Malaysia

Executive Summary Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth The conditions for a major rally/outperformance in Malaysian equities are absent. Profits have been the primary driver of Malaysian equity prices historically, and the corporate earnings outlook is mediocre. Domestic demand is facing headwinds from tightening fiscal policy as well as from impaired credit channels.  Muted wage growth and deflating house prices are sapping consumer confidence. This will dent domestic demand going forward. This backdrop is bullish for bonds. Malaysian bonds offer value, as real bond yields are among the highest in Emerging Asia. The yield curve is far too steep given the growth and inflation outlook.  The Malaysian ringgit is cheap and has limited downside. Bottom Line: We recommend equity investors implement a neutral stance toward Malaysia in overall EM and Emerging Asian equity portfolios. Absolute return investors should avoid this bourse for now. Fixed-income investors, on the other hand, should stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. In the rate markets, investors should continue receiving 10-year swap rates or bet on yield curve flattening. Feature Chart 1Malaysian Equity Underperformance May Be Late, But It’s Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian Equity Underperformance May Be Late, But It's Not Yet Time To Overweight Malaysian stocks are still in search of a stable bottom in absolute terms. Relative to their EM and Emerging Asian counterparts however, a bottom has been forming over the past year (Chart 1). So, could Malaysia’s prolonged underperformance be coming to an end?  Our analysis suggests caution. The underlying reasons behind this market’s substantial and protracted underperformance – dwindling earnings both in absolute terms and relative to its peers – are yet to show any signs of a reversal.  While cheap, the ringgit is also negatively impacted by the meager corporate profits generated by Malaysian firms. Investors would do well to stay neutral on this bourse for now in EM and Emerging Asian equity portfolios. Fixed income investors, however, should continue to stay overweight Malaysia in both EM domestic (local currency) and sovereign credit portfolios. Also, Malaysia’s yield curve is too steep and offers value given the sluggish cyclical growth outlook. It’s All About Profits Chart 2 shows that the bull and bear markets in Malaysian stocks have been all about the rise and fall in earnings per share (EPS). Stock multiples, the other possible driver of the equity prices, have been remarkably flat over the past two decades, with only brief periods of fluctuations around the GFC and COVID-19 pandemic. The same can be said about Malaysia’s relative performance vis-à-vis EM and Emerging Asian stocks. The trajectory of the relative stock performance was set by the relative earnings (Chart 3). Chart 3Malaysia’s Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Malaysia's Relative Performance Is Also Dictated By Relative Corporate Profits Chart 2Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Bull Markets In Malaysian Stocks Are Fully Dependent On Profit Growth Thus, it is reasonable to expect that for this bourse to usher in a new bull market in absolute terms, Malaysian firms need to grow their earnings sustainably. And in order to outperform the rest of the EM stocks, Malaysian earnings need to grow at a faster clip than their peers. The question therefore is, are there signs of profit recovery in Malaysian companies in absolute and relative terms? The short answer is no. Bottom-up analysts do not expect any change in the downward trend in Malaysia’s relative profits over the coming 12 months. This outlook is corroborated by our macro analysis, as is outlined below. Sluggish Growth  Malaysian profits are languishing in large part because of subdued topline growth. While profit margins are returning to pre-pandemic levels – thanks to cost cutting – subdued sales are causing the corporate profits to stay low. Chart 4Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian Domestic Demand Is Subdued Malaysian gross output as of Q4 last year was barely at pre-pandemic levels. The weak recovery is most evident in the dismal level of capital investments. Gross fixed capital formations – in both real and nominal terms – are still a good 15% below their pre-pandemic levels (Chart 4, top two panels). Apathy among businesses in ramping up productive capacity indicates a lack of confidence in consumer demand going forward. Consumption is indeed weak: Unit sales for passenger vehicles continue to be sluggish, and commercial vehicle sales are not faring any better. Consumer sentiment has ticked down in the latest survey indicating retail sales might decelerate (Chart 4, bottom two panels) Consistently, industrial production in consumer goods-related industries is struggling to surpass previous highs, even though strong export demand has provided a fillip to sales. In more domestic-oriented industries such as construction goods, the weakness is palpable (Chart 5). Meanwhile, unemployment rates have fallen marginally, but are still higher than they were before the pandemic. As a result, wages remain subdued. The resulting weak household income is contributing to depressed consumption. With mediocre household income growth, demand for houses has also slowed meaningfully. This is reflected in dwindling property unit sales. The advent of the pandemic and the resulting loss of household income have further aggravated the situation. In fact, prices of certain types of dwelling units, such as semi-detached houses and high-rise apartments, are deflating outright (Chart 6, top panel). Falling house prices