Competitiveness Meant Imported Consumer Goods Flooded The Market Loss Of Competitiveness Meant Imported Consumer Goods Flooded The Market Loss Of Competitiveness Meant Imported Consumer Goods Flooded The Market Given that manufacturing exports constitute over 50% of GDP, this lack of pricing power has been a major headwind to the economy. There are other signs that local manufacturing has gradually been losing its competitive edge. Imported consumer goods have been flooding the Malaysian domestic market (Chart 5). This is at a time when the country has been importing fewer capital goods – corroborating its aversion to capital expenditure as discussed above. Malaysian manufacturers’ lack of pricing power in the goods it produces, along with their dwindling domestic market share, has caused a steady fall in their profit margins (Chart 6). Sectors such as industrials, consumer discretionary and consumer staples – which are exposed to manufacturing competition – were hit particularly hard (Chart 7). Chart 6Manufacturing Sectors' Profit Margins Saw A Steady Decline Manufacturing Sectors' Profit Margins Saw A Steady Decline Manufacturing Sectors' Profit Margins Saw A Steady Decline Chart 7Total Manufacturing Profits Fell By A Factor Of Five Relative To The Economy Total Manufacturing Profits Fell By A Factor Of Five Relative To The Economy Total Manufacturing Profits Fell By A Factor Of Five Relative To The Economy Chart 8Declining Profits Led To A Secular Bear Market In Malaysian Stocks Declining Profits Led To A Secular Bear Market In Malaysian Stocks Declining Profits Led To A Secular Bear Market In Malaysian Stocks This proves that it’s the erosion in manufacturing competitiveness that has been plaguing Malaysian profits all these years. Indeed, this has been the main reason why the MSCI Malaysia equity index witnessed a secular downtrend in profits (Chart 8). Looking ahead, the poor state of capital expenditure will make any turnaround in competitiveness and, hence, profitability extremely hard. Indeed, the eerie correlation between stocks’ EPS and firms’ investment in machinery and equipment corroborates this (Chart 2, bottom panel).  Fading External Tailwinds … Chart 9Export Bonanza In Both Commodity And Manufacturing Is Set To Wane Export Bonanza In Both Commodity And Manufacturing Is Set To Wane Export Bonanza In Both Commodity And Manufacturing Is Set To Wane In the past two years, Malaysia has benefitted considerably from a surge in exports of both manufactured goods and commodities (Chart 9). But going forward, external conditions will likely deteriorate considerably for this economy. Manufacturing exports will fall significantly − as these had benefitted from a one-off surge in consumer goods demand in the developed world − following their massive pandemic-era stimulus. That demand is set to wane materially in the months ahead. Commodity prices are also set to decline as the global growth outlook is deteriorating. The consequent fall in Malaysia’s export revenues will hurt Malaysian firms’ profits further. A shrinking trade balance has never been a good omen for Malaysian earnings. The looming external headwinds will likely herald another down leg in Malaysian stock prices in absolute terms. …Will Spill Into The Larger Economy The negative effects of the budding external headwinds will spill beyond the stock market and into the larger economy. The one-off export windfall over the past year was an added boost to national income and spending – but will fade soon. As such, the recent surge in private consumption will also fade sooner rather than later. Indeed, the rise has been partly due to the base effect. In the second quarter of 2021, real private consumption was 9% below the level in the same quarter of 2019 due to the Covid-19 outbreak. In fact, domestic demand in Malaysia in real terms is still below the pre-pandemic level (Chart 10). Looking ahead, consumer demand will stay mediocre as real wages (i.e., inflation adjusted wages) are now shrinking. Credit growth rate is also muted. The impending contraction in exports revenues will add to those headwinds. On the supply side, industrial production will slow. Notably, it’s the export-oriented industries, rather than domestic-oriented ones, that have been the driver of industrial production growth recently. This divergence is more prominent between the consumer goods-related cluster of industries and the construction-related cluster (Chart 11). Now, as external goods demand shrinks, overall industrial production will likely contract. Chart 10Real Domestic Demand In Malaysia Is Still Below The Pre-Pandemic Levels Real Domestic Demand In Malaysia Is Still Below The Pre-Pandemic Levels Real Domestic Demand In Malaysia Is Still Below The Pre-Pandemic Levels Chart 11Industrial Production May Contract Along With Global Consumer Goods Demand Industrial Production May Contract Along With Global Consumer Goods Demand Industrial Production May Contract Along With Global Consumer Goods Demand Chart 12Fiscal Thrust Will Be Negative As Statutory Debt Has Hit The Ceiling Fiscal Thrust Will Be Negative As Statutory Debt Has Hit The Ceiling Fiscal Thrust Will Be Negative As Statutory Debt Has Hit The Ceiling Incidentally, the economy will also be facing a restrictive fiscal policy. Fiscal thrust will be negative this year and the next, as per the IMF estimates (Chart 12, top panel). A major reason why fiscal policy is bound to be restrictive is the ceiling on the federal ‘statutory debt’. The lawmakers had imposed this ceiling at 60% of GDP via the COVID-19 Act of 2020. Statutory debt has already hit that ceiling, leaving little room for further stimulus (Chart 12, bottom panel). Monetary policy, however, remains accommodative. Even though the central bank has raised the policy rate by a total of 75 basis points this year to 2.50%, it remains far below pre-pandemic levels. Average bank lending rates are also rather low. In fact, over the past year, average private sector borrowing costs have been no higher than the government’s borrowing cost (10-year government bond yields) (Chart 13).  