Macro Analysis /

Pakistan Strategy: Iran-US conflict means thesis gets delayed, not derailed

    Intermarket Securities
    6 January 2020

    Pakistan’s program has over-performed on a number of fronts, but risks remain

    Following the assassination of Iranian Commander Qassem Soleimani by a US drone attack, security concerns in the Middle East have escalated significantly. Iran and its allies have vowed to retaliate and, there is a high possibility of a series of attacks from both sides in the coming months, in our view. Nonetheless, we think the likelihood of an all-out war between Iran and the US with its Middle Eastern allies is thin, because it will likely extend to a wide range of countries, and there may be limited popular support for it in the US.

    Oil prices have shot up 6% to US$70/bbl since the event unfolded. It is likely that they may remain high in the coming months, given potential supply disruptions in the Strait of Hormuz (near the coast of Iran and a major route for oil shipments out of the Middle East). Note that we have taken an oil price assumption of US$65/bbl for the IMS Universe estimates.

    Risk to our thesis of an economic recovery…

    Higher oil prices, if extended for more than a quarter, is a risk to Pakistan’s ongoing economic recovery, in our view. As such, it is also a major risk to our thesis of the market’s rerating to mean valuations, on the back of economic transition from stability to growth and rebound in corporate profitability. 

    An annualized US$10/bbl increase in international oil prices will swell Pakistan’s import bill and the current account deficit by an estimated US$2.0bn. Just because of the increase in petrol prices (by an estimated PKR12.0/liter) CPI will rise by 0.3ppt, not counting the effects that increased transportation costs will have on prices of various consumer goods. Gas and power tariffs are also affected by higher oil prices, where we expect a 4-5% increase in both as a result of US$10/bbl higher oil prices. All in all, this will alter the inflation outlook and persuade the SBP to delay monetary easing. 

    ...but our medium-term investment case remains intact

    Even if higher oil prices will delay the economic recovery, a complete derailment appears unlikely, in our view. The government will need to transition to pro-growth policies after two years of austerity measures, in order to enable a more conducive business environment and appease public sentiment ahead of the next general elections. Any spike in inflation will be temporary and ultimately moderate due to a high-base effect. A BoP crisis is also unlikely, as potential hot-money flows (while interest rates remain high for longer) and other bilateral and multilateral support will mitigate the increase in imports and current account deficit, in our view.

    Our 2020 Strategy advocated being Overweight on Banks and increasing exposure in Construction and Consumer plays. Our thesis greatly premised on monetary easing and continued rerating (continuation of P/E expansion from 7x to 8.5x). This is still intact but it is possible that P/E come off first amid higher oil prices. In that scenario, we advocate increasing investment in Banks and E&Ps and trimming exposure to cyclical sectors (which collectively have rallied the most since August 2019). A sensitivity of E&P earnings to oil prices is given below.

    Pakistan has, rightly, come out and advocated for regional peace while stating its soil will not be used against any country. GCC markets and Egypt were significantly lower in yesterday’s trade. If security conditions in Pakistan remain intact, and they should in our view, it is possible that Pakistan starts to look better to foreign investors, relative to peers.

    To conclude, we would be buyers on dips close to an Index level of 40,000pts (P/E of 6.5x). In the near term, we prefer Banks, E&P, and Textile sectors compared to Cements, Steel and Autos.