The first half of this year was characterised by upside surprises to economic activity data and a regional banking crisis in the US with the collapse of SVB as well as banking sector stresses in Europe against a backdrop of subdued commodity prices. That said, the US economic activity data has generally been surprising on the upside, especially for the labour market, which poses a quandary for policymakers. The US Federal Reserve has hiked its policy rate for ten straight meetings but may skip for the June FOMC meeting. Geopolitical tensions also persist with US-China relations remaining challenging, albeit with talks between high-level officials having resumed. Against this backdrop, global commodity prices remained subdued. Oil prices have dropped by an average 19% in 2023 year-to-date from average 2022 levels. This is despite the OPEC+ instituting production cuts in April 2023 and Saudi Arabia unilaterally announcing a 1mn bpd cut from July. Risk appetite has, however, meaningfully reversed in 2Q23 as evidenced by the S&P500 index rising more than 20% from its nadir in October 2022.

Some signs of slowing resilience of the US economy have created room for the US Fed to pause on its rate hiking cycle. Strong labour market conditions are increasingly contrasting with weaker manufacturing sector output, a lack of a recovery in the semiconductor sector and pockets of stress in the information technology and regional banking sectors. Importantly, the reopening of the global economy from pandemic associated restrictions exacerbated the divergence between a weakening manufacturing sector and strengthening services sector. The corroborates with the stickiness in core inflation, which has been a concern for the US Federal Reserve.

Even so, market participants have re-priced Fed rate expectations to become more hawkish, a sharp contrast to expectations of a ‘pivot’ to rates cuts earlier this year. A 25bp rate hike from the Federal Reserve by July is almost fully priced in by the markets, but a reversal is still tipped by markets for 4Q23. Our house view is for a similar end-year policy rate, but we lean towards the Fed keeping its policy rate unchanged for the rest of this year. The underlying dilemma for the US Fed will be to signal an end to the tightening cycle but guide the narrative on the timing of rate cuts.

EU entered a technical recession in 1Q23 but despite this, we expect the ECB to remain hawkish in the near-term. Downside surprises to Euro Area inflation may give ECB some room to revise down its headline and core inflation forecasts for this year and for 2024. Even so, the ECB is likely to press on with a 25bp hike at its 15 June meeting and its rhetoric will be watched closely on future rate signals.

The downside surprise so far this year has been from China. We expect statistical base effects aside, that the economy will continue to grapple with structural constraints for the rest of 2023 and into 2024. These constraints were becoming evident prior to the pandemic, for example in the property sector, but were exacerbated by the stringent pandemic lockdowns, shifts in the supply chain and a more subdued consumption recovery following the economy’s re-opening in January this year.

The lack of a growth fillip from China is already being reflected onto the ASEAN-5 countries, with regards to a slow recovery in Chinese tourism but also weak goods export growth to China. While tourist arrivals in the ASEAN region remain supported by non-Chinese tourists so far this year, the uptrend in tourist arrivals from China is becoming more evident. We expect that the October 2023 Golden Week holiday in China will support greater international travel into ASEAN. By contrast, the goods export growth from the ASEAN region to China has showed limited signs of recovery, suggesting that Chinese domestic demand, remains soft. Given the differentiated product mix of export from ASEAN into China, we believe that a broad-based economic recovery in China is critical for a convincing export recovery. Furthermore, the diversification of manufacturing bases into these ASEAN economies implies that the China+1 diversification strategy is ongoing amid heightened geopolitical tensions. This boosts the medium-term prospects for the ASEAN economies to gain a stronger foothold in the global supply chain. This is underscored by resilient FDI inflows into the region not just from China and but also from other global players.

For Malaysia, economic growth remained strong in 1Q23 at 5.6% YoY from 7.1% in 4Q22, supported by resilient domestic demand. Momentum is, however, slowing in 2Q23 and will continue to slow in 2H23 as external economic headwinds intensify. We expect GDP growth to slow to 4.1% YoY from 2Q-4Q23.  The main drag on growth will be from goods exports, reflective not only of weaker external demand, but also fading commodity price tailwinds and a prolonged downturn in the global semiconductor cycle. Importantly, the expected boost from China re-opening at the start of 2023 has disappointed and this may persist for the rest of the year. Our forecast is for China’s 2024 GDP growth to slow to 5.0% YoY from 5.7% in 2023. Hence, we lower our 2024 GDP growth forecast for Malaysia to 4.5% YoY from 4.7% previously.

