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UBS Investment Research
Asia Equity Strategy
All eyes on the two I’s - India and Indonesia
„ How to think about the recent moves
Unsurprisingly, given the recent moves and weakness, we are getting a lot of
questions on the two markets – India and Indonesia. Clients are asking if it’s time
to buy or remain on the sidelines. While MSCI India has corrected 6%, MSCI
Indonesia is down 8%, in the last few days.
„ What caused it, and how this might change
The sell-off in India has been driven by tight liquidity conditions and expensive
relative valuations. In Indonesia, it is mainly inflation. We think that bond yields in
Indonesia still look very low relative to inflation which poses a challenge to equity
markets. In India, we have greater confidence in liquidity conditions improving in
the coming months. In Indonesia, we think a positive inflation shock or a rise in
bond yields is necessary for a firmer base from which equities could advance.
„ Valuations, Earnings and Sentiment
Relative to each other, India is now at the lowest premium to Indonesia, both on
P/B and Fwd PE, over the last decade. Earnings momentum looks a little better in
India than Indonesia. Technicals are washed out in both countries, but foreign
flows in India last year dwarfed Indonesia and appear more of a concern.
„ Underweight Indonesia, Neutral India
On balance, we remain underweight Indonesia, despite the recent fall, still
concerned about inflation and tightening, although technicals suggest that the
correction is probably overdone. On India, though it looks relatively better, in our
view, liquidity conditions keep us neural on this market for now.
In our meetings with clients over the last ten days, along with inflation, the most
frequent questions are on India and Indonesia (both in many respects an
extension of inflation fears). So far this year both have performed poorly, down
6% and 8% (MSCI India and Indonesia respectively). Inevitably with the recent
corrections, we are being asked whether it is time to step in, or has something
more fundamental happened to disrupt what are both, in our view, good longterm investments.
On Indonesia, we have been concerned about what we have felt was a growing
inflation threat that was not priced into bond markets and is the major reason
why we have been underweight. In India, liquidity conditions are clearly very
tight, we have not been underweight the market though, only neutral.
Today’s note takes a look at what caused the sell off and how this might change
in the coming months. We then look at the earnings picture, valuation, and
sentiment/micro liquidity environment for each market.
In summary, we have more confidence that liquidity conditions in India may
improve than inflation data gets better in Indonesia. Absent a bigger sell off in
Indonesian government bonds, we think that from a macro perspective the
situation in India, on balance, is likely to improve faster than in Indonesia.
Both problems related to inflation and credit in India are more likely to unwind
themselves than in Indonesia. Philip Wyatt, our India economist, sees the credit
conditions in India to be ‘as tight as it gets’, and Reserve Bank of India (RBI) is
more likely, in his view, to be closer to the end of its interest rate hikes.
Ed Teather, our Indonesia economist, thinks that the inflation is not just food
related which the Bank Indonesia (BI) seems to think. As a result, measures to
increase food supply and improve logistics look too narrow to solve this
problem. The BI also seems to be more inclined now to tighten by raising rates
(for the first time post-crisis) or other tightening measures, which are likely to
weigh on sentiment. Bond yields have moved up a little bit but are still low
relative to the inflation threat.
Our conclusion is that from a fundamental perspective, there is more scope that
conditions might change for the positive in India than Indonesia. India now
trades at one of the lowest premiums to Indonesia on both the book and earnings
multiples in the last ten years. Earnings momentum also looks slightly better in
India than Indonesia. While technicals are equally washed out in both, foreign
ownership levels look much higher, and more concerning, in India (based on just
the flows in 2010). Although at an absolute level foreigners own a much bigger
part of the Indonesian equity market.
On the whole, although technicals look quite washed out in both markets, we
think India looks better than Indonesia fundamentally, and we maintain our
neutral on India, while we would continue to remain underweight Indonesia.
Table 4 (page 14) summarises our view on the two markets. Although we have
not changed our views on both and think that its too early to do so, we do think
that the relative environment looks better for India. We remain neutral on India
for now and underweight on Indonesia.