weigh on consumer sentiment and discourage future consumption. Chart 6Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Contracting House Prices Is Hurting Real Estate Sector And Denting Consumer Confidence Chart 5Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production Weak Domestic Demand Is A Headwind To Industrial Production What’s more, the housing sector does not expect an early recovery in sales and prices either. This is evident in the very depressed level of new construction starts (Chart 6, bottom panel). As such, this sector is likely to remain a drag on Malaysia’s post-pandemic recovery. Fiscal And Credit Headwinds Going forward, the recovery will face other headwinds worth noting. One of them is a restrictive fiscal policy. This is because the “statutory debt” ceiling of the government – at 60% of GDP – has already been reached (Chart 7, top panel). This ceiling for statutory debts was fixed by lawmakers as part of a stimulus bill (COVID-19 Act) passed in 2020; and leaves little room for additional fiscal stimulus. Indeed, the IMF estimates that the ‘fiscal thrust’ this year will be negative at 2% of GDP (Chart 7, bottom panel). The country’s credit channel is also compromised. The reason is that Malaysian banks are still saddled with unresolved NPLs. These NPLs are a legacy of a very rapid expansion of bank loans following the GFC. In just five years (2009 -2014), bank credit doubled in nominal terms to 1500 billion ringgit or from 95% of GDP to 125% (Chart 8, top panel). Such fast deployment of credit was bound to cause significant misallocation of capital. And yet banks were averse to recognize impaired loans in any good measure. In fact, during the years of rapid credit growth, banks were recognizing ever fewer amounts in absolute terms as impaired loans. They were also setting aside ever lower amounts as loan loss provisions (Chart 8, second panel). Chart 7Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Fiscal Policy Will Stay Constrained As Statutory Debt Has Hit The Ceiling Chart 8Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised Both Demand And Supply Of Bank Credit In Malaysia Remains Compromised While bad debt recognition and provisions have risen modestly over the past year, Malaysia’s reported NPL ratio remained under 1.5% of loans (Chart 8, third panel). Loan loss provisions have been equally meager. This indicates that banks’ balance sheets are far from clean. In reality, Malaysian borrowers never went through any deleveraging process following their last credit binge. The bank credit-to-GDP ratio remains at around the same level as it was in 2015 (125% of GDP). By comparison, during Malaysia’s previous deleveraging phase, bank credit was shed from 150% of GDP to 90% (1998 - 2008). Borrowers already saddled with large amounts of debt are much less likely to borrow more to invest and/or consume. This is therefore going to cap credit demand. Chart 9Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans Banks Are Piling Up On Government Securities By Shunning Loans As for banks, an increase in impaired loans makes them reticent to engage in further lending. Instead, they seek to accumulate safer assets such as government bonds. In fact, this is what Malaysian banks have been doing. They have ramped up their holdings of government securities materially since 2015 at the expense of loans and advances (Chart 9, top panel).   After the pandemic-related slowdown in the economy, banks’ loan books are now probably more encumbered with impaired loans.  As such, banks are even less likely to ramp up their loan books in any major way. That will be yet another headwind to economic recovery (Chart 9, bottom panel).    Value In Fixed Income The headwinds to growth do not entail a bullish outlook for Malaysian equities. The outlook for Malaysian local currency bonds, however, is promising. A tightening fiscal policy amid weak domestic demand and subdued inflation is a bullish cocktail for domestic bonds. There is a good chance that Malaysian bond yields will roll over. At a minimum, they will rise less than most other EM countries or US Treasuries. Notably, Malaysia offers one of the highest real yields (nominal yield adjusted for core inflation) in Emerging Asia (Chart 10, top panel). Given the country’s mediocre growth outlook, odds are high that Malaysian local bonds will outperform their EM / Emerging Asian peers (Chart 10, bottom panel). Chart 10Malaysian Bonds Offer One Of The Best Values In Emerging Aisa Malaysian Bonds Offer One Of The Best Values In Emerging Asia Malaysian Bonds Offer One Of The Best Values In Emerging Asia Chart 11Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks Steep Yield Curve Indicate Value In Bond Space; But Spell Trouble For Bank Stocks The Malaysian swap curve is also far too steep given the country’s macro backdrop. Going forward, the 10-year/1-year swap curve is set to flatten from its decade-steep level of 130 basis points (Chart 11, top panel). That means investors should continue receiving 10-year swap rates. On a related note, a fall in bond yields will not augur well for Malaysian stocks in general, and bank stocks in particular. The middle panel of Chart 11 shows that bank stocks struggle in absolute terms whenever bond yields decline. Incidentally, at 38% of total, banks are by far the largest sector in the MSCI Malaysia Index. And in recent months bank stocks have been propelling the Malaysian market (Chart 11, bottom panel). Should the bourse begin to miss the tailwind from rising bond yields, Malaysian equity performance will be hobbled.    