Consistent with weakening external demand, Malaysia’s domestic demand is likely to moderate in 2H23 and 2024. Nominal manufacturing and services sector wage growth remained solid in 2022 and Q1 ’23 supporting private consumption but with manufacturing output slowing, wage growth will likely moderate and in turn weigh on private consumption. Furthermore, given the sharp depreciation in the currency (MYR depreciated 4.6% versus USD from January through to 12 June ‘23) and fading commodity tailwinds, we expect investor sentiment to remain cautious into 2H23.

Growth support from the public sector will be limited by the government’s fiscal consolidation agenda. The authorities are on track to achieving the fiscal deficit target of 5.0% of GDP in 2023 from 5.6% in 2022 supported by higher revenues collections and lower subsidy and social assistance spending. Moreover, the government has indicated its intention to follow through with the implementation of a targeted subsidy mechanism on electricity and retail fuel, which will create fiscal space to focus on infrastructure spending and other development priorities. The implementation of targeted electricity subsidies may be as early as this year, followed by targeted fuel subsidies in 2024.

This, however, leaves room for pipeline inflationary pressures. Our baseline for headline inflation is to ease to 2.9% YoY in 2023 from 3.4% in 2022, while core inflation remains unchanged at 3.0% this year. This is within BNM’s 2.8-3.8% forecast range for this year for headline and core inflation. The stickiness in core inflation is a key concern for Bank Negara Malaysia (BNM), which is expected to maintain a clear hawkish bias into 2H23. Our baseline forecast is for BNM to remain on hold for the rest of 2023 and into 2024. However, if the Fed is more hawkish than our baseline forecast, then there is a chance of an incremental 25bp hike by BNM later this year.

While the recent MYR depreciation has caught a lot of attention, we believe the underperformance of MYR relative to its peers is due to a multitude of external factors including RMB depreciation, resurgence in USD strength, much higher US Treasury (UST) yields and broad softness in oil prices. Domestic factors include a shrinking current account surplus and lesser impetus for BNM to tighten monetary policy after headline CPI slipped.

Given the above factors, MYR may continue to stay under pressure in the near-term. For the situation to improve, some of these exogenous factors need to turnaround. RMB depreciation needs to slow or reverse, China data to pick up (to bring back hopes of China reopening trade), and/or a Fed pause to be in place (i.e. tightening cycle to end or pivot to rate cuts) to see USD strength fade and UST yields to ease lower. Our forecast for USDMYR is 4.5 by end-2023 and 4.4 by end-2024.

Furthermore, a sustained upcycle in commodity prices is also unlikely at this point, weighing on Malaysia’s external weakness. Oil prices have fallen since the post pandemic highs but remains above the pre-pandemic average. We expect 2023 Brent oil forecasts to average ~USD90/bbl from the current ~USD74/barrel, implying further upside for the rest of the year. We expect specifically for oil prices to rebound in 2H23 as accumulated oil stocks began to wear down and the market shifts to a physical deficit situation.

Similarly, palm oil prices have more than halved from its record high last year but remains above the pre-pandemic average. The price correction reflects improving global edible oil supplies and reducing palm oil premiums over rival soft oil such as soy and rapeseed oil. In addition, declining demand from India, a key importer, followed by higher supplies from Indonesia and Malaysia have added to some bearish sentiment for palm oil. For the rest of this year, we expect the supply of palm oil to normalise as labour shortages in Malaysia’s CPO sector ease. That said, El Nino associated risks warrant close attention.

In summary, the Malaysian economy is likely to grow around 4.4% YoY in 2023. After a healthy 1Q23 growth pace, the growth momentum is likely to moderate for the remaining quarters of this year.