1. The Cause Behind the Fall
India
The Indian market has fallen 10% since early November last year. The major
reason for the sell-off in our view was 1) the alleged scandals relating to the
telecom and financial industry, which left a deep uncertainty upon the market, 2)
relatively expensive valuations, at a time when alternatives (mostly in the form
of Taiwan and Korea) looked more attractive due to the rebound in LEIs
globally, and 3) tightening liquidity conditions, as inflation picks up and loan
growth has been strong. 4) rising policy rates to tackle inflation, which has
helped interest rates to climb.
The combination of 1 & 2, which encourages foreign selling (chart 1) has
compounded domestic liquidity conditions such that local interest rates have
spiked up. This is most visible in the 3 month commercial paper rates, which are
now 9.5% having risen by more than 500 basis points since the end of 2009.
Policy interest rates have risen in the meantime by only 150 basis points.
Indonesia
To our mind, the bond market and equity markets have been telling us a
different story on inflation. More recently however, this has become a concern
for investors, as headline inflation continues to pick up and remains stubbornly
high (chart 7) and Bank Indonesia remain on the sidelines. Meanwhile, bond
yields which in nominal terms are low and in real terms, very low, have seemed
to us to be mispriced (chart 8). Unfortunately for equity investors, bonds and
equities in Indonesia tend to be positively correlated (we suspect because of the
large foreign investor presence in each asset – which reinforces currency moves).
Since the second quarter of 2009, there has been a virtuous circle of rising
currency attracting (and helping) foreign participation in the bond market (chart
2), making Indonesian government bonds look like a great ‘carry’ asset.
However as we showed, real and nominal yields are very low relative to an
inflation rate that is picking up
With the most recent inflation prints surprising on the upside, and Bank
Indonesia doing little, it seems, about it, investors are now fretting about the risk
of a major upward shift in inflation and bond yields. Though equities are ‘cheap’
relative to bonds, and may well outperform bonds, the absolute correlation of
both in our view makes them susceptible both to a sell off in bonds, weak
currency and potentially earnings downgrades
2. What might change?
These moves have resulted in pretty savage falls in recent days, with Indonesia
off 8%, India 6% (MSCI). So how might perceptions change?
India
It strikes to us that liquidity conditions tightening have taken India down, so it is
likely to be liquidity conditions that take it back up. So how might these change?
We see three principal ways this could happen.
Firstly, one of the major headwinds is that deposit growth has been slowing
(chart 3) relative to loan growth. With the loan to deposit ratio close to its
ceiling, this is causing a headache for the banks and bidding up deposit rates.
Our colleague Philip Wyatt, UBS’s India economist, is expecting the economy
to slow from here, as his leading indicator of activity suggests (chart 4). This
would suggest less demand growth for loans at the same time that seasonal
factors come back into play to help deposits. This would allow less scramble for
deposits in the coming months, particularly if seasonal shortages unwind. Philip
expects liquidity tightness for these reasons to start to reverse by February
(please see his note ‘India: As Tight As It Gets’ dated 11th January 2011).
The second way, which we doubt will happen any time soon, is that inflation
pressures cool enough to allow the RBI to reverse the current tight monetary
policy settings. Chart 5 shows the path of rate hikes (along with commercial
paper rates) making the point that it is not policy rates alone that have caused
tight market interest rates. But they are not ‘helping’ at this point. A sharp
slowdown in the rate of inflation would certainly help alleviate fears however.
Again, Philip is sanguine that inflation pressures will cool, allowing headline
data to stabilize. We are not holding our breath however for relief from tight
liquidity from the RBI.
The third change is relief from foreign investors. Net foreign equity selling (see
chart 1) toward the end of last year allied with already tightening domestic
liquidity has combined to further amplify monetary conditions. Any turnaround
in flows, though this is a circular reference, given that rising rates are a concern
for foreign investors, could help alleviate liquidity tensions. Another source of
relief could come from a step-up in borrowed foreign capital.