Finally, investors should stay overweight in Malaysian sovereign credit. The country’s orthodox fiscal policy has accorded a defensive nature to this market. As such, periods of global risk-off witness Malaysian sovereign spreads fall relative to their EM counterparts, as they did in 2015 and again in 2020. In the months ahead, rising US inflation and a slowdown in Chinese property markets could cause another such period. That will lead Malaysian sovereign US dollar bonds to continue outperforming their EM peers. What’s With The Ringgit? Chart 12Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency Malaysia Has Not Been Able To Benefit From A Cheap Currency The Malaysian currency is cheap, both in nominal and real terms (Chart 12, top panel). As such, it will likely be one of the most resilient currencies in EM this year. That said, the ringgit has been cheap for a while now (since 2015), and yet the Malaysian economy does not seem to have benefitted much all these years. The inability to take advantage of a cheap currency points to a fundamental malaise in the Malaysian economy: Loss of manufacturing competitiveness, as explained in our previous report on Malaysia. Perhaps equally worryingly, the country has not been able to attract much in the way of capital inflows. What this implies is that global investors did not find Malaysian assets attractive enough despite the benefits of a significantly cheaper currency (Chart 12, bottom panel). A major reason investors have not found the country attractive is because the return on capital on Malaysian assets has continued to deteriorate relative to the rest of the world. The upshot of the above is that, should Malaysian firms be able to improve their profits going forward, Malaysian stocks’ relative performance would get a boost from both higher relative earnings and a stronger currency. However, given the sluggish business cycle outlook as explained above, a sustainable rally in Malaysian stocks or currency is not imminent. Investment Conclusions Chart 13Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Malaysian Relative Stock Valuations Are On The Cheaper Side Equities: Malaysian stocks have cheapened. Both in terms of P/E ratio and P/book ratio, they are at the lower end of the spectrum relative to their EM counterparts (Chart 13). Yet, given the mediocre growth outlook, we recommend that dedicated EM and Emerging Asian equity portfolios stay neutral on this market for now. Absolute return investors should stay on the sidelines in view of the worsening risk outlook in global markets, and wait for a better entry point later in the year. For local asset allocators in Malaysia, it is too early to overweight stocks relative to bonds over a cyclical horizon. Even though the equity risk premium in general has been much higher since the advent of the pandemic, stocks have struggled to outperform bonds in a total return basis over the past two years. That will likely be the case for several more months given the country’s growth outlook and rising global risks. Fixed Income: Malaysian domestic bonds will outperform their overall EM / Emerging Asian peers. So will Malaysian sovereign credit. Fixed income investors should overweight them in their respective EM / Emerging Asian portfolios. In the rate markets, investors should continue receiving 10-year swap rates. Finally, Malaysian yield curves are set to flatten. Investors should position for a narrowing of the 10-year/1-year yield curve, which is at a decade-high level of 180 basis points. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Highlights The Malaysian economy is struggling. The latest surge in Covid-19 cases will further hamper the recovery. Shrinking employment and household incomes are accentuating deflationary forces.  Fiscal support will be elusive until the statutory debt ceiling is raised, and therefore will be late to arrive. A sustainable rally in Malaysian stocks is contingent upon improved competitiveness and profit margins for companies. That seems unlikely to happen in the near term.  Dedicated Asian/EM equity investors should stay neutral on this bourse. Fixed-income investors should continue overweighting Malaysia in both EM local currency and sovereign bond portfolios. Feature Chart 1Malaysian Equity Underperformance Will Likely Continue… Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks The Malaysian economy is struggling to recover. Its stock market will therefore likely stay weak both in absolute terms and relative to their EM peers (Chart 1). The country’s local currency and sovereign credit (USD bonds), on the other hand, have a better outlook. A cheap currency and, hence, limited risk of large depreciation, also adds to the attractiveness of bonds for foreign investors. An Underwhelming Recovery New mobility restrictions initiated last month after the most recent surge in Covid-19 cases are accentuating Malaysia’s domestic demand woes. Worryingly, unlike in the previous two instances when social restrictions quickly helped reduce the number of new cases, daily infections remain stubbornly high this time around (Chart 2). This will further delay the already lackluster recovery: Industrial production levels for the domestic-oriented industries in Malaysia are still well below 2019 levels (Chart 3, top panel). The same can be said for construction-related industries (Chart 3, bottom panel). While the export-oriented industries, especially in consumer goods sectors, have recovered somewhat – thanks to strong demand in developed countries – they have not been enough to steer the local economy out of its funk. Chart 2… As Surging Covid-19 Cases Forced New Mobility Restrictions … Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 3… In An Economy Already Struggling To Recover … Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks   