Analysis: Euro Downgrades: Stay with Domestic Plays

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S&P’s recent debt rating cuts in nine European countries (exhibit 1) will mean that the low consensus forecast of the euro to the US dollar (USD) of 1.2 (exhibit 2) could occur sooner rather than later in our view.

We note that commodity prices generally have the propensity to follow the performance of the USD — for example, oil is 86 percent correlated to the USD (exhibit 3). Thus, expectations of a stronger USD will mean weaker commodity prices.

That said, the recent weakness in the Indonesian rupiah (IDR) against the dollar is likely to remain at least in the short term, although we believe Moody’s rating upgrade to investment grade will help shore up a confidence in the local currency. While the IDR has only depreciated by 0.7 percent year-to-date (ytd), we note that since Aug. 1, 2011, after reaching IDR8,464/US$1, the IDR has depreciated by more than 7 percent to current levels, making it one of the weakest performing currencies in Asia.

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That said, IDR weakness, based on our study, does not bode well for earnings of listed companies. Our sensitivity analysis shows that every 1 percent IDR weakness will lead to 0.6 percent lower profit growth for the Indonesian stock market as a whole.

Additionally, we note that a stronger dollar will mean greater imported inflation for Indonesia, adding inflationary pressure ahead of April’s 10 percent average electricity tariff hike and the government’s move to limit subsidized oil. Hence, we applaud the central bank’s move to maintain its benchmark rate given the propensity of the USD to strengthen coupled with higher inflation stemming from administered price hikes.

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Despite these challenges, Indonesia’s domestic economy is displaying resilience from the adverse impact of the European debt crisis. Consumer confidence remains high, retail sales have been robust and credit is continuing to expand strongly with November’s 2011 loan growth reaching 25.4% y-y and 21.2% ytd.

Indonesia is one of the most well-insulated, domestically driven economies in the region, making it relatively immune from external shocks. Hence, we expect 2012 GDP to expand 6.4 percent y-y, making it one of the best performing economies in Asia.

This means that the Indonesian stock market remains as one of the most attractive globally for investors. However, at this stage of the cycle, we caution investors that while in a weak IDR operating environment dollar earners in general have the tendency to benefit from currency gains, exporters’ earnings could be wiped out by lower commodity prices, which would come off in line with stronger dollar.

Hence, we retain our preference for domestic plays as top picks. We like companies that benefit from the trickle-down effects of rising direct investments, substantially higher minimum wage increases and the land clearing law. (The Jakarta Post, Harry Su The writer is senior vice president and head of research at PT Bahana Securities).

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