Our views on Pakistan’s economy and market

Dear Friends,

During my days as a Partner at Autonomous Research in London (click here), once an investor said to me that the situation with European banks is “so bad that it is actually good”. Of course in the investment community, there are similar rules of thumb such as the view that a company’s third consecutive profit warning is typically a good time to buy. In essence, these rules are based on the promise of mean reversion. Philosophically, the belief in mean reversion extends beyond the capital markets and underpins our general set of beliefs. In the capital markets, there are various academic studies across multiple markets and across time which support that there is some validity to this strategy (click here for a paper published by the CFA Society). The problem with this view point is that it fails to capture black swan events (such as the 2008 crisis) and structural changes (for example such as technological shifts – as the shareholders of Nokia, HTC, Motorola etc will remember). However, moving back to the Pakistani context, I believe that the statement is a good description of the current outlook.

Despite the market volatility and continued outflows of foreign portfolio investment, the fact that now there is a broad realization of the severity of the economic imbalances created by policy mistakes of the previous economic management team of Dar/Miftah is a big relief. As we wrote in our 25th April blog (click here), we did not end up in this situation suddenly and many economists such as Dr. Ashfaque Hasan Khan and Saqib Sherani were repeatedly warning about it. The good thing is now the situation has reached a stage, where it has to be solved. As we have written in our previous blogs, we think the end game will involve an IMF program by 3Q18.

Revising economic estimates for FY18/FY19

The prescription of IMF is well known; fiscal discipline, monetary tightening, reserve accumulation and eventually institutional reforms. In the past, Pakistan has done a decent job at adhering to the first three requirements, at least in the short term but the last one has been the Achilles heel. Consequently, we have revised our economic forecasts. We now expect interest rates to reach 8% by December 2018 and 10% by June 2019. We are revising our FY18/19 GDP growth forecast to 4% (we think consensus is around 5.3%) and Inflation expectation for FY18/19 to 8%. We expect the exchange to reach PkR/USD130 by Dec 2018 and another 5-6% depreciation by June 2019. Our forecasts are substantially different from the economic targets given by the previous government. We wrote in our May blog (A budget which doesnt matter – click here) that we think the budget lacked credibility and we a reset when the new government comes in.

Imperative to stop the drag from PSE

The bigger elephant in the room is the institutional reforms. These include a wide range of topic; which include giving autonomy to the State Bank of Pakistan, infrastructure spending, government borrowing, and most importantly, the privatization of public sector enterprises. According to an assessment by IMF, the annual losses from these PSE which include Pakistan Steel, PIA, Railways etc account for 4% of the GDP (PkR1.2 trillion). Political governments have repeatedly failed to deliver on the privatization agenda and now the drag from these PSE is created systemic challenges to the whole economy. We believe that privatization should be high on the agenda of any new IMF program. Not only will privatization help bring foreign investment but it will open up significant resources which can potentially be deployed to provide stimulus to export based sectors.

We do not think that exchange rate adjustment alone will be sufficient to close the trade deficit. Many EM currencies have depreciated since the start of the year and consequently, the pricing benefit from exchange rate might not be that strong. In our opinion the government will need to provide direct incentives, which is why we are bullish on the outlook for sectors such as textiles and tech (software exports).

Source: Bloomberg

EM markets look more vulnerable
US trade wars continues to escalate and the risks on the EM have risen since we last wrote on this topic. Also despite OPEC production increase oil prices still rose after it and prices are now 54% up over the past 12 months. As we wrote in our earlier blog, we think oil prices will remain high, especially due to the new environment standards on sulfur levels. This bodes positively for oil majors as well as for refineries who have the capacity to produce oil will low sulfur content. On the macro side, there are three factors impacting EM.

1) Rising interest rates in the US – especially with sluggish economic growth in Europe.
2) Strengthening of the US dollar, especially against EM currencies.
3) Tarrifs on trade by the US government. According to the World Bank this could lead to a 9% reduction in global flows, similar to the decline in 2008 (click here) and reduce global growth by 0.5-0.6%. The US is playing a dangerous balancing game. One hand, the US economy is growing at its fastest levels since 2008 (2.8% growth expected in FY18) driven by the tax cuts provided by the Trump Administration. To counter rising inflation (Fed’s inflation target is 2%), the Fed is expected to continue to raise rates 3 times in 2018 and further in 2009. However on the other hand, with the trade war, the US government is playing with the risks of a recession. This is a fine balancing act. If the US-China trade war escalates, it could threaten global trade supply chains and push the economy back into a recessionary environment (click here).

For Pakistan this has three main implications. First, it means that that the outflows from global EM funds might continue. Second, tapping international bond might be tough. Third on the positive side, it means that CPEC will become strategically more important to China. I strongly believe that over the next 5 years, there will be more direct conflict between the economic expansion of China and the US. Unlike in the past, where both countries shared economic space and countered each other using commercial incentives, we suspect that the US will take a more direct approach to restrict Chinese influence.

Focus on structural winners

While we began this blog on a cyclical theme, we think investors should focus on structural factors. Indeed this is what is happening globally as sectors as such technology continue to outperform. Tech leaders such as the FAANG (Facebook, Apple, Amazon, Netflix and Google) are making new records, despite the concerns on the economic side and steep valuations. Indeed even in Pakistan, although the Tech sector only accounts for 1% of the KSE100 index, it has significantly outperformed YTD. We have written a lot onthis in the past and the digitization theme remains our focus area.

Structural growth in data, processing power and decline in cost of storage

Source: Bloomberg

We have been looking at a lot of private companies in this space. The three areas we like the most are 1) Logistics – for eCommerce 2) Digital media and 3) Fintech.

In our opinion, the recent acquisitions by AliBaba and Ant Financial are a structural game changers. Pakistan is now ranking high in fintech league tables. This means that while public market investors might be pulling out, private equity and tech investors could be looking to enter the market.

Our sales team is busy onboarding accounts. Please email me or Kamlaish if you want to work with us. Investor education is a big focus area for us and we have launched a video log series, in collaboration with Investors Lounge (click here for my last video).

I am, yours truly,

Muhammad Ali

Ali Farid Khwaja, CFA
Khadim Ali Shah Bukhari Securities

Trade with us. Download forms to open account with us from here or email k.kumar@kasb.com.

Research Views

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

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