Indonesia
We see three principal ways in which investor attitude towards Indonesia can
change. The first is that inflation just starts falling. This is not what we or our
economist, Ed Teather, expects. But if we were to see a sharp fall in inflation,
then this could alleviate concerns that bonds are vulnerable. Indonesian inflation
data is released at the beginning of each month, so these are clear events to
watch.
The second thing that could change is that policy starts to respond more
vigorously to inflation fears. So far, the central bank has not done much, beyond
raising reserve requirements and imposing loan to deposit ceilings (and,
unconventionally, floors) beyond which penalties will be imposed on the banks.
The problem for Bank Indonesia, and others in the region, is how to do this
without attracting further hot money flows.
Raising interest rates will impose higher sterilisation costs with the gap to Fed
Funds so high. Allowing the currency to appreciate further should dampen
inflation pressure but Bank Indonesia has shied away from this in the past
because of the implications for international competitiveness. While Indonesia's
trade surplus is 5% of GDP, this is due to commodity exports. Monthly data
shows the balance of trade on manufactured goods, where price competition
matters, to be in deficit. To be sure, Bank Indonesia has sounded more inclined
towards currency appreciation in rhetoric of late, but this is in the context of
recent rupiah weakness. The tolerance for a sustained currency appreciation
remains to be seen.
The problem of tighter policy is that it might well lead to a further raft of
downgrades of earnings (which as we show slightly later, are already lagging the
region in momentum terms). A big currency hike would most likely be positive
in the short term for equity investors, rate hikes less so. But at least, investors
might take comfort that BI was not letting inflation get out of control.
The final thing that could happen is that bond markets do sell-off, repricing risk
of inflation such that they start to look more attractive, laying the foundation for
a more sustained positive move on flows back into Indonesian equities.
Unfortunately to get there, probably means more pain before gain. As chart 8
shows, real bond yields in Indonesia are at very low levels, having averaged
3.8% since late 2006, they would need to rise almost 250 basis points to reach
average levels.
Comparison between Indonesia and India
Looking at what could change, we think deposit growth in India is likely to
improve but is a slow burn played out over the next few months, not starting
imminently. Foreign investor appetite probably has the greatest chance of
turning liquidity around, with inflation the wild card. Inflation is also, equally
the wild card in Indonesia. Unfortunately, a comparison of policy responses
would have underlying structural inflation pressures (not caused by spikes in
food) more contained in India, given at least some action on the policy front,
over Indonesia (where there has been little policy response). Aggressive policy
responses in Indonesia, while perhaps quite negative for earnings (although
short term rate rises are positive for banks earnings, a 7% earnings upgrade for
every 100 bps rise according to our Indonesia Strategist Joshua Tanja, it’s the
long end movement that is far more negative due to rising cost of equity) may
help stabilize the inflation risk premium in bonds, and thereby support equities.
Otherwise, it looks like we need prices to clear – i.e. bonds yields rise – to
inflation recognizing levels, before equities look out of the woods, in terms of
what has taken them down. On balance, we think Indian equities have a better
chance of seeing a reversal of what has carried them down, in the short-term,
over Indonesian equities, absent a more pronounced move up in bond yields in
Indonesia in the very near future.
3. Relative Valuation
Of course, there is a price for everything, and the relatively savage corrections
are prompting interest from investors. Where do valuations stand now? Are
things so beaten up as to be compelling enough to drag investors back-in,
regardless of the fundamental reasons behind the sell-off?
On a P/B basis, India is now on the lowest relative multiples since 2004, though
still commands a premium valuation from an earnings perspective, the 20%
premium is now the lowest, bar the financial crisis, since the bull market in
Indian equities started in 2004. Indonesia has been one of the great re-rating
stories in the region, along with India. Though the market trades at a substantial
premium to its own history compared to Asia ex Japan, only recently did it
break through to commanding an actual premium valuation on a P/forward
earnings basis.
The bottom line here is that neither market looks expensive right now, especially
when one factors in likely stronger growth compared to the region, in the years
to come.
