Will economic fundamentals support further stock gains?

The Jakarta Post ,  Jakarta   |  Thu, 10/18/2007 11:10 AM  |  Business

Purbaya Yudhi Sadewa, Chief Economist

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?

It should be remembered that the state of the 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, 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 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. Yet since March 2007 the CEI has headed higher. Indeed, in the five months up to July 2007 the CEI had risen every time, suggesting that the economy is on a sound footing. Improving purchasing power has been one of the pillars of 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.

Note that rice prices have a significant impact on people's purchasing power since this foodstuff has a large weighting in consumer 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 seasonal factors. Hence, the year-on-year inflation rate is expected to hover around 6.9 percent from September to November.

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 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. 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 central bank shall cut its benchmark rate to as low as 7 percent by the end of that year.

As such, people's purchasing power is likely to remain strong in the near term. And the government's plan to raise civil servant salaries by around 20 percent next year will -- to some extent at least -- increase household purchasing power further.

The brisker economic activity 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.

Based on our surveys, the BSI has increased consistently since January, 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; 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 U.S., Indonesian exports to the global market have remained strong. This shows that global demand for Indonesian products remains strong.

Furthermore, Indonesia has been able to diversify its export destination markets.

Against this backdrop, we believe that the current economic recovery is sustainable. Hence, the 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.

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