- Pakistan’s macroeconomic reforms are delivering and stabilization has come through quicker than expected. This led the KSE-100 to stage a swift recovery in 4Q19 (up 29% in US$ terms), enabling a flat close for the year. We think this bullish momentum will extend into 2020f, led by valuation rerating and an improving outlook for corporate profitability.
- Much reduced twin deficits and a downward inflationary path have set the stage for monetary easing. We expect a modest cumulative 100-125bps rate cut across 2020f and a sharper 200bps reduction in 2021f. Pro-growth fiscal policies should ensue, in our view, including a public infrastructure push, as Pakistan begins to move towards a higher GDP growth trajectory.
- Forward P/E is 6.6x and mean reversion on valuations suggests an Index level of 51,000pts by December 2020 (1yr total return: 25%). Our liking for the Pakistan market is also backed by anticipated strong local institutional flows, after net selling in 2019.
Macro reforms are working; pace of rate cuts is less import
Pakistan is witnessing classic macroeconomic stabilization under an IMF program, with the current account deficit reducing by 73%yoy in 5MFY20, Fx reserves filling out quickly, a primary surplus on the fiscal side, and yield curve inversion. Authorities appear cognizant of the need for a longer cycle as compared to the short-lived boom and bust episodes of the past, which should lead to a sustained push on reforms. Moreover, due to the delay in approaching the IMF, the ongoing EFF program will end in mid-2022, just about 12 months ahead of general elections, which may prevent a derailment even if populist policies make a comeback. As a result, it is possible that Pakistan is able to deliver more sustainable economic growth going forward. This, to us, is more important than the pace and timing of monetary easing during 2020 (we expect only a 100-125bps rate cut in 2020f, followed by 200bps in 2021f).
Earnings growth looks good under a medium-term lens
After flattish earnings in 2019, we expect profits for the IMS Universe to grow by 12%yoy in 2020f and then by 20%yoy in 2021f (ex-E&Ps), both higher than the historical profit growth rate of 10%pa (since 2006). While 2020f growth will largely be led by Banks, 2021f should see more broad-based participation. Importantly, we find that investors are increasingly willing to ignore the current weak corporate profit environment (especially for cyclical sectors such as Cements and Autos) and look through-the-cycle. Interim misses on profits can test this resolve but we would treat dips as opportunities to build positions.
Valuation reversion can drive a c.25% Index return
Since 2006, Pakistan market has traded at an average P/E of 8.5x, P/B of 1.5x and earnings yield spread of 2.2ppt over 12m T-Bills. Presently, it is trading at a c.25% discount to all these metrics. Full convergence would lead to an Index level of 51,000pts by December 2020. While the long-term Pakistan story faces a number of challenges such as generating growth without over-heating and navigating an often volatile political landscape, we believe this conversation can be put off until the market has reverted to historical mean valuations, and it is still some way off that. For 2020f, we advocate remaining Overweight on Banks while gradually increasing positions in Cements and Consumer companies. Our top picks are UBL, BAFL, OGDC, HUBC, LUCK and MUGHAL. Outside our active coverage, we like ICI, NATF, PKGS, TGL, INIL and FABL.