Investors Prepare for Volatility Ahead of Indonesia Election

Investors Prepare for Volatility Ahead of Indonesia Election

JAKE MAXWELL WATTS

Updated June 23, 2014 7:03 p.m. ET

Investors are turning wary of Indonesian stocks ahead of a presidential election early next month that could make or break one of Asia’s best-performing markets.

Enthusiasm for Jakarta Governor Joko Widodo, the reformist frontrunner who had a strong early lead in the polls, has helped push Indonesian stocks up more than 13% this year. But as the race has grown tighter, some fund managers have held their bets or taken them off entirely while preparing for volatility.

Maybank Kim Eng, Southeast Asia’s largest brokerage by value traded, said most of 80 institutional clients from Singapore, Kuala Lumpur and Hong Kong it met with in early June showed strong interest in Indonesia, but around 40% had stopped adding to their Indonesian holdings due to nervousness about the election. One in 10 had begun selling.

Trimegah Asset Management, which oversees around $390 million in Indonesia, has increased its cash holdings to limit its exposure to a stock selloff. “It is truly a two-way race…The best way [to minimize risk] is to diversify a bit,” said Ivan Chamdani, head of research at the fund.

Taking a stance is difficult, he said. A victory for Mr. Widodo, whom investors favor, would likely trigger an immediate rally in stocks and bonds, leaving overcautious managers behind, while a loss would cause a market-wide selloff, Mr. Chamdani said.

Mr. Widodo—known as Jokowi—is a populist with a reputation for honesty. His opponent, former special forces commander Prabowo Subianto, is a conservative from the country’s business and political elite.

Indonesia’s benchmark equity index surged more than 11% in the first three months of the year, when the polls showed Mr. Widodo far ahead of his opposition. But the race has narrowed, and so have the market’s gains. The benchmark index is up only 1.7% from the beginning of April and has slipped 2.8% from its 12-month high in May. It still ranks just behind the Philippines’ PSEi as Southeast Asia’s second-best performer this year, however, having gained more than 13%. The PSEi has risen nearly 15%.

Foreign funds were net buyers of just $252 million of Indonesian equities in the first three weeks of June, down from more than $700 million in the two previous months and $1.3 billion in March, according to data provided by Citigroup Inc.C +1.52%

The rupiah, meanwhile, has strengthened nearly 1.6% against the U.S. dollar, ending a dive that had knocked around a fifth from its value in 2013. Bonds, too, have rallied, pushing the yields on the 10-year government bond down to 8.1% from 9.1% in January. Yields fall when prices rise.

Indonesia’s next president will need to meet the high standards of international investors, who have aggressively dumped and then bought Indonesian assets in the past 12 months based on the country’s outlook.

Investors say stocks will no longer look attractive if the country doesn’t follow through with overhauls and strengthen economic growth. The country’s stock index trades at a price-to-earnings ratio of 20.7, compared with 17.6 times for Japan’s Nikkei Stock Average and 16.1 times for Korea’s Kospi, according to FactSet, a data provider.

The July 9 election will mark the first time in Indonesia’s history that one elected president will pass power to another. It will take place at a time when Southeast Asia’s largest economy is in urgent need of fiscal and structural improvements.

Growth is slowing. Indonesia’s economy expanded 5.2% in the first quarter of this year, its weakest pace since late 2009. The country is under pressure to rein in a current-account deficit that earned it a place last year in Morgan Stanley‘sMS +0.71% “fragile five” list of countries thought to be most vulnerable to pressure on their currencies pressures from an expected rise in global interest rates.

“A favorable election outcome would help to create a tailwind of supporting policy direction over the next five years,” said Michelle Sim, a portfolio manager at Fullerton Fund Management, which manages nearly $10 billion globally. She said that if Mr. Widodo loses there is a risk of a market selloff, while a narrow win would create political uncertainty that “would be negative for the market.”

Fullerton has reduced its exposure to some Indonesian stocks this year, but says the move was more due to high valuations than political concerns.

Other fund managers have said they have taken profits on the year’s gains to date and would be open to pursuing more opportunities if the election goes favorably.

“While Jokowi is not the perfect candidate from an economic perspective, I do think he is the type of pragmatic populist that could really help move Indonesia in the right direction,” said Eric Stein, portfolio manager at Eaton Vance EV -0.57%Investment Managers in the U.S., which manages around $12.8 billion globally.

Eaton Vance has cut the exposure of its relevant fund to the Indonesian rupiah to 1% from 2.3% at the end of March. Mr. Stein says the cut was more to take profits than for political reasons. He said he he expects election-related volatility to offer opportunities later in the year.