Macro Analysis /

Pakistan Strategy: July’s poor performance belies several positive developments

    Raza Jafri
    Raza Jafri

    Executive Director, Research

    Intermarket Securities
    1 August 2019

    Local mutual funds sold over US$40mn of equities in July, more than double the monthly pace in 1H19. Foreign buying also accelerated to US$30mn, but this was concentrated in cements and banks, and not enough to offset broad-based local selling. As a result, the KSE-100 shed 5.8% in the month, bringing the 2019td decline to 13.8% (down 28.5% in US$ terms).  

    On various valuation metrics, Pakistan is now trading 1 standard deviation below the long-term mean. Local confidence remains low which can prolong the selling pressure but, for those willing to look through the cycle, Pakistan offers significant returns potential. July saw the commencement of the IMF program, a successful US visit by Prime Minister Khan, and the PKR finding a foothold. These are all major positives that are currently being ignored.  

    The record six-month losing streak may yet extend, but we see the KSE-100 closing north of 35,000pts by year-end. Important checkpoints that can drive a turnaround in the market include (i) fx reserves buildup as the government taps global markets, (ii) a clean chit by FATF (next review in October), and (iii) moderation of redemptions at local funds.

    Flows are not supportive, for now…

    Amidst very thin volumes (seven-year low), the KSE-100 shed 5.8% in July, to bring the 2019td decline to 13.8% (down 28.5% in US$ terms). Local mutual funds turned aggressive sellers, offloading more than US$40mn of equities, perhaps due to redemption pressure with 12m T-bills now offering 14%. Local mutual fund selling was more than double the 1H19 monthly rate, and can potentially continue over the next few months, in our view. Following the limits on government guarantees under the IMF, it is unclear whether the PKR20bn (US$125mn) stock market support fund will come through, which leaves foreign investors to do the heavy lifting, at least for now. FPI inflow in July alone was an encouraging US$30mn (vs. US$48mn across 1H19), but it is not broad-based as yet.  

    …but the positives are adding up

    July saw several important positives that are being ignored for now, but have the potential to lead a sustainable turnaround in the market. Some of these include: (i) commencement of the IMF program and the release of a first tranche of c US$1bn, (ii) the PKR stabilizing at 160 to the US$, and (iii) a successful US visit by Prime Minister Imran Khan (initial impression). Although the SBP again raised interest rates by 100bps, bringing the policy rate to 13.25%, we believe it has also firmly signaled an end to monetary tightening. This is now being reflected by an inverted yield curve. There are near-term challenges - business and consumer confidence remain low, and corporate profitability is passing through a tough phase - but we believe it will be increasingly difficult to ignore the positives going forward. The US$5.9bn Reko Diq arbitration decision against Pakistan was a prominent negative in the month under review, but we believe a negotiated settlement is possible.   

    Valuations and earnings are both at cross-cycle lows

    Since its peak in mid-2017, the KSE-100 Index has shed 40%; the decline in US$-based market capitalization is a much sharper 60%. Our coverage universe now trades at a 2020f P/E of 5.6x, more than 1 standard deviation below its long-term mean of 9x. The market capitalization-to-gdp metric, which ignores analyst estimates, also shows that the Index is trading at a cross-cycle low. We see the KSE-100 closing the year north of 35,000pts, as domestic selling abates and as foreign interest picks up. Other possible triggers include an fx reserves buildup, with the IMF program unlocking access to diversified funding sources, and also a possible clean chit by FATF. Across the medium-term, there is significant room for mean reversion in both valuations and corporate profitability, which can drive a multiyear rally, in our view. At current levels, our top picks include HBL, BAFL, OGDC, HUBC, PSO, EFERT, ENGRO and LUCK.

    Risks: (i) Failure to grow fx reserves which could lead to adverse implications for interest and exchange rate, (ii) worse than expected corporate profitability and (iii) possible FATF blacklisting.