As a result, the jobs market has not yet recovered: in fact, the unemployment rate was hovering at a very elevated level in Q1 2021 prior to the most recent social restrictions (Chart 4). A weak job market has put downward pressure on wages. Average manufacturing wages are shrinking. This has contributed to depressed household incomes, leading to weak consumption and falling house prices (Chart 5). Chart 4… Where Employment Is Contracting… Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 5… Wages Are Shrinking, And House Prices Are Deflating Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks The country’s monetary stimulus attempts have proved inadequate. Even though the central bank had cut rates by a meaningful 125 basis points between January and July 2020 to 1.75%, bank credit growth has remained meagre. As of May this year loans grew at a paltry 3.5% annually. Working capital loans are even weaker at 2%. In sum, weakness in the domestic economy is palpable. As such, disinflationary forces are taking hold. Both the core and services sector consumer inflation have slipped to below 1%. Chart 6Entrenched Deflationary Forces Led Core CPI To Decouple From The Ringgit Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Notably, as a small open economy, the strength/weakness of the trade-weighted ringgit often dictates inflation in Malaysia. Currently, however, they have diverged materially: core and services CPI are much lower than what the currency strength would imply. This anomaly underscores that the disinflationary pressures are entrenched (Chart 6).    Headline CPI, at 4%, might look high; but that is entirely due to base effect including that for oil prices, and will soon be a thing of the past. The bottom line is that a depressed job market and an underwhelming economy is heralding a disinflationary period in Malaysia.   Bond Bullish Notably, the softness in the Malaysian economy lingers despite a rather robust fiscal thrust last year – amounting to 2.6% of potential GDP. By comparison, the fiscal thrust this year would be a negative 0.2%, and a further negative 1.3% in 2022 as per IMF estimates (Chart 7). In other words, fiscal policy will be more constrained this year and the next than it was in 2020. Part of the reason fiscal policy will be constrained has to do with the debt ceiling that lawmakers imposed on the country’s “statutory debt”1 at 60% of GDP, as per the Covid-19 Act of 2020. As things stand now, the statutory debt has already hit that ceiling, and hence there is little room left for further fiscal stimulus (Chart 8, top panel). Also noteworthy is the fact that a significant portion of economic stimulus in Malaysia has come in the form of government guaranteed financing in recent years. While these have not caused an immediate rise in public debt, they have certainly caused the government’s contingent liabilities to spike to more than 20% of GDP (Chart 8, bottom panel). There is a good chance that some of these liabilities will morph into new debts in future. All these have made policymakers reluctant to add more fiscal spending. Chart 7Malaysia Will See A Negative Fiscal Thrust This Year And The Next … Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 8… As The Statutory Debt Ceiling Is Capping Further Fiscal Stimulus Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks The fact that Prime Minister Muhyiddin Yassin is in an apparently weaker position now, after having lost support from the “United Malays National Organization”, the largest party in his coalition, also does not augur well for approving more fiscal stimulus and/or raising the statutory debt ceiling. The latter is something the government would be forced to do eventually, but the dithering would cause more economic hardship in the interim. A constrained fiscal policy amid weak domestic demand and undershooting inflation have made the outlook for domestic bonds attractive. There is a good chance that local bond yields will roll over. A Cheap Currency Part of the allure in Malaysian bonds for foreign investors comes from a rather stable outlook for the ringgit: The demand recovery in developed economies and in China has helped Malaysian exports. The latter is surging at 50% from a year ago (based on its 3-month moving average). This has led to a notable rise in the trade surplus, which is usually a positive force for the ringgit (Chart 9). The ringgit is also cheap vis-à-vis the US dollar when viewed from a purchasing power parity angle. Chart 10 shows that the ringgit is currently about 2.5% below what would be its “fair value” versus the greenback. The fair value has been computed from a regression between the manufacturers’ producer prices of the two countries and the exchange rate. Chart 9The Ringgit Will Be Buoyed By A Surging Trade Surplus Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 10The Malaysian Currency Is Also Relatively Cheap Versus The US Dollar Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks In real effective terms also, the Malaysian currency is quite cheap (Chart 11); especially when compared to its competitor currencies in Asia. A positive backdrop for both domestic bonds and the currency have encouraged foreign investors to buy into Malaysian bonds. In fact, they have been the major buyer of Malaysian local currency bonds over the past year, and their holdings have risen by 30% annually. That said, foreign holdings as a share of the total (at 24%) are still not as elevated as they have been in the past decade, and can, therefore, rise further (Chart 12). Chart 11In Real Effective Exchange Rate Terms, The Ringgit Is Even Cheaper Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 12A Deflationary Backdrop And A Cheap