Conclusion: We’ve taken advantage of the opportunity presented via lower prices to invest in a great long-term idea.
Late yesterday afternoon, we initiated a long position in Indonesian equities in the Hedgeye Virtual Portfolio. We’ve been bullish on Indonesian equities since 3Q10 and we continue to expect the steady performance out of the Indonesian economy that we have come to know over the last few quarters. And with the world’s fourth-largest population and strong demographic tailwind (Indonesia’s labor force is set to expand +20% over the next 20 years), Indonesia’s bullish long-term TAIL story remains intact. As such, we’ve taken advantage of the opportunity presented via lower prices to invest in a great long-term idea.
Much like the Philippines, which we are also long of on the equity front in the V.P., Indonesia draws our admiration for being a relatively defensive play amid an uncertain at best Global Macro backdrop.
Indonesian economic growth is stable: real GDP growth came in flat in 2Q at +6.5% YoY and our models point to a flat-to-slightly-down outlook for 2H (vs. “down-to-down-a lot” in many other major economies). Though an absolute acceleration in GDP remains the most supportive catalyst in our models, we also like countries where economic growth is accelerating on a relative basis to vs. the rest of the world. Indonesia certainly fits the latter of those setups quite well:
Though up marginally in August, consumer price inflation has slowed to +4.8% YoY, coming in from the January peak of +7% YoY:
Core inflation, which has accelerated to a 26-month high of + 5.2% YoY in Aug, remains a key concern. Coupled with a our model’s outlook for Indonesian headline inflation (marginally higher over the next two months), we think Bank Indonesia will be forced to maintain rates on hold and perhaps introduce a hawkish lean in their statement – depending on the absolute level of inflation. Still, even adopting our model’s most inflationary estimates would leave CPI well within the central bank’s target of 5% +/- 100bps – meaning that we’re unlikely to see any tightening over the intermediate term.
For reference, Bank Indonesia’s Reference rate (currently at 6.75%) has been on hold since February; moreover, their recent commentary suggests they are perhaps more concerned about the [global] risks to Indonesian economic growth than a measured and sustained pickup in inflation:
“Bank Indonesia has room to cut its benchmark rate if inflation behaves.” – Hartadi Sarwono, Bank Indonesia Deputy Governor
“Policymakers are ready to adjust the rate and mix monetary policy toward loosening if price gains slow and the economy expands less than expected due to a global slowdown.” – Perry Warjiyo, Bank Indonesia Director of Economic Research
In addition to having an ace in the hole on the monetary policy front, Indonesia’s fiscal positioning also remains supportive should it become necessary. With a small and improving deficit/GDP ratio of -2.1% and a incredibly healthy debt/GDP ratio of 26.9%, Indonesia isn’t in a box as it relates to being able stimulate its economy should it become necessary as a function of the global growth outlook deteriorating further. Though we’re certainly not ever going to be labeled proponents of Keynesian “countercyclical” policy, even us football and hockey players can recognize the profound effects “stimulus” has on stock markets.
One key risk we see to holding Indonesian [and other emerging market] equities, is on the currency front. Should Bank Indonesia make due on their promise to “loosen” monetary policy, we could see the rupiah come under continued pressure vs. the USD (down -2.5% over the last five trading days alone). To that effect, the central bank intervened yesterday in the country’s FX and bond markets to stop the bleeding, so to speak. The meaningful backup in Indonesia’s sovereign debt yields (2yr up +47bps wk/wk; 10yr up +59bps wk/wk; and 30yr +27bps wk/wk) isn’t a result of renewed inflation/tightening speculation (1yr on-shore interest rate swaps down -90bps wk/wk). Rather, we view it as foreign investors exiting the market en masse, as both Indonesia’s equity and bond markets are subject to a great deal of Winner’s Risk as a result of their outperformance over the last year.
A hockey stick in the country’s external debt burden also remains a risk to the currency – particularly if Indonesian corporations are forced to buy USD/EUR/JPY by selling the IDR to meet debt service requirements. External debt growth, both on a public and private level, has accelerated to roughly +22% YoY and each segment is growing at the highest rate on record, which dates back to 2004:
As it currently stands we don’t see a re-do of the ’97 Asian Financial Crisis, but if the Indonesian equity market blows through its long-term TAIL of support (less than 1% below), we’d argue that the risk of a larger-scale external debt crisis is definitely in play. Still, our positioning indicates that we have confidence that this critical quantitative line will hold and, as such, we have chosen to go long the IDX in our Virtual Portfolio.