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Rough diamond or polished gem?

Indonesia has been a stellar performer among Asian markets over recent years, writes Bee-Lin Ang. But it has a history of volatility, and it could be about to deliver another dose

The Indonesian stock market has been flirting with its all-time highs around 4,350 since October 2012. Its economy, supported by strong domestic consumption, has defied the global market turmoil to post growth above 6% annualised for the last eight quarters. A growing middle class has sent car sales soaring at double-digit rates and boosted the shares of cement companies amid a real estate boom. However, as the 2014 election looms in a country with a history of social upheaval – and where almost half the population still lives on under $2 (€1.54) a day – will Indonesia be able to maintain its resilience?

“I think the idiosyncratic risks associated with the Indonesian elections are much higher than the general risks associated with weak global growth and the uncertainties with respect to the US and Europe,” says Kenneth Akintewe, a bond portfolio manager at Aberdeen Asset Management. “Moving forward, existing investors should be asking what exposure they already have and whether it makes sense to [continue] running that kind of exposure.”

President Susilo Bambang Yudhoyono is constitutionally barred from running for a third term. “After 10 years of relative stability under President Yudhoyono, the country will have to find a good successor,” says Maarten-Jan Bakkum, global emerging market equity strategist at ING Investment Management. “At this stage, there is no clear candidate.”
Will a change in government result in the continuity of the existing policies, or lead to changes that will cause instability in the investment environment? Despite Indonesia’s robust economic growth, issues that remain unresolved include the government’s disproportionately high spending on energy subsidies, its outdated infrastructure, corruption and confusing regulations.

Yudhoyono handily won presidential elections in 2004 and 2009 on a platform of zero tolerance for corruption. He has pledged to build more highways, airports and ports to help meet an average annual growth target of 6.6% by the end of his second term in 2014.
Under his government, Indonesia’s growth has outperformed every major Asian economy, except for China’s, as strong domestic consumption, which accounts for over half of the country’s GDP, helped to offset weaker exports of coal and palm oil.

Businesses have warned that the government will probably opt for more populist policies ahead of the 2014 elections and, as such, Yudhoyono is unlikely to push for major reforms.
A concern among investors is the country’s misaligned spending on infrastructure and fuel subsidies. Indonesia’s level of spending on infrastructure, at under 5% of GDP, is half that of neighbouring Vietnam, a considerably smaller country.

“It makes a good macro story but, with regard to the so-called infrastructure deficit, there is
still a big shortfall and that is where the picture starts to get a little bit less positive,” says Akintewe.

Indonesia’s spending on fuel subsidies averages about 2.5% of GDP, or 15% of the government budget. The budget assumes an average oil price of $80/bbl. As the elections nears, Yudhoyono is likely to tread cautiously, with fuel subsidies remaining highly popular. Higher fuel subsidies will raise government debt, which might sour investor sentiment – and about 30% of government debt is held by foreigners.

“While it is still one of the higher-yielding bond markets, we would be arguing that you probably want to start taking some defensive positions,” said Akintewe. “Maybe, try running the risks with less duration.”

Bakkum at ING Asset Management says that while growth prospects remain good, the outlook for the equity market isn’t as positive.

“For the long term, Indonesia remains one of the most interesting emerging markets, but in the coming 12 months we think the market might have difficulties performing well,” he says. “A widening current-account deficit needs to be financed with speculative capital that might not always be easy to attract. Also, corporate earnings growth relative to the global emerging markets average is less solid than before, which will make it more difficult for the Indonesian market to justify its high valuation levels.”

James Thom, Akintewe’s colleague in Asian equities at Aberdeen, agrees. “You have to be selective and try to find companies that are going to benefit from the growth story but aren’t overpriced,” he says. “We feel it is a stock-pickers market. The challenge is to find good-quality, well-run, trustworthy companies that have sufficient liquidity. In Indonesia there aren’t too many choices.”

The P/E and P/B ratios for the Jakarta Composite index has risen close to its 2007 peak of 16.6 times and 3.8 times respectively.

Meanwhile, the county’s exports, 47% of GDP, continue to fall as growth slows in its largest markets of Japan, China and the US. The biggest concern is weak commodity prices, which have been falling because of a slowdown in China.

The financial sector has the biggest weighting on the Indonesian stock market at 30%. The market capitalisation of consumer goods companies makes up 26% of the benchmark index; industrials, 11%; materials 10%; and telecoms, 8%. To gain exposure to Indonesia’s strong domestic consumption and real estate growth, Aberdeen is invested in Unilever Indonesia and cement producer Indocement Tunggal Prakarsa. Among holdings in financial companies are Bank OCBC NISP and Bank Permata. Aberdeen also owns shares in energy companies Perusahaan Gas Negara and AKR Corporindo.

“A large part of the banking sector is still government controlled, or government owned, but there are a couple of private-sector banks which we like and they are a sort of proxy for GDP,” says Thom. “Household consumption and infrastructure investment are the key themes where growth is likely to remain solid in the coming years,” adds Bakkum at ING IM.

While the elections are likely to bring about investor uncertainty, it is worth noting that the Indonesian stock market has historically been volatile, and the threat of instability is nothing new. During the Asian financial crisis in 1998 the Jakarta Composite index dropped 35.5% before staging an impressive comeback the next year, rising 95.1%. In 2000 it fell again by 51.6%, and then rose 68.2% in 2003. The ride can be exciting – but is there any market that better captures the essence of the still-unfolding Asian growth story?

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