Affirmative Reaction 

11/18/2009 10:40 am EST

Focus: GLOBAL

Yiannis Mostrous

Editor, The Capitalist Times

Malaysia looks promising despite persistent ethnic tensions and political gridlock, writes Yiannis G. Mostrous in the Silk Road Investor.

Malaysia has underperformed the broader Asian market this year. Investors have been chasing high-beta and cyclical plays, and Malaysia, widely viewed as a defensive market, has been ignored.

The domestic political situation has also alienated investors. Malaysia’s current leadership has never demonstrated the willingness to implement necessary structural changes. This will be the case for the foreseeable future, because Malaysia’s complicated, institutionalized sociopolitical structure, marked by a racial quota system that gives preference to Malays for education, government, and other jobs, is designed to resist efforts at reform.

Nevertheless, there’s a constant undercurrent that would transform the society, and this impulse is finding its way to the top. It will be a long process, but the system will eventually be sufficiently modified. In the process the Malays will be empowered—to prove that they don’t really need “charity” jobs—and the potential of the rest of the society will be unlocked.

Prime Minister Najib Razak is widely viewed as someone willing to take Malaysia’s economy forward. His efforts and their level of success provide a useful gauge of the country’s long-term developmental path.

In the short term, the economic outlook is moving in the country’s favor; 2010 is forecast to be a solid year for Malaysia’s economy, with GDP growth returning to positive territory at around 5% to 6%. The Malaysian economy is recovering from depressed production levels, and demand is gradually rebounding. At the same time, fiscal and monetary policies continue to be supportive.

The government continues to provide direct stimuli, and Malaysia’s central bank is expected to keep monetary policy unchanged next year—interest rates are at an all-time low. Global economic growth should improve next year, which bodes well for Malaysian exports.

In an effort to reduce its fiscal deficit, the government plans to privatize some state-controlled companies and to take steps to maximize rental income from its property assets. The government will also impose a 5% tax on gains from the disposal of real estate made after 1 January 2010 as well as a service tax on credit cards. To offset these measures, the government plan will reduce the highest marginal tax rate for individuals from 27% to 26%.

Potential risks to keep in mind when investing in Malaysia: the reform agenda loses steam, much-worse-than-expected global growth next year, and the failure by companies to deliver on forecast earnings growth. Market valuations in Malaysia aren’t as supportive as they were last year, as the market is trading at 15.7 times 2010 earnings, compared to Asia-ex Japan at 15.6 times. If these risks or a combination thereof materializes the market could easily drop 10% to 15%. At this point, however, the market’s valuation would be more attractive in absolute terms, making it a good time to allocate funds.

The iShares MSCI Malaysia Index Fund (NYSE: EWM), an exchange traded fund and a new addition to the Silk Road Investor Portfolio, is a buy.

Subscribe to Silk Road Investor here…

Related Articles on GLOBAL