By Yantoultra Ngui and Jongwoo Cheon
KUALA LUMPUR/SINGAPORE (Reuters) - Malaysian stocks surged nearly 8 percent to a record high and the local currency jumped to its strongest in 20 months on Monday after the Barisan National (BN) coalition extended its 56-year rule and fended off a strong opposition challenge that had unnerved investors.
Prime Minister Najib Razak's BN won 133 seats in the 222-member parliament, well short of the two-thirds majority it lost in 2008.
Opposition leader Anwar Ibrahim People's Alliance won 89 seats, up seven from the 2008 election but still well short of unseating one of the world's longest-serving governments.
Investors cheered the prospect of policy continuity in Southeast Asia's third-largest economy. Economists predicted a swift move to rein in spending after populist pre-election giveaways, keeping the government on track to trim its deficit-to-GDP ratio to 3 percent by 2015 from 4.5 percent last year.
"We are expecting a surge in buying activity led by foreign and local institutional investors who are attracted to our lagging market performance versus the regional peers and strong economic fundamentals," said David Ng, chief investment officer at Kuala Lumpur-based Hwang Investment Management Bhd.
The benchmark FTSE Bursa Malaysia KLCI Index rose 7.8 percent at one point to a lifetime high of 1,826.22, with stocks linked to the coalition and its favored tycoons gaining. It later pared gains and was up 3.1 percent by early afternoon.
Malaysian stocks have sharply underperformed other Southeast Asian markets so far this year due largely to concerns over political risk, with the benchmark index up only 0.3 percent as of Friday's close, compared with gains in the mid-teens in Thailand and Indonesia and around 25 percent in the Philippines.
Malaysia's second-largest lender by assets, CIMB Group Holdings Bhd, rose nearly 10 percent on Monday. Its chief executive, Nazir Razak, is the brother of Prime Minister Najib.
State-linked firms also rose, such as hospitals operator IHH Healthcare Bhd, up 3.5 percent, and oil and gas services firm SapuraKencana Petroleum, up 11.2 percent.
Australia's Lynas Corp Ltd, which is building in Malaysia the world's largest rare earths plant outside China, jumped as much as 18 percent.
"There was a concern that the opposition would move fairly quickly against Lynas giving that there were a number of groups actively protesting against the plant," said Michael McCarthy, chief market strategist at CMC Markets in Sydney.
The ringgit jumped 2.2 percent to 2.9665 per dollar by around midday. If the ringgit maintains those offshore fund-fueled gains, it would be the largest daily percentage appreciation since May 2010, according to Thomson Reuters data.
Some strategists, however, expressed caution over the prospect of future volatility if Najib's position comes under pressure. Ruling party sources said Najib could resign by year-end, after his coalition haemorrhaged Chinese and Malay voters in its worst-ever general election performance.
"We could see Najib step down by the end of this year," said a senior official in the dominant United Malays National Organisation (UMNO), which leads the coalition, speaking on condition of anonymity.
Former Prime Minister Mahathir Mohamad, still a powerful figure in UMNO, told Reuters last year that Najib must improve on the 140 seats won in 2008 or his position would be unstable.
BONDS POISED FOR RALLY
Bank of America Merrill Lynch analysts expect the government to focus on fiscal consolidation and expect cuts to fuel subsidies in the second half and a consumption tax next year.
Economists at HSBC said an eradiction in fuel subsidies this year could add an extra 0.5 percentage point to inflation, but that this would still be within Bank Negara Malaysia's 2-3 percent comfort range.
"However, along with other factors including a robust economic backdrop and elevated household debt, we believe this will be enough to prompt the central bank to normalize policy rates by 50 bps later this year, to 3.50% by the year-end."
It predicted a 10-15 basis point (bps) rally in Malaysian bonds, led by longer-dated issues.
On Monday, 10-year bond prices rose and yields fell to 3.363 percent, their lowest since July 25 last year, from Friday's 3.376 percent. Five-year yields slid to 3.135 percent from 3.158 percent. Three-year yields slipped to 2.921 percent from 2.933 percent.
As investors returned to the market, the cost of insuring Malaysian corporate and sovereign bonds against non-payment dropped, according to credit-default swap (CDS) traders.
Malaysia 5-year CDS were indicated about 8 bps tighter at 75 bps in the morning.
There are no liquid cash sovereign bonds, but investors are playing out their views through recent debt from quasi-sovereigns.
Petronas 2022s were at 102/97 basis points over U.S. Treasuries, about 4 bps tigher, and Export-Import Bank of Malaysia bonds due 2017 were at 106/101 bps, about 5 bps tighter.
Ahead of the elections, foreigners were increasing their holdings of Malaysian government debt.
They reversed some of the $3.5 billion outflows in February with inflows of $2.39 billion in March.
April data is not available but analysts say there was no major swing in either direction in that month. Foreign ownership of Malaysian government debt stands at 30.9 percent, up from 26.3 percent at the beginning of 2012.
(Additional reporting by Sonali Desai and Umesh Desai; Editing by Jason Szep & Kim Coghill)