Macroeconomics (Radhika Rao)

Growth momentum

Indonesia registered a stronger than consensus growth in 2Q, taking 1H pace to 5.2%. Second quarter growth of 5.4%yoy benefited from a combination of reopening boost to demand, strong external trade performance alongside second derivative benefits of high commodities on consumption and a pick-up in service sector activity. This helped offset inflation headwinds and moderation in public spending. Headline growth (four quarter moving sum) has surpassed pre-pandemic levels, with household consumption also a shade higher.

Into 2H, even as headline growth might moderate below 5% on base effects, we expect the reopening of borders and resumption in international travel to boost employment as well as income levels. Monetary conditions also remain favourable, with loan growth set to improve to around 9-11%. Assuming commodity prices stay at elevated levels, Indonesia’s external trade performance should continue to benefit from higher volume and price effects as well as offset the increase in oil imports bill. In addition, the positive terms of trade position with commodities benefits parts of the country which are dominated by mining activity, including West Sumatra, West Kalimantan, Sulawesi etc. World Bank studies show that the past commodity driven trade upcycles have benefited household consumption significantly. As a counter, , as domestic demand gains ground in the tail-end of the year, imports growth will catch momentum. This year’s growth range is likely to fall within 4.8-5%yoy.

Inflation, a bugbear

Jan-Jul22 inflation has averaged 3.3%yoy vs 1.6% in 2021. In particular, July CPI inflation quickened to a five year high of 4.9%yoy, from 3.7% in May and 4.3% in June. Food inflation was the largest contributor, on higher flour, chillies, beef, oil, etc., accounting for more than half of the increase in the headline. Transportation and higher utilities were the other two contributors.

Core inflation also quickened to 2.9%, closing in on the 3% mark and highest since March 2020. While food prices are buoyant, the pass through of higher global energy prices onto domestic prices is incomplete due to fuel and electricity subsidies.

Rising global energy prices had spurred calls for a rationalization in subsidies and reduction in price controls, but wariness over piling additional pressure on consumers’ purchasing power and to limit inflationary concerns, energy subsidies were raised by 56% for 2022. Restrictions were also imposed temporarily (ban on palm oil exports) to tame domestic cooking oil prices. Inflation will be a key factor this year as pressure to pass on elevated input prices, adjustments in non-subsidised fuel variants, food and tax increase underpin the headline and demand restoration points to risks of generalised inflation. We forecast 2022 average inflation at 4%yoy and 2.7% in 2023.

Bank Indonesia to normalise rates, albeit gradually

Bank Indonesia has stayed out of the region’s hawkish camp. Domestic policy rates have been kept steady since 1Q21, through US Federal Reserve’s aggressive rate hikes this year. Moves to normalise policy has been dominated by liquidity management steps, demonstrated by incremental hikes in the reserve requirement ratio to 9% by September. Between March and mid-July, adjustments to rupiah reserve requirements and incentives have absorbed ~IDR 219trn of liquidity in the banking industry. Cash conditions are, however, still flush supporting credit growth.

Concurrently, the BI has also begun to sell part of its bond holdings (first tranche IDR 390bn), leaning towards 5y and less tenors in the start. As of mid-July, BI held IDR 824.5trn worth of bonds, excluding those used in banks’ monetary operations. At the July review, BI flagged the uncertain global backdrop and an aggressive US Fed, but signs of an impending shift in policy direction were largely absent.

In our view, the central bank’s decision to sit out of the hawkish camp is premised on -

a) a higher subsidy budget which is helping to contain inflation pressures, thereby providing more headroom to BI to remain in sync with a growth-supportive fiscal policy;
b) despite rupiah’s recent depreciation, on year-to-date basis the currency is amongst the regional outperformers owing to the commodity windfall. Our DBS Equilibrium Exchange Rate (DEER model) projects the rupiah to be slightly overvalued in our latest update, questioning the need for tightening rates;
c) Terms-of-trade benefits will counter risks of any deterioration in the external balance;
d) US-Indonesia rate differentials have narrowed but the share of rate sensitive flows in the bond market has fallen vs the last tightening cycle (from 38-39% of outstanding bonds to 16%).

Heading into 2H, signs of buoyancy in core inflation (headed above 3%) as well as the need to preserve financial market stability (rupiah) is expected to see the central bank gradually tighten policy from late-3Q onwards. We see the room for 75bp hikes. There is a small probability that resilient commodity prices and contained market volatility provides the headroom for policymakers to stay on extended pause. This, however, might leave IDR assets vulnerable to any sharp swings in market sentiments, given much narrower differentials with the US.

Macro stability will be paramount

The economy’s fiscal books registered a surplus of 0.57% of GDP in Jan-Jul22 compared to full-year budgeted target of -4.85%. Total revenues stood at a little over a third of state budget by Jul22, whilst expenditure lagged. Revenues (21% yoy) benefited from economic reopening, corporate taxes (boosted by processing industry), strong non-tax collections comprising of resource-based earnings, and implementation of the Harmonised Tax Law (HPP) i.e., VAT increase, crypto tax etc. Spending disbursements were slower due to lag in ministerial spending, whilst allocations towards subsidies and social assistance programs increased to shield the populace’s real purchasing power. This revenue-spending mix backs the government’s conviction that the 2022 fiscal deficit could narrow sharply to -3.9% of GDP (IDR 732.2trn) vs earlier indication of -4.5% and budgeted -4.85%. This effectively signals that this year’s financing needs might be lower than the projected IDR 991.3trn worth of borrowings. We see room for fiscal outperformance despite higher subsidy outlays, expecting deficit to be closer to -3.7%.

