Will Economic Fundamentals Support Further Stock Gains?

9 10 2007

The Jakarta Composite Index rose sharply in late September and early October. But is the recent stock market rally supported by strong economic fundamentals? And, looking forward, what are the prospects for the Indonesian economy?

Well firstly it should be remembered that the state of the Indonesian economy is very important in determining the sustainability of a stock market rally. This is because a strong economy will boost corporate profitability, thus increasing the value of those companies and therefore, in turn, leading to higher stock prices. Market speculation and trading based on rumors will, in contrast, only affect share price movements in the short to medium term.

To ascertain the overall current economic conditions, Danareksa Research Institute has developed a Coincident Economic Index (CEI) for Indonesia. The CEI is constructed using data on cement consumption, car sales, imports, real money supply, and retail sales. An increase in this index suggests improving economic conditions, and vice versa.

In the first two months of 2007 the CEI fell. This indicated that the economy was slowing. Yet since March 2007 the CEI has headed higher. Indeed, in the five months up to July 2007 the CEI has risen every time, suggesting that the economy is on a sound footing. Improving purchasing power has been one of the pillars underpinning brisker economic activity. Inflation, which had dented consumer purchasing power at the beginning of the year, started to come under control in the second quarter of 2007. More specifically, the price of rice – a staple foodstuff in Indonesia – has fallen steadily since March 2007. And by July/August, rice prices were at their lowest levels in 8 months, or significantly lower than in the first quarter of 2007. Note that rice prices have a significant impact on the people’s purchasing power since this foodstuff has a large weighting in consumers’ expenditures.

And looking ahead, inflation is likely to remain benign. Nonetheless, there will be some short-lasting pressures on inflation during the fasting month and also over Lebaran due to seasonality factors. Hence, the year-on-year inflation rate is expected to hover around 6.9 percent from September to November. Importantly, however, the long-term trend for Indonesian inflation is not likely to be altered. And the impact of Ramadan and Lebaran on inflation is likely to be completely gone by the end of December when inflation is expected to fall to 6.26 percent.

One of the main reasons for the expected fall in December’s inflation rate is that rice prices are not likely to increase as much as they did in December 2006. This year the government has imported rice of various qualities (including prime quality rice) in a bid to prevent a significant increase in rice prices at the end of the year.

Thus, with the prospect of relatively low inflationary pressures, consumer purchasing power shall not be eroded further. Moreover, the relatively low inflation shall also give room to the Indonesian central bank to cut its benchmark rate further in the near term. Nevertheless, the likelihood of the central bank cutting interest rates in the period October-December is rather slim, we feel, given that inflation is likely to stay relatively high at around 6.9 percent during this period.

In January 2008, however, the central bank may opt to cut its benchmark rate again since inflation shall fall to around 6.26 percent in December (the data is released in early January 2008). For the year of 2008, inflation is expected to remain benign and even fall to around 5.3 percent by year-end. Thus, we believe the Indonesian central bank shall cut its benchmark rate to as low as 7 percent by the end of that year.

As such, the people’s purchasing power is likely to remain strong in the near term. And the government’s plan to hike civil servant salaries by around 20% next year will – to some extent at least – increase household purchasing power further. Note that since household spending accounts for around three quarters of Indonesian GDP, the greater purchasing power should be able to drive brisker economic growth going forward.

The brisker economic activities and the brighter economic prospects are also revealed by our business sentiment survey. Every other month we survey around 700 CEOs of companies operating in Indonesia. From the survey’s findings, we construct a Business Sentiment Index (BSI). The reading of the index is quite simple: a reading above 100 indicates that the CEOs are optimistic (which often means that economic conditions are improving), while a reading below 100 indicates that CEOs are pessimistic (usually a reflection of deteriorating economic and business conditions). Based on our surveys, the BSI has increased consistently since January 2007, thereby indicating that the CEOs’ businesses are doing better. From a reading of 115.0 in January the BSI rose to 123.5 in July 2007; this improving trend suggesting that the economy is picking up its growth pace.

In addition to the improving domestic factors, external factors are also proving to be favorable for the Indonesian economy. Since despite the sub-prime lending debacle in the US, Indonesian exports to the global market have remained strong in 2007. In August, for example, exports reached US$ 9.61 bn. And in the first eight months of 2007 exports reached US$ 73.75 bn, or up by 13.4 percent from the same period in the previous year. This shows that global demand for Indonesian products remains strong.

Furthermore, Indonesia has been able to diversify its export destination markets. In 1996, for example, Japan accounted for 25.9 percent of Indonesia’s total exports. Yet by 2007, Japan’s share had fallen to 20.8 percent. Meanwhile, Indonesia’s exports to the US declined from 13.6 percent of the total in 1996 to around 10.4 percent in 2007. In contrast, however, China’s share of Indonesian exports rose from 4.1 percent in 1996 to 8.4 percent in 2007. This suggests that Indonesia has been able to diversify its export destination markets; a positive development considering that Indonesia’s exports will be less affected overall by any instability in one of the countries.

Against this backdrop, we believe that the current economic recovery is sustainable. Hence, the Indonesian economy is likely to continue picking up its growth pace going forward. Indeed, the Indonesian economy is expected to grow by 6.2 percent in 2007 and by 6.3 percent in 2008.

As such, the current rally in the stock market is likely to be sustainable, we believe, given that it is supported by good economic fundamentals.