MSCI confirmed, on 7 September, the reclassification of Pakistan from the EM equity index (2bps weight) to the FM index (1.9%), in one step, with effect from 1 December 2021. There is potential inclusion in the FM100 index (5.8%) and the FM 15% country-capped index (2.8%), with effect from 1 June 2022. This follows a consultation period initiated in June 2021 and comes as no surprise. There is no mention of inclusion in the FEM index. Separately, Pakistan remains in the FTSE EM index (2bps).
Pakistan was abandoned by foreigners long ago, with US$2.3bn of net outflows since the start of 2015. To put that into perspective, consider that current total free-float market capitalisation is merely US$15bn and, after a tripling in activity over the past year or so, average daily traded value over the past six months is merely US$70mn.
Pakistan has gone from an irrelevant weight (too small for EM funds) to an irrelevant index (the FM indices have been largely abandoned by those "FM" funds which have survived and either adopted the FEM index or their own customised one, which includes much more of the "orphaned" tail of MSCI EM, ie c20 countries with weights below 2%).
Furthermore, the foreign contingent of "Frontier" funds have been so pulverised by years of redemptions that they no longer possess the firepower to move the market. Instead, in Pakistan, as in other Frontier and small Emerging markets, local investors, recently buoyed by low or negative real interest rates, are the overwhelming marginal price setter.
There is another net foreign funds outflow likely as a result of this reclassification; perhaps cUS$100mn, concentrated in Lucky Cement and Banks HBL and MCB. That would imply a repeat of the outflow seen in the first six months of 2021; unhelpful, clearly, for market performance but hardly a deal-breaker for the top-down investment case.
MSCI index classification, on the way up to EM or down to FM, is no indication of fundamental outlook; instead, it is a reflection of the change in ease of access and trading liquidity available for foreigners. It can be a precursor to substantial funds flows from passive funds or active funds that like to "hug" their benchmark. In the case of Pakistan's shift back to MSCI FM, it is neither a signal of fundamentals nor of major funds flows.
Therefore, more important than focusing on MSCI classification is taking note of the cheap value of Pakistan equities, which reflect very widely understood risks much more than the structural improvement underway.
Cheap equity valuations, reflecting low expectations
Pakistan equities (KSE100 index) are up 2% ytd in total US$ return terms, not far behind MSCI FEM (up 4%, dragged down by the Philippines) and in line with MSCI Asia ex-Japan (up 2%, dragged down by China-HK) but significantly underperforming regional peers like Bangladesh (up 32%) and Vietnam (up 24%).
Valuations suggest considerable pessimism on the continuation of growth, institutional reform, and improvement in security is priced in: trailing PB is 1.0x, a 30% discount to the 5-year median, for 17% trailing ROE, and forward 2021 PE is 5.5x, a 33% discount to the 5-year median, for 7% consensus earnings growth in 2022.
For foreign investors, there are FX risks present, but modest current account deficits (below 2% for 2021-22, according to IMF forecasts), little short-term external debt (below 5% of GDP), FX reserves of 3.7 months of imports and an REER of c100 (7% below the 5-year median), suggest there is no imminent crisis.
For local investors, who remain over 90% of trading activity, forward dividend yield of 6.7% remains compelling relative to the local real interest rate of negative 1.4%, albeit less attractive than local currency 5-year bond yields of 8.8%.
We are in for a testing period for investors’ faith in the economic (does the IMF program get back on track?), security (is there negative spillover from Afghanistan?) and political/institutional reform (will there be a wobble before the October 2023 election?) stories but performance and valuation of equities imply a very low base of expectations, setting up attractive risk-reward in our view.
Equity investment case
Pakistan: The reform story foreigners forget, February 2021
Pakistan: Budget solidifies shift from stabilisation to growth, June 2021 (Curran)
Pakistan central bank strikes optimistic tone on economic and reform outlook, April 2021 (Curran)
Pakistan: Time to get back on track, December 2020 (Curran)
Benchmark, identity and confidence crises, January 2019