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In late-April, Merrill Lynch introduced a quantitative model to provide the foundation for its country asset allocation. The model makes use of three predictive variables and two current variables.
The predictive variables are: currency, GDP growth, and brokersÆ estimate system (IBES) for 12-month earnings growth. IBES is a system that gathers and compiles earnings estimates of stock analysts.
The current variables are: a hybrid of five valuation measures û including dividend yield, trailing P/E ratios, forward P/E, and price-to-cash and price-to-book values û that are taken as an average and compared to the average of the region and the Merrill Lynch global quantitative strategy teamÆs earnings revision ratio (ERR). The ERR is a count of the number of stocks where analyst earnings estimates have been revised up, divided by the number revised down, according to IBES consensus data. A three-month moving average is used to get a trend.
Each countryÆs variables are summed to a composite number, which is the basis for its weighting relative to the MSCI Asia Pacific ex-Japan Index benchmark.
The results from the model have led Merrill Lynch to make several adjustments to its asset allocation, the most surprising of which was for Indonesia.
IndonesiaÆs earnings revision ratio is the highest in the region and the only one that is positive. Its forecast real GDP growth is the third-highest, after China and India. Merrill LynchÆs previous allocation for Indonesia was 4%, versus the MSCI benchmark weighting of 1.8%. The model raised it to 5.3%, making Indonesia by far its largest overweight of any country, at three times the benchmark.
ôThis is surprising, because most investors view Indonesia as being in the midst of a serious inflation problem,ö Merrill Lynch says in a report. ôIndia and the Philippines, other countries which are similarly perceived, went from over to underweight based on our new model.ö
While most countries in Asia have benefited from the improved global risk appetite since March, Indonesian financial assets have fallen further. The 10-year bond yield which was 10% in February is almost 13% today.
It is actually not inflation itself that is the problem in Indonesia, Merrill Lynch notes. The latest reading of 9% is below the 10-year average of 14.7% and the 20-year average of 11.7%. Neighbouring SingaporeÆs inflation, at 6.7% is the highest in 26 years.
ôThe difference between the two is that Singapore has allowed its currency to rise at an unprecedented rate to combat its inflation. Whereas in Indonesia, there has been a total lack of policy response,ö Merrill Lynch says. ôThe government continues to provide fuel subsidies.ö
IndonesiaÆs monetary policy has been in a vacuum as the governor of the countryÆs central bank kept rates low. He is currently in detention and is facing corruption charges, which he denies.
While SingaporeÆs Straits Times Index is 13% off its low, and down just 4% year-to-date, IndonesiaÆs Jakarta Composite Index is 6% off its low, and down 16% year-to-date. With no response from the authorities, the assumption the market has made is that inflation will be allowed to reach crisis proportions, before prompting capital outflow and an emergency response.
Recent history offers a precedent. In August 2005, Indonesian stocks lost a quarter of their value in US dollar terms when authorities responded belatedly to inflation. Rates rose 575 basis points and real lending growth slowed from positive double digits to a sharp contraction.
ôToday Indonesian stocks are priced for the worst,ö says Merrill Lynch.
For example, property company Ciputra Surya û which Merrill Lynch rates as a buy û is trading below reported book value, which has not been revalued since its establishment in 1993.
ôThis presents an opportunity, if the government and central bank switch from doing nothing, to doing something,ö Merrill Lynch says.
The catalyst for that switch is when Chief Economics Minister Boediono becomes Bank of Indonesia governor on May 17. Merrill Lynch notes that Boediono comes with a reputation for honesty and has strong credentials. He has been a Minister of Finance, Minister of the National Development Planning, board member of Bank Indonesia, and is a Wharton School PhD. ôHe is considered to be a person who knows how to get things done inside IndonesiaÆs labyrinthine bureaucracy, who can coordination policy-making between the central bank and the government,ö the firm says.
Meanwhile, in a surprise move Tuesday, Bank Indonesia raised its benchmark one-month rate by 25 basis points to 8.25% as it expects inflationary pressures to remain high in the coming months after consumer prices rose to a 19-month high in April. That was the first rate hike in 30 months after the central bank went on a monetary easing mode in May 2006.
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