India's growth rate accelerated to 8.2% in the second quarter of 2018 as the shocks from demonetization and the imposition of the Goods and Services Tax (GST) wore off, supported by inventory restocking and a low base of comparison. The principal drivers of growth were government and private spending. Investment remains anaemic on modest corporate credit growth as the banking sector's balance sheet repair remains a work in progress.
Inflation accelerated as the output gap narrowed and will get an additional boost as the impact of the Minimum Support Price (MSP) hike filters through, while higher oil prices (and the impact of the Iran sanctions) push the current account into a wider deficit. In response to pressure added by Emerging Market volatility, the Reserve Bank of India (RBI) hiked rates. Despite this, the U.S. dollar (USD)/Indian rupee (INR) rate rose to a historical high of 72. RBI policymakers have shown tolerance for a weaker currency, providing a shock absorber for the external account while preserving international reserves and improving manufacturing competitiveness. In the near term, India's economic growth may be mixed but should improve after the 2019 national election when there should be less political uncertainty.
Equity returns have been resilient amid net foreign outflows. The deepening local investor pool has responded to the government's policy reforms (GST, bankruptcy law, state bank recapitalization) and sustained earnings growth momentum. Equity valuations have thus re-rated to the high end of the past five-year range.
Key risks are: 1) higher oil prices, putting pressure on the current account deficit, inflation and compromising fiscal stability; and 2) election outcomes, since a change in government to a less stable coalition could deflate Indian valuation premiums.
The macro environment has improved steadily this year, with GDP growth reaching 5.3% in 2Q18 as private domestic demand rebounded. The improvement in growth momentum, however, was interrupted by a bout of external volatility related to Turkey. The central bank has raised interest rates by 125 basis points (1.25%) since May, making Indonesian rupiah (IDR) assets more attractive to investors and dampening IDR volatility, but also pushing borrowing costs higher. Fiscal policy will also tighten in 2019, as the government moves toward a balanced primary budget in 2020. Inflation has moderated and should ease going forward, providing support to low-income purchasing power.
Political noise around the upcoming presidential election is expected to increase, but presidential ticket nominations have eased concerns of a drawn-out campaign with only two tickets—those of President Jokowi and Opposition candidate Prabowo Subianto. Jokowi's choice of a senior Muslim cleric as VP candidate should help to deflect extremist racial and religious attacks seen in the 2017 Jakarta gubernatorial election, reducing potential volatility during the campaign.
The Indonesian stock market has struggled so far in 2018, with the Jakarta Stock Exchange Composite Index down 16.5% YTD as of September 18 in U.S. dollar terms. Underperformance has been due in part to IDR depreciation, as the unwinding of developed market monetary stimulus and rising U.S. rates has spurred portfolio outflows, leading investors to focus on the vulnerability of current account deficit (CAD) economies such as Indonesia. IDR depreciation is a potential near-term headwind for corporate earnings, as many Indonesian corporations rely on imports as their input costs. Valuations are at 13.9X forward price-to-earnings (P/E), below the average of the past five years.