Relative to each other, India’s premium on both P/b and P/forward earnings that
it used to command has virtually vanished. Certainly, with reference to history,
India looks a more compelling relative valuation case today than does Indonesia.
Within the market, we are also interested in how the recent underperformance
has played out in terms of sector shifts. Table 1 shows our sector ‘heat maps’ for
each country, now and three months back. The way to read these tables is that
the number in each box corresponds to the actual multiple (p/forward earnings
or p/book) and the colour scheme how relatively expensive that industry group
is compared to Asia ex Japan, relative to history (i.e. a sector is on a p/b relative
of 0.8x which is ‘cheap’, but if it has traditionally been on 0.5x relative, then
today’s multiple appears expensive). Red is expensive, orange, somewhat
expensive, blue cheap, light blue somewhat cheap and white neutral valuations.
So what has changed?
In India, Materials, Telcos, Utilities and Household sectors have all moved from
slightly expensive to neutral relative valuations in the last three months. While
banks in India were very expensive earlier, they are now less expensive on both
relative price to book and forward earnings multiples. In Indonesia, Telcos and
Food & Beverage look less expensive than three months earlier, while Energy
has become more expensive on a market relative basis.
4. Earnings
As it is, earnings momentum in Indonesia was already beginning to fade in
relative terms compared to the region, albeit it has remained positive (along with
the region for the last year). In India, where it has also been volatile, earnings
momentum in relative terms is not negative.
Earnings are likely to get further impacted by either tight credit conditions
continuing to prevail in India or policy rate rises in Indonesia. Joshua Tanja, our
Indonesia strategist, thinks that a gradual tightening will probably not result in
downgrades in earnings or the top line forecasts. However a steep change might
result in panic moves, for example in mid-2006, when earnings forecasts for
Astra International (one of the most cyclicals stocks in Indonesia) dropped by
30% from a trend growth of 7%, and Banks net interest income growth declined
to 8% from the usual trend growth of 20-25%.
In India also, higher rates and tight liquidity tend to be negative for earnings in
most sectors. Our analyst for Indian Autos, Sonal Gupta, thinks that higher
commercial lending rates impact the sector negatively by slowing down the
volume growth. Firstly, tighter lending standards result in the marginal customer
not being able to get financing and secondly, higher EMIs may lead to
postponement of purchase decisions. Tight liquidity also affects the
Infrastructure/Construction sectors negatively in India, according to our analyst
Sandip Bansal. Since most infrastructure projects are financed at 70:30 debt to
equity, this increases the project cost during construction and interest out-go
during operational phases. He also thinks that higher commercial lending rates
are negative for the Cement sector as construction activity is likely to get
postponed in such an environment. Our analysts for NBFCs in India (Nonbanking financial companies), Ajitesh Nair and Vishal Goyal, believe that an
immediate increase in the average cost of borrowings in unlikely, but prolonged
tight liquidity conditions can impact the ability to grow for this sector (please
see ‘Liquidity pangs’ dated 11
th
January 2011 for more details).
5. Technicals/Sentiment
Finally, we look at technicals and ownership data as a proxy for sentiment.
Where do we stand?
Firstly on the technicals, the RSIs on both markets have, unsurprisingly, fallen
back sharply. Generally, from a tactical perspective, when these hover around
the 30 level suggests oversold states. Neither market is there yet, though both
are close to getting there. We are not yet at washed out levels.
Looking at the current correction in the context of history, suggests that a large
part of the corrections have already happened in both countries. The average
corrections in the last seven years have been around 13% in India and 14% in
Indonesia. As of 12th January close, MSCI India had corrected by 10% and
MSCI Indonesia by 12% from their respective peaks in November. Table 2-3
show all the corrections (bigger than 5%) since 2004 in each of the markets and
the corresponding change in the 3 month rate in India, and the 10 year
government bond yield in Indonesia.
