Indonesia Inflation: "Lucky" Scenario Becomes Base Case For 2011 (update1) - Morgan Satnley

Our economist put out a note this morning changing her call on Indonesia inflation and policy rate outlook. She thinks the inflation peak in 2011 is now behind us and she is delaying her expectation of policy rate normalisation till 2012. On the back of this, our ASEAN Strategist, Hozefa Topiwalla, has removed his tactical caution on the Indonesia mkt. He now recommends investors to play the domestic structural growth stories (O/W Financials, Consumer Discretionary and Industrials). Our ASEAN Banks' analyst, Nick Lord, upgraded the bank sector view to attractive and initiated on Bank Mandiri (O/W) & Bank Negara Indonesia (E/W). Details and report attachments as follows.

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ASEAN MacroScope: Indonesian Inflation: "Lucky" Scenario Becomes Base Case for 2011

KEY SUMMARY:

Investment conclusion: We think Indonesian inflation peaked in 1Q11 and the worst of inflation fears for 2011 are likely behind the nation. We are revising our inflation forecasts, bringing down 2011 from 6.5% YoY to 5.9% but bumping up 2012 from 5.5% to 6.8%. We are also changing our policy rate forecasts for 2011 and 2012 from 7.5% and 7.0% to 6.75% and 7.75%. We now expect further policy rate normalization only in 2012.

Our inflation framework has not changed - but when facts change, our conclusions change: Indonesia's inflation is a tug of war between structural forces (downwards), cyclical factors (upwards) and idiosyncratic factors such as weather and retail fuel price policy (uncertain).

In an earlier report, we described a "lucky" scenario in which Indonesia may muddle through if food/oil prices ease. Both have happened, reducing idiosyncratic risks. On food, prices have fallen back to the levels where they would have been if weather disruptions have not happened in 2H10. This would pose a significant dampener on %YoY headline inflation when high base effects start kicking in in the next 3-6 months. Meanwhile, strong global growth and commodity supply shocks had been a bad combination for inflation in economies where domestic demand has been strong, like Indonesia. The current growth scare hence helps take some heat off Indonesia as commodity prices fall and reduce pressures on policymakers to hike retail fuel prices. Structural forces from currency stability as FX reserves cross the US$100bn milestone have also helped anchor inflation. We expect these factors to overwhelm demand-pull pressures in 2H11, keeping headline inflation below 6% before inflation reacceleration gathers pace in 2012.

Where we differ: Consensus is higher in inflation expectation for 2011 (6.4% YoY) and lower for 2012 (6.1%). Consensus expects more policy normalization towards late 3Q11 and 4Q11.

Key risks & where we could go wrong? Inflation risks are skewed to the upside from binary events like retail fuel price change. Commodity prices are the wild card. Key indicators to watch are oil price (US$140/bbl is an important level), refined oil trade deficit, credit growth and current account balance.