Why investors are snubbing Malaysian 'bargains'

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Malaysia's stocks and currency have tumbled but bargain buyers don't appear likely to step up any time soon as foreign investors remain leery, analysts said.

"Our economists are constructive on Malaysia's medium-term prospects," Khoon Goh, senior foreign-exchange strategist at ANZ, said in a note Wednesday. "Unfortunately, the fundamentals are being overshadowed by domestic political developments that have soured sentiment towards Malaysian assets."

Read More Malaysia's ringgit takes a wild ride

Amid calls for his resignation, embattled Prime Minister Najib Razak shuffled his cabinet in July, sacking his deputy after he called on Najib to explain the controversy surrounding a Wall Street Journal (WSJ) report that nearly $700 million from heavily indebted quasi-sovereign wealth fund One Malaysia Development Bhd. (1MDB) was deposited into the prime minister's personal bank accounts.

Najib has denied accepting money for personal gain and is reportedly considering a defamation lawsuit against the WSJ. On Monday, Malaysia's anti-corruption commission said the funds in Najib's private accounts were a "contribution" from a Middle East donor unconnected to 1MDB; it said the donor's identity couldn't be disclosed.

Malaysia began seeing large portfolio outflows in September as prices of oil, which accounts for around 16 percent of gross domestic product, started to slide, with the equity market seeing around 14 straight weeks of foreign outflows, Goh said. In total since September, around $18 billion has exited, larger than during the 2013 taper tantrum, Goh said. He also cited a risk that the bond market could face outflows as foreign investors hold around 50 percent of Malaysian government securities.

The greenback was fetching 3.8761 ringgit in early trade Thursday, with the Malaysian currency hovering around its weakest levels since 1998, during the Asian Financial Crisis (AFC), making it among the world's worst performing after falling nearly 11 percent so far this year. At its weakest during the AFC, the greenback was buying as much as 4.7650 ringgit. The KLCI is down around 7.6 percent from its peak in April.

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"Despite the currency being undervalued, we struggle to see how sentiment towards ringgit will improve in the near-term," Goh said. "The risk is that the ringgit continues to depreciate, particularly if oil prices remain under pressure and weak sentiment starts to impact on the real economy." He cut his end-year forecast for the ringgit, expecting the U.S. dollar will fetch 3.95 ringgit, compared with the previous 3.82 ringgit forecast.

Stocks and bonds may not be the only place Malaysia could see a sentiment pinch.

Foreign direct investment (FDI) into the country dropped 11 percent in 2014, while on a net basis, outflows exceeded inflows, ANZ said in a separate report, citing U.N. Conference on Trade and Development data. In the first quarter of this year, the country saw around 9.9 billion ringgit ($2.55 billion) in FDI inflows, up from 7.21 billion ringgit in the first quarter of last year, according to a Malaysian media report. That was outpaced by around 11.12 billion ringgit in Malaysian investment abroad over the quarter, the report said.

ANZ isn't alone in expecting Malaysian assets to remain a tough sell.

"We believe political risks will continue to drive the market in the near term," Nomura said in a note Wednesday after investor meetings in the country's capital, Kuala Lumpur. Despite the investors' citing no major concerns about systemic risks, Nomura noted that foreign ownership levels of equities are less than 20 percent of the total, a multi-year low and the lowest of several regional peers.

Nomura expects Najib will keep his position and policy direction will remain unchanged. "This should mean that the uncertainty levels, even though they may rise further from here, will eventually fall in the coming months," it said. "The weak sentiment, though, is likely to persist, we believe, as the eroded trust will take a long time to rebuild (if at all)."

Nomura doesn't appear to expect the ringgit to rise any time soon, suggesting getting equity exposure to beneficiaries of a weaker currency, such as banks and condom maker Karex. But overall, Nomura has a neutral call on the Malaysian market.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1