Indonesia Strategy:Basking in the commodity after-glow

Event

    We are downgrading our market strategy call to Neutral from Overweightgiven i) peaking commodity prices in 1Q17 with key export price momentumset to become a headwind in 2H17, ii) recent domestic political events whichhave effectively brought forward the Central Gov’t political cycle from 2018/19to 2017 and increasing uncertainty probably affecting investment andiii) market outperformance ytd with the JCI already trading close to the 5,700index target we set for FY17 and at an elevated 16.2x consensus P/E.

    Impact

    Commodities rolling over. Our regional strategists’ view and recent Chinamacro releases indicate the reflation effects driving commodity prices peakedin Mar 2017. Commodity forward curves suggest momentum on prices forIndonesia’s key exports will become a headwind in 2H17. Corporate earnings,led by commodity sectors, have already started to capture higher commodityprices and are on track to reach our FY17e 14% aggregate EPS growthtarget. Outside direct commodity producers in CPO and Coal, mid-high retailsales has also reflected an early part of the multiplier effect.

    Gov’t spending the next leg into 2H17... The next leg we predict is a recoveryin public sector spending in 2H17 as tax revenue flows through from corporates.

    Our model projects Gov’t spending to expand +7.7% for April-Dec 17(or +6.6% for FY17e on a full year basis) up on +2.3% in 1Q17. Regionalconsumption and companies levered to Gov’t budget spend (contractors)typically benefit in that type of environment.

    ...but a pickup in private sector investment seems unlikely. For thecommodity cycle to lead to a higher growth path of 5.0-5.2% in Indonesia,there has to be a pickup in private business investment. The negativedistraction of domestic politics on reforms and sentiment, we expect, dampenchances of an investment upswing. A hiatus in reform efforts evidenced by nonew well-intentioned ‘stimulus’ packets for more than 7 months and the use ofhard-line Islamic elements in domestic politics present challenges toIndonesia’s PR efforts in attracting investment, in our view.

    Valuations are elevated. The JCI has done well already and is trading closeto the 5,700 Index target we set for FY17. Forward and trailing P/E are both1-std above their average since 2010 at 16.2x and 23.0x.

    Outlook

    We make three adjustments to our model portfolio removing property namesCTRA and BSDE and Nickel proxy INCO. The investment case for theproperty sector is incrementally challenged in our view given recent politicalevents. Macquarie’s commodities team downgraded Nickel on raw materialoversupply concerns cutting forecast prices by -15%/-9% in FY17e/FY18e.

    To capture the next leg of the cycle on public spend, we add 1 constructionand 1 cement name to the portfolio namely PTPP and INTP. PTPP isleveraged to a pickup on Gov’t spending, which we expect to improve in 2H17with the lowest FCF burn of the top 4 SOE contractors. INTP is Outperformrated on an anticipated recovery in Java-cement and capacity utilisation.