Our views on Pakistan’s economy and market
Over the last week, I have been on a roadshow in Karachi and meeting domestic institutional investors and our clients. One frequent question which I get is regarding the sentiment on Pakistan with foreign investors.
Foreign funds have been net sellers for most of the past 18 months. Since the start of the year, there have been net outflows of $88m and just over the last week, there were net outflows of $30m. In our opinion the volatility in global Emerging Markets, both on the equity and fixed income side will limit foreign inflows in the near term. However, on the positive side, Pakistan could outperform other EM markets as it has lesser participation of global funds. As we wrote in our March strategy report (click here), Pakistan’s equity market has historically displayed relatively low level of correlation with the global markets.
The outlook for emerging markets remain quite shaky. Inflation in the US is close to their target level of 2% and the economic growth is accelerating due to the tax cuts and fiscal stimulus (4.5% GDP growth in 2Q18). Since the Fed has a mandate to maintain inflation at 2% target, there is increasing consensus that the Fed will continue to raise rates in 2018 and 2019. Three to four rate hikes are expected in 2018 (click here) to 3%.
The hike in the US policy rates has significant impact on global markets. Firstly, its worth pointing out that the US equity markets are still going up despite the tightening. Some investors in Pakistan expressed concern that the domestic tightening cycle could extend the bear run on the PSX. We are not too worried about it, as long as the rates remain below 10%. We expect another 150bps rates increase this year. At 8%, real interest rates will actually decline to 2% as we expect around 6% inflation in 2018. Indeed equity prices reflect multiple factors. There is no robust negative relationship between interest rates and stock market (especially when the rates are low). Indeed in Pakistan during 2004-08, both the market and the interest rates went up.
More importantly, the hike in the US interest rates pulls global liquidity into US bonds and consequently leads to stronger US dollar and triggers outflows from high risk asset classes such as EM currencies, equities and bonds. Since April, currencies of EM countries such as Argentina, Brazil, Turkey, and Mexico are down 20-30%. Currencies of other EM markets such as South Africa, India and Indonesia have also tanked.
This risk-off trade is also impacting the equity markets. In May, the US based Emerging Markets funds saw the highest amount of outflows since 2016 (click here). MSCI EM index is down more than 10% YTD. Interestingly, Pakistan is again one of the best performing markets in this cohort.
Selected EM market performance (YTD)
A stronger dollar is forcing the central banks in emerging markets to also raise their interest rates and consequently triggering a tightening cycle. Consequently, countries which have a balance of payment deficit and rely on foreign inflows are most exposed. Argentina had to resort to $50bn package from the IMF yesterday. Besides the dollar move, Emerging markets as an asset class is also exposed to the headwinds arising from credit tightening in China, threatened by the trade wars initiated by the US and hurt by higher oil prices.
Given the confluence of these factors, we think global emerging market funds will continue to see outflows over the next 18 months. Net selling by foreign investors is not surprising. As I discussed with some of the clients I met over the last week, global asset managers come in different shapes and sizes and different risk appetites. Their investment pattern in Pakistan reflects these characteristics.
For example, there are some funds who run frontier market mandates or who have sector focused mandates. Typically these funds are more specialised. They would have spent more time visiting Pakistan and meeting the companies and could have a greater risk tolerance and a long investment horizon. In our view, such funds are buying and building positions in the market. There are other kind of investors who take a top down approach and invest in a much broader set of markets. These funds would typically like to reduce exposure to more ill-liquid markets such as Pakistan in periods of volatility. The third kind of investors could be long short hedge funds, who would like to ride on the momentum and take short positions.
In our opinion, we could be past the selling cycle. Pakistan’s low correlation with global markets should help and we expect Pakistan to continue to outperform in 2008.
We remain optimistic on the market
In our opinion, there are 3 main factors which have kept the market depressed. First, the uncertainty around FATF. Second, political uncertainty and third, balance of payments issue. As we wrote in our last blog (click here), we think the outcome of the FAFT meeting on the 24th of June will be to place Pakistan on the watchlist. The market should take that positively, as there were fear of a blacklisting. On the political front, the interim government should provide some return to the normal. Dr. Shashad Akhtar brings much needed (and missed) credibility on the economic front. So the second negative factor should also be addressed in the coming weeks. Lastly on the balance of payment front, we think the chances of an IMF program have increased substantially. Given the fiscal excess and debt binge of the last 5 years, we think its probably much more prudent to have IMF manage Pakistan’s economic policies. We expect Pakistan to enter an IMF program by the 3Q18.
Based on these views, we think that while the market may remain volatile, 2Q18 could be a good time to accumulate, high quality stocks, especially those with good cash flows and high dividend yields. On the research desk, our team likes MCB, Bank Alfalah, UBL and Indus Motors. On the sales desk, Kamlesh Kumar also likes oil and gas (OGDC, PRL), tech and textile.
Please feel free to contact us if you want to discuss any of the stocks in detail. Here is a link to my recent interview with VCAST (click here). Investor education is a big focus area for us and in the coming weeks, you will hear more from us on this side. Stay tuned.
I am, yours truly,
Ali Farid Khwaja, CFA
Khadim Ali Shah Bukhari Securities
Autos: Cyclical concerns could create good entry points
We initiated coverage on the Auto sector on 9th of May 2018 with stock initiations on Indus Motors, Honda Atlas Car and Pak Suzuki Motors. We think the sector could remain under pressure due to cyclical headwinds, especially due to unfavourable FX movements. However, we think the structural drivers will remain intact and companies like Indus Motors could be well positioned to deal with the headwinds. Our industry channel checks confirm our view that Indus has a strong brand and pricing power. Indus has a strong balance sheet (15% of market cap is in cash), cash generative business model (8% FCF yield) and benefits from high barrier to entry.
Pakistan: Digitalization Boom & CPEC Wave
In this report, published on 1st March 2018, we tracked more than 500 early-stage tech companies in Pakistan and produced the first market map of the sector. We think digitalization will drive the next wave of earnings growth and investment returns. On the back of the report, we hosted the first Tech Investment Conference in Pakistan. Hadi Hafeez, our digital analyst focuses on this sector and is on the looking out for interesting companies.
Banks: Digitalization, Consolidation & Compliance
We initiated coverage on the banking sector on 11th of April 2018 with stock initiations on UBL, Bank Alfalah, MCB and HBL. We think digitalization could lead to 120-150% increase in the profits of the sector over the next 5 years and would drive relative out performance. The other two drivers of share price returns would be consolidation and compliance risks. Please contact us if you want the full report