Finally, we look at ownership levels. Looking at the flows into the markets last
year reveals that there is more risk in India than Indonesia, should foreign
investors find fresh reasons to worry. Foreign ownership, based on just the flows
in 2010, had climbed to 10.3% (of MSCI India) at its peak at the end of last year
in India, and the inflows in India have been far more substantial than in
Indonesia, as chart 19 suggests. This does, to be honest, provide us with a sense
of concern in India’s case, if the world economy were to continue to pick-up
structurally not just cyclically, and investors turn their attentions away from the
India story. Otherwise, we suspect that investors are likely to remain positive on
what is one of the best growth stories in the region, in our view.
Chart 19 just shows the flow of capital last year which is more of a concern.
Looking at chart 20, however, reveals that although foreign investors bought a
lot of Indian equities last year they hold a much bigger part of the Indonesian
equity market in absolute terms. One concern we have for India is that an
outflow of equity capital puts further pressure on the currency given the current
account deficit (chart 20, for India, is based on data received directly for foreign
ownership of BSE 500 from CapitalLine as opposed to the flows data from the
stock exchange that forms a basis for the trend in chart 19).
Table 4 summarises our view on the two markets. Although we have not
changed our views on both and think that it’s too early to do so, we do think that
the relative environment looks better for India. We remain neutral on India for
now and underweight on Indonesia.
Strategy Conclusion
Looking firstly at the fundamentals that have taken both markets down, we see
more scope that these might change for the positive in India than Indonesia in
the short-term. The correction has seen valuations come back substantially, with
India now at its lowest premium to the region in 6 years (on P/B). Indonesia,
while at a modest premium looks expensive compared to its history versus Asia
ex Japan, but only on this measure.
For longer-term investors, these pull-backs do look very interesting. Relative to
each other, India is now as cheap as it has been relative to Indonesia both on a
P/B and P/FE basis in the last decade. The earnings picture currently looks a
little better in India than in Indonesia. Technicals look to be getting to resistance
levels in both, while ownership levels in India look higher than in Indonesia,
based on the flows in 2010.
Between the two on balance, we think India looks a little better. From a
fundamental perspective, we also think that India has a better chance of seeing a
turnaround of events that have carried it down (either through faster deposit
growth or foreign equity inflows) than Indonesia, where we think either a
positive inflation shock (likely to be felt in India too) or a move up in bond
yields to clear the inflation risk (negative in the short-term) is what is required.
On the whole, although technicals look quite washed out in both markets, we
think India looks better than Indonesia fundamentally and we maintain our
neutral on the market and continue to remain underweight Indonesia.
Summary of our Strategy View
We remain positive on Asia ex-Japan equities in 2011. Earnings growth
forecasts look achievable and valuations are attractive, especially relative to
other assets. With liquidity now becoming a tailwind, growth less of a concern
and the domestic credit cycle set to improve, we think Asia could re-rate from
its current discount to its historical average PE, and potentially even a premium.
We upgrade our 2011 year-end MSCI Asia ex-Japan index target to 670 from
650, based on 13.7x forward PE, in line with the long-term average.
Our key country picks are Singapore and China. We are neutral the G7 proxy
markets of Taiwan and Korea. Valuations have moved back toward neutral, and
leading indicators have already stabilized. There is less compensation, unless
convinced one way or other of external demand (which we are not) for taking an
aggressive view on these markets now. We are generally underweight the
expensive ASEAN markets. Of which Indonesia with low bond yields, rising
inflation and huge foreign ownership look the most vulnerable beyond
valuation. At the sector level, we are overweight financials, as the best proxy for
the liquidity theme and the credit cycle. We are underweight defensive sectors,
expecting them to underperform a rising market.
We believe there is an elevated risk that Asian markets could reach a ‘euphoric’
state, fuelled by inappropriately loose monetary policy. On the downside,
inflation, sharply higher US bond yields and government intervention are risks.
Key Calls
What are Key Calls?
Key Calls represent our highest conviction single stock research ideas across the
region. The list is designed to generate bottom-up ‘alpha’ and is not a portfolio
that we use to express our top-down view. The key selection criteria are analyst
conviction, liquidity (>US$10m average daily turnover for most stocks) and a
strategy overlay in terms of the macro outlook, market positioning and risk
management.
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