Indonesia Market Outlook Indonesia: A place to hide? (update1) - BNP Paribas

ƒ Supported by strong fundamentals, Indonesia outperforms YTD
ƒ Indonesia more resilient to external headwinds given domestic focus
ƒ There are pressure points, but look to be manageable at this point
ƒ Good opportunity to BUY banks, consumers and cement

Supported by strong fundamentals, Indonesia has outperformed YTD. After surviving the first half of the year relatively unscathed from the continued escalation of the European debt crisis, the market finally caved in on US growth scare and the US sovereign downgrade. The market has lost about 6.6% in the past two trading sessions.

While the market could remain volatile for a while longer, it is worth pointing out that the economy remained resilient during the recent global financial crisis, having delivered GDP growth of 4.5% in 2009, while earnings growth was relatively robust at 13.2%. This time around too, we expect the economy and the stock market to be able to weather the onslaught of external factors.

The pressure points for the economy and the market, in our view, will come from: 1) a potential reversal in funds inflow, 2) current account potentially turning negative if the slowdown in exports due to weak demand is not matched by a slowdown in imports, especially capital goods, and 3) lower commodities prices could result in earnings downgrades for commodity stocks, which account for 20% of total market cap.

There are mitigating factors at play as well. For example, the relatively insulated economy due to less dependency on exports resulted in the country being more resilient to global demand shocks. In addition, lower commodity prices are not necessarily bad for the economy as lower oil price will also reduce the burden of fuel subsidy in the government budget.

The recent correction has resulted in valuations retreating to more reasonable levels. The Indonesian market is trading at 13.5x our 2012 earnings estimates, around 1 standard deviation from the mean. We believe this is justified to reflect the tremendous progress that Indonesia has made. As we are likely to enter into turbulent times when external factors are likely to be the main driver of the market, we maintain our stance since the beginning of the year that it is better to focus investments on the domestic sectors such as banks, consumers and cement and to stay away from the commodity sector.

What are the pressure points from US sovereign downgrade?
Indonesia's excellent performance YTD has been driven by the fact that it is partly seen as a "safe haven" for investments. Structurally, stronger economic undamentals which have been proved to be resilient in the recent global financial crisis are seen as a good bet given the uncertainties in the US, Japan and Europe.

The recent US downgrade by S&P will probably not affect Indonesia much from an economic standpoint, as Indonesia is basically a domestic-driven economy. Thus, the country is less dependent on exports than its peers in the region. The downgrade could further weaken the USD, but the pressure points could come from the following factors:
1. A reversal of funds inflow
Year to July, Indonesia recorded an inflow of USD2.7 b vs. only USD2.4b in 2010. If risk aversion increases and if Indonesia is seen as a riskier market despite its solid fundamentals due to the lack of depth and breadth, this might trigger funds outflow. However, investors still remember that this is what happened during the global financial crisis and despite the sharp correction, the market rebounded strongly and subsequently touched new highs

2. Current account turning negative
This could be the case if the domestic economy continues to grow at a fast pace, driving imports (especially for capital goods partly due to strong FDI), while exports would not grow as fast due to global uncertainties undermining demand. If the current account turns negative, it could undermine the balance of payment (BOP), especially in the event that the FDI levels off. This could eventually hit the IDR. However, given the tendency of a stronger IDR as a result of the US sovereign downgrade, this risk could be mitigated.

3. Weaker commodity prices
Around 50% of Indonesia's exports are commodity-related: oil and gas, vegetable oils and crude materials. The weak economies in the US, Europe and Japan are likely to reduce demand for commodities. Add to that the fact that a stronger IDR is generally unfavourable for commodities, this could result in lower earnings for commodity companies, which account for around 20% of Indonesia’s total market cap. We believe this can be partly offset by earnings upgrade from domestic companies whose raw materials are commodity-based (hence USD-linked), so the potential impact may not be as bad.