Banking on terms-of-trade benefits from higher commodity prices, and post pandemic boost, the 2023 fiscal deficit path is geared to return to sub-3% of GDP path. The mandate of Law No. 2/2020 on state fiscal policy and system stability was to provide the government the temporary provision of exceeding the budget deficit cap of -3.0% of GDP for a maximum of three years, due to the pandemic. In line with this provision, 2023 deficit has been pegged at -2.61-2.85% of GDP vs -4.85% in 2022. The underlying math assumes:

• 2023 deficit at IDR 528trn-IDR 585trn (-30% yoy)
• State revenues IDR 2267trn to 2399trn (11.2% to 12.2% of GDP)
• State spending IDR 2795trn to IDR 3096trn (13.8-15.1% of GDP)
• Around IDR 27trn to 30trn is likely to be allocated towards the new capital

Notably, there will be savings in 2023 as pandemic-led stimulus measures are unwound next year and new taxes are considered. In addition, public debt peaked at around 40.7% of GDP and is likely to moderate to 38-39% this year.

External trade account is resilient due to a strongly supportive goods trade surplus. We expect the full year balance to turn in a modest 0.2% of GDP surplus, a second consecutive year of surplus. This balance is likely to tip over to a small deficit next year, assuming commodity price stabilise and a jumpstart in the demand as well as investment cycle pushes up imports. At the same time, the economy has not been spared by capital outflows that has impacted most of the regional peers. Debt markets have witnessed steady outflows, whilst equity interests had proved to be more resilient except the past couple of months. Notwithstanding steady FDI, the financial account has been in deficit, weighing on the aggregate balance of payments balance.

Stepped up currency defence and external debt repayments saw foreign reserves moderate to $132bn by end-July 2022, but import coverage stays comfortable above 6months. On most macro stability metrics, the economy continues to fare well this year, with a strong trade account providing an important tailwind. The trajectory of commodity prices, slowdown risks in the US/ Europe and US dollar direction will be key determinants for the emerging markets’ price action in 2H22.

Markets outlook – currency and rates

IDR has been resilient to a stronger USD and held its post-Covid range of 13900-15000 per USD. On year-to-date basis, the currency is amongst the better performers in the region, reflecting the robust external trade account. Contingent on commodity prices, our FX Strategist expect USDIDR to pullback in 2H, due to our call for the broader USD index to stabilise in 2H after a sharp rally on policy differentials in first half of the year.

On rates, we prefer to maintain a neutral stance on Indonesia bonds as duration returns could be challenging for some time, at least until BI is more advanced along its hike cycle. Indonesia bonds' nominal yield differentials vs the US and Asia are low relative to historical ranges and could adjust wider if the global risk environment remains cautious and global liquidity maintains its tightening trend.

Risks

A key risk to the outlook is the direction of global commodity prices. If prices of base metals, coal, nickel palm oil etc. correctly sharply from prevailing levels, this could threaten the stability in external trade. On the other hand, a sharp rally whilst positive for trade/ current account, could pose inflationary concerns, testing the authorities resolve to maintain subsidies. This might trigger volatility in the domestic financial markets, particularly for the currency.  

Equity outlook (Maynard Arif)

Improving sentiment post Fed rate hike in July

The US rate hike seems to have peaked in July and market expects the Fed to slow down the pace of the hike. This has lifted the sentiment on Indonesia market (since the late July 2022) and provides some support for JCI index to stay around the 7,000 level in the near term.

Earnings growth outlook still intact

We remain positive on the earnings growth outlook for Indonesia. 2Q22 earnings results in general have been good although some sectors did not do well. We see the potential for some upward revisions on the 2022 earnings growth outlook once all corporates reported the 2Q results. In particular, the banking and commodity related sectors are expected to continue to deliver solid results in 2H22.

Some headwinds in 2H

While we remain positive on the growth outlook for Indonesia, the key question is whether the Indonesian equity market can continue to outperform in 2H22. From a regional perspective, we are more neutral on JCI given the solid performance in 1H22 and the valuation relative to regional markets despite better growth prospects.

While the Fed has been raising rates aggressively, BI has kept to its rates since pre-pandemic level. Therefore, the real interest rate and the rate differentials between Indonesia and the US rates became a factor that could hold back the market from moving higher. In addition, currency stability is another factor for foreign flow to return to Indonesia.

Furthermore, commodity price trend is a potential risk on the sentiment toward Indonesia market in 2H22.

2022 JCI target - 7,500

We maintain our 2022 year-end JCI index target of 7,500, pegged to +1.5SD of 10-year mean blended forward PE or c.16.2x. With the recent rally, our target represented less than 10%. We believe investors are better off to wait for a market pullback to buy Indonesia market.

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