Short-term pain, long-term gain. One says this is the perfect phrase to describe Indonesia’s moderate economic recovery as a result of the country’s focus on infrastructure reform. However, infrastructure development is necessary to reduce logistics cost and improve the country’s competitiveness, hence transforming the country into ‘higher-middle income’ from ‘lower-middle income’. Thus, the moderate recovery in the short run is justifiable as the optimum impact of infrastructure development would be fruitful in the long term. However, is it only infrastructure reform that the country is missing? We believe there is the other side of the coin.

The missing reform: manufacturing sector development. Another reason for the moderate recovery is the inability of the manufacturing sector to rise to the top. We are witnessing a shrinking share of manufacturing to GDP since the end of commodity boom era, which we believe has been the cause of lower quality of employment and persistent ease of private consumption. There has been a shift towards sectors such as services and telecommunication, yet these sectors have not been able to fully accommodate Indonesia’s low skilled labors. That said, we believe it is imperative for policymakers to not only focus on infrastructure development ahead, but also to push the development of higher value-added sectors, expand the role of small medium enterprises (SMEs), and promote services sector such as tourism. If not, we fear the country could enter a phase called “premature deindustrialization” i.e. failure to develop its manufacturing sector before per capita income reach or exceed the upper-middle-income category, and move to service sectors with low value-added.

What will the story be in 2018? Despite structural challenges, fortunately, the domestic economy will be supported by two factors which can be summed up in “good luck” and “good policies” (FY18F: 5.3%). The political parade and relatively high commodity prices could be a charm for this year’s growth, while the government has also committed to maintaining low inflation environment (YE18F:3.6%). The fiscal spending is also expected to provide a short-run cushion for private consumption. We estimate the combination of regional elections as well as parliamentary & presidential campaign activities to contribute by around 0.2ppt to economic growth whereas the relatively high & stable commodity prices would benefit the economy of non-Java regions. Java’s economy will be backed by infrastructure with the support of higher financing from both banking and non-banking sectors. Additionally, the rising trend of fin-tech and capital market-based financing is likely to be the new trend going forward.

The potential headwinds. We believe climbing oil price would be a risk to inflation this year, while global monetary normalization agenda may trigger exchange rate volatility (we estimate exchange rate to remain flat compared to last year at IDR13,598/US$ in YE18). That said, we expect Bank Indonesia to step up its intervention this year, especially when it has ample ammunition from its foreign exchange reserves, and maintain the 7-DRRR at 4.25% throughout the year.

End-2018 JCI target at 6,725. On the equity side, we expect JCI to close at 6,725 by end-2018 with more upside risk in the first half. The Fed’s tightening will cap valuation but we are not overly worried given the constructive global growth while G4 balance sheet would still expand, albeit slower, into 1H18. Lofty valuation, thin market breadth, politics and inflation are more worrying. SMID-caps offer more value, but we need to be selective from flows perspective. Three themes to play: Election, Connectivity, and Digitization.

The 10-year INDOGB yield is projected at 6.36% YE 2018. As we expect the US Treasury yield will increase and that there will be no more BI rate cut this year, the risk for bond yields to increase tends to be higher. However, we are still bullish in 1Q2018, that might send the 10-yr INDOGB break 6% amid low inflation and expectation on Moody’s upgrade rating, before continuing to increase to our base scenario of 6.36% (ranging 6.08-6.64%) by YE 2018. We also see that the probability for INDOGB to crash (like in 2013, which reported losses 13.3%yoy after gaining 22% previously) is still small this year. The Government’s action to reduce primary balance deficit this year is a very positive action in our view. With lower capital gain appreciation expectation for INDOGB, we expect corporate bonds will give better opportunity for returns in fixed income asset class in 2018. The main risks are if Fed Fund Rate rose faster than expected (we forecast three hikes) and if the ECB reduced quantitative easing more than anticipated (we forecast ECB will still do quantitative easing until 3Q and maintain negative interest rate in 2018). Meanwhile, from domestic, the main risks are coming from the increase in subsidized fuel price (which could drive inflation and trigger a rise in Bank Indonesia’s benchmark rate) and the increase in government bond supply if the budget deficit widened from 2.2% of GDP.

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