Indonesia’s stock market has outperformed Asian rivals for each of the past three years, but fears are rising that demanding valuations at a time of unpredictable global growth could turn the bourse into a regional laggard.

So far this year, the market is one of the region’s weakest: the MSCI Indonesia has risen only 1.4 per cent, falling far short of the MSCI Asia ex-Japan’s 15.8 per cent rise. Over the past three years, Indonesia has outperformed the regional index by over 130 per cent.

The slowdown comes as the country recorded annual growth of 6.5 per cent last year, up from 6.1 per cent in 2010, and its fastest since the Asian financial crisis, according to the World Bank.

Inflation last year was 3.8 per cent, having fallen steadily since a spike in food prices in late-2010.

Investors have been drawn to Indonesia in part because of its coal, copper and palm oil. Even more attractive has been the burgeoning consumer power of its population of 240m, the third largest in Asia. Consumption has kept the economy buoyant despite slowing export demand from Europe and the US.

Morgan Stanley analysts believe Indonesia can sustain this Goldilocks scenario of growth and just-right inflation as domestic demand supports earnings.

They predict that Indonesia’s corporate earnings per share will rise 15.5 per cent this year, or 4 percentage points more than the rest of south-east Asia.

Business confidence has received a boost from the passage of a land acquisition bill that could bring improvements to Indonesia’s bad infrastructure. Upgrades by Moody’s and Fitch Ratings of Indonesia’s sovereign debt to investment grade will cut companies’ funding costs.

Nevertheless, investors seem nervous. Foreign institutional investors in February became net sellers of equities, offloading more than $200m, according to Bloomberg data.

One reason for the apprehension is that Indonesian equities are valued at a premium of nearly 50 per cent to their global emerging market peers, by Credit Suisse’s estimates.

Investors say some of that is justified by a return on equity far above the rest of the region. The market is trading on a price-to-book ratio of around 3.5, above the average for the region excluding Japan of 1.5, according to HSBC.

Yet the bank points out that Indonesia’s current return on equity is nearly 25 per cent while the regional average is below 15 per cent. That rich valuation means “even a small bit of bad news could have dramatic consequences”, says Robert Prior-Wandesforde, a Credit Suisse economist. And the fact that Indonesia relies heavily on domestic consumption means that if global growth brightens, investors could turn back towards Asia’s more export-driven markets, which had been less attractive as export demand from Europe and the US fell off.

In the meantime, even as the bulls in Jakarta’s bourse pause, the country’s bond markets have jumped on the back of Indonesia’s ratings upgrade and government efforts to limit volatility by pushing foreign capital towards longer-term debt and away from short-term securities.

At a debt auction last week, the government raised 50 per cent more than the Rp8tn it had been targeting.

Indonesia’s newly minted investment-grade rating has pushed yields on the country’s 10-year bonds down by around 100 basis points this year to a near-all-time low of 5.3 per cent. Foreign ownership of tradable government debt has more than doubled since 2008 to Rp234tn ($26bn).

Investors are watching to see whether Jakarta can manage inflation and follow through with reforms.

The country’s fiscal position is strong, in part because spending has been slower than expected. The government must implement the land reform bill and allocate money for infrastructure, says Shaun Levine, a political analyst with Eurasia.

While inflation has been trending downwards alongside food prices, economists are concerned that the central bank last week cut rates to a record low 5.75 per cent while growth remains strong. Even so, many economists expect it will continue cutting rates.

Plans to cut fuel subsidies later this year, which would free space in the budget for infrastructure spending, have added to the spotlight on inflation, says Teddy Oetomo, Credit Suisse’s head of Indonesia research.

The risk is “more about execution” and “managing the inflation that comes with low interest rates”, says Kelly Chung, an ING portfolio manager.

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