Currency Is Attracting Foreign Bond Investors Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Stock Bearish As detailed above, a faltering cyclical recovery, along with the policymakers’ inability to offer much fiscal support to the economy, means the bear market in Malaysian stocks could continue. What’s more important however is that Malaysia is also suffering from structural malaise. As explained in detail in our previous report, decades of meagre investments in productive capacity have weaned Malaysia off a competitive manufacturing sector and have hurt the company profit margins. This has become a structural headwind for earnings and share prices. Chart 13Decades Of Slowing Capex Has Weaned Malaysia Off Manufacturing Competitiveness Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks The country’s real capex has steadily declined from 27% of GDP in 2013 to 21% currently. Capital investment in machinery and equipment have also fallen in tandem (Chart 13). As a result, not only have the country’s overall exports suffered, but the country has also fallen behind in the race for producing high-quality, technologically superior products that fetch a premium price. This can be seen in Malaysia’s export data. The country’s export unit prices have barely risen over the past decade, even though export volumes have risen decently. This is particularly true for exports of manufactured goods and machinery and equipment. These measurements indicate that Malaysian manufacturing has been relegated to producing commoditized products where they have little pricing power (Chart 14). Faltering capital investments is hurting Malaysian firms from two sides. First, the lack of pricing power is weighing on the profitability of the firms. Manufacturing producer prices have remained flat in level terms since 2013. Second, manufacturing unit labor costs (ULC) kept rising – as meagre capex stymied labor productivity (Chart 15, top panel). The net result was that the value of manufacturing output failed to keep pace with rising labor costs. As such, profit margins of the non-financial firms rolled over around the same time (2013) (Chart 15, middle and bottom panels). Chart 14Malaysia Is Unable To Raise Its Unit Export Prices As It Has Little Pricing Power Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Chart 15Flat Selling Prices Amid Rising Labor Costs Led To Falling Profit Margins Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Even though the margins appear to have recovered this year from the depth of the Covid-19 recession last year, they are still at a lower level compared to the recent past. Further, given the softness in the economy, it’s far from clear that margins would not again fall. Chart 16A Malaysian Equity Bull Market Is Contingent Upon Earnings And Margins Recovery Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks On a related note, the sole driver of Malaysian stock prices since 2003 has been company earnings. Stock multiples have had practically no contribution (Chart 16). As such, Malaysian stocks will likely bottom only when its earnings make a bottom. However, given the weakness in top line growth, the earnings can bottom only when margins make a sustainable bottom. In essence, therefore, for this bourse to usher in a new structural bull market, Malaysian firms need to see a secular bottom in its profit margins. Yet, shrinking capex and a negative net FDI do not instill confidence that a turnaround in Malaysia’s competitiveness, and therefore, its’ firms’ profit margins, is around the corner. As such, it is hard to be bullish on the longer-term outlook of this equity market just yet. Investment Conclusions Stocks: Despite the unattractive longer-term outlook, from a near-term (6 to 12 months) market strategy viewpoint, we recommend that dedicated EM and Asian equity portfolios stay neutral this bourse in an EM equity portfolio. The reason is that the underperformance has already been steep and prolonged. The valuations are also somewhat cheap, with P/E and P/Book value being 15% and 25% cheaper than their respective EM counterparts. Finally, the currency is likely to be stable compared to its Asian peers. Currency: Going forward, the ringgit should hold up well. The trade surplus is substantial, and fiscal orthodoxy means that the Malaysian bonds will remain an attractive destination for foreign investors. Chart 17A Positive Ringgit Outlook Warrants Overweighting Malaysian Sovereign Bonds Malaysia: Favor Bonds, Not Stocks Malaysia: Favor Bonds, Not Stocks Bonds: At 3.3%, Malaysian 10-year domestic bond yields now compare well with the average dividend yield of 3% from MSCI Malaysia since 2010. Moreover, given the rather constrained fiscal spending and lingering weakness in the economy, odds are that the central bank will be forced to cut rates later this year. As such, bond yields will likely stay soft going forward. We recommend that fixed-income investors stay overweight Malaysia in an EM local currency bond portfolio.  In the rate markets, investors should continue receiving 10-year swap rates for similar reasons. Sovereign credit: The top panel of Chart 17 shows that Malaysian sovereign spreads move with the rise and fall of the ringgit. Given that the ringgit will outperform many of its EM peers, it makes sense, therefore, to stay overweight Malaysia in an EM sovereign bonds basket (Chart 17, bottom panel).   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1Statutory debt as per the Covid19 Act of 2020 is different from and less than the total debt of the government, and is comprised of only Malaysian government securities, Malaysian government investment issues (i.e., Islamic bonds) and Malaysian Islamic treasury bills.

