This reflects better-than-expected 3Q09 growth. Indeed, the real economy declined only 1.2%Y in 3Q09, performing better than our (-2.8%Y) and consensus expectations (-2.0%Y). More specifically, the bulk of our revision stems from stronger-than-expected public consumption momentum, given the relatively loose fiscal policy as well as a lesser pace of destocking. Consensus expectation for 2009 growth is -2.6%Y. We expect 2009 GDP momentum to come in at -2.5%Y in our bull case and -3.1%Y in our bear case.
...but Cyclical Outlook Beyond 2009 Remains Unchanged
Beyond 2009, our growth forecasts remain unchanged. We continue to expect Malaysian GDP to grow at 4.3%Y in 2010 and 4.8%Y in 2011. Our 2010 forecast is roughly in line with consensus expectations of +4.4%Y. More specifically in terms of the cyclical dynamics, as we have often highlighted before, Malaysia's economy comprises three growth legs: 1) manufacturing trade, 2) commodity trade and 3) the public sector economy. We think the three factors combined should help Malaysia to deliver reasonable growth momentum in 2010.
Indeed, in terms of manufacturing trade, Malaysia is the second most exposed to global trade within ASEAN. We believe that global economic growth in 2010 and 2011 (at 3.7%Y for both years) is unlikely to return to the leverage-driven vigor seen in the last cycle in 2004-07 (+4.8%Y CAGR). Yet, the rebound in US ISM New Orders Index still indicates some cyclical support as a rising tide lifts all boats.
Having said that, we think the differentiating cyclical factors for Malaysia versus other ASEAN economies lie more in terms of the commodity trade and the public sector economy. On the commodity side, we note that Malaysia is the top net commodity exporter (mainly of oil and crude palm oil) within Asia. Our commodity team believes that supply-side dynamics will support energy quotes even if demand does not come back in a big way. Meanwhile, our CPO analyst also expects crude palm oil to remain supported at US$800/ton in 2010. In this regard, Malaysia is poised to be the biggest beneficiary. We calculate that from a purely oil balance perspective, a US$10/bbl increase in oil price will add around 0.5pp of GDP to growth due to positive terms of trade. Commodity trade aside, the large natural resource endowment also helps to fill government coffers in terms of revenue. Revenue from commodities constitutes about 40% of total government revenue. This, in turn, helps to support what is one of the largest public sector economies within Asia.
In terms of the public sector economy, the recently announced 2010 budget points to a lower fiscal deficit of -5.6% of GDP. This is a smaller deficit compared to 2009's -7.4% of GDP. However, the fiscal policy stance still remains relatively loose compared to other ASEAN economies.
Structural Gaps Persist, but Some Change at the Margin
Beyond the cyclical short term, structural gaps persist. These could dampen longer-term growth prospects unless the pace of real reforms picks up. Indeed, the growth buffer accorded by the commodity resource endowment has reduced the urgency for policymakers to improve growth via productivity and enabled market inefficiencies to go on for longer. However, the global recession and the change in political climate have recently prompted the government to undertake change. An international public relations firm has been hired to overhaul the image of policymakers. Divisive issues have been avoided. De-ethnicization of Malaysian politics may now be underway. The affirmative action policies in favor of the Bumiputras have now been replaced by the more inclusive 1Malaysia. Reform measures - such as the liberalization of the financial sector, relaxation of the Bumiputra equity requirement ratio, and the implementation of the National Key Results Areas - have been undertaken.
Inevitably, the crux of reform measures boils down to the execution and the consistency of policy action with policy rhetoric. Sceptics point out that old guards in the government may impede execution and that some policy actions have diverged from policy rhetoric. On the other hand, optimists believe that reform measures may start as political rhetoric but would gain substance over time. After all, policymakers need to undertake a certain critical mass of reforms ahead of the next elections in 2013, if they want to stay in power.
We are far from turning bullish on Malaysia's structural story. We think that some measures which have been announced (such as the switch in teaching medium for Science and Mathematics to Bahasa from English) have been less ideal than others. However, we have become less bearish than we were earlier because, during the past 1-2 quarters, measures have been announced. In our view, the combination of the weak election results in March 2008 and the emergence of alternative parties to the incumbent Barisan National Government are more likely than not to force some change at the margin.
Important Disclosure Information at the end of this Forum
New RPI Proposals: Downside Risk to Forecasts, but Short-Dated IL Gilts Still Cheap
December 07, 2009
By Melanie Baker, CFA & Anton Heese | London
Summary and Conclusions
While unlikely to have any effect on Bank of England monetary policy deliberations, the ONS' proposed changes to RPI methodology would have a significant effect on the path of RPI over the monetary policy tightening cycle and therefore have implications for index-linker trades and potentially also for regulated utilities and wage settlements.
On our estimate, proposed changes to the calculation of the mortgage interest payments component would lower our forecast for year-on-year RPI inflation by 0.3pp on average over the year-and-a-half following a 1Q10 implementation.
However, we still believe that short-dated IL Gilts offer value as the inflation rate implicit in current prices is significantly below our revised RPI forecast as well as the inflation swaps market. We therefore still like being long the front of the UKTi curve on real yield, breakeven and asset swap, but recommend taking profits on our long 5y breakeven versus the money market curve, given that the appropriate beta on this trade going forward is uncertain.
What Has Happened: ONS Proposals
The ONS has proposed altering the methodology for calculating the mortgage interest payments (MIP) component of RPI. The changes proposed are economically sensible and would replace the basis of calculation from standard variable interest rates (SVR) to a more representative ‘average effective rate' (AER). This would then better reflect the actual interest rate that borrowers are, on average, paying on their mortgage debt. Only around 10% of mortgages pay SVR. According to the consultation paper, the first opportunity to update the methodology would be the February 2010 index levels, published in March 2010.
Our Existing Forecasts
The profile of our existing RPI forecast is driven to a significant extent by the mortgage interest payments (MIP) component. This reflects 1) base effects and 2) forecast interest rate increases. It is over a prospective tightening cycle that changing the MIP methodology would have a strong impact on our RPI forecasts.
• Base effects: We should see significant positive base effects through to April 2010 as comparisons with interest rates from the previous year become less dramatic. For example, in September 2009 the average standard variable rate (SVR) according to BoE data was 3.91%. In September 2008 that rate was 6.95%. As a result, year-on-year inflation in the MIP component of RPI was -45.6% in September! Given that this component currently has a weight of 4.1% in RPI, the MIP component of RPI is weighing down on RPI to the tune of about two percentage points (2pp). This MIP component is also the key reason why RPI inflation is so much lower than CPI inflation at present (MIP are not included in the CPI index). By April 2010, however, we'd expect year-on-year inflation in the MIP component of RPI to be +5.4% (that's before any changes in methodology and before we get to any forecast BoE interest rate rises). As inflation in the MIP component moves from -45.6% to 5.4% between September 2009 and April 2010, this therefore has a strong upward effect on headline RPI inflation too.
• Forecast interest rate increases: Our central forecast is for the BoE to start raising the policy interest rate in 4Q10 and for the policy rate to reach 2.25% by end-2011 (see UK Economics: Later 2010 Rate Rises, M Baker and C Sleeman, December 2, 2009). The average SVR rate tends to move in a fairly predictable way with interest rate changes, moving the month after the policy interest rate change. In our current RPI forecasts, the path for MIP is a function of past changes in the BoE policy rate and a constant (i.e., not the SVR directly). On our current forecasts, MIP component inflation reaches a peak of 28.8%Y in November 2011. At that point it accounts for about 1.2pp on our headline RPI inflation forecast.
What Is the Likely Effect of the Methodology Change?
• A smoother path for MIP... The ONS consultation paper gives an indication of what the effect on the MIP component of RPI would have been if the AER had been used to calculate the MIP component rather than the SVR. Intuitively, the AER should mean a smoother path for MIP since it effectively incorporates the large number of mortgages that are fixed-rate (around 50% of the stock). Many of these fixed-rate mortgage terms are relatively short (two-year fixes are relatively common) and so will adjust to changing interest rates (or swap rates more specifically) over time. But since this adjustment takes time, whereas changes in the policy rate feed through quickly into the SVR, using the AER rather than the SVR to calculate the MIP component will naturally lead to a smoother profile.
• ...and RPI: Given the size of recent moves in the MIP component, using the AER would also have implied a smoother profile for RPI inflation.
• A smoother future path too: We have had a first go at approximating what using the AER would imply for a forecast of the MIP component. By January 2011, given our existing interest rate forecasts, our analysis points to a sizeable difference in inflation in this MIP component if the AER is used.
Implications for Our Overall Inflation Forecasts
Using AER would make a substantial difference to our RPI projection. Our analysis suggests a dampening effect on RPI inflation compared to our current forecasts of around 0.4pp at its peak and 0.3pp on average over the 20 months following a March methodology change.
Implications for Our Inflation Trades
We have previously recommended being long the front end on real yield and versus the money market slope, and also thought they offered value on breakeven and asset swap (see Headwinds and Tailwinds, June 26, 2009, and Moving Core-Periphery to 30-Years, October 16, 2009). The potential change in MIPS methodology requires us to revisit our valuations to see if these recommendations still make sense. In particular, we use the revised RPI forecast, which uses the methodological change to the MIP, to value short-dated IL Gilts and swaps. Beyond our formal forecasting horizon (i.e., Sep-11), we assume that RPI convergences to a long-term fair value of 2.7%Y, based on the BoE achieving its 2% CPI target and the historical basis between CPI and RPI remaining around 70bp. We use this forecast to estimate the expected nominal cash flows from short-dated IL Gilts, which we then discount using the nominal Gilt zero coupon curve to give us the bonds' present ‘fair value'. What we find is that the Aug-11, Aug-13 and Jul-16 IL Gilts will still offer significant value even if the ONS proposal is adopted, with the Aug-13 UKTi the cheapest of three, currently trading 43bp cheap to our estimate of fair value.
IL Gilt Implied Inflation Rate Well Below Our Forecast...
An alternative way to make the same point is to estimate the RPI rate implied by current IL Gilt prices, i.e., calculate the inflation rate that solves for the current market price. This reveals that inflation expectations boot-strapped from the IL Gilt curve are well below our RPI forecast as well as the 1y forward RPI swap curve out to 2013. The Jan-13 to Nov-15 forward RPI rate from the inflation bond curve does rise to 3%, above our long-term RPI assumption, but the average implied inflation rate over the lifetime of the Jul-16 UKTi is still 53bp below our forecast (i.e., 2.28% versus 2.81%). There are even larger gaps between our forecast and the implied inflation rates for the 2011 and 2013 securities (i.e., 137bp and 105bp, respectively).
...but Inflation Swap Pricing Rich to Our Estimates
By contrast we find the UK RPI swap curve richly priced relative to our forecast, although admittedly in longer maturities this merely reflects that our inflation assumption is lower than the inflation swap curve. Nonetheless, it does suggest that while short-dated inflation bond breakevens offer attractive fundamental value, the opposite applies to inflation swaps.
Investment Recommendation: Long Aug-13 IL Gilt on Real Yield, Breakeven or Asset Swap
Our analysis leads us to conclude that it is still attractive to be long the front end of the IL Gilt curve, the Aug-13 UKTi in particular. For investors with a long duration bias, it makes sense to do this on a real yield basis, while those that are more neutral or bearish on rates should implement the trade in breakevens. The way to take advantage of the divergence between inflation bond and swap valuations is to be long inflation versus nominal Gilts on asset swap, a trade that we currently recommend in the 10y sector due to its better liquidity.
Take Profits on Long Breakevens versus Money Market Slope
We also think, though, it is prudent to take profits on our recommendation to be long 5y inflation versus the money market slope: the potential change in RPI methodology means the beta between the money market slope and RPI may change going forward. Therefore, it is more difficult to know what the appropriate hedge ratio ought to be if one wishes to take advantage of differences in inflation expectations implied by the inflation market and front-end nominal rates.
Trade Risks
The main risk to our breakeven recommendations is that realised inflation turns out to be significantly lower than we currently forecast, a perennial threat given the volatility of commodity prices. The performance of the real yield recommendation will to a significant degree be driven by general changes in interest rates (i.e., nominal duration) rather than the under-pricing of the UKTi's inflation protection. The asset swap recommendation will primarily be affected by inflation versus nominal market supply-demand conditions, e.g., the impact of the BoE's AFP and the potential increase in banks' liquid asset buffers that could lead to disproportionate support for nominal Gilts.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").
Global Research Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosure for Morgan Stanley Smith Barney LLC Customers
The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.
|
![](/img/clear.gif"){kind=spacer}