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3Q19 Themes: Finding a floor

By August 21, 2019 No Comments

Dear Friends,

In my view, the behavior of the stock market indicates that it is in the search for a floor.

Domestic institutional investors are still shifting from equities to fixed income in the search of stable yields.  I suspect this trade is more momentum-driven than coming out of conviction. Domestic mutual funds and insurance companies are still net sellers, while individuals are net buyers along with companies. Last week, Nishat Chunian announced a massive buyback of 25% of their free float. JS Global announced a buyback of 19.7% today. There has been insider buying in many companies (please email me for the full list). Global funds, which have been net buyers year to date, pulled back on the recent newsflow on Kashmir.

One of my 9 for 19 predictions was that Pakistan and India will enter into peace negotiations this year. While Imran Khan has admitted to taking steps in this direction, Modi in India seems to be on a different path. The Time magazine called Modi, the Divider in Chief (click here). I think the overstep in Kashmir has at least brought the attention of global media on the issue (click here for coverage by the Financial Times). Maybe, the moral pressure will allow the US to play a mediatory role in Kashmir, something with President Trump offered again yesterday (click here). So maybe in a twisted way, India’s actions in Kashmir might end up bringing the two countries on negotiating table.

I think Pakistan’s response to India’s move in Kashmir will remain diplomatic and legal. This might seem a bit out character, but in recent times, the new government and the army have proven their commitment to greater international integration and building diplomatic bridges. Pakistan’s role in helping the US pull out of Afghanistan is a good example but even beyond that, Pakistan’s restrained positions regarding Iran and the Yemen conflict also show this shift towards a mature strategic position.

I think the newsflow on India-Pakistan tensions will subside by the end of the month and any positive development on this front could bring back global portfolio inflows.

Domestically, investors are concerned about the sellings from mutual funds and insurance companies but there is a general recognition of the attractive valuations, which are near 2008 troughs. Dividend yields on some stocks such as Engro Fertilizer, Fauji Fertilizer, Ghani Glass are in the teens. HUBCO is expected to have a 33% dividend yield next year. The overall market is trading at 5x PE and close to 10% Dividend yield levels. This is more than a 50% discount to the regional peers.

I think the biggest news for this week is the three-year extension of the Army Chief, General Bajwa. The Chief’s original tenure was set to end in November this year but given the regional security situation, the Prime Minister has extended his term for another 3 years. While, a bit controversial, I think this is a good development for the market, economy and the country.

Firstly, this should ensure that there is lesser volatility in the operating environment as Khan’s political term will end at the same time as the General’s tenure. Any incremental change towards greater consistency should help. I think the biggest obstacle for foreign investment in the country has been the uncertainty in prices, people and policies.

Volatility in prices, i.e. exchange rate depreciation should almost be over now, though I think investors might want to see more evidence of stability. The general consensus is that the interest rates have peaked (on the back of last monetary policy statement) and the market is expecting a rate cut in 1Q20.

Now the government needs to show greater stability in people and policies. Over the past 12 months, there has been a lot of churn in the top positions and the whole economic team including the finance minister, Secretary of Finance, Chairman Board of Investment, Chairman Securities and Exchange Commission and Governor State Bank of Pakistan have been replaced. The whole government apparatus still seems stuck in a crisis management mode. Similarly, each successive political government has shown little respect for the policies set up by their predecessors. Even contracts with sovereign guarantees have been challenged.

Secondly, the General has already been quite active on the economic front. According to the recent admission by members of the government, the General played a big role in helping the government attract loan commitments from “friendly countries”. General Bajwa has been quite vocal about the significance of economic security, which he thinks is an important part of national security. He has also become a member of the Economic Security Council formed by the government. This is the first time, that the army has taken an official role in the management of the economy. I think clarity on this is a good measure. In one of my earlier blogs, “Who Owned Pakistan”, where we tracked the top 20 groups which collectively control companies which account for  50% Pakistan Stock Exchange’s total market cap. The Fauji Group is top 3 in that list. Indeed if we include the value of the private companies in sectors such as real estate, the Fauji Group will probably be the biggest business conglomerate in Pakistan.

Third, I think generally, the “Bajwa Doctrine”, which emphasizes on better relationships with the US and a focus towards economic progress is a good strategic vision for Pakistan. The most important thing is that it is aligned with the policies of the political government, which should ensure stability and consistency. I think the army’s formal engagement in economic matters can provide more continuity and stability to economic policy and give it a strategic direction.

I think the market might remain volatile will low volumes in 3Q19. I suspect that the selling from mutual funds and insurance companies is not done yet. Around 40% of the assets of mutual funds are still invested in equities. I think these investors will continue to shift assets to fixed income. Global inflows might also remain weak due to global economic sentiment and fears of a recession. FATF decision is expected in September. I expect Pakistan will avoid blacklisting but stay on the grey list. Corporate earnings will be disappointing but expectations of buyback could help the market. However, things should improve by the end of the quarter, especially if the State Bank of Pakistan can establish credibility on its forecasts. SBP’s inflation forecast is lower than IMF and it expects stronger growth. Yesterday’s current account data showed an improvement in exports and a sharp contraction in imports. This should give more credence to the expectations of a stable exchange rate and peak interest rates.

There has been no progress on the state-backed stock market support fund which was announced by the government. I think it was a good idea for the government to provide liquidity in the market, especially in companies which are majority-owned by the government. This could not only create confidence in the market and break the negative feedback loop the economy is stuck in but also make the companies more attractive for privatizations. This could be a major upside catalyst and could lead to a short squeeze in the market in the near term.

I think current valuations might not remain there for long.

I am, yours truly,

Ali Farid Khwaja

Managing Director
K
hadim Ali Shah Bukhari Securities

* This is not research material and there is no investment recommendation in this blog. These are my personal views. 

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