Indonesian Strategy:Inconvenient truths for 2016

Event

We review our market outlook for 2016, and maintain our underweight stanceand 3.6–4.2k JCI index valuation. Although we are less pessimistic on the JCIoutlook than we were in early 2015, on account of lower valuations, wecontinue to believe the market to be overvalued; profitability and growthexpectations too high; and the JCI’s risk/reward balance unfavourable.

In particular, a significant recent lift in expectations for 2016, centred aroundrecovering growth, reform, and an upcoming BI easing cycle, make usespecially uncomfortable, because this bullish narrative ignores a number of‘inconvenient truths’ which suggest the outlook moving into 2016 may actuallybe deteriorating. We conclude that risks are skewed towards further earningsand economic disappointments in 2016. In addition, external risks are growingand we believe the JCI offers investors little to no risk premium.

Impact

A false paradigm: We believe pundits’ increasingly bullish outlooks for 2016continue to place excessive focus on domestic factors (e.g. government policytargets) to the neglect of important cyclical and external factors, whichcontinue to deteriorate. This domestic orientation – and especially theunderestimation of the importance of commodity prices to Indonesia’s outlook– has been a key reason why Indonesia’s recent slowdown was not foreseen.

We highlight that Indonesia in fact heads into 2016 facing a deepeningcommodity downturn; an increasingly uncertain liquidity outlook; slowinginvestment and FDI; and a fiscal deficit perilously close to breaching the 3%constitutionally-mandated deficit cap. This latter factor introduces a significantbut much under-discussed risk of contractionary fiscal policy being forced.

Policy is improving, but too slowly: We discuss that while the direction ofpolicy has indeed improved, gains so far have been merely incremental ratherthan transformative. In the long run (10yrs), they could add up to somethingmaterial, but we feel too much faith is being placed in policy driving a swiftturnaround. If the economy weakens in 2016, confidence will likely falter.

What to buy? Valuations in general remain too high in our view, renderingstock picking challenging. Indonesia’s big-4 banks are now reasonably priced,and amongst the cheapest in Indonesia’s large cap space, but are tacticallyrisky. We recommend trading them (adding on weakness; trimming on rallies).

Telcos (TLKM, ISAT) also continue to offer a solid mix of defensive attributesand improving bottom-up industry D/S fundamentals, while commodity stocksare already cheap (but are facing a very challenging medium-term outlook).

Outside of these areas, stocks appear much too optimistically priced to us.

We would avoid domestic cyclicals (cement, construction, poultry, media), aswell as staples and retail, with the exceptions of ACES and INDF.

Outlook

Indonesia is moving into 2016 with relatively high valuations and expectations,whereas the outlook is arguably deteriorating. High expectations in the face ofdeteriorating realities is generally a recipe for underperformance. 2015 wasmostly an ‘earning story’, with corporate profitability collapsing but earningsmultiples remaining resilient (or even rising) on the expectation that weakerROEs are merely temporary. We do not believe they will be, and as thatreality sinks in, it is quite possible 2016 will prove to be a ‘multiple story’.