As such, restrictive interest rates are not the problem in Malaysia. Instead, meagre credit demand as well as banks' willingness to lend − particularly to the productive sectors of the economy − are the main problems. Banks continue to ramp up their government securities holdings, shunning loans, just as they have done over the past several years (Chart 14). Chart 13Private Sector Borrowing Costs Are Not Prohibitive Private Sector Borrowing Costs Are Not Prohibitive Private Sector Borrowing Costs Are Not Prohibitive Chart 14Banks Continue To Pile Up On Government Securities By Shunning Loans Banks Continue To Pile Up On Government Securities By Shunning Loans Banks Continue To Pile Up On Government Securities By Shunning Loans Even within bank loans, an ever-larger share continues to go towards less productive projects. Loans for the purchase of residential properties have witnessed a secular rise, while firms’ working capital loans have declined – both as a share of total loans and as a share of the economy. The same can be said for all other loans combined (Chart 15). Chart 15In Malaysia, Less Productive Loans Have Seen A Secular Rise In Malaysia, Less Productive Loans Have Seen A Secular Rise In Malaysia, Less Productive Loans Have Seen A Secular Rise What’s notable is that even the windfall emanating from the recent surge in commodity prices and global goods demand has not been able to dent these secular trends in banks’ asset structures. The continued lack of bank credit to productive purposes does not bode well for the economy’s productivity and competitiveness outlook.  Is Inflation A Problem? The short answer is no. Both headline and core inflation will be peaking soon as there is no genuine underlying inflation in the economy: The relatively high headline CPI prints were caused by high commodity prices. The positive terms-of-trade shock also helped as it boosted domestic income. But both are abating now. As export income falls, inflationary pressures will give in to disinflationary ones.  Chart 16Inflation Will Peak Soon As There Is No Wage Pressures In The Economy Inflation Will Peak Soon As There Is No Wage Pressures In The Economy Inflation Will Peak Soon As There Is No Wage Pressures In The Economy Malaysian wages are muted, and manufacturing unit labor costs are contracting (Chart 16). This entails that companies are not under pressure to raise their selling prices. This is a major difference from that of the US and other developed economies where a wage-inflation spiral has taken hold. Finally, the Malaysian currency has appreciated in trade-weighted terms (even though it depreciated versus the dollar). As a very open economy, where foreign trade accounts for 150% of the GDP, the currency strength has a major impact on inflation dynamics in Malaysia. A strong currency usually heralds slowing inflation. This time should be no different. Investment Conclusions Chart 17Malaysian Stocks Will Struggle To Break-Out In Relative Tearms Malaysian Stocks Will Struggle To Break-Out In Relative Tearms Malaysian Stocks Will Struggle To Break-Out In Relative Tearms Equities:  Malaysian stocks are at their long-term resistance level relative to the EM equity benchmark (Chart 17). Any breakout will not last long. Overall, the Malaysian bourse’s longer-term outlook is unattractive both in absolute and relative terms. From a near term (three to six months) market strategy perspective, however, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on Malaysia. The reason is that the overall EM stock universe is also vulnerable. Absolute return investors should avoid Malaysian stocks for now. Fixed Income And Rates: The coming headwinds to growth and peaking inflation makes the outlook for domestic bonds promising. At 4.03%, the 10-year bond yields are at par with the dividend yield of MSCI Malaysia stocks. However, the latter is vulnerable to capital loss in the months ahead. This suggests that in a domestic balanced portfolio, investors should overweight bonds vis-a-vis stocks. Relative to their EM counterparts, Malaysian domestic bonds have significantly outperformed over the past few years − in line with our forecast. Going forward, the relative bond outlook remains sanguine. The reason is that Malaysia’s domestic fundamentals are disinflationary and core CPI will decline. Moreover, if the US dollar keeps strengthening as we currently expect, the high-beta EM local bond markets will continue to underperform Malaysian domestic bonds. Investors should also continue to receive 10-year swap rates for similar reasons. In the case of sovereign credit, our overweight recommendation on Malaysia is playing out well. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, a looming global risk-off period entails that Malaysian sovereign spreads will widen much less than the overall EM index – just as it did in 2015 and 2020. This calls for staying overweight Malaysia in an EM sovereign credit portfolio. Currency: The ringgit will likely weaken a bit more versus the US dollar in coming months, but the depreciation will be muted compared to other EM currencies. The reason is that the ringgit is cheap in real terms. Moreover, Malaysia’s positive net international investment position accords the currency certain stability during risk-off periods. In times of uncertainty, global capital tends to head home. As such, the countries who have relatively more capital invested in other nations than the other way around (i.e., who have a net positive international investment position), typically witness capital repatriation. That, in turn, supports their currencies.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary Favor ASEAN And The Philippines Favor ASEAN And The Philippines Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Chart 4Opinion Shifts Against China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance ​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s ASEAN's Exports To US Surge Ahead Of China's ASEAN's Exports To US Surge Ahead Of China's Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 8China Threatens ASEAN With Import Substitution Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 12BProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 13Capital Formation Favors Philippines Capital Formation Favors Philippines Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ​​​​​​ Chart 15Favor The Philippines Favor The Philippines Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix