Budget 2014: Fiscal Reforms for Malaysia

The Malaysian government has pledged to put the economy on a sustainable growth path while undertaking steps aimed at reducing the country’s budget deficit, a move widely expected by the market.

Budget 2014 contains spending cuts and subsidy discipline that would ultimately contribute to a reduction in government debt. This year’s Budget focussed primarily on fiscal consolidation towards gradually reducing the budget deficit to the targeted 3.5% of GDP for 2014 (2013: 4% of GDP). This would form part of the roadmap to achieve a balanced budget even before 2020. Malaysia recorded a budget deficit of 4.5% of gross domestic product (GDP) in 2012, and a shrinking current account surplus of RM2.6 billion in the second quarter of 2013. The surplus is estimated to narrow to RM26.6 billion this year from RM57.3 billion in 2012.

Apart from the fiscal discipline objective, Budget 2014 strives to sustain healthy GDP growth and improve living standards of the “rakyat”.

The following are pertinent issues that were addressed:

Goods and Services Tax (GST)

Set at 6% with basic food items such as rice, flour, and cooking oil exempted, the GST would be effective 1 April 2015 to replace the current sales tax of 5%-10% and service tax of 6%. This rate is the lowest in ASEAN countries. The government would also provide one-off payment of RM300 to households eligible for the 1Malaysia People’s Aid Programme (BR1M) upon implementation of GST.

It is clear the implementation of GST is positive for the economy, as it broadens the tax base and is a fairer and equitable tax. However, from an equity market’s perspective, it will have limited near term impact given its long dated implementation. It does however augur well for the government’s efforts on fiscal prudence. The GST would lessen strain on Malaysia’s fiscal deficit and provide a more efficient tax regime.

Income Tax (Corporate and Personal)

Introduction of the GST would imply a revision to the corporate (currently 25%) and personal (26% for top bracket) income taxes. As such, this is timely with corporate taxes being lowered to 24% and personal tax rates reduced by 1%-3% that will take effect post GST. The reduction in corporate tax rates would eventually lead to higher tax revenues because the lower cost of doing business would tend to encourage business growth.

Costs of Living

Middle-income earners are the worst hit population segment by rising costs of living, and were previously not entitled to the BR1M Programme meant for those with a household income of RM3,000 and below. The government has raised the BR1M payment to its target recipients by: increasing cash handouts (to RM650 from RM500 previously), and making more households eligible (RM4,000 monthly income from RM3,000 previously). Families with RM4,000 monthly incomes will not be subject to income tax, while middle-income households would also receive tax exemption of RM2,000.

Strengthening Financial Market

Amendments will be made to existing laws and Bank Negara Malaysia will lead the initiative in formulating the Netting Act to protect enforcement rights of “close-out netting” under the financial contract. This is to reduce credit risk and promote a healthier derivatives market, reducing systemic risks in the domestic financial market as well as the cost of doing business. Currently, the domestic bond market is the largest in Southeast Asia with a value exceeding RM1 trillion, while daily transactions in the foreign exchange and money markets are more than RM30 billion.

Pension Scheme

The government has proposed a one-off incentive of RM500 to contributors who participate in the Private Retirement Scheme (PRS) scheme with a minimum cumulative investment of RM1,000 within a year. This measure is designed to promote the PRS market. This incentive – available for individuals aged between 20 and 30 years – is expected to attract 420,000 youth contributors nationwide, and will be implemented from 1 January 2014, for a period of 5 years, involving an allocation of RM210 million.

Short Term Impact on Equity Market

The Malaysian equity market has been firm in the last 1-2 months. This is partly a reflection of regional market strength. The market has factored in the positive effects of the budget. Hence, we believe post-budget, action for the equity markets will be neutral as shorter term investors take profit on news, countering any positive impact of the budget.

With the strong political mandate, the government is implementing tougher and more sensible policies for nation building. But successful implementation of those policies will largely depend on execution discipline, which the government seems to have a greater appreciation of the expectations of the Rakyat. Also, top government officials and corporate figures will be going to the US to meet global funds in the Invest Malaysia roadshow shortly after the Budget.

Investment Strategy

Overall, we believe the budget is a step in the right direction from a market perspective. Despite the neutral impact of the budget, we are still quite bullish on the market. We believe a return of global growth and the delay in Quantitative Easing (QE) tapering by the US Federal Reserve will provide impetus to drive the market higher by year end. By historical standards, valuations are not excessive and foreign positioning in the market is relatively low. As such, we remain bullish and continue to increase our exposure in the market.

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Obama Signs Bill to end Government Shutdown

President Barack Obama signed a bill that ends the 16-day partial government shutdown – which had cost the US economy USD24 billion – effectively ending the nation’s fiscal impasse and raising the debt ceiling.

Policymakers worked round the clock with the October 17 deadline approaching amid warnings the government could run out of money to pay its bills if it did not raise the debt limit. With potential default averted, federal workers should be expected to return to work.

The House of Representatives voted 285-144 to end the current fiscal impasse and pave the way for increasing the USD16.7 trillion debt ceiling. House Republicans were split, with 87 in favour and 144 opposed. All 198 Democrats who were present voted yes. The House vote came after the Senate had earlier passed the bill, 81-18. However, policymakers did not resolve their long-term divides on fiscal policy and will have to debate the same issues again in four months time.

Washington Post earlier reported that US Senate leaders announced a bipartisan deal to avert a threatened default, possible downgrade of its AAA sovereign ratings, and reopen the federal government for business. The agreement would fund the government through January 15, 2014 and allow the Treasury to increase the nation’s borrowing authority through February 7, 2014.

The Dow Jones Industrial Average soared 205 points or 1.36% to 15,373.83 on news of this last-minute deal to extend the debt ceiling, ending the fiscal impasse, avoiding the worst possible debt default by the US government that shutdown the country for 16 days.

US stocks rallied, sending the benchmark Standard & Poor’s 500 Index rising 1.4% to 1,721.47 in New York. Regional markets opened higher this morning on the positive news. The MSCI Asia Pacific Index gained 0.8% to 142.11 this morning in Tokyo. (Source: Bloomberg)

The US Government had remained shut for 16 days after the two political parties failed to meet its deadline to compromise on the government’s budget on October 1, 2013. Americans rejoiced after a Bill was passed which enabled those put on “furlough” to receive back-pay. Concerns initially arose after an estimated USD400 million spending would be curtailed by the “furlough” as federal staffs were put on leave-without-pay during the government shutdown.

Impact on World Markets

Failure to meet its deadline could have a significant impact on global financial markets with the potential of debt default. The US currently stands as the world’s largest lender through its bonds which are also sold outside America. Investors may decide to retract their investments should a default occur.

Top five owners of US debt:

1) China – USD1.3 trillion

2) Japan – USD1.1 trillion

3) Carribean banking centres – USD287.7 billion

4) Oil exporters – USD257.7 billion

5) Brazil – USD256.4 billion

Top five upcoming internal obligations:

1) Social security benefits (due Oct 23) – USD12 billion

2) Federal employee salaries (due Oct 28) – USD3 billion

3) Medicaid payment (due Oct 30) – USD2 billion

4) Interest payment on public debt (due Oct 31) – USD6 billion

5) Medicare payment to providers (due Nov 1) – USD25 billion

(Source: Washington Post)

Funds’ Positioning as at October 9, 2013

Please refer to the PDF file

Strategy Going Forward

While we still retain a healthy cash buffer, we have started to selectively deploy cash into the markets as we believe that the concerns surrounding the ASEAN countries have abated.  Government and central bank policies in the region should meet with approval from foreign investors.  As well, recent trade and inflation data of regional countries are encouraging. These factors, combined with:

(i) a delay in tapering in the US;

(ii) signs of recovery globally; and

(iii) positive seasonal effects, should be supportive of markets.

On the fixed income side, we also believe that the delay in tapering, low inflation environment and reduction in fund outflows, should lead to stability in the debt markets.  As such, we have also deployed cash and lengthened duration for our portfolios. We advise investors to look beyond the short-term concerns and invest with a mid-to-long term horizon of 3-5 years. Our fund managers have weathered through several market cycles and financial crisis before.

Our investment philosophy remains intact and believe that we will be able to deliver consistent performance over the mid to long term. We believe our portfolios have been well positioned and we are optimistic that the markets will be able to benefit from the clarity provided by the US government. As at October 9, 2013, we continue to stay about 75% to 85% invested in our equity funds.

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US Government Shutdown and Debt Ceiling Concerns

US markets rallied overnight, recovering from losses since the partial government shutdown more than 10 days ago, on news of progress towards a potential deal with the Republicans to avert a debt default on October 17.

A plausible breakthrough in the political stalemate seemed evident when House of Representatives Speaker John Boehner offered an olive branch to President Obama to extend the US borrowing authority for six weeks. But his proposal would not mean an end to the shutdown. What was significant about the development? It essentially suggests that both sides appreciate the gravity and the repercussions of a default on the global financial markets.

Both sides of the political parties acknowledge that: ‘‘It’s not worth sending our country into a tailspin over ideological differences. I think investors are breathing a sigh of relief.’’ Bond prices fell. The yield on the 10-year US Treasury rose to 2.68% from 2.65% on Wednesday, while the 30-year increased to 3.74% from 3.72%. Prices and yields move inversely.

We examine some of the issues, as well as the various scenarios and probabilities of a resolution in order to assist us in positioning our portfolios during this period, particularly the impact on the Asian markets where most of our funds are invested.

October 17 – Debt ceiling (USD16.7 trillion)

Treasury Secretary Lew has said that the Treasury’s extraordinary measures will be exhausted by October 17 deadline.  The US treasury estimated that they have about USD30 billion of cash on hand to continue its payment obligations, albeit it is possible for the Treasury to meet its obligations for some days past October 17.  The US government is rapidly exhausting its extraordinary measures (kept under USD16.7 trillion debt ceiling) and if the statutory limit is not revised, Nomura Research indicates that the US government, as well as market participants, will face a limited number of highly adverse alternatives, an outright default being the worst-case scenario. It is also believed that a solution will come very close to October 17 before current debt limit becomes binding. T-Bills and the repo market are already factoring in some expectation and broader markets will be considering the potential scenarios in the days ahead. We do not foresee a hard default even if the debt ceiling is not extended, as alternative solutions will weigh in, although such outcomes may result in some uncertainty.

Base Case – Solution ahead of October 17 (70% probability)

Similar to events in 2011, consensus view is that a resolution will be found before the deadline. There could also be a possibility that both sides agree to extension of one to three months.  This would be the preferred outcome than a default. However, pressures in the money market will remain as investors simply widen the window for securities that may eventually default.

Second-best Case – Deadline breached but a solution is in progress (20% probability)

October 17 deadline passes by and no firm solution in place due to a procedural delay – such as getting a bill through Congress and obtaining the President’s signature on it.  If there is a clear framework and political agreement in place, with formal approval to follow shortly after (i.e. October 18-20), prospects of agreement will be clearer. Market would most probably price in (based on money market expectations this week).

Dangerous Option – Deadline is breached but cash on hand buys time (8% probability)

Passing October 17 without a clear path in place towards a solution will raise the question when the Treasury will run out of money. Treasury has sufficient resources to avoid non-payment up to the end of October.

Worse Case – Treasury resorts to emergency solutions as cash runs out (2% probability)

Treasury runs out of resources and unable to fulfill all of its obligations.  In this situation, Treasury can still avoid a default on interest and principal payments, either by prioritizing debt payments ahead of other expenditure, or by a “legal fix”, whereby the president somehow raises the debt ceiling unilaterally. (Source: Nomura)

How have markets re-acted since May 22?

Please refer to the PDF file

Funds’ positions as at October 2, 2013

Please refer to the PDF file

Strategy moving forward

We continue to hold more cash in our portfolios to allow us to better weather through the volatility by capping our downside risks.  As prices become relatively more attractive, we will be ready to deploy our monies back into the market. We advise investors to look beyond the short-term concerns and invest with a mid-to-long term horizon (3-5 years). Our fund managers have weathered through several market cycles and financial crisis before. Our investment philosophy remains intact and believe that we will be able to deliver consistent performance over the mid to long term.