Highlights The prolonged bear market in Malaysian stocks is rooted in a subpar, credit-fueled, consumption-led growth. Years of meagre capital investments has robbed its manufacturing sector of any pricing power. Firms’ already fading profitability now faces the specter of a deleveraging phase, amid a deflationary backdrop. Investors should use any rally from the oversold positions to downgrade this bourse to underweight. Feature Chart 1Malaysian Stocks' Underperformance Has Not Yet Run Its Course Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Malaysian stocks have been in a bear market since 2013, both in absolute terms and relative to their EM counterparts. This has been the longest bear market for the country, albeit not the deepest (Chart 1). The question is what prompted such prolonged underperformance; and, more importantly, when will this underperformance end? Underperformance Is Rooted In Poor Quality Growth The Malaysian real GDP managed to grow at a steady 5% clip over the past decade. Yet the quality of that growth has been subpar. From 2009 to 2013, supported by loose policy, the country engaged in a consumption binge while its capital investments languished (Chart 2). In the same vein, imports of consumption goods continued unabated, while imports of capital goods were cut substantially (Chart 2, bottom panel): This consumption-led growth was aptly supported by a credit splurge that began in the aftermath of the global financial crisis (GFC) of 2008. Non-financial private credit rose to 135% of GDP, aided by a remarkable and unprecedented surge in household indebtedness (Chart 3). Chart 2Malaysian Growth Was Fueled By A Consumption Binge... Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 3...And Duly Supported By A Credit Splurge Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   If non-financial corporations’ domestic and foreign debt issuances and other foreign liabilities are also included, the total non-public, non-financial indebtedness figure would reach a staggering 200% of GDP – a figure higher than that of the US and Japan but lower than that of only China (Chart 3, bottom panel). By 2013, the debt load on the economy had become far too high, and the debt service coverage ratio unsustainable. Notably, Malaysian firms’ debt service obligations have always been more onerous than that of their counterparts in neighboring countries (Chart 4). And the obligations kept rising till 2019. The end of re-leveraging coincided with the peak of its relative equity performance versus the EM benchmark (Chart 5). Chart 4Debt Load On Malaysian Borrowers Are More Onerous Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 5Stocks Began To Underperform As Debt Cycle Came To An End Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   Flagging Competitiveness Chart 6Weak Investments In Machinery Chipped Away Malaysia's Competitiveness... Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? While on one hand the country indulged in a credit splurge, on the other hand, diminishing capital spending began to cripple Malaysian firms’ productivity. This impeded competitiveness and, ultimately, profitability. Notably, even within the dwindling capex pie, an ever-lower share of spending was directed towards investments in machinery and equipment, while a rising share went to spending on structures (Chart 6, top panel). The building of structures such as residential and retail/commercial spaces are not as productivity-enhancing as the spending on new plants and machinery. Eventually, this strategy began to weigh on the country’s competitiveness: the share of exports in GDP kept falling in tandem with a lower capex on plants and machinery (Chart 6, bottom panel). Over time, it altered the very structure of the country’s exports composition: Manufacturing exports dropped from a high of 82% of GDP in 2000 to half that level a decade later. Instead, the country increasingly veered towards commodities exports (Chart 7). This shift worked relatively well for the economy as long as global commodities commanded a high price. Provided exports have historically made a large share of GDP (75% average for 2000-2019), export prices have always had an outsized impact on income growth. High commodity prices initially boosted the income and wages of commodity producers and labors, and then spilled over to other sectors of the economy and eventually to asset prices. As such, when the commodity bull run came to an end in 2012, export price deflation had the opposite effect, bringing the last bull market in Malaysian stocks to a halt (Chart 8). Chart 7...Undermining Manufacturing Exports, Even As Commodity Boom Came To An End Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 8Rising Export Unit Prices Lifted Up All Boats, Including Stock Markets Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   The bottom line is that chronically lower investments in productive capacity prevented the development of a competitive manufacturing sector and raised Malaysia’s dependence on the commodity cycle. Total exports as a share of the economy is now lying close to a generation low of 62% (Chart 6, bottom panel). Fading Profitability A lack of adequate capital investments in new plants, machinery or technology often means falling behind in the race for producing high-quality and technologically superior products that fetch a premium price. Instead, firms risk being relegated to producing commoditized products, where they have little pricing power. Malaysia shows signs of suffering from that malaise: The total value of Malaysia’s manufacturing output has rolled over relative to its labor cost. This can be partly attributed to the relatively lower unit value of the goods the nation manufactures. Indeed, Malaysia’s low unit export price for manufactured goods and machinery and equipment also points in that direction: in the past ten years, they have barely risen (Chart 9, top panel). Imported consumer goods are increasingly flooding the Malaysian economy even as imports of intermediate goods are steadily declining (Chart 9, bottom panel). This is a major sign that local manufacturing is losing its competitive edge to foreign imports. Intensifying import penetration has kept a lid on domestic goods prices, weighing on business earnings. The adverse impact on corporate profits was further amplified when Malaysian businesses could not keep their unit labor cost (ULC) in check as productivity gains have been insufficient to offset wage increases. Indeed, over the past several years, Malaysia’s manufacturing ULC was rising at a faster clip than the country’s manufacturing PPI - the price at which the producers sell their goods. This obviously did not bode well for non-financial firms’ profit margins – the latter dropped materially after ULC began to rise at a faster rate (Chart 10). Chart 9Malaysia Has Little Pricing Power In Its Manufacturing Sector... Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 10...And Facing Rising Labor Costs; Both Are Hurting Firms' Margins Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   And A Frail Job Market In recent years, it is not just capex on machinery and equipment that has been weak. As the credit binge ended, investment in structures have also slowed meaningfully since its 2013 peak. While the latter is not as productive as the former, it still helps create jobs and income. New jobs, in turn, create new demand for goods and services, which other firms can cater to. In other words, capital investments usually lead to a virtuous growth cycle. Hence, when aggregate capital expenditure slowed, the negative effect on job markets was amplified: As Chart 11 shows, Malaysia’s capex cycle has been instrumental to its job markets. With rising capex came more jobs, and vice versa. A decelerating job market is negative for consumer demand; it leads to weak overall growth and lower stock prices (Chart 11, bottom panel). Indeed, weaker income growth led to a slump in property demand, and eventually construction activity began to collapse (Chart 12, top panel). The outcome has been a plunge in construction jobs and related industries. Chart 11Flagging Capex Can Lead To A Frail Job Market, And Even A Bear Market Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 12As Capex On Structures Peaked, So Did Construction Jobs And Property Prices Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   House prices also began to decelerate and have recently been deflating (Chart 12, bottom panel). A weak property market exacerbated the negative impact on consumer demand via the wealth effect. Notably, apathy towards capital investments can be seen in Malaysia’s listed firms as well. They continue to pay out a much larger chunk of their earnings – rather than retaining it for re-investing – especially compared to their EM peers (Chart 13). If anything, the difference between them and EM firms has been widening dramatically, indicating that there is no impending change in corporate capex strategy. Also, the retention ratio for Malaysian non-banks has been lower than that of their banking peers.  What Lies Ahead? Looking ahead, we see few signs of any change in Malaysia’s structural path. Therefore, it is hard to be bullish on the longer-term outlook of this equity market. Making matters worse, the fallout of the post-GFC re-leveraging phase is far from over. Even though it’s been several years since the credit cycle ended, the leverage accumulated during that period has not yet been digested. Nor have the banks recognized their non-performing loans in any good measure (Chart 14): Chart 13Listed Firms Are Averse To Retained Earnings, Indicating Little Future Capex Plans Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 14Banks' Reported NPLs Are Far Too Low Vis-à-vis Recent Credit Splurge Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 15Deflationary Pressures Will Make De-Leveraging More Painful Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Unlike Malaysia’s previous deleveraging phase wherein the country’s non-financial private sector credit was shed from 170% of GDP to 110% by 2006, the same ratio in the current cycle has been moving sideways. Notably, this has contributed to the bear market in the Malaysian bourse in relative terms (Chart 5) – even though the latter has also to do with the loss of competitiveness and, hence, fading profitability as well as lower resource prices (as detailed above). Notably, deflationary pressures in the Malaysian economy are acute now as is evident in negative GDP deflator and headline CPI, albeit not core CPI (Chart 15, top panel). This bodes ill for the leveraged entities going forward, because falling price levels increase the real debt load and makes debt repayment even more difficult. The deflationary backdrop also means elevated real borrowing costs. Real prime lending rates now stand at a relatively high 5.0% when deflated by GDP deflator; and 4.7% when deflated by core CPI (Chart 15, bottom panel). High real borrowing costs usually lead to higher loan delinquencies down the road. Thus, banks will see a higher share of their loans turning into non-performing assets going forward. Since banks are currently reporting an NPL ratio of only 1.4% and their NPL provisions stand at a mere 1.6% of total loans, they would be forced to make significantly more loan loss provisions in the years ahead when reported NPL rises (Chart 14). This will lead to further erosion of bank earnings. Incidentally, at 25%, banks make up the single-largest sector of the MSCI Malaysia index. With depressed bank earnings, this bourse will be hard pressed to embark on a new bull market. Notably, banks’ changing asset profile over the past few years indicate that they have been shunning loans to the real economy and piling up on safe, but low-yielding, government securities (Chart 16). While this shift to safe-haven assets is understandable as banks grow increasingly wary of a spike in NPL down the road, it cannot save banks from the fallout of an impending NPL spike. This is because government securities still make up only 10% of total bank assets. Besides, their yield is lower than the cost of deposits, making it unviable to accumulate them in any significant amount.  