Dear Friends,

Over the past couple of months, I have been busy working for a multilateral development agency as a consultant for Equity Market Reforms in Pakistan. One thing which impressed me that despite issues of capacity, everyone I met was keen and almost passionate about reforms and development in the financial markets. They say that the first step to the solution is recognizing that there is a problem. I think we are way past that. I think some of the structural reforms which the government is working on under its commitment to bodies such as the IMF and FATF can truly lead to the unlocking of the moribund financial system. It could lead to an influx of domestic capital into the financial markets which are currently trapped in unproductive assets such as real estate and gold.

The market is up over 38% since its level at the end of August. I think technically, anything above +20% is officially regarded as a bull market. There are two things which have caught the market by surprise in this rally. Firstly, most of the buying has come from Individual investors and not by institutional capital, and secondly, that most of the outperformance has been driven by stocks with the weakest earnings outlook.

Of course, a rally was due. To a certain extent, it reflects the stability in the exchange rate, enabled by interest rates tightening and the confidence driven by the IMF program. Timing an inflection point is never easy. In hindsight, I feel that the 3rd October meeting between the Army Chief and the group of businessmen was perhaps one key catalyst of this turnaround. The market is up 25% since then.

The other thing which has been surprising is that the market has ignored all the political swings of the last quarter. Fazal-ur-Rehman march in Islamabad, Judiciary’s questions of the Army Chief’s extensions and the recent incident of lawyers clashing with doctors in Lahore – the market seem to have a clear disconnect with politics.

So where do we go now?

There are 50 companies amongst the KSE100 which are up more than 50% from their trough levels this year. This sample includes 5 companies from the cement sector (Cherat +136%, Maple Leaf +112%, Kohat, 80%, DGKhan +79%, Pioneer +77%), Steel companies such as ISL (+100%), and automotive Honda Atlas (+84%) and Pak Suzuki (+68%). These are previously sectors that have been hurt the most by the contraction in domestic demand due to high-interest rates and the slowdown in the economy (see chart below for the complete trough to the current level recovery of the KSE100 stocks).

The rally in the cyclical is essentially indicating that it is premised upon the view that the interest rate cycle will turn in 2020. The consensus opinion seems to be for a rate cut by 1Q19 (March). Though some bulls were even expecting a rate cut in November.

The yields have already declined by around 200bps in the market and now the policy rate is higher than the equivalent tradeable bond. So essentially, for the rally to continue into 2020, it is essential for the market to get a rate cut. Not surprising that this is also is the main demand of most business representatives.

On the other hand, the Central Bank is now perhaps the most independent it has ever been in its history. The State Bank has seen good initial success in its project of attracting global flows into domestic bond markets. Pakistan has attracted more than $1bn in domestic bond markets chasing the carry trade. Raza Baqir, the Governor of the State Bank would want to emulate his success in Egypt, which attracted more than $20bn into the domestic debt markets. To do so, the SBP will need to demonstrate that it is aggressive in inflation targetting. It will also need to maintain a stable exchange rate and interest rates are the primary tool. Consequently, I suspect that there might not be a quick reversal in the interest rate cycle. I also fear that there could be greater political/media backlash against the State Bank if it maintains a high-interest rate policy.

So far the rally has been primarily driven by individuals. It has been a technical recovery driven by oversold positions in some stocks and then unwinding of the short-interest which was becoming a crowded trade. In my view, there could be a rally into quality in 1Q20 once the institutional investors jump in. I do not think the cyclical will be able to report the kind of earnings improvement which are getting priced in at the moment. The economy is showing all signs of macroeconomic recovery and seems to be coming out of the balance of payment crisis it faced earlier this year. However, there are no real signs of a meaningful recovery in the real economy. I think textiles, technology, power, banks, and E&P are still fundamentally the only investible sectors.

I think there are two wild cards for the market in the medium term. Firstly, for the uber bull case; there could be inflows of domestic capital which is currently deployed in gold, National Savings and real estate once those sectors get documented due to FATF demands. Only 0.1% of the population invests in stocks. Even a marginal increase could lead to a massive impact. On the negative side, the key risk for Pakistan’s economy is from higher oil prices. I am a believer in peak oil view but still, any spike in oil price tends to have a major balance of payment shock to Pakistan.


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