Indonesian Underperformance Likely To Continue

Indonesian assets have underperformed this year.  A weak economic outlook and disappointment with stalled economic reforms suggest that this underperformance will continue in H2. 

INTRODUCTION

Indonesian assets have underperformed this year. A weak economic outlook and disappointment with stalled economic reforms suggest that this underperformance will continue in H2. USD/IDR should continue to make new cycle highs along the way to the June 1998 high near of 16950.

POLITICAL OUTLOOK

President Joko Widodo (Jokowi) came into office with great fanfare and heightened expectations for economic reforms. But after almost a year in office, he has been unable to deliver significant reforms. Perhaps expectations were too high in the first place. With his political situation made more complicated by internal developments, it seems likely that Jokowi will soon reshuffle his cabinet. This should be greeted favorably by markets, since it will improve the countries governability and bring back hope that the Jokowi’s original agenda will be put back on track.

As a relative outsider, Jokowi has so far been unable to push his reform agenda through parliament. His party lacks a majority in the 560-seat lower house (DPR), and so he has had to recruit other parties for support on a case-by-case basis. Jokowi’s five-year term ends in 2019.

ECONOMIC OUTLOOK

High inflation has prevented Bank Indonesia from cutting rates recently. Its last move was a 25 bp cut to 7.5% in February. Since then, inflation has accelerated four straight months to 7.3% y/y in June, well above the 3-5% target range. Core inflation has remained stuck at 5% y/y for six straight months.

GDP rose only 4.7% y/y in Q1, the weakest rate since Q3 2009. The IMF sees 2015 and 2016 GDP growth at 5.0% and 5.5%, respectively. But with signs pointing to further slowing in Q2 and Q3, we think these forecasts may be too optimistic. Bank Indonesia would like to resume cutting rates, but cannot given current domestic and external conditions. Market consensus is for easing to resume in Q1 2016.

Jokowi was able to push through cuts in fuel subsidies early in his administration. The cuts were more palatable due to lower global oil prices, which helped minimize the hit to consumers. The government’s fuel subsidy costs fell as a result, and the budget gap is seen remaining close to -2% of GDP in both 2015 and 2016.

The external accounts remain in decent shape, with slower imports offsetting the plunge in exports. Imports have fallen more than exports, and so the trade balance has moved into surplus. The current account deficit should remain quite manageable at around -2.5% of GDP in both 2015 and 2016.

INVESTMENT OUTLOOK

USD/IDR just made a new high for the cycle near 13422, trading at levels not seen since 1998. Charts point to a test of the June 1998 high near 16950. Our EM FX model taps IDR to underperform within EM over the next three months. High inflation and a dovish central bank won’t help matters.

Indonesian stocks have underperformed within EM this year. MSCI Indonesia is -7.5% YTD, and compares to -2.0% YTD for MSCI EM. Our EM equity model taps Indonesia to underperform EM over the next three months. Foreign equity investment has been weak, totaling only $343 mln YTD. This compares to $7.3 bln YTD for India and $6.4 bln YTD for Korea.

Indonesian local currency government bonds have underperformed over the last three months. Its 10-year yield has risen 75 bp, one of the worst EM performers that also includes Peru (up 124 bp) and Czech Republic (up 73 bp). We think that the BI easing cycle ahead of a rising inflation environment has been a major factor behind this underperformance.

In June, foreigners held nearly 40% of total government bond issuance. This is up sharply from around 30% in Q3 2013 and only 20% at the start of 2010. This makes the nation quite vulnerable to shifts in market sentiment and investment flows.

On the other hand, we note that our own sovereign rating model now views Indonesia as a BBB/Baa2/BBB credit, up one notch from the previous quarter. With actual ratings at BB+/Baa3/BBB-, we see upgrade potential for the sovereign ratings.