I spent most of the last month in Islamabad and then in the US. I seem to have missed some action. The market is up more than 20% from its trough and seems to have maintained momentum through the on-going earning season. My sell-side colleagues are generally in unison on their commentary: Valuations were cheap, macro numbers are showing stability, the exchange rate has now been stable for over a quarter, interest rates have peaked, FATF blacklisting risk has faded and investor confidence is returning. All of these are valid points. I am all for optimism and of course, have been writing about these subjects extensively over the past few months now. However, to be honest, I am a bit scared about the sudden wave of euphoria.
All of these factors were valid even two months ago. The only incremental thing which I can notice is the meeting between the Army Chief and a group of leading business groups. Perhaps that is the biggest factor which has given some confidence to local business groups. This confidence might be getting reflected in the market reaction. I adhere to the school of thought which supports the role of the army in governance. I think the reforms demanded by the IMF as well as additional structural changes with Imran Khan is trying to achieve requires massive support from not just the army but also from other institutions such as the media, and the bureaucracy.
In Islamabad, I hear horror stories that the bureaucratic machinery has ground to a halt. Everyone seems to be scared in making a decision and “signing on a file”, as they think it could land them in trouble with the guys running the accountability drive. The only ones who can get anything done in the government seem to be the multilateral donor agencies, who enjoy immunity.
Imran Khan’s accountability drive is a great thing but I hope this doesn’t end up as a game of chicken, where both sides end up inflicting losses to the economy.
In the US, the mood on the economy is fairly grim. Even in the Valley, there is now a sense of a party coming to an end. WeWork has become a case study and there is a deep sense of fear about anything which was touched by Softbank. There is also concern about the $70 trillion US debt. All this could unwind if there any hike in the interest rates. This means that central banks have exhausted the policy option of interest rates. Globally, more $15trillion of debt has negative yields. As my friend, Dr. Salman Ahmad of Lombard Odier calls the global economy might be facing Japanization (click here). A period of low growth, low inflation and no tool for generating activity.
This is why I think the US economy cannot risk an oil price shock which is why the US government will be very careful in its geo-political engagement in the Middle East.
World Bank and IMF’s annual meetings are going on in DC this week. They downgraded Pakistan’s GDP growth forecast for FY20 to 2.4%. The overall assessment of the reforms was positive but the Fund believes that inflation will go higher and they think the growth rate will be lower than earlier expectations. This means there is a widening gap between the State Bank of Pakistan’s forecasts and IMF’s expectations. More importantly, this means that there is a massive wedge between sell-side expectations in Pakistan and the Fund. Especially since the general consensus is that inflation has peaked and interest rates might be coming down. One detailed report on the market which I read last week estimated 22% EPS growth for KSE100 in the calendar year 2020. This seems excessive, given the nominal GDP growth of mid teens. I fear that the risk of downgrades is still not over.
As I wrote in one of my earlier blogs, the Pakistan market is a momentum market and the share prices follow earnings momentum. This might not be unique to Pakistan, I suppose most cyclical stocks are momentum stocks by definition. At the risk of sounding like a party spoiler, I am a bit nervous that the current rally might be a false dawn.
I think until the interest rates are at this level, it is difficult to meaningfully attract funds to equities. From an asset allocation perspective, risk-free government bonds still seem quite attractive. I think the FATF risk has also not disappeared. I think it will continue to be a real threat unless the government takes visible action against the banned organization. While I was in Pakistan, watching the media, I got the view that the US-Pakistan relationship has significantly swung in our favor and there has been some structural change post-Imran Khan’s UNGA speech. Unfortunately, I didn’t get that sense in DC. Yes, there is a marginal improvement. However, the US’s engagement with Pakistan is still on two subjects only; Afghanistan and counter-terrorism. While India enjoys a deep structural alignment on trade, economics, security, etc. So from the US perspective, there is not much on the table for Pakistan beyond dealing with those two issues. The only silver lining on this is the Pakistani diaspora in the US has become active due to their trust in and support of Imran Khan, and they have started to get engaged with political activism to support Pakistan. I think it is imperative for the government to use this momentum to attract investment from this cohort.
I will be heading back to DC next week and then will be in Islamabad in November. We will be soon opening up an office in the US (more on this in the next blog). For the market, I will try to curb the FOMO (fear of missing out) and stick with the high-quality sectors and stocks that are not exposed to domestic demand.
I am, yours truly,
Ali Farid Khwaja
Khadim Ali Shah Bukhari Securities
* This is not research material and there is no investment recommendation in this blog. These are my personal views.