Financial Market Implications Over a cyclical horizon (twelve months), we have the following observations to make on various asset classes: Currency: The ringgit is cheap in real effective terms (Chart 17). It is also cheap when compared to its long-term fair value in purchasing power parity terms vis-à-vis the US dollar. Chart 16Banks Will Face Specter Of Rising NPL And Cannot Hide In Bonds For Long Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 17Even A Cheap Ringgit Proved Inadequate To Boost Competitiveness Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   Going forward, the ringgit will likely hold up well. Foreign exchange reserves are adequate, and Malaysian bonds remain an attractive destination for foreign investors, as discussed below. Incidentally, foreign holdings now account for 22% of total local currency government bonds; and are thus no longer elevated. That said, the country now seems to be unable to take advantage of an inexpensive currency. The basis is that the nation has not been investing in the right industries and, consequently, has not boosted its competitiveness in high-value sectors/products. Fixed Income and Rates: Chart 18Longer End Of The Swap Curve Offers A Better Value Now Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? In the wake of a slowing economy and Covid-19, bond yields dropped materially from 4.2% to 2.7%. Going forward, yields will still likely stay low. The outright deflationary backdrop warrants lower rates, and the central bank will be forced to cut again in the new year as fiscal stimulus could prove inadequate.  Incidentally, Malaysia’s fiscal stimulus attempts are constrained by a self-imposed public debt ceiling. Although that ceiling was temporarily raised from 55% of GDP to 60% earlier in the year, there is little room left for any meaningful expenditure program. This is a reason to be bullish on the long end of the yield curve. In rate markets, investors should book profits in our recommended trade of receiving two-year swap rates, which generated a profit of 130 bps since its initiation on October 31st last year. Instead, they should receive ten-year swap rates which offer better value (Chart 18). Stocks Covid-19 and the policies adopted thereafter have not resolved the structural underlying issues of falling competitiveness and lingering indebtedness. Hence, these structural issues will remain in the post-COVID-19 environment as well: In absolute terms, Malaysian stocks are back to pre-pandemic levels. As the economy gets back to a more normal growth rate and fiscal support continues – as promised in the budget for 2021 – we will likely see sequential economic growth in the next few quarters. This will help stocks on the margin but is unlikely to usher in a new bull market. Relative to overall EM, Malaysia’s underperformance is not yet over. Other countries, such as India and Indonesia, could prove to be more attractive investment destinations in the medium and long term given their attempts at structural reforms. Notably, despite a prolonged bear market, Malaysian stocks are not particularly cheap – either in absolute terms (with a trailing P/E at 23, forward P/E at 16, and P/Book at 1.6), or relative to EM benchmarks (Charts 19 and 20). In the near run, EM dedicated equity portfolios should maintain a neutral allocation to this bourse. However, any outperformance from a very oversold level (Chart 1, bottom panel) should be used to downgrade it to underweight. Finally, for domestic Malaysian asset allocators, local bonds outperformed stocks massively in total return terms over the past two years. However, given ten-year bonds now offer only 2.7% against a healthy 2.8% dividend yield in stocks, the outperformance is late. Chart 19Malaysian Stocks Are Not Cheap … Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End? Chart 20… Not Even In Relative Terms Malaysia: When Will The Equity Underperformance End? Malaysia: When Will The Equity Underperformance End?   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com​​​​​​​

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-2Population Above 60 Years Old COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-4Intensive Care Unit (ICU) Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-7Decline In Traffic From ##br##A Year Ago COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers ...And Relative To Their EM Peers ...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.

Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked   The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative Chart I-4Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low   If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed   Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Chart I-7Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. Chart I-11The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.

Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked Malaysia's Business And Household Total Leverage Has Peaked   Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates Malaysia: Nominal GDP Growth Dipped Below Lending Rates   Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering Malaysia: Consumer Spending Is Teetering   Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Peruvian Local Rates Have Risen Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure.  Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Peru: The Economy Is Weak Peru: The Economy Is Weak   Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming Peruvian Equities Have Been Underperforming   Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-1The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households Chart I-3Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Chart I-5Malaysian Households Are Retrenching Malaysian Households Are Retrenching Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com