Investors watching a new Malaysia with interest

Investors are reacting cautiously as Malaysia embarks on its first political housecleaning in six decades, but analysts predict they'll find a growing number of reasons to warm to the country's stocks and bonds.

The opposition coalition, which unexpectedly bested a scandal-plagued United Malays National Organization last month, has pledged to root out rampant corruption and introduce greater checks and balances on government power.

Meanwhile, the new government's initial Cabinet appointments, which have looked beyond the country's politically dominant Malay majority to award key posts to ethnic Chinese- and Indian-Malaysians, suggest a more inclusive style of governance than the country has seen in decades.

If sustained, such a shift could eventually moderate a brain drain that has made Malaysia one of the world's most consistent net exporters of "clever people," noted a Singapore-based portfolio manager, who declined to be named.

For the moment, short-term hurdles loom larger in investors' minds than the potential payoffs from far-reaching reforms. Following the May 9 election, Malaysia's Kuala Lumpur Composite index tumbled as much as 7% over the latter half of the month — roughly twice the declines or more of Southeast Asian neighbors such as Indonesia, Singapore and Thailand. Since the start of June, Malaysian stocks have rebounded, together with global markets.

While the current moment could prove "a new dawn for Malaysia," investors are focusing on the "here and now," including how moves such as the cancellation of some big infrastructure projects with China could negatively affect growth, said Jayant Menon, lead economist in the economic research and regional cooperation department at the Manila, Philippines-based Asian Development Bank.

The new government acted quickly to honor its campaign pledges to do away with the unpopular 6% goods-and-services tax introduced in 2015 and revive fuel subsidies, moves that Moody's Investors Service termed credit negative.

The government also provided greater clarity on tens of billions of dollars of contingent liabilities, part of a strategy one Singapore-based trader with a U.S. bank, who declined to be named, described as "kitchen sink-ism" — throwing out every negative detail about the economic situation bequeathed by the previous government in order to set a new baseline for recovery.

Bond market veterans welcomed the transparency.

In the past, it was "very hard for me to have a good sense of these contingent liabilities," said Jean-Charles Sambor, BNP Paribas Asset Management's London-based deputy head of emerging market debt. He called the additional detail being provided under the new government "hugely positive."

"Uncertainty is being replaced by a bit more clarity," agreed Gerald Ambrose, CEO of Kuala Lumpur-based Aberdeen Islamic Asset Management Sdn. Bhd.

Hayden Briscoe, Hong Kong-based head of Asia-Pacific fixed income with UBS Asset Management, likewise welcomed the greater transparency. But he noted investor concerns that rating agencies could respond to the potential increase in Malaysia's debt burden — just more than 50% of gross domestic product at present — by downgrading the country's A credit rating.

Anushka Shah, a vice president and senior analyst with Moody's sovereign risk group in Singapore, said her firm continues to monitor the situation, adding that only if government guarantees are called would a contingent liability crystallize as debt.

While the specifics of new government policies are giving some investors pause, broader concerns recently about emerging markets are making the current moment an awkward one for a public display of the dirty laundry left behind by Malaysia's previous government.

On June 7, for example, Argentina — one of several countries struggling to defend their currencies in recent months — reached a three-year standby arrangement with the International Monetary Fund to secure $50 billion in emergency credit.

The timing is horrible, in terms of what's going on in places like Turkey and Argentina now, said Robert Samson, a Singapore-based managing director and senior portfolio manager with Nikko Asset Management's global multiasset absolute return strategies business. While Malaysia is a great story on the political front, "everybody is waiting for the next shoe to drop in the emerging markets space," he said.

Amid news that countries such as Argentina, Turkey and Venezuela have been struggling this year, a lot of institutional investors aren't willing to boost allocations to emerging markets now, said Aberdeen's Mr. Ambrose.

With neighboring Indonesia forced recently to boost rates to defend its currency, what the Malaysian government's election promises and megaproject cancellations will all mean for its economy is at the top of investors' minds just now, said Ayaz Ebrahim, managing director and portfolio manager with J.P. Morgan Asset Management's emerging markets and Asia-Pacific equities team in Hong Kong.

People are "quite positive" about the broader reforms being pursued but "more in the medium term," Mr. Ebrahim said. For now, they're mostly "biding their time," waiting for more detail, he said.

At the broadest level, the Kuala Lumpur Composite index's drubbing in May reflects "pure uncertainty" about a new, untested government, said the ADB's Mr. Menon.

If the coalition is filled with politicians new to power, the same can't be said of 92-year-old Mahathir Mohamad, who came out of retirement — after a 22-year stint as prime minister through 2003 — to lead the opposition's unlikely campaign against UMNO.

This time around, however, the hard-driving leader — who effectively dismantled institutional checks on prime ministerial power during his previous tenure — appears determined to rebuild competing power centers, including the country's judiciary. Critics say the dominant powers Mr. Mahathir previously grabbed for the office of prime minister set the stage for the alleged abuses of Najib Razak, the one-time protege he dislodged in May.

On June 5, Mr. Mahathir confounded cynics by naming prominent lawyer and constitutional law expert Tommy Thomas as attorney general — an ethnic Indian-Malaysian and the first non-Malay, non-Muslim in that influential post since Malaysia's transition to independence. Earlier, Mr. Mahathir named veteran opposition lawmaker Lim Guan Eng as finance minister — the first Chinese-Malaysian to hold that post in more than 40 years.

Last week saw the pace of housecleaning pick up, with influential figures such as Muhammad Ibrahim, the governor of Bank Negara Malaysia, and Shazalli Ramly, the head of key government-linked company Telekom Malaysia, stepping down.

The central bank governor quit amid allegations that Bank Negara Malaysia had participated in a land deal aimed at bolstering the balance sheet of 1Malaysia Development Bhd., the sovereign wealth fund launched a decade ago by ousted Prime Minister Najib that ultimately played an outsized role in his — and UMNO's — demise. The U.S. Justice Department had all but accused Mr. Najib of involvement in the misappropriation of $4.5 billion in 1MDB money.

While much remains uncertain, some managers say they're ready to boost allocations to the country — especially to Malaysian government debt, which has a roughly 6% weighting in global local currency emerging market debt indexes.

BNP Paribas Asset Management was overweight Malaysian local currency debt in 2017 but adopted a neutral weighting heading into the election, Mr. Sambor said. Now the firm's $3.8 billion emerging markets debt business is inclined to "take some risk on Malaysia again," he said.

Meanwhile, if the appointments of ethnic Indian- and Chinese-Malaysians to key Cabinet posts amount to a deliberate policy shift by Prime Minister Mahathir, as opposed to the one-off instance of expediency some observers fear, that could eventually have an outsized positive impact on the country's long-term growth trajectory.

During his previous 22-year run as prime minister, Mr. Mahathir had extended the system of preferences for the country's Malay majority.

While welcoming the prime minister's moves so far, a number of Malaysian expatriates living in Hong Kong and Singapore said they'll be hard to convince.

"I left because I didn't want my kids to feel like … second-class citizens," said the ethnic Chinese-Malaysian trader in Singapore with a U.S. bank.

The new government is off to a good start, but the pillars of Malaysia's race-based society remain in place, he said. Still, if the government continues "to follow down this road, in six months